CHAPTER 15
Long-Term Financing
AN INTRODUCTION
In July 2011, a budget battle took place in Washington that left few, if any, winners. In the end, a
compromise was reached that was designed to reduce the federal budget deficit by $2.1 trillion
over 10 years. However, bond rating agency Standard & Poor’s felt that the cuts weren’t deep
For updates on the
latest happenings
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blogspot.com
enough, saying there should have been $4 trillion in savings. As a result, S&P downgraded the U.S.
government’s debt from AAA to AA1. Besides the loss of prestige resulting from the downgrade, it
was estimated that the lower credit rating could result in an increase of $100 billion in borrowing
costs for the U.S. government.
Also during 2011, Italy, Spain, Ireland, Portugal, Cyprus, and Greece all saw their sovereign debts
downgraded. Greece’s credit rating was cut to CCC, just a step or two above default. In large part
due to the low credit rating, investors demanded a yield of 14 percent on Greek bonds at a time
when the yield on a 10-year U.S Treasury note was less than 3 percent.
15.1 Some Features of Common
and Preferred Stocks
In this chapter, we examine specific features of both stocks and bonds. We begin
with stock, both common and preferred. In discussing common stock features, we
focus on shareholder rights and dividend payments. For preferred stock, we explain
what the “preferred” means, and we also debate whether preferred stock is really
debt or equity.
COMMON STOCK FEATURES
The term common stock means different things to different people, but it is usually
applied to stock that has no special preference either in receiving dividends or in
bankruptcy.
Shareholder Rights A corporation’s shareholders elect directors who, in turn,
hire management to carry out their directives. Shareholders, therefore, control the
corporation through the right to elect the directors. Generally, only shareholders have
this right.
Directors are elected each year at an annual meeting. Although there are exceptions (discussed next), the general idea is “one share, one vote” (not one shareholder,
one vote). Corporate democracy is thus very different from our political democracy.
With corporate democracy, the “golden rule” prevails absolutely.1
1
The golden rule: Whosoever has the gold makes the rules.
474
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Directors are elected at an annual shareholders’ meeting by a vote of the holders of
a majority of shares who are present and entitled to vote. However, the exact mechanism for electing directors differs across companies. The most important difference is
whether shares must be voted cumulatively or voted straight.
To illustrate the two different voting procedures, imagine that a corporation has
two shareholders: Smith with 20 shares and Jones with 80 shares. Both want to be
a director. Jones does not want Smith, however. We assume there are a total of four
directors to be elected.
The effect of cumulative voting is to permit minority participation.2 If cumulative
voting is permitted, the total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled)
multiplied by the number of directors to be elected.
With cumulative voting, the directors are elected all at once. In our example, this
means that the top four vote getters will be the new directors. A shareholder can distribute votes however she wishes.
Will Smith get a seat on the board? If we ignore the possibility of a five-way tie,
then the answer is yes. Smith will cast 20 3 4 5 80 votes, and Jones will cast 80 3 4 5
320 votes. If Smith gives all his votes to himself, he is assured of a directorship. The
reason is that Jones can’t divide 320 votes among four candidates in such a way as to
give all of them more than 80 votes, so Smith will finish fourth at worst.
In general, if there are N directors up for election, then 1/(N 1 1) percent of the
stock plus one share will guarantee you a seat. In our current example, this is 1/(4 1 1) 5
20 percent. So the more seats that are up for election at one time, the easier (and
cheaper) it is to win one.
With straight voting, the directors are elected one at a time. Each time, Smith can
cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of the candidates. The only way to guarantee a seat is to own 50 percent plus one share. This also
guarantees that you will win every seat, so it’s really all or nothing.
EXAMPLE 15.1
Buying the Election Stock in JRJ Corporation sells for $20 per share and features cumulative
voting. There are 10,000 shares outstanding. If three directors are up for election, how much does
it cost to ensure yourself a seat on the board?
The question here is how many shares of stock it will take to get a seat. The answer is 2,501,
so the cost is 2,501 3 $20 5 $50,020. Why 2,501? Because there is no way the remaining 7,499
votes can be divided among three people to give all of them more than 2,501 votes. For example,
suppose two people receive 2,502 votes and the first two seats. A third person can receive at most
10,000 2 2,502 2 2,502 2 2,501 5 2,495, so the third seat is yours.
As we’ve illustrated, straight voting can “freeze out” minority shareholders, which
is why many states have mandatory cumulative voting. However, in states where
cumulative voting is mandatory, corporations have ways to minimize its impact.
One such way is to stagger the voting for the board of directors. With staggered
elections, only a fraction of the directorships are up for election at a particular time.
For example, if only two directors are up for election at any one time, it will take
1/(2 1 1) 5 33.33 percent of the stock plus one share to guarantee a seat.
2
By minority participation, we mean participation by shareholders with relatively small amounts of stock.
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Overall, staggering has two basic effects:
1.
2.
Staggering makes it more difficult for a minority to elect a director under cumulative voting because fewer directors are elected at one time.
Staggering deters takeover attempts because of the difficulty of voting in a
majority of new directors.
However, staggering can also serve a beneficial purpose. It provides “institutional
memory” from continuity on the board of directors. Continuity may be important for
corporations with significant long-range plans and projects.
Proxy Voting At the annual meeting shareholders can vote in person, or they can
transfer their right to vote to another party. A proxy is the grant of authority by a
shareholder to someone else to vote her shares. For convenience, much of the voting
in large public corporations is actually done by proxy.
Obviously, management wants to accumulate as many proxies as possible. However,
an “outside” group of shareholders can try to obtain proxies in an attempt to replace
management by electing enough directors. The resulting battle is called a proxy fight.
Classes of Stock Some firms have more than one class of common stock.
