Zoologic Learning Solutions. Finance Essentials II. Financing with Debt. Copyright SS&C Technologies, Inc. All rights reserved.

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1 Zoologic Learning Solutions Finance Essentials II Financing with Debt Copyright SS&C Technologies, Inc. All rights reserved.

2 Course: Finance Essentials II Lesson 4: Financing with Debt

3 Now that Ian Raymond has decided that issuing debt is the best financing strategy, he must focus on executing the transaction in the debt capital markets. Every transaction in the capital markets needs at least two participants the user of capital and the provider of that capital. N-Style, a user of capital, will play the role of a borrower by issuing debt securities. Investors, the providers of capital, will purchase the N-Style debt securities, and thereby lend money to the company. Frequently, an intermediary will be in the middle of the transaction to bridge the gap between buyer and seller, or issuer and investor. This is particularly true for smaller companies such as N-Style. capital markets Marketplace for securities of one year or greater in maturity. Why might a buyer and seller need an intermediary? An intermediary might be needed for one of several reasons. The buyer and seller cannot find each other The buyer and seller do not trust each other The seller may want to sell more than the buyer wants to buy (or vice versa) The timing of the buyer and seller may not be compatible The buyer does not want to buy exactly what the seller is selling (or vice versa) What entities may serve as intermediaries? The following entities may serve as intermediaries. Investment banks, Merchant banks, and Commercial banks Pension funds Mutual funds Savings and Loans Insurance companies Brokers Market makers

4 The primary market is where companies raise fresh cash by issuing new debt or equity securities. Once securities have been purchased in the primary market, it is possible that future transactions involving those securities will occur on an exchange such as the New York Stock Exchange. Shares of stock (other than OTC shares), futures, and options on futures are generally traded on an exchange and the prices are made public. To raise funds, N-Style will issue debt securities in the primary market. An important decision for Ian Raymond is whether to issue the securities through a public offering or a private placement. What is the difference between a public offering and private placement? In a public offering, the issue is offered to all prospective investors in the capital markets, regardless of their level of financial sophistication. That's why public offerings are subject to extensive regulation by central authorities. With a private placement, the issue is offered to a small group of sophisticated investors. Since no public offering is involved, the issue avoids much of the regulation of the public placement. Most emerging companies use private placements for funding.

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6 A wide variety of investors might be interested in purchasing N-Style's newly issued debt securities. Many institutional investors (but typically not pension funds or insurance companies) invest in shorterterm, lower-yielding securities issued by companies of high credit quality. Pension funds and insurance companies, because they are funded to meet long-term obligations, typically invest in longer-term securities. How important are individual investors in the capital markets? With the increasing number of institutions that manage pooled investments, individual direct investors are proportionally less of a presence in the capital markets.

7 Having decided to fund the Southern Expansion with debt, Ian Raymond must decide what the terms of the debt should be. Ian must balance the needs of N-Style and the needs of investors by choosing terms acceptable to both. The key is to choose terms that make the issue attractive enough to investors that the needed funds are raised, while still keeping the cost of capital as low as possible. Are there ways for investors to lend money other than purchasing debt securities? An investor may always choose to lend money directly to a borrower. Commercial banks, for example, are in the business of lending money to borrowers either directly or in concert with other banks through a lending syndicate.

8 In the event of a direct loan, the instrument used is typically not a security, but rather a note or other loan document which spells out the terms and the various duties and obligations of the borrower.

9 The maturity of the debt impacts the demand and the cost. For long-term bonds, for example, price volatility associated with market and political uncertainty becomes more of a concern. Hence, investors will demand a higher return on bonds that have maturity dates far out in the future. For N-Style, a repayment horizon of 4-7 years would be most useful, as the returns from the expansion should be realized by then. However, such a 4-7 year horizon might end up being more costly than it could be if the expansion is immediately successful and funds are available to pay down the debt more quickly. What does perpetual, callable, putable, and extendable mean? It's possible for the stated maturity of a bond to be "perpetual" or "irredeemable." Callable bonds can be redeemed in whole or in part (at the option of the issuer), after a specified date, and either at par (i.e., face value) or possibly at a premium. These bonds will typically carry a higher return. However, there is always the risk that the issuer will call the bonds back. Holders of putable bonds can require the issuer to repurchase the bonds on specified terms and as of a specified date. These bonds typically carry a lower return since the ability to force the issuer to repurchase the bonds is valuable to investors. Extendable bonds are those whose maturity can be extended at the option of the bondholder. These bonds carry a lower return since the ability to extend the maturity is an advantage for the investor.

