DEBT MANAGEMENT

What is Debt?

 Debt is something owed, an obligation to pay or render something to another.

What is Debt Management?

 Debt Management involves a designated third party assisting a debtor with repayment of his or her debt.
 It is a structured repayment plan set up by a designated third party, either as result of a court order or a result
of personal initiation.

Types of Debt

1. Commercial Paper
 Is unsecured debt that is issued by a company and has a fixed maturity ranging from 1 to 270 days.
 A company uses commercial paper to meet its short - term working capital obligations. It is commonly sold
at a discount from face value; with the discount (and therefore the interest rate) being higher if the term is
longer.
 A company can sell its commercial paper directly to investors, such as money market funds, or through a
dealer in exchange for a small commission.
2. Factoring
 Under a factoring arrangement, a finance company agrees to take over a company ’ s accounts receivable
collections and keep the money from those collections in exchange for an immediate cash payment to the
company.
 This process typically involves having customers mail their payments to a lockbox that appears to be
operated by the company but is actually controlled by the finance company.
 A similar arrangement is accounts receivable financing, under which a lender uses the accounts receivable as
collateral for a loan and takes direct receipt of payments from customers, rather than waiting for periodic
loan payments from the company.
 Though both variations on the factoring concept will accelerate a company’s cash flow dramatically, it is an
expensive financing option, and so is not considered a viable long - term approach to funding a company’s
operations. It is better for short - term growth situations where money is in short supply to fund a sudden
need for working capital.
3. Field Warehouse Financing
 Under a field warehousing arrangement, a finance company (usually one that specializes in this type of
arrangement) will segregate a portion of a company’s warehouse area with a fence.
 All inventory within it is collateral for a loan from the finance company to the company. The finance
company will pay for more raw materials as they are needed, and is paid back directly from accounts
receivable as soon as customer payments are received.
 Field warehousing is highly transaction intensive, especially when the finance company employs an on - site
warehouse clerk, and therefore is a very expensive way to obtain funds.
4. Floor Planning
 Some lenders will directly pay for large assets that are being procured by a distributor or retailer (such as
kitchen appliances or automobiles) and be paid back when the assets are sold to a consumer. In order to
protect itself, the lender may require that the price of all assets sold be no lower than the price the lender
originally paid for it on behalf of the distributor or retailer.
 This financing option is a good one for smaller or underfunded distributors or retailers, since the interest rate
is not excessive (due to the presence of collateral).
5. Lease
 A lease covers the purchase of a specific asset, which is paid for by the lease provider on the company’s
behalf.
 In exchange, the company pays a fixed rate, which includes interest and principal, to the leasing company. It
may also be charged for personal property taxes on the asset purchased.
 The lease may be defined as an operating lease, under the terms of which the lessor carries the asset on its
books and records a depreciation expense, while the lessee records the lease payments as an expense on its
books. This type of lease typically does not cover the full life of the asset, nor does the buyer have a small -
dollar buyout option at the end of the lease.
 The reverse situation arises for a capital lease, where the lessee records it as an asset and is entitled to record
all related depreciation as an expense. In the latter case, the lease payments are split into their interest and
principal portions and recorded on the lessee ’ s books as such.
 The leasing option is most useful for those companies that want to establish collateral agreements only for
specific assets, thereby leaving their remaining assets available as a borrowing base for other loans. Leases
can be arranged for all but the most financially shaky companies, since lenders can always use the
underlying assets as collateral and rarely impose any other financing restrictions.
6. Line of Credit
 A line of credit is a commitment from a lender to pay a company whenever it needs cash, up to a preset
maximum level. It is generally secured by company assets, and for that reason bears an interest rate not far
above the prime rate.
 One problem with a line of credit is that the bank can cancel the line or refuse to allow extra funds to be
drawn down from it if the bank feels that the company is no longer a good credit risk. Another issue is that
the bank may require a company to maintain a compensating balance in an account at the bank; this
increases the effective interest rate on the line of credit, since the company earns little or no interest on the
funds stored at the bank.
 The line of credit is most useful for situations where there may be only short - term cash shortfalls or
seasonal needs that result in the line ’ s being drawn down to zero at some point during the year.
7. Loans
a. Asset-Based Loans - A loan that uses fixed assets or inventory as its collateral is a common form of
financing by banks.
- Loans may also be issued that are based on other forms of collateral, such as the
cash surrender value of life insurance, securities, or real estate.
 - Given the presence of collateral, this type of loan tends to involve a lower interest
rate. Lenders typically require minimal covenants in association with these loans,
giving corporate management more control over company operations.
b. Bonds - A bond is a fixed obligation to pay, usually at a stated rate of $1,000 per bond that is issued
by a corporation to investors. It may be a registered bond, under which a company maintains a list of
owners of each bond. The company then periodically sends interest payments, as well as the final
principal payment, to the investor of record. It may also be a coupon bond, for which the company
does not maintain a standard list of bondholders.

