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Introduction to Long-Term Financing


Financial Management-II; S2
Prof. Jijo Lukose P.J.; IIM Kozhikode

Agenda

Basic features of common and preferred stock.


Debt.

Patterns of Financing

Corporate Long-Term Debt


Different Types of Bonds
Bank Loans
Recent Trends in Capital Structure

Debt by any Other Name


Accounts Payable: Good received, not yet paid for
Unfunded obligations; Senior debt, e.g., employee pensions
Special-Purpose Entities (SPEs)(Eg: Enron): Do not show up on balance
sheet
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Features of Common Stock

Voting rights (Cumulative vs. Straight) and Proxy voting


Other rights
Share proportionally in declared dividends
Share proportionally in remaining assets during liquidation
Preemptive right

Classified/Staggered BoD entrenches management; but


provides continuity.
India: Proportional representation for appointment of BoD

The AoA may provide for the appointment of not less than twothirds BoD in accordance with the principle of proportional
representation (single transferable vote or by a system of cumulative
voting ) and such appointments may be made once in every three
years. (Section 163)
Financial Management -II, S2

Dual-Class Shares and DVR in India

Under CA 2013 both private companies and public companies


can have share capital of 2 kinds ; (i) Equity shares with voting
rights and equity shares with differential rights as to dividend,
voting or otherwise and (ii) preference shares.

Conditions for DVR

Share with differential rights shall not exceed 26%;

consistent track record of distributable profits for the last 3 years;

no default in filing FSs and annual returns for the last 3 years

EG:Tata Motors' DVR one vote for every 10 shares held an 5%


more dividend than ordinary shareholders. Other Examples:
Pantaloon Retail India, Gujarat NRE Coke, Jain Irrigation

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Features of Preferred Stock

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.

Financial Management -II, S2

Tata Motors BS as on 31.03.2015 (Rs Crore)

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Share Capital
As on Jan 8 2016
MKT CAP (Rs Cr)
1,20,020
BOOK VALUE (Rs)
78.55
PRICE
353.45
PRICE/BOOK
4.5
DVR
FACE VALUE (Rs)
2
Tata Motors
264.1
MKT CAP (Rs Cr)
8,474.40

Financial Management -II, S2

Debt

Equity

Not an ownership interest

Ownership interest

Creditors do not have voting


rights

Common stockholders vote for


the board of directors and other
issues

Interest is considered a cost of


doing business and is tax
deductible

Dividends are not considered a


cost of doing business and are not
tax deductible

Creditors have legal recourse if


interest or principal payments are
missed

Dividends are not a liability of the


firm, and stockholders have no
legal recourse if dividends are not
paid

Excess debt can lead to financial


distress and bankruptcy

An all-equity firm cannot go


bankrupt (?)

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Tata Motors: Long-term and Short-term


borrowings

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Debt

Debt Comes in Many Forms: Bonds, Bank Loans, Leases

Short-term Vs long-term
Fixed Vs floating rate
Rupees Vs foreign currency
Senior Vs junior debt
Straight Vs convertible bonds

Bond Indenture: Contract between the company and the bond


holders

The basic terms of the bonds and security : Issuer, Issue date, & Maturity
date, Coupon rate, & Contractual features
Issued amount & Outstanding amount
Credit rating category, Sinking fund provisions, Call provisions
Details of protective covenants: dividend covenants, financing covenants
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Features of Corporate Debt Securities


1. Term (number of years to maturity); less than 1 yr: Commercial papers
2. Price vs. par value /face value: par bond, discount bond, and premium
bond
3. Coupon

Zero-coupon bond: Sometimes called zeroes, deep discount bonds, or


original issue discount bonds (OIDs). Treasury Bills and principal-only
Treasury strips are good examples of zeroes
Fixed Vs variable

4. Repayment: Amortizing Bonds, Sinking fund Provisions


5. Credit risk and rating: Investment Grade, Junk
6. Seniority and security
7. Option provisions: Call, Put, Convertibility
8. Registered vs. Bearer Forms
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Bond Classifications

Security

Collateral secured by financial securities


Mortgage secured by real property, normally land or
buildings
Debentures unsecured
Notes unsecured debt with original maturity less than 10
years

Seniority: Junior Vs Senior

This is standard terminology in the US, but it may not transfer to


other countries. For example, debentures are secured debt in
the United Kingdom. What about India?
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Bond Types

Floating Rate Bonds : Coupon rate floats depending on some


index value

International Bonds

floaters and inverse floaters


Coupons may have a collar the rate cannot go above a specified
ceiling or below a specified floor. Caps, Floors, Range Notes
There is less price risk with floating rate bonds.
Eurobonds: bonds denominated in a particular currency and issued
simultaneously in the bond markets of several countries
Foreign bonds: bonds issued in another nations capital market by a
foreign borrower

Other Bond Types

Income bonds, Convertible bonds, Put bonds


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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 debt versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
A Bond with put provisions vs without put provisions
Convertible Vs NC bond

it is important to recognize how various provisions affect required


returns
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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

Syndicated Loan

Large banks frequently have more demand for loans than they
fund.
Small banks are often in the opposite situation.
As a result, a lager banks may arrange a loan with a firm and
then sell portions of the loan to a syndicate of other banks.
A syndicated loan may be publicly traded.

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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%

Financial
deficit
Long-term
debt and
equity 20%
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Internal
cash flow
(Plowing
back profits)

External
cash flow
(Debt sources
Vs Equity
sources)
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Patterns of Financing

Internally generated cash flow dominates (70%-90%) as a source of


financing. This preference has increased through time
Net new issues of equity are dwarfed by new sales of debt.

Net stock buybacks accelerated in 2002-2014 (Declined in 2008, likely


as a result of the financial crisis)

Sources of funds, u.s. nonfinancial corporations

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Debt Ratios

There are two ways to calculate the debt ratio.


TL/TA (TL includes short-term and long-term liabilities).
[LTD/(LTD+EQUITY).
Interest Bearing debt Vs Total Liabilities

Book values or Market values?

Book value tells us how much capital the firm has raised in the
past. The market value of the firm is forward looking and measure
the value that shareholders place on those shares today..
In general, financial economists prefer MV. However, many
corporate treasurers may find BV more appealing due to the
volatility of market values.
Whether we use BV or MV , debt ratios for non-financial firms
have been below 50 percent of total financing.
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