Often, the classes are created with unequal voting rights. For example, Ford Motor
Company’s Class B common stock is held by Ford family interests and trusts and not
publicly traded. This class has 40 percent of the voting power, even though it represents less than 10 percent of the total number of shares outstanding.
There are many other cases of corporations with different classes of stock. Berkshire
Hathaway Class B shares have 1/200th vote of Class A shares, though each Class A
share can be converted to only 30 Class B shares. The CEO of cable TV giant Comcast,
Brian Roberts, owns about .4 percent of the company’s equity, but he has a third of all
the votes, thanks to a special class of stock. Google has two classes of common stock,
A and B. The Class A shares are held by the public, and each share has one vote. The
Class B shares are held by company insiders, with each Class B share having 10 votes.
As a result, Google’s founders and management control the company.
Historically, the New York Stock Exchange did not allow companies to create
classes of publicly traded common stock with unequal voting rights. However, exceptions (e.g., Ford) appear to have been made. In addition, many non-NYSE companies
have dual classes of common stock. Limited-voting stock allows management of a
firm to raise equity capital while maintaining control.
The subject of unequal voting rights is controversial in the United States, and the
idea of one share, one vote, has a strong following and a long history. Interestingly,
however, shares with unequal voting rights are quite common around the world.
Other Rights The value of a share of common stock in a corporation is directly
related to the general rights of shareholders. In addition to the right to vote for directors, shareholders usually have the following rights:
1.
2.
3.
ros34779_ch15_474-493.indd 476
The right to share proportionally in dividends.
The right to share proportionally in assets remaining after liabilities have been
paid in a liquidation.
The right to vote on stockholder matters of great importance, such as a merger.
Voting usually occurs at the annual meeting or a special meeting.
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In addition, corporations sometimes give the preemptive right to their stockholders.
A preemptive right forces a company to sell stock to its existing stockholders before
offering the stock to the general public. The right lets each stockholder protect his
proportionate ownership in the corporation.
Dividends Corporations are legally authorized to pay dividends to their shareholders. The payment of dividends is at the discretion of the board of directors.
Some important characteristics of dividends include the following:
1.
2.
3.
Unless a dividend is declared by the board of directors of a corporation, it is not
a liability of the corporation. A corporation cannot default on an undeclared
dividend. As a consequence, corporations cannot become bankrupt because of
nonpayment of dividends. The amount of the dividend and even whether it is
paid are decisions based on the business judgment of the board of directors.
Dividends are paid out of the corporation’s aftertax cash flow. They are not
business expenses and are not deductible for corporate tax purposes.
Dividends received by individual shareholders are taxable. However, corporations are permitted to exclude 70 percent of the dividends they receive from
other corporations and are taxed only on the remaining 30 percent.3
PREFERRED STOCK FEATURES
Preferred stock pays a cash dividend expressed in terms of dollars per share. Preferred
stock has a preference over common stock in the payment of dividends and in the
distribution of corporation assets in the event of liquidation. Preference means only
that holders of preferred shares must receive a dividend (in the case of an ongoing
firm) before holders of common shares are entitled to anything. Preferred stock typically has no maturity date.
Preferred stock is a form of equity from a legal and tax standpoint. It is important
to note, however, that holders of preferred stock usually have no voting privileges.
Stated Value Preferred shares have a stated liquidating value, usually $100 per
share. For example, General Motors’ “$5 preferred,” paying an annual dividend of $5,
translates into a dividend yield of 5 percent of stated value.
Cumulative and Noncumulative Dividends A preferred dividend is not
like interest on a bond. The decision of the board of directors not to pay the dividends on
preferred shares may have nothing to do with the current net income of the corporation.
Dividends payable on preferred stock are either cumulative or noncumulative; most
are cumulative. If preferred dividends are cumulative and are not paid in a particular
year, they will be carried forward as an arrearage. Usually, both the accumulated
(past) preferred dividends and the current preferred dividends must be paid before the
common shareholders can receive anything.
Unpaid preferred dividends are not debts of the firm. Directors elected by the common shareholders can defer preferred dividends indefinitely. However, in such cases,
common shareholders must also forgo dividends. In addition, holders of preferred
3
More specifically, the 70 percent exclusion applies when the recipient owns less than 20 percent of the outstanding
stock in a corporation. If a corporation owns more than 20 percent but less than 80 percent, the exclusion is 80 percent.
If more than 80 percent is owned, the corporation can file a single “consolidated” return and the exclusion is effectively
100 percent.
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shares are sometimes granted voting and other rights if preferred dividends have not
been paid for some time.
Is Preferred Stock Really Debt? A good case can be made that preferred
stock is really debt in disguise. Preferred shareholders receive a stated dividend only,
and, if the corporation is liquidated, preferred shareholders get a stated value. Often,
preferred stocks carry credit ratings much like those of bonds. Preferred stock is
sometimes convertible into common stock. In addition, preferred stocks are often
callable, which allows the issuer to repurchase, or “call,” part or all of the issue at a
stated price. More will be said about the call feature in the next section.
Though preferred stock typically has no maturity date, many issues have obligatory
sinking funds. A sinking fund requires a company to retire a portion of its preferred
stock each year. A sinking fund effectively creates a final maturity, since the entire
issue will ultimately be retired. More will be said on sinking funds in the next section.
For these reasons, preferred stock seems to be a lot like debt. However, for tax purposes, preferred dividends are treated like common stock dividends.
