CHAPTER 5.

OTHER LONG-TERM FINANCING & INVESTMENT

5.0. Learning Objectives:

After studying this unit, you will be able to:
 explain the meaning and purpose of long-term finance;
 identify the various sources of long-term finance; and
 explain the merits and demerits of the various sources of long-term finance

5.1.
5.1. Introduction

As you are aware finance is the life blood of business. It is of vital significance for modern business
which requires huge capital. Funds required for a business may be classified as long term and short
term. Finance is required for a long period also. It is required for purchasing fixed assets like land and
building, machinery etc. Even a portion of working capital, which is required to meet day to day
expenses, is of a permanent nature. To finance it we require long term capital. The amount of long
term capital depends upon the scale of business and nature of business.

In this unit, you will learn about various sources of long term finance and the advantages and
disadvantages of each source.

5.2 Long-term Finance: Its Meaning & Purpose

A business requires funds to purchase fixed assets like land and building, machinery, furniture etc.
These assets may be regarded as the foundation of a business. The capital required for these assets is
called fixed capital.
capital. A part of the working capital is also of a permanent nature. Funds required for
this part of the working capital and for fixed capital are called long term finance.
finance.

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Purpose of long-term finance:
Long term finance is required for the following purposes

 To Finance fixed assets: Business requires fixed assets like machines, building, furniture etc.
Finance required to buy these assets is for a long period, because such assets can be used for a
long period and are not for resale.
 To finance the permanent part of working capital: Business is a continuing activity. It
must have a certain amount of working capital which would be needed again and again. This
part of working capital is of a fixed or permanent nature. This requirement is also met from
long term funds.
 To finance growth and expansion of business: Expansion of business requires investment
of a huge amount of capital permanently or for a long period.

Factors determining long-term financial requirements:

The amount required to meet the long term capital needs of a company depend upon many factors.
These are:
 Nature of Business: The nature and character of a business determines the amount of fixed
capital. A manufacturing company requires land, building, machines etc. So it has to invest a
large amount of capital for a long period. But a trading concern dealing in, say, washing
machines will require a smaller amount of long term fund because it does not have to buy
building or machines.
 Nature of goods produced: If a business is engaged in manufacturing small and simple
articles it will require a smaller amount of fixed capital as compared to one manufacturing
heavy machines or heavy consumer items like cars, refrigerators etc. which will require more
fixed capital.

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  Technology used: In heavy industries like steel the fixed capital investment is larger than in
the case of a business producing plastic jars using simple technology or producing goods
using labor intensive technique.

Sources of long-term finance

The main sources of long-term finance are as follows:

 Shares: These are issued to the general public. These may be of two types: (i) Equity and (ii)
Preference. The holders of shares are the owners of the business.
 Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
 Public Deposits: General public also like to deposit their savings with a popular and well-
established company which can pay interest periodically and pay-back the deposit when due.
 Retained earnings: The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.
 Term loans from banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of three to five years.

5.3 Shares
Issue of shares is the main source of long-term finance. Shares are issued by companies to the public.
A company divides its capital into units of a definite face value, say of Br. 10 each or Br. 100 each.
Each unit is called a share.
share. A person holding shares is called a shareholder.
shareholder.
Characteristics of shares: The main characteristics of shares are following:
 It is a unit of capital of the company.
 Each share is of a definite face value.
 A share certificate is issued to a shareholder indicating the number of shares and the amount.
 Each share has a distinct number.
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  The face value of a share indicates the interest of a person in the company and the extent of
his liability.
 Shares are transferable units.

Investors are of different habits and temperaments. Some want to take lesser risk and are interested in
a regular income. There are others who may take greater risk in anticipation of huge profits in future.
In order to tap the savings of different types of people, a company may issue different types of shares.
These are:
 Preference shares, and
 Equity Shares.

Table 5.1 Differences between Equity Shares and Preference Shares

Basis of Difference Preference Shares Equity shares

Choice It is not compulsory to issue It is compulsory to issue these
these shares. shares.
Payment of Dividend Dividend is paid on these Dividend is paid on these
shares in preference to the shares only after paying
equity shares. dividend on preference
shares.
Return of Capital In case of winding up of a Capital on these shares is
company the capital is refunded in case of winding
refunded in preference over up of the company after
the equity shares. refund of preference share
capital.

5.3.1 Equity Shares

Equity shares (also called common shares) are shares which do not enjoy any preferential right in the
matter of payment of dividend or repayment of capital. The equity shareholder gets dividend only
after the payment of dividends to the preference shares. There is no fixed rate of dividend for equity

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shareholders. The rate of dividend depends upon the surplus profits. In case of winding up of a
company, the equity share capital is refunded only after refunding the preference share capital. Equity
shareholders have the right to take part in the management of the company. However, equity shares
also carry more risk.

From the management’s viewpoint, there are several advantages and disadvantages to equity shares
financing.

Advantages: Following are the merits of equity shares for the management:

 Common stock does not entail fixed charges. If the company does not generate the earnings,
it does not have to pay common stock dividends. This is very much in contrast to interest on
debt, which must be paid regardless of the level of earnings.
 Common stock has no fixed maturity date -it is permanent capital which does not have to be
"paid back." The capital raised by issuing equity shares is not required to be paid back during
the life time of the company. It will be paid back only if the company is wound up.
 If a company raises more capital by issuing equity shares, it leads to greater confidence
among the investors and creditors. Since common stock provides a cushion against losses to
the firm's creditors, the sale of common stock increases the creditworthiness of the firm.

 Common stock can, at times, be sold more easily than debt. It appeals to certain investor
groups because

 It typically carries a higher expected return than does preferred stock or

debt,

 It provides investors with a better hedge against inflation than does

preferred stock or bonds, and

 Returns from capital gains on common stock are not taxed until the gains are
realized.

