Sources of finance – debt

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1 Introduction

In this chapter we will look at the various ways available to a company of raising debt finance.

2 Types of long-term debt

2.1 Debentures, Loan Stock or Bonds

A debenture is a written acknowledgement of a debt containing provisions for the payment of interest and repayment of the principal.

The debentures may be secured or unsecured. Secured means that if the company goes into liquidation then the debenture holders have first charge on the assets that are used as security. Unsecured debentures do not have this benefit and therefore usually need a higher rate of interest to compensate lenders.

Debentures can be traded on a stock exchange, normally in units of $100 nominal. They carry a fixed rate of interest and the interest is expressed as a % of nominal value.

Irredeemable debentures are never repaid (and do not exist in practice!). Redeemable debentures are repayable at a fixed date (or during a fixed period) in the future. They are usually repaid at their nominal value (at par) but may be issued as repayable at a premium on nominal value.

E.g.   10% Debentures 2005 quoted at 96 p.c.

1. Advantages

• The interest paid by the company is usually less than the dividend the company would have to pay to shareholders. This is because investors find them less risky than shares and therefore require a lower return.

• The interest paid is tax allowable to the company and therefore the net cost to the company is reduced.

1. Disadvantage

• The higher the amount of debt finance, the more fixed interest has to be paid out of profits that would otherwise be available to shareholders. This makes the dividends more risky as far as the shareholders are concerned. This point will be explained in more detail in the next chapter.

2.2 Debt redeemed at a premium

These are debentures which are issued at a nominal value, but are repayable at a premium on nominal value on maturity.

Investors will effectively receive a ‘bonus’ on maturity and will therefore be prepared to accept a lower rate of interest from year to year.

The advantage to companies which are growing is that they pay low interest during the life of the debentures. Hopefully, when the time comes to redeem the debentures the company will be in a position to redeem them at a premium

3 Returns on debt

3.1 Interest yield:

This measures the return to investors each year ignoring any ‘profit’ or ‘loss’ on redemption.

3.2 Redemption yield:

This is the overall return earned by investors taking into account both the annual interest and the gain or loss on redemption.

(Note that you will not be required to calculate the redemption yield in Paper F9 – you are only expected to understand what it represents)

4 Convertibles and Warrants

4.1 Convertibles

Convertibles are debentures that give the investor the choice on redemption of either taking cash or taking a pre-determined number of shares in the company.

The attraction of convertibles to investors is that they allow them to gain if the company does well (and the share price increases), but they do not lose if the company does badly (provided that the company does not collapse completely!).

The advantage to the company is that they will be able to offer a lower rate of interest (because investors find them attractive). Also, provided the company does well and investors do convert, the company will avoid any cash flow problem associated with repaying the debentures.

4.2 Warrants

A warrant is a right given to investors to subscribe for new shares at a future date at a fixed price.

They are sometimes issued with debentures in order to make them more attractive to investors (and therefore allow the company to pay lower interest).

The warrants may be bought or sold separately from the debentures during the exercise period.

5 Crowd funding and peer-to-peer funding

Crowd funding is not a source of debt finance (despite using this chapter to explain it!).

It is the practice of funding a project by raising money from a large number of people - most commonly via the internet. In return for their funding the investors will sometime receive shares in the company or (more often) will receive a reward such as, for example, early receipt of the product being produced and/or a discount on the price of the product.

Peer-To-Peer funding is debt finance, and again is very much internet based. Businesses or individuals needing to borrow money apply online and the software determines the credit risk and the rate of interest to be charged. Individuals with money to invest stipulate the amount they are prepared to invest and select the level of interest they wish to earn. The software then allocates the investments to the borrowers, and the operators of the system make money by taking a service fee.

6 Preference shares

These are shares with a fixed rate of dividend having a prior claim on profits available for distribution (unlike ordinary shares where the dividend can fluctuate).

Although legally equity, these are often treated as debt because they carry a fixed rate of dividend.

Dividends are only payable if there are sufficient distributable profits. If not sufficient, then the right to dividend is carried forward if they are cumulative preference shares. Otherwise the right to dividend for that year is lost.

The dividends are not tax deductible to the company.

On liquidation of a company, preference shares rank before ordinary shareholders.

1. Advantages:

• they do not carry voting rights and there is therefore no loss of control

• unlike debt, dividends do not have to be paid if not enough profits and the shares are not secured on the company’s assets

1. Disadvantages:

• dividends are not tax allowable, unlike debt interest

• to attract investors there will be a need to pay a higher rate of interest because of the extra risk for shareholders.