Long-Term%20Financing:

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Long-Term Financing
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Corporate Long-Term Debt
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Why issue debt?

• If the asset return is greater than the cost of
  debt, then the higher debt ratio, the higher ROE
• ROE ROA (ROA Cost of Debt) x Financial
  Leverage
• The use of debt increases the volatility in ROE
  (and EPS)
• Usually when economy is good (thus, the firms
  earnings is sound), a levered firms equity would
  have better return (than it is un-levered)
  otherwise when economy is poor, a levered firms
  equity would have poorer return (than it is
  un-levered).

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Assets Debt and Equity
Assets (100) (ROA 20) Debt (50) Cost of Debt 10
Assets (100) (ROA 20) Equity (50) Return on Equity 30
Assets Debt and Equity
Assets (100) (ROA 20) Debt (75) Cost of Debt 10
Assets (100) (ROA 20) Equity (25) Return on Equity 50
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Un-levered (Equity 175,000) 50 debt (debt 87,5000, Kd10, Equity 87,500) 50 debt (debt 87,5000, Kd10, Equity 87,500)
If Expected EBIT is 35,000 (before tax ROA 20) If Expected EBIT is 35,000 (before tax ROA 20) If Expected EBIT is 35,000 (before tax ROA 20) If Expected EBIT is 35,000 (before tax ROA 20) If Expected EBIT is 35,000 (before tax ROA 20)
Expected EBIT 35,000 35,000 35,000 35,000
Interest Exp. 0 0 0 8,750
Profit before Taxes 35,000 35,000 35,000 26,250
Income Taxes (40) 14,000 14,000 14,000 10,500
Profit after Taxes 21,000 21,000 21,000 15,750
Expected ROE 21,000/175,00012 21,000/175,00012 21,000/175,00012 15,750/87,50018
If the actual EBIT is ONLY 5,000 (before tax ROA 2.86) If the actual EBIT is ONLY 5,000 (before tax ROA 2.86) If the actual EBIT is ONLY 5,000 (before tax ROA 2.86) If the actual EBIT is ONLY 5,000 (before tax ROA 2.86) If the actual EBIT is ONLY 5,000 (before tax ROA 2.86)
Actual EBIT Actual EBIT 5,000 5,000 5,000
Interest Exp. Interest Exp. 0 0 8,750
Profit before Taxes Profit before Taxes 5,000 5,000 (3,750)
Income Taxes (40) Income Taxes (40) 2,000 2,000 1,500
Profit after Taxes Profit after Taxes 3,000 3,000 (2,250)
Actual ROE Actual ROE 3,000/175,0001.7 3,000/175,0001.7 (2,250)/87,500-2.6
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Different Types of Debt

• A debenture is an unsecured corporate debt,
  whereas a bond is secured by a mortgage on the
  corporate property.
• A note usually refers to an unsecured debt with a
  maturity shorter than that of a debenture,
  perhaps under 10 years.

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Different Types of Bonds

• Callable Bonds
• Put-table Bonds
• Convertible Bonds
• Deep Discount Bonds
• Income Bonds
• Floating-Rate Bonds

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Protective Covenants

• Agreements to protect bondholders
• Negative covenant Thou shalt not
• pay dividends beyond specified amount
• sell more senior debt amount of new debt is
  limited
• refund existing bond issue with new bonds paying
  lower interest rate
• buy another companys bonds
• Positive covenant Thou shalt
• use proceeds from sale of assets for other assets
• allow redemption in event of merger or spin-off
• maintain good condition of assets
• provide audited financial information

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Bond Ratings

• What is rated?
• The likelihood that the firm will default.
• The protection afforded by the loan contract in
  the event of default.
• Who pays for ratings?
• Firms pay to have their bonds rated.
• The ratings are constructed from the financial
  statements supplied by the firm.
• What are the most important financial ratios in
  rating?
• Interest coverage ratio and leverage ratio.
• Ratings can change, and raters can disagree.

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Bond Ratings Investment Grade
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Bond Ratings Below Investment Grade
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Junk bonds

• Anything less than an SP BB or a Moodys Ba
  is a junk bond.
• A polite euphemism for junk is high-yield bond.
• There are two types of junk bonds
• Original issue junkpossibly not rated
• Fallen angelsrated
• Current status of junk bond market
• Private placement
• Yield premiums versus default risk

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Convertible Bonds

• Why are they issued?
• Why are they purchased?
• Conversion ratio
• Number of shares of stock acquired by conversion
• Conversion price
• Bond par value / Conversion ratio
• Conversion value
• Price per share of stock x Conversion ratio
• In-the-money versus out-the-money

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Convertible Bond Prices
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Preferred Stock
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Preferred Stock

• Represents equity of a corporation, but is
  different from common stock because it has
  preference over common in the payments of
  dividends and in the assets of the corporation in
  the event of bankruptcy.
• Preferred shares have a stated liquidating value,
  usually 100 per share.
• Preferred dividends are either cumulative or
  noncumulative.

