Lecture 4

Chapter 15
Long-Term Financing

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Outline

1 Features of Common and Preferred Stock

2 Corporate Long-Term Debt
3 Different Types of Bonds
4 Patterns of Financing and Recent Trends in Capital
Structure

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Features of Common Stock
 Voting rights (Cumulative vs. Straight)
 Proxy voting (proxy fight/contest)
grant of authority by a shareholder to someone
else to vote her shares
 Classes of stock
Eg. Google Class A shares – 1 share 1 vote,
Class B shares – 1 share 10 votes
 Other rights
Dividend
Preemptive right: Rights to subscribe to new
shares

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Features of Common Stock
 Voting rights. Eg. election of directors at Annual General
Meeting(AGM)
 One share, one vote
 Straight voting
– The directors are elected one at a time. Less
minority participation.
– eg. Smith owns 20 shrs, Jones 80 shrs, N=4
directors. Jones elected all the directors. To own 50
percent plus one shr to guarantee a seat.

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Features of Common Stock
Cumulative voting
– The directors are elected all at once. Permit more
minority participation.
– Number of shares to guarantee a board seat =
[Shrout/(N+1)]+1.
– eg. Shrout=100 shares, N=4 directors, number of
shares needed=(100/(4+1))+1 = 21 shares
– eg. Jones owns 80 shrs, Smith 20 shrs, N=4 directors.
Total number of votes for Smith=80 votes and Jones=320
votes. Ignore the possibility of five-way tie, Smith can win
a seat.

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Features of Preferred Stock
 A kind of equity (hybrid security)
 Like debt
preferred stock generally does not carry
ownership, voting rights and control rights.
Stated dividend must be paid before dividends
can be paid to common stockholders.
 Unlike debt
dividends are not a liability of the firm, and failure
to pay preferred dividend won’t lead to bankruptcy
preferred dividends can be deferred indefinitely.
for tax purposes, dividends are usually not tax-
deductible
Most preferred dividends are cumulative
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Bond Valuation: A Review
 Two year maturity
 Face value:$1000
 Annual coupon rate: 5% -paid annually
 Sell at $950

 950 = 50/(1+YTM) + 1050/(1+YTM)2YTM = 7.796%

 The determination of YTM can be difficult

 The different relationship between face value and market
value of bond: issue-at-par/issue-at-premium/issue-at-
discount
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JOHNSON & JOHNSON Bond Indenture

Bond Indenture - Contract between company and bondholders

Issue amount $1 Billion Bond issue total face value is $1 Billion
Issue date 08/16/2007
Maturity date 08/15/2037
Face value $2,000 Face value denomination is $2,000 per bond
Annual Coupon 5.95 Annual coupons are $ per bond (5.95%)
Coupon dates 2/15, 8/15 Coupons are paid semiannually
Offering price 99.488 Offer price is 99.488% of face value
Security None Bonds are not secured by specific assets
Sinking fund None Bonds have no sinking fund
Call provision At any time Bonds do not have a deferred call
Call price Treasury rate + 0.2% Par value plus ..
Rating Moody's Aaa, S&P Bond have the highest credit rating possible
AAA

Bond price =
Each coupon =
Call price = 7
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Another Example
Issue amount $20 million Bond issue total face value is $20 million
Issue date 12/15/03 Bonds offered to the public in December 2003
Maturity date 12/31/23 Remaining principal is due December 31,
2023
Face value $1,000 Face value denomination is $1,000 per bond
Coupon interest $100 per annum Annual coupons are $100 per bond
Coupon dates 6/30, 12/31 Coupons are paid semiannually
Offering price 100 Offer price is 100% of face value
Call provision Callable after 12/31/08 Bonds are call protected for 5 years after
issuance
Call price 110 before 12/31/13, Callable at 110 percent of par value through
100 thereafter 2008. Thereafter callable at par.
Trustee United Bank of Trustee is appointed to represent
Florida bondholders
Security None Bonds are unsecured debenture
Rating Moody's A1, S&P A+ Bond credit quality rated upper medium
grade by Moody's and S&P's rating

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Bond Classifications
 Security
 Secured debt
 Mortgage (Mortgage bonds) – secured by real property,
normally land or buildings
 Collateral – secured by financial securities
 Unsecured debt
 Debentures, Subordinated debentures
 Notes – unsecured debt with original maturity less than 10
years
 Seniority
 The order of repayment in the event of a bankruptcy of the issuer;
senior debt must be repaid before subordinated (or junior) debt is
repaid
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Bond Classifications
 Bonds with/without sinking fund
a provision that allows the company to make regular
payments into a fund administered by a trustee,
instead of repaying the entire principal balance on the
maturity date