In the 1990s, firms began to sell securities that looked a lot like preferred stock but
were treated as debt for tax purposes. The new securities were given interesting acronyms like TOPrS (trust-originated preferred securities, or toppers), MIPS (monthly
income preferred securities), and QUIPS (quarterly income preferred securities),
among others. Because of various specific features, these instruments can be counted
as debt for tax purposes, making the interest payments tax deductible. Payments made
to investors in these instruments are treated as interest for personal income taxes
for individuals. Until 2003, interest payments and dividends were taxed at the same
marginal tax rate. When the tax rate on dividend payments was reduced, these instruments were not included, so individuals must still pay their higher income tax rate on
dividend payments received from these instruments.
15.2 Corporate Long-Term Debt
In this section, we describe in some detail the basic terms and features of a typical
long-term corporate bond. We discuss additional issues associated with long-term
debt in subsequent sections.
Securities issued by corporations may be classified roughly as equity securities or
debt securities. A debt represents something that must be repaid; it is the result of borrowing money. When corporations borrow, they generally promise to make regularly
scheduled interest payments and to repay the original amount borrowed (that is, the
principal). The person or firm making the loan is called the creditor, or lender. The
corporation borrowing the money is called the debtor, or borrower.
From a financial point of view, the main differences between debt and equity are:
Information for
bond investors
can be found at
www.
investinginbonds.
com.
1.
2.
3.
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Debt is not an ownership interest in the firm. Creditors generally do not have
voting power.
The corporation’s payment of interest on debt is considered a cost of doing
business and is fully tax deductible. Dividends paid to stockholders are not tax
deductible.
Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally
claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of
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Long-Term Financing
issuing debt is the possibility of financial failure. This possibility does not arise
when equity is issued.
IS IT DEBT OR EQUITY?
Sometimes it is not clear if a particular security is debt or equity. For example, suppose a corporation issues a perpetual bond with interest payable solely from corporate
income if, and only if, earned. Whether or not this is really a debt is hard to say and
is primarily a legal and semantic issue. Courts and taxing authorities would have the
final say.
Corporations are very adept at creating exotic, hybrid securities that have many
features of equity but are treated as debt. Obviously, the distinction between debt
and equity is very important for tax purposes. So, one reason that corporations try to
create a debt security that is really equity is to obtain the tax benefits of debt and the
bankruptcy benefits of equity.
As a general rule, equity represents an ownership interest and is a residual claim.
This means that equityholders are paid after debtholders. As a result, the risks and
benefits associated with owning debt and equity are different. To give just one example, note that the maximum reward for owning a debt security is ultimately fixed by
the amount of the loan, whereas there is no upper limit to the potential reward from
owning an equity interest.
Equity versus Debt
Feature
Equity
Debt
Income
Tax status
Dividends
Dividends are taxed as personal
income, although currently
capped at 15%. Dividends are
not a business expense.
Control
Common stock usually has
voting rights.
Firms cannot be forced into
bankruptcy for nonpayment
of dividends.
Interest
Interest is taxed as personal
income. Interest is a business
expense, and corporations can
deduct interest when computing their corporate tax liability.
Control is exercised with loan
agreement.
Unpaid debt is a liability of the
firm. Nonpayment results in
bankruptcy.
Default
Bottom line: Tax status favors debt, but default favors equity. Control features of debt
and equity are different, but one is not better than the other.
LONG-TERM DEBT: THE BASICS
Ultimately, all long-term debt securities are promises made by the issuing firm to
pay principal when due and to make timely interest payments on the unpaid balance.
Beyond this, there are a number of features that distinguish these securities from one
another. We discuss some of these features next.
The maturity of a long-term debt instrument is the length of time the debt remains
outstanding with some unpaid balance. Debt securities can be short term (with
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Information on
individual bonds
can be found at
www.nasdbondinfo.
com.
Part IV Capital Structure and Dividend Policy
maturities of one year or less) or long term (with maturities of more than one year).4
Short-term debt is sometimes referred to as unfunded debt.5
Debt securities are typically called notes, debentures, or bonds. Strictly speaking, a
bond is a secured debt, meaning that certain property is pledged as security for repayment of the debt. However, in common usage, the word bond refers to all kinds of
secured and unsecured debt. We will therefore continue to use the term generically to
refer to long-term debt. Also, usually, the only difference between a note and a bond
is the original maturity. Issues with an original maturity of 10 years or less are often
called notes. Longer-term issues are called bonds.
Long-term debt can be issued to the public or privately placed. Privately placed
debt is issued to a lender and not offered to the public. Because this is a private transaction, the specific terms are up to the parties involved. We concentrate on publicissue bonds. However, most of what we say about them holds true for private-issue,
long-term debt as well.
There are many other aspects to long-term debt, including such terms as security,
call features, sinking funds, ratings, and protective covenants. The following table
illustrates these features for a bond issued by Intel. If some of these terms are unfamiliar, have no fear. We will discuss them all presently.
Features of an Intel Bond
Term
Amount of issue
$1.5 billion
Date of issue
Maturity
Face value
Annual coupon
09/19/2011
10/01/2041
$2,000
4.80
Offer price
99.258
Coupon payment dates
04/01, 10/01
Security
None
Sinking fund
Call provision
Call price
Rating
None
At any time
Treasury rate plus .25%
Moody’s A1, S&P A1
Explanation
The company issued $1.5 billion worth
of bonds.
The bonds were sold on 09/19/2011.
The bonds mature on 10/01/2041.
The denomination of the bonds is $2,000.
Each bondholder will receive $96 per
bond per year (4.80% of face value).
The offer price will be 99.258% of the
$2,000 face value, or $1,985.16, per
bond.
Coupons of $96/2 5 $48 will be paid
on these dates.
The bonds are not secured by specific
assets.
The bonds have no sinking fund.
The bonds do not have a deferred call.
The bonds have a “make whole” call price.
The bonds have relatively high credit
rating (but not the best possible rating).
Many of these features will be detailed in the bond indenture, so we discuss this first.
