LESSON#6 small - dollar buyout option at the end of the lease.

The reverse situation arises for a capital lease,

DEBT MANAGEMENT
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
TYPES OF DEBT interest and principal portions and recorded on the
The typical form of corporate debt is either a lessee’s books as such.
secured or unsecured loan, and many treasurers do Loans
not explore further than these two basic formats.
Asset - Based Loans A loan that uses fixed assets or
However, there are quite a few alternative forms of inventory as its collateral is a common form of
debt that bear consideration, based on the duration financing by banks. Loans may also be issued that
of a company’s cash needs, its financial condition, are based on other forms of collateral, such as the
and the presence of various types of collateral. This cash surrender value of life insurance, securities, or
section contains descriptions of more than a dozen real estate
forms of financing. In addition, please refer to
Chapter 5for a discussion of how to reduce working Bonds-A bond is a fixed obligation to pay, usually
capital, thereby offsetting the need for debt. at a stated rate of $1,000 per bond, that is issued by
a corporation to investors. It may be a registered
Commercial Paper bond, under which a company maintains a list of
Commercial paper is unsecured debt that is issued owners of each bond. The company then
by a company and has a fixed maturity ranging from periodically sends interest payments, as well as the
1 to 270 days. A company uses commercial paper to final principal payment, to the investor of record. It
meet its short - term working capital obligations. It may also be a coupon bond
is commonly sold at a discount from face value, • Collateral trust bond. A bond that uses as collateral
with the discount (and therefore the interest rate) a company ’ s security investments.
being higher if the term is longer. A company can
sell its commercial paper directly to investors, such • Convertible bond. A bond that can be converted to
as money market funds, or through a dealer in stock using a predetermined conversion ratio. The
exchange for a small commission. presence of conversion rights typically reduces the
interest cost of these bonds, since investors assign
Factoring some value to the conversion privilege. See the “
Under a factoring arrangement, a fi nance company zero coupon convertible bond ”for a variation on
agrees to take over a company’s accounts receivable this approach.
collections and keep the money from those • Debenture. A bond issued with no collateral. A
collections in exchange for an immediate cash subordinated debenture is one that specifies debt
payment to the company. This process typically that is senior to it.
involves having customers mail their payments to a
lockbox that appears to be operated by the company • Deferred interest bond. A bond that provides for
but is actually controlled by the fi nance company. either reduced or no interest in the beginning years
of the bond term, and compensates for it with
Field Warehouse Financing increased interest later in the bond term. Since this
Under a fi eld warehousing arrangement, a fi nance type of bond is associated with fi rms having short -
company (usually one that specializes in this type of term cash flow problems, the full - term interest rate
arrangement) will segregate a portion of a can be high.
company’s warehouse area with a fence. All • Floorless bond. A bond whose terms allow
inventory within it is collateral for a loan from the fi purchasers to convert them to common stock, as
nance company to the company. well as any accrued interest. The reason for its “
Lease death spiral ”nickname is that bondholders can
convert some shares and sell them on the open
A lease covers the purchase of a specific asset, market, thereby supposedly driving down the price
which is paid for by the lease provider on the and allowing them to buy more shares, and so on. If
company ’ s behalf. In exchange, the company pays a major bondholder were to convert all holdings to
a fixed rate, which includes interest and principal, to common stock, the result could be a major stock
the leasing company. It may also be charged for price decline, possibly resulting in a change of
personal property taxes on the asset purchased. The control to the former bondholder
lease may be defined as an operating lease, under
the terms of which the lessor carries the asset on its Guaranteed bond. A bond whose payments are
books and records a depreciation expense, while the guaranteed by another party. Corporate parents will
lessee records the lease payments as an expense on sometimes issue this guarantee for bonds issued by
its books. This type of lease typically does not cover subsidiaries in order to obtain a lower effective
the full life of the asset, nor does the buyer have a interest rate.
