Chapter 5

Debt:

• Borrowed money that must be repaid with interest

• Not an ownership interest

• Creditors do not have voting rights

• Interest is tax deductible

• Legal obligation to repay

Equity:

• Ownership stake in a company

• Common stockholders have voting rights

• Dividends are not tax deductible

• Dividends are not a liability of the firm

• Stockholders have no legal recourse if dividends are not paid

• An all-equity firm cannot go bankrupt

1. Public Debt:

   • Debt that is publicly traded (e.g., bonds)

2. Private Debt:

   • Debt that is not publicly traded (e.g., bank loans)

Public Debt:

• Traded on public markets

• Large issues have lower registration costs

• Requires registration and disclosure

• Offers more liquidity and favorable financial terms

• Subject to credit ratings

Private Debt:

• Main funding source for most firms, typically larger in size

• Lower issuance costs and more flexibility, but usually larger than public debt

• Allows borrowing small amounts while avoiding registration costs

1. Long-term debt instruments issued by corporations

2. Governed by a bond indenture (legal contract with repayment terms)

3. Typically pay semiannual coupons (interest payments)

4. Maturities usually range from 5 to 15 years

5. Face Value: Usually $1,000 per bond

6. Actual money raised may be lower due to underwriting fees or issuance at a discount

7. Original Issue Discount (OID) Bonds: Issued at a price lower than face value

Secured Debt:

• Specific assets are pledged as collateral

• Types:

  • Mortgage bonds: Secured with property

  • Asset-backed bonds: Secured with assets

Unsecured Debt:

• Not backed by assets; claim only to assets not already pledged

• Types:

  • Notes: Maturity less than 10 years

  • Debentures: Not secured by collateral

Seniority in Claiming Assets:

• Senior Debt: Highest priority in bankruptcy

• Subordinated Debentures: Lower priority; paid only after senior debts are settled

1. Domestic Bonds: Issued and traded in the issuer’s home country

2. Foreign Bonds: Issued by a foreign company but denominated in the local currency (e.g., Samurai Bonds in Japan)

3. Eurobonds: Issued in a currency different from the country of issuance

4. Global Bonds: Sold in multiple international markets at the same time; can be offered in the same currency

Term Loans:

• Fixed-term bank loans with regular payments for a specific term

  • Syndicated Bank Loan: Large loan provided by multiple banks

  • Revolving Line of Credit: Flexible credit line used as needed (typically 2–3 years)

Private Placements:

• Bonds sold directly to a small group of investors, bypassing public markets

  • No registration required; less costly than public debt

  • Tradable between financial institutions; slightly less liquid than public debt

Sovereign Debt:

• Debt issued by national governments

Types of U.S. Treasury Securities:

• Bills:

  • Type: Discount

  • Maturity: 4, 13, and 26 weeks

• Notes:

  • Type: Coupon

  • Maturity: 2, 3, 5, and 10 years

• Bonds:

  • Type: Coupon

  • Maturity: 20 and 30 years

• Inflation-Indexed Securities:

  • Type: Coupon

  • Maturity: 5, 10, and 20 years

1. Issued by state and local governments to fund public projects

2. Not taxable at the federal level (sometimes also state and local)

3. Often tax-exempt, making them attractive to investors

4. Most pay semi-annual interest

   • Fixed Rate: Same coupon over the bond’s life

   • Floating Rate: Coupon is adjusted periodically

• Financial instruments backed by pools of assets like mortgages or loans

Types:

• Mortgage-Backed Security (MBS):

  • Largest sector of the asset-backed security market

  • Backed by home mortgages

• Collateralized Debt Obligation (CDO):

  • Promise to pay investors in a prescribed sequence

  • Backed by a pool of loans and other assets

• Bond covenants are restrictive clauses in a bond contract

• They prevent issuers from weakening their ability to repay the bonds

Examples of covenant restrictions:

• Restrict dividend payments

• Limit additional borrowing

• Require issuer to maintain a minimum amount of working capital

Callable Bonds:

• Issuer has the right to repurchase bonds before maturity at a set call price

• Typically called when interest rates drop

• Benefits the issuer but creates reinvestment risk for bondholders

• Call price is usually at or above face value, expressed as a % of face value

• Issuer may call the bond on or after a specific call date

Behavior on the Call Date:

• If yield < coupon, issuer will likely call the bond → price stays at par

• If yield > coupon, issuer won’t call the bond → price acts like a regular (non-callable) bond

• A company makes regular payments into a fund managed by a trustee over the bond’s life

• Used to gradually repay or retire bonds

• If bonds are trading at a discount, the company repurchases them in the market

• If bonds are trading at face value, they are repurchased at par

• Repurchased bonds are selected by a lottery

1. A convertible bond gives the bondholder the option to convert the bond into a fixed number of common stock shares before maturity

2. Conversion Ratio:

   • Number of shares received per $1,000 of face value upon conversion

3. Conversion Price:

   • Face value of the bond ÷ number of shares received upon conversion

1. A warrant is a call option issued by a company on its own stock

2. When exercised, the holder buys stock, and the company issues new shares

3. Convertible debt often includes an embedded warrant

   • This allows the company to offer lower interest rates on the debt

1. Combine features of callable and convertible bonds

2. If the issuer calls the bond, the holder can either:

   • Convert it into stock, or

   • Accept the call price

3. Forces bondholders to decide earlier whether to convert

4. Bondholders usually convert if stock price > conversion price, otherwise accept the call