L5 FINANCIAL MANAGEMENT

DEBT FINANCE: BANK LOANS & BONDS/FINANCING DECISIONS

Question 1.
Restrictive covenants can be described as rules or conditions attached to bonds
which prevent the issuer of the bond (i.e. the company management) from doing
certain things. Such preventions are designed to protect the interests of the investor.
Often, restrictive covenants are focussed on preventing any increase in financial risk
over and above that which was present when the bonds were issued. In the simplest
and most common terms restrictive covenants usually focus on the issue of further
debt. Examples of restrictive covenants are:

 Gearing ratio caps

 Specific restrictions on further debt issues
 Restriction on any further capital issues (equity or debt)
 Prevention of sale or placing security on certain assets
 Minimum current ratio

Question 2.
All of the following factors should be taken into consideration:

 Cost: Is the company able to get the debt at a lower annual cost by using
disintermediation or via a bank loan
 Issue costs: the arrangement fees associated with bank loans are nearly almost
lower than the issue costs of bonds
 Speed with which finance is required: it is quicker to arrange a bank loan than
arrange an issue of debt securities
 Type of interest rate: does the company want to raise debt via a fixed interest
rate (most likely via bonds) or rather than a floating rate (most likely bank loans)
 Flexibility: there is more flexibility in terms of terms and conditions using
debentures
 Variety: bonds give companies the ability to issue a number of different varieties
of debt including convertibles and bonds with warrant attached compared to the
more standardised bank loans
 Security requirements: more favourable in terms of issue bonds (loan stock does
not need to be secured) rather than a bank loans (almost always have to be
secured)
 Repayment versus redemption: the redemption of bonds tends to occur in one
big amount while bank loans can have the facility to make repayments over time

Question 3.
Here we need to work out the present value of the bond. This is calculated as
follows by using the appropriate discount factors at 12 per cent.

Year Cashflow £ Disc factor@ 12% PV

1-4 Interest 8 3.037 £24.30
4 Principal 110 0.636 £69.96
£94.26
Current market value is therefore £94.26

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LECTURE 5
 L5 FINANCIAL MANAGEMENT
DEBT FINANCE: BANK LOANS & BONDS/FINANCING DECISIONS

Question 4.

(a) Deep discount bonds: this refers to the discount between the issue price and
the redemption price. A deep discount bond is sold for a price much less than
what it will be redeemed for at the end of the maturity period. The amount of
discount will affect the coupon rate that is offered. The general rule is the
bigger (deeper) the discount the lower the coupon rate.

(b) Vanilla bonds: like Vanilla being a simple form of ice cream. Vanilla is a term
commonly used in finance to describe simple and straightforward products. A
vanilla bond is a bond with straightforward characteristics. A bond will be
described as vanilla if it has a fixed maturity date, a fixed coupon rate and if it
redeems at the same price as it is issued (usually par).

(c) Zero coupon bonds: the coupon is the interest rate payable on a bond and
hence if a bond is zero coupon then it doesn’t pay interest. Zero coupon
bonds are attractive to issuers because they do not incur a regular cash
outflow (i.e. interest payments) although the amount raised is usually
substantially less than the redemption liability.

Question 5.
Possible scenarios are:

 A Company’s existing gearing level is too high, and they want to bring it down
 The relative cost of equity finance is favourable compared with debt
 Bonds often require security and the company may not have enough assets to
provide the required security
 The capital may be required indefinitely rather than a defined (but long) period.
Ordinary shares never have a redemption requirement whereas bonds commonly
have a maturity date
 The company may be restricted by existing debt covenants from raising more
debt
 The company does not have enough taxable profit to make the tax efficiency of
debt worthwhile
 Long term capital investors may prefer equity in the current conditions and
circumstances of the company making it cheaper and more easily accessible.

Question 6.
The expected market values will be equal to the present values of expected future
cash flows.

(1) 12% debenture

PV of interest with 10% cost of debt = 12 x 5.335 = £64.02
PV of redemption value = 100 x 0.467 = £46.70
Expected market value = 64.02 + 46.70 = £110.72

(2) Zero coupon bond

PV of £100 received in 8 years = 100 x 0.467 = £46.70

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LECTURE 5
 L5 FINANCIAL MANAGEMENT
DEBT FINANCE: BANK LOANS & BONDS/FINANCING DECISIONS

The debentures could be issued at a premium to par and the zero-coupon bonds at a
deep discount to par. Although no interest is payable on the zero-coupon bonds,
Permafrost plc would need to find a much larger sum to redeem them.

Redemption cost = 800,000 x (100/46.70) = £1,713,062

Annual interest is payable on the debentures, but the redemption cost is less than
the initial funds raised.

Redemption cost = 0.8m/1.1072 = £722,543

This lower redemption cost is offset by high annual interest payments.

Interest paid = 722,543 x 0.12 = £86,705

The interest payments on the bank loan, being at a floating rate, cannot be
determined without forecasting future interest rates. However, the annual interest
payments are likely to decrease as the capital is repaid.

Both the debenture issue and the bank loan require security and Permafrost plc
needs to have adequate assets to offer as security. Although no security is
mentioned in connection with the zero-coupon bonds, these too are likely to need
some security on issue. The amount of funds to be raised seems small for a
debenture issue or an issue of zero-coupon bonds. The bank loan seems to be
more appropriate on this count.

The repayment terms of the loan may seem severe (an annual capital amount of
£100,000), but they are not much higher than interest on the debenture and there will
no redemption problem after 8 years.

All three debt financing methods match the expected life of the computer system, but
in order to choose between them Permafrost plc will need to consider its ability to
meet their respective annual cash demands.

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LECTURE 5
 L5 FINANCIAL MANAGEMENT
DEBT FINANCE: BANK LOANS & BONDS/FINANCING DECISIONS

Phase Test Preparation:

Q1. B Prevent a company from increasing the risk to current investors

This statement is true – once a bond holder has invested in a company, the want to
stop the company from significantly increasing its financial risk by borrowing more,
given their interest rate is fixed.

Q2. A Only (2) is correct

Statement (1) is incorrect as bond issue costs tend to be higher than bank
arrangement fees. Statement (2) is correct. Some bonds do not require security,
especially if the company has a good credit rating. Statement (3) is incorrect – bonds
tend to pay fixed rates of interest.

Q3. C £103.23
Here the current ex-interest value of the bond is given by:
( £5 x 4.212) + (£110 x 0.747) = £103.23

Q4. D Fixed charge security is where debt is secured against a pool of assets
This is the only false statement. Floating charge security involves securing debt
against a pool of assets.

Q5. B The company is concerned about diluting its ownership structure

This is a reason for a company to go for bank loan rather than a rights issue and
hence is the correct answer.

Q6. C Increase from 38.7% to 45.5%

Current gearing:
(£4m x 1.0545)/ (2m x £3.34) + (£4m x 1.0545) = £4.218m/£10.858 = 38.7%
New Gearing:
£5.218m/(£5.218m + £6.24m) = 45.5%

Q7. C £71
Here a fair price for the zero-coupon bond is given by:
£100 x 0.705 = £70.5 i.e. £71.

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LECTURE 5