Long-term financing
Review item
 When
a firm creates value through a
financial transaction, who gets the
increase?
Answer
 Old
equity gets the gains.
 Old equity means the shareholders at
the time the decision is made.
 Why? Old equity has no competitors.
Everyone else is competitive and must
accept a market return.
 Recall the first problem set.
Chapter 14 Long-Term
Financing: An Introduction
 Common
Stock
 Corporate
 Preferred
 Patterns
 Recent
Long-term Debt: The Basics
Stock
of Financing
Trends in Capital Structure
Shareholders rights
 Preemptive
right to 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 all
minority directors.
Cumulative voting
 All
n seats are filled by a single election.
 There are m candidates, m > n.
 The n highest vote getters are elected.
 Each shareholder has votes in
proportion to her shares.
 A minority can elect a director by putting
all of its voting weight on her or him.
How many votes are needed
to elect one director?
 Minority
has a fraction x of all votes.
 Majority has a fraction 1-x.
 Worst case: The majority spreads votes
evenly over n candidates.
 Each majority candidate gets (1-x)/n.
 Minority needs x > (1-x)/n
 That is, x > 1/(n+1) (plus one vote)
Example page 374
 Smith
and Marshall
 Four seats.
 Smith is the minority.
 Fraction of votes needed to elect is 1/5.
 Out of 400 votes, Smith needs only 81.
Having 319, Marshall can muster 80
votes for 3 candidates, 79 for the fourth.
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 to 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.
 Dividends accumulate if 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.
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 very 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.
Review Item
 Two
assets have the same expected
return.
 Each has a standard deviation of 2%.
 The correlation coefficient is .5.
 What is the standard deviation of an
equally weighted portfolio?
Answer
 Var
P=
.5x.5x4+.5x.5x4+2x.5x.5x.5x2x2
= 3
 Standard deviation = sq. root of 3
 =1.732