10 What are the advantages of callable or putable bonds? Callable bonds offer the issuer an opportunity to refinance at lower cost if interest rates fall during the life of the bond. For the investor, the bonds carry a higher yield than do bonds that lack the call option. Putable bonds offer the investor the opportunity to sell back the bond to the issuer. If interest rates rise during the life of the bond, the investor may sell the bond back and reinvest elsewhere at higher rates. For the investor, these types of bonds carry a lower yield than do bonds that lack the put option. For the issuer, putable bonds give an assurance of funds availability only to the put date. The type of interest paid may be a important concern for N-Style, as investors will have strong preferences about the type of interest they are paid. Fixed rates are pre-determined interest rates that are fixed for the life of the debt instrument. Floating rates are interest rates tied to short-term interest rates, such as 3- or 6-month LIBOR. During the life of the debt instrument, the interest rate to be paid will be periodically reset. Often times, a floating rate will include a margin over or under the reference rate, such as LIBOR + 1/4%. "Zero coupon" bonds are unique debt instruments. These bonds pay no explicit interest during the life of the bond; they are issued at a discount and redeemed at par (face value).

11 What are the advantages of a zero coupon bond? Advantages for the issuer: There are no payments of any kind until the bond matures. This type of bond is advantageous for capital-intensive projects, such as a factory construction, that may not generate positive cash flows for some time. Advantages for the investor: There is no reinvestment risk. (The investor does not need to find new investments in which to deploy interim receipts of interest payments; there are no such receipts.) There are some tax advantages in some countries (i.e., the yield is treated as a capital gain, which receives a favorable tax treatment in comparison to the tax treatment of ordinary income). How do interest rate changes affect the bond prices in the secondary markets? Over the life of a bond, the market price adjusts so the bond yield reflects the change in interest rates. For example, imagine that an investor buys a bond with a yield of 6% and three years later interest rates have changed so that a bond of the same maturity now yields 9%. If the investor wishes to sell that 6% bond, he will need to reduce the price in order to sell the bond. The price will need to fall until the effective interest rate (the 6% coupon plus the discount from par as a result of the lower current price) equals 9%.

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14 The seniority of debt describes its priority in terms of repayment in the event of bankruptcy of the issuer. Secured debt carries the least risk for lenders, since the borrower pledges specific assets to provide collateral for the debt securities. In the event of bankruptcy, secured lenders can take possession of the pledged assets in order to satisfy the claims. Senior debt gets repaid first, ahead of subordinated debt. Therefore, senior debt is relatively less risky than subordinated debt and carries a lower return. For N-Style, current debt obligations preclude more senior debt being introduced without the approval of current debt holders. Since subordinate debt is unlikely to be very attractive to investors, this USD 45 million issue will be a general obligation of N-Style equal in bankruptcy proceedings to the existing debt. How are bonds rated? Bonds may have a credit rating provided by a rating agency, such as Moody's or Standard & Poor's. This credit rating provides an indication of the risk of default on the particular bond. When assigning a rating, the agency looks at the issuer's ability to meet the financial

15 requirements of the bond and the terms of the bond itself. The higher the credit rating, the lower the risk of default. Therefore, a highly rated bond can command a lower yield, while a low-rated bond must carry a higher yield. In order to decide upon the appropriate method of issuance, Ian Raymond must weigh the size of the issue, the attractiveness of the issue, the price he hopes to get, and the general economic climate. The best choices include: Public placement: offering the new issue to specific individual or institutional clients through an intermediary. Public offering: inviting all investors to purchase the new issue. In the U.S., a public offering can be costly and time consuming, since the offering must be registered with the Securities and Exchange Commission (SEC) and meet rigid criteria. Private placement: offering the new issue to a small number of sophisticated investors. In contrast to a public offering, private placements are less costly, less time consuming, and involve fewer disclosure requirements. However, private placements do not provide the trading liquidity and price discovery/transparency that are usually associated with publicly registered and traded issues.

16 What's a useful rule of thumb for deciding between a public offering and a private placement? Think of the investors' perspective first. If the company issuing the security is fairly large (e.g., a market value of > $500 million), and if the size of the security issue itself is substantial (e.g., > $25 million for equity), then there is likely to be aggregate investor interest that is sufficient to support an efficient level of trading in the secondary market. If so, then a public offering is viable and more cost-attractive to the issuer. What debt instrument is commonly offered in a private placement? When there are multiple investors, a private placement of debt will probably take the form of corporate bonds It is not uncommon, however, for a private placement to be issued to a very small group of investors, or even a single investor. In this case, the private placement takes a form more similar to that of a loan individually negotiated between the parties.

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19 Ian Raymond has decided that a private placement is the best solution for N-Style. Ian's decision is predominantly driven by the fact that USD 45 million is a relatively small offering, and he wants to save as much money as possible in the issuance process. Ian works out a 5-year private placement with a single investor, a large insurance company. The money is expected to be "drawn dawn" (i.e., actually borrowed) in two installments and will be based on the detailed cash projections of N-Style. With the financing decision complete, N-Style is now prepared to begin the Southern Expansion project and continue with the success of the business.