Viney7e Sm Ch10
Oct 14, 2015
Chapter 10
Medium- to long-term debt
True/False questions1.F A term loan provided by a commercial bank to a corporate client will always have a fixed interest rate structure.2.T A fully drawn advance provided by a commercial bank is simply another name for a term loan.3.T An amortised loan is one in which the loan is repaid through a series of regular equal instalments that comprise interest and principal.4.T A variable rate loan contract will specify a reference interest rate; changes in the reference interest rate will impact the interest paid on a variable rate loan.5.T The lenders assessment of the credit risk of a borrower will affect the rate of interest charged on a term loan.6.F A 10-year term loan with a fixed interest rate will not be re-priced for the entire period of the loan.7.F LIBOR (London inter-bank offered rate) is the rate of interest charged on short-term corporate loans in the UK market.
8.T Reuters is a major provider of electronic information to participants in the financial markets.9.F A company is paying BBSW plus 8 basis points on a loan. BBSW is currently 7.00 per cent per annum. The cost of the loan is therefore 15.00 per cent per annum.
10.F If a bank provides a company with a term loan with a fixed-interest rate, the company will not have to pay any other fees as they are incorporated in the fixed rate.
11.F A loan covenant is a guarantee provided by the directors of a company that a term loan will be repaid by the maturity date.
12.T A mortgage is a form of security taken over land that is granted by a borrower as collateral to support a loan facility.
13.T With mortgage finance, the mortgagor is the borrower and the mortgagee is the lender.
14.T If a borrower defaults on a mortgage loan, the lender will foreclose and sell the property to recover loan funds outstanding.
15.F The terms debenture and unsecured note can be interchanged, since they are both corporate bonds that have identical features.
16.T The crowding-out effect contends that there will be a negative correlation in the growth in the corporate bond market with any significant change in the amount government borrows in the capital markets.
17.F Subordinated debt holders receive their interest payments and are able to redeem their principal before other corporate bondholders.
18.T An operating lease tends to be a short-term relationship, wherein the lessor may lease the same asset to successive lessees in order to earn a return on the asset.
19.F One of the attractions of a finance lease from the point of view of the lessor is that at the end of the lease the ownership of the asset passes to the lessee, and thus the lessor is not faced with residual value risk.
20.F In a leveraged lease arrangement, the lessors contribute the bulk of the finance for the acquisition of the asset that is to be leased and borrow a small proportion of the total required finance from the debt parties.Essay questionsThe following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.
1. The commercial lending manager at ANZ Bank has a meeting scheduled with a business client. The purpose of the meeting is to review the structure of the loans provided by the bank. In the period following the economic slow-down that occurred after the global financial crisis, the business is concerned about the relationship of its longer-term debt commitments and the cash flows being generated by the business.
(a) Within the context of the economic down-turn, why is the client concerned about the timing of cash flows?
A firm should endeavour to match the maturity structure of its assets with the maturity structure of its sources of funds, being its liabilities and shareholder funds. For long-term projects it is preferable for the repayment schedule associated with debt finance to be aligned with the expected future cash flows generated from the project. A firm also needs to consider the timing of its cash flows at the commencement of a project and throughout the life of the project.
In the event of an economic downturn, the borrower may find that its business contracts and therefore its expected cash flows will decline and may not be enough to cover loan repayments.
A borrower needs to consider a potential worst-case scenario when making a borrowing decision in relation to a project.(b) Discuss with the client the different longer-term loan repayment structures that ANZ Bank offers.
