The Many Different Kinds of Debt

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will Chapter 24

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Topics Covered

Domestic Bonds and International Bonds The Bond Contract Security and Seniority Asset-Backed

Securities Repayment Provisions Restrictive Covenants Private Placements and Project Finance Innovation in the Bond Market

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Bond Terminology

Foreign bonds - Bonds that are sold to local investors in another country's bond market.

Yankee bond- a bond sold publicly by a foreign company in the United States.

Sumari - a bond sold by a foreign firm in Japan.

Eurobond market - wind European and American multinationals were forced to tap into international markets for capital.

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Bond Terminology

Indenture or trust deed - the bond agreement between the borrower and a trust company.

Registered bond - a bond in which the Company's records show ownership and interest and principle are paid directly to each owner.

Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principle.

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Bond Terminology

Accrued interest - the amount of accumulated interest since the last coupon payment

Debentures - long-term unsecured issues on debt

Mortgage bonds - long-term secured debt often containing a claim against a specific building or property

Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets

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Bond Terminology

Sinking fund - a fund established to retired debt before maturity.

Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price.

Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds.

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Straight Bond vs. Callable Bond

Value ofstraight bond

25 50 75 100 125 150

25

50

75

100

bondValue of

Straight bond

bond callableat 100

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Bond Terminology

Restrictive covenants - Limitations set by bondholders on the actions of the Corporation.

Negative Pledge Clause - the processing of giving unsecured debentures equal protection and when assets are mortgaged.

Poison Put - a clause that obliges the borrower to repay the bond if a large quantity of stock is bought by single investor, which causes the firms bonds to beat down rated.

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Bond Terminology

Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value.

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Covenants

Debt ratios: Senior debt limits senior borrowing Junior debt limits senior & junior borrowing

Security: Negative pledge

Dividends Event risk Positive covenants:

Working capital Net worth

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Event Risk: An Example

October 1993 Marriott spun off its hotel management business worth 80% of its value.

Before the spin-off, Marriott’s long-term book debt ratio was 2891/3644 = 79%. Almost all the debt remained with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%.

Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%.

Bondholders sued and Marriott modified its spinoff plan.

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Project Finance

1. Project is set up as a separate company.

2. A major proportion of equity is held by project manager or contractor, so provision of finance and management are linked.

3. The company is highly levered.

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Parties In Project Finance

Contractor Supplier(s)

Equity investors

Government Projectcompany

Equity sponsor

Lenders

Purchaser(s)

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Risk AllocationRisk Shifted to: Contract

Completion/continuingmanagement

Sponsor Management contract/completion gtees / workingcapital maintenance

Construction cost Contractor Turnkey contract/ fixed price/delay penalties

Raw materials Supplier(s) Long-term contract/ indexedprices/ supply or pay

Revenues Purchaser(s) Long-term contract/ indexed tocosts/ take or pay/ throughputagreements/ tolling contract

Concession/regulation Government Concession agreement/provision of supportinginfrastructure

Currencyconvertibility

Government Gtees or comfort letters/ hardcurrency paid to offshoreescrow account