COMM 309 — Business Finance | Chapter 18: Debt Instruments
COMM 309 — Business Finance
CHAPTER 18: Debt Instruments
Comprehensive Exam Preparation Notes
18.1 What Is Debt?
Debt is a contract between a lender and a borrower that stipulates the terms of repayment of a loan.
Unlike equity, which gives investors ownership rights with no specific contractual cash flow obligations,
debt creates fixed contractual commitments — specific, legally enforceable obligations to pay interest
and repay principal on a set schedule. Failing to meet these commitments has serious legal
consequences, including the right of creditors to initiate bankruptcy proceedings.
Debt vs. Equity — The Essential Distinction
Feature Debt Equity
Legal nature Contract — creates specific, Ownership claim — no specific
enforceable payment obligations. contract detailing expected cash flows.
Investor role Lender (creditor) — expects fixed Owner (shareholder) — 'residual
interest and principal repayment. claimant'; gets what's left after all
contractual commitments are met.
Payment Fixed contractual commitments No contractual obligation. Dividends
obligations (interest + principal) — must be paid are discretionary; paid only if declared
regardless of firm performance. by the board.
Tax treatment Interest is FULLY TAX DEDUCTIBLE Dividends are NOT tax deductible —
(payer) for the borrower — treated as a paid out of after-tax profits.
legitimate cost of doing business.
Tax treatment Interest is fully taxable income for the Dividends receive preferential tax
(recipient) lender. treatment (dividend tax credit in
Canada).
Claim priority Senior claim — debt holders are paid Junior (residual) claim — equity
before equity holders in bankruptcy. holders are paid last, if anything
remains.
Risk to investor Lower risk — fixed, known cash flows; Higher risk — residual claim; returns
senior priority in default. uncertain.
The Tax Advantage of Debt — Interest Tax Shield
Because interest is tax deductible, the effective cost of debt to the firm is the after-tax cost, not the
stated (before-tax) rate. The government effectively subsidizes a portion of the interest payment by
reducing the firm's tax bill.
Eq. 18-1 | After-Tax Cost of Debt k = after-tax cost of debt (the true net cost to the firm)
k =kd × ( 1−T ) kd = before-tax interest cost (stated rate on debt)
Page 1
,COMM 309 — Business Finance | Chapter 18: Debt Instruments
T = corporate tax rate
Example: kd = 7%, T = 30% → k = 7% × (1 − 0.30) = 4.9%
Numerical Illustration: Firm with $10M assets, EBIT = $1M,
T = 30%
No debt: Tax = $300,000. Net income = $700,000.
$5M debt at 7%: Interest = $350,000. Taxable income =
$650,000. Tax = $195,000. Net income = $455,000.
Tax saving = $300,000 − $195,000 = $105,000 (=
$350,000 × 30%).
Net income fell by only $245,000 despite $350,000 in
extra interest — the government absorbed $105,000.
→ Of the $350,000 interest, only 70% (= $245,000) is
truly borne by the firm's owners.
CRA's Three Tests for Tax-Deductible Interest
The Canada Revenue Agency (CRA) uses three criteria to confirm that a payment qualifies as interest
(and is therefore tax deductible). All three must be satisfied:
• 1. Interest is compensation for the use or retention of money owed to another. The interest
must represent the cost of 'renting' the principal — not a return of capital or a disguised dividend.
• 2. Interest must be referable to a principal sum. The interest must be calculable from a specific
outstanding principal balance. Interest cannot exist without an associated principal.
• 3. Interest accrues from day to day. As the loan remains outstanding, interest accumulates
continuously — the longer the loan is out, the more interest is owed. This is the time-linked nature
of interest.
📌 Why the CRA Tests Matter — Saskatchewan Farm Security Act (1944)
The Province of Saskatchewan wanted to reduce farmers' debt burdens. It could not waive
interest (a federal responsibility under the Income Tax Act), so it reduced the principal associated
with the required interest payments — effectively setting principal reductions equal to the interest
owed, eliminating the real burden of interest.
The Supreme Court of Canada ruled: the interest payments could no longer be regarded as
'interest' because the principal sum was being simultaneously reduced — violating Test #2
(interest must be referable to a stable principal).
Implication: 'Innovative' financing vehicles are frequently created to make non-deductible
payments look like tax-deductible interest. The CRA scrutinizes these aggressively. If a
deduction is disallowed, the loophole closes — but clever financiers find new ones. This cycle of
innovation vs. regulation is a constant feature of finance.
Practical rule: Corporations always try to structure financing costs as tax-deductible interest
(debt) rather than non-deductible equity returns — reducing their tax bill. The CRA enforces the
Income Tax Act to prevent abuse.
