UNIT:5 LONG TERM FINCING

LONG TERM DEBT

A firm needs funds for the different purposes. Therefore a firm fulfills its
financial needs using different sources of financing. Long term debt is one of
major long-term sources of financing. The big firms can raise fund by selling
long-term bonds in the open market. It is suitable for both big and small
firms.
Debt holder becomes the creditor of the debt issuing company. There is a
claim on firm’s income and assets as stated in the bond contract called
indenture. The rights, facilities, obligation of the investors are indicated in
the indenture.
There are many types of long term debt instruments such as term loans,
bonds, secured and unsecured notes, marketable and non marketable debt
and so on. Therefore, the long-term debt includes all long term borrowing
incurred by the firm. Debenture, bonds, long-term loan etc. are major source
of debt or borrowed capital.

CHARACTERISTICS OF LONG TERM DEBT

Claims on Income and Assets
In case of bankruptcy, debt holder has prior claim on company’s income and
assets. Debt holders have a prior claim over the claims of both common and
preferred stockholders to a firm’s income and assets.

Fixed Interest
Bonds and debenture are issued with a promise to pay a certain rate of
interest. Therefore, we can say that interest rate on debt is fixed. Interest is
paid annually or semiannually. The company must pay interest whether it
earns profit or suffers from loss.

Maturity
The maturity date represents the date on which the bond matures. Debt
usually has a fixed maturity date i.e. the date on which the face value is
repaid. The maturity of debt indicates the length of time in which the last
coupon payment is also paid on the maturity date.
Call Provision
A call provision gives the issuing corporation the right to redeem the bonds
prior to maturity under specified terms, usually at a price greater than the
maturity value or we can say call price is equal or greater than par value but
never less than the par value. This difference is called call premium.

Sinking Funds
In most bonds issue there is a sinking fund provision. A sinking fund is a
provision that requires the corporation to restive a portion of the bond issue
each year. The purpose of the sinking fund is to provide for the orderly
retirement of the issue.

Security
Debt is either secured or unsecured. A secured debt is secured by a lien on
the company’s specific assets. If the company is unable to pay the bond
amount the bondholder may recover their money by selling the assets.

Convertibility
Bonds may be convertible or non-convertible. If it is convertible the bond
can be converted into preference share or equity share.

Voting Rights
There is no voting right to debt holders.

Advantages and Disadvantages of Debt

Advantages (Borrower’s Point of View)

The advantages of debt financing from borrower’s point of

view are as follows:
1. Less costly: It involves less cost to the firm than the equity financing
because investors consider debentures as a relatively less risky
investment alternative and therefore, required a lower rate of return.
2. No ownership dilution: The firm is able to raise funds without
dilution of ownership because the bondholders do not have voting
right in the election of board of directors.
3. Fixed payment of interest: Generally, the interest rate of debt
(bond/debenture) is fixed. When the company earns high profit, the
debt holders receive only limited income.
4. Low issuance cost: Issue cost of debt is significantly lower than those
on equity and preference capital.
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 117
5. Reduced real obligation: During the period of high inflation,
debenture issue benefits the company. Its obligation of paying interest
and principal which are fixed decline in real terms.
6. Flexibility: Flexibility in the financial structure of the corporation can
be achieved by inserting a call provision in the bond indenture. Some
loans can be repaid before being matured.
7. Tax deductible: Interest on debt is a tax-deductible expense, whereas
equity and preference dividends are paid out of profit after tax.

Disadvantages (Borrower’s Point of View)

The disadvantages of debt financing from borrower’s point of view are as

follows:
1. Obligatory payments: Debt financing entails fixed interest and
principal repayment obligation. Failure to meet these commitments can
cause a great deal of financial embarrassment and even lead to
bankruptcy.
2. Increase financial risk: It increases the firm’s financial leverage, which
may be particularly disadvantageous to those firms which have
fluctuating sales and earnings. In addition, debt financing increases
financial leverage which raises the cost of equity to the firm.
3. Restricted covenants: Debt contracts impose restrictions that limit the
borrowing firm’s financial and operating flexibility. These restrictions
may impair the borrowing firm’s ability to resort to value maximizing
behavior.
4. Increased real cost: If the rate of inflation turns out be unexpectedly
low, the real cost of debt will be greater than expected.
5. Cash outflows: Debt usually has a fixed maturity date. The debt must
be paid on maturity, and therefore, at some points, they involve
substantial cash outflows. The financial manager must make provision
for repayment of the debt.
6. Limit of the loan: There is a limit on the extent to which funds can be
raised through long term debt. According to the financial policy, the
debt ratio should not exceed certain limits. When debt goes beyond
these limits, its cost rises rapidly.

