7.4 Secured Loans with Bonds, Notes and Mortgages
Secured lending involves a contract between a borrower and lender, where the lender can be an individual, a financial institution or a trust organization. Notes and mortgages represent formal contracts between financial institutions and owners. Usually, repayment amounts and timing are specified in the loan agreement. Public facilities are often financed by bond issues for either specific projects or for groups of projects. For publicly issued bonds, a trust company is usually designated to represent the diverse bond holders in case of any problems in the repayment. The borrowed funds are usually secured by granting the lender some rights to the facility or other assets in case of defaults on required payments. In contrast, corporate bonds such as debentures can represent loans secured only by the good faith and credit worthiness of the borrower.
Under the terms of many bond agreements, the borrower reserves the right to repurchase the bonds at any time before the maturity date by repaying the principal and all interest up to the time of purchase. The required repayment Rc at the end of period c is the net future value of the borrowed amount Q - less the payment made at intermediate periods compounded at the borrowing rate i to period c as follows:
The required repayment Rc at the end of the period c can also be obtained by noting the net present value of the repayments in the remaining (n-c) periods discounted at the borrowing rate i to t = c as follows:
For coupon bonds, the required repayment Rc after the redemption of the coupon at the end of period c is simply the original borrowed amount Q. For uniform payment bonds, the required repayment Rc after the last payment at the end of period c is:
Many types of bonds can be traded in a secondary market by the bond holder. As interest rates fluctuate over time, bonds will gain or lose in value. The actual value of a bond is reflected in the market discount or premium paid relative to the original principal amount (the face value). Another indicator of this value is the yield to maturity or internal rate of return of the bond. This yield is calculated by finding the interest rate that sets the (discounted) future cash flow of the bond equal to the current market price:
where Vc is the current market value after c periods have lapsed since the - issuance of the bond, is the bond cash flow in period t, and r is the market yield. Since all the bond cash flows are positive after the initial issuance, only one value of the yield to maturity will result from Eq. (7.14).
Several other factors come into play in evaluation of bond values from the lenders point of view, however. First, the lender must adjust for the possibility that the borrower may default on required interest and principal payments. In the case of publicly traded bonds, special rating companies divide bonds into different categories of risk for just this purpose. Obviously, bonds that are more likely to default will have a lower value. Secondly, lenders will typically make adjustments to account for changes in the tax code affecting their after-tax return from a bond. Finally, expectations of future inflation or deflation as well as exchange rates will influence market values.
Another common feature in borrowing agreements is to have a variable interest rate. In this case, interest payments would vary with the overall market interest rate in some pre-specified fashion. From the borrower's perspective, this is less desirable since cash flows are less predictable. However, variable rate loans are typically available at lower interest rates because the lenders are protected in some measure from large increases in the market interest rate and the consequent decrease in value of their expected repayments. Variable rate loans can have floors and ceilings on the applicable interest rate or on rate changes in each year.
Example 7-5: Example of a corporate promissory note
A corporation wishes to consider the option of financing the headquarters building in Example 7-4 by issuing a five year promissory note which requires an origination fee for the note is $25,000. Then a total borrowed amount needed at the beginning of the first year to pay for the construction costs and origination fee is 10.331 + 0.025 = $10.356 million. Interest payments are made annually at an annual rate of 10.8% with repayment of the principal at the end of the fifth year. Thus, the annual interest payment is (10.8%)(10.356) = $1.118 million. With the data in Example 7-4 for construction costs and accrued interests for the first two year, the combined operating and and financial cash flows in million dollars can be obtained:
Year 0, AA0 = 10.356 - 0.025 = 10.331
At the current corporate MARR of 15%,
Year 1, AA1 = 1.033 - 5.0 - 1.118 = -5.085
Year 2, AA2 = 0.636 - 7.0 - 1.118 = -7.482
Year 3, AA3 = -1.118
Year 4, AA4 = -1.118
Year 5, AA5 = -1.118 - 10.356 = -11.474
which is inferior to the 20-year coupon bond analyzed in Table 7-3.
For this problem as well as for the financing arrangements in Example 7-4, the project account is maintained to pay the construction costs only, while the interest and principal payments are repaid from corporate earnings. - Consequently, the terms in Eq. (7.10) will disappear when the account balance in each period is computed for this problem:
At t=0, N0 = 10.356 - 0.025 = $10.331 million
At t=1, N1 = (1 + 0.1) (10.331) - 5.0 = $6.364 million
At t=2, N2 = (1 + 0.1) (6.364) - 7.0 = $0
Example 7-6: Bond financing mechanisms.
