Long-term financing
Review item
 When
a firm creates value through a
financial transaction, who gets the
increase?
Answer
 Old
equity means the shareholders at
the time the decision is made.
 Old equity gets the gains.
 Why? Old equity has no competitors.
Everyone else is competitive and must
accept a market return.
Chapter 14 Long-Term
Financing: An Introduction
 Common
Stock
 Corporate
 Preferred
 Patterns
Long-term Debt: The Basics
Stock
of Financing
Shareholders rights
 Preemptive
right to a proportionate
share of any new stock sold.
 Proportionate share in dividends.
 Proportionate share in liquidation.
 Voting rights … of some kind
Straight voting
 Each
seat on the board of directors is a
separate election.
 In each election, the shareholder has
votes in proportion to her shares.
 A thin majority can freeze out minority
directors.
Cumulative voting
 All
directors are elected in a single
election.
 The n highest vote getters are elected.
 Each shareholder has votes in
proportion to her shares.
 When can a elect at least one director?
How many votes are needed
to elect one director?
n
directors.
 Minority has fraction x of all votes.
 The majority plays optimally.
 Majority votes (1-x)/n for each of n
seats (no cheap seats).
 Minority needs x > (1-x)/n, that is, x >
1/(n+1)
 x = 1/(n+1) plus one vote
Example
 Adam
Smith and Alfred Marshall
 Four seats.
 Smith is the minority, needs 1/5 of the
votes to elect one director.
 Check: Smith has 1/5 + 1 vote. Marshall
can muster 3/5 of the total votes for 3
candidates and 1/5 – 1 votes for the
fourth. The fourth loses. Smith gets a
director.
Example: majority lacks discipline
 Hamas
has 40% of the voters.
 Fatah has 60%.
 6 seats to be filled.
 Hamas runs 4 candidates, gets 10% per
candidate
 Fatah runs 10 candidates, gets 6% per
candidate.
 Hamas gets 4 of the 6 seats.
 Fatah could have had 4 of 6.
Dividend facts
 Dividends
are not tax deductible to the
corporation that pays them.
 Corporations owning other corporations
are exempt from 70% of the tax that
would otherwise fall on dividends.
 Skipping dividends does not put a firm
in default.
Debt
 Contractual
relation with the firm, via
the indenture.
 No voting rights.
 Interest is deductible from corporate
taxes.
 Missing any interest payment puts the
firm in default.
Notes, debentures, bonds
 Notes
are shorter term, unsecured.
 Debentures are long term, unsecured.
 (Mortgage) bonds are secured.
Sinking funds
 Debt
is gradually extinguished.
 Money in the fund buys back the bonds
steadily.
Call provisions
 Specified
in the indenture.
 Call price is above par …
 but is below market when called.
 Call protection for 5 or 10 years
Indenture
 Among
creditors, a coordination
problem. Prisoner’s dilemma. Free
rider problem.
 Solution: trustee (a law firm)
 Restrictive covenants -- new debt, size
of dividends, minimum working capital
Default of bonds
 If
the firm misses a debt payment to any
bond, repayment of all other bonds is
immediately due, an impossible task.
 Bondholders get control of the firm.
 Bankruptcy proceedings or
reorganization.
Preferred stock
 Stated
percentage dividends.
 No voting rights.
 Preferred dividends can be skipped but
are rarely, and only if common
dividends are skipped.
 Contingent voting rights when the firm
is near bankruptcy.
Corporations hold preferred
stock
 Not
individuals, because taxes are
higher to them.
 Individuals hold preferred by holding
common in firms that hold preferred.
 Corporations pay tax on interest from
the debt of other corporations but only
30% on preferred dividends.
The Long-Term Financial Deficit
(2002)
Uses of Cash
Flow (100%)
Sources of Cash
Flow (100%)
Capital
spending
98%
Internal cash
flow (retained
earnings plus
depreciation)
97%
Financial
deficit
Net
working
capital
plus other
uses 2%
Long-term
debt and
equity 3%
Internal
cash flow
External
cash flow
Financing Decisions by U.S.
Non-financial Corporations
Percent
90
60
30
0
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Internal financing
New debt
New stock
-30
Year
Source: Board of Governors of the Federal
Reserve System, Flow of Funds Accounts.
Convertible debt – an option
 Can
be traded for shares at a fixed
price.
 Need not be traded.
 Rationale: cash in on success if the firm
becomes vary valuable
 Retain rights of debt if the firm fails.
Debt-to-Asset Ratio (Book Value) for U.S.
Non-financial Firms from 1979 to 1994
Percent
50
40
30
20
10
0
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
Source: OECD data from the 1995 edition of
Financial Statements of Nonfinancial Enterprises.
Debt-to-Asset Ratio (Market Value) for U.S.
Non-financial Firms from 1980 to 1994
Percent
30
20
10
0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
Source: Board of Governors of the Federal
Reserve System, Flow of Funds Accounts.