Long-Term Liabilities and Financing
Long-term liabilities and financing decisions shape a company's capital structure. Debt financing involves borrowing money, while equity financing raises capital by selling ownership stakes. Each method carries distinct advantages and drawbacks that affect a firm's financial health and flexibility.
Interest rates drive the cost of mortgage loans and the pricing of bonds. Higher rates increase borrowing costs for mortgages, while bond prices move inversely to market interest rates. Understanding these relationships is essential for managing long-term financial obligations.
Debt vs. Equity Financing
Debt financing obtains funds by borrowing from lenders (banks, bondholders) and requires repayment with interest. Equity financing raises capital by selling ownership stakes to investors. Companies often use a mix of both, and the choice between them depends on factors like cost, risk tolerance, and how much control current owners want to retain.
Debt financing:
- Advantages include tax-deductible interest expense (which lowers the effective cost of borrowing), maintaining ownership control, and predictable repayment schedules
- Disadvantages include strain on cash flow from regular interest payments, increased financial risk of default, and restrictive covenants that can limit the company's flexibility
Equity financing:
- Advantages include no repayment obligation, the ability to raise capital without adding liabilities, and investors who share risk and may provide expertise
- Disadvantages include diluting existing ownership and control, sharing profits through dividends or capital gains, and more complex legal and regulatory requirements
The tax deductibility of interest is a big deal here. Because interest expense reduces taxable income, debt financing is often cheaper on an after-tax basis than equity financing. That's a key reason companies take on debt even when they could issue more stock.
Interest Rates in Mortgage Loans
Interest rates represent the cost of borrowing. Higher rates lead to higher monthly payments and greater total loan costs over the life of the mortgage.
- Fixed-rate mortgages lock in the same interest rate for the entire loan term, giving the borrower predictable payments.
- Adjustable-rate mortgages (ARMs) have rates that change periodically based on a market index. The initial rate is usually lower than a fixed-rate mortgage, but payments can increase if rates rise.
Loan terms refer to the repayment period. A longer term (e.g., 30 years) produces lower monthly payments but significantly more total interest paid over the life of the loan compared to a shorter term (e.g., 15 years).
Points are upfront fees paid to the lender, expressed as a percentage of the loan amount:
- Discount points buy down the interest rate. Each point typically costs 1% of the loan amount and reduces the rate by roughly 0.25% (though this varies). For example, on a $200,000 loan, one discount point costs $2,000 and might lower the rate from 6.5% to 6.25%.
- Origination points cover the lender's loan processing costs and do not reduce the rate.
- Paying discount points tends to benefit borrowers who plan to keep the loan long-term, since the upfront cost is recouped over time through lower monthly payments.
Bond Prices and Market Rates
Bonds are fixed-income securities that pay a predetermined interest rate (the coupon rate) to bondholders. The critical concept here is the inverse relationship between bond prices and market interest rates:
- When market rates rise, existing bonds become less attractive because new bonds offer higher coupon rates. To compensate, the price of existing bonds falls so that their effective yield matches the new, higher market rate.
- When market rates fall, existing bonds with higher coupon rates become more desirable. Increased demand pushes their prices above face value.
Think of it this way: a bond's coupon payments are fixed at issuance. The only thing that can adjust to reflect changing market conditions is the bond's price.
Bond valuation involves calculating the present value of all future cash flows the bond will generate. Those cash flows include the periodic coupon (interest) payments and the return of face value at maturity. The discount rate used in this calculation is the current market interest rate. When the market rate equals the coupon rate, the bond trades at face value (par). When the market rate exceeds the coupon rate, the bond trades at a discount. When the market rate is below the coupon rate, the bond trades at a premium.
Bond Characteristics and Terms
- Face value (par value): The principal amount of the bond, repaid to the bondholder at maturity. Most corporate bonds have a face value of $1,000.
- Maturity date: The date when the issuer must repay the face value. Bond maturities can range from a few years to 30 years or more.
- Indenture: The legal contract between the issuer and bondholders. It spells out the coupon rate, payment schedule, maturity date, any collateral, and covenants (restrictions on the issuer's actions).
- Callable bonds: Bonds the issuer can redeem before the maturity date, typically at a price above face value (a call premium). Issuers are most likely to call bonds when market interest rates have fallen, since they can refinance the debt at a lower rate. This is favorable for the issuer but a risk for bondholders, who lose a higher-yielding investment.