Firm may have a number of choices on how it will structure the repayments, or outward cash flows, on its longer-term liabilities. One alternative is to obtain debt whereby the debt repayment schedule only requires interest payments to be made during the term of the loan, and the repayment of principal is due in full on the maturity of the loan. Another loan repayment schedule may require regular periodic loan instalments to be paid. Each loan instalment will require the payment of interest and part repayment of the principal. With the payment of the final loan instalment the loan will have been fully repaid. This type of loan is said to be an amortised loan, or a credit foncier loan. A further option is for the business to obtain a loan that takes into consideration that it may be some time before the project generates positive cash flows. In this situation it may be preferable to arrange a deferred repayment type of loan. Under such an arrangement, loan instalments will only commence after a specified period, which is determined on the basis of expectations about when the project will generate positive cash flows, with amortisation of the debt to be achieved over the remaining loan term.2. The chief financial officer (CFO) of a corporation has arranged a term loan for the company with the following conditions attached. The loan will have a variable rate of interest of BBSW plus 120 basis points. The loan interest will be reset every six months for the duration of the loan. (a) Explain the operation of these specific loan conditions. A term loan is a loan provided by a bank, or other financial institution, for a specific purpose, over a defined period of time. The amount and period of the loan is specified in the loan contract. A loan with a variable interest rate means that the interest rate charged on the principal amount outstanding will be reset periodically under the terms of the loan contract. A variable rate loan contract will specify a reference interest rate. Various published reference rates are available including BBSW, LIBOR, USCP or an institutions own prime rate.(b) How would the CFO obtain the new interest rate every six months? (LO 10.1) the above loan is using BBSW, the Bank Bill Swap Rate, which is the average mid-point of banks bid and offer rates in the bank bill secondary market
the loan is set at BBSW plus 120 basis points, therefore if BBSW is currently 6.45% per annum then the loan interest rate will be 7.65% per annum
both the borrower and lender are able to find BBSW published electronically daily by Reuters
At the reset date each six months they will look up the relevant Reuters BBSW 6-month money screen to ascertain the new rate
3. When a bank provides a loan to a corporation, the interest rate charged on the loan will depend on the banks analysis of a number of factors, including the credit risk of the borrower, the term of the loan and the repayment schedule. Discuss why these factors will impact the interest rate charged by a bank. (LO 10.1)The credit risk of the borrower
This is the perceived creditworthiness of the borrower
Before granting a loan, a lender will analyse factors such as the total debt-to-equity ratio of the firm, projected cash flows, the financial strength of the borrower, past loan repayment performance, the projected performance of the industry and the economy generally, forecast interest rates, the management of the firm, and the life cycle of the firms products
Each borrower will be perceived to have a different level of credit risk and therefore will pay a different rate of interest on the loan.
The term of the loan
Typically, longer-term loans will attract a higher rate of interest than short-term loans due to the assumed higher risk of a longer-term commitment.
For example, risk factors that affect interest rates include changes in the official interest rate by the central bank and the amount of liquidity in the credit markets. These and other factors affect the cost of funds to the lender and therefore are passed on to the borrower.The repayment schedule
The frequency of loan repayments and the form of repayment may influence the interest rate applied to a loan; for example, the rate for a borrower who has a loan which requires monthly repayments may be different from that of a borrower who makes quarterly loan repayments. Different interest rates may be applied between an amortised loan and an interest-only loan. 4. As the finance manager of a small manufacturing business, you are negotiating a fully drawn advance from the local bank, but the board of directors has indicated concern at the fees being charged by the bank. Explain to the directors the range of fees typically charged, and why the bank charges these fees. (LO 10.1) Establishment feerepresents the costs incurred by the bank in considering the loan application and in the preparation of documentation on approval of the loan
Service feerepresents the ongoing administrative costs incurred by the bank in maintaining the loan account. Service fees are generally charged monthly
Once a loan has been approved, the borrower will be given a short period to draw-down the loan; that is, to take the funds from the bank
A commitment fee will usually be applied by the bank to any portion of the total approved loan amount that is not drawn-down within a specified period, usually paid in arrears
Line feeapplied to the total amount of the facility and is normally payable in advance.5. Westpac Banking Corporation is currently writing a loan contract for a medium-sized pharmaceutical company. Within the loan contract Westpac intends to incorporate a number of positive and negative loan covenants.