Decisions on the Use of Long Term Debt

There are the situations which favor the use of long-term debt. Some of the
major facts are as follows:
 The firm can use additional level of debt, if the existing debt ratio is
relatively low.
 The use of debt increases earning per share.
 The firm which has higher interest coverage ratio can use more debt.
 The firm which has stable earnings and sales and are growing can use
debt. It is not difficult to firm to pay interest and principal amount.
 Common stock price earning ratios are low in relation to the level of
interest rates.
 Control considerations are important. The existing common stock
holders do not want to loose their current control power, their firm can
not issue common stock. The firm would be forced to issue debt.

Instruments of Long Term Debt Financings

It is necessary to be familiar with some basic terms in order to understand
different forms of long-term debt financing.

Bond
The bond is a long-term promissory note. Bond is known as fixed income
security because an investor knows the exact amount of cash he will get back
until maturity. A mortgage bond is secured by fixed assets of issuing firm’s
property. The major condition of the loan is pledging of collateral.

Debenture
It is also a long term security. It is not secured by a mortgage on the issuer’s
property. It may have call provision that gives the company right to redeem
the debenture before the maturity period. It is more risky than bond to an
investor.

Indenture
Indenture is a legal contract between two parties (issuer and bondholder)
regarding interest payment system, the period for repayment, if the bond is
convertible, call provision and other terms and conditions. It will be helpful
to resolve the agency problems among managers (shareholders) and
creditors. It may include the following features:
 The authorized amount of bond issue.
 Detail of property pledged.
 Call provision
 Redemption procedure.
 Protective clauses or covenants. such as:
a. Restriction on merger activity
b. Restriction to issue new debt
c. Restriction on the dispositions of the firm assets
d. Restrictions on dividend payments.
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 119
e. Minimum level of working capital that the firm must maintain.

Sinking Fund
It is a provision that facilitates the orderly retirement of a bond issue. It
requires the firm to retire a portion of the bond each year. Generally, it is
used to purchase back a certain proportion of the issue each year. A failure
to meet the requirement of sinking fund causes the bond issue to be thrown
into default that may result the firm into bankruptcy. The sinking fund may
operate in one of the two ways:
(i) To redeem the required face amount of the bonds. It can buy the bonds
from the open market.
(ii) The firm may buy a fraction of the outstanding bonds at a specific call
price associated with the sinking fund provision. The firm has an option
to buy the bonds at either the market price or the sinking fund price,
whichever is lower.

Call Provision
A call feature is an optional retirement provision that permits the issuing
company to redeem or call a debt issue prior to its maturity date at a
specified price termed as the call price. Many firms use the call feature
because it provides them with the potential flexibility to retire debt prior to
maturity if interest rates decline. The call price is greater than the par value
of the debt, and the difference between the two is the call premium. The call
premium usually equal to about one year’s interest. Some debt issues specify
fixed call premiums, whereas others specify declining call premiums.
Call provision increases risk to the bondholders but invaluable to the firm. It
helps the firm to retire the bond before maturity if the market interest rate
fall sharply and the firm earns high return.

Trustee
A trustee is a third party to a bond indenture. A paid individual, firm, or
commercial bank trust department that acts as the third party to a bond
indenture to ensure that the issue firm does not default on its contractual
responsibilities to the bondholders. In other words, the trustee is paid to act
as “watchdog” on behalf of the bondholders and empowered to take
specified actions on behalf of the bondholders if the terms of the bond
indenture are violated. The trustee is responsible for monitoring the
covenants and for taking appropriate action if a violation exists. The trustee
is also responsible for deciding that the investors would be better served by
giving the company a chance to work out its problems and thus avoid
forcing it into bankruptcy.
PREFERRED STOCK
Preferred stock, also called as preference share, is a security that combines
features of both fixed income bonds and equity securities. Therefore it is also
known as hybrid security. Preferred dividends are similar to interest
payments on bonds in that they are fixed in amount and must be paid before
common stock dividends. Preferred stocks may be issues with or without a
maturity period like common stock, preferred stock represents partial
ownership in a company, although preferred stock shareholders do not
enjoy any of the voting rights of common stockholders. Preferred
shareholders always receive their dividends first and in the event the
company bankruptcy, preferred shareholders are paid off before common
stockholders.

