Debt FinancingDebt Financing

IllustrationsIllustrations A company needs Rs 5,00,000 for

construction of a new plant . The following three financial plans are feasible:

i. The company may issue 50,000 ordinary shares at Rs 10 per share.

ii. The company may issue 25,000 ordinary shares at Rs 10 per share and 2500 debentures of Rs 100 denominations bearing 8% interest.

iii. The company may issue 5000 debentures of Rs 100 denominations bearing 8% interest.

The company ‘s EBIT is Rs 1,00,000. what are the EPS under each of the three financial plans. Assume a corporate tax rate of 50%.

Illustrations Illustrations A company has assets of Rs 10,00,000

financed wholly by equity share capital . There are 1,00,000 shares outstanding with a book value of Rs 10 per share. Last year’s profit before tax was Rs 2,50,000. the tax rate is 35%. The company is thinking of an expansion plan that will cost 10,00,000. the financial manager considers the three financing plans

i. Selling 1,00,000 shares at Rs 10 per shareii. Borrowing Rs 10,00,000 at an interest rate

of 14%iii. Selling Rs 10,00,000 of preference shares

with a dividend rate of 14%.

Introduction Debt market is many times bigger in most

developed countries than other financial markets

The US bond market is the largest securities market with a size of $13.5 trillion and a daily turnover exceeding $500 billion.

Size of world debt market is close to US $ 31.4 trillion which is nearly equal to total GDP of all countries.

Size of Indian debt market is $100 billion and accounts for 30% of the GDP.

It is the third largest debt market in Asia followed by Japan and Korea.

Indian Debt Market Traditionally a wholesale market with

participation restricted to few institutional players- mainly banks

Market was generally underdeveloped due to administered interest rate regime and availability of investment avenues giving higher rate of return.

Presently a fairly developed debt market has emerged comprising of:

i. Private corporate debt marketii. Public sector undertaking bond marketiii. Government securities market

Reserve bank of India regulates the government securities market and money market while corporate debt market managed by SEBI.

Money market is a market for short term debt instrument and debt market is a market for long term debt instruments

Characteristics for efficient debt market Competitive market structure Low transaction cost Strong and safe market infrastructure High level of heterogeneity among market participants.

Participants in the debt market

Major participants in the debt market are Central and state governmentPrimary dealersPublic sector undertakingsCorporatesBanksMutual fundsForeign institutional investorsProvident fundsCharitable institutions and trust

Primary and Secondary debt market

New issues are floated either through prospectus, rights or private placement

Debt instruments are traded on OTCEI, BSE and WDM segment of NSE.

Instruments traded in the market include govt. securities, T- bills, bonds issued by PSUs, floating rate bonds, zero coupon bonds, index bonds, commercial paper, certificates of deposit, corporate debentures, state government loans, SLR and Non SLR bonds issued by financial institutions and local bodies and securitised debt.

Brokers, trading members and participants are involved in the NSE WDM segment

Measures to promote corporate debt market

Interest rate ceiling on corporate debt has been removed

Ceiling of bank investment in corporate debt has been removed.

FII has been permitted to participate in the corporate debt market

All debt instruments irrespective of their maturities are required to be rated by credit rating agency.

Provident fund has been allowed to invest in bonds rated by at least two rating agencies

Depositories have been set up to facilitate dematerialization and safe settlement of instruments.

Public Sector Undertaking Bond Market

These bonds are medium and long term obligations issued by Public sector undertakings

Majority of PSU bonds are privately placed with banks or large investors.

They generally issue tax free and taxable bonds

Government Securities Market

Government securities are called as Gilt edged securities

It is the largest market in any economy and therefore is a benchmark for other markets.

Govt. securities are issued by the central government, state government, and semi- government authorities.

Investors can be categorized into three segments

1. Wholesale market segment2. Middle segment3. Retail segment There are two types of securities- treasury bills and

government dated securities. Govt securities are issued either through auction,

sale or private placement with the RBI.