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Disadvantages of common stock

 The sale of common stock normally extends voting rights, or even control, to the additional
stock owners who are brought into the company. For this reason, additional equity financing
is often avoided by small firms, whose owner- managers may be unwilling to share control of
their companies with outsiders. Note, though, that firms can use special classes of common
stock that do not carry voting rights.
 Conflict of interests: As the equity shareholders carry voting rights, groups are formed to
corner the votes and grab the control of the company. There develops conflict of interests
which is harmful for the smooth functioning of a company.
 The use of debt enables the firm to acquire funds at a fixed cost, whereas the use of common
stock means that more stockholders will share in the firm's net profits.
 The costs of underwriting and distributing common stock are usually higher than the costs of
underwriting and distributing preferred stock or debt.
 The sale of new common stock may be perceived by investors as a negative signal, hence
may cause the stock price to fall.

5.3.2 Preference Shares

Preference Shares are the shares which carry preferential rights over the equity shares. These rights
are (a) receiving dividends at a fixed rate, (b) getting back the capital in case the company is wound-
up. Investments in these shares are safe, and a preference shareholder also gets dividend regularly.

There are both advantages and disadvantages to selling preferred stock. Here are the major
advantages from the issuers' standpoint:

Advantage of preferred stock

 In contrast to bonds, the obligation to pay preferred dividends is not contractual in nature, and
the passing (omission) of preferred dividends cannot force a firm into bankruptcy.

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  By selling preferred stock, the firm avoids the dilution of common equity that occurs when
common stock is sold.
 Since preferred stock often has no maturity, and since preferred sinking fund payments, if
present, are typically spread over a long period, preferred issues avoid the cash flow drain
from repayment of principal that is inherent in debt issues.

Disadvantages of preferred stock

 Preferred stock dividends are not deductible as a tax expense to the issuer; hence, the after-tax
cost of preferred is typically higher than the after-tax cost of debt. However, the tax
advantage of preferred to corporate purchasers lowers the effective cost to issuers.
 Although preferred dividends can be passed, investors expect them to be paid, and firms
intend to pay the dividends if conditions permit. Thus, preferred dividends are considered to
be a fixed cost, hence the use of preferred stock, like debt, increases the financial risk of the
firm and thus increases the cost of common equity.

5.4 Debentures

Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can
borrow from the general public by issuing loan certificates called debentures. The total amount to be
borrowed is divided into units of fixed amount say of Br.100 each. These units are called
debentures.
debentures. These are offered to the public to subscribe in the same manner as is done in the case of
shares. A debenture is issued under the common seal of the company. It is a written
acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest,
time repayment, security offered, etc.
Characteristics of Debenture. Following are the characteristics of Debentures:

 Debenture holders are the creditors of the company. They are entitled to periodic payment of
interest at a fixed rate.
 Debentures are repayable after a fixed period of time, say five years or seven years as per
agreed terms.

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  Debenture holders do not carry voting rights.
 Ordinarily, debentures are secured. In case the company fails to pay interest on debentures or
repay the principal amount, the debenture holders can recover it from the sale of the assets of
the company.
Types of Debentures: Debentures may be classified as:

1. Redeemable Debentures and Irredeemable Debentures

2. Convertible Debentures and Non-convertible Debentures.

Redeemable Debentures and Irredeemable Debentures

 Redeemable Debentures: These are debentures repayable on a pre-determined date or at any
time prior to their maturity, provided the company so desires and gives a notice to that effect.
 Irredeemable Debentures: These are also called perpetual debentures. A company is not
bound to repay the amount during its life time. If the issuing company fails to pay the interest,
it has to redeem such debentures.

Convertible Debentures and Non-convertible Debentures

 Convertible Debentures: The holders of these debentures are given the option to convert
their debentures into equity shares at a time and in a ratio as decided by the company.
 Non-convertible Debentures: These debentures cannot be converted into shares.

Merits of debentures: Following are some of the advantages of debentures:

 The cost of debt is independent of earnings, so debt holders do not participate if profits soar.
There is, however, a flip side to this argument -if profits fall, the bondholders must still be
paid their interest.
 Raising funds without allowing control over the company: Debenture holders have no
right either to vote or take part in the management of the company.

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  Reliable source of long term finance: Since debentures are ordinarily issued for a fixed
period, the company can make the best use of the money. It helps long term planning.
 Tax Benefits: Interest paid on debentures is treated as an expense and is charged to the
profits of the company. The company thus saves income tax.

Demerits of debentures: Following are the demerits of debentures:

 As the interest on debentures has to be paid every year whether there are profits or not, it
becomes burdensome in case the company incurs losses.

 Usually the debentures are secured. The company creates a charge on its assets in favor of
debenture holders. So a company which does not own enough fixed assets cannot borrow
money by issuing debentures. Moreover, the assets of the company once mortgaged cannot be
used for further borrowing.

 Debenture-finance enables a company to trade on equity. But too much of such finance
leaves little for shareholders, as most of the profits may be required to pay interest on
debentures. This brings frustration in the minds of shareholders and the value of shares may
fall in the securities markets.

 Burdensome in times of depression: During depression the profits of the company decline.
It may be difficult to pay interest on debentures. As interest goes on accumulating, it may
lead to the closure of the company.

Until now you have learnt about issue of shares and debentures as two main sources of raising long
term finance. You have also learnt about the merits and demerits of the two. Now let us make a
comparative study of shares and debentures for raising long term capital.
Table 5.1 Differences between Equity Shares and Debentures
Basis of Difference Equity shares Debentures
Status Shareholders are the owners Debenture holders are the

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 of the company. They creditors of the company.
provide ownership capital They provide loans generally
which is not refundable for a fixed period. Such loans
are to be paid back.

Nature of Return on Shareholders get dividends. Interest is paid on debentures

Investment The amount is not fixed. It at a fixed rate. Interest is
depends on the profit of the payable even if the company
company. Hence only those is running at a loss. So it is
persons invest in shares who good investment for those
are ready to take risk. who do not want to take risk.

