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Part 7 Debt Financing

CHAPTER

24

The Many Different Kinds of Debt

I

n Chapters 17 and 18 we discussed how much a company

should borrow. But companies also need to think about

what type of debt to issue. They can choose to issue short-or

long-term debt, straight or convertible bonds; they can issue

in the United States or in the international debt market; and

they can either sell the debt publicly or place it privately with

a few large investors.

As a financial manager, you need to choose the type of

debt that makes sense for your company. For example, if

a firm has only a temporary need for funds, it will generally

issue short-term debt. Firms with a substantial overseas busi-

ness may prefer to issue foreign currency debt. Sometimes

competition between lenders opens a window of opportu-

nity in a particular sector of the debt market. The effect may

be only a few basis points reduction in yield, but on a large

issue that can translate into savings of several million dollars.

Remember the saying, “A million dollars here and a million

there—pretty soon it begins to add up to real money.”^1

Figure 24.1 provides a road map through this chapter.

Our initial focus is on the long-term bond market. In Sec-

tion 24-1 we concentrate on the more standard bonds. We

examine the differences between senior and junior bonds and

between secured and unsecured bonds, including a special

kind of secured bond called an asset-backed security. We

describe how bonds may be repaid by means of a sinking

fund and how the borrower or the lender may have an option

for early repayment. As we review these different features of

corporate debt, we try to explain why sinking funds, repay-

ment options, and the like exist. They are not simply matters

of custom or neutral mutations; there are generally good rea-

sons for their use.

In Section 24-2 we look at some less common bonds,

starting with convertible bonds and their close relative,

the package of bonds and warrants. We also illustrate

the enormous variety of bond designs by looking at a few

unusual bonds and at some of the motives for innovation in

the bond market.

In Section 24-3 we turn to shorter-term debt, much of

which is supplied by banks. Often companies arrange a

revolving line of credit with a bank that allows them to borrow

up to an agreed amount whenever they need financing. This

is often intended to tide the firm over when it has a temporary

shortage of cash and is therefore repaid in only a few months.

However, banks also make term loans that sometimes extend

for five years or more. Some loans are too large to be made

by a single bank. We describe how such loans are syndicated

among a group of banks. We also look at how banks protect

their loans by imposing restrictions on the borrower and by

requiring security.

Rather than borrowing from a bank, large blue-chip com-

panies sometimes bypass the banking system and issue their

own short-term debt to investors. This is called commercial

paper. Somewhat longer-term loans that are marketed on a

regular basis are known as medium-term notes. We discuss

both in turn in Section 24-4.

In the Appendix to the chapter, we look at another form

of private placement known as project finance. This is the

glamorous part of the debt market. The words project

finance conjure up images of multimillion-dollar loans to

finance huge ventures in exotic parts of the world. You’ll

find there’s something to the popular image, but it’s not the

whole story.

(^1) The remark was made by the late Senator Everett Dirksen. However, he was talking billions.