Secondary Market in Govt. Securities It can be categorized into wholesale

institutional segment and retail segment Securities are traded in SGL form in market

lots of Rs 5 crore It is wholesale in nature with most deals

negotiated over the phone. Wholesale segment consists of banks, PD,

mutual fund, insurance, others Retail segment includes cooperative banks, PF,

NBFCs and others Securities are traded in lots of Rs 1 crore NSE offers trading on NEAT

Debentures

Debenture/bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay it in future under clearly

defined terms.

It is also defined as an acknowledgement of debt, given under the seal of company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest

at fixed rate percentage until the principal sum is repaid, and it may or may not give the charge on the asset of the company as security of the loan.

Attributes

Trust indenture: it is a complex and lengthy legal document stating the conditions under which a bond has been issued.

It provides the specific terms of agreement such as description of debenture, rights of debenture holder, rights of the issuing company and responsibilities of the trustees.

Trustees is a bank or financial institution that acts as a third party to the bond to ensure that the issue does not default on its contractual responsibilities to the bond holders.

Interest: the debenture carries a fixed rate of interest, payment of which is legally binding

Maturity: It indicates the length of time for redemption

Debenture redemption reserve: It is a requirement in the debenture indenture to provide for systematic retirement of debenture on maturity.

Call and put provision: the call/buyback provides an option to the issuing company to redeem the debenture at a specified price before maturity. The put option is the right to the debenture holder to seek redemption at a specified time at a predetermined price.

Security

Convertibility

Credit rating

Claim on income and assets

Types of Debenture Bearer debenture: Registered debentures Perpetual or irredeemable debentures Redeemable debentures Debentures issued as collateral security

for a loan. Secured debentures Unsecured debentures Convertible and non convertible

debentures Floating rate debenture

Advantages of debentures Trading on equity i.e. fixed cost capital help in

increase in profit available for equity shareholders.

The debenture holders have no right to participate and vote in the shareholders meeting.

The company can adjust its debt-equity ratio according to its financial plan just by redemption of debenture or raising of finance. This much ease is not available with equity capital.

Interest payable on debenture is tax deductible making it a cheaper source of finance.

At the time of winding up debentures are serviced before share capital

Debentures are generally secured on assets of the company and therefore carry lesser risk and assured return on investment.

Drawbacks of debentures It is obligatory on the part of the company to pay

interest at regular intervals and repayment of principal on scheduled dates.

The debenture trust deed will contain restrictive covenants which may not be favourable to management control or equity shareholders.

Debentures usually have fixed maturity date. Because of the fixed maturity date provision must be made for repayment of the cost.

There is a limit to which fund can be raised through debt.

Since long term debt is a commitment for long period, it involves risk

Innovative debt InstrumentsInnovative debt Instruments

Zero Interest BondZero Interest Bond- They do not carry any explicit rate of interest- They are sold at a discount from their maturity value- The difference between face value of the bond and the

acquisition cost is the gain.

Deep Discount bond- It is issued at a deep/steep discount at its face value- It appreciates to its face value during the maturity

period

IDBI in 1992 had come up with a deep discount bond of face value Rs 1,00,000 at a deep discount price of Rs 2,700 with a maturity period of 25 years. If the investors hold it for 25 years the annualized return comes out to be 15.54%. The investor had the option to withdraw at the end of every five years with a specified maturity and face value ranging between Rs 5,700 (after 5 years) and Rs 50,000 after 20 years, the implicit annual rate of interest being 16.12 and 15.71 respectively

Equity Warrants with NCD Equity warrant is a piece of paper attached to a non

convertible debenture which gives the buyer or holder right to apply for and acquire an equity share at a future date.

The benefits to the corporate are- It increases the marketability of debentures.- The opportunity of receiving equity shares at a future date

is a great attraction for investors particularly for blue chip companies.

- Provides an effective tool for long term planning of capital structures to minimize cost of capital.

Benefits to investors- Assured rate of interest over the life of the debenture- Equity shares of the company can be acquired.

Secured premium notes- It is a secured debenture redeemable at premium

over the face value/ purchase price- There is a lock in period during which no interest is

paid- The redemption is made in installment

Junk Bonds- They are corporate bonds with low credit rating- They are traded in dealer market.- Institutional investors hold largest share of junk

bond.- Firms with low credit rating are ready to pay 3-4%

more for junk bonds to compensate for the greater risk.

- They are widely used as a source in takeover and leveraged buyout.