Rights Share holders are the real Debenture holders do not

owners of the company. They have the right to attend
have the right to vote and meetings of the company. So
frame the objectives and they have no say in the
policies of the company. management of the company.
Security No security is required to Generally debentures are
issue shares. secured. Therefore sufficient
fixed assets are required when
debentures are to be issued.
Order of Repayment Shareholders take the Debenture holders have the
maximum risk because their priority of repayment over
capital will be paid back only shareholders.
after repaying the loan of
debenture holders.

5.5. BONDS: Its Characteristics, Pricing & Rating

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A bond is a security that is issued in connection with a borrowing arrangement. The borrower
issues (i.e., sells) a bond to the lender for some amount of cash; the bond is the “IOU” of the
borrower. The arrangement obligates the issuer to make specified payments to the bondholder on
specified dates. A typical coupon bond obligates the issuer to make semiannual payments of
interest to the bondholder for the life of the bond. These are called coupon payments because in
pre computer days, most bonds had coupons that investors would clip off and present to claim the
interest payment. When the bond matures, the issuer repays the debt by paying the bondholder the
bond’s par value (equivalently, its face value ). The coupon rate of the bond serves
to determine the interest payment: The annual payment is the coupon rate times the bond’s par
value. The coupon rate, maturity date, and par value of the bond are part of the bond indenture,
which is the contract between the issuer and the bondholder.

To illustrate, a bond with par value of $1,000 and coupon rate of 8% might be sold to a buyer for
$1,000. The bondholder is then entitled to a payment of 8% of $1,000, or $80 per year, for the
stated life of the bond, say, 30 years. The $80 payment typically comes in two semiannual
installments of $40 each. At the end of the 30-year life of the bond, the issuer also pays the $1,000
par value to the bondholder.

Bonds usually are issued with coupon rates set just high enough to induce investors to pay par
value to buy the bond. Sometimes, however, zero-coupon bonds are issued that make no coupon
payments. In this case, investors receive par value at the maturity date but receive no interest
payments until then: The bond has a coupon rate of zero. These bonds are issued at prices
considerably below par value, and the investor’s return comes solely from the difference between
issue price and the payment of par value at maturity.

5.5.1. BOND PRICING

Because a bond’s coupon and principal repayments all occur months or years in the future, the
price an investor would be willing to pay for a claim to those payments depends on the value of
dollars to be received in the future compared to dollars in hand today. This “present value”
calculation depends in turn on market interest rates. The nominal risk-free interest rate equals the
sum of (1) a real risk-free rate of return and (2) a premium above the real rate to compensate for
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expected inflation. In addition, because most bonds are not riskless, the discount rate will embody
an additional premium that reflects bond-specific characteristics such as default risk, liquidity, tax
attributes, call risk, and so on.

We simplify for now by assuming there is one interest rate that is appropriate for discounting cash
flows of any maturity, but we can relax this assumption easily. In practice, there may be different
discount rates for cash flows accruing in different periods. For the time being, however, we ignore
this refinement.

To value a security, we discount its expected cash flows by the appropriate discount rate. The cash
flows from a bond consist of coupon payments until the maturity date plus the final payment of par
value. Therefore,

Bond value = Present value of coupons + Present value of par value

If we call the maturity date T and call the interest rate r, the bond value can be written as

( Eq. 5.1)

The summation sign in Equation 5.1 directs us to add the present value of each coupon payment;
each coupon is discounted based on the time until it will be paid. The first term on the right-hand
side of Equation 3.1 is the present value of an annuity. The second term is the present value of a
single amount, the final payment of the bond’s par value. You may recall from an introductory
finance class that the present value of a $1 annuity that lasts for T periods when the interest rate
equals

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We call this expression the T-period annuity factor for an interest rate of r %. Similarly, we call

the PV factor, that is, the present value of a single payment of $1 to be received in
T periods. Therefore, we can write the price of the bond as

(5.2)

EXAMPLE Bond Pricing

We discussed earlier an 8% coupon, 30-year maturity bond with par value of $1,000 paying 60
semiannual coupon payments of $40 each. Suppose that the interest rate is 8% annually, or r = 4%
per 6-month period. Then the value of the bond can be written as

It is easy to confirm that the present value of the bond’s 60 semiannual coupon payments of $40
each is $904.94 and that the $1,000 final payment of par value has a present value of $95.06, for a
total bond value of $1,000. You can calculate the value directly from Equation 14.2, perform these
calculations on any financial calculator, or use a set of present value tables.

In this example, the coupon rate equals the market interest rate, and the bond price equals par
value. If the interest rate were not equal to the bond’s coupon rate, the bond would not sell at par

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value. For example, if the interest rates were to rise to 10% (5% per 6 months), the bond’s price
would fall by $189.29 to $810.71, as follows:

FIGURE 5.1 shows the inverse relationship between bond prices and yields.

At a higher interest rate, the present value of the payments to be received by the bond holder is
lower. Therefore, the bond price will fall as market interest rates rise. This illustrates a crucial
general rule in bond valuation. When interest rates rise, bond prices must fall because the present
value of the bond’s payments is obtained by discounting at a higher interest rate.

Figure 5.1 shows the price of the 30-year, 8% coupon bond for a range of interest rates, including
8%, at which the bond sells at par, and 10%, at which it sells for $810.71. The negative slope
illustrates the inverse relationship between prices and yields. Note also from the figure that the
shape of the curve implies that an increase in the interest rate results in a price decline that is

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smaller than the price gain resulting from a decrease of equal magnitude in the interest rate. This
property of bond prices is called convexity because of the convex shape of the bond price curve.
This curvature reflects the fact that progressive increases in the interest rate result in progressively
smaller reductions in the bond price. Therefore, the price curve becomes flatter at higher interest
rates.

Corporate bonds typically are issued at par value. This means that the underwriters of the bond
issue (the firms that market the bonds to the public for the issuing corporation) must choose a
coupon rate that very closely approximates market yields. In a primary issue of bonds, the
underwriters attempt to sell the newly issued bonds directly to their customers. If the coupon rate is
inadequate, investors will not pay par value for the bonds. After the bonds are issued, bondholders
may buy or sell bonds in secondary markets, such as the one operated by the New York Stock
Exchange or the over-the-counter market, where most bonds trade. In these secondary markets,
bond prices move in accordance with market forces. The bond prices fluctuate inversely with the
market interest rate.

