11/5/2022

Chapter 05
Medium- to Long-term
Debt

10-1

Learning Objectives
• Identify the types of medium- to long-term debt
instruments in the market
• Describe the main features of these facilities
• Identify the financial institutions and parties
involved in the provision of these facilities
• Undertake calculations related to the pricing of
these debt instruments

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Chapter Organisation
5.1 Term Loans or Fully Drawn Advances
5.2 Mortgage Finance
5.3 Debentures, Unsecured Notes and
Subordinated Debt
5.4 Calculations: Fixed-interest Securities
5.5 Leasing
5.6 Summary

10-3

10.1 Term Loans or Fully Drawn Advances

• Term loan
– A loan advanced for a specific period (3 to 15 years),
usually for a known purpose, e.g purchasing land,
premises, plant and equipment
– Secured by mortgage over asset purchased or other
assets of the firm
• Fully drawn advance
– A term loan where the full amount is provided at the start
of the loan

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10.1 Term Loans or Fully Drawn Advances

(cont.)
• Provided by
– Mainly commercial banks and finance companies
– To a lesser degree, investment and merchant banks,
insurance offices and credit unions

10-5

10.1 Term Loans or Fully Drawn Advances

(cont.)
• Term loan structures
– Interest only during term of loan and principal repayment
on maturity
– Amortised loan
▪ Periodic loan instalments consisting of interest due and
reduction of principal
– Deferred repayment loan
▪ Loan instalments commence after a specified period related
to project cash flows and the debt is amortised over the
remaining term of the loan

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10.1 Term Loans or Fully Drawn Advances

(cont.)
• Term loan structures (cont.)
– Interest may be fixed (for a specified period of time, e.g.
2 years) or variable
– Interest rate charged on term loan is based on:
▪ An indicator rate (e.g. BBSW or a bank’s own prime lending
rate) and is also influenced by
• Credit risk of borrower—risk that borrower may default on loan
commitment, giving rise to a risk premium
• Term of the loan—usually longer-term attracts a higher
interest rate
• Repayment schedule—frequency of loan repayments (e.g.
monthly or quarterly) and form of the repayment (e.g.
amortised or interest-only loan)

10-7

10.1 Term Loans or Fully Drawn Advances

(cont.)
• Term loan structures (cont.)
– Other fees include
▪ Establishment fee
▪ Service fee
▪ Commitment fee
▪ Line fee
▪ Bill option clause fee

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10.1 Term Loans or Fully Drawn Advances

(cont.)
• Loan covenants
– Restrict the business and financial activities of the
borrowing firm
▪ Positive covenant
• Requires borrower to take prescribed actions, e.g. maintain a
minimum level of working capital
▪ Negative covenant
• Restricts the activities and financial structure of borrower, e.g.
maximum D/E ratio, minimum working-capital ratio, unaudited
periodic financial statements
– Breach of covenant results in default of the loan contract,
entitling lender to act

10-9

10.1 Term Loans or Fully Drawn Advances

(cont.)
• Calculating the loan instalment—ordinary annuity

A
R=
1− (1+ i )−n
[ ]
i (10.1)

where :
R = the instalment amount
A = the loan amount (present value)
i = the current nominal interest rate per period expressed as a decimal
n = the number of compoundin g periods.

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10.1 Term Loans or Fully Drawn Advances

(cont.)
• Calculating the loan instalment— ordinary annuity
(cont.)
– Example 1: Floppy Software Limited has approached
Mega Bank to obtain a term loan to finance the purchase
of a new high-speed CD burner. The bank offers a
$150 000 loan, amortised over five years at 8% per
annum, payable monthly. Calculate the monthly loan
instalments.

10-11

10.1 Term Loans or Fully Drawn Advances

(cont.)
• Calculating the loan instalment— ordinary annuity
(cont.)
– Example 1 (cont.)