 • Income bond. A bond that pays interest only if LESSON#7
income has been earned. The income can be tied to
EQUITY MANAGEMENT
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 STOCK REGISTRATION
for doing so. If a treasurer wants to sell stock to investors that in
• Mortgage bond. A bond offering can be backed by turn can be immediately traded by the investors,
any real estate owned by the company (called a real then it is necessary to fi le a registration statement
property mortgage bond), or by company - owned with the Securities and Exchange Commission
equipment (called an equipment bond), or by all (SEC). Compiling a registration statement and
assets (called a general mortgage bond ). walking it through the SEC review process is one of
the most expensive and time - consuming tasks that
• Serial bond. A bond issuance where a portion of a treasurer can engage in.
the total number of bonds are paid off each year,
resulting in a gradual decline in the total amount of FORM S-1
debt outstanding. A key factor in the preparation of a Form S - 1 is
• Variable rate bond. A bond whose stated interest whether the company can incorporate a number of
rate varies as a percentage of a baseline indicator, required items by referencing them in the form,
such as the prime rate. Treasurers should be wary of which can save a great deal of work. Incorporation
this bond type because jumps in the baseline by reference is available only if the company has
indicator can lead to substantial increases in interest not been for the past three years a blank check
costs. company, a shell company, or a registrant for an
offering of penny stock.
• Zero coupon bond. A bond with no stated interest
rate. Investors purchase these bonds at a LESSON#8
considerable discount to their face value in order to INVESTMENT MANAGEMENT
earn an effective interest rate.
• Zero coupon convertible bond. A bond that offers
no interest rate on its face but allows investors to Surplus funds not needed for either operating
convert to stock if the stock price reaches a level purposes or compensating bank balances are
higher than its current price on the open market. available for investment. Prudent use of these funds
can add to income, though the treasurer must
CREDIT - RATING AGENCIES consider a range of investment criteria, types of
If a publicly held company issues debt, it can elect investments, and investment strategies before
to have that debt rated by either Moody ’ s, Standard selecting the appropriate investment vehicle. This
&Poor ’ s, or Fitch. These are the three top – tier chapter describes these issues, as well as the
credit - rating agencies that the Securities and accounting, controls, policies, and procedures
Exchange Commission SEC allows to issue debt required for an ongoing investment program.
ratings. A debt rating results in a credit score that INVESTMENT STRATEGIES
indicates the perceived risk of default on the
underlying debt, which in turn impacts the price of The treasurer should develop a standard
the debt on the open market. Having a credit score methodology for investing funds. This goes beyond
is essentially mandatory, since most funds are the selection of a type of investment, and enters the
prohibited by their internal investment rules from ream of strategies that can range from being passive
buying debt that does not have a specific level of (and requiring no attention) to those that are quite
credit rating assigned to it active and call for continuing decision making. This
section describes a range of possible investment
Convertible Debt strategies.
The convertible bond contains a feature allowing
the holder to turn in the bond in exchange for stock At the most minimal level of investment strategy,
when a preset strike price for the stock is reached, the treasurer can do nothing and leave idle balances
sometimes after a specific date. This involves a in the corporate bank accounts. This is essentially
specific conversion price per share, which is an earnings credit strategy, since the bank uses the
typically set at a point that makes the transaction earnings from these idle balances to offset its
uneconomical unless the share price rises at some service fees. If a company has minimal cash
point in the future. balances, then this is not an entirely bad strategy —
the earnings credit can be the equivalent of a modest
rate of return, and if there is not enough cash to plan
for more substantive investments, leaving the cash
alone is a reasonable alternative
OUTSOURCED INVESTMENT MANAGEMENT comparing the price of one currency to another, the
base currency is the unit of currency that does not
A treasurer may conclude that investment
fluctuate in amount, while the quoted currency or
management is not a core competency, or have little
price currency does fluctuate
funding for a professional in - house investment
staff. If so, it is possible to shift cash into a separate Insist on Home Currency Payment
account that is managed by outside investment
It is possible to insist on being paid in the
advisors. Under this arrangement, the outside firm
company’s home currency, so that the foreign
invests the cash under the terms of a customized
exchange risk shifts entirely to the customer. This is
investment agreement with the company. The
a likely strategy for a company that is dominant in
company can choose from a variety of possible
its industry and can therefore impose terms on its
investment strategies, as well as restrict investments
customers. However, smaller fi rms will find that
to certain classes of assets.
they have a modest competitive advantage if they
RISK - REDUCTION STRATEGIES allow customers to pay in their own currencies.