(a) What are loan covenants? Loan covenants are specified within a loan contract and typically restrict the business and financial activities and actions of the borrowing firm. Common covenants will require a firm to maintain a minimum level of interest cover; another may restrict the level of debt that a firm may accumulate relative to its equity.(b) Explain why a financial institution would incorporate loan covenants into a loan contract. Loan covenants are designed to protect the exposure of the lender to the borrower. A firm is in technical default on its loan contract if it breaches a loan covenant. The lender then has the right, within the terms specified in the loan contract, to act to protect its exposure. This might involve taking possession of the assets of the company. However, if the company has not defaulted on loan repayments, it is more likely that the term loan may become repayable on demand.(c) Discuss the nature of positive and negative covenants and give two examples of each. (LO 10.1) Protective loan covenants are classified as either positive covenants or negative covenants. A positive covenant states actions that a company must comply with, such as maintaining a minimum level of working capital, or the provision of audited financial statements. A negative loan covenant limits or restricts the business activities or financial structure of the company. For example, there may be a limitation placed on the amount of a dividend that can be paid to shareholders, or a requirement that the bank must approve further long-term borrowings of the company.6. As the owner of a small architectural firm, you approach the Commonwealth Bank to obtain a term loan so that the firm can buy a new computer -aided drawing machine. The bank offers your company a loan of $37000 over a four-year period at a rate of interest of 9.25 per cent per annum, payable at the end of each month. Calculate the monthly loan instalment. (LO 10.1)
where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods
A = $37 000
i = 0.0925 / 12 = 0.007708
n= 4 years x 12 months = 48
7. The architectural firm owner in Question 6 also approaches the National Australia Bank to obtain a quote on the loan facility. The competitor bank (NAB) offers the company a fully drawn advance of $37000 over a four-year period at a rate of interest of 9.25 per cent per annum, payable in advance at the beginning of each month. Calculate the monthly loan instalment. Explain why the instalment payment is different from the instalment in Question 6. (LO 10.1)
where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods
A = $37 000
i = 0.0925 / 12 = 0.007708
n= 4 years x 12 months = 48
In question 6 the series of cash flows occurred at the end of each period; this is an ordinary annuity. In question 7 the loan instalments are payable at the beginning of the period; this is an annuity due. The change in the formulae recognises the change in the timing of the cash flows. The earlier loan instalment repayments at the start of each month mean that the monthly instalment is lower.8. Mr and Mrs Lim have recently married and are in the process of purchasing their first home. They have lodged an application to the Commonwealth Bank for a housing loan. The bank has offered them a mortgage loan. Outline the main features of a mortgage loan. In particular, define a mortgage, explain the purpose and operation of a mortgage loan and identify and describe the parties to a mortgage loan. (LO 10.2) A mortgage is a form of security against which a loan is advanced. Under a mortgage agreement, the borrower (mortgagor) conveys an interest in the land or property to the lender (mortgagee). The mortgage is discharged when the loan is repaid. During the life of the agreement, if the mortgagor fails to meet the terms of the loan, the mortgagee is entitled to take control of the property, and to dispose of it in order to recover its debt due. This is called the right of foreclosure. A mortgage loan is simply a term loan with a specific form of security attached, being the mortgage. Mortgage finance lenders include banks, building societies, life insurance offices, superannuation funds, trustee institutions, finance companies, private individuals, and government and semi-government instrumentalities. There are residential mortgages and commercial mortgages. Residential mortgages (housing loans) typically taken over 30 years in Australia. Commercial mortgages are usually for a period of less than 10 years. Fixed interest and variable interest mortgage loans are available, however a fixed rate loans will typically be reset every two to three years. Mortgage loans are usually amortised (credit foncier) with monthly loan instalments. Mortgage loans for amounts above 80% of the loan-to-valuation-ratio will generally require mortgage insurance.9. As the proprietor of a business, you plan to purchase new business premises costing $975 250. In addition, establishment expenses of 0.60 per cent of the purchase price, plus legal expenses of $7500 are payable. The total cost to purchase the property will be financed by $350 000 of your own funds plus a mortgage loan from your bank at 9.75 per cent per annum. The loan will be amortised by monthly instalments over the next 10 years. What is the amount of each monthly instalment?
Total outlays:
( cost of premises
$975 250
( establishment expenses $5 851
( legal expenses
$7 500
$988 601Funding arrangements:
( own savings
$350 000
( mortgage finance
$638 601
$988 601Formula: R = A
1 - (1 + i)-n
i
where:A = $638 601
i = .008125 (9.75% p.a. / 12 months)
n = 120 (10 years * 12 months)
R = 638 601
1 - (1.008125) -120
0.008125
R = $8 351.00 monthly instalment
10. A corporation listed on the ASX is expanding its business operations into China. In order to expand, the company will need to raise additional funds through the issue of corporate bonds direct to the capital markets. Two securities that are issued into the corporate bond market are debentures and unsecured notes.
(a) Outline the attributes of each of these securities. In your answer, include a discussion on the nature of a fixed and floating charge.
