Long-Term Debt Sources of Financing

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

Long-Term Debt Sources of Financing

Interest rate levelsTypes of long-term debtRisks of long-term debtDebt valuation

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Capital Financing Basics

Businesses need capital to acquire the assets needed to provide services.

Capital comes in two basic forms:Debt capital (loans, bonds, debentures) -- liability sources of capitalEquity capital (stock, retained earnings) -- non-liability sources of

capital

HSO utilization of debt and equity capital

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Common Long-Term Debt Instruments

Term loans (3-15 year maturities)Amortized interest/principal paymentsLender as financial intermediary (bank)Advantages: speed, flexibility, low cost

Bonds (10-30 year maturities)Bond issuesMultiple creditors/investors per issuePublic vs. private placement of bond issues

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Types of BondsCorporate Bonds

• Investor-owned organizational debt issue• Longer maturity debt (10-30 years)• Fixed vs. variable interest rates• Payment of interest and principal

Mortgage Bonds• Corporate debt issues backed by pledge of organizational assets• Primary vs. secondary mortgage issues

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Types of BondsCorporate Debentures

• Corporate debt backed by revenue-generating capacity of organization (no fixed assets)• Higher cost form of corporate debt than MB’s• Rationale for use

Subordinated Debentures• “Junk” or below investment grade debt issues• High-risk, high-cost corporate debt• Rationale for use

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Types of BondsMunicipal Bonds (“Munis”)

• Debt issues from non-federal governmental entities and/or their representative organizations

• Types of munis -- general obligation munis, special tax bonds, revenue bonds (NFP’s)• Fixed interest, longer-term maturities• “Serial issue” municipal bonds• Tax exemption of municipal bond interest• Public vs. private placement of munis

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Debt Contract Provisions

Bond indenturesGeneral provisions

• Maturity of bonds• Interest rate (coupon rate)

Restrictive covenants (creditor obligations of borrower)Trustee (bond fiduciary)

Call provisions -- advantages and disadvantages to issuer/borrowers

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Bond Ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Rating agencies assign bond ratings that reflect the probability of default:

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Bond Rating Concepts

Bond rating criteriaIssuer’s financial conditionCompetitive situationQuality of management

Importance of ratingsTo investors/creditorsTo issuers (cost of capital)

Changes in ratings (factors affecting)

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Credit Enhancement

Credit enhancement (bond insurance) is available on municipal bonds.

Insured bonds have the rating of the insurer (AAA), not the issuer.

Issuers must pay an up-front fee to obtain bond insurance. (50-75 basis points based on total debt service)

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Interest Rate Components

Interest as opportunity cost of debtThe interest rate on any debt security

can be thought of a base rate plus one or more components.

Here is the model:

Rate = RRF + IP + DRP + LP + PRP + CRP.

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Here:

RRF = Real risk-free rate.

IP = Inflation premium.

DRP = Default risk premium.

LP = Liquidity premium.

PRP = Price risk premium.

CRP = Call risk premium.

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Interest Rate Example 1

1-Year Treasury Security RRF = 2%; IP = 3%:

Rate = RRF + IP + DRP + LP + PRP + CRP = 2% + 3% + 0 + 0 + 0 + 0 = 5%.

Why are there zeros for DRP, LP, PRP, and CRP?

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Interest Rate Example 2

30-Year Columbia/HCA Callable BondRRF = 2%; IP = 4%; DRP, LP, PRP = 1%;CRP = 0.4%:

Rate = RRF + IP + DRP + LP + PRP + CRP = 2% + 4% + 1% + 1% + 1% + 0.4% = 9.4%.

Callable vs. non-callable rates of interest

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The Term Structure of Interest Rates

Term structure is the relationship between interest rates and debt maturities. (years to maturity)

Thus, term structure tells us the relationship between short-term and long-term rates.

A graph of the term structure is called the yield curve.

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Treasury Yield Curve (July 1998)

0

5

6

7

10 20 30Years to Maturity

InterestRate (%) 1 yr. 5.3%

5 yr. 5.410 yr. 5.520 yr. 5.630 yr. 5.7

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Bond Yield Curves

What does a bond yield represent?YTM (bond yield to maturity) -- (1)

coupon rate/yield for bonds that sell at par value (new issues, mature issues); (2) coupon rate/yield for bonds plus or minus capital gain/loss for bonds that sell below or above par value (outstanding bond issues)

Normal vs. inverted yield curves

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Debt Valuation

Why should healthcare managers worry about debt valuation?Managers must understand how

investors make resource allocation decisions.

Cost of financing is important to good capital investment decisions.

Debt valuation concepts are used to value other assets.

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General Valuation Model

The financial value of any asset stems from the cash flows that the asset is expected to produce.

Thus, all assets are valued in the same way:Estimate the expected cash flows.Set the required rate of return/discount rateDiscount the cash flows.Sum the present values.

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General Valuation Model (Cont.)

0 1 2 NR(R)

CF1 CFNCF2

...

PV CF1

PV CF2

PV CFN

Value

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Bond Definitions

1. Par value: Stated face value of the bond. Generally the amount borrowed and repaid at maturity. Often $1,000 or $5,000.

2. Coupon rate: Stated interest rate on the bond. Multiply by par value to get dollar coupon payment. Usually fixed.

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3. Maturity date: Date when the bond will be repaid. Note that the effective maturity of a bond declines each year after issue.

4. New versus outstanding bonds: When a bond is issued, its coupon rate reflects current conditions. When conditions change, bond values change.

