Sources and Forms of Long-Term
Financing
Chapter 16
The Money and Capital Markets
• Two types of external markets for funds:
1. Money market
•
•
Short-term debt securities: maturity of less than 1 year
T-bills, commercial paper, bankers’ acceptances, and shortterm certificates of deposit
2. Capital market (focus of this chapter)
•
•
•
Intermediate-term securities: maturity of more than 1 but
less than 10 years
Long-term securities: maturity of 10 or more years
Equity securities: preferred and common stock have
longest time horizon since they are issued for life of
corporation
Intermediate- and Long-Term Debt
• Two primary sources of intermediate- and
long-term debt:
1. Term loans
2. Bonds
Intermediate- and Long-Term Debt
1. Term loans
– Paid off over some number of years
– Usually negotiated with commercial bank,
insurance company, or some other financial
institution
– Fully amortized (principal and interest are paid
off in installments over life of loan)
Intermediate- and Long-Term Debt
2. Bonds
– Intermediate to long term debt agreements
issued by governments, corporations, and other
organizations
– Issued in units of $1,000 principal value per bond
– Two “promises” to:
•
•
Repay $1,000 principal value at maturity
Pay stated interest rate (coupon rate) when due
– Most bonds pay interest semiannually at a rate
equal to one-half of the annual coupon rate
Intermediate- and Long-Term Debt
2. Bonds (continued)
– Bond indenture: complete statement of legal
obligations of issuing organization to
bondholders
•
Specifies number of restrictive covenants
–
–
•
Protect bondholders’ interests
Describe various standards that issuer must meet or action
that issuer must not take
If issuer violates terms of indenture, bond is in default
and trustee must do whatever is necessary to remedy
default.
Intermediate- and Long-Term Debt
•
Different types of bond issues:
– Mortgage bonds: bonds that are collateralized by a
mortgage on some fixed asset (e.g. building, land,
equipment)
– Debenture: unsecured bond that is baked by full
faith and credit of issuer
•
•
No specific assets are pledged as collateral
If default or bankruptcy occurs, debenture holders become
general creditors of the issuer
– Subordinated debenture: debenture that is
specifically subordinated to some other debt issue
•
If default or bankruptcy, junior debt has no claim on
issuer’s assets until senior debt is satisfied
Intermediate- and Long-Term Debt
• Different types of bonds (continued)
– Convertible bonds: corporate bonds that may be
converted into common stock at the option of
bondholder
• Conversion rate: number of shares of stock into which
bond may be converted
– Income bonds: bonds on which interest is paid
only when corporation earns a specified level of
income
Intermediate- and Long-Term Debt
• Different types of bond issues (continued)
– Floating-rate bonds: like regular bullet bonds
except that coupon rate is tied to some variable
rate benchmark (e.g. LIBOR: London Interbank
Offered Rate)
– Zero coupon bond: sold at substantial discounts
from par buy pay no current interest
• Investors earn their rate of interest from interest
accreting as bond approaches maturity
• Recall Chapter 14
Intermediate- and Long-Term Debt
• Different types of bond issues (continued)
– Call provisions: issuing corporation has the right to “call in”
bond for retirement prior to maturity
• May not be called until some number of years after original issue
• Must be called at a premium above par value
– Sinking fund: establishes procedure for orderly retirement
of a bond over life of issue
• Requires periodic (usually annual) repurchase of stated percentage
of outstanding bonds
• Repurchasing corporation may either buy bonds in open market or
call in bonds for redemption
– Bonds to be called are determined by lottery based on serial numbers of
bonds
– When high interest rates drive bond prices down, open-market purchases
at discounts from par value are more attractive
Intermediate- and Long-Term Debt
Bond Yields
• Four common yield measures:
1.
2.
3.
4.
Coupon yield rate
Current yield
Yield to maturity (YTM)
Yield to first call date (YTC)
Intermediate- and Long-Term Debt
Bond Yields
1.Coupon yield rate: rate of interest specified
on bond coupons at the time bond is issued
– Stated in bond indenture
– Does not change once bond is issued
– If interest rates rise after issue, then bond price
will fall.
– If interest rates fall after issue, then bond price
will rise.
Intermediate- and Long-Term Debt
Bond Yields
2.Current yield: calculated by dividing coupon
interest in dollars by current market price of
bond
– Seasoned bond: bond that has been issued and
is traded freely on open market
•
Interest rates fluctuate and thus, prices of seasoned
bonds also fluctuate.
Intermediate- and Long-Term Debt
Bond Yields
3. Yield to maturity: average annual compound
rate of return that would be earned if bond
were purchased at its current market value
and held to maturity
– Includes return from interest payments and
capital gain/loss if bond is purchases at
discount/premium
Intermediate- and Long-Term Debt
Bond Yields
4.Yield to first call date: yield to maturity on
callable bond, assuming bond is purchased at
current market price and then called at first
eligible date
Lease Financing
• Many businesses lease assets as an alternative
to owning them.