MAJOR PROVISION OF PREFERRED STOCK ISSUE

Among the characteristics given below some are common to all types of
preferred stock while some are specific to certain types of preferred stock
only. However, the basic characteristics are:

Fixed Dividend
The dividend rate is fixed at the rate expressed as percentage of par value.
The amount of dividend will be equal to rate multiplied by par value of
preferred stock capital i.e. dividend is always calculated on the par value.

Par Value
The par value of each share of preferred stock is Rs. 100; par value is the
stated price of the preferred stock.

Claims on Income and Assets

Preferred stock has prior claim on company’s income and assets. The
company must pay the preference dividend before paying ordinary
dividend. At the time of liquidation, the preference shareholder claim is
prior on the residual assets than the ordinary shareholder’s claim.

Voting Rights
Because of their prior claim on assets and income preferred stockholders are
normally given a voice in management. But, they may be provided with
contingent voting right when company fails to provide dividend for certain
specific period. In such circumstances they can elect or nominate specific
number of members on the board as directors.
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 121
Convertibility
Preference share may be convertible or non-convertible. If dividend
provided on preferred stock is at lower rate than that on others securities,
the preference shares can be converted into debentures or ordinary shares.

Call Provision
A call provision gives the issuing corporation the right to redeem the
preferred stock prior to maturity under specified terms, usually at a price
greater than the par value. This difference is called call premium.

Sinking Fund
Sinking fund is created for the purpose of redemption of preferred stock.
That means it is created to call the preference stock or even to purchase the
preferred stock issued in open market.

Participative Feature
This allows preferred stockholder to participate in extraordinary profit or
residual earning of the company. If the common stockholders receive
increasing dividend, the preferred stockholders too participate in increasing
dividend equally and thereby get dividend amount in excess of fixed
dividend e. g. for 15 percent preference share, the regular dividend is 15
percent. If company pays 20 percent ordinary dividend then preference
share holder too would get 20 percent i.e. 5 percent extra dividend. These
stockholders may also participate in the residual asset while winding up the
company.

Redemption/Retirement
Preference share may be redeemable and irredeemable. The perpetual/
irredeemable stocks have no maturity period but redeemable stock mature
after specified period.

Cumulative Dividend
The unpaid dividend in any single year has to be carried forward and the
company must pay the dividends in arrears on it’s preferred stock before
only ordinary dividends are paid. Hence, this feature protects the interest of
preference shareholders. The company has no legal obligation to pay
preferred dividend and can also omit such dividend if needed. Since
preference shareholders do not have dividend enforcement power,
cumulative feature is needed to protect their interest.
 Advantage and Disadvantage of Preferred Stock

Advantages (Company’s Point of view)

Preferred stock offers the following advantages.
1. No obligatory payments : There is no legal obligation to pay
preference dividend. A company does not face bankruptcy or legal
action if it skips preference dividend. Moreover, financial distress on
account of redemption obligation is not high because periodic sinking
fund payments are not required and redemption can be delayed
without significant penalties
2. Increase creditworthiness: Preference capital is generally regarded as
part of net worth. Thus, it enhances the creditworthiness of the firm.
The firm can use more amount of debt.
3. No dilution of control: In general, preferred stocks do not carry voting
right. Therefore, there is no dilution of control. While financing through
preferred stock, the control of the shareholders on the firm is protected.
They get the rights only if dividend could not be paid for certain
specified time.
4. Conserve assets: No assets are pledged in favour of preferred
stockholders. Therefore, the mortgageable assets of the firm are
conserved.
5. Riskless leverage advantage: Preference share provides financial
leverage advantages since preference dividend is a fixed obligation.
This advantage occurs without a serious risk of default. The non-
payment of preference dividend does not force the company into
insolvency.
6. Fixed dividend: The preference dividend payments are restricted to the
stated amount. Thus preference shareholders do not participate in
excess profits as do the ordinary shareholders.