Suppose that the net operating expenditures and receipts of a facility investment over a five year time horizon are as shown in column 2 of Table 7-3 in which each period is six months. This is a hypothetical example with a deliberately short life time period to reduce the required number of calculations. Consider two alternative bond financing mechanisms for this project. Both involve borrowing $2.5 million at an issuing cost of five percent of the loan with semi-annual repayments at a nominal annual interest rate of ten percent i.e., 5% per period. Any excess funds can earn an interest of four percent each semi-annual period. The coupon bond involves only interest payments in intermediate periods, plus the repayment of the principal at the end, whereas the uniform payment bond requires ten uniform payments to cover both interests and the principal. Both bonds are subject to optional redemption by the borrower before maturity.
The operating cash flow in column 2 of Table 7-3 represents the construction expenditures in the early periods and rental receipts in later periods over the lifetime of the facility. By trial and error with Eqs. (7.9) and (7.10), it can be found that Q = $2.5 million (K = $0.125 or 5% of Q) is necessary to insure a nonnegative balance in the project account for the uniform payment bond, as shown in Column 6 of Table 7-3. For the purpose of comparison, the same amount is borrowed for the coupon bond option even though a smaller loan will be sufficient for the construction expenditures in this case.
The financial cash flow of the coupon bond can easily be derived from Q = $2.5 million and K = $0.125 million. Using Eq. (7.5), Ip = (5%)(2.5) = $0.125 million, and the repayment in Period 10 is Q + Ip = $2.625 million as shown in Column 3 of Table 7-3. The account balance for the coupon bond in Column 4 is obtained from Eqs. (7.9) and (7.10). On the other hand, the uniform annual payment U = $0.324 million for the financial cash flow of the uniform payment bond (Column 5) can be obtained from Eq. (7.6), and the bond account for this type of balance is computed by Eqs. (7.9) and (7.10).
Because of the optional redemption provision for both types of bonds, it is advantageous to gradually redeem both options at the end of period 3 to avoid interest payments resulting from i = 5% and h = 4% unless the account balance beyond period 3 is needed to fund other corporate investments. corporate earnings are available for repurchasing the bonds at end of period 3, the required repayment for coupon bond after redeeming the last coupon at the end of period 3 is simply $2.625 million. In the case of the uniform payment bond, the required payment after the last uniform payment at the end of period 3 is obtained from Equation (7-13) as:
R3 = (0.324)(P|U, 5%, 7) = (0.324)(5.7864) = $1.875 million.
TABLE 7-3 Example of Two Borrowing Cash Flows (in $ thousands)
Example 7-7: Provision of Reserve Funds
Typical borrowing agreements may include various required reserve funds. Consider an eighteen month project costing five million dollars. To finance this facility, coupon bonds will be issued to generate revenues which must be sufficient to pay interest charges during the eighteen months of construction, to cover all construction costs, to pay issuance expenses, and to maintain a debt service reserve fund. The reserve fund is introduced to assure bondholders of payments in case of unanticipated construction problems. It is estimated that a total amount of $7.4 million of bond proceeds is required, including a two percent discount to underwriters and an issuance expense of $100,000.
Three interest bearing accounts are established with the bond proceeds to separate various categories of funds:
The total sources of funds (including interest from account balances) and uses of funds are summarized in Table 7-4
TABLE 7-4 Illustrative Sources and Uses of Funds from Revenue Bonds During Construction
Example 7-8: Variable rate revenue bonds prospectus
The information in Table 7-5 is abstracted from the Prospectus for a new issue of revenue bonds for the Atwood City. This prospectus language is typical for municipal bonds. Notice the provision for variable rate after the initial interest periods. The borrower reserves the right to repurchase the bond before the date for conversion to variable rate takes effect in order to protect itself from declining market interest rates in the future so that the borrower can obtain other financing arrangements at lower rates.
TABLE 7-5 Provision of Variable Rate for Bonds
7.5 Overdraft Accounts
Overdrafts can be arranged with a banking institution to allow accounts to have either a positive or a negative balance. With a positive balance, interest is paid on the account balance, whereas a negative balance incurs interest charges. Usually, an overdraft account will have a maximum overdraft limit imposed. Also, the interest rate h available on positive balances is less than the interest rate i charged for borrowing.
Clearly, the effects of overdraft financing depends upon the pattern of cash flows over time. Suppose that the net cash flow for period t in the account is denoted by At which is the difference between the receipt Pt and the payment Et in period t. Hence, At can either be positive or negative. The amount of overdraft at the end of period t is the cumulative net cash flow Nt which may also be positive or negative. If Nt is positive, a surplus is indicated and the subsequent interest would be paid to the borrower. Most often, Nt is negative during the early time periods of a project and becomes positive in the later periods when the borrower has received payments exceeding expenses.
