Chapter 15
Long-Term Financing: An Introduction

Long term financing ?= Long term debt

Describe the basic features of common and preferred
stock.
Understand the different types of bonds and how
bond characteristics impact the required yield.

15-1
15.1 Some Features of Common and Preferred Stock
15.2 Corporate Long-Term Debt
15.3 Some Different Types of Bonds
15.4 Bank Loans
15.5 International Bonds
15.6 Patterns of Financing
15.7 Recent Trends in Capital Structure
15-2

What does Alphabet Inc use for long-term
finance?
15-3





Internal cash flow
Common stock
Preferred stock
Long-term debt
Long-term leasing
15-4




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 – the right to purchase new stock issued,
so as to maintain proportional ownership
15-5

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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15-6



Capital markets are markets for equity and
debt instruments with original issue maturities
of more than one year
Bonds are long-term debt obligations issued
by corporations and government units
Bond markets are markets in which bonds are
issued and traded
◦ Treasury notes (T-notes) and bonds (T-bonds)
◦ Municipal bonds (Munis)
◦ Corporate bonds
6-7
15-7
6-8
15-8

Debt
◦ Not an ownership interest
◦ Creditors do not have
voting rights
◦ Interest is considered a
cost of doing business
and is tax deductible
◦ Creditors have legal
recourse if interest or
principal payments are
missed
◦ Excess debt can lead to
financial distress and
bankruptcy

Equity
◦ Ownership interest
◦ Common stockholders
vote for the board of
directors and other issues
◦ Dividends are not
considered a cost of doing
business and are not tax
deductible
◦ Dividends are not a
liability of the firm, and
stockholders have no legal
recourse if dividends are
not paid
◦ An all-equity firm cannot
go bankrupt
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15-9
What does Bond look like?
15-10
7-11
15-11
7-12
15-12

Alphabet Inc Bond Issuance Prospectus (File
452B2 to SEC).
15-13

Contract between the company and the bondholders
that includes:
◦ The basic terms of the bonds: par (face value), coupon rate,
maturity, the total amount of bonds issued
◦ A description of property used as security, if applicable
(collateral)
◦ Sinking fund provisions
◦ Call or put provisions
◦ Details of protective covenants
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15-14

Secured vs Unsecured
◦ 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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15-15

Payment Seniority Ranking: within each
group of debt, there are finer grades (or
types) of rankings. The higher the ranking,
the higher priority in getting pay in
bankruptcy:
1.
2.
3.
4.
5.
6.
First Lien Loan – Senior Secured
Second Lien Loan – Secured
Senior Unsecured
Senior Subordinated
Subordinated
Junior Subordinated
6-16
15-16


The coupon rate depends on the risk characteristics of
the bond when issued. Higher risk, high coupon to
compensate investors.
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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15-17

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
All else equal, we should see higher risk and hence higher coupon rates set for
 Debenture (compared to secured debt)
 Subordinated debenture (compared to senior debt)
 A bond without a sinking fund (compared to a bond with sinking fund)
 A callable bond (compared to a non-callable bond)
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15-18





Make no periodic interest payments (coupon rate =
0%)
How do investors make money? 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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15-19
Information needed for valuing pure discount bonds:
◦ Time to maturity (T) = Maturity date - today’s date
◦ Face value (F)
◦ Discount rate (r)
$0
0


$0
$0
$F
2
T  1
T


Present value
of a pure discount
bond at
time 0:



F
PV 
T
(1  r)
15-20
Find the value of a 30-year zero-coupon bond with a
$1,000 par value and a YTM of 6%.
$0
0

$0
$0
$ 1, 0 0 0
2
29
30

PV 
F   $1,000  
T  
3 0  $174.11

(1.06)
 (1  r)
=PV(6%, 30, 0,-1000)
15-21




Apple Bond Issuance Propspectus (File 452B2
to SEC).
What is its yield to maturity (YTM)?
In Excel: RATE( nper, pmt, pv, [fv], [type],
[guess] )
=RATE(26, 2.5,-992.48,1000,0)=0.28%
15-22


Alphabet Inc Bond Issuance Prospectus
(File 452B2 to SEC).
What is its yield to maturity (YTM)?
15-23



Coupon rate floats depending on some index value
Examples – adjustable rate mortgages and inflationlinked 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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15-24




Income bonds
Convertible bonds
Call or 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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15-25

Eurobonds: A eurobond is a special type of bond
issued in a currency that is different from that of the
country or market in which the bond is issued.
Eurobnds normally are issued simultaneously in the
bond markets of several countries.
◦ For example, GE’ US Dollar bonds issued in Italy.

