CHAPTER 18

LONG-TERM FINANCING

I. Questions

1. Three major sources of long-term financing for a corporation are bonds,

preferred stock, and common stock.

2. A bond is a security that carries a promise to pay interest and principal at

specified dates.

3. An indenture is the agreement under which a bond is issued.

4. There are three parties to a public