Sources and Forms of Longterm Financing

1
Chapter 14

• Sources and Forms of Long-term Financing

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The Money and Capital Markets

• Money markets short-term securities (less than
  one year)
• Capital markets intermediate-term (1 to 10
  years) and long-term (over 10 years)
• Floating rate bonds and floating rate mortgages
  popular as hedge against rising interest rates

3
Intermediate- and Long-term Debt

• Term loans are usually negotiated with commercial
  bank or insurance company, they are quick and
  have low administration costs
• Corporate bond promises pay interest
  semiannually and repay principal at maturity

4
Intermediate- and Long-term Debt

• Bonds may be privately placed (for example,
  insurance company or corporate pension fund) or
  sold to the public via investment bankers
• Bond indentures specifies restrictive covenants
  that result in default if violated

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Types of Bond

• Mortgage bond bond backed by mortgage
• Debenture bond unsecured bond
• Subordinated debenture debenture specifically
  junior to other debt
• Convertible bond bond convertible into common
  stock
• Income bond interest paid only when corporation
  earns a specified level on income
• Floating rate bonds variable interest rate
• Zero coupon bonds no payment of current interest

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Additional Bond Provisions

• Call provision bond may be called in for
  redemption, usually at a premium, prior to
  maturity
• Sinking fund procedure for orderly retirement
  of bond over is life span bonds are usually
  repurchased in open market or called by lottery

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Bond Yields

• Coupon rate interest payment specified on bond
  coupon
• Current yield interest payment in dollars as a
  percent of bonds current market price
• Yield to maturity (YTM) average annual compound
  rate of return earned if bond purchased at
  current market price and held to maturity
• Yield to first call date (YTC) YTM on a
  callable bond purchased at current market price
  and held to first call date

8
Lease and Financing

• Lease financing is conceptually similar to
  borrowing to buy
• Lease is considered a capital lease if it meets
  any one of four conditions
• Title is transferred to lessee at end of lease
  term
• It has bargain purchase option
• Term of lease is greater than or equal to 75 of
  expected useful life of asset
• Present value of minimum lease payments is
  greater than or equal to 90 of fair value

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Lease and Financing

• Capital lease must be capitalized on balance
  sheet as capital lease asset and associated
  obligation under capital lease liability
• Operating leases are leases that are not capital
  leases and are not capitalized
• Corporate preference for leasing is mainly
  related to tax benefits

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Lease and Financing

• Leasing is also attractive to a firm with low
  credit rating
• Sale and leaseback is a potential source of
  financing
• Leveraged lease involves a third-pary lender

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Preferred Stock

• Preferred stock equity security with preference
  to dividends and preference to liquidation
• It its also a hybrid type of security with some
  bond characteristics (fixed payment and
  preference over common stock) and some equity
  characteristics (dividend must be approved by
  board of directors)

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Preferred Stock

• Most preferred stock is cumulative, with voting
  rights if arrearages reach a specified level
• As a practical matter, dividend payment is very
  important to the corporation due to impact of
  arrearages on ability to raise future capital
• Preferred is often convertible corporation can
  force conversion via call provision

13
Common Stock

• Common stockholders are owners of the corporation
• Each share of common has one vote for each member
  of the board of directors
• Most stockholders sign proxies or vote with
  management
• Proxy fights and unfriendly takeovers are
  possible
• Common stock provides equity cushion
• Corporation sometimes have two classes of common
  stock

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Dividend Policy

• Dividend policy is a major responsibility of the
  board of directors
• Factors influencing dividend policy
• Growth rate
• Stability of earnings
• Return on equity capital
• Liquidity
• Access to money and capital markets
• Restrictive covenants on long-term debt
• Legal constraints, such as capital impairment rule

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Residual Theory of Dividend Policy

• This is a policy to maximize the value of
  outstanding common stock
• Determine optimal-size capital budget by
  intersection of investment opportunity schedule
  and marginal cost of capital
• Optimal capital structure determines percentage
  of capital budget to be supplied by equity capital

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Residual Theory of Dividend Policy

• Compare earnings available for reinvestment and
  dividend payout to equity capital needed for
  capital budget
• If available earnings are less than or equal to
  required, then no dividend sell stock to raise
  additional equity if required
• If available earnings exceed required, pay out
  residual as a dividend

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Dividend Theory in Practice

• Many corporations follow theory approximately,
  that is, high-growth companies low or no dividend
  and low-growth companies pay high dividends
• Most companies attempt to maintain stable
  dividend policy

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Stock Dividends and Stock Splits

• Stock dividend is payment of dividend in
  additional shares of stock
• Stock split is a stock dividend of 25 or more