Debentures and unsecured notes are corporate bonds issued into what is often described as the corporate bond market
Debentures and unsecured notes are contracts between the borrower and the lender that specify that the lender will receive regular interest payments during the term of the loan, and receive the face value of the instrument on maturity. A debenture is the form of security attached to the corporate bond. The security takes the form of either a fixed and/or a floating charge over the issuing companys unpledged assets. Unsecured note are corporate bonds issued on an unsecured basis. The ranking of bond holders is as follows:
first: fixed charge debenture holders are entitled to the proceeds of the sale of the assets over which the charge has been placed. If the proceeds from the sale prove to be inadequate to repay the debenture holders in full the outstanding balance ranks equally with unsecured debt holders. second: floating charge debenture holders have no claim over the proceeds from the sale of the pledged assets (until fixed charge debenture holders claims have been satisfied). However, they rank ahead of unsecured creditors in their entitlement to the proceeds of the sale of unpledged assets. third: unsecured note holders have no priority claim over the assets of the company and rank equally with other unsecured creditors. However, note holders may be somewhat protected if a deed limits the company in relation to total secured liabilities relative to total liabilities. Issues to the public require a prospectus. This is time consuming and expensive. Therefore many issuers tend to issue by direct placement with institutional investors, where the prospectus requirements are less stringent. The yield on a debenture will be lower than that on an unsecured note, reflecting the lower risk because of the underlying security and the higher liquidity of debentures listed on the stock exchange.(b) Explain which types of borrowers will have access to funds through the issue of debentures and unsecured notes into the capital markets. (LO 10.3) An issuer of corporate bonds will need to obtain a credit rating on the issue; for example, a corporation may require an investment grade credit rating of BBB or above issued by a credit rating company such as Standard and Poors. Only issuers with a very good rating will be able to issue unsecured notes because of the higher risk associated with this type of paper. Issuers of debentures will generally also require an investment grade credit rating, but the security of the debenture may lower the cost of funds (yield). Issuers of debentures and unsecured notes include finance companies, multi-national corporations and commercial banks.11. The corporate bond market is a significant source of funds for corporations raising finance direct from the capital markets. (a) Describe the structure and operation of the corporate bond market. In your answer explain why corporations seek to raise debt funds direct from the markets, why investors provide debt funds directly to the capital markets and who are the main providers of direct finance in the capital markets.
Direct finance occurs when a borrower issues a financial security into the debt markets in order to raise funds
The corporate bond market includes the issue of debentures, unsecured notes and subordinated debt
Debenturea corporate bond issued with a fixed or floating charge over the assets of the issuer
Unsecured notea corporate bond issued without any form of underlying security attached
Includes both domestic and international capital markets.Why do corporations seek to raise debt funds direct from the markets?
If a corporation can borrow without the need to use a bank then it is able to save the cost of the banks profit margin. Another important reason that a corporation will borrow direct from the markets is to diversify its funding sources. If a corporation obtains debt funds from a number of different sources then it is able to choose the most cost effective sources.Why do investors provide debt funds directly to the market?
By lending direct an investor is accepting the credit risk associated with the ultimate borrower and should receive a higher return for the higher risk. Investors will endeavour to measure the credit risk of a particular debt issuer. One international standard used as a measure of the credit worthiness of a borrower is a credit rating. A credit rating is the rating agencys view of the credit worthiness of a debt issue.Where do direct investment funds come from?
Deregulation of the financial system with the removal of constraints that would otherwise limit the flow of funds around the world, coupled with technology to support the rapid and efficient conduct of financial transactions, has encouraged the development of direct investment markets. Increased investor sophistication and the expectation of higher yields on investments have also drawn a greater pool of investors into the markets, in particular, managed funds.
In many countries there is an ever-increasing pool of accumulated retirement and superannuation savings that are available for investment. In recent years there has been a practice by many governments to limit and reduce their net debt outstanding. This has resulted in an even greater pool of funds available for direct business investment.(b) Commercial banks also issue bonds into the capital markets. Some of these bonds may be described as covered bonds. What are covered bonds issued by commercial banks? (LO 10.3) Covered bonds is the term used to describe a bond issued into the capital markets by commercial banks. Covered bonds are regarded as being less risky as they are supported by an underlying security, being a claim against mortgage securities held by the issuer bank.
If the commercial bank issuer defaulted on bond repayment the holder of the bonds are able to seek repayment of the bonds from the sale of mortgage assets held by the bank.