– Business has the use of the asset and incurs an
obligation either to pay off loan or meet monthly
lease payment.
– At the end of lease term, residual value of asset
belongs to lessee.
– Leasing is a form of debt financing.
Lease Financing
• FASB 13 (governing lease accounting): defines
difference between capital lease and operating lease
• Capital leases meet any one of these four conditions:
1. Title is transferred to lessee at end of lease term.
2. Lease contains bargain purchase option (an option to buy
asset at very low price).
3. Term of lease is greater than or equal to 75% of
estimated economic life of asset.
4. Present value of minimum lease payment is greater than
or equal to 90% of fair value of leased property.
Lease Financing
• Capital lease on balance sheet:
– Asset: “capital lease asset”
– Liability: “obligation under capital lease”
– Amount of asset and liability equals present
value of minimum future lease payments
• Leasing does not provide source of off-balance-sheet
financing
Lease Financing
• Operating leases
– More like true rentals rather than means to
finance long-term use of asset
– For substantially less than expected useful life of
asset and provide for both financing and
maintenance
– Contain cancellation clauses so that lessee is not
locked into long-term agreement.
– No asset and associated liability are created
Lease Financing
• Tax benefits are the major motivation that
firms prefer leasing to owning.
– Lessor is entitled to tax benefits from
depreciation.
– Lessor’s after-tax return is higher than it would be
under straight debt arrangement.
– Lessor prices lease payments at lower rate of
return than would otherwise be charged the
lessee on straight loan arrangement.
Lease Financing
• Leasing may be attractive to firm with low credit
rating.
– Lease can be obtained more easily than loan can be
arranged because lessor retains title to asset.
– Full recovery of asset in the event of default is much
easier than if asset were owned by lessee.
– Down payment in purchased asset is much higher
than deposit required on lease
– Use of operating leases may increase lessee’s overall
credit availability since they do not appear on the
balance sheet.
Lease Financing
Sale and Leaseback
• Firm sells fixed asset (e.g. building) to
lender/lessor and then immediately leases
back the property.
• Seller/lessee receives large inflow of cash
that may be used to finance other aspects of
business and in return, enters into long-term
lease obligation.
Lease Financing
Leveraged Lease
• Involves third-party lender:
– Lessor (e.g. commercial bank) borrows 80% or less
of cost of asset from third-party lender.
– Lessor purchases asset and leases it to lessee.
• Lessor has title to asset and is thus entitled to
full depreciation benefits.
Preferred Stock
• Two important preferences over common
stock:
1. Payment of dividends
2. Stockholders’ claims on assets of business in
event of bankruptcy
Preferred Stock
• Preferred stock combines some of the
characteristics of bonds and some of the
characteristics of common stock
– Fixed in amount
– Holders do not participate in growth of corporate
earnings, but rather collect only dividends promised in
indenture
– Payments must be voted on and approved by board of
directors of corporation
– Issues are cumulative (missed dividends accumulate
as arrearages and must be paid off before dividends
on common stock can be paid)
Preferred Stock
• Payment of preferred dividends is nearly as
important as timely payment of bond
interest.
– It is difficult for corporations with preferred
dividends in arrears to raise other forms of capital.
– Nonpayment of bond interest can force
corporation into bankruptcy.
– Preferred stockholders cannot legally force
bankruptcy for nonpayment of dividends.
Preferred Stock
• Conversion ratio: specified exchange rate
(common for preferred) at which preferred
stock is convertible into common stock
– If company prospers and price of common stock
rises, conversion becomes attractive.
– If convertible preferred stock is callable,
corporation is allowed to call stock and/or force
conversion into common stock in the future if
advantageous.
Common Stock
• Common stockholders: owners of the corporation
– Each share of common stock has one vote in electing
members of corporation’s board of directors.
– Board is responsible to stockholders.
– Board selects president.
– President reports to board.
– If one person is a majority stockholder, he/she may serve
as both president and chairman.
• In large, publicly held corporations, no single individual
or small group holds enough shares to exercise voting
control of corporation.
Common Stock
• Directors are elected in annual meetings.
• Prior to each meeting, current management
solicits voting proxies of stockholders, which
allows management to vote the shares of
stockholders who sign proxy.
– Dissident stockholder group or outside group
seeking to take over company can also solicit
proxies.
– Party with most proxies gains control of
corporation.
Common Stock
• Tender offer: another corporation buys up
enough stock in market to exert majority
control of takeover target
– Acquiring corporation publicly announces its
willingness to buy shares at a given price above
current market price from all stockholders who
tender their shares be specified expiration date.
Common Stock
• Common stock serves as corporation’s equity
cushion.
– Money paid to corporation for common stock does
not have to be repaid.
– Board declares when dividends are paid.
– Dividends do not accumulate as arrearages.
– Stockholders cannot legally claim any specified
dividend level.
– As corporation prospers, board votes to increase
dividend along with increased growth in earnings.
