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
short-term 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 LongTerm Debt

Two primary sources of
intermediate- and long-term
debt:
1. Term loans
2. Bonds

Intermediate- and LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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

issuers assets until senior debt is satisfied

Intermediate- and LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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 LongTerm 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 offbalance-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.
Lessors 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 lessees
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 longterm lease obligation.

Lease Financing
Leveraged Lease
Involves third-party lender:
Lessor (e.g. commercial bank) borrows
80% or less of cost of asset from thirdparty 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 corporations 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 corporations
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
Corporations 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 corporations earnings

High level of earnings stability reduces corporations
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 nextbest-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 corporations 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 investmentopportunity 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.