12. XYZ Limited is a subsidiary of a multinational organisation rated AA+. The company plans to issue debentures to raise additional funds to finance further growth within the company. The investment bank advising the company on the debenture issue has informed the company that it could issue the debentures through a public issue, a family issue or a private placement. Explain each of the three issue methods. Include in your answer a brief discussion on prospectus and information memorandum requirements. (LO 10.3) A debenture is a corporate bond issued with a fixed or floating charge over the assets of the issuer. A public issue occurs when the debenture offer is made to the public at large. A family issue occurs when the debentures are offered to parties associated with the issuer such as parties who are already holders of the companys securities, including share-holders, bond-holders and holders of convertible notes. A private placement occurs when the offer is made only to institutional investors such as funds managers and insurance offices. Corporations law will require that an offer of debentures to the public must be accompanied by a prospectus that has first been registered with the regulator. A prospectus is a formal written offer to sell securities to the public and will provide detailed information on the business, including: financial statements
directors and executive managers
specialist accounting, taxation and legal reports
any material information that may affect the company
strategic business plans and the intended use of the funds gained from the issue.
The prospectus should enable an investor to make an informed decision regarding the investment opportunity. A prospectus is time-consuming to prepare and register, which can be especially costly during periods of volatile interest rates. The time delay could prevent a borrower being able to come to the market with an issue at the most advantageous time. A private placement does not require the preparation of a prospectus; rather the issuer only needs to provide institutional investors with an information memorandum. Institutional investors are more informed than the general public and therefore it is not necessary to provide the full extent of the detail that is incorporated in a prospectus. The information memorandum must include up-to-date financial statements, material changes that may affect the business, and the purpose of the debt issue.13. BHP Billiton Limited has issued $10 million of debentures, with a fixed-interest coupon equal to current interest rates of 8.25 per cent per annum, coupons paid half-yearly and a maturity of seven years.
(a) What amount will BHP Billiton have raised on the initial issue of the debentures?
The amount raised by BHP Billiton on the initial issue of the debentures into the market will be equal to the face value of the debentures; that is, $10 million. This is because current yields on this type of security, at the issue date, are equal to the fixed interest rate paid on the debenture.(b) After two years, yields on identical types of securities have fallen to 7.75 per cent per annum. The existing debenture now has exactly five years to maturity. What is the value, or price, of the existing debenture in the secondary market?
In order to calculate the value, or price, of the existing debentures in the market, it is necessary to determine the present value of the face value, plus the present value of the coupon stream (note: the price is being calculated at a coupon date exactly one year after initial issue).
A = $10 000 000
C = $412 500
n = 5 x 2 = 10
i = .0775 / 2 = 0.03875Present value of the face value:
= A(1 + i)-n
= $10 000 000 (1 + .03875)-10
= $6 837 378.66plus:
Present value of coupon stream:
= C [1 - (1 + i)-n ]
i
= $412 500 [1 - (1 + .03875)-10 ]
.03875
= $3 366 661.43Price of the debenture: = $6 837 378.66 + $3 366 661.43
= $10 204 040.09(c) Explain why the value of the debenture has changed; that is, discuss using the above example the bond price/yield relationship. (LO 10.4) The price of the existing fixed interest security (debenture) has risen because yields in the market have fallen; that is, there is an inverse relationship between interest rate movements and price. The coupon payments on the existing bond are fixed; therefore the higher coupon being paid on the existing bond is worth more to an investor.14. On 1 January 2011 a company issued five-year fixed-interest bonds with a face value of $3 million, paying half-yearly coupons at 9.36 per cent per annum. Coupons are payable on 30 June and 31 December each year until maturity. On 15 August 2012 the holder of the bonds sells at a current yield of 9.84 per cent per annum. Calculate the price at which the investor sold the bond. (LO 10.4)
where k is the fraction of elapsed interest period since the last coupon payment.
Therefore:
i = 0.0984/2 = 0.04920
n = 7 [one coupon due 31.12.12, then 2013(2), 2014 (2) and 2015 (2)]
C = $3 000 000 x 0.0936/2 = $140 400
k = 46 days elapsed in 184 day period = 46/184 = 0.25(a) Present value of face value:
= $3 000 000 (1 + .04920) 7
= $2 143 449.63plus
(b) Present value of coupon stream:
Therefore: (a) + (b) = $2 143 449.63 + $814 767.43
= $2 958 217.06Price (adjusted for elapsed day):
= $2 958 217.06 (1.04920)0.25
= $2 993 950.45Note elapsed days July 31
August 15
46 days elapsed
Note days in the full coupon period = 184Therefore: k = 46 / 184
= 0.2500
15. At GE Finance you are the manager of lease finance. You have begun to talk to local companies to try and sell the concept of lease finance for their businesses.