4
There is no universally agreed-upon distinction between short-term and long-term debt. In addition, people often refer
to intermediate-term debt, which has a maturity of more than 1 year and less than 3 to 5, or even 10, years.
5
The word funding is part of the jargon of finance. It generally refers to the long term. Thus, a firm planning to “fund”
its debt requirements may be replacing short-term debt with long-term debt.
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THE INDENTURE
The indenture is the written agreement between the corporation (the borrower) and its
creditors. It is sometimes referred to as the deed of trust.6 Usually, a trustee (a bank
perhaps) is appointed by the corporation to represent the bondholders. The trust
company must (1) make sure the terms of the indenture are obeyed, (2) manage the
sinking fund (described in the following pages), and (3) represent the bondholders in
default, that is, if the company defaults on its payments to them.
The bond indenture is a legal document. It can run several hundred pages and generally makes for very tedious reading. It is an important document, however, because
it generally includes the following provisions:
1.
2.
3.
4.
5.
6.
The basic terms of the bonds.
A description of property used as security.
Seniority.
The repayment arrangements.
The call provisions.
Details of the protective covenants.
We discuss these features next.
Terms of a Bond Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value and it is stated on the bond certificate. So, if a corporation wanted to borrow $1 million, 1,000 bonds would have to be
sold. The par value (that is, initial accounting value) of a bond is almost always the
same as the face value, and the terms are used interchangeably in practice. Although
a par value of $1,000 is most common, essentially any par value is possible. For
example, looking at our Intel bonds, the par value is $2,000.
Corporate bonds are usually in registered form. For example, the indenture might
read as follows:
Interest is payable semiannually on July 1 and January 1 of each year to the person in
whose name the bond is registered at the close of business on June 15 or December 15,
respectively.
This means that the company has a registrar who will record the initial ownership of
each bond, as well as any changes in ownership. The company will pay the interest and
principal by check mailed directly to the address of the owner of record. A corporate
bond may be registered and have attached “coupons.” To obtain an interest payment,
the owner must separate a coupon from the bond certificate and send it to the company registrar (the paying agent).
Alternatively, the bond could be in bearer form. This means that the certificate is
the basic evidence of ownership, and the corporation will “pay the bearer.” Ownership
is not otherwise recorded, and, as with a registered bond with attached coupons, the
holder of the bond certificate detaches the coupons and sends them to the company
to receive payment.
There are two drawbacks to bearer bonds. First, they are difficult to recover if
they are lost or stolen. Second, because the company does not know who owns its
6
The phrases loan agreement, or loan contract are usually used for privately placed debt and term loans.
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bonds, it cannot notify bondholders of important events. Bearer bonds were once
the dominant type, but they are now much less common (in the United States) than
registered bonds.
Security Debt securities are classified according to the collateral and mortgages
used to protect the bondholder.
Collateral is a general term that frequently means securities (for example, bonds
and stocks) that are pledged as security for payment of debt. For example, collateral trust bonds often involve a pledge of common stock held by the corporation.
However, the term collateral is commonly used to refer to any asset pledged on a debt.
Mortgage securities are secured by a mortgage on the real property of the borrower.
The property involved is usually real estate, such as land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture or trust deed.
Sometimes mortgages are on specific property, such as a railroad car. More often,
blanket mortgages are used. A blanket mortgage pledges all the real property owned
by the company.7
Bonds frequently represent unsecured obligations of the company. A debenture is
an unsecured bond for which no specific pledge of property is made. The term note is
generally used for such instruments if the maturity of the unsecured bond is less than
10 or so years from the date when the bond was originally issued. Debenture holders
have a claim only on property not otherwise pledged, in other words, the property that
remains after mortgages and collateral trusts are taken into account.
The terminology that we use here and elsewhere in this chapter is standard in the
United States. Outside the United States, these same terms can have different meanings. For example, bonds issued by the British government (“gilts”) are called treasury
“stock.” Also, in the United Kingdom, a debenture is a secured obligation.
At the current time, public bonds issued in the United States by industrial and
financial companies are typically debentures. However, most utility and railroad
bonds are secured by a pledge of assets.
The Securities
Industry and Financial
Markets Association
(SIFMA) site is
www.sifma.org.
Seniority In general terms, seniority indicates preference in position over other
lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some
debt is subordinated, as in, for example, a subordinated debenture.
In the event of default, holders of subordinated debt must give preference to other
specified creditors. Usually, this means that the subordinated lenders will be paid off
only after the specified creditors have been compensated. However, debt cannot be
subordinated to equity.
Repayment Bonds can be repaid entirely at maturity, at which time the bondholder receives the stated, or face, value of the bond, or they may be repaid in part or
in entirety before maturity. Early repayment in some form is more typical and is often
handled through a sinking fund.
A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the
funds to retire a portion of the debt. The trustee does this by either buying up some of
the bonds in the market or calling in a fraction of the outstanding bonds. This second
option is discussed in the next section.
7
Real property includes land and things “affixed thereto.” It does not include cash or inventories.
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There are many different kinds of sinking fund arrangements, and the details are
spelled out in the indenture. For example:
1.
2.
3.
Some sinking funds start about 10 years after the initial issuance.
Some sinking funds establish equal payments over the life of the bond.
Some high-quality bond issues establish payments to the sinking fund that are
not sufficient to redeem the entire issue. As a consequence, there may be a large
“balloon payment” at maturity.
The Call Provision A call provision allows the company to repurchase, or
“call,” part or all of the bond issue at stated prices over a specific period. Corporate
bonds are usually callable.
Generally, the call price is above the bond’s stated value (that is, the par value). The
difference between the call price and the stated value is the call premium. The amount
of the call premium may become smaller over time. One arrangement is to initially
set the call premium equal to the annual coupon payment and then make it decline to
zero as the call date moves closer to the time of maturity.