Page 2
, COMM 309 — Business Finance | Chapter 18: Debt Instruments
Debt Maturity Classifications
Two key dimensions of any debt instrument are its maturity and its marketability (tradability in a
secondary market):
• Bill or Paper: Maturity less than 1 year. All outstanding bills and short-term paper constitute the
money market.
• Note: Maturity of 1 to 7 years.
• Bond: Maturity greater than 7 years.
18.2 Short-Term Debt and the Money Market
The money market consists of all short-term (< 1 year) debt instruments outstanding. It is a huge, liquid
market of instruments treated as virtually default-free and very safe. Most money market instruments
are sold on a discount basis — they are issued below their par value and redeemed at par at maturity;
the difference is the 'interest.' The three primary instruments are Government Treasury Bills,
Commercial Paper, and Bankers' Acceptances.
Government Treasury Bills
A treasury bill (T-bill) is a short-term promissory note issued by a government treasury department. T-
bills are the simplest, most default-free debt instruments:
• Issuer: Government of Canada (federal), provincial governments (Ontario, Quebec), and major
municipalities.
• Maturity: Up to 1 year; standard reference is the 91-day T-bill. Its yield is commonly called 'the' T-
bill yield.
• Pricing: Sold at a DISCOUNT to par value. The 'interest' = par value − purchase price. No
coupon is paid; investor earns the difference.
• Auction process: Bank of Canada acts as fiscal agent. Orders submitted through government
securities distributors (GSDs). Primary dealers (largest banks) must bid at every auction.
Competitive bids = at a specific price; Non-competitive bids = at the average auction price.
• Outstanding: As of May 2015: $119.7 billion (Canada T-bills) + $49.1 billion (provincial/municipal
T-bills) = $168.8 billion.
• Credit risk: Essentially ZERO — backed by the full faith and credit of the Government of Canada.
The promised yield ≈ expected yield.
T-bills are priced as pure discount instruments (zero-
coupon).
Par (face value) = amount paid at maturity
k = periodic yield (for the specific maturity)
Annual rate quoting convention: k_annual = k_period ×
T-Bill Pricing Formula (365 / days to maturity)
Par
Purchase Price=
1+ k Example: $1,000 par, 91-day T-bill, purchase price =
where k =period yield $990.099
k_91-day = (1,000/990.099) − 1 = 1.00%
Annual quoted rate = 1% × (365/91) = 4.011%
Note: CRA treats the discount (par − purchase price) as
INTEREST income (not capital gain) because the 'gain' is
locked in at purchase.
Page 3
COMM 309 — Business Finance
CHAPTER 18: Debt Instruments
Comprehensive Exam Preparation Notes
18.1 What Is Debt?
Debt is a contract between a lender and a borrower that stipulates the terms of repayment of a loan.
Unlike equity, which gives investors ownership rights with no specific contractual cash flow obligations,
debt creates fixed contractual commitments — specific, legally enforceable obligations to pay interest
and repay principal on a set schedule. Failing to meet these commitments has serious legal
consequences, including the right of creditors to initiate bankruptcy proceedings.
Debt vs. Equity — The Essential Distinction
Feature Debt Equity
Legal nature Contract — creates specific, Ownership claim — no specific
enforceable payment obligations. contract detailing expected cash flows.
Investor role Lender (creditor) — expects fixed Owner (shareholder) — 'residual
interest and principal repayment. claimant'; gets what's left after all
contractual commitments are met.
Payment Fixed contractual commitments No contractual obligation. Dividends
obligations (interest + principal) — must be paid are discretionary; paid only if declared
regardless of firm performance. by the board.
Tax treatment Interest is FULLY TAX DEDUCTIBLE Dividends are NOT tax deductible —
(payer) for the borrower — treated as a paid out of after-tax profits.
legitimate cost of doing business.
Tax treatment Interest is fully taxable income for the Dividends receive preferential tax
(recipient) lender. treatment (dividend tax credit in
Canada).
Claim priority Senior claim — debt holders are paid Junior (residual) claim — equity
before equity holders in bankruptcy. holders are paid last, if anything
remains.
Risk to investor Lower risk — fixed, known cash flows; Higher risk — residual claim; returns
senior priority in default. uncertain.
The Tax Advantage of Debt — Interest Tax Shield
Because interest is tax deductible, the effective cost of debt to the firm is the after-tax cost, not the
stated (before-tax) rate. The government effectively subsidizes a portion of the interest payment by
reducing the firm's tax bill.
Eq. 18-1 | After-Tax Cost of Debt k = after-tax cost of debt (the true net cost to the firm)
k =kd × ( 1−T ) kd = before-tax interest cost (stated rate on debt)
Page 1
,COMM 309 — Business Finance | Chapter 18: Debt Instruments
T = corporate tax rate
Example: kd = 7%, T = 30% → k = 7% × (1 − 0.30) = 4.9%
Numerical Illustration: Firm with $10M assets, EBIT = $1M,
T = 30%
No debt: Tax = $300,000. Net income = $700,000.