The inverse relationship between price and yield is a central feature of fixed-income securities.
Interest rate fluctuations represent the main source of risk in the fixed-income market, and we
devote considerable attention in Chapter 16 to assessing the sensitivity of bond prices to market
yields. For now, however, it is sufficient to highlight one key factor that determines that sensitivity,
namely, the maturity of the bond.

A general rule in evaluating bond price risk is that, keeping all other factors the same, the longer
the maturity of the bond, the greater the sensitivity of price to fluctuations in the interest rate. For
example, consider Table 5.1 , which presents the price of an 8% coupon bond at different market
yields and times to maturity. For any departure of the interest rate from 8% (the rate at which the
bond sells at par value), the change in the bond price is greater for longer times to maturity.

This makes sense. If you buy the bond at par with an 8% coupon rate, and market rates
subsequently rise, then you suffer a loss: You have tied up your money earning 8% when
alternative investments offer higher returns. This is reflected in a capital loss on the bond a fall in

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its market price. The longer the period for which your money is tied up, the greater the loss, and
correspondingly the greater the drop in the bond price. In Table 3.2, the row for 1-year maturity
bonds shows little price sensitivity—that is, with only 1 year’s earnings at stake, changes in interest
rates are not too threatening. But for 30-year maturity bonds, interest rate swings have a large
impact on bond prices. The force of discounting is greatest for the longest-term bonds.

This is why short-term Treasury securities such as T-bills are considered to be the safest.

They are free not only of default risk but also largely of price risk attributable to interest rate
volatility.

Table 5:1. Price of an 8% coupon bond with 30-yearmaturity making semiannual payments

5.5.2. Bond Rating

Although bonds generally promise a fixed flow of income, that income stream is not risk less
unless the investor can be sure the issuer will not default on the obligation. While U.S. government
bonds may be treated as free of default risk, this is not true of corporate bonds. Therefore, the
actual payments on these bonds are uncertain, for they depend to some degree on the ultimate
financial status of the firm.

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 Bond default risk, usually called credit risk, is measured by Moody’s Investor Services,
Standard & Poor’s Corporation, and Fitch Investors Service, all of which provide financial
information on firms as well as quality ratings of large corporate and municipal bond issues.
International sovereign bonds, which also entail default risk, especially in emerging markets, also
are commonly rated for default risk. Each rating firm assigns letter grades to the bonds of
corporations and municipalities to reflect their assessment of the safety of the bond issue. The top
rating is AAA or Aaa, a designation awarded to only about a dozen firms. Moody’s modifies each
rating class with a 1, 2, or 3 suffixes (e.g., Aaa1, Aaa2, Aaa3) to provide a finer gradation of
ratings. The other agencies use a + or - modification.

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Figure 5.1 Definition of each bond rating class

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5. 6 Retained Earnings

Like an individual, companies also set aside a part of their profits to meet future requirements of
capital. Companies keep these savings in various accounts such as General Reserve, Debenture
Redemption Reserve and Dividend Equalization Reserve etc. These reserves can be used to meet
long term financial requirements. The portion of the profits which is not distributed among the
shareholders but is retained and is used in business is called retained earnings or ploughing back of
profits. Companies may also be required to transfer a part of their profits in reserves. The amount so
kept in reserve may be used to buy fixed assets. This is called internal financing.
financing.

Merits: Following are the benefits of retained earnings:

 Cheap Source of Capital: No expenses are incurred when capital is available from this
source. There is no obligation on the part of the company either to pay interest or pay back
the money. It can safely be used for expansion and modernization of business.
 Financial stability: A company which has enough reserves can face ups and downs in
business. Such companies can continue with their business even in depression, thus building
up its goodwill.
 Benefits to the shareholders: Shareholders may get dividend out of reserves even if the
company does not earn enough profit. Due to reserves, there is capital appreciation, i.e. the
value of shares go up in the share market.

Limitation: Following are the limitations of Retained Earnings:

 Huge Profit: This method of financing is possible only when there are huge profits and that
too for many years.

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  Dissatisfaction among shareholders: When funds accumulate in reserves, bonus shares are
issued to the shareholders to capitalize such funds. Hence the company has to pay more
dividends. By retained earnings the real capital does not increase while the liability increases.
In case bonus shares are not issued, it may create a situation of under–capitalization because
the rate of dividend will be much higher as compared to other companies.

 Fear of monopoly: Through ploughing back of profits, companies increase their financial
strength. Companies may throw out their competitors from the market and monopolize their
position.
 Mis-management of funds: Capital accumulated through retained earnings encourages
management to spend carelessly.

5.7 Public Deposits

It is a very old source of finance. When modern banks were not there, people used to deposit their
savings with business concerns of good repute. Even today it is a very popular and convenient
method of raising medium term finance. The period for which business undertakings accept public
deposits ranges between six months to three years.

An undertaking which wants to raise funds through public deposits advertises in the newspapers. The
advertisement highlights the achievements and future prospects of the undertaking and invites the
investors to deposit their savings with it. It declares the rate of interest which may vary depending
upon the period for which money is deposited. It also declares the time and mode of payment of
interest and the repayment of deposits. A depositor may get his money back before the date of
repayment of deposits for which he will have to give notice in advance.
Features of Public deposits:

 These deposits are not secured.

 They are available for a period ranging between 6 months and 3 years.

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  They carry fixed rate of interest.
 They do not require complicated legal formalities as are required in the case of shares or
debentures.

Keeping in view the malpractices of certain companies, such as not paying interest for years together
and not refunding the money, governments frame certain rules and regulations regarding inviting
public to deposit their savings and accepting them.