If the borrower uses overdraft financing and pays the interest per period on the accumulated overdraft at a borrowing rate i in each period, then the interest per period for the accumulated overdraft Nt-1 from the previous period (t-1) is It = iNt-1 where It would be negative for a negative account balance Nt-1. For a positive account balance, the interest received is It = hNt-1 where It would be positive for a positive account balance.
The account balance Nt at each period t is the sum of receipts Pt, payments Et, interest It and the account balance from the previous period Nt-1. Thus,
where It = iNt-1 for a negative Nt-1 and It = hNt-1 for a positive Nt-1. The net cash flow At = Pt - Et is positive for a net receipt and negative for a net payment. This equation is approximate in that the interest might be earned on intermediate balances based on the pattern of payments during the period instead of at the end of a period. The account balance in each period is of interest because there will always be a maximum limit on the amount of overdraft available.
For the purpose of separating project finances with other receipts and payments in an organization, it is convenient to establish a credit account into which receipts related to the project must be deposited when they are received, and all payments related to the project will be withdrawn from this account when they are needed. Since receipts typically lag behind payments for a project, this credit account will have a negative balance until such time when the receipts plus accrued interests are equal to or exceed payments in the period. When that happens, any surplus will not be deposited in the credit account, and the account is then closed with a zero balance. In that case, for negative Nt-1, Eq. (7.15) can be expressed as:
and as soon as Nt reaches a positive value or zero, the account is closed.
Example 7-9: Overdraft Financing with Grants to a Local Agency
A public project which costs $61,525,000 is funded eighty percent by a federal grant and twenty percent from a state grant. The anticipated duration of the project is six years with receipts from grant funds allocated at the end of each year to a local agency to cover partial payments to contractors for that year while the remaining payments to contractors will be allocated at the end of the sixth year. The end-of-year payments are given in Table 7-6 in which t=0 refers to the beginning of the project, and each period is one year.
If this project is financed with an overdraft at an annual interest rate i = 10%, then the account balance are computed by Eq. (7.15) and the results are shown in Table 7-6.
In this project, the total grant funds to the local agency covered the cost of construction in the sense that the sum of receipts equaled the sum of construction payments of $61,525,000. However, the timing of receipts lagged payments, and the agency incurred a substantial financing cost, equal in this plan to the overdraft amount of $1,780,000 at the end of year 6 which must be paid to close the credit account. Clearly, this financing problem would be a significant concern to the local agency.
TABLE 7-6 Illustrative Payments, Receipts and Overdrafts for a Six Year Project
Example 7-10: Use of overdraft financing for a facility
A corporation is contemplating an investment in a facility with the following before-tax operating net cash flow (in thousands of dollars) at year ends:
The MARR of the corporation before tax is 10%. The corporation will finance the facility be using $200,000 from retained earnings and by borrowing the remaining $300,000 through an overdraft credit account which charges 14% interest for borrowing. Is this proposed project including financing costs worthwhile?
The results of the analysis of this project is shown in Table 7-7 as follows:
N0 = -500 + 200 = -300
N1 = (1.14)(-300) + 110 = -232
N2 = (1.14)(-232) + 112 = -152.48
N3 = (1.14)(-152.48) + 114 = -59.827
N4 = (1.14)(-59.827) +116 = +47.797
Since N4 is positive, it is revised to exclude the net receipt of 116 for this period. Then, the revised value for the last balance is
N4' = N4 - 116 = - 68.203
The financial cash flow resulting from using overdrafts and making repayments from project receipts will be:
= - N0 = 300
= - A1 = -110
= - A2 = -112
= - A3 = -114
= N4 - A4 = - 68.203
The adjusted net present value of the combined cash flow discounted at 15% is $27,679 as shown in Table 7-7. Hence, the project including the financing charges is worthwhile.
The adjusted net present value of the combined cash flow discounted at 15% is $27,679 as shown in Table 7-7. Hence, the project including the financing charges is worthwhile.
TABLE 7-7 Evaluation of Facility Financing Using Overdraft (in $ thousands)
7.6 Refinancing of Debts
Refinancing of debts has two major advantages for an owner. First, they allow re-financing at intermediate stages to save interest charges. If a borrowing agreement is made during a period of relatively high interest charges, then a repurchase agreement allows the borrower to re-finance at a lower interest rate. Whenever the borrowing interest rate declines such that the savings in interest payments will cover any transaction expenses (for purchasing outstanding notes or bonds and arranging new financing), then it is advantageous to do so.