A = $150 000
0.08
i= = 0.006667
12
n = 5 years  12 months = 60
$150 000
R=
1 − (1 + 0.006667) −60
[ ]
0.006667
R = $3041.49 per month

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10.1 Term Loans or Fully Drawn Advances

(cont.)
• Calculating the loan instalment—annuity due

A
1− (1+ i )−n
R=
[ ](1 + i )
i (10.2)

10-13

10.1 Term Loans or Fully Drawn Advances

(cont.)
• Calculating the loan instalment—annuity due
(cont.)

– Example 2: A business proprietor is purchasing a

computer system for the business at a cost of $21 500. A
finance company has offered a term loan over seven
years at a rate of 12% per annum. The loan will be repaid
by equal monthly instalments at the beginning of each
month. Calculate the amount of the loan instalments.

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10.1 Term Loans or Fully Drawn Advances

(cont.)
– Example 2 (cont.)

A = $21 500
0.12
i= = 0.01
12
n = 7  12 = 84
$21 500
R=
1 − (1 + 0.01) −84
[ ] (1 + 0.01)
0.01
$21 500
=
57.21494
= $375.78 monthly instalment

10-15

Chapter Organisation
10.1 Term Loans or Fully Drawn Advances
10.2 Mortgage Finance
10.3 Debentures, Unsecured Notes and
Subordinated Debt
10.4 Calculations: Fixed-interest Securities
10.5 Leasing
10.6 Summary

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10.2 Mortgage Finance

• A mortgage is a form of security for a loan
– The borrower (mortgagor) conveys an interest in the land
and property to the lender (mortgagee)
• The mortgage is discharged when the loan is
repaid
• If the mortgagor defaults on the loan the
mortgagee is entitled to foreclose on the property,
i.e. take possession of asset and realise any
amount owing on the loan

10-17

10.2 Mortgage Finance (cont.)

• Use of mortgage finance
– Mainly retail home loans
▪ Up to 30-year terms
– To a lesser degree commercial property loans
▪ Up to 10 years as businesses generate cash flows enabling
earlier repayment
• Providers (lenders) of mortgage finance
– Commercial banks, building societies, life insurance
offices, superannuation funds, trustee institutions, finance
companies and mortgage originators

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10.2 Mortgage Finance (cont.)

• Interest rates
– Both variable and fixed interest rate loans are available to
borrowers
▪ With fixed interest loans, interest rates reset every 5 years
or less
– With interest-only mortgage loans, interest-only period is
normally a maximum of 5 years
• Mortgagee (lender) may reduce their risk exposure
to borrower default by
– Requiring mortgagor to take out mortgage insurance up
to 100% of the mortgage value

10-19

10.2 Mortgage Finance (cont.)

• Securitisation and mortgage finance
– Mortgage originators, commercial banks and other
institutions use securitisation to manage their mortgage
loan portfolios
– Involves conversion of non-liquid assets into new asset-
backed securities that are serviced with cash flows from
the original assets
– Original lender sells bundled mortgage loans to a special-
purpose vehicle
▪ i.e. a trust setup to hold securitised assets and issue asset-
back securities like bonds, providing investors with security
and payments of interest and principal

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10.2 Mortgage Finance (cont.)

• Calculating the instalment on a mortgage loan

A
R=
1 − (1 + i )−n
[ ]
i
(10.3)

10-21

10.2 Mortgage Finance (cont.)

• Calculating the instalment on a mortgage loan
(cont.)

– Example 3: A company is seeking a fully-amortised

commercial mortgage loan of $650 000 from its bank.
The conditions attached to the loan include an interest
rate of 8% per annum, payable over five years by equal
end-of-quarter instalments. The company treasurer needs
to ascertain the quarterly instalment amount.

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10.2 Mortgage Finance (cont.)