Advantages: Following are the advantages of public deposits:

 Simple and easy: The method of borrowing money through public deposit is very simple. It
does not require many legal formalities. It has to be advertised in the newspapers and a
receipt is to be issued.
 No charge on assets: Public deposits are not secured. They do not have any charge on the
fixed assets of the company.
 Economical: Expenses incurred on borrowing through public deposits is much less than
expenses of other sources like shares and debentures.
 Flexibility: Public deposits bring flexibility in the structure of the capital of the company.
These can be raised when needed and refunded when not required.

Disadvantages: Following are the disadvantages of public deposits:

 Uncertainty : A concern should be of high repute and have a high credit rating to attract
public to deposit their savings. There may be sudden withdrawals of deposits which may
create financial problems.
 Insecurity : Public deposits do not have any charge on the assets of the concern. It may not
always be safe to deposit savings with companies particularly those which are not very sound.
 Lack of attraction for professional investors: As the rate of return is low and there is no
capital appreciation, the professional investors do not appreciate this mode of investment.

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  Uneconomical: The rate of interest paid on public deposits may be low but then there are
other expenses like commission and brokerage which make it uneconomical.
 Hindrance to growth of capital market: If more and more money is deposited with the
companies in this form there will be less investment in securities. Hence the capital market
will not grow. This will deprive both the companies and the investors of the benefits of good
securities.
 Over–capitalization: As it is an easy, convenient and cheaper source of raising money,
companies may raise more money than is required. In that case it may not be able to make the
best use of the funds or may indulge in speculative activities.

5.8 Borrowing from Commercial Banks:

Traditionally, commercial banks do not grant long term loans. They grant loans only for short period
not extending one year. But recently they have started giving loans for a long period. Commercial
banks give term loans i.e. for more than one year. The period of repayment of short term loan is
extended at intervals and in some cases loan is given directly for a long period. Commercial banks
provide long term finance to small scale units in the priority sector.
Merits of long term borrowings from Commercial Banks: The merits of long-term borrowing
from banks are as follows:

 It is a flexible source of finance as loans can be repaid when the need is met.
 Finance is available for a definite period; hence it is not a permanent burden.
 Banks keep the financial operations of their clients secret.
 Less time and cost is involved as compared to issue of shares, debentures etc.
 Banks do not interfere in the internal affairs of the borrowing concern, hence the
management retains the control of the company.
 Loans can be paid-back in easy installments.
 In case of small-scale industries and industries in villages and backward areas, the interest
charged is low.
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Demerits: Following are the demerits of borrowing from commercial banks:

 Banks require personal guarantee or pledge of assets and business cannot raise further loans
on these assets.
 In case the short term loans are extended again and again, there is always uncertainty about
this continuity.
 Too many formalities are to be fulfilled for getting term loans from banks. These formalities
make the borrowings from banks time consuming and inconvenient.

5.9. Hybrid Financing

In addition to debt and equity instruments, a company may finance with an option, a contract giving
its holder the right to buy common stock or to exchange something for it within a specific period of
time. As a result, the value of the option instrument is strongly influenced by changes in value of the
stock. Options belong to a broad category of financial instruments known as derivative securities. In
this section we consider three specific types of derivative instruments employed by business firms in
their financing – the convertible security, the warrant, and Options

5.9.1. WARRANTS
A warrant is a certificate issued by a company that gives the holder the right to buy a stated number
of shares of the company’s stock at a specified price for some specified length of time.
A warrant is an option to purchase common stock at a specified exercise price (usually higher than
the market price at the time of warrant issuance) for a specified period (often lasting for years and, in
some cases, in perpetuity). In contrast, a right is also an option to buy common stock, but normally it
has a subscription price lower than the market value of the common stock and a very short life (often
two to four weeks).
Warrants often are employed as “sweeteners” to a public issue of bonds or debt that is privately
placed. As a result, the corporation should be able to obtain a lower interest rate than it would
otherwise. For companies that are marginal credit risks, the use of warrants may spell the difference
between being able and not being able to raise funds through a debt issue. Occasionally, warrants are

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sold directly to investors for cash. In addition, warrants are sometimes used in the founding of a
company as compensation to underwriters and venture capitalists. Still, the origin of most warrants is
in connection with a debt issue, often a private placement. The warrant itself contains the provisions
of the option. It states the number of shares the holder can buy for each warrant. Frequently, a
warrant will provide the option to purchase 1 share of common stock for each warrant held, but it
might be 2 shares, 3 shares, or 2.54 shares.
Generally, warrants are issued along with debt, and they are used to induce investors to buy long-
term debt with a lower coupon rate than would other- wise be required. For example, when
Informatics Corporation, a rapidly growing high-tech company, wanted to sell $50 million of 20-year
bonds in 2010, the company’s investment bankers informed the financial vice president that the
bonds would be difficult to sell and that a coupon rate of 10% would be required. However, as an
alternative the bankers suggested that investors might be willing to buy the bonds with a coupon rate
of only 8% if the company would offer 20 warrants with each $1,000 bond, each warrant entitling the
holder to buy one share of common stock at a strike price (also called an exercise price) of $22 per
share. The stock was selling for $20 per share at the time, and the warrants would expire in the year
2020 if they had not been exercised previously.
Why would investors be willing to buy Informatics’ bonds at a yield of only 8% in a 10% market just
because warrants were also offered as part of the package? It’s because the warrants are long-term
call options that have value, since holders can buy the firm ’s common stock at the strike price
regardless of how high the market price climbs. This option offsets the low interest rate on the bonds
and makes the package of low-yield bonds plus warrants attractive to investors. (See Chapter 8 for a
discussion of options.)
Use of Warrants in Financing
Warrants generally are used by small, rapidly growing firms as sweeteners when they sell debt or
preferred stock. Such firms frequently are regarded by investors as being highly risky, so their bonds
can be sold only at extremely high coupon rates and with very restrictive indenture provisions. To
avoid such restrictions, firms like Informatics often offer warrants along with the bonds.
Getting warrants along with bonds enables investors to share in the company’s growth, assuming it
does in fact grow and prosper. Therefore, investors are willing to accept a lower interest rate and less