Call provisions are often not operative during the first part of a bond’s life, making the call provision less of a worry for bondholders in the bond’s early years. For
example, a company might be prohibited from calling its bonds for the first 10 years.
This is a deferred call provision. During the period of prohibition, the bond is said to
be call protected.
In just the last few years, a new type of call provision, a “make-whole” call, has
become widespread in the corporate bond market. With such a feature, bondholders
receive approximately what the bonds are worth if they are called. Because bondholders don’t suffer a loss in the event of a call, they are “made whole.”
To determine the make-whole call price, we calculate the present value of the
remaining interest and principal payments at a rate specified in the indenture. For
example, looking at our Intel issue, we see that the discount rate is “Treasury rate
plus .25%.” What this means is that we determine the discount rate by first finding
a U.S. Treasury issue with the same maturity. We calculate the yield to maturity on
the Treasury issue and then add on an additional .25 percent to get the discount
rate we use.
Notice that, with a make-whole call provision, the call price is higher when interest
rates are lower and vice versa (why?). Also notice that, as is common with a makewhole call, the Intel issue does not have a deferred call feature. Why might investors
not be too concerned about the absence of this feature?
Protective Covenants A protective covenant in the indenture or loan agreeWant detailed
information on the
amount and terms
of the debt issued
by a particular firm?
Check out its latest
financial statements
by searching SEC
filings at
www.sec.gov.
ros34779_ch15_474-493.indd 483
ment affects certain corporate actions. Protective covenants can be classified into two
types: negative covenants and positive (or affirmative) covenants.
A negative covenant is a “thou shalt not” type of covenant. It limits or prohibits
actions that the company might take. For example, the firm must limit the amount of
dividends it pays according to some formula.
A positive covenant is a “thou shalt” type of covenant. It specifies an action that
the company must take or a condition that the company must abide by. For example,
the company must maintain its working capital at or above some specified minimum
level.
A particular indenture may feature many different negative and positive covenants.
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15.3 Some Different Types of Bonds
Thus far, we have considered only “plain vanilla” corporate bonds. In this section, we
look at corporate bonds with unusual features.
FLOATING-RATE BONDS
The conventional bonds we have talked about in this chapter have fixed-dollar obligations because the coupon rate is set as a fixed percentage of the par value and the
principal is set equal to the par value. With floating-rate bonds (floaters), the coupon
payments are adjustable. The adjustments are tied to an interest rate index such as the
Treasury bill interest rate or the London Interbank Offered Rate (LIBOR).
The value of a floating-rate bond depends on how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate.
For example, suppose a coupon rate adjustment is made on June 1. The adjustment
might be based on the simple average of Treasury bond yields during the previous
three months.
In addition, the majority of floaters have the following features:
1. The holder has the right to redeem his note at par on the coupon payment date
after some specified amount of time. This is called a put provision, and it is discussed in the following section.
2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be
“capped,” and the upper and lower rates are sometimes called the collar.
OTHER TYPES OF BONDS
Many bonds have unusual or exotic features. One such feature is called a warrant. For
a bond with warrants attached, the buyers also receive the right to purchase shares of
stock in the company at a fixed price per share over the subsequent life of the bond.
Such a right can be very valuable if the stock price climbs substantially. (A later chapter discusses this subject in greater depth.) Bonds with warrants differ from convertible bonds because the warrants can be sold separately from the bond.
Bond features are really only limited by the imaginations of the parties involved.
Unfortunately, there are far too many variations for us to cover in detail here. We
therefore close out this section by mentioning only a few of the more common types.
Income bonds are similar to conventional bonds, except that coupon payments are
dependent on company income. Specifically, coupons are paid to bondholders only
if the firm’s income is sufficient. This would appear to be an attractive feature, but
income bonds are not very common.
A convertible bond can be swapped for a fixed number of shares of stock anytime
before maturity at the holder’s option. Convertibles are relatively common, but the
number has been decreasing in recent years.
A put bond allows the holder to force the issuer to buy the bond back at a stated
price. For example, International Paper Co. has bonds outstanding that allow the
holder to force International Paper to buy the bonds back at 100 percent of face value
given that certain “risk” events happen. One such event is a change in credit rating
from investment grade to lower than investment grade by Moody’s or S&P. The put
feature is therefore just the reverse of the call provision.
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A given bond may have many unusual features. Two of the most recent exotic
bonds are CoCo bonds, which have a coupon payment, and NoNo bonds, which
are zero coupon bonds. CoCo and NoNo bonds are contingent convertible, putable,
callable, subordinated bonds. The contingent convertible clause is similar to the normal conversion feature, except the contingent feature must be met. For example, a
contingent feature may require that the company stock trade at 110 percent of the
conversion price for 20 out of the most recent 30 days. Valuing a bond of this sort
can be quite complex, and the yield to maturity calculation is often meaningless. For
example, in 2011, a NoNo issued by the American International Group (AIG) was
selling at a price of $1,032.50, with a yield to maturity of negative 1.6 percent. At the
same time, a NoNo issued by Merrill Lynch was selling for $1,205, which implied a
yield to maturity of negative 107 percent!
15.4 Bank Loans
In addition to issuing bonds, a firm may simply borrow from a bank. Two important
features of bank loans are lines of credit and syndication.
Lines of Credit Banks often provide a business customer with a line of credit,
setting the maximum amount that the bank is willing to lend to the business. The
business can then borrow the money according to its need for funds. If the bank is
legally obligated, the credit line is generally referred to as a revolving line of credit or a
revolver. As an example, imagine a revolver for $75 million with a three-year commitment, implying that the business could borrow part or all of the $75 million anytime
within the next three years. A commitment fee is generally charged on the unused
portion of the revolver. Suppose the commitment fee is .20% and the corporation
borrows $25 million in a particular year, leaving $50 million unborrowed. The dollar
commitment fee would be $100,000 (5 .20% 3 $50 million) for that year, in addition
to the interest on the $25 million actually borrowed.