Disadvantages (Company’s Point of view)

Preferred stock, however, suffers from some serious shortcomings:
1. High cost: Compared to debt capital, it is a very expensive source of
financing because the dividend paid to preference shareholders is not a
tax deductible expense. Characteristically, preferred stock must be sold
on a higher yield basis than that for bonds.
2. Prior claim on the assets and earnings: Compared to equity
shareholders, preferred stockholders have a prior claim on the assets
and earnings of the firm.
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 123
3. Difficult to sale: Unlike bondholders, there is no guarantee of the
payment of dividend of preference shareholders. The preference
shareholders take additional risk than the bondholders. Therefore, it is
difficult to sell preference shares in the market.

Use of Preferred Stock in Financing Decisions

Preferred stock is a hybrid security that is some features of it are similar to
bonds and to common stock in other ways. It imposes a fixed charge and
thus increases the firm’s financial leverage, yet omitting the preferred
dividend does not force a company into bankruptcy. Because of tax factor,
preferred stocks are more costly to firms as they get no tax saving (because
preferred dividend is paid from earning after tax), but owning preferred
stock of other firms will be beneficial. Corporations are exempt from taxes
on preferred dividend income. Therefore, preferred stocks are mostly held
by firms than individual investors. The major favorable conditions of
preferred stock financing are:
 Omitting the preferred dividend does not force a company into
bankruptcy.
 Preferred stock normally has no voting rights.
 Preferred stock is attractive to corporate investors because of tax exempt
provision on dividend.
 The firm can gain from the additional leverage provided by preferred
stock.
 If call provision is included, company can call preferred stock and
redeem it.

Ranking of Securities
Here we are tanking the securities from lowest to highest in terms of their riskiness.

Expected and Required

After-Tax Rate of Return
(%)

J Warrant
Risk
I Common
Premium
H Convertible Preferred
G Preferred Stock
F Income Bonds
E Subordinated
D Second mortgage
C First mortgage
B Floating Rates Notes
kRF A Short-term U.S. Treasury

Risk-Free
Rate of Return

O Risk to investors
 Figure 5.1
Expected and Required after-tax rate of return (%).
In the above figure we are tanking the securities from lowest to the highest
in terms of there riskiness. There is significant relationship between risk and
rate of return. Securities with higher expected rate of return are more risky
than the securities with the lowest rate or return. First, short term U.S.
Treasury Bills represent risk free rate. Floating rate notes is little riskier than
U.S. Treasury bills. First mortgage and second mortgage bonds are some
riskier than U.S. Treasury bills and floating rate notes like wise subordinated
debentures, income bonds, preferred stock convertible preferred, common
stock and warrants are all increasingly risk and their expected return
increase accordingly. A warrant is the risky securities among the other
therefore it has the highest required rate of return.

REFUNDING OF DEBT OR PREFERRED STOCK

Refunding is the process of retiring the existing debt or preferred stock.
Market interest rate does not remain constant for a longer time. Various
factors like inflation, demand and supply of capital, trade cycle, government
policy etc. determine interest rate, when interest rate decrease in a market
company may be benefited from refunding decision. Moreover refunding is
the replacement of old debt or preferred stock with new issue. In other
words, refunding is the process of retiring an existing bond issue with the
proceeds of newly issue bond or preferred stock. The old securities may be
retired by calling them or by purchasing decision also helps to avoid
restrictive covenants.
Refunding decision is moreover similar to the capital budgeting decision.
The refunding is desirable only if the present value of the benefits exceeds
the initial outlay. Thus the net present value (NPV) method is used to
analyze the advantages of refunding.

Refunding Process of Bonds

Step 1: Determine the investment outlay required to the new issue:
a. Call premium after taxes xxx
(Face value of old issue × premium rate × (1 – t)
b. After tax flotation cost on new issue:
Total flotation cost of new issue xxx
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 125
Less: PV of annual tax saving on flotation cost of new issue xxx xxx
× t × PVIFAkdt
c. After tax interest on old issue during overlap period xxx
Face value (old) × Interest rate × Time × (1 – t)
Less: After tax return from investment during overlap period xxx xxx
[Face value (new) × Investment rate × Time × (1 – t)]
d. Tax savings on unamortized flotation cost of old issue xxx
×t
Less: PV of annual tax saving lost on flotation cost old issue xxx xxx
× t × PVIFAkdt, n(remaining life)
Total initial cash outlay (a + b + c – d) xxx

Step 2 Calculate PV of annual after tax interest saving: xxx

Face value (old) × [Interest rate (old) – Interest rate (new)] × (1 – t) × PVIFA kdt, n

