Long-Term Financing: An
Introduction
Chapter 15
1-1
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
2
Outline
• Some Features of Common and Preferred Stock
• Corporate Long-Term Debt
• Some Different Types of Bonds
• Bank Loans
• International Bonds
• Patterns of Financing
• Recent Trends in Capital Structure
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Features of Common Stock
• Voting rights (Cumulative vs. Straight)
• Proxy voting
• Classes of stock
• Other rights
• Share proportionally in declared dividends
• Share proportionally in remaining assets during
liquidation
• Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired
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Features of Preferred Stock
• Dividends
• Stated dividend must be paid before dividends can be
paid to common stockholders
• Dividends are not a liability of the firm, and preferred
dividends can be deferred indefinitely
• Most preferred dividends are cumulative – any missed
preferred dividends have to be paid before common
dividends can be paid
• Preferred stock generally does not carry voting
rights
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Debt versus Equity
• Debt • Equity
• Not an ownership interest • Ownership interest
• Creditors do not have • Common stockholders vote
voting rights for the board of directors
• Interest is considered a and other issues
cost of doing business • Dividends are not
and is tax deductible considered a cost of doing
• Creditors have legal business and are not tax
recourse if interest or deductible
principal payments are
• Dividends are not a liability
missed
• Excess debt can lead to of the firm, and stockholders
financial distress and have no legal recourse if
bankruptcy dividends are not paid
• An all-equity firm cannot go
bankrupt
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The Bond Indenture
• Contract between the company and the bondholders
that includes:
• The basic terms of the bonds
• The total amount of bonds issued
• A description of property used as security, if
applicable
• Sinking fund provisions
• Call provisions
• Details of protective covenants
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Bond Classifications
• Registered vs. Bearer Forms
• Security
• Collateral – secured by financial securities
• Mortgage – secured by real property, normally land or
buildings
• Debentures – unsecured
• Notes – unsecured debt with original maturity less
than 10 years
• Seniority
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Required Yields
• The coupon rate depends on the risk characteristics
of the bond when issued
• Which bonds will have the higher coupon, all else
equal?
• Secured debt versus a debenture
• Subordinated debenture versus senior debt
• A bond with a sinking fund versus one without
• A callable bond versus a non-callable bond
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Zero-Coupon Bonds
• Make no periodic interest payments (coupon rate =
0%)
• The entire yield to maturity comes from the
difference between the purchase price and the par
value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are
good examples of zeroes
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Pure Discount Bonds
Information needed for valuing pure discount bonds:
• Time to maturity (T) = Maturity date - today’s date
• Par value (face value, F)
• Discount rate (r)
$0 $0 $0 $F
0 1 2 T 1 T
Present value of a pure discount bond at time 0:
F
PV
(1 r ) T
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Pure Discount Bonds: Example
Find the value of a 30-year zero-coupon bond with
a $1,000 par value and a YTM of 6%.
$0 $0 $0 $1,000
0 1 2 29 30
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Floating Rate Bonds
• Coupon rate floats depending on some index value
• Examples – adjustable-rate mortgages and inflation-
linked Treasuries
• There is less price risk with floating rate bonds
• The coupon floats, so it is less likely to differ
substantially from the yield to maturity
• Coupons may have a “collar” – the rate cannot go
above a specified “ceiling” or below a specified
“floor”
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Other Bond Types
• Income bonds
• Convertible bonds
• Put bonds
• There are many other types of provisions that can
be added to a bond, and many bonds have several
provisions – it is important to recognize how these
provisions affect required returns
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Bank Loans
• Lines of Credit
• Provide a maximum amount the bank is willing to lend
• If guaranteed, referred to as a revolving line of credit
• Syndicated Loan
• Very large banks frequently have more demand for
loans than they have supply
• Small regional banks are often in the opposite situation
• As a result, a very large bank may arrange a loan with
a firm or country and then sell portions of the loan to a
syndicate of other banks
• A syndicated loan may be publicly traded
15
International Bonds
• Eurobonds: bonds denominated in a particular
currency and issued simultaneously in the bond
markets of several countries
• Foreign bonds: bonds issued in another nation’s
capital market by a foreign borrower
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Patterns of Financing
• Internally generated cash flow dominates as a
source of financing
• This preference has increased through time
• Net stock buybacks accelerated in 2002-2007 in
the U.S.
• Declined in 2008, likely as a result of the
financial crisis
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The Long-Term Financial Deficit
Uses of Cash Sources of Cash
Flow (100%) Flow (100%)
Capital Internal cash
spending flow (retained
80% earnings plus Internal
depreciation) cash flow
80%
Financial
deficit
Net
working
capital plus Long-term External
other uses debt and cash flow
20% equity 20%
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Recent Trends in Capital Structure
• Which are best: book or market values?
• In general, financial economists prefer market values
• However, many corporate treasurers may find book
values more appealing due to the volatility of market
values
• Whether we use book or market values, debt
ratios for U.S. non-financial firms have been
below 50 percent of total financing
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Quick Quiz
• Describe the basic characteristics of common and
preferred stock.
• Differentiate between cumulative voting and straight
voting.
• Identify the rights of shareholders and bondholders.
• How would the following characteristics impact the
yield on a bond:
• Callable
• Sinking Fund