Syndicated Loans Very large banks such as Citigroup typically have a larger
demand for loans than they can supply, and small regional banks frequently have
more funds on hand than they can profitably lend to existing customers. Basically,
they cannot generate enough good loans with the funds they have available. As a
result, a very large bank may arrange a syndicated loan with a firm or country and
then sell portions of it to a syndicate of other banks. With a syndicated loan, each
bank has a separate loan agreement with the borrowers.
The syndicate is generally composed of a lead arranger and participant lenders. As
the name suggests, the lead arranger takes the lead, creating the relationship with the
borrower and negotiating the specifics of the loan. The participant lenders are typically not involved in the negotiation process. The lead arranger works with the participant lenders to determine shares of the loan, and generally lends the most. While
all lenders receive interest and principal payments, the lead arranger also receives an
up-front fee as compensation for his additional responsibilities.
A syndicated loan may be publicly traded. It may be a line of credit and be
“undrawn,” or it may be drawn and used by a firm. Syndicated loans are always rated
investment grade. However, a leveraged syndicated loan is rated speculative grade (i.e.,
it is “junk”).
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15.5 International Bonds
A Eurobond is a bond issued in multiple countries but denominated in a single currency, usually the issuer’s home currency. For example, an American firm may issue a
dollar-denominated bond in a number of foreign countries. Such bonds have become
an important way to raise capital for many international companies and governments. Eurobonds are issued outside the restrictions that apply to domestic offerings
and are syndicated and traded mostly from London. However, trading can and does
take place anywhere there are buyers and sellers. Eurobonds had been trading for
many years before the euro, the single currency across many European countries, was
created in 1999. However, because the two terms are so similar, people mistakenly
think Eurobonds must be denominated in euros. To avoid confusion, many refer to
Eurobonds as international bonds.
Foreign bonds, unlike Eurobonds, are issued in a single country and are usually
denominated in that country’s currency. For example, a Canadian firm might issue
yen-denominated bonds in Japan. Often, the country in which these bonds are
issued will draw distinctions between them and bonds issued by domestic issuers—
including different tax laws, restrictions on the amount issued, and tougher disclosure rules.
Foreign bonds often are nicknamed for the country where they are issued: Yankee
bonds (United States), Samurai bonds (Japan), Rembrandt bonds (the Netherlands),
Bulldog bonds (Britain). Partly because of tougher regulations and disclosure requirements, the foreign bond market hasn’t grown in past years with the vigor of the
Eurobond market.
15.6 Patterns of Financing
The previous sections of this chapter discussed some institutional details related to
long-term financing. We now consider the relationship between long-term financing
and investments. As we have seen in earlier chapters, firms want to spend on capital
projects with positive NPV. How can these firms get the cash to fund investments in
positive NPV projects? First, firms generating positive cash flow internally can use
that flow for positive NPV investments. In accounting terms, this cash flow is net
income plus depreciation minus dividends. Second, firms can fund positive NPV capital spending through external financing, i.e., by issuing debt and equity.
This relationship between investment and financing is described in Figure 15.1.
The left-hand side of the figure shows that cash flow can fund both capital spending
and investment in net working capital. As indicated in the figure, U.S. firms have historically used about 80 percent of cash flow on capital spending and about 20 percent
on investment in net working capital. The right-hand side of the figure shows the two
sources of cash flow, internal and external financing. In the figure, uses of cash flow
exceed internal financing. Thus, stocks and bonds must be issued to fill the financial
deficit.
In practice, what has been the split between internal and external financing?
Figure 15.2 breaks down total financing for U.S. businesses into internal financing,
financing through new equity, and financing through new debt for each year from
1995 to 2010. Consider 1995, for example. Internal financing in the U.S. was about
75 percent of the total, new debt was somewhat above 25 percent of the total, and new
equity was a slightly negative number. Notice that in this year, as in all the years, the
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Figure 15.1
487
Long-Term Financing
Uses of cash flow
(100%)
The Long-Term
Financial Deficit
Sources of cash flow
(100%)
Capital
expenditures
80%
Internal
cash flow
(retained earnings
plus depreciation)
Internal
cash flow
Long-term debt
and equity
(net new issues
of bonds
and stocks)
External
cash flow
Financial
deficit
Net working capital
plus other uses
20%
The deficit is the difference between long-term financing uses and internal financing.
Figure 15.2
Financing Decisions
by U.S. Nonfinancial
Corporations
150%
125%
100%
Internal financing
New equity
New debt
75%
50%
25%
0%
–25%
–50%
–75%
–100%
–125%
–150%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
SOURCE: Board of Governors of the Federal Reserve System. “Flow of Funds Accounts of the United States.” Federal Reserve
Statistical Release. June 9, 2011, <http://www.federalreserve.gov/releases/zl/20110609.
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three sources of funds must add to 100 percent. If you are wondering why net equity is
a negative number, it is because corporations repurchased more stock than they issued
in that year. In fact, new equity was negative in all the years of our sample, indicating
that the dollar amount of stock buybacks exceeded the dollar amount of stock issues
in each year of the sample period.
The figure illustrates a number of points. First, internally generated cash flow has
been the dominant source of financing. Second, this dominance has increased over
the sample period, with internal financing actually exceeding 100 percent for most
of the years from 2002 to 2010. A number above 100 percent implies that external
financing is negative. In other words, corporations are, in dollar terms, redeeming
more stocks and bonds than they are issuing. Third, net stock buybacks appear
to have accelerated from 2002 to 2007. It is argued that firms were flush with cash
during this time and found stock repurchases more attractive than dividend payments. However, the economic problems beginning in 2008 greatly reduced the dollar
amount of stock repurchases. Stock repurchases will be discussed in more detail in
later chapters.
