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Sources and Forms of Long-Term Financing

Chapter 16

The Money and Capital Markets


Two types of external markets for funds:
1. Money market
Short-term debt securities: maturity of less than 1 year T-bills, commercial paper, bankers acceptances, and shortterm certificates of deposit Intermediate-term securities: maturity of more than 1 but less than 10 years Long-term securities: maturity of 10 or more years Equity securities: preferred and common stock have longest time horizon since they are issued for life of corporation

2. Capital market (focus of this chapter)


Intermediate- and Long-Term Debt


Two primary sources of intermediate- and long-term debt:
1. Term loans 2. Bonds

Intermediate- and Long-Term Debt


1. Term loans
Paid off over some number of years Usually negotiated with commercial bank, insurance company, or some other financial institution Fully amortized (principal and interest are paid off in installments over life of loan)

Intermediate- and Long-Term Debt


2. Bonds
Intermediate to long term debt agreements issued by governments, corporations, and other organizations Issued in units of $1,000 principal value per bond Two promises to:
Repay $1,000 principal value at maturity Pay stated interest rate (coupon rate) when due

Most bonds pay interest semiannually at a rate equal to one-half of the annual coupon rate

Intermediate- and Long-Term Debt


2. Bonds (continued)
Bond indenture: complete statement of legal obligations of issuing organization to bondholders
Specifies number of restrictive covenants
Protect bondholders interests Describe various standards that issuer must meet or action that issuer must not take

If issuer violates terms of indenture, bond is in default and trustee must do whatever is necessary to remedy default.

Intermediate- and Long-Term Debt


Different types of bond issues:
Mortgage bonds: bonds that are collateralized by a mortgage on some fixed asset (e.g. building, land, equipment) Debenture: unsecured bond that is baked by full faith and credit of issuer
No specific assets are pledged as collateral If default or bankruptcy occurs, debenture holders become general creditors of the issuer

Subordinated debenture: debenture that is specifically subordinated to some other debt issue
If default or bankruptcy, junior debt has no claim on issuers assets until senior debt is satisfied

Intermediate- and Long-Term Debt


Different types of bonds (continued)
Convertible bonds: corporate bonds that may be converted into common stock at the option of bondholder
Conversion rate: number of shares of stock into which bond may be converted

Income bonds: bonds on which interest is paid only when corporation earns a specified level of income

Intermediate- and Long-Term Debt


Different types of bond issues (continued)
Floating-rate bonds: like regular bullet bonds except that coupon rate is tied to some variable rate benchmark (e.g. LIBOR: London Interbank Offered Rate) Zero coupon bond: sold at substantial discounts from par buy pay no current interest
Investors earn their rate of interest from interest accreting as bond approaches maturity Recall Chapter 14

Intermediate- and Long-Term Debt


Different types of bond issues (continued)
Call provisions: issuing corporation has the right to call in bond for retirement prior to maturity
May not be called until some number of years after original issue Must be called at a premium above par value

Sinking fund: establishes procedure for orderly retirement of a bond over life of issue
Requires periodic (usually annual) repurchase of stated percentage of outstanding bonds Repurchasing corporation may either buy bonds in open market or call in bonds for redemption
Bonds to be called are determined by lottery based on serial numbers of bonds When high interest rates drive bond prices down, open-market purchases at discounts from par value are more attractive

Intermediate- and Long-Term Debt


Bond Yields Four common yield measures:
1. 2. 3. 4. Coupon yield rate Current yield Yield to maturity (YTM) Yield to first call date (YTC)

Intermediate- and Long-Term Debt


Bond Yields 1.Coupon yield rate: rate of interest specified on bond coupons at the time bond is issued
Stated in bond indenture Does not change once bond is issued If interest rates rise after issue, then bond price will fall. If interest rates fall after issue, then bond price will rise.

Intermediate- and Long-Term Debt


Bond Yields 2.Current yield: calculated by dividing coupon interest in dollars by current market price of bond
Seasoned bond: bond that has been issued and is traded freely on open market
Interest rates fluctuate and thus, prices of seasoned bonds also fluctuate.

Intermediate- and Long-Term Debt


Bond Yields 3. Yield to maturity: average annual compound rate of return that would be earned if bond were purchased at its current market value and held to maturity
Includes return from interest payments and capital gain/loss if bond is purchases at discount/premium

Intermediate- and Long-Term Debt


Bond Yields 4.Yield to first call date: yield to maturity on callable bond, assuming bond is purchased at current market price and then called at first eligible date

Lease Financing
Many businesses lease assets as an alternative to owning them.
Business has the use of the asset and incurs an obligation either to pay off loan or meet monthly lease payment. At the end of lease term, residual value of asset belongs to lessee. Leasing is a form of debt financing.