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restrictive indenture provisions. A bond with warrants has some characteristics of debt and some
characteristics of equity. It is a hybrid security that provides the financial manager with an
opportunity to expand the firm’s mix of securities and thereby appeal to a broader group of investors.
Virtually all warrants issued today are detachable. In other words, after a bond with attached warrants
is sold, the warrants can be detached and traded separately from the bond. Further, even after the
warrants have been exercised, the bond (with its low coupon rate) remains outstanding.
The strike price on warrants is generally set some 20% to 30% above the market price of the stock on
the date the bond is issued. If the firm grows and prospers, causing its stock price to rise above the
strike price at which shares may be purchased, then warrant holders could exercise their warrants and
buy stock at the stated price. However, without some incentive, warrants would never be exercised
prior to maturity their value in the open market would be greater than their value if exercised, so
holders would sell warrants rather than exercise them. There are three conditions that cause holders to
exercise their warrants:
1) Warrant holders will surely exercise and buy stock if the warrants are about to expire and the
market price of the stock is above the exercise price.
2) Warrant holders will exercise voluntarily if the company raises the dividend on the common
stock by a sufficient amount. No dividend is earned on the warrant, so it provides no current
income. However, if the common stock pays a high dividend, then it provides an attractive
dividend yield but limits stock price growth. This induces warrant holders to exercise their
option to buy the stock.
3) Warrants sometimes have stepped-up strike prices (also called stepped-up exercise prices),
which prod owners into exercising them. For example, Williamson Scientific Company has
warrants outstanding with a strike price of $25 until December 31, 2014, at which time the
strike price rises to $30. If the price of the common stock is over $25 just before December
31, 2014, many warrant holders will exercise their options before the stepped-up price takes
effect and the value of the warrant’s falls.
Another desirable feature of warrants is that they generally bring in funds only if funds are needed. If
the company grows, it will probably need new equity capital. At the same time, growth will cause the
price of the stock to rise and the warrants to be exercised; hence the firm will obtain the cash it needs.

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If the company is not successful and it cannot profitably employ additional money, then the price of
its stock will probably not rise enough to induce exercise of the warrants

5.9.1.1 Valuation of a Warrant

The theoretical value of a warrant can be determined by
max [(N)(Ps) − E, 0]
where N is the number of shares that can be purchased with one warrant, Ps is the market price of one
share of stock, E is the exercise price associated with the purchase of N shares, and max means the
maximum value of (N)(Ps) − E, or zero, whichever is greater. The theoretical value of a warrant is
the lowest level at which the warrant will generally sell. If, for some reason, the market price of a
warrant were to go lower than its theoretical value, arbitragers would eliminate the differential by
buying the warrants, exercising them, and selling the stock.

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Figure5Figure 5.2: Relationship between the theoretical value and the market value of a warrant

When the market value of the associated stock is less than the exercise price, the theoretical value of
the warrant is zero, and it is said to be trading “out of the money.” When the value of the associated
common stock is greater than the exercise price, the theoretical value of the warrant is positive, as
depicted by the solid diagonal line in Figure 5.1. Under these circumstances, the warrant is said to be
trading “in the money.”
The primary reason that a warrant sells at a price higher than its theoretical value is the opportunity
for leverage. To illustrate the concept of leverage, consider the Textron warrants. For each warrant
held, one share of common stock can be purchased, and the exercise price is $10. If the common
stock were selling at $12 a share, the theoretical value of the warrant would be $2. Suppose, however,
that the common stock increased by 25 percent in price to $15 a share. The theoretical value of the
warrant would go from $2 to $5, a gain of 150 percent.
The opportunity for increased gain is attractive to investors when the common stock is selling near its
exercise price. For a particular dollar investment, the investor can buy more warrants than common
stock. If the stock moves up in price, the investor will make more money on the warrants than on an
equal dollar investment in common stock. Of course, leverage works both ways. The percentage
change can be almost as pronounced on the down- side. However, there is a limit to how far the
warrant can fall in price because it is bounded at zero. Moreover, for the market price to drop to zero,
there would have to be no probability that the market price of the stock would exceed the exercise
price during the exercise period. Usually there is some probability.
The market prices of many warrants are in excess of their theoretical values because of the potential
for upside movements in the value of the warrant while, at the same time, downside movements are

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cushioned. In particular, this event occurs when the market price of the associated common stock is
near the exercise price of the warrant.

5.9.2. CONVERTIBLE SECURITIES

Convertible securities, exchangeable securities, and warrants are options under which the holder can
obtain common stock.
A convertible security is a bond or a share of preferred stock that can be converted at the option of
the holder into common stock of the same corporation. For the issuing corporation, convertibles often
represent “delayed” common stock financing. For a given amount of financing, there will be less
dilution with a convertible issue than with a common stock issue, assuming that the convertible is
eventually converted and is not simply left “overhanging.”
As a hybrid security, a convertible bond has a straight bond value floor and a conversion, or stock,
value. As a result, the distribution of possible returns to the security holder is skewed to the right, and
there is a trade-off between the two factors.
Convertible securities are also defined as those bonds or preferred stocks that, under specified terms
and conditions, can be exchanged for (that is, converted into) common stock at the option of the
holder. Unlike the exercise of warrants, which brings in additional funds to the firm, conversion does
not provide new capital; debt (or preferred stock) is simply replaced on the balance sheet by common
stock. Of course, reducing the debt or preferred stock will improve the firm’s financial strength and
make it easier to raise additional capital, but that requires a separate action.
Conversion Ratio and Conversion Price

The ratio of exchange between the convertible security and the common stock can be stated in terms
of either a conversion price or a conversion ratio. The conversion ratio, CR, for a convertible
security is defined as the number of shares of stock
s a bondholder will receive upon conversion. The
conversion price, Pc, is defined as the effective price investors pay for the common stock when
conversion occurs. The relationship between the conversion ratio and the conversion price can be
illustrated by Silicon Valley Software Company’s convertible debentures issued at their $1,000 par
value in July of 2010. At any time prior to maturity on July 15, 2030, a debenture holder can

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exchange a bond for 18 shares of common stock. Therefore, the conversion ratio, CR, is 18. The
bond cost a purchaser $1,000, the par value, when it was issued. Dividing the $1,000 par value by the
18 shares received gives a conversion price of $55.56 a share:

Conversion Price (Pc) =

Conversion Price (Pc) = = = $55.56

Conversely, by solving for CR, we obtain the conversion ratio:

Conversion Ratio (CR) = = = $18

Once CR is set, the value of Pc is established, and vice versa. Like a warrant’s exercise price, the
conversion price is typically set some 20% to 30% above the prevailing market price of the common
stock on the issue date. Generally, the conversion price and conversion ratio are fixed for the life of
the bond, although sometimes a stepped-up conversion price is used.