15.7 Recent Trends in Capital Structure
Figure 15.2 indicates that, since 1995, U.S. firms tended to issue debt while retiring
stock. This pattern of financing suggests the question: Did the capital structure of
firms change over this time period? One might expect the answer to be yes, since debt
issuances and stock retirements should raise the ratio of debt to equity. However, look
at Figure 15.3, where the ratio of total debt to the book value of equity is shown for
each year from 1995 to 2010. The ratio was actually lower in 2010 than it was in 1995,
Figure 15.3
Book Debt Ratio:
Total Debt as a
Percentage of
the Book Value
of Equity for
U.S. Nonfarm,
Nonfinancial Firms
from 1995 to 2010
80%
70%
60%
50%
40%
30%
20%
10%
0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
SOURCE: Board of Governors of the Federal Reserve System. “Flow of Funds Accounts of the United States.” Federal Reserve
Statistical Release. June 9, 2011, <http://www.federalreserve.gov/releases/z1/20110609.
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Figure 15.4
Market Debt
Ratio: Total Debt
as a Percentage
of the Market
Value of Equity
for U.S. Nonfarm,
Nonfinancial Firms
from 1995 to 2010
Long-Term Financing
489
60%
50%
40%
30%
20%
10%
0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
SOURCE: Board of Governors of the Federal Reserve System. “Flow of Funds Accounts of the United States.” Federal Reserve
Statistical Release. June 9, 2011, <http://www.federalreserve.gov/releases/z1/20110609.
though the decline was modest. This result is not surprising once retained earnings
are considered. As long as net income exceeds dividends, retained earnings will be
positive, raising the book value of equity.
Of course, equity can be measured in terms of market value, rather than book
value. Figure 15.4 shows the ratio of total debt to the market value of equity for
U.S. firms for each year since 1995. While the ratio here has also fallen slightly over
the 15-year period, the pattern is somewhat different. This is not surprising, since
movements in the stock market affect market values of individual firms. Taken
together, both figures suggest that the ratio of debt to equity has changed little,
in spite of the pattern exhibited in Figure 15.2 of debt issuance funding equity
retirements.
WHICH ARE BEST: BOOK OR MARKET VALUES?
To test your
mastery of this
material, take
a quiz at mhhe.
com/rwj
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Financial economists generally prefer market values when calculating debt ratios,
since, as Chapter 14 indicates, market prices reflect current information. However, the
use of market values contrasts with the perspective of many corporate practitioners.
Our conversations with corporate treasurers suggest to us that the use of book
values is popular because of the volatility of the stock market. It is frequently claimed
that the inherent volatility of the stock market makes market-based debt ratios move
around too much. In addition, restrictions of debt in bond covenants are usually
expressed in book values rather than market values. Moreover, firms such as Standard
& Poor’s and Moody’s use debt ratios expressed in book values to measure creditworthiness.
A key fact is that whether we use book or market values, debt ratios for U.S. nonfinancial firms generally have been well below 100 percent of total equity in recent
years; that is, firms generally use less debt than equity.
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Summary and Conclusions
The basic sources of long-term financing are long-term debt, preferred stock, and common stock. This chapter described the essential features of each.
1. We emphasized that common shareholders have:
a. Residual risk and return in a corporation.
b. Voting rights.
c. Dividends are not a business expense and firms cannot be forced into bankruptcy
for non payment of a dividend.
2. Long-term debt involves contractual obligations set out in indentures. There are many
kinds of debt, but the essential feature is that debt involves a stated amount that must
be repaid. Interest payments on debt are considered a business expense and are tax
deductible.
3. Preferred stock has some of the features of debt and some of the features of common
equity. Holders of preferred stock have preference in liquidation and in dividend
payments compared to holders of common equity, but often hold no voting rights.
4. Firms need financing for capital expenditures, working capital, and other long-term
uses. Most of the financing is provided from internally generated cash flow.
5. For many years, U.S. firms have been retiring large amounts of equity. These share
buybacks have been financed with new debt.
Concept Questions
1.
Bond Features What are the main features of a corporate bond that would be listed
in the indenture?
2.
Preferred Stock and Debt What are the differences between preferred stock and debt?
3.
Preferred Stock Preferred stock doesn’t offer a corporate tax shield on the
dividends paid. Why do we still observe some firms issuing preferred stock?
4.
Preferred Stock and Bond Yields The yields on nonconvertible preferred stock are
lower than the yields on corporate bonds. Why is there a difference? Which investors
are the primary holders of preferred stock? Why?
5.
Corporate Financing What are the main differences between corporate debt and
equity? Why do some firms try to issue equity in the guise of debt?
6.
Call Provisions A company is contemplating a long-term bond issue. It is debating
whether to include a call provision. What are the benefits to the company from
including a call provision? What are the costs? How do these answers change for a
put provision?
7.
Proxy
8.
Preferred Stock
9.
Long-Term Financing As was mentioned in the chapter, new equity issues are
generally only a small portion of all new issues. At the same time, companies
continue to issue new debt. Why do companies tend to issue little new equity but
continue to issue new debt?
10.
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What is a proxy?
Do you think preferred stock is more like debt or equity? Why?
Internal versus External Financing
financing and external financing?
What is the difference between internal
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11.
Internal versus External Financing What factors influence a firm’s choice of
external versus internal equity financing?
12.
Classes of Stock Several publicly traded companies have issued more than one
class of stock. Why might a company issue more than one class of stock?
13.
