Modelling Debt Part I – The Capital Structure

Any financial model that has been developed to support a transaction, whether it be for project finance, a merger or acquisition (M&A), a leveraged (LBO) or a management (MBO) buyout will have an associated capital structure and will have a ‘debt’ section. This section is very different to the ‘operations’ section of the model and is usually the most complex.

At the simple end of the scale a capital structure may consist of one tranche of debt, with scheduled principal repayments at a fixed margin. At the other end of the scale the structure could consist of multiple loans or hybrids with varying payment mechanisms with margins changing over time. And the structure may have conversations to equity and refinancings during the forecast period.

There is no set formula for calculating  an optimal capital structure.  However the key variables to consider when designing a structure is the type of company, the nature and growth of its cash flows, the available assets and the cost of debt & equity. The constraints are what risks the lenders are prepared to take and what security they require.

Below is a quick guide to the more common items that make up this capital structure and their key defining characteristics. This is not an exhaustive list and there are numerous ingenious types of debt that could also be included.

The guide is set out in risk order, ie the least risky (or secured or senior) debt is at the top of the page where as the most risky item (equity) is at the bottom.

For information on how to best approach modelling the debt items in this list see the tutorial titled – Developing Debt Calculations.

Bonds

·         Bonds are a certificate of debt issued by either the government or a corporation in order to raise money.

·         The debt (principle) is paid back at a specified fixed interest rate (coupons) and at a fixed date (maturity).

·         Bonds are tradable debt instruments and are rated dependant on their risk, likelihood to default.

·         Bonds are rated by independent companies depending on their risk etc. e.g. Treasury bonds having the least risk are rated AAA.

Senior Debt or Term Loan

·         Loan issued by a bank or syndicate of banks and is used to fund the purchase of assets.

·         Debt is senior in the issuers capital structure and has priority in the case of liquidation (Secured)

·         Interest is a variable rate and charged as a margin to an under lying rate (LIBOR, ERIBOR, BBSY)

·         In addition to interest banks may charge a fee to establish the loan, a fee ‘commitment’ fee on the undrawn amount

Mezzanine or Subordinated debt

·         Loan issued by a bank or syndicate of banks

·         Senior in the capital structure to equity but subordinate to senior debt. Therefore unsecured.

·         Drawn down after senior debt

·         Due to the higher risk (unsecured) this type of financing is more expensive.

Payment in Kind (PIK) loan

·         Similar in nature to the Mezzanine debt (Unsecured) but there are no cash flows associated with this loan

·         All interest is accrued into the loan balance until maturity and there are no principal repayments

·         The loan carries the right to purchase a certain number of company shares a a point in time (warrant)

·         Allows a borrower to achieve high levels of gearing

·         Typically short maturity (5 years) at a high interest margin

Shareholder loan

·         A loan made by a shareholder into the company.

·         Typically used to fund special purpose vehicles (SPVs) in a project finance transaction

·         Usually the most junior loan in the companies debt portfolio

·         Provides advantages in terms of a tax shield and the ability to remove locked up cash out of an SPV

Working Capital or Short Term Facility

·         As suggested by the description this is usually a small, short term unsecured loan.

·         Used to finance a companies everyday operations, accounts payable, inventory, wages etc.

·         Usually short terms (60 – 90 days) at high margins

Finance lease

·         Asset is leased for a period equal to the useful life of the asset.

·         Structure of the payments are similar to the amortisation of a loan

·         Lessee responsible for the maintenance of asset, penalties arise for cancellation of a lease.

Capital Notes

·         A range of financial instruments or unsecured debt.

·         They are unsecured subordinate debt i.e. they are last to be paid upon liquidation.

·         Pay a fixed rate of interest for a specified period.

·         At an election date (or maturity date) the holder has the option of holding the notes for a further period of time at a new interest rate, or converts them into ordinary shares.

·         If converted into shares, the company has the option to repay the capital notes in cash.

Equity Bridge

·         The providers of senior debt purchase equity as part of their lending package

·         Typical of a private equity type transaction as it requires less capital from the PE house to complete the transaction.

·          Usually provided on a short term basis and once or soon after the transaction completes the PE house sells this equity to investors

Equity

·         Either common or preference stock issued as ownership of a company

·         Can be traded either directly or via derivatives. Value changes as a results of company, sector or country news or issues.

·         Stock holders have voting rights on some corporate decisions

·         Stock holders receive dividends from the company

·         Equity is the most risky slice of the capital structure and may be expected to receive the highest returns