5.9.3 Option financing & its pricing

An option is simply a contract that gives the holder the right to buy or sell the common stock of a
company at some specified price. Among a variety of option contracts, the most prevalent are the
call option and the put option. The call option gives the holder the right to buy a share of stock at a
specified price, known as the exercise price. We might have a call option to buy one share of ABC
Corporation’s common stock at $10 through December 31, which is the expiration date. The party
that provides the option is known as the option writer. In the case of a call option, the writer must
deliver stock to the option holder when the latter exercises the option.

As is evident from our discussions in this chapter, a warrant is a form of call option, as is a
convertible security. Both give the holder an option on the company’s stock. In contrast to a call
option, a put option gives the holder the right to sell a share of stock at a specified price up to the

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expiration date. It is the mirror image of a call option. In what follows, we will focus only on the
valuation of call options.

5.9.3.1. Valuation on Expiration Date

Suppose that we are concerned with the value of a call option (hereafter simply called an option) on
its expiration date. The value of the option, Vo, is simply

Vo = max (Ps − E, 0)

where Ps is the market price of one share of stock, E is the exercise price of the option, and max
means the maximum value of (Ps − E), or zero, whichever is greater.

To illustrate the formula, suppose that one share of Lindahl Corporation’s common stock is $25 at the
expiration date and that the exercise price of an option is $15. The value of the option would be $25 −
$15 = $10. Note that the value of the option is determined solely by the price of the common stock
less the exercise price. However, the value of the option cannot have a negative value. When the
exercise price exceeds the price of the common stock, the value of the option becomes zero.

This notion is illustrated graphically in Figure 5.1, where the theoretical value of a warrant is shown.
The expiration value of the option lies along the theoretical value line. The horizontal axis represents
the price of a share of common stock at the expiration date.

5.9.3.2. Valuation Prior to Expiration

Consider now the value of the option with one period to expiration. For simplicity, let us assume that
it can be exercised only on the expiration date. The price of the common stock at the expiration date
is not known but rather is subject to probabilistic beliefs. As long as there is some time to expiration,
it is possible for the market value of the option to be greater than its theoretical value. The reason is
that the option may have value in the future. This idea was explored when we discussed warrants, so
further discussion here is not necessary. The actual value of the option might be described by the
dashed line in 5.2

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Factors determining option price

1. The Effect of Time to Expiration:

In general, the longer the time to expiration, the greater the value of the option relative to its
theoretical value. This makes sense in that there is more time in which the option may have
value. Moreover, the further in the future one pays the exercise price, the lower its present
value, and this too enhances the option’s value. As the expiration date of an option
approaches, the relationship between the option value and the common stock price becomes
more convex (rounded outward). This is illustrated in Figure 5.2. Market value line 1
represents an option with a shorter time to expiration than that for market value line 2, and
market value line 2 represents an option with a shorter time to expiration than that for market
value line 3.
2. The Interest Rate Employed:
Another feature crucial to option valuation is the time value of money. When an investor
acquires a share of common stock by means of an option, he or she makes an initial “down
payment” on the total price to be paid for the exercised option. The “final installment” (i.e.,
the exercise price) is not due until the option is exercised sometime in the future. The higher
that interest rates are in the market, the more valuable this delay (until the time the exercise
price is paid) is to the investor. Thus, an option will be more valuable the longer the time to
its expiration and the higher the interest rate.
3. The Influence of Volatility:
Usually the most important factor in the valuation of options is the price volatility of the
associated common stock. More specifically, the greater the possibility of extreme outcomes,
the greater the value of the option to the holder, all other things the same.

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 Figure 5.3. Relationship between common stock price and option value for various expiration dates

We may, at the beginning of a period, be considering options on two common stocks that have the
following probability distributions of possible values at the expiration of the option:

PROBABILITY OF PRICE OF PRICE OF

OCCURRENCE COMMON STOCK COMMON STOCK
A B
0.10 $30 $20
0.25 36 30
0.30 40 40
0.25 44 50
0.10 50 60
1.00

The expected stock price at the end of the period is the same for both common stocks, namely $40.
For common stock B, however, there is a much larger dispersion of possible outcomes. Suppose that
the exercise prices of options to purchase common stock A and common stock B at the end of the

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period are also the same, say, $38. Thus, the two common stocks have the same expected values at
the end of the period, and the options have the same exercise price. The expected value of the option,
Vo, for common stock A at the end of the period, however, is

(1) (2) (3) (4)

PROBABILITY PRICEOF

OF OCCURRENCE COMMON STOCK A, Ps max(Ps − $38, 0) (1) × (3)

0.10 $30 $ 0 $0.00

0.25 36 0 0.00

0.30 40 2 0.60

0.25 44 6 1.50

0.10 50 12 1.20

1.00 Vo = $3.30

Figure 5.4. Stock price volatility and option values for two common stocks

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whereas that for common stock B is

(1) (2) (3) (4)

PROBABILITY PRICE OF
Thus, the
OF OCCURRENCE COMMON STOCK B, Ps max(Ps − $38, 0) (1) × (3)
greater 0.10 $20 $ 0 $0.00
0.25 30 0 0.00
0.30 40 2 0.60
0.25 50 12 3.00
0.10 60 22 2.20
1.00 vo = $5.80

dispersion of possible outcomes for common stock B leads to a greater expected value of option price
on the expiration date. The reason is that values for the option cannot be negative. As a result, the
greater the dispersion, the greater the magnitude of favorable outcomes as measured by the common
stock price minus the exercise price. Increases in the volatility of the common stock price therefore
increase the magnitude of favorable outcomes for the option buyer, and hence increase the value of
the option.