(a) Explain to the companies the nature of lease finance, and distinguish between operating leases, finance leases, sale and lease-back leases, and cross-border leases.
A lease is a contract whereby the owner of an asset, the lessor, grants to another party, the lessee, the exclusive right to use the asset, usually for an agreed period of time, in return for the payment of rent. The lessor is the owner of an asset that is subject to a lease agreement; receives lease rental payments. The lessee is the user of an asset subject to a lease agreement; makes lease rental payments. Leasing is the borrowing (renting) of an asset instead of the borrowing of funds to purchase the asset.Operating lease:
A short-term arrangement where the lessor may lease the same asset to successive lessees over time in order to earn a return on the asset. The lease arrangements normally contain only minor penalties for cancellation of the lease. This feature leaves the risk of obsolescence of the asset with the lessor. An operating lease is usually a full service lease; that is, the maintenance and insurance of the leased asset is the responsibility of the lessor.Finance lease:
Generally a longer-term arrangement between the lessor and the lessee. The lessor earns a return on the asset from the one lease contract. The lessor's role is essentially one of financing. The lessee contracts to make regular lease rental payments, usually monthly, over the period of the lease, which may be for more than two years. A distinguishing characteristic of the finance lease is that the lessee contracts to make a lump sum payment, representing the residual value of the asset, at the end of the lease period. When the residual payment is made, the ownership of the asset normally passes to the lessee and appears on its balance sheet. A finance lease is usually a net lease; the costs of ownership and operation of the asset are borne by the lessee. These costs include maintenance and repairs, insurance, taxes and stamp duties associated with the lease.Sale and lease-back lease: involves the sale of an asset by its original owner, but the original owner immediately enters into an agreement with the new owner to lease back the asset for an agreed period
has no need to continue funding the asset from the balance sheet
payments are derived from the income earned from leasing the asset.Cross-border lease:
means a lessor in one country leases an asset to a lessee in another country
means there is a need to consider additional factors, including:
how to recover an asset if the lessee should default on the agreement.
foreign exchange risk; that is, cash flows will need to be converted into another currency at the current exchange rate.
the legal jurisdiction that will apply if legal action needs to be taken under the terms of the lease.(b) Provide examples of how a business might use each of these forms of lease arrangement.
Operating lease example: a plumber may lease a mechanical digger for a short-term to install gas pipes in a new residential development. Alternatively, a special events organiser may lease an outdoor sound system for a weekend festival.
Finance lease example: a corporation leases a number of desk top computer systems for (say) two years; or a government department leases a motor vehicle fleet for (say) three years.
Sale and lease-back lease: A government may sell its railway rolling stock to an investment company and then immediately lease the railway stock back to continue operating the railway service.
Cross-border lease: an airline company such as Qantas may lease aircraft from an international finance group, or perhaps lease surplus aircraft from British Airways over the summer tourist season.
(c) List and explain the advantages of lease finance to a business.
Leasing does not involve the use of the company's capital and other unused lines of credit. This allows the company to use its capital to take advantage of other investment opportunities that may arise. Leasing provides 100% financing in that the lessor provides the asset required for use by the company. Other forms of debt funding may require the borrower to contribute a portion of its own funds. Rental payments under the lease agreement may be structured to reflect the cash flows generated by the asset, that is, repayment scheduling may be more flexible under lease agreements than under other forms of debt repayment schedules. Lease rental payments are generally tax-deductible, and so it is important to structure the repayments to match taxable income streams. Existing borrowing covenants in loan and note agreements may allow lease financing while restricting further debt funding. Where the asset that is the subject of the lease is required for only a relatively short term, it may be preferable to lease, rather than to buy and then have to seek to dispose of the asset at the end of the period.(d) From the perspective of a lessor, explain the structure of a direct finance lease versus a leveraged finance lease contract. (LO 10.5) A direct lease involves two parties, the lessor and the lessee. The lessor retains ownership of the asset and may also seek additional guarantees to support the lease contract.
A leveraged lease is an arrangement whereby the lessor borrows to fund the purchase of an asset that is to be leased. Often a lessor partnership is formed for very large ticket items such as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will be responsible for the management of the contract.
