Sources of Long-term Financing

Learning Outcomes:
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Identify the sources of business capital
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Understand the nature, features, pros and cons, of these
sources
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Calculate the intrinsic value of preferred shares
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Compute the ordinary shares valuation using the finite
and infinite period methods
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Understand leases as source of capital
 Sources of capital for Businesses
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Equity
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Debt
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Debentures
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Retained Earnings
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Term loans
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Working capital loans
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Letter of credit
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Euro Issue
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Venture funding
-THEY ARE GROUPED BASED ON TIME PERIOD, OWNERSHIP CONTROL, AND SOURCE
GENERATION
 Time-period Financing
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Classified into three
1. Long-term sources of finance
2. Medium-term sources of finance
3. Short-term sources of finance
 Time-period Financing
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Long-term sources of finance
-capital needed for a period of more than 5 years to
10 to 15 and 20 years or even more
-Examples: share capital, preference shares,
retained earnings, bonds, term loans from financial
institutions, international financing by means of euro
issue, foreign currency loans.
 Time-period Financing
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Short-term sources of financing
-financing is funding for a short period of less than one year
-this usually funds current assets like inventory of materials,
debtors etc.
- In the form of trade credits
short-term loan from commercial banks, advances received from
customers, creditors, factoring services and bill discounting
 Finances categorized as to
Ownership and Control
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1. Owned capital or ownership shares
-Referred to as equity capital
-Preference capital
-Retained Earnings
Convertible debentures (long-term debt that can be converted into
shares of equity stock)
-bonds
-private equity (investors directly invest into the business)
 Finances categorized as to
Ownership and Control
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2. Borrowed capital
-Also called debt financing
-sourced from outside including loans from family,
relatives, and friends, financing institutions,
commercial banks and the general public in the
form of debentures/bonds
 Features of borrowed capital:
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The company-borrower will pay the creditors first in case
of liquidation
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Regular payment of interest and repayment of capital
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There is no reduction in ownership and business control
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Interest or the cost borrowed funds is a deduction for tax
purposes resulting to decrease in taxes for the company
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It provides the firm a leverage benefit
Disadvantages of borrowed capital:
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Principal and interest obligations have to be paid
regardless of the economic condition of the company
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Some restrictions in the indenture agreement may
be a burden on the firm
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Debt may weaken outstanding ordinary shares if
used in a long period
 Finance Source Origin
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1. Internal Sources
-capital is generated internally which have the same
characteristics of owned capital, include retained earnings,
reduction or controlling working capital, sale of assets
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2. External sources
-one in which the capital is generated from outside or third
party
 Major sources of long-term
financing:
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1. Bonds
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2. Preference shares
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3. Ordinary or common shares
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4. Lease
 Bond
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Is a promise in writing under seal, to pay a definite sum of money with a fixed rate
of interest thereon
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Evidenced by a bond certificate issued by a corporation or a government body
representing the loan made by the investor to the issuer of bonds.
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Bond certificate shows the name of the company-issuer, the principal amount the
firm borrowed from the bondholder, the bond’s face value, interest rate to be paid
by the issuer, dates of payment, maturity date and value.
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Issuance of bonds usually requires the services of a security underwriter, which
can be a an investment bank or other financial institutions. The underwriter
purchases the bonds from the issuing company and resells them to prospective
clients.
 Other agreements between the
underwriter and the issuing firm in
trading bonds
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The Investment bank can negotiate directly with the issuer
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The underwriter can participate in bidding for the purchase of bonds
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An investment bank can be a sole underwriter by acquiring exclusive
right to sell the bonds.
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The investment bank can make an agreement with the issuer to sell the
bonds at the best market price it can for issuing company, not
guaranteeing a fixed price with the selling firm.
 Advantages of using bonds in the
capital structure
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Long-term debts are less expensive and the interest payments
are deductible for tax purposes
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Many investors considered these as a relatively safe investment
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Bondholders are paid interest and do not share in the
extraordinary earnings of the firm
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Bondholders are not corporate voters
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Bond’s flotation costs are lower than those of ordinary
 Time-period Financing
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Medium-term financing
-Financing for a period of three to five years
-Examples: preference shares, bonds, medium term
loans from financial institutions, ,lease
 Disadvantages of Utilizing bonds
are:
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Long-term debts can cause the firm’s bankruptcy if it fails to meet
interest payments.
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The fixed charges on bonds,other than income bonds, increase the
company’s financial leverage, This is unfavorable for firms with
unstable income
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Bond repayment at maturity (principal amount)involves a huge cash
outflow.
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Bonds’ restricting agreements may hamper the firm’s future financial
flexibility
 Bond attributes and Prices
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Par value-refers to the face value of the bonds that is returned to the the
bondholder at maturity date
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Contract interest rate or stated interest rate-pertains to the interest rate
that determines the amount of interest to be paid by the issuer and to be
received by the bondholder each year. The contract rate is stated in the
bond certificate or contract and does not change during the duration of
the bonds
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Coupon interest rate-refers to the percentage of par value that will be paid
annually in the form of interest. Computed by dividing stated interest
payment by par value.
 Bond attributes and Prices
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Market interest rate or effective interest rate-is
the interest rate that investors demand for
lending their money to the bond issuer
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Maturity (date) -date or time that the bond
issuer returns the par value of the bond and
terminates it.
 Bond attributes and Prices
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Market price of the bonds- bond’s present value
which is the total of the present value of the
principal amount/payment and the present value
of the cash interest payments
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Present value- is the amount that an investors
would invest now to receive a greater amount at
a future date.
 Bond attributes and Prices
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Yield to maturity-refers to the bonds internal rate of return (IRR). It is
the discount rate that equates the present value of the interest and
principal payments with the current market price of the bonds.
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Current yield-pertains to the ratio of the annual interest payment to the
market price of the bonds.
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Indenture-the arrangements between the issuer and the bond trustee
who represents the bondholders. It includes the specific terms of the
loan agreement, description of the bonds, the bondholders’ rights, the
issuing firm’s rights and the responsibilities of the trustee.
 Bond attributes and Prices
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Bond premium-is the excess of the bond’s issue price over its
maturity or par value
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Bond Discount-is the excess of the bond’s maturity or par
value over its issue price
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Credit quality risk-refers to the possibility that the issuer of the
bonds will not be able to meet timely payments.
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Bond ratings-relate to the opinions or perceptions about the
future risk potential of the bond,
 Factors affecting the bond ratings:
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Profitable operations
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Little inconsistencies of previous earnings
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Firm’s size
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Less usage of subordinated debt
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Less application of financial leverage