Lease Financing
FASB 13 (governing lease accounting): defines difference between capital lease and operating lease Capital leases meet any one of these four conditions:
1. Title is transferred to lessee at end of lease term. 2. Lease contains bargain purchase option (an option to buy asset at very low price). 3. Term of lease is greater than or equal to 75% of estimated economic life of asset. 4. Present value of minimum lease payment is greater than or equal to 90% of fair value of leased property.

Lease Financing
Capital lease on balance sheet:
Asset: capital lease asset Liability: obligation under capital lease Amount of asset and liability equals present value of minimum future lease payments
Leasing does not provide source of off-balance-sheet financing

Lease Financing
Operating leases
More like true rentals rather than means to finance long-term use of asset For substantially less than expected useful life of asset and provide for both financing and maintenance Contain cancellation clauses so that lessee is not locked into long-term agreement. No asset and associated liability are created

Lease Financing
Tax benefits are the major motivation that firms prefer leasing to owning.
Lessor is entitled to tax benefits from depreciation. Lessors after-tax return is higher than it would be under straight debt arrangement. Lessor prices lease payments at lower rate of return than would otherwise be charged the lessee on straight loan arrangement.

Lease Financing
Leasing may be attractive to firm with low credit rating.
Lease can be obtained more easily than loan can be arranged because lessor retains title to asset. Full recovery of asset in the event of default is much easier than if asset were owned by lessee. Down payment in purchased asset is much higher than deposit required on lease Use of operating leases may increase lessees overall credit availability since they do not appear on the balance sheet.

Lease Financing
Sale and Leaseback Firm sells fixed asset (e.g. building) to lender/lessor and then immediately leases back the property. Seller/lessee receives large inflow of cash that may be used to finance other aspects of business and in return, enters into long-term lease obligation.

Lease Financing
Leveraged Lease Involves third-party lender:
Lessor (e.g. commercial bank) borrows 80% or less of cost of asset from third-party lender. Lessor purchases asset and leases it to lessee.

Lessor has title to asset and is thus entitled to full depreciation benefits.

Preferred Stock
Two important preferences over common stock:
1. Payment of dividends 2. Stockholders claims on assets of business in event of bankruptcy

Preferred Stock
Preferred stock combines some of the characteristics of bonds and some of the characteristics of common stock
Fixed in amount Holders do not participate in growth of corporate earnings, but rather collect only dividends promised in indenture Payments must be voted on and approved by board of directors of corporation Issues are cumulative (missed dividends accumulate as arrearages and must be paid off before dividends on common stock can be paid)

Preferred Stock
Payment of preferred dividends is nearly as important as timely payment of bond interest.
It is difficult for corporations with preferred dividends in arrears to raise other forms of capital. Nonpayment of bond interest can force corporation into bankruptcy. Preferred stockholders cannot legally force bankruptcy for nonpayment of dividends.

Preferred Stock
Conversion ratio: specified exchange rate (common for preferred) at which preferred stock is convertible into common stock
If company prospers and price of common stock rises, conversion becomes attractive. If convertible preferred stock is callable, corporation is allowed to call stock and/or force conversion into common stock in the future if advantageous.

Common Stock
Common stockholders: owners of the corporation
Each share of common stock has one vote in electing members of corporations board of directors. Board is responsible to stockholders. Board selects president. President reports to board. If one person is a majority stockholder, he/she may serve as both president and chairman.

In large, publicly held corporations, no single individual or small group holds enough shares to exercise voting control of corporation.

Common Stock
Directors are elected in annual meetings. Prior to each meeting, current management solicits voting proxies of stockholders, which allows management to vote the shares of stockholders who sign proxy.
Dissident stockholder group or outside group seeking to take over company can also solicit proxies. Party with most proxies gains control of corporation.

Common Stock
Tender offer: another corporation buys up enough stock in market to exert majority control of takeover target
Acquiring corporation publicly announces its willingness to buy shares at a given price above current market price from all stockholders who tender their shares be specified expiration date.

Common Stock
Common stock serves as corporations equity cushion.
Money paid to corporation for common stock does not have to be repaid. Board declares when dividends are paid. Dividends do not accumulate as arrearages. Stockholders cannot legally claim any specified dividend level. As corporation prospers, board votes to increase dividend along with increased growth in earnings. As dividends increase, value of stock increases.