Extended learning questions
16. (a) Define the purpose of securitisation.
Securitisation is a form of financing in which the cash flows associated with existing financial assets are used to service funding raised through the issue of asset-backed securities; for example, the securitisation of mortgages involves the pooling of like assets such as registered first mortgages, and then issuing securities that give investors a proportional entitlement to the assets and the income stream that the underlying assets generate.(b) Draw a diagram of a basic securitisation structure.
(c) Use your diagram to explain in detail the securitisation process.
The diagrammatic representation of the securitisation process may be summarised as follows:
Financial assets, for example housing loans, accumulate and are funded on a balance sheet by the loan originator. Assets with comparable maturity and risk structures, including interest rate, liquidity and credit risks, are pooled together and sold into a special-purpose vehicle (SPV) controlled by a trustee. The assets have now moved from the balance sheet of the originator to the balance sheet of the SPV. The trustee issues new negotiable securities to investors to raise funds to finance the purchase of the assets into the SPV. The new securities are attractive to investors because they are supported by the mortgage assets held by the trustee, and by the associated future cash flows, being the periodic interest and principal repayments due from the original housing loan borrowers. To improve the marketability of the new issue, a AA+ credit enhancement may be created by guarantees given by a financial institution and supported by the credit rating issued by a credit rating agency. A service or administration manager will generally be appointed by the trustee to manage the associated cash flows. These are the receipts from repayments due from the original borrowers, and payment of interest and principal due on the asset-backed securities issued by the trustee to investors. The service manager may also provide custodial services for the underlying securities. The trustee may outsource these roles back to the originator. As cash flows are received from the original assets, they are used by the trustee to repay interest and principal due on the asset-backed securities issued to investors.17. Up until mid-2007, the growth in the securitisation of assets in the international capital markets had been enormous.
(a) Identify and discuss at least six reasons why this form of funding had become so attractive.
Increased return on equity: business growth is increased without the need to dilute shareholders' funds
A source of finance when other traditional sources of intermediated and debt finance may not be available
Improved return on assets, particularly where, through the securitisation process, assets with lower credit ratings are upgraded with credit enhancement
Diversify funding sources: asset-backed securities are often attractive to a new range of investors
Reduced credit exposure: the sale of assets may transfer the credit risk associated with the pooled assets to the SPV and ultimate investors
Regulatory advantage: banks in particular are required to maintain minimum capital requirements based, in part, on their balance-sheet assets
Securitisation, where there is no recourse back to the bank, removes assets from the balance sheet and removes the capital cost imposition
Increased balance-sheet liquidity: assets which previously were non-liquid and remained on the balance sheet are converted to cash
Reduced asset concentration: for example, banks tend to provide a large proportion of their asset portfolio in mortgage financesecuritisation allows the bank to divest itself of some of these assets and to give new mortgage finance without increasing its overall mortgage asset concentration
Accelerated income: by divesting assets through securitisation, an institution effectively brings forward returns that would otherwise have progressively occurred over time
Improved financial ratios: return on investment and return on equity may be improved through the process of securitisation.
(b) What occurred after mid-2007 to slow down growth significantly in the securitisation market? (LO 10.6) The initial event that occurred that had a negative impact on the securitisation market was the sub-prime crisis in the USA. Large amounts of mortgage loans in the USA had been securitised into the international financial markets. Significant increases in loan default rates caused the failure of some financial institutions and diminished confidence in the market. The mortgage loan problems extended to other countries, in particular, the UK, further impacting the securitisation market. The sub-prime crisis evolved into a credit crisis within the financial system and ultimately led to a major global economic downturn. In an economic downturn it is expected that default rates on loans will increase which also reduced any remaining confidence in the securitisation market. The global financial crisis was further compounded by a massive increase in sovereign debt, particularly in the USA, the Euro-zone and the UK. As the sovereign debt crisis worsened, investors withdrew further from the bond markets, including securitised assets.(c) Do you think the market will recover? Why?
Once global economic growth and international financial market credit conditions return to normal it is expected that confidence will slowly return to the securitisation market. However, it is also expected that the risk structure of future securitised issues will change; that is, investors will seek greater protection from default losses.Financial intermediary
Special purpose vehicle (trustee)
Investors
Service manager
Credit enhancer
Sell loan assets
Receive funds
Issue securities
Receive funds
Cash flows from loan asset repayments
Cash flows to investors in asset-backed securities
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