Foundations of Financial Management: An Analysis (part 62)

Everyday is a bank account, and time is our currency. No one is rich, no one is poor, we've got 24 hours each. 

Christopher Rice

Long-Term Debt and Lease Financing

by

Charles Lamson

Other Forms of Bond Financing

This post examines the zero-coupon rate bond and the floating rate bond.

The zero-coupon rate bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. For example, in early 1982, Bank of America Corporation offered $1,000 zero-coupon rate bonds with maturities of 5, 8, and 10 years. The five-year bonds were sold for $500, the 8-year bonds for $333.33, and the 10-year bonds for $250. All three provided an initial yield to maturity (through gain in value) of approximately 14.75 percent. A dramatic case of a zero-coupon bond was an issue offered by PepsiCo, Inc., in 1982, in which the maturities ranged from 6 to 30 years. The 30-year $1,000 par value issue could be purchased for $26.43, providing a yield of approximately 12.75%. The purchase price per bond of $26.43 represented only 2.643 percent of the par value. A million dollars worth of these 30-year bonds could be initially purchased for a mere $26,430.

The advantage to the corporation is that there is immediate cash inflow to the corporation, without any outflow until the bonds mature. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes by the corporation over the life of the bond. This means the corporation will be taking annual deductions without current cash outflow.

From the investor's viewpoint, the zero-coupon bonds allow him or her to lock in a multiplier of the initial investment. For example, investors may know they will get three times their investment after a specified number of years. The major drawback is that the annual increase in the value of bonds is taxable as ordinary income as it accrues, even though the bondholder does not get any cash flow until maturity. For this reason most investors in zero-coupon rate bonds have tax-exempt or tax-deferred status (pension funds, foundations, charitable organizations, individual retirement accounts, and the like).

A second type of innovative bond issue is the floating rate bond (long popular in European capital markets). In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly). Thus, a bond that was initially issued to pay 9 percent may lower the interest payments to 6 percent during some years and raise them to 12 percent in others. The interest rate is usually tied to some overall market rate, such as the yield on Treasury bonds (perhaps 120 percent of the going yield on long-term treasury bonds).

The advantages to investors in floating rate ponds is that they have a constant (or almost constant) market value for the security, even though interest rates vary. An exception is that floating-rate bonds often have broad limits that interest payments cannot exceed. For example, the interest rate on a 9 percent initial offering may not be allowed to go over 16 percent or below 4 percent. If long-term interest rates dictate an interest payment of 20 percent, the payment would still remain at 16 percent. This could cause some short-term loss in market value. To date, floating-rate bonds have been relatively free of this problem.

Zero-coupon rate bonds and floating-rate bonds still represent a relatively small percentage of the total market of new debt offerings. Nevertheless, they should be part of a basic understanding of long-term debt instruments. 

Advantages and Disadvantages of Debt

The financial manager must consider whether debt will contribute to or detract from the firm's operations. In certain industries, such as airlines, very heavy debt utilization is a way of life, whereas in other industries (drugs, photographic equipment) reliance is placed on other forms of capital.

Benefits of Debt

The advantages of debt may be enumerated as:

1. Interest payments are tax-deductible.

2.  The financial obligation is clearly specified and of a fixed nature (with the exception of floating rate bonds). Contrast this with selling an ownership interest in which stockholders have open-ended participation and profits; however, the amount of profits is unknown.

3.  In an inflationary economy, debt may be paid back with cheaper dollars. A $1,000 bond obligation may be repaid in 10 or 20 years with dollars that have shrunk in volume by 50 or 60 percent. In terms of "real dollars," or purchasing power equivalents, one might argue that the corporation should be asked to repay something in excess of $2,000. Presumably, high interest rates and inflationary periods compensate the lender for low loss in purchasing power, but this is not always the case.

4.  The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that debt does not strain the risk position of the firm, its low aftertax cost may aid in reducing the weighted overall cost of financing to the firm.

Drawbacks of Debt

Finally, we must consider the disadvantages of debt:

1. Interest and principal payment obligations are set by contract and must be met, regardless of the economic position of the firm.

2.  Indenture agreements may place burdensome restrictions on the firm, such as maintenance of working capital at a given level, limits on future debt offerings, and guidelines for dividend policy. Although bondholders generally do not have the right to vote, they may take virtual control of the firm if important indenture provisions are not met.

3.  Utilized beyond a given point, debt may depress outstanding common stock values.

Eurobond Market

A market with an increasing presence in world capital markets is that in Eurobonds. A Eurobond may be defined as a bond payable in the borrower's currency but sold outside the borrower's country. The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold by companies in Switzerland, Japan, the Netherlands, Germany, the United States, and Britain, to name the most popular countries. An example might be a bond of a U.S. company, payable in dollars and sold in London, Paris, Tokyo, or Frankfurt. Disclosure agreements in the Eurobond market are less demanding than those of the Securities and Exchange Commission or other domestic regulatory agencies. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 480-483*

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