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Is Preferred Stock Really Debt?

• A good case can be made that preferred stock is
  really debt in disguise.
• The preferred shareholders receive a stated
  dividend.
• In the event of liquidation, the preferred
  shareholders are entitled to a fixed claim.
• Unlike debt, preferred stock dividends cannot be
  deducted as interest expense when determining
  taxable corporate income.
• Most U.S. preferred stock are held by
  corporations.
• They get a 70-percent income tax exemption on
  dividend received.

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Angel Investors and Preferred Stock

• Preferred stock are often used by start-up firms,
  which are hesitated to issue common equity and
  are unable to use debt.
• Preferred stocks have fixed dividends at the
  beginning, and sometimes they are able to be
  converted into common stocks (convertible
  preferred) if the firms that issued preferred
  have upside potential.
• Issuing preferred can avoid right dilution that
  caused by issuing common. It can also be done by
  setting a high conversion price for a convertible
  preferred.

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Common Stock
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Common Stocks

• Common shareholders have voting rights, limited
  liability, and a residual claim on the
  corporation.

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Shareholders Rights

• The right to elect the directors of the
  corporation by vote constitutes the most
  important control device of shareholders.
• Directors are elected each year at an annual
  meeting by a vote of the holders of a majority of
  shares who are present and entitled to vote.
• The exact mechanism varies across companies.
• The important difference is whether shares are to
  be voted cumulatively or voted straight.

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Classes of Stock

• When more than one class of stock exists, they
  are usually created with unequal voting rights.
• Many companies issue dual classes of common
  stock. The reason has to do with control of the
  firm.
• Lease, McConnell, and Mikkelson found the market
  prices of stocks with superior voting rights to
  be about 5 percent higher than the prices of
  otherwise-identical stocks with inferior voting
  rights.

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The Public Issue -- The Basic Procedure

• Management gets the approval of the Board of
  Directors.
• The firm prepares and files a registration
  statement with the SEC.
• The SEC studies the registration statement during
  the waiting period.
• The firm prepares and files an amended
  registration statement with the SEC.
• If everything is completely satisfactory with the
  SEC, a price is set and a full-fledged selling
  effort gets underway.

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The Process of A Public Offering

• Steps in Public Offering Time
• 1. Pre-underwriting conferences
• 2. Registration statements
• 3. Pricing the issue
• 4. Public offering and sale
• 5. Market stabilization

Several months 20-day waiting period
Usually on the 20th day
After the 20th day 30 days after
offering
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The Process of A Public Offering

• Two methods for issuing securities for cash
• Firm Commitment
• Best Efforts
• Two methods for selecting an underwriter
• Competitive
• Negotiated

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Firm Commitment

• Under a firm commitment underwriting, the
  investment bank buys the securities outright from
  the issuing firm.
• Obviously, they need to make a profit, so they
  buy at wholesale and try to resell at retail.
• To minimize their risk, the investment bankers
  combine to form an underwriting syndicate to
  share the risk and help sell the issue to the
  public.

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Best Efforts

• Under a best efforts underwriting, the
  underwriter does not buy the issue from the
  issuing firm.
• Instead, the underwriter acts as an agent,
  receiving a commission for each share sold, and
  using its best efforts to sell the entire
  issue.
• This is more common for initial public offerings
  than for seasoned new issues.

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The Announcement of New Equity and the Value of
the Firm

• The market value of existing equity drops on the
  announcement of a new issue of common stock.
• Reasons include
• Managerial Information
• Since the managers are the insiders, perhaps
  they are selling new stock because they think it
  is overpriced.
• Debt Capacity
• If the market infers that the managers are
  issuing new equity to reduce their debt-equity
  ratio due to the specter of financial distress,
  the stock price will fall.
• Falling Earnings

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The Private Equity Market

• For start-up firms and firms in financial
  trouble, the public equity market is often not
  available.
• Avoid the costly procedures associated with the
  registration requirements that are a part of
  public issues.
• The SEC restricts private placement issues to no
  more than a couple of dozen knowledgeable
  investors including institutions such as
  insurance companies and pension funds.
• The biggest drawback is that the securities
  cannot be easily resold.

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Venture Capital

• The limited partnership is the dominant form of
  intermediation in this market.
• There are four types of suppliers of venture
  capital
• Old-line wealthy families.
• Private partnerships and corporations.
• Large industrial or financial corporations have
  established venture-capital subsidiaries.
• Individuals, typically with incomes in excess of
  100,000 and net worth over 1,000,000. Often
  these angels have substantial business
  experience and are able to tolerate high risks.