14: Long-Term Debt and Leasing14 -1a THE CHOICE BETWEEN PUBLIC AND PRIVATE DEBT ISSUES
Once a company’s managers decide to employ long-term debt financing, they face a series of practical
choices regarding how to structure the debt. The first decision managers make is whether to issue public
or private debt. Public long-term debt offerings involve selling securities (bonds and notes) directly to
investors, usually with the help of investment bankers. Companies must register these offerings with the
Australian Securities and Investments Commission (ASIC). Most long-term corporate bond offerings
take the form of secured bonds, and the majority of Australian public debt offerings are fixed-rate offerings,
meaning they have a coupon interest rate that remains constant.
Private debt issues usually take one of two forms. Loans are private debt agreements arranged between
corporate borrowers and financial institutions, especially commercial banks, whereas private placements
are unregistered security offerings sold directly to accredited investors. The best-known and most common
form of loan is a term loan arranged between a borrower and a single bank. However, very large volume
funding is raised via syndicated loans that are arranged for a single borrower but funded by multiple
banks because no single bank is willing and able to supply the full volume of lending. The overwhelming
majority of both term loans and syndicated loans extended are floating-rate issues, where the loan is priced
at a fixed spread above a base interest rate, such as the Australian Bank Bill Swap Rate (BBSW), the
London Interbank Offered Rate (LIBOR) or the US bank prime rate. The interest rate paid by issuers of
floating-rate debt thus moves as the base interest rate changes.14 -1b LOAN COVENANTS
Most debt agreements include certain loan covenants. These are contractual clauses that place specific
operating and financial constraints on the borrower. Loan covenants typically remain in force for the life
of the debt agreement, but do not normally place a burden on a financially sound business. Covenants
allow the lender to monitor and control the borrower’s activities to protect itself against the agency
problem created by the differing objectives of owners and lenders. Without these provisions, the borrower
could take advantage of the lender by investing in riskier projects or by distributing cash to shareholders
without compensating lenders with a higher interest rate on their loans.
There are two types of covenants. Positive covenants require the borrower to take a specific action,
and negative covenants prohibit certain actions.Positive Covenants
Positive covenants specify things that a borrower must do. Some of the most common positive covenants
include the following:1 The borrower must maintain satisfactory accounting records in accordance with the standard
accounting requirements of the country (such as the Australian International Financial Reporting
Standards).2 The borrower must supply audited financial statements.
3 The borrower must pay taxes and other liabilities when due.
4 The borrower must maintain all facilities in good working order.
5 The borrower must maintain a minimum level of net working capital. Inadequate liquidity is a
common precursor to default.fixed-rate offerings
Debt issues that have a
coupon interest rate that
remains constant throughout
the issue’s life
loans
Private debt agreements
arranged between corporate
borrowers and financial
institutions, especially
commercial banks
private placements
Unregistered security
offerings sold directly to
accredited investors
floating-rate issues
Debt issues with an interest
(coupon) rate that is a fixed
spread above a base rate that
periodically changes
loan covenants
Contractual clauses that
place specific operating and
financial constraints on the
borrowerLO 14.1
Annette Poulsen, University
of Georgia
‘The covenant is the
promise about what the
corporation is going to
do or not do.’
See the entire interview on
the CourseMate website.Source: Cengage LearningCOURSEMATE
SMART VIDEO