Another reason to repurchase bonds is to permit changes in the operation of a facility or new investments. Under the terms of many bond agreements, there may be restrictions on the use of revenues from a particular facility while any bonds are outstanding. These restrictions are inserted to insure bondholders that debts will be repaid. By repurchasing bonds, these restrictions are removed. For example, several bridge authorities had bonds that restricted any diversion of toll revenues to other transportation services such as transit. By repurchasing these bonds, the authority could undertake new operations. This type of repurchase may occur voluntarily even without a repurchase agreement in the original bond. The borrower may give bondholders a premium to retire bonds early.
Example 7-11: Refinancing a loan.
Suppose that the bank loan shown in Example 7-4 had a provision permitting the borrower to repay the loan without penalty at any time. Further, suppose that interest rates for new loans dropped to nine percent at the end of year six of the loan. Issuing costs for a new loan would be $50,000. Would it be advantageous to re-finance the loan at that time?
To repay the original loan at the end of year six would require a payment of the remaining principal plus the interest due at the end of year six. This amount R6 is equal to the present value of remaining fourteen payments discounted at the loan interest rate 11.2% to the end of year 6 as given in Equation (7-13) as follows:
The new loan would be in the amount of $ 9.152 million plus the issuing cost of $0.05 million for a total of $ 9.202 million. Based on the new loan interest rate of 9%, the new uniform annual payment on this loan from years 7 to 20 would be:
The net present value of the financial cash flow for the new loan would be obtained by discounting at the corporate MARR of 15% to the end of year six as follows:
Since the annual payment on the new loan is less than the existing loan ($1.182 versus $1.324 million), the new loan is preferable.
7.7 Project versus Corporate Finance
We have focused so far on problems and concerns at the project level. While this is the appropriate viewpoint for project managers, it is always worth bearing in mind that projects must fit into broader organizational decisions and structures. This is particularly true for the problem of project finance, since it is often the case that financing is planned on a corporate or agency level, rather than a project level. Accordingly, project managers should be aware of the concerns at this level of decision making.
A construction project is only a portion of the general capital budgeting problem faced by an owner. Unless the project is very large in scope relative to the owner, a particular construction project is only a small portion of the capital budgeting problem. Numerous construction projects may be lumped together as a single category in the allocation of investment funds. Construction projects would compete for attention with equipment purchases or other investments in a private corporation.
Financing is usually performed at the corporate level using a mixture of long term corporate debt and retained earnings. A typical set of corporate debt instruments would include the different bonds and notes discussed in this chapter. Variations would typically include different maturity dates, different levels of security interests, different currency denominations, and, of course, different interest rates.
Grouping projects together for financing influences the type of financing that might be obtained. As noted earlier, small and large projects usually involve different institutional arrangements and financing arrangements. For small projects, the fixed costs of undertaking particular kinds of financing may be prohibitively expensive. For example, municipal bonds require fixed costs associated with printing and preparation that do not vary significantly with the size of the issue. By combining numerous small construction projects, different financing arrangements become more practical.
While individual projects may not be considered at the corporate finance level, the problems and analysis procedures described earlier are directly relevant to financial planning for groups of projects and other investments. Thus, the net present values of different financing arrangements can be computed and compared. Since the net present values of different sub-sets of either investments or financing alternatives are additive, each project or finance alternative can be disaggregated for closer attention or aggregated to provide information at a higher decision making level.
Example 7-12: Basic types of repayment schedules for loans.
Coupon bonds are used to obtain loans which involve no payment of principal until the maturity date. By combining loans of different maturities, however, it is possible to achieve almost any pattern of principal repayments. However, the interest rates charged on loans of different maturities will reflect market forces such as forecasts of how interest rates will vary over time. As an example, Table 7-8 illustrates the cash flows of debt service for a series of coupon bonds used to fund a municipal construction project; for simplicity not all years of payments are shown in the table.
In this financing plan, a series of coupon bonds were sold with maturity dates ranging from June 1988 to June 2012. Coupon interest payments on all outstanding bonds were to be paid every six months, on December 1 and June 1 of each year. The interest rate or "coupon rate" was larger on bonds with longer maturities, reflecting an assumption that inflation would increase during this period. The total principal obtained for construction was $26,250,000 from sale of these bonds. This amount represented the gross sale amount before subtracting issuing costs or any sales discounts; the amount available to support construction would be lower. The maturity dates for bonds were selected to require relative high repayment amounts until December 1995, with a declining repayment amount subsequently. By shifting the maturity dates and amounts of bonds, this pattern of repayments could be altered. The initial interest payment (of $819,760 on December 1, 1987), reflected a payment for only a portion of a six month period since the bonds were issued in late June of 1987.
TABLE 7-8 Illustration of a Twenty-five Year Maturity Schedule for Bonds