Chapter 10

 

Sources of finance: debt

 

Solutions to questions

 
1.    The answer will depend on the features of the updated data. Answers should compare the amount of funding raised from institutional loans and the amount raised by debt securities. Some discussion of where bills should be classified could also be useful.
2.    A debt contract will either specify the amount and timing of each interest payment or it will specify a set of rules that will be used to calculate those payments. It will also specify how the principal is to be repaid. Other specifications usually included in debt contracts are outlined in Section 10.2.
3.    (a)   If debt is secured, the borrower’s promise to repay is supported by a fixed or floating charge over assets. Unsecured debt does not involve any charge over assets.
(b)   Subordinated debt ranks below other debt in the event that the borrower is wound up. Unsubordinated debt is debt that has not been subordinated.
(c)   Indirect debt finance is provided through a financial intermediary acting as a principal. In the case of direct debt, funds are provided by investors who lend to the borrower, usually by purchasing marketable debt securities.
4.    Borrowing causes financial risk which involves a leverage effect and also increases the risk of financial distress. These effects are discussed in Section 10.2.2.
5.    Unlike shareholders, lenders do not have voting rights, and therefore they do not normally have any control over the operations of a borrowing company. However, if a company breaches its obligations to a lender, the lender will gain considerable control because it will then have rights such as the right to take control of assets, appoint an administrator and ultimately have the borrower wound up.

Solutions to problems

 
1.    Sealex Ltd
The maximum annual interest payment is
       Interest on the existing loan is $2 000 000 ´ 0.0875 = $175 000 per annum. Therefore, the additional interest must be no more than $400 000 – $175 000 = $225 000 per annum, which corresponds to additional debt of  = $3 000 000
 
2.    Cominco Ltd
       (a)   For the bank loan:
              $2 000 000      =    
                                      =     R´ 3.275597
                               R     =     $610 575.79 per annum
       (b)   $2 000 000     =    
                               i      =    
                                      =     0.084, or 8.4 per cent
(c)   The three alternatives can be compared by calculating the NPV of each using the interest rate on the bank loan.
              (i)    At the interest rate of 8.5 per cent, the NPVof the bank loan is zero.
 
              (ii)   Supplier’s finance
                     NPV      =     $2 000 000 – $500 000 –   
                                   =     $1 500 000 – $1 506 774.62
                            =     –$6 774.62
      
              (iii)  Broker’s loan
                     NPV      =     $2 000 000 ´ 0.99 –
                            =     $1 980 000 – $1 992 637.77
                            =     –$12 636.77
 
Since the supplier’s finance and the broker’s loan both have negative NPVs, the bank loan provides the lowest cost finance.
 
3.    Using Equation 10.1:
      
P= $1 000 000/[1+0.089*180/365] = $957 955.34
 
The company borrows $485 000 and repays 180 days later by paying the face value of $500 000. Therefore, the interest paid is $15 000 and the interest rate is:
      
       for a 180-day period.
 
       Using simple interest, the annual yield is
      
 
       The implicit effective annual interest rate is therefore:
      
5.    The completed table is:
 

	Yield = 5.1 per cent per annum	Yield = 5.2 per cent per annum	Yield = 5.3 per cent per annum
Term = 30 days	$995825.72	$995744.22	$995662.73
Term = 90 days	$987580.83	$987340.40	$987100.09
Term = 180 days	$975466.35	$974997.33	$974528.76

 
 
In each case we simply apply Equation 10.1. For example,
           
 
The most obvious patterns in the tableare that the price is negatively related to both the yield (r) and the term (d).For example, if the yield increases (decreases) then the price decreases (increases). Slightly less obvious patterns are present in the price changes.Suppose yields were 5.2 per cent per annum for all terms to maturity, and then they decrease to 5.1 per cent per annum, or increase to 5.3 per cent per annum.Then the capital gains and losses would be:
 
 

	Yield decreases to 5.1 per cent per annum	Yield increases to 5.3 per cent per annum
Term = 30 days	$81.50 gain	$81.49 loss
Term = 90 days	$240.43 gain	$240.31 loss
Term = 180 days	$469.02 gain	$468.57 loss

 
 
We can see that: (1) the absolute size of the gain or loss increases with term and (2) the losses are slightly less (in absolute value) than the gains.