Step 3 Determine NPV of the refunding:

NPV of refunding = PV of annual after tax interest saving – Total initial cash outlay i.e. step ___
2 – step 1 xxx

Note: Kdt = Kd new (1 – t), t = tax rate, PV = present value

Refunding process of perpetual preferred stocks

Step 1 Determine the cash outlay:
a. Call premium (not tax deductible) xxx
[Face value (old) × Premium rate]
b. Flotation cost on the new issue xxx
Total flotation cost (1 – t)
c. Preferred stock dividend during overlap period
Face value (Old) × Dividend rate × Time xxx
Less: After tax return from investment during overlap period
Face value (new) × Investment rate × Time × (1 – t) xxx xxx
Total initial cash outlay (a + b + c) xxx
Step 2 Calculate PV of annual dividend saving: xxx

Step 3 Determine NPV of the refunding:

NPV = Total PV of annual dividend saving – Initial cash outlay xxx

Decision:
(i) Refunding is worthwhile if NPV of refunding is positive.
(ii) Refunding is not worthwhile if NVP of refunding is negative.

WORKED OUT ILLUSTRATIONS

 ILLUSTRATION –1 Mechi Kali Corporation (MKC) is considering whether to refund a Rs. 60
million, 16 percent coupon, 30-year bond issue that was sold 5 years ago. It
is amortizing Rs. 3 million of flotation costs on the 16 percent bonds over the
issue’s 30 years life. MKC’s investments bankers have indicated that the Co.
could sell a new, 25 year issue at an interest rate 13 percent in today’s
market. Neither they nor MKC’s management sees much chance that interest
rates will fall below 13 percent any time soon, but there is a chance that rate
will increase.
A call premium of 16 percent would be required to retire the old bonds, and
flotation costs on the new issue would amount to Rs. 3 million. MKC’s
marginal federal plus state tax is 40 percent. The new bonds will be issued
one month before the old bonds were called; with the proceeds being
invested in short-term government securities returning 10 percent annually
during the interim period. Is the refunding process is desirable?
Solution
Call premium after tax Face value of old issue × Premium % × (1 – t)
Rs. 60 million × 16% × (1 – 0.40)

Flotation cost of the new issue

Less: PV of annual tax saving on flotation cost of new issue

After tax interest on old issue during overlap period

Face value (old) × Interest rate × time × (1 – t)
(Rs. 60 million × 16% × (1 – 0.40)
Less: After tax interest on short term government securities
(Rs. 60 million × 10% × (1 – 0.40)

Tax saving on unamortized flotation cost of old issue

Less: PV of annual tax saving loss on flotation cost of old issue

 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 127

Initial after-tax cash outflow

Calculation of annual after tax interest savings

Annual after tax interest savings
Face value (old) × rate × (1 – t) Rs. 1,080,000
Rs. 60 million × 3% (1 – 0.40)

PV of annual after-tax interest saving

PV of annual after-tax interest saving
(Annual after-tax interest saving × PVIFAkdT, n)
(Rs. 1,080,000 × PVIFA7.8%, 25)
(Rs. 1,080,000 × 10.8597) Rs. 11,728,476

Calculation of NPV of refunding

NPV = PV of annual after tax interest savings – Initial outlay
= Rs. 11,728,476 – Rs. 7,853,122
= Rs. 3,875,354
Since the net present value of refunding is positive, the refunding is
desirable.
ILLUSTRATION –2 The B&B Company has a Rs. 600,000 long term twenty year bond issue
outstanding which has an additional fifteen years to maturity and bears a
coupon interest rate of 12 percent. The interest payments are made annually.
Financial market conditions have given the company the opportunity of
refinancing the debt with another fifteen-year bond but a lower rate of 10
percent. The company plans to use all debt financing for the proposed bond-
refunding project. The relevant data on the old issue and on the new
refunding issue are summarized below:
Old Issue New Issue
Face amount Rs. 600,000 Rs. 626,020
Interest rate 12 percent 10 percent
Life of bond 20 years 15 years
Maturity date Shrawan 1, 2060 Shrawan 1, 2060
Floatation costs 2 percent of face amount 2 percent of face amount
Date issued Shrawan 1, 2040 Shrawan 1, 2045
Redemption date Shrawan 1, 2045 
Call price 104 
Is it worthwhile to refund the old issue? Note that the company's applicable
corporate tax rate is 40 percent.
Solution
Cost of debt after-tax (kdt) = kd × (1 – Tax)
= 10% × (1 – 0.4) = 6%
Call premium = × 100
= 4%
Calculation of Initial Cash Outlay
a. Call premium after-tax
Total face value (old) × Premium rate × (1 – t)
Rs. 600,000 × 0.04 × (1 – 0.40) Rs. 14,400

