Foundations of Financial Management: An Analysis (part 58)

Capital is that part of wealth which is devoted to obtaining further wealth.

Alfred Marshall

Long-Term Debt and Lease Financing

by

Charles Lamson

The Expanding Role of Debt

Corporate debt has increased dramatically in the last four decades. This growth is related to rapid business expansion, the inflationary impact on the economy, and, at times, inadequate funds generated from the internal operations of business firms. The expansion of the U.S. economy has placed pressure on U.S. corporations to raise capital and will continue to do so. In this context a new set of rules has been developed for evaluating corporate bond issues.

The Debt Contract

The corporate bond represents the basic long-term debt instrument for most large U.S. corporations. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date.

Par Value This is the initial value of the bond. The par value is sometimes referred to as the principal or face value. Most corporate bonds are initially traded in $1,000 units.

Coupon Rate This is the actual interest rate on the bond, usually payable in semi-annual installments. To the extent that interest rates in the market go above or below the coupon rate after the bond has been issued, the market price of the bond will change from the par value.

Maturity Date The maturity date is the final date on which repayment of the bond principal is due.

The bond agreement is supplemented by a much larger document termed a bond indenture. The indenture, often containing over 100 pages of complicated legal wording, covers every detail surrounding the bond including collateral pledged, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation. The corporation appoints a financially independent trustee to administer the provisions of the bond indenture under the guidelines of the Trust Indenture Act of 1939. Let's examine two items of interest in any bond agreement: the security provisions of the bond and the methods of repayment.

Security Provisions

A secured debt is one in which specific assets are pledged to bondholders in the event of default. Only infrequently are pledged assets actually sold and the proceeds distributed to bondholders. Typically the defaulting corporation is reorganized and existing claims are partially satisfied by issuing new securities to the participating parties. The stronger and better secured the initial claim, the higher the quality of the new security to be received in exchange. When a defaulting corporation is reorganized for failure to meet obligations, existing management may be terminated and, in extreme cases, held legally responsible for any imprudent actions.

A number of terms are used to denote collateralized or secured debt. Under a mortgage agreement, real property (plant and equipment) is pledged as security for the loan. A mortgage may be senior or junior in nature, with the former requiring satisfaction of claims before payment is given to the latter. Bondholders may also attach an after-acquired property clause, requiring that any new property be placed under the original mortgage.

The reader should realize not all secured debt will carry every protective feature, but rather represents our carefully negotiated position including some safeguards and rejecting others. Generally, the greater the protection offered a given class of bondholders, the lower is the interest rate on the bond. Bondholders are willing to assume some degree of risk to receive a higher yield.

Unsecured Debt

A number of corporations issue debt that is not secured by a specific claim to assets. In Wall Street jargon, the name debenture refers to a long-term, unsecured corporate bond. Among the major participants in debenture offerings are such prestigious firms as ExxonMobil, IBM, Dow Chemical, and Intel. Because of the legal problems associated with "specific" asset claims in a secured bond offering, the trend is to issue unsecured debt---allowing the bondholder a general claim against the corporation---rather than a specific lien against an asset.

Even unsecured debt may be divided between high-ranking and subordinated debt. A subordinated debenture is an unsecured bond in which payment to the holder will occur only after designated senior debenture holders are satisfied. The hierarchy of creditor obligations for secured as well as unsecured debt is presented in Figure 2, along with consideration of the position of stockholders. For a further discussion of payment of claims and the hierarchy of obligations, the reader should see the next post "Financial alternatives for distressed firms," which also covers bankruptcy considerations.

Figure 2 Priority of claims

Methods of Repayment

The method of repayment for bond issues may not always call for one lump sum disbursement at the maturity date. Some Canadian and British government bonds are perpetual in nature. More interestingly, West Shore Railroad 4 percent bonds are not scheduled to mature until 2361 (approximately 340 years in the future). Nevertheless most bonds have some orderly or preplanned system of repayment. In addition to the simplest arrangement---a single sum payment at maturity---bonds may be retired by serial repayments, through sinking-fund provisions, through conversion, or by a call feature.

Serial Payments Bonds with serial payment provisions are paid off in installments over the life of the issue. Each bond has its own predetermined date of maturity and receives interest only to that point. Although the total issue may span over 20 years, 15 or 20 different maturity dates may be assigned specific dollar amounts.

Sinking-Fund Provision A less structured but more popular method of debt retirement is through the use of a sinking fund. Under this arrangement semiannual or annual contributions are made by the corporation into a fund administered by a trustee for purposes of debt retirement. The trustee takes the proceeds and purchases bonds from willing sellers. If no willing sellers are available, a lottery system may be used among outstanding bondholders.

Conversion A more subtle method of reducing debt outstanding is to provide for debt conversion into common stock. Although this is exercised at the option of the bondholder, a number of incentives or penalties may be utilized to encourage conversion. The mechanics of convertible bond trading are discussed at length in a future series of posts, "Convertibles, Warrants, and Derivatives."

Call Feature A call provision allows the corporation to retire or force in the debt issue before maturity. The corporation will pay a premium over par value of 5 to 10 percent---a bargain value to the corporation if bond prices are up. Modern call provisions usually do not take effect until the bond has been outstanding at least five to ten years. Often the call provision declines over time, usually by 0.5 to 1 percent per year after the call period begins. A corporation may decide to call in outstanding debt issues when interest rates on new securities are considerably lower than those on previously issued debt (let's get the high cost, old debt off the books).

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 468-471*

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