This effect of stock price volatility on option value is illustrated in Figure 5.2. Two common stocks
with different end-of-period share price distributions are shown. The exercise price is the same for
each stock, so the lower boundary for expiration date option values (theoretical values) is also the
same. This is shown by the hockey-stick-shaped portion of the line at the bottom of the figure. The
probability distribution of end-of-period share price is wider for common stock W than it is for
common stock N, reflecting greater price volatility for stock W. Because common stock W provides
a greater chance for a big payoff (i.e., one that is far to the right of the exercise price), its option is
worth more than that for common stock N.

5.9.3.3. Hedging with Options

Having two related financial assets – a common stock and an option on that common stock– we can
set up a risk-free hedged position. Price movements in one of the financial assets will be offset by
opposite price movements in the other. A hedged position can be established by buying the common
stock (termed holding it long) and by writing options. If the common stock goes up in price, we gain
in our long position – that is, in the value of the common stock we hold. We lose in the options we

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have written, because the price we must pay for the com- mon stock to deliver to the person
exercising the option is higher than it was when the option was written.

Thus, when one holds a combination of common stock and options written, movements upward or
downward in the price of the common stock are offset by opposite movements in the value of the
option position written. If one does this properly, one can make the overall position (long in common
stock coupled with options written) approximately risk free. In market equilibrium, one would expect
to earn only the risk-free rate on a perfectly hedged position.

5.9.3.4 Black-Scholes Option Model

In a landmark paper, Fischer Black and Nobel laureate Myron Scholes developed a precise model for
determining the equilibrium value of an option.2 This model is based on the hedging notion just
discussed. Black-Scholes assume an option that can be exercised only at maturity; no transactions
costs or market imperfections; a common stock that pays no dividend; a known short-term interest
rate at which market participants can both borrow and lend; and, finally, changes to common stock
prices that follow a random pattern where the probability distribution of returns is normal and
variance is constant.

Given these assumptions, we can determine the equilibrium value of an option. Should the actual
price of the option differ from that given by the model, we could establish a riskless hedged position
and earn a return in excess of the short-term interest rate. As arbitragers enter the scene, the excess
return would eventually be driven out, and the price of the option would equal that value given by the
model.

To illustrate a hedged position, suppose that the appropriate relationship between the option and the
common stock of XYZ Corporation is that shown in Figure 5.3. Suppose further that the current
market price of the common stock is $20 and the price of the option $7. At $20 a share, the slope
(rise over run) of the market value line in Figure 22A.3 is one-half, or 1 to 2. The slope determines
the appropriate hedged position. Therefore, in this particular situation a hedged position could be

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undertaken by buying one share of stock for $20 and writing two options at $7 each. The “net
money” invested in this position would be $20 − 2($7) = $6.

The combination of holding one share of common stock long and two options short leaves us
essentially hedged with respect to risk. If the common stock drops slightly in price, the value of the
short position goes up by approximately an equal amount. We say approximately because, with
changes in the price of the common stock and with changes in time, the ideal hedge ratio changes.
With a common stock price increase, for example, the slope of the market value line in Figure 5.3
increases. Therefore, fewer options would need to be written. If the common stock price declines, the
slope decreases, and more options would need to be written to maintain a hedge. In addition to
modifications to the slope of the line caused by stock price changes, the line itself will shift
downward as time goes on and the expiration date approaches.

Figure 5.4. Relationship between the option value and the common stock price for XYZ Corporation

Thus, one’s short position in options must be continually adjusted for changes in the common stock
price and for changes in time if a riskless hedged position is to be maintained. The assumptions of
the model make this possible. But in the real world, transactions costs make it impractical to adjust
one’s short position continuously. Even here, however, the risk that will appear as a result of

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moderate changes in common stock price or of the passage of time will be small. Moreover, it can
be diversified away. For practical purposes, then, it is possible to maintain a hedged position that is
approximately risk free. Arbitrage will ensure that the return on this position is approximately the
short-term, risk-free rate.

The Exact Formula and Implications. In this context, the equilibrium value of the option,

Vo, that entitles the holder to buy one share of stock is shown by Black and Scholes to be

Vo = (Ps)(N(d1)) − (E/ert) (N(d2)) -----------------------------------Eq. 1

where Ps = current price of the underlying common stock

E = exercise price of the option

e = 2.71828, the base of the natural system of logarithms

r = short-term, risk-free annual interest rate, continuously compounded

t = length of time in years to the expiration of the option

N(d) = probability that a standardized, normally distributed random variable will

have a value less than d

ln = natural logarithm

σ = standard deviation of the continuously compounded annual rate on the stock

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The important implication of this formula is that the value of the option is a function of the short-
term, risk-free interest rate; of the time to expiration; and of the variance of the rate of return on
the stock; but that it is not a function of the expected return on the stock. The value of the option in
Eq.1 increases with the increase of the time to expiration, t, the standard deviation, σ, and the short-
term, risk-free interest rate, r. The reasons for these relationships were discussed earlier in section.

In solving the formula, we know the current common stock price, the time to expiration, the
exercise price, and the short-term interest rate. The key unknown, then, is the standard deviation of
the annual rate of return on the common stock. This must be estimated. The usual approach is to
use the past volatility of the common stock’s return as a proxy for the future. Black and Scholes, as
well as others, have tested the model using standard deviations estimated from past data with some
degree of success. Given the valuation equation for options, Black and Scholes have derived the
hedge ratio of shares of common stock to options necessary to maintain a fully hedged position. It
is shown to be N(d1), which was defined earlier. Thus, the Black-Scholes model permits the
quantification of the various factors that affect the value of an option. As we saw, the key factor is
estimating the future volatility of the common stock.

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