$5M debt at 7%: Interest = $350,000. Taxable income =
$650,000. Tax = $195,000. Net income = $455,000.
Tax saving = $300,000 − $195,000 = $105,000 (=
$350,000 × 30%).
Net income fell by only $245,000 despite $350,000 in
extra interest — the government absorbed $105,000.
→ Of the $350,000 interest, only 70% (= $245,000) is
truly borne by the firm's owners.
CRA's Three Tests for Tax-Deductible Interest
The Canada Revenue Agency (CRA) uses three criteria to confirm that a payment qualifies as interest
(and is therefore tax deductible). All three must be satisfied:
• 1. Interest is compensation for the use or retention of money owed to another. The interest
must represent the cost of 'renting' the principal — not a return of capital or a disguised dividend.
• 2. Interest must be referable to a principal sum. The interest must be calculable from a specific
outstanding principal balance. Interest cannot exist without an associated principal.
• 3. Interest accrues from day to day. As the loan remains outstanding, interest accumulates
continuously — the longer the loan is out, the more interest is owed. This is the time-linked nature
of interest.
📌 Why the CRA Tests Matter — Saskatchewan Farm Security Act (1944)
The Province of Saskatchewan wanted to reduce farmers' debt burdens. It could not waive
interest (a federal responsibility under the Income Tax Act), so it reduced the principal associated
with the required interest payments — effectively setting principal reductions equal to the interest
owed, eliminating the real burden of interest.
The Supreme Court of Canada ruled: the interest payments could no longer be regarded as
'interest' because the principal sum was being simultaneously reduced — violating Test #2
(interest must be referable to a stable principal).
Implication: 'Innovative' financing vehicles are frequently created to make non-deductible
payments look like tax-deductible interest. The CRA scrutinizes these aggressively. If a
deduction is disallowed, the loophole closes — but clever financiers find new ones. This cycle of
innovation vs. regulation is a constant feature of finance.
Practical rule: Corporations always try to structure financing costs as tax-deductible interest
(debt) rather than non-deductible equity returns — reducing their tax bill. The CRA enforces the
Income Tax Act to prevent abuse.
Page 2
, COMM 309 — Business Finance | Chapter 18: Debt Instruments
Debt Maturity Classifications
Two key dimensions of any debt instrument are its maturity and its marketability (tradability in a
secondary market):
• Bill or Paper: Maturity less than 1 year. All outstanding bills and short-term paper constitute the
money market.
• Note: Maturity of 1 to 7 years.
• Bond: Maturity greater than 7 years.
18.2 Short-Term Debt and the Money Market
The money market consists of all short-term (< 1 year) debt instruments outstanding. It is a huge, liquid
market of instruments treated as virtually default-free and very safe. Most money market instruments
are sold on a discount basis — they are issued below their par value and redeemed at par at maturity;
the difference is the 'interest.' The three primary instruments are Government Treasury Bills,
Commercial Paper, and Bankers' Acceptances.
Government Treasury Bills
A treasury bill (T-bill) is a short-term promissory note issued by a government treasury department. T-
bills are the simplest, most default-free debt instruments:
• Issuer: Government of Canada (federal), provincial governments (Ontario, Quebec), and major
municipalities.
• Maturity: Up to 1 year; standard reference is the 91-day T-bill. Its yield is commonly called 'the' T-
bill yield.
• Pricing: Sold at a DISCOUNT to par value. The 'interest' = par value − purchase price. No
coupon is paid; investor earns the difference.
• Auction process: Bank of Canada acts as fiscal agent. Orders submitted through government
securities distributors (GSDs). Primary dealers (largest banks) must bid at every auction.
Competitive bids = at a specific price; Non-competitive bids = at the average auction price.
• Outstanding: As of May 2015: $119.7 billion (Canada T-bills) + $49.1 billion (provincial/municipal
T-bills) = $168.8 billion.
• Credit risk: Essentially ZERO — backed by the full faith and credit of the Government of Canada.
The promised yield ≈ expected yield.
T-bills are priced as pure discount instruments (zero-
coupon).
Par (face value) = amount paid at maturity
k = periodic yield (for the specific maturity)
Annual rate quoting convention: k_annual = k_period ×
T-Bill Pricing Formula (365 / days to maturity)
Par
Purchase Price=
1+ k Example: $1,000 par, 91-day T-bill, purchase price =
where k =period yield $990.099
k_91-day = (1,000/990.099) − 1 = 1.00%
Annual quoted rate = 1% × (365/91) = 4.011%
Note: CRA treats the discount (par − purchase price) as
INTEREST income (not capital gain) because the 'gain' is
locked in at purchase.
Page 3
