Advanced Corporate

Finance
Long Term Financing

Key Concepts and Skills

Describe the basic features of common
and preferred stock.
Understand the different types of bonds
and how bond characteristics impact the
required yield.

Chapter Outline
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

Features of Common Stock

Voting rights
BOD Election: Cumulative vs. Straight
Other matters such as M&A

Proxy voting
Classes of stock
Other rights
Share proportionally in declared dividends
Share proportionally in remaining assets during
liquidation
Preemptive right first right of refusal at new stock
issue to maintain proportional ownership if desired

Cumulative Voting
Allows minority shareholders to guarantee (as long
as they are above a certain threshold) some level
of board representation.
With cumulative voting, the directors are elected all
at once.
In general, if there are N directors up for election,
then 1/(N + 1) percent of the stock plus one share
will guarantee you a seat.
The more seats that are up for election at one time,
the easier (and cheaper) it is to win one.

D = number of directors you want

elected
N = Total number of Directors
S = Total Number of Shares
X = Shares Required

Cumulative Voting Example

Stock in Corporation X sells for $20 per share and
features cumulative voting. There are 10,000 shares
outstanding. If three directors are up for election, how
much does it cost to ensure yourself a seat on the
board?
The question here is how many shares of stock it will
take to get a seat. The answer is 2,501, so the cost is
2,501 $20 = $50,020.
Because there is no way the remaining 7,499 votes can
be divided among three people to give all of them more
than 2,501 votes, so at worse you will end up in third
position
For example, suppose two people receive 2,502 votes
and the first two seats. A third person can receive at
most 10,000 2,502 2,502 2,501 = 2,495, so the
third seat is yours.

Straight Voting
With straight voting, the directors are
elected one at a time
The only way to guarantee a seat is to own
50 percent plus one share. This also
guarantees that you will win every seat
Straight voting can freeze out minority
shareholders
Straight voting makes it too hard for
minority representation, cumulative makes
it to easy

Staggered Elections
Only a fraction of the directorships are up for
election at a particular time.
If only two directors are up for election at
any one time, it will take 1/(2 + 1) = 33.33
percent of the stock plus one share to
guarantee a seat.
Staggering has two basic effects:
Makes it more difficult for a minority to elect a
director when there is cumulative voting because
there are fewer directors to be elected at one
time.
Staggering makes takeover attempts less likely to
be successful because it makes it more difficult to
vote in a majority of new directors.

Proxy voting

A proxy is the grant of authority by a

shareholder to someone else to vote his/her
shares.
Management always tries to get as many
proxies as possible transferred to it.
If shareholders are not satisfied with
management, an outside group of
shareholders can try to obtain votes via
proxy. They can vote by proxy in an attempt
to replace management by electing enough
directors. The resulting battle is called a
proxy fight

Classes of Stock
Created with unequal voting rights.
Google has two classes of common stock, A and
B.
The Class A shares are held by the public, and each
share has one vote.
The Class B shares are held by company insiders, and
each Class B share has 10 votes.
As a result, Googles founders and management
control the company

Primary reason for creating dual or multiple

classes of stock has to do with control of the firm.
If such stock exists, management of a firm can
raise equity capital by issuing nonvoting or
limited-voting stock while maintaining control

Dividends
Represent a return on the capital
The payment of dividends is at the
discretion of the board of directors.
Unless a dividend is declared by the
board of directors of a corporation, it
is not a liability of the corporation
A corporation cannot default (go
bankrupt) on an undeclared dividend

Features of Preferred Stock

Has preference over common stock in the
payment of dividends and in the distribution of
corporation assets in the event of liquidation
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.
Is Preferred Stock Really Debt? Preferred stock is
a form of equity from a legal and tax standpoint

14.2 Corporate Long Term Debt

Debt is the result of borrowing money.
All long-term debt securities/loans are promises
made by the issuing firm/borrowers to pay
principal when due and to make timely interest
payments on the unpaid balance
Interest versus Dividends
Debt is not an ownership interest in the firm.
Creditors do not usually have voting power.
The corporations payment of interest on debt is
considered a cost of doing business and is fully
tax-deductible.
Dividends are paid out of after-tax dollars.
Unpaid debt is a liability of the firm. If it is not
paid, the creditors can legally claim the assets of
the firm.

Debt versus Equity

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, a
residual claim
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

Is It Debt or Equity?
Corporations are very adept at creating
exotic, hybrid securities that have many
features of equity but are treated as debt.
The distinction between debt and equity
is very important for tax purposes.
One reason that corporations try to create
a debt security that is really equity is to
obtain the tax benefits of debt and the
bankruptcy benefits of equity
Courts and taxing authorities would have
the final say.

Long Term Debt Basics

Maturity of a long-term debt instrument
is the length of time the debt remains
outstanding with some unpaid balance
Bond refers to all kinds of secured and
unsecured debt
The main difference between publicissue and privately placed debt is that
the latter is directly placed with a
lender and not offered to the public.