Callable Bonds Do you agree or disagree with the following statement: In an
efficient market, callable and noncallable bonds will be priced in such a way that
there will be no advantage or disadvantage to the call provision. Why?
14.
Bond Prices If interest rates fall, will the price of noncallable bonds move up
higher than that of callable bonds? Why or why not?
15.
Sinking Funds Sinking funds have both positive and negative characteristics for
bondholders. Why?
Questions and Problems
®
Corporate Voting The shareholders of the Stackhouse Company need to elect
seven new directors. There are 850,000 shares outstanding currently trading at
$43 per share. You would like to serve on the board of directors; unfortunately no
one else will be voting for you. How much will it cost you to be certain that you can
be elected if the company uses straight voting? How much will it cost you if the
company uses cumulative voting?
2.
Cumulative Voting An election is being held to fill three seats on the board
of directors of a firm in which you hold stock. The company has 7,600 shares
outstanding. If the election is conducted under cumulative voting and you own 300
shares, how many more shares must you buy to be assured of earning a seat on the
board?
3.
Cumulative Voting The shareholders of Motive Power Corp. need to elect
three new directors to the board. There are 13,000,000 shares of common stock
outstanding, and the current share price is $10.50. If the company uses cumulative
voting procedures, how much will it cost to guarantee yourself one seat on the board
of directors?
4.
Corporate Voting Candle box Inc. is going to elect six board members next month.
Betty Brown owns 17.4 percent of the total shares outstanding. How confident can
she be of having one of her candidate friends elected under the cumulative voting
rule? Will her friend be elected for certain if the voting procedure is changed to the
staggering rule, under which shareholders vote on two board members at a time?
5.
Valuing Callable Bonds KIC, Inc., plans to issue $5 million of bonds with a
coupon rate of 8 percent and 30 years to maturity. The current market interest rates
on these bonds are 7 percent. In one year, the interest rate on the bonds will be either
10 percent or 6 percent with equal probability. Assume investors are risk-neutral.
a. If the bonds are noncallable, what is the price of the bonds today?
b. If the bonds are callable one year from today at $1,080, will their price be greater
or less than the price you computed in (a)? Why?
6.
Valuing Callable Bonds New Business Ventures, Inc., has an outstanding perpetual
bond with a 10 percent coupon rate that can be called in one year. The bond makes
annual coupon payments. The call premium is set at $150 over par value. There
is a 60 percent chance that the interest rate in one year will be 12 percent, and a
40 percent chance that the interest rate will be 7 percent. If the current interest rate
is 10 percent, what is the current market price of the bond?
BASIC
(Questions 1–6)
INTERMEDIATE
(Questions 5–10)
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7.
Valuing Callable Bonds Bowdeen Manufacturing intends to issue callable, perpetual
bonds with annual coupon payments. The bonds are callable at $1,175. One-year
interest rates are 9 percent. There is a 60 percent probability that long-term interest
rates one year from today will be 10 percent, and a 40 percent probability that they
will be 8 percent. Assume that if interest rates fall the bonds will be called. What
coupon rate should the bonds have in order to sell at par value?
8.
Valuing Callable Bonds Illinois Industries has decided to borrow money by issuing
perpetual bonds with a coupon rate of 7 percent, payable annually. The one-year
interest rate is 7 percent. Next year, there is a 35 percent probability that interest
rates will increase to 9 percent, and there is a 65 percent probability that they will
fall to 6 percent.
a. What will the market value of these bonds be if they are noncallable?
b. If the company decides instead to make the bonds callable in one year, what coupon will be demanded by the bondholders for the bonds to sell at par? Assume
that the bonds will be called if interest rates rise and that the call premium is
equal to the annual coupon.
c. What will be the value of the call provision to the company?
9.
Bond Refunding An outstanding issue of Public Express Airlines debentures has a
call provision attached. The total principal value of the bonds is $250 million, and
the bonds have an annual coupon rate of 9 percent. The company is considering
refunding the bond issue. Refunding means that the company would issue new bonds
and use the proceeds from the new bond issuance to repurchase the outstanding
bonds. The total cost of refunding would be 10 percent of the principal amount
raised. The appropriate tax rate for the company is 35 percent. How low does the
borrowing cost need to drop to justify refunding with a new bond issue?
10.
Bond Refunding Charles River Associates is considering whether to call either of
the two perpetual bond issues the company currently has outstanding. If the bond
is called, it will be refunded, that is, a new bond issue will be made with a lower
coupon rate. The proceeds from the new bond issue will be used to repurchase one
of the existing bond issues. The information about the two currently outstanding
bond issues is:
Coupon rate
Value outstanding
Call premium
Transaction cost of refunding
Current YTM
Bond A
Bond B
7.00%
$125,000,000
7.50%
$ 11,500,000
6.25%
8.00%
$132,000,000
8.50%
$ 13,000,000
7.10%
The corporate tax rate is 35 percent. What is the NPV of the refunding for each
bond? Which, if either, bond should the company refinance? Assume the call
premium is tax deductible.
CHALLENGE
(Questions 11–12)
11.
Valuing the Call Feature Consider the prices of the following three Treasury issues
as of February 24, 2012:
6.500
8.250
12.000
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May 16
May 16
May 16
106.31250
103.43750
134.78125
106.37500
103.5000
134.96875
−13
−3
−15
5.28
5.24
5.32
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The bond in the middle is callable in February 2013. What is the implied value of the
call feature? (Hint: Is there a way to combine the two noncallable issues to create an
issue that has the same coupon as the callable bond?)
12.
Treasury Bonds The following Treasury bond quote appeared in The Wall Street
Journal on May 11, 2004:
9.125
May 09
100.09375
100.12500
...
−2.15
Why would anyone buy this Treasury bond with a negative yield to maturity? How
is this possible?
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