– As dividends increase, value of stock increases.
Common Stock
• Some corporations have two classes of common
stock:
– Class A stock:
• Voting stock
– Class B stock:
• Nonvoting stock
• Possesses right to participate in earnings and dividends
• Cannot vote on corporate matters
• Large, publicly held corporations rarely offer two
different classes.
Dividend Policy
• Board of directors is responsible for dividend
policy.
– Most dividends are paid quarterly.
– Board votes on and approved each payment.
– Dividend policy requires compromise between:
• Stockholders’ desire to receive some of the earnings
through cash dividends
• Corporation’s desire to reinvest earnings to finance
future growth.
Dividend Policy
• Factors that influence dividend policy:
– Growth rate
• High-growth corporations have high demands for funds and
pay low dividends.
– Stability of corporation’s earnings
• High level of earnings stability reduces corporation’s
business risk
• Allows higher dividend payout
– Rate of return earned on equity capital
• If ROE is higher than stockholders’ opportunity rate of return
(return stockholders expect to earn on next-best-available
investment opportunity), stockholders will benefit if
corporation reinvests earnings.
Dividend Policy
• Factors (continued):
– Overall liquidity position and access to money and
capital markets
• Highly liquid corporation with easy access to capital markets
can pay out a higher percentage of earnings in dividends
than less liquid corporation
– Outstanding debt repayment requirements and/or
restrictive covenants on long-term debt agreements
• Restrictive covenants prohibit dividend payments out of past
retained earnings and place a lower limit on dollar amount
of net working capital that must be maintained.
Dividend Policy
• Factors (continued)
– Capital-impairment rule
• Normal cash dividend payments may not exceed
retained earnings
• Corporations may not pay dividends when insolvent
(total liabilities exceeds total assets)
• This rule protects creditors
• Firm may pay “liquidating dividends” out of capital
(assets minus liabilities)
Dividend Policy
The Residual Theory of Dividend Policy
• Board should select dividend policy that will
maximize value of outstanding common stock.
• Residual theory: assumes that investors prefer to
have corporation retain and reinvest earnings
rather than pay them out as in dividends if
corporation’s ROE is greater than stockholders’
opportunity rate of return (recall slide 34)
Dividend Policy
The Residual Theory of Dividend Policy
1.Determine optimal size of capital budget by
noting where investment-opportunity
schedule intersects marginal-cost-of-capital
curve (recall Chapter 13; see Exhibit 13.3)
2.Optimal capital structure (see Exhibit 13.5)
determines what percentage of optimal
capital budget must be financed by equity
capital
Dividend Policy
The Residual Theory of Dividend Policy
3. Compare total amount of earnings available for
reinvestment and dividend payout to total dollars of
equity capital needed for capital budget
– If available earnings are less than required earnings, all
earnings should be reinvested and no dividend should be
paid.
•
–
If available earnings equal required earnings, all earnings
should be reinvested.
•
–
Firm must sell new stock to raise amount of equity capital
required.
Firm does not need to sell additional stock.
If available earnings exceed required earnings, excess
(“the residual”) should be paid out as dividend.
Dividend Policy
Dividend Theory in Practice
• Companies in high-growth industries face
attractive investment opportunities.
– High demands for equity capital to finance growth
– Pay no dividends or very low dividends
• Companies in low-growth industries have high
dividend-payout ratios.
Dividend Policy
Dividend Theory in Practice
• Companies do not follow residual theory exactly
because they face different capital budgeting
opportunities from year to year.
– Residual theory may require payment of very high
dividend, no dividend, or “normal” dividend from year
to year.
– Erratic dividend policy reduces value of stock
compared with what it would be with a stable policy.
– Investors interpret dividend cut to be symptom of
financial weakness rather than for some extraordinary
investment opportunity.
Dividend Policy
Dividend Theory in Practice
• Firms strive to maintain stable dividend
payment from year to year.
– Board considers likelihood that increased dividend
can be maintained in the future.
• Constant percentage-payment ratio: firm pays
out same percentage of income to
stockholders each year
Dividend Policy
Stock Dividends and Stock Splits
• Stock dividend: payment of dividend in the form of
additional shares of stock in corporation
• Stock split: stock dividend of 25% or more (each existing
share is paid 0.25 or more shares as dividend)
• Shareholder gains nothing from either stock dividend or
stock split.
– Total number of shares claiming equity position is increased.
– Each shareholder increases number of shares held in
proportion to number of shares held before split/dividend
• Price of outstanding shares will decline by amount of split
if it is not accompanied by increase in earnings/dividends
per share.
Dividend Policy
Stock Repurchases
• Companies can repurchase their own stock with
excess cash rather than pay dividend.
• Stock repurchases (treasury stock) do not share in
future earnings/dividends.
• After repurchase, there are fewer shares
outstanding.
– Earnings per share increase if aggregate corporate
earnings remain the same.
– Value of stock increases.
– Stockholders receive capital gain rather than
dividend.