• Calculating the instalment on a mortgage loan
(cont.)
– Example 3 (cont.):

A = $650 000
0.08
i= = 0.02
4
n = 5  4 = 20
$650 000
R=
1− (1+ 0.02) −20
[ ]
0.02
= $39 751.87 monthly instalment

10-23

Chapter Organisation
10.1 Term Loans or Fully Drawn Advances
10.2 Mortgage Finance
10.3 Debentures, Unsecured Notes and
Subordinated Debt
10.4 Calculations: Fixed-interest Securities
10.5 Leasing
10.6 Summary

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10.3 Debentures, Unsecured Notes and

Subordinated Debt
• These securities are issued in the corporate bond
market
– Markets for the direct issue of longer-term debt securities
– Lenders face higher
▪ Risk compared to lending indirectly through intermediaries
▪ Yield due to sharing in the profit margin usually taken by
intermediaries

10-25

10.3 Debentures, Unsecured Notes and

Subordinated Debt (cont.)
• Debentures and unsecured notes
– Are corporate bonds
– Specify that the lender will receive regular interest
payments (coupon) during the term of the bond and
receive repayment of the face value at maturity
– Unsecured notes are bonds with no underlying security
attached

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10.3 Debentures, Unsecured Notes and

Subordinated Debt (cont.)
• Debentures and unsecured notes (cont.)
– Debentures
▪ Are secured by either a fixed or floating charge over the
issuer’s unpledged assets
▪ Are listed and traded on the stock exchange
▪ Have a higher claim over a company’s assets (e.g. on
liquidation) than unsecured note holders

10-27

10.3 Debentures, Unsecured Notes and

Subordinated Debt (cont.)
• Issuing debentures and notes
– There are three principal issue methods
▪ Public issue—issued to the public at large, by prospectus
▪ Family issue—issued to existing shareholders and
investors, by prospectus
▪ Private placement—issued to institutional investors, by
information memorandum
– Usually issued at face value, but may be issued at a
discount or with deferred or zero interest
– A prospectus contains detailed information about the
business

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10.3 Debentures, Unsecured Notes and

Subordinated Debt (cont.)
• Subordinated debt
– More like equity than debt. i.e. quasi-equity
– Claims of debt holders are ‘subordinated’ behind all other
company liabilities
– Agreement may specify that the debt is not presented for
redemption until after a certain period has elapsed
– May be regarded as equity in the balance sheet,
improving the credit rating of the issuer

10-29

Chapter Organisation
10.1 Term Loans or Fully Drawn Advances
10.2 Mortgage Finance
10.3 Debentures, Unsecured Notes and
Subordinated Debt
10.4 Calculations: Fixed-interest Securities
10.5 Leasing
10.6 Summary

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10.4 Calculations: Fixed-interest Securities

• Price of a fixed-interest bond at coupon date

– The price of a fixed interest security is the sum of the
present value of the face value and the present value of
the coupon stream

1− (1+ i )−n
P = C[ ] + A(1+ i )−n
i
(10.4)

10-31

10.4 Calculations: Fixed-interest

Securities (cont.)
• Price of a fixed interest bond at coupon date
(cont.)

– Example 4: Current AA+ corporate bond yields in the

market are 8% per annum. What is the price of an
existing AA+ corporate bond with a face value of $100
000, paying 10% per annum half-yearly coupons, and
exactly six years to maturity?

A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12

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10.4 Calculations: Fixed-interest

Securities (cont.)
– Example 4 (cont.):

10-33

10.4 Calculations: Fixed-interest

Securities (cont.)
• Price of a fixed-interest bond between coupon
dates

 1− (1+ i )−n  −n  k

P = C   + A(1+ i ) (1+ i )
  i  

(10.7)

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10.4 Calculations: Fixed-interest

Securities (cont.)
• Price of a fixed interest bond between coupon
dates (cont.)

– Example 5: Current AA+ corporate bond yields in the

market are 8% per annum. An existing AA+ corporate
bond with a face value of $100 000, paying 10% per
annum half-yearly coupons, maturing 31 December 2012,
would be sold on 20 May 2007 at a price of:

10-35

10.4 Calculations: Fixed-interest

Securities (cont.)
– Example 5 (cont.):

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10.4 Calculations: Fixed-interest

Securities (cont.)
– Example 5 (cont.):

10-37

Chapter Organisation
10.1 Term Loans or Fully Drawn Advances
10.2 Mortgage Finance
10.3 Debentures, Unsecured Notes and
Subordinated Debt
10.4 Calculations: Fixed-interest Securities
10.5 Leasing
10.6 Summary

