LongTerm Financing

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Lecture 14

• Long-Term Financing

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Stocks (equity) and Bonds (debt)
Debt and equity are broad categories of firm
liabilities.
Key distinguishing features of debt and equity
are
- Whether asset yields are a legal obligation or
discretionary
- Whether asset owners can vote to choose
directors
- Priority in sharing values in liquidation
- The tax deductibility of payments to asset
owners
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Stocks and Bonds (continued)
Various financial instruments are also used in
practice
Common stock can have different voting rights
Preferred stock, that has precedence in payment
of dividends and in liquidation, has some
debt-like features
Long-term debt, that is unsecured or
subordinated, has some equity-like features
Debt, that receives interest payment conditional
on corporate income, also resembles the
discretionary dividend yield of equity
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Trends in Financing Patterns (US Industrial firms)
Internally generated cash flow has dominated as a
source of financing, and the proportion of
internal financing has grown. (Table 1)
External financing has been dominated by
borrowing. (Figure 1)
During 1984-1990, new issues of equity were
negative as firms repurchased stock, largely
through increased borrowing.
Nevertheless, during 1977-1992, the market value
of firms equity increased more than 500
compared to only 350 for debt.
Internal financing tends to be higher in
recessions or periods of slower growth in the
economy (1979, 1982, 1991)
Firms in the US use more internal financing than
do firms in other comparable countries. (Figure 2)
Only firms in the US retired stocks in the 1980s
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Table 1 Historical U.S. Financing Patterns
(percent), 1979 to 1992
Figure 1 Sources of financing for U.S.
industrial firms
Figure 2 International Financing Patterns,
1990-1992
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Common Stocks
These assets represent ownership shares that have
no special preferences in bankruptcy or rights to
dividends.
Dividend payment is at the discretion of the
board of directors, but once declared is a legal
liability that can force bankruptcy.
Dividends are double-taxed -- except a
corporate owner is taxed on only 30 of receipts.
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Table 2 Definitions of some share value concepts
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Voting of Shareholders
Shareholders elect directors who select executive
officers. Votes may decide mergers.
A proxy is a legal grant of authority for someone
else to vote an owners shares.
Under cumulative voting, votes can be distributed
to over one or more candidates.
Under straight voting, votes for each candidate
equal the shares owned.
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Voting of Shareholders (continued)
Although cumulative voting assists minority
shareholders, election can be staggered so that
only one director is elected at a time.
Stocks with superior voting rights sell at a
premium, particularly in a takeover battle.
Preferred stocks usually do not have voting
rights, but may do if dividends are skipped.
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Example Problem 14.4
Shareholders of unicorn Co. need to elect 7 new
directors. There are 2 million shares
outstanding. How many shares do you need to be
certain that you can elect one director?
Straight voting case One share is one vote, so
you need at least 1,000,001 ( 2,000,000/2 1)
votes.
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Debt
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Debt (continued)
Creditors can claim the firms assets if
principal and interest are not paid on time
Interest payments on debt are tax-deductible.
However, debt increases the risk of a costly
bankruptcy.
The principal, face or par value is usually
dominated in units of 1000. Hence debt
selling at 90 could be bought for 900.
Interest is generally expressed as a fraction of
par value. For example, 7 debt at a par value
of 1000 would pay 70 interest payment annually,
usually in semi-annual installments of 35.
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Debt (continued)
Different broad categories of debt

• a bond is secured by a mortgage on company
  property
• a debenture is unsecured by specified property
• a note is a short-term obligation, usually under
  seven years
• unfunded debt is due in less than one year and is
  a current liability
• funded debt is payable more than one year from
  when issued
• debt with no specific maturity is called consol

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Preferred Stock
Has a preference, stated as a liquidating value
and a (maximum) dividend payment, in the event of
liquidation.
Skipped cumulative dividends are carried forward
(without interest) to be paid before common stock
holders receive anything.
Holders of preferred stock usually dont vote,
but may be given voting rights if preferred
dividends have not been paid.
Preferred dividends are not tax deductible.
However, since 70 of preferred dividends
received by corporations are tax exempt,
preferred stocks are often bought by other
corporations.
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Preferred Stock (continued)
Preferred stock does not impose a tax penalty on
companies reporting losses to IRS. On the other
hand, the deductibility of interest payments on
debt would be wasted.
Unlike straight debt, preferred stock cannot
force bankruptcy.