Kinds of bonds:

 Collateral trust bond. A bond that uses as collateral a company’s security investments.
 Convertible bond. A bond that can be converted to stock using a predetermined conversion
ratio. The presence of conversion rights typically reduces the interest cost of these bonds, since
investors assign some value to the conversion privilege. See the “zero coupon convertible bond
“for a variation on this approach.
 Debenture. A bond issued with no collateral. A subordinated debenture is one that specifies debt
that is senior to it.
 Deferred interest bond. A bond that provides for either reduced or no interest in the beginning
years of the bond term, and compensates for it with increased interest later in the bond term.
Since this type of bond is associated with firms having short - term cash flow problems, the full
- term interest rate can be high.
 Floorless bond. A bond whose terms allow purchasers to convert them to common stock, as
well as any accrued interest. The reason for its “death spiral “nickname is that bondholders can
convert some shares and sell them on the open market, thereby supposedly driving down the
price and allowing them to buy more shares, and so on. If a major bondholder were to convert
all holdings to common stock, the result could be a major stock price decline, possibly resulting
in a change of control to the former bondholder. However, this conversion problem can be
 controlled to some extent by including conversion terms that allow bondholders to convert only
at certain times or with the permission of company management.
 Guaranteed bond. A bond whose payments are guaranteed by another party. Corporate parents
will sometimes issue this guarantee for bonds issued by subsidiaries in order to obtain a lower
effective interest rate.
 Income bond. A bond that pays interest only if income has been earned. The income can be tied
to total corporate earnings or to specific projects. If the bond terms indicate that interest is
cumulative, then interest will accumulate during nonpayment periods and be paid at a later date
when income is available for doing so.
 Mortgage bond. A bond offering can be backed by any real estate owned by the company
(called a real property mortgage bond), or by company - owned equipment (called an equipment
bond), or by all assets (called a general mortgage bond).
 Serial bond. A bond issuance where a portion of the total number of bonds are paid off each
year, resulting in a gradual decline in the total amount of debt outstanding.
 Variable rate bond. A bond whose stated interest rate varies as a percentage of a baseline
indicator, such as the prime rate. Treasurers should be wary of this bond type because jumps in
the baseline indicator can lead to substantial increases in interest costs.
 Zero coupon bond. A bond with no stated interest rate. Investors purchase these bonds at a
considerable discount to their face value in order to earn an effective interest rate.
 Zero coupon convertible bond. A bond that offers no interest rate on its face but allows
investors to convert to stock if the stock price reaches a level higher than its current price on the
open market. The attraction to investors is that, even if the conversion price to stock is marked
up to a substantial premium over the current market price of the stock, a high level of volatility
in the stock price gives investors some hope of a profitable conversion to equity. The attraction
to a company is that the expectation of conversion to stock presents enough value to investors
that they require no interest rate on the bond at all, or at least will only purchase the bond at a
slight discount from its face value, resulting in a small effective interest rate. A twist on the
 concept is a contingent conversion clause (or “ co - co ”clause) that requires the stock price to
surpass the designated conversion point by some fixed amount before allowing investors to
actually switch to stock, thereby making the conversion even more unlikely. This concept is
least useful for company whose stock has a history of varying only slightly from its current
price, since investors will then see little chance to convert and so will place little value on the
conversion feature, requiring instead a higher interest rate on the bonds.
c. Bridge Loans - A bridge loan is a form of short - term loan that is granted by a lending institution on
the condition that the company will obtain longer -term financing shortly that will pay off the bridge
loan. This option is commonly used when a company is seeking to replace a construction loan with a
long - term note that it expects to gradually pay down over many years. This type of loan is usually
secured by facilities or fixtures in order to obtain a lower interest rate.
d. Economic Development Authority Loan - Various agencies of state governments are empowered to
guarantee bank loans to organizations that need funds in geographic areas where it is perceived that
social improvement goals can be attained.

8. Long-Term Loans
 There are several forms of long - term debt. One is a long - term loan issued by a lending institution. These
loans tend to be made to smaller companies that do not have the means to issue bonds.
 Long - term debt is a highly desirable form of financing, since a company can lock in a favorable interest
rate for a long time, and keeps it from having to repeatedly apply for shorter - term loans during the
intervening years, when business conditions may result in less favorable debt terms.
9. Receivable Securitization
 A large company can consider securitizing its accounts receivable, thereby achieving one of the lowest
interest rates available for debt. To do so, it creates a special purpose entity (SPE) and transfers a selection of
its receivables into the SPE. The SPE then sells the receivables to a bank conduit, which in turn pools the
receivables that it has bought from multiple companies, and uses the cash flows from the receivables to back
the issuance of commercial paper to investors, who in turn are repaid with the cash flows from the
receivables.
  Receivables securitization is available only to large companies having a broad customer base whose
receivables experience minimal defaults.
10.Sale and Leaseback
 Under this arrangement, a company sells one of its assets to a lender and then immediately leases it back for
a guaranteed minimum time period. By doing so, the company obtains cash from the sale of the asset that it
may be able to use more profitably elsewhere, while the leasing company handling the deal obtains a
guaranteed lessee for a time period that will allow it to turn a profit on the financing arrangement.
 A sale and leaseback is most commonly used for the sale of a corporate building, but can also be arranged
for other large assets, such as production machinery.
 A sale and leaseback is useful for companies in any type of financial condition, for a financially healthy
organization can use the resulting cash to buy back shares and prop up its stock price, while a faltering
organization can use the cash to fund operations.

Summary of Debt Types