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10.5 Leasing
• Leasing defined

– A lease is a contract where the owner of an asset (lessor)

grants another party (lessee) the right to use the asset for
an agreed period of time in return for periodic rental
payments

– Leasing is the borrowing (renting) of an asset, instead of

borrowing the funds to purchase the asset

10-39

10.5 Leasing (cont.)

• Advantages of leasing for lessee over ‘borrow and
purchase’ alternative

– Conserves capital
– Provides 100% financing
– Matches cash flows (i.e. rental payments with income
generated by the asset)
– Rental payments are tax deductible

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10.5 Leasing (cont.)

• Advantages of leasing for lessor over a straight
loan provided to a lessee

– Leasing has relatively low level of overall risk as asset

can be repossessed if lessee defaults
– Leasing can be administratively cheaper than providing a
loan
– Leasing is an attractive alternative source of finance to
both business and government

10-41

10.5 Leasing (cont.)

• Types of leases
– Operating lease
▪ Short-term lease
• Lessor may lease the asset to successive lessees (e.g. short-
term use of equipment)
• Lessee can lease asset for a short-term project
▪ Full service lease—maintenance and insurance of the asset
is provided by the lessor
▪ Minor penalties for lease cancellation
▪ Obsolescence risk remains with lessor

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10.5 Leasing (cont.)

• Types of leases (cont.)
– Finance lease
▪ Longer-term financing
▪ Lessor finances the asset
▪ Lessor earns a return from a single lease contract
▪ Net lease—lessee pays for maintenance and repairs,
insurance, taxes and stamp duties associated with lease
▪ Residual amount due at end of lease period
▪ Ownership of the asset passes to lessee on payment of the
residual amount

10-43

10.5 Leasing (cont.)

• Types of leases (cont.)
– Sale and lease-back
▪ Existing assets owned by a company or government are
sold to raise cash, e.g. government car fleet
▪ The assets are then leased back from the new owner
▪ This removes expensive assets from the lessee’s balance
sheet
– Cross-border lease
▪ A lessor in one country leases an asset to a lessee in
another country

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10.5 Leasing (cont.)

• Lease structures
– Direct finance lease
▪ Involves two parties (lessor and lessee)
▪ Lessor purchases equipment with own funds and leases
asset to lessee
▪ Lessor retains legal ownership of asset and takes control or
possession of asset if lessee defaults
▪ Security of the lessor provided by
• Lease agreement
• Leasing guarantee—an agreement by a third party to meet
commitments of the lessee in the event of default

10-45

10.5 Leasing (cont.)

• Lease structures (cont.)
– Leveraged finance lease
▪ Lessor contributes limited equity and borrows the majority of
funds required to purchase the asset
▪ Lease manager
• Structures and negotiates the lease and manages it for its life
• Brings together the lessor (or equity participants), debt parties
and lessee
▪ Asset then leased to lessee
▪ Lessor gains tax advantages from the depreciation of
equipment and the interest paid to the debt parties

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10.5 Leasing (cont.)

• Lease structures (cont.)
– Equity leasing
▪ Similar to a leveraged lease, except funds needed to buy
asset are provided by the lessor
▪ Therefore it is usually smaller than a leveraged lease
▪ Has many characteristics of a leveraged lease, including the
formation of a partnership to purchase the asset, but not the
advantage of leverage

10-47

Chapter Organisation
10.1 Term Loans or Fully Drawn Advances
10.2 Mortgage Finance
10.3 Debentures, Unsecured Notes and
Subordinated Debt
10.4 Calculations: Fixed-interest Securities
10.5 Leasing
10.6 Summary

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10.6 Summary
• When choosing the most appropriate source of
medium- to long-term debt, a borrower should
consider the following factors
– Fixed or variable interest rate
– Term of the financing arrangement
– Repayment schedule
– Loan covenants
– Whether secured by fixed or floating charge, or
unsecured
– Leasing an asset as opposed to buying an asset

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