Common Stock
Some corporations have two classes of common stock:
Class A stock:
Voting stock

Class B stock:
Nonvoting stock Possesses right to participate in earnings and dividends Cannot vote on corporate matters

Large, publicly held corporations rarely offer two different classes.

Dividend Policy
Board of directors is responsible for dividend policy.
Most dividends are paid quarterly. Board votes on and approved each payment. Dividend policy requires compromise between:
Stockholders desire to receive some of the earnings through cash dividends Corporations desire to reinvest earnings to finance future growth.

Dividend Policy
Factors that influence dividend policy:
Growth rate
High-growth corporations have high demands for funds and pay low dividends.

Stability of corporations earnings


High level of earnings stability reduces corporations business risk Allows higher dividend payout

Rate of return earned on equity capital


If ROE is higher than stockholders opportunity rate of return (return stockholders expect to earn on next-best-available investment opportunity), stockholders will benefit if corporation reinvests earnings.

Dividend Policy
Factors (continued):
Overall liquidity position and access to money and capital markets
Highly liquid corporation with easy access to capital markets can pay out a higher percentage of earnings in dividends than less liquid corporation

Outstanding debt repayment requirements and/or restrictive covenants on long-term debt agreements
Restrictive covenants prohibit dividend payments out of past retained earnings and place a lower limit on dollar amount of net working capital that must be maintained.

Dividend Policy
Factors (continued)
Capital-impairment rule
Normal cash dividend payments may not exceed retained earnings Corporations may not pay dividends when insolvent (total liabilities exceeds total assets) This rule protects creditors Firm may pay liquidating dividends out of capital (assets minus liabilities)

Dividend Policy
The Residual Theory of Dividend Policy Board should select dividend policy that will maximize value of outstanding common stock. Residual theory: assumes that investors prefer to have corporation retain and reinvest earnings rather than pay them out as in dividends if corporations ROE is greater than stockholders opportunity rate of return (recall slide 34)

Dividend Policy
The Residual Theory of Dividend Policy 1.Determine optimal size of capital budget by noting where investment-opportunity schedule intersects marginal-cost-of-capital curve (recall Chapter 13; see Exhibit 13.3) 2.Optimal capital structure (see Exhibit 13.5) determines what percentage of optimal capital budget must be financed by equity capital

Dividend Policy
The Residual Theory of Dividend Policy 3. Compare total amount of earnings available for reinvestment and dividend payout to total dollars of equity capital needed for capital budget If available earnings are less than required earnings, all earnings should be reinvested and no dividend should be paid.
Firm must sell new stock to raise amount of equity capital required.

If available earnings equal required earnings, all earnings should be reinvested.


Firm does not need to sell additional stock.

If available earnings exceed required earnings, excess (the residual) should be paid out as dividend.

Dividend Policy
Dividend Theory in Practice Companies in high-growth industries face attractive investment opportunities.
High demands for equity capital to finance growth Pay no dividends or very low dividends

Companies in low-growth industries have high dividend-payout ratios.

Dividend Policy
Dividend Theory in Practice Companies do not follow residual theory exactly because they face different capital budgeting opportunities from year to year.
Residual theory may require payment of very high dividend, no dividend, or normal dividend from year to year. Erratic dividend policy reduces value of stock compared with what it would be with a stable policy. Investors interpret dividend cut to be symptom of financial weakness rather than for some extraordinary investment opportunity.

Dividend Policy
Dividend Theory in Practice Firms strive to maintain stable dividend payment from year to year.
Board considers likelihood that increased dividend can be maintained in the future.

Constant percentage-payment ratio: firm pays out same percentage of income to stockholders each year

Dividend Policy
Stock Dividends and Stock Splits Stock dividend: payment of dividend in the form of additional shares of stock in corporation Stock split: stock dividend of 25% or more (each existing share is paid 0.25 or more shares as dividend) Shareholder gains nothing from either stock dividend or stock split.
Total number of shares claiming equity position is increased. Each shareholder increases number of shares held in proportion to number of shares held before split/dividend

Price of outstanding shares will decline by amount of split if it is not accompanied by increase in earnings/dividends per share.

Dividend Policy
Stock Repurchases Companies can repurchase their own stock with excess cash rather than pay dividend. Stock repurchases (treasury stock) do not share in future earnings/dividends. After repurchase, there are fewer shares outstanding.
Earnings per share increase if aggregate corporate earnings remain the same. Value of stock increases. Stockholders receive capital gain rather than dividend.