1. Corporate Bonds,
Preferred Stock,
and Leasing
1

2. Learning Objectives
 Bond contract terms
 Differences among types of bonds
 Features of preferred stock
 Lease versus purchase
 Balance sheet treatment of leases
2

3. Bond Basics
 Bondholders are lending the corporation
funds for some stated period of time.
 The corporation promises to make certain
payments to the owner of the bond.
3

4. Bond Basics
 Indenture
 Definition: the contract between the
corporation and the investor
 Provisions included in the indenture:
 par value
 coupon rate and payment dates
 maturity date
 any special features
4

5. Bond Basics
 Par Value
 (e.g. $1,000) also called Face Value
 Coupon Interest Rate
 The stated rate of interest. The rate that is
multiplied by the par value to determine the
annual dollar interest paid.
 Maturity
 Time at which the original principal (Par
Value) is repaid to the bondholder.
5

6. Special Features of Bond Indentures
 Collateral
 If the debt is secured by specific assets, the
lender is entitled to take the assets in the
event of default.
 Plan for repayment at maturity
 Staggered maturities makes it easier for the
firm to raise the necessary funds. Sinking
funds allow the firm to set aside the funds
over time to ensure the ability to repay the
loan.
6

7. Special Features of Bond Indentures
 Provisions for early repayment
 Call provisions allow the issuer to refinance
the debt, usually done if interest rates fall.
 Issuing new bonds to replace old bonds is
known as refunding.
7

8. Call example
 Original issue: 12% coupon
 Coupon currently required for similar risk bonds:
10% coupon
 Refinancing will save $20 per year on each
$1,000 bond.
 Interest savings offset by the expenses of
calling the original issue and issuing the new
bonds. In addition, the call price the issuer must
pay is usually greater than the face value.
8

9. Special Features of Bond Indentures
 Restrictions on company operations that are
designed to reduce risk to bondholders.
 Restrictions on additional debt
 Restrictions on payment of dividends
 Minimum working capital required
 Name of independent trustee to oversee the
bond issue
9

10. Bond Ratings
 Moody’s and Standard & Poor’s regularly monitor
issuer’s financial condition and assign a rating to the
debt
Link to Standard and Poor’s Rating Services
Link to Moody’s Investor Services
10

11. Bond Ratings
 Moody’s and Standard & Poor’s regularly monitor
issuer’s financial condition and assign a rating to the
debt
AAA Best Quality
Investment AA High Quality
Grade A Upper Medium Grade
BBB Medium Grade
BB Speculative
Below B Very Speculative
Investment CCC Very Very Speculative
Grade CC
(Junk) C No Interest Being Paid
D Currently in Default
11

12. Types of Bonds
 Debenture
 Subordinated Debenture
Link to Investing In Bonds
Link to 10K Wizard
12

13. Types of Bonds
 Debenture
 Subordinated Debenture
A debenture is an unsecured bond.
A subordinated debenture is a
debenture that has lower priority for
payment than other debentures
designated as senior.
13

14. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
A mortgage bond is secured by real
assets such as airplanes, railroad cars,
or real estate.
14

15. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
A convertible bond is a bond that gives the
investor the right to convert the bond into a
given number of shares of stock on or after
a given future date.
The conversion ratio is the number of shares
the investor will get for each bond converted.
15

16. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
The conversion value is the market price per
share times the conversion ratio.
e.g. If the stock price = $20 and the conversion
ratio = 45, the conversion value = $20 x 45 = $900.
16

17. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
 Variable Rate Bond
A variable rate bond pays investors interest that
is adjusted according to an established time
table and a market rate index.
e.g. Coupon rate is LIBOR + 300 basis points
17

18. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
 Variable Rate Bond
 Putable Bond
A putable bond can be cashed in
before maturity at the option of
the bond’s owner.
18

19. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
 Variable Rate Bond
 Putable Bond
 Junk Bond
A junk bond is a bond that is rated below
investment grade.
19

20. Types of Bonds
 Debenture
 Subordinated Debenture
 Mortgage Bond
 Convertible Bond
 Variable Rate Bond
 Putable Bond
 Junk Bond
 International Bond
International bonds are bonds that
are sold in countries other than
where the issuer is domiciled.
20

21. Bond Risk Hierarchy
More Common Stock
Risk Preferred Stock
Subordinated Debentures
Senior Debentures
2nd Mortgage Bonds
1st Mortgage Bonds
Less
Risk
Higher Priority of Claim Lower
21

22. Features of Preferred Stock
 A hybrid security with both debt and equity
characteristics.
 Has priority over common stock in receipt of
dividends and in liquidation.
 Dividends are fixed as a percentage of par
value.
 Only participating preferred stock (which is rare)
shares in the residual income with the common
stockholders.
22

23. Investors in Preferred Stock
 Corporations can generally exclude from
taxable income 70% of dividend income
received on preferred stock issued by another
corporation.
 e.g. Company X owns Company Y preferred
stock that pays 12% dividends. If Company
X’s marginal tax rate = 40%, the after tax
yield on this investment
AT yield = 12%[1-(.3x.4)] = 10.56%
 Compare to 12% on fully taxable investment:
AT yield = 12%(1-.4) = 7.2%
23

24. Leasing
 A lease is a contractual arrangement where
a party who needs an asset (lessee)
contracts with another party who owns the
asset (lessor) to use that asset for a specified
period of time, without conveyance of title.
 A long-term non-cancelable lease contract is
very similar financially to a debt obligation
from the perspective of the lessee.
24

25. Benefits of Leasing to the Lessee
 Flexibility and convenience
 Few restrictions
 Avoid the risk of obsolescence
 100 percent financing
 Tax savings
 Ease of obtaining credit
25

26. Genuine Leases Versus Shams
 Lease payments are fully deductible to businesses
but only interest portions of debt payments are
deductible.
 The IRS strictly examines lease arrangements to
ensure that they are genuine lease agreements and
not installment sales in disguise.
26

27. Operating and Capital Leases
 An operating lease has a term that is
substantially shorter than the useful life of the
asset and is cancelable by the lessee (e.g.
car rental for a business trip).
 A capital lease is long term and non-
cancelable. The economic value is mostly
depleted by the end of the lease (e.g. a ten
year lease of a truck.)
27

28. Accounting Treatment of Leases
 Both operating and capital leases appear on
the income statement.
 Payments on leases are tax-deductible
expenses.
 Capital leases also appear on the balance
sheet because they are the functional
equivalent of a purchase financed with debt.
28

29. Accounting Treatment of Leases
 A lease is classified as capital if any of the following
conditions is met:
 Lessee becomes owner at end of lease
 Lessee has option to buy the asset at a bargain
price at the end of lease
 Lease period > 75% of useful life
 PV of lease payments > 90% of market value at
time of lease origination (using the lesser of the
lessee’s cost of debt or the lessor’s rate of return
on the lease)
29