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5. Debt service requirements: Issuers are concerned with their total debt service payments, including both interest expense and repayment of principal. Many municipal bond issues (serial issues) are structured so that debt service requirements are roughly constant over time.

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What’s the value of a 15-year, 10% coupon bond if R(R) = 10%?

100 100

0 1 2 1510%

100 + 1,000

...

$ 760.61 239.39

$1,000.00

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15 10 -100 -1000N I/YR PV PMT FV

1000

The bond consists of a 15-year, 10% annuity of $100 per year plus a $1,000 lump sum at t = 15:

$ 760.61 239.39

$1,000.00

PV annuity PV maturity value PV annuity

===

INPUTS

OUTPUT

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14 10 -100 -1000N I/YR PV PMT FV

1000

If interest rates (the required rate of return on the bond) stay constant, the bond’s value remains at $1,000.

What’s the value after one year if interest rates remain constant?

INPUTS

OUTPUT

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14 5 -100 -1000N I/YR PV PMT FV

1494.93

When R(R) falls, a bond’s value increases. Now the bond sells above its par value, or at a premium. (logic?)

Now suppose interest rates fell, so that R(R) is now only 5 percent.

INPUTS

OUTPUT

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What would happen if interest rates rise, and R(R) is now 15 percent?

14 15 -100 -1000N I/YR PV PMT FV

713.78

INPUTS

OUTPUT

When R(R) rises, a bond’s value decreases. Now the bond sells below its par value, or at a discount. (logic?)

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Assume the bond has 14 years to maturity. What would happen to bond values over time if interest rates remained at the levels given: 5 percent, 10 percent, and 15 percent?

Remember that the bond has a 10 percent coupon rate.

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M

Bond Value ($)

Years to Maturity

1,495

1,216

1,000

832

714

14 10 5 0

R(R) = 5%.

R(R) = 15%.

R(R) = 10%.

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At maturity, the value of any bond must equal its par value.

The value of a premium bond will decrease to par value at maturity.

The value of a discount bond will increase to par value at maturity.

A par bond value will remain at par if interest rates remain constant.

The return in each year consists of an interest payment and a price change.

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Capitalgains yield

Definitions

Current yield =

Capital gains yield =

= +

Annual interest payment . price

Change in price .Beginning price

Totalreturn

Current yield .

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Find the current yield, capital gains yield, and total return during Year 1 when the interest rate falls to 5%.

Current yield = = 0.100 = 10.00%. $100 $1,000

Capital gains = = 0.495 = 49.5%.

Total return = 10.0% + 49.5% = 59.5%.

$495 $1,000

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Repeat the calculation,but this time for Year 2.

Current yield = = 0.670 = 6.70%. $100 $1,495

Capital gain = = -0.170 = -1.70%.

Total return = 6.7% - 1.7% = 5.0%.

-$25 $1,495

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Yield to Maturity

The yield to maturity (YTM) on a bond is the expected rate of return assuming the bond is held to maturity. (reported bond yields)

Mathematically, it is the discount rate that forces the present value of the cash flows from the bond to equal the bond’s price.

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What’s the YTM on a 14-year, 10% annual coupon, $1,000 par value bond

that sells for $1,494.93?

100 100 100

0 1 9 10YTM = ?

1,000PV1 . .PV9

PV10

PVM$1,495 Find the discount rate that “works”!

...

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Using a Financial Calculator for YTM

INPUTS

OUTPUT

14 1494.93 -100 -1000N I/YR PV PMT FV

5.00

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Find YTM if price were $713.78.

INPUTS

OUTPUT

14 713.78 -100 -1000N I/YR PV PMT FV

15.0

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Bonds Actually HaveSemiannual Coupons

Therefore, there are twice as many interest payments compared to annual coupon payments.

But, the interest payment is only half of the annual payment.

And, the required rate of return (discount rate) is only half of the annual rate.

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2x14 5 / 2 100 / 2 28 2.5 -50 -1000

N I/YR PV PMT FV 1499.12

Find the value of a 14-year, 10%coupon, semiannual bond if the

required rate of return is 5 percent.

INPUTS

OUTPUT

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2x14 100 / 2 28 1400 -50 -1000

N I/YR PV PMT FV2.90

Find the YTM of a 14-year, 10%coupon, semiannual bond if the

bond is selling for $1,400.

INPUTS

OUTPUT

Thus, the annual YTM = 2 x 2.90% = 5.80%.

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Interest Rate Risk

Interest rates change constantly, which gives rise to two types of interest rate risk.

Price risk arises because bond values decline when interest rates rise.

Reinvestment rate risk arises because reinvested coupon (and principal) payments earn less when interest rates fall.

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Does a 1-year or 10-year 10 percent bond have more price risk?

R(R) 1-year Change 10-year Change

5% $1,048 $1,386

10% 1,000+4.8%

-4.4%1,000

+38.6%

-25.1%15% 956 749

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0

$500

$1,000

$1,500

0% 5% 10% 15%

1-year

10-year

R(R)

Value

.

..

. ..

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Does a 1-year or 10-year bond have more reinvestment rate risk?

Reinvestment rate risk depends both on the bond’s maturity and the investor’s holding period.

In general, the shorter the maturity, the greater the reinvestment rate risk.

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Long-term bonds have high price risk but low reinvestment rate risk.

Short-term bonds have low price risk but high reinvestment rate risk.

Nothing is riskless! However, risk can be minimized by matching the maturity of the bond to the holding period.

How can interest rate riskbe minimized?

Long-Term Debt Sources of Financing

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