1

MBA 622

Types of Debt Financing

2

Types of Long-Term Debt

Secured debt Mortgage bonds Collateral trust bonds Equipment trust certificates Conditional sales certificates

Unsecured debt

Tax-exempt corporate debt

3

Main Features of Corporate Debt

Stated maturity

Stated principal amount

Stated coupon rate of interest

Mandatory redemption (or sinking fund) schedule

Optional redemption provision

Protective covenants

4

Optional Redemption Provisions

Call Provisions Bond is usually protected against calls in the first

few years of its life. Call price declines over time.

5

Convertible Bonds

Why do firms issue convertible bonds? Gives investors limited downside risk and

unlimited upside risk. Allows equity to be “sold” later with no

transactions costs Makes debt self-liquidating if conversion occurs

6

Risk Considerations

Bond Ratings See the list at

http://www.bondsonline.com/asp/research/bondratings.asp

Effect on Risk of the Company

Effect on Risk of the Common Stock

Effect on the Cost of Capital

7

Short-Term Financing

Trade Credit

Secured and unsecured bank loans

Commercial Paper

8

Cost of Trade Credit

Discount Music Stores buys its inventory on “1/10, net 30” terms. What is the cost of not taking the discount?

9

Cost of Trade Credit

Let d = the amount of the discount (= 1%)

Let DP = the discount period (= 10 days)

Let TP = the total payment period (= 30 days)

10

Cost of Trade Credit

1030

365

01.1

01.1843.

365

1

DPTPd

dAPR

11

Effective Use of Trade Credit

Advantages: Readily available Informal Flexible Stretching payments

Disadvantages High cost of discounts foregone Excessive stretching of payments

12

Bank Loans

Short-term unsecured loans Transaction loan Line of credit Revolving credit agreement

Term loans Bullet maturity Balloon payment

13

4 Major Criteria for Granting Bank Loans

(1) What is the character of the borrower? This goes beyond just being honest and trustworthy. It involves the level of commitment on the part of the borrower to repay the loan. Will they stick it out for the long haul even if things get nasty? Will they do everything they can to make sure that the debt is paid? Do the managers have enough experience and expertise to do what they say they are going to do?

14

4 Major Criteria for Granting Bank Loans

How will the lender assess your honesty?

Do you have good business references?

Do you have a good credit history? (Don’t omit any bad news.)

Do you have ties to the business? (Equity stake)

Do you have ties to the area?

Will you personally guarantee the loan?

15

4 Major Criteria for Granting Bank Loans

(2) What is the purpose of the loan? The lenders want to know that the money will be used for a legitimate business purpose. They will look for whether there is congruency between the loan and its stated use. They will also want to see a link between the loan use and the source of its repayment. In addition, they will be looking to fund the portion of the business’s activities that are relatively SAFE.

16

4 Major Criteria for Granting Bank Loans

The lender wants to be able to separate the IDEA from the COMMON FACTORS OF PRODUCTION.

The IDEA is a risky, nebulous, hard to describe, hard to market thing. Thus, it is not appealing to a banker. Bankers do not finance ideas.

The COMMON FACTORS OF PRODUCTION are the things that the business owns that are needed to do what the business does: equipment, inventory, etc. These items are tangible and more easily values. While they are not always completely liquid, there is usually some sort of marketability associated with them. Thus, they can be turned into cash if necessary. Bankers will finance these common factors of production.

To get the loan, you need to show that the funds will be used to acquire or support the common factors of production not the idea.

17

4 Major Criteria for Granting Bank Loans

(3) What is the primary source of repayment?

Needs to be dependable.

Must be supported by the CASH CYCLE of the business.

18

4 Major Criteria for Granting Bank Loans

(4) What is the secondary source of repayment?

Needs to be absolutely dependable. This is invoked when the cash cycle fails. COLLATERAL is usually the basis for the secondary source of repayment – generally inventory, accounts receivable, or liens on fixed assets. Collateral means that the lender has FIRST RIGHTS to the assets that are pledged. However, in the case of a Chapter 11 filing, the law requires a 90-day “cooling off period”, after which there can still be a lot of court interference. So, collateral is not as secure as it might seem. To the lenders, it is a last resort to be able to recover some of their money.

19

4 Major Criteria for Granting Bank Loans

If a loan is UNSECURED, it means that there is no collateral.

In the case of a bankruptcy, unsecured lenders share equally in the sale value of the company’s assets after all secured debt has been paid from the proceeds of the secured assets.

20

The Four C’s of Credit

You will also hear about the 4 (or 5) C’s of credit, which are similar to the above. They are:

Character of the borrower(s)

Capacity to repay the loan and service the debt

Capital (sometimes listed as Collateral or listed separately) – the security behind the loan

Conditions in the economy that will impact the company

21

Credit Scoring

A typical credit scoring system is the following:

35%: Credit history – account payment information of specific types of accounts and contracts

30%: Amounts owed against income and net worth

15%: Length of credit history

10%: New credit – number and amounts of recently opened accounts

10%: Types of credit used (credit cards, installment loans, mortgages, etc.)

22

Sources of Start-Up Funding

So, if it’s so hard to get a bank loan to start a business, what do people who need credit do?

According to a 2004 Wall Street Journal Article (The Great Money Hunt – Nov 2004): “Among small businesses using credit, the percentage that tap these types of funding to finance their operations are:”

23

Sources of Start-Up Funding