b. After-tax flotation cost of the new issue

Total flotation cost (Rs. 626,020 × 0.02) Rs. 12,520
Less: PV of annual tax saving on flotation cost of new issue
× t × PVIFAkdt, n
= × 0.40 × PVIFA6%, 15
= × 0.40 × 9.7122 Rs. 3,243

Rs. 9,277

c. After tax interest on old issue during overlap period

Face value old × Interest rate × Time × (1 – t) 0

d. Tax savings on unamortized flotation cost of old issue

× Remaining life × t
× 15 × 0.40 Rs. 3,600

Less: PV of annual tax saving lost on flotation cost of old issue

= × t × PVIFAkdt, n
= × 40 × PVIFA6%, 15
= × 40 × 9.7122 Rs. 2,331

(Rs. 1,269)

Initial cash outlay (a + b + c – d) Rs. 22,408

Calculation of PV of annual after-tax interest savings

= Face value (old) × (Interest rate old – Interest rate new) × (1 – t) ×
PVIFAkdt, n
= Rs. 600,000 × 0.02 × (1 – 0.40) × PVIFA6%, 15
= Rs. 7,200 × 9.7122
= Rs. 69,928
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 129
Calculation of NPV of refunding
= PV of annual after tax interest savings – Initial cash outlay
= Rs. 69,928 – Rs. 22,408
= Rs. 47,520
The net present value of refunding is positive; so it is worthwhile to refund
the old issue.
ILLUSTRATION –3 The Pasmina Company has a Rs. 30,000,000 long-term 20-year bond issue
outstanding, which has an additional fifteen years to maturity and bears a
coupon interest rate of 11.5%. The interest payments are made semiannually.
Financial market conditions have given the firm the opportunity of
refinancing the debt with another 15-year bond but at lower rate of 10%. The
firm plans to use all debt financing for the proposed bond refunding project
the relevant data on the old issue and on the new refunding issue are
summarized below:
Face amount Rs. 30,000,000 Rs.31, 302,000
Interest rate 11.5% 10%
Life of bond 20years 15years
Maturity date Augest10, 1993 Augest10, 1993
Flotation costs Rs. 600,000 –
Net proceeds of sale Rs.29, 400,000 –
Date issued Augest14, 1973 Augest10, 1978
Redemption date Augest10, 1978 –
Call price Rs.105 –
A flotation costs on both the old new issue are 2.0 percent of gross proceeds.
The firm’s application corporate tax rate is 40%. The after tax cost of debt is
used as the discount factor in the analysis. Based on the provided, evaluate
the planned refunding issue.
Solution
Calculation of initial cash outlay
a. Call premium after-tax
Total face value (old) × Premium rate × (1 – t)
Rs. 30,000,000 × 0.05 × (1 – 0.40) Rs. 900,000
b. After-tax flotation cost of the new issue
Total flotation cost Rs. 626,040
Tax saving on amortized portion of flotation cost of on the old issue
× Remaining life × t
= × 15 × 0.4
Rs. 180,000
Initial outlay 13,46,040
c. Present value of after tax interest saving
Face value of old × Differential interest rate (1 – t)
= × (1 – 0.4) 135,000
 d. PV of semi-annual after-tax interest saving
135,000 × 19.6004 26,46,054
e. Present value of differential after-tax annual saving on flotation cost
Tax saving on flotation cost on new issue
× 0.4 16,694.40
Less: Tax saving lost on flotation cost on old issue
× 0.4
12,000
Tax saving on flotation cost (differential) 4,694.40
PV of differential tax saving on flotation cost
6494.40 × PVIFA7%, 15 45592.9510
Net present value of refunding = PV of after tax interest saving + PV of
differential tax saving on flotation cost – Initial cash outlay
= 2646054 + 45592.9510 – 1346040
= Rs. 1345606.9510

The company should refund the existing bond because NPV of refunding is
positive.