The Bond Indenture

Contract or a written agreement between the
company and the bondholders that includes:
The basic terms of the bonds
Face Value (or Par Value)

The total amount of bonds issued

A description of property used as security, if
applicable
Sinking fund provisions
Call provisions
Details of protective covenants

The Bond Indenture

Registered vs. Bearer Forms
Security
Collateral assets that are pledged as security for
payment of debt
Common Stock
Mortgage secured by real property, normally land or
buildings
Mortgage Securities secured by mortgages
Debentures unsecured
Notes unsecured debt with original maturity less
than 10 years
Seniority
Preference (in the event of liquidation) in position over
other lenders, debts are labeled as senior or junior
(subordinate) to indicate seniority
Debt cannot be subordinated to equity.

The Bond Indenture

Sinking fund
is an account managed by the bond trustee for the
purpose of repaying the bonds.
The company makes annual payments to the trustee,
who then uses the funds to retire a portion of the debt.
The trustee does this by either buying up some of the
bonds in the market or calling in a fraction of the
outstanding bonds
The Call Provision
A call provision allows the company to repurchase, or
call, part or all of the bond issue at stated prices over
a specific period.
a New type of call provision, a make-whole bondholders receive approximately what the bonds are
worth if they are called. Bondholders dont suffer a loss

The Bond Indenture

Protective Covenants
A protective covenant is that part of the
indenture or loan agreement that limits
certain actions a company might otherwise
wish to take during the term of the loan.
A negative covenant limits or prohibits
actions that the company might take. For
example, the firm must limit the amount of
dividends it pays according to some formula
A positive covenant specifies an action that
the company agrees to take or a condition
the company must abide by. For example, the
company must maintain its working capital at
or above some specified minimum level.

Required Yields
The coupon rate depends on the risk
characteristics of the bond when issued.
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

Zero Coupon Bonds

Make no periodic interest payments
(coupon rate = 0%)
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

F
P
V
(1
r)

$
0
$
0
$
0
$
F

0
1

1
2T
T
T

Pure Discount Bonds

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date

Face value (F)
Discount rate (r)

Present value of a pure discount bond at

time 0:

R
s
.
0
R
s
.
0
R
s
0
R
s
.
1
,
0

3
0
2
0P
2
9
1
F
R
s
.
1
,
0
V
(1r)T(6)30R
s.174

Pure Discount Bonds:

Example

Find the value of a 30-year zerocoupon bond with a Rs.1,000 par

value and a YTM of 6%.

0$0,1$

2930
2
1
0

15.3 Some Different Types of bonds

Floating Rate Bonds
Coupon rate floats depending on some index
value vs. fixed-dollar obligations in conventional
bond where the coupon rate is set as a fixed
percentage of the par value.
Examples adjustable rate mortgages and
inflation-linked 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.

Other Bond Types

Income bonds
Coupon payments are dependent on company
income. Specifically, coupons are paid to
bondholders only if the firms income is
sufficient.
Convertible bonds
swapped for a fixed number of shares of stock
anytime before maturity at the holders option
Put bonds
Allows the holder to force the issuer to buy the
bond back at a stated price
Issuer buy the bonds back at 100 percent of
face value given that certain risk events
happen such as a change in credit rating from
investment grade to lower than investment
grade by Moodys or S&P.

Other Bond Types

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.
Warrant - A bond with warrants attached, the buyers
receives the right to purchase shares of stock in the
company at a fixed price per share over the subsequent life
of the bond.
Valuable if the stock price climbs substantially
Bonds with warrants differ from convertible bonds
because the warrants can be sold separately from the bond
Securitized Bonds:
Mortgage-backs are the best known type of asset-backed
security.
With a mortgage-backed bond, a trustee purchases
mortgages from banks and merges them into a pool. Bonds
are then issued, and the bondholders receive payments
derived from payments on the underlying mortgages

15.4 Bank Loans

Lines of Credit
Provide a maximum amount the bank is willing
to lend
If guaranteed, referred to as a revolving line of
credit, with a fixed term of up to three years or
more.
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 larger 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.

15.5 International Bonds

Eurobonds:

A bond issued in a currency other than the currency

of the country or market in which it is issued.
The four main Eurocurrencies are the US dollar, the
euro-zone euro, the British pound and the Japanese
yen; the currencies of the major economies of the
world
important way to raise capital for many international
companies and governments

Foreign bonds:
A bond that is issued in a domestic market by a
foreign entity, in the domestic market's currency.
Foreign bonds often are nicknamed for the country
where they are issued: Yankee bonds (United States),
Samurai bonds (Japan), Rembrandt bonds (the
Netherlands), Bulldog bonds (Britain).

15.6 Patterns of Financing

Internally generated cash flow dominates
as a source of financing
This preference has increased through
time
Net stock buybacks accelerated in 20022007
Declined in 2008, likely as a result of the
financial crisis

The Long-Term Financial Deficit

Uses of Cash Flow
(100%)

Sources of Cash Flow

(100%)

Capital
spending
80%

Internal cash
flow (retained
earnings plus
depreciation)
80%

Net
working
capital plus
other uses
20%

Internal
cash flow

Financial
deficit
Long-term
debt and
equity 20%

External
cash flow

15.7 Recent Trends in

Capital Structure

Which are best: book or market values?

In general, financial economists prefer
market values.
However, many corporate treasurers may
find book values more appealing due to
the volatility of market values.
Whether we use book or market values, debt
ratios for U.S. non-financial firms have been
below 50 percent of total financing.

Quick Quiz
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