A simple risk - reduction strategy is to avoid Currency Surcharges
investments in the securities of any single entity, in
If a customer will not pay in a company ’ s home
favor of investments solely in one or more money
currency, then a related option is to bill the
market funds. These funds provide instant
customer a currency surcharge if the company
diversification across a multitude of issuers, with
incurs a foreign exchange loss between the time of
the attendant risk being constantly reviewed by a
billing and payment. The surcharge may not be
staff of risk management professionals. The use of
billed for minor changes in the exchange rate (to
money market funds is especially cost - effective for
avoid paperwork), but is triggered by a significant
smaller treasury departments that cannot afford the
decline in the exchange rate. Customers are rarely
services of an in - house investment manager.
happy about this, since they are taking on the
foreign exchange risk, and they cannot budget for
ACCOUNTING FOR INVESTMENTS the amount of the surcharge. It is also hardly a
competitive advantage for a company to impose this
A company will normally invest in marketable
practice on its customers.
securities, so that it can more easily liquidate its
investments. Marketable securities are investments Get Paid on Time
that can be easily liquidated through an organized
When a company deals with a counterparty in
exchange
another country, the payment terms may be quite
INVESTMENT MANAGEMENT POLICIES long, due to longer delivery schedules, border –
crossing delays, or simply because of longer
An investment policy is used to defi ne the level of
customary payment intervals in the other country. If
risk that a company is willing to tolerate and define
a payment period is unusually prolonged, then the
the exact types of investment vehicles to be used (or
company is exposed to changes in the spot rate to a
not used). Such a policy should cover the level of
much greater extent than would be the case if the
allowable liquidity
payment interval were compressed. Consequently, it
behooves a company’s sales staff to constantly
strive toward sales agreements with shorter payment
LESSON#9
terms, while the collections staff should be
FOREIGN EXCHANGE RISK MANAGEMENT unusually aggressive in collecting from foreign
customers.
When a company accepts foreign currency in
payment for its goods or services, it accepts some Foreign Currency Loans
level of foreign exchange risk, since the value of
It is possible to offset a foreign currency risk
that currency in comparison to the company ’ s
exposure by creating a counter liability, such as a
home currency may fluctuate enough between the
loan. To do so, a company can borrow an amount of
beginning of the contract and receipt of funds to
money in the foreign currency that matches the
seriously erode the underlying profit on the sale.
amount of the receivable. When the customer pays
This is becoming more of an issue over time
off the receivable, the company uses the proceeds to
because global competition is making it more likely
pay off the loan all in the same currency
that a company must accept payment in a foreign
currency
FOREIGN EXCHANGE QUOTE
TERMINOLOGY
Before delving into foreign exchange risk, it is
useful to understand the terminology used in the
foreign exchange quotation process. When
Sourcing Changes An option is easier to manage than a forward
exchange contract because a company can choose
If there is a large amount of foreign currency cash
not to exercise its option to sell currency if a
flows coming from a specific country, then one way
customer does not pay it. Not exercising an option
to hedge this risk is to start using suppliers located
is also useful when it becomes apparent that a
in the same country. By doing so, the company can
company can realize a gain on changes in the
find a ready use for the incoming currency, by
exchange rate, which would not have been the case
turning it around and sending it right back to the
if it were tied into a forward exchange contract.
same country
Currency Swaps
Foreign Currency Accounts
A currency swap is a spot transaction on the over -
If a company regularly receives and pays out funds
the counter market that is executed at the same time
in a particular foreign currency, it may make sense
as a forward transaction, with currencies being
to open a foreign exchange account, in which it
exchanged at both the spot date and the forward
maintains a sufficient currency balance to meet its
date. One currency is bought at the spot rate and
operational needs. This approach can be cost -
date, while the transaction is reversed at the forward
effective, because the company would otherwise
date and rate.
have to buy the foreign currency in order to pay
those suppliers requiring payment in that currency, Proxy Hedging
and then separately sell the same currency upon
If a company elects to receive a currency that is not
receipt of customer payments. While the company
actively traded, then it may have a difficult time
is still accepting the risk of loss on fluctuations in
locating a hedge in the same currency. However,
the exchange rate, it is eliminating the cost of
changes in the value of the currencies of a large
continually buying and selling the currency.
economic area, such as Southeast Asia, tend to be
Forward Exchange Contracts closely correlated with each other. If the treasurer
feels that this correlation will continue, then it may
Under a forward exchange contract, which is the
make sense to instead hedge through a highly
most commonly used foreign exchange hedge, a
correlated currency. However, just because the
company agrees to purchase a fixed amount of a
respective values of a currency pair were highly
foreign currency on a specific date, and at a
correlated in the past does not mean that they will
predetermined rate. This allows it to lock in the rate
continue to be in the future, since a multitude of
of exchange up front for settlement at a specified
political and economic issues can break the
date in the future. The counterparty is typically a
correlation.
