Topic 9 Cap Structure Design: Covenants maturity callability and loans

Question 1

Public vs Private Bonds

Answer 1

Publics sold to many investors and hard to renegotiate
Private is so to a small group qualified under rule 144A and does not trade publically

Question 2

5 characteristics Identified in Debt Indenture

Answer 2

A long contract covering Covenants, maturity, collateral description, seniority, and callability

Question 3

2 broad types of covenants

Answer 3

1) Restriction of financing activities and dividends
-restrict the availability of cash to the firm
2)Restriction of investment or restructuring
-mergers, change of control, asset sales

Question 4

How do covenants help D/E conflicts

Answer 4

Risk Shifting -> Covenants create obstacles for managers to undertake risky projects
Debt overhang-> Cov limits the amount of debt or increases cash on hand through dividend caps * however can also cause debt overhang through restrictions on investment

Question 5

Maturity Matching

Answer 5

Firms should match the maturity of the debt with the maturity of the assets
-benefits such that revenues from those assets match the expense of debt over time

Question 6

Risks of not matching

Answer 6

if you borrow for shorter than the life of the assets
-refinancing risk of higher costs in the future or losing the ability to refinance
if longer
-where do you reinvest cash at the end of the asset life and at what return
thus reinvestment risk

Question 7

Short-term debt signal

Answer 7

short term debt can be a signal in the presence of information asymmetry that the project is good because it shows refinancing risk to managers
*Short term also good to address the debt overhang

Question 8

4 ways to Retire Existing Debt

Answer 8

1) Repurchases -repurchase bonds at MP
2) Call -firm announces that it will pay down debt to the investor at a price slightly above par
3) Make-whole call -> firm buys back bonds at par plus a premium
4) The firm offers to buy a specific number of bonds at a specified price, generally at a slight premium

Question 9

Advantage/Disadvantage to the firm with callable debt

Answer 9

adv-replace with new debt at different terms
disadv- higher debt cost than noncallable debt

Question 10

2 reasons firms call their debt

Answer 10

1) interest cost
-gets rid of coupon payments and decreases the offering yield
2)Debt Maturity
-Inv grade firms replace debt with similar maturity
-Spec-grade firms replace retiring debt with debt of longer maturity to reduce refinancing risk

Question 11

2 ways Bank loans are special

Answer 11

1) banks are good at finding and analyzing information
2) Banks get the “delegated monitor role” where they can process and analyze information better than individual parties