Theoretical Questions
1. What are the major features of long-term debt?
2. Explain the importance of long-term debt financing. How can long-term funds be raised
by Nepalese firm?
3. What do you mean by long-term debt financing? Explain the conditions that favor the use
of long-term debt.
4. What are the various instruments of long-term debt financing?
5. What considerations should a firm make while issuing the appropriate instruments of
long-term financing in Nepal?
6. Explain the advantage and disadvantage of long-term debt financing. Briefly explain
different type of corporate bonds.
7. What are the features of preferred stock? Explain the general provisions contain in
preferred stock agreement.
8. Describe the advantage and disadvantage of preferred stock. Explain why the firms
should use the preferred stock.
9. Explain the development of corporate bond and preferred stock financing in Nepal.
10. Write short notes on:
(i) Refunding decision
(ii) Common stock vs preferred stock
(iii) Preferred stock vs debt
(iv) Sinking fund
 LONG TERM DEBT AND PREFERRED STOCK Chapter Five 131
(v) Trustee
(vi) Indenture
(vii) Call provision
(viii) Income bond

Practical Problems
PROBLEM–1 Norvic Incorporate Company is considering refunding its preferred stock.
The dividend rate on this stock is Rs.6, and it has a par value of Rs.50 a share. The call
price is Rs. 52 a share, and 500,000 shares are outstanding. Mr. Devkota, vice president of
finance, feels the company can issue new preferred stock in the current market at an
interest rate of 11 percent. With this rate, the new issue could be sold at par; the total par
value of the issue would be Rs. 25 million. Floatation costs of Rs. 780,000 are tax
deductible, but the call premium is not tax deductible; the company's marginal tax rate is
30 percent. A 90-day period of overlap is expected between the time the new preferred
stock is issued and the time the old preferred stock is retired. Should the company refund
its preferred stock using a capital budgeting analysis of refunding?
Ans: – Rs. 23,273
PROBLEM–2 Megha Corporation has Rs. 50 million of 14 percent debentures outstanding,
which are due in 25 years. The company could refund these bonds in the current market
with new 25-year bonds, sold to the public at par (Rs. 1,000 per bond) with a 12 percent
coupon rate. The spread to the underwriter is 1 percent, leaving Rs. 990 per bond in
proceeds to the company. The old bonds have an unamortized discount of Rs. 1 million,
unamortized legal fees and other expenses of Rs. 1,00,000, and a call price of Rs. 1,140 per
bond (Rs. 114 on Rs. 100 face value convention). The tax rate is 40 percent. There is a 1-
month overlap during which both issues are outstanding, and issuing expenses are Rs.
2,00,000. Compute the present value of the refunding, using the after-tax rate on the new
bonds as the discount rate. Is the refunding worthwhile?
Ans: Rs. 1,84,702
PROBLEM–3 S&S Company has Rs. 20 million of 10 percent debentures outstanding,
which are due in 20 years. The Company could refund these bonds in the current market
with new 20-year bonds, sold to the public at par (Rs. 1,000 per bond) with an 8 percent
coupon rate. The spread to the underwriter is 1 percent. The old bonds have an
unamortized discount of Rs. 0.8 million, unamortized legal fees and other expenses of Rs.
2,00,000, and a call price of Rs. 1,100 per bond. The tax rate is 40 percent. There is a 1-
month overlap during which both issues are outstanding, and issuing expenses are Rs.
5,00,000. Compute the present value of the refunding, using the after-tax rate on the new
bonds as the discount rate. Is the refunding worthwhile?
Ans: Rs. 13,66,254
 PROBLEM–4 Bridgestone Company is considering refunding an old preferred stock issue.
There are 30,000 shares of the preferred outstanding. Bridgestone is paying an Rs. 8
dividend per year on each share. The par value is Rs. 100 per share, and Bridgestone can
call the stock at Rs. 102 per share. Bridgestone’s financial analysts feel that they can issue
30,000 new shares of preferred at their par value of Rs.100. since the market rate of
interest on similar issues is 7 percent, the analysts feel that if the preferred promises a Rs.
7 dividend it can be sold at par, thus saving the firm Rs. 30,000 annually in dividends.
Flotation costs on the new issue would be Rs. 90,000; this Rs. 90,000 cost is completely
deductible in the current year. Bridgestone is in the 40 percent tax bracket. Assume that
the call premium on the outstanding preferred stock is not tax deductible. Should
Bridgestone refund the preferred stock issue?

Ans: Rs. 314,571

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