bank, which requires a deposit to secure the
contract, with a final payment due in time to be
cleared by the settlement date. If the company has a HEDGE ACCOUNTING
credit facility with the bank acting as its
There are complex hedging rules that permit a
counterparty, then the bank can allocate a portion of
company to elect to obtain special accounting
that line to any outstanding forward exchange
treatment relative to foreign currency risks. These
contracts and release the allocation once the
rules include the establishment, at inception, of
contracts have been settled.
criteria for measuring hedge effectiveness and
Currency Futures ineffectiveness. Periodically, each hedge must be
evaluated for effectiveness, using the preestablished
A currency future is the same as a forward exchange
criteria, and the gains or losses associated with
contract, except that it trades on an exchange. Each
hedge ineffectiveness must be reported currently in
contract has a standardized size, expiry date, and
earnings, and not deferred to future periods.
settlement rules. The primary currency futures
center with substantial volume is the Chicago LESSON#10
Mercantile Exchange (CME). The CME offers
INTEREST RISK MANAGEMENT
futures trading between the major currencies, as
well as some of the emerging market currencies; Interest rate risk is the possibility of a change in
however, the volume of contracts in the emerging interest rates that has a negative impact on a
market currencies is quite low. company’s profits. A company incurs interest rate
risk whenever it borrows or extends credit. This is a
Currency Options
serious issue for companies with large amounts of
A foreign currency option requires the payment of a outstanding debt, since a small hike in their interest
premium in exchange for a right to use one currency expense could not only have a large negative impact
to buy another currency at a specified price on or on their profits, but possibly also violate several
before a specified date. A call option permits the loan covenants, such as the interest coverage ratio
buyer to buy the underlying currency at the strike
price, while a put option allows the buyer to sell the
underlying currency at the strike price.
INTEREST RISK MANAGEMENT OBJECTIVES Options
Does a treasurer care if interest rates change over An options contract is a trade that gives the buyer
time? After all, if a company acquires debt at a the right to buy or sell an amount of futures
certain interest rate that subsequently varies, then contracts at some date in the future. The cost of this
rates over the long term should vary both above and right is the options premium, and is paid to the
below the benchmark of the initial rate. counterparty at the beginning of the contract. This
cost will vary based on such factors as the
INTEREST RISK MANAGEMENT STRATEGIES
remaining term of an option, the strike price, and
There are a variety of strategies for managing the volatility of the reference interest rate. If the
interest risk. Before addressing methods that require option is entered into through an exchange, the
interaction with outside parties, a treasurer should exchange will ask for a deposit, which is refundable
first explore a variety of available internal when the deal is completed.
techniques. One possibility is cash netting across
the company in order to avoid excess investments in
A call option on interest rates protects the option
one part of the company while a different subsidiary
buyer from rising interest rates, while a put option
must borrow. Chapter 4discussed the various
protects the option buyer from declining rates. Both
methods for combining cash flows from different
types of options are benchmarked against a
parts of a company. Another alternative is an
reference rate that is set forth in the option contract.
intercompany netting center that reduces the
number of payment transactions between related Swaptions
companies.
A swaption is an option on an interest rate swap.
Forwards The buyer of a swaption has the right, but not an
obligation, to enter into an interest rate swap with
A forward rate agreement (FRA) is an agreement
predefined terms at the expiration of the option. In
between two parties to lock in an interest rate for a
exchange for a premium payment, the buyer of a
predetermined period of time. Under the FRA
swaption can lock in either a fixed or variable
agreement, a borrower wants to guard against the
interest rate. Thus, if a treasurer believes that
cost of rising interest rates, while the counterparty
interest rates will rise, he can enter into a swaption
wishes to protect against declining interest rates.
agreement, which he can later convert into an
The counterparty is usually a bank
interest rate swap if interest rates do indeed go up.
Futures
An interest rate future is an exchange - traded
forward contract that allows a company to lock in
an interest rate for a future time period
Interest Rate Swaps
The interest rate swap is an agreement between two
parties (where one party is almost always a bank) to
exchange interest payments in the same currency
over a defined time period, which normally ranges
from one to ten years. One of the parties is paying a
fixed rate of interest, while the other is paying a
variable rate. The variable interest rate is paid
whenever a new coupon is set, which is typically
once a quarter. Fixed interest is usually paid at the
end of each year.

Debt Call Provisions

If a company is issuing its own debt, it can include a
call provision in the debt instrument that allows the
company to retire the debt at a predetermined price.
A treasurer would take advantage of this provision
if market rates were to decline subsequent to
issuance of the debt, and could then refinance at a
lower interest rate. The call provision typically
incorporates higher prices for earlier calls, which
gradually decline closer to par pricing further into
the future.