Long-Term Debt and Lease Financing
|LO 16-1||Analyzing long-term debt requires consideration of the collateral pledged, method of repayment, and other key factors.|
|LO 16-2||Bond yields are important to bond analysis and are influenced by how bonds are rated by major bond rating agencies.|
|LO 16-3||An important corporate decision is whether to call in and reissue debt (refund the obligation) when interest rates decline.|
|LO 16-4||Long-term lease obligations have many characteristics similar to debt and are recognized as a form of indirect debt by the accounting profession.|
|LO 16-5||When a firm fails to meet its financial obligations, it may be subject to bankruptcy.|
For those who invest in the highly rated bonds of firms such as Exxon Mobil, Johnson & Johnson, and Microsoft, there is very little to worry about. You get a higher return than you could get on U.S. Government securities while still being able to sleep soundly at night.
However, for those who invest in bonds of companies in telecommunications or the home building industry, sleep may not come so easily. In the case of the latter, 16 of the 21 largest homebuilders had negative cash flow in 2009 and the outlook was no better for the next 12–24 months. Bond buyer beware when purchasing bonds of companies in cyclical industries.
As one example, D. R. Horton Inc. of Fort Worth, Texas, the second largest homebuilder in the United States, saw its earnings per share drop from a peak value of $4.62 in 2005 to a negative $8.34 in 2008 and a continued loss in 2009. It suffered from high inventories of unsold homes, rising foreclosures, tightened lending standards, and declining home values. By 2012 year-end, the housing market started to recover and D. R. Horton reported earnings per share of $2.77. The improving housing market allowed the company to increase prices on the homes it sold. Between 2008 and 2012, Horton brought down its debt-to-equity ratio from 105 percent to 59 percent, and management stated that the company was in the best position of its existence. By early 2015, Standard & Poor’s had raised Horton’s credit rating to BB.
The Expanding Role of Debt
The amount of corporate debt has increased over time as corporations grew with the economy. Sometimes the increased use of debt was due to business expansion in capital-intensive industries like airlines and telecommunications. Some companies simply did not generate enough internal funds from operations to fund expansion, so they sold bonds to finance their growth. Other firms decided to recapitalize and repurchased their common stock with funds raised from bond offerings. One thing that hasn’t changed is the cyclical nature of financial leverage ratios as the economy expands and contracts and interest rates move up and down.
One ratio you may remember from Chapter 3 is the times-interest-earned ratio. This ratio divides the operating income (EBIT) by the interest expense and indicates how many times the company can cover its interest expense. The higher the number, the more protected are the interest payments and the bondholders. The interesting thing about this ratio is that it indirectly includes the amount of debt on the balance sheet. As the amount of debt goes up, interest payments usually rise also. However, when interest rates fall, companies can refinance their debt at lower interest rates just like homeowners refinance their homes when mortgage rates decline. So the times–interest-earned ratio is also affected by the interest rates (coupon rates) on their bonds. Two companies can have the same amount of debt but different interest rates associated with their debt, and even though they have the same operating income, their interest coverage ratios would be different.
In 1977, the average U.S. manufacturing corporation had its interest payment covered by operating earnings at a rate of eight times. By the time the financial crisis ended in 2007–08, the average times interest earned was down to 2.4 times. Figure 16-1 shows times interest earned for Walmart Stores, Inc. since 1998, along with the interest rate on AAA-rated long-term corporate debt. Walmart may be the most financially sound large retailer. Over the last 20 years, interest rates declined dramatically. As interest rates fell, Walmart’s interest coverage initially rose from around 8 percent to almost 16 percent in 2004. However, like many other companies, Walmart took advantage of low interest rates to increase its leverage and to borrow using longer-term debt, which carries a higher interest rate. Although Walmart has more long-term debt than it had in the 1990s, lower average interest costs have allowed the firm to record a times interest earned that is better (higher) in 2015 than it had in the 1990s when it borrowed less.
Figure 16-1 Times interest earned for Walmart Stores, Inc. and AAA long-term debt rates, 1998–2015