Foreign bonds: bonds issued in another nation’s
capital market by a foreign borrower
◦ For example, GE’s Euro bonds issued in Italy.
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15-26

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
◦ Large money-center banks frequently have more demand
for loans than they have supply.
◦ Small regional banks are often in the opposite situation.
◦ As a result, a lager money center 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.
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15-27

Internally generated cash flow dominates as a source
of financing
◦ This preference has increased through time

Net stock buybacks accelerated in 2002-2007
◦ Declined in 2008, likely as a result of the financial crisis

Debt ratios for U.S. non-financial firms have been
below 50 percent of total financing.
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15-28
Uses of Cash Flow
(100%)
Sources of Cash Flow
(100%)
Capital
spending
Internal cash
flow (retained
earnings plus
depreciation)
Net
working
capital plus
other uses
Internal
cash flow
Financial
deficit
Long-term
debt and
equity
External
cash flow
15-29
0
Value
r%
1
2
CF1
CF2
...
N
CFN
CF1
CF2
CFN
Value 

 ... 
1
2
(1  r)
(1  r)
(1  r)N
7-30
15-30
0
1
2
100
100
r%=10%
VB = ?
VB 
VB 
INT
(1  rd )
1
$100
1

INT
(1  rd )
 ... 
2
N
...
100 + 1,000
 ...... 
$100
10

INT
(1  rd )
N

Par Value
(1  rd ) N
$1,000
(1.10)
(1.10)
(1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
7-31
15-31

This bond has a $1,000 lump sum (the par
value) due at maturity (t = 10), and annual
$100 coupon payments beginning at t = 1
and continuing through t = 10, the price of
the bond can be found by solving for the PV
of these cash flows. The bond sells at par.
INPUTS
OUTPUT
10
10
N
I/YR
PV
100
1000
PMT
FV
Excel: =PV(10%,10,100,1000,0)
7-32
15-32

This bond has an annual coupon payment of
$130. Since the risk is the same the bond
has the same yield to maturity as the
previous bond (10%). In this case the bond
sells at a premium because the coupon rate
exceeds the yield to maturity.
INPUTS
10
10
N
I/YR
PV
130
1000
PMT
FV
OUTPUT
Excel: =PV(10%,10,130,1000,0)
7-33
15-33

This bond has an annual coupon payment of
$70. Since the risk is the same the bond has
the same yield to maturity as the previous
bonds (10%). In this case, the bond sells at a
discount because the coupon rate is less
than the yield to maturity.
INPUTS
10
10
N
I/YR
PV
70
1000
PMT
FV
OUTPUT
Excel: =PV(10%,10,70,1000,0)
7-34
15-34
1.Multiply years by 2:
Number of periods = 2N
2.Divide nominal rate by 2:
Periodic rate (I/YR) = rd/2
3.Divide annual coupon by 2:
PMT = Annual coupon/2
INPUTS
2N
rd/2
OK
cpn/2
OK
N
I/YR
PV
PMT
FV
OUTPUT
7-35
15-35
1.Multiply years by 2:
N = 2 x 10 = 20.
2.Divide nominal rate by 2:
I/YR = 13/2 = 6.5.
3.Divide annual coupon by 2:
PMT = 100/2 = 50.
INPUTS
20
6.5
N
I/YR
PV
50
1000
PMT
FV
OUTPUT
Excel: =PV(6.5%,20,50,1000,0)
7-36
15-36




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
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15-37