 Fixed/Floating rate bonds

Fixed rate bonds
Deep discount bonds (Zero-coupon bonds, pure
discount bonds, zeros), cannot sell for more than
par value
Floating rate bonds
Inflation linked bonds (Eg. ibond by HK government)
Interest rate linked bonds
• HIBOR rate +2% (Hongkong interbank offered
10
rate)
Bond Classifications

 Convertible bonds
bonds can be converted into shares of common
stock at the bondholders discretion before maturity
a hybrid security with debt- and equity-like features
usually issued by firms that are experiencing
financial problems and expected to perform well in
the future

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Deep Discount Bonds: An Example

Find the value of a 30-year zero-coupon bond with a

$1,000 par value and a YTM of 6%.

$0 $0 $0 $ 1, 000

0 1 2 29 30

F $ 1,000
PV    $ 174 .11
(1  r ) T
(1 .06 ) 30

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Call Provisions
 Callable bond
A call provision gives the company an option to
repurchase the bond issue at a predetermined price
(i.e., call price) over a specified period of time.
 Call premium
Difference between call price and face value
Normally one-year interest
 Deferred call - cannot use the call within the first few
years, e.g. 5 years

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Call Provisions
 Why and when to call bonds?
When interest rate declines
save interest payment in low-interest environment
purchase the bond at a price lower than its market
value

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Call Provisions: An Example
 A Kraus Co issues a perpetual bond of $1,000 at par at a
10% coupon rate (annual interest $100).
“Issue at par” indicates the bond’s coupon rate is equal
to YTM (see this on next slide)
 The issuer and bondholders believe there is an equal
chance that at the end of the year market interest rate will
be one of the following,
Fall to 6 2/3 percent -> bond price increases to 1500
Increase to 20 percent -> bond price decreases to 500
 Determine the coupon payment that allows the callable
bond to be issued at par.

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Call Provision: Example

Assume the bond is non-callable,

if interest rate decreases to 6 2/3%,
P1= 100/(6 2/3)%=1,500
if interest rate increases to 20%,
P1 = 100/20%=500
P0 P1=?

0 1
0.5  (100  1,500)  0.5  (100  500)
P0   $1,000
1  YTM

YTM = 10%

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Call Provision: Example
Callable
 Interest rate drops to 6 2/3 percent
->bond called at $1100
->BH receives $1,100+C at yr end
 interest rate rises to 20 percent,
->bond NOT called
C
->BH receives 0.2  C

price 

C=

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Required Yields
 Required yield depends on the risk characteristics of the
bond when issued.
 Which bonds will have the higher required yield, all else
equal?
A debenture versus secured debt
Subordinated debenture versus senior debt
A bond without a sinking fund versus one with
A callable bond versus a non-callable bond

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Debt versus Equity

 Equity  Debt
Ownership interest  Not an ownership
interest
Can vote for the board
 No voting rights
of directors and other
 Interest is considered a
issues
cost of doing business
Dividends are not tax and is tax deductible
deductible  Have legal recourse if
Dividends are not a interest or principal
legal liability of the firm. payments are missed
An all-equity firm cannot  Excess debt can lead to
go bankrupt financial distress and
bankruptcy

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 Long-term Financial Deficit
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)

Capital Internal cash

spending flow (retained
80% earnings plus Internal
depreciation) cash flow
80%
Financial
deficit
Net
working
capital plus Long-term External
other uses debt and cash flow
20% equity 20%

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Patterns Of Financing

 Firms usually spend more than they generate

internally—the deficit is financed by new sales of debt
and equity.
 Internally generated cash flow dominates as a source of
financing, typically between 70 and 90%.
 Net new issues of equity are dwarfed by new sales of
debt.
 Firms in other countries rely to a greater extent than U.S.
firms on external equity.
 Debt ratios for U.S. non-financial firms have been below
50 percent of total financing.

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Summary
 Understand the different rights for equity-/debt-holders
 Understand the concepts of different types of bond
securities
 Be familiar with the concepts of coupon, maturity, yield to
maturity
 Determine the bond price with discount cash flow model
 Explain the phenomenon of bond to be traded-at-premium,
traded-at-discount and traded-at-par
 Understand the factors that impact the yield to maturity of
bond
 Apply the discount cash flow model to compute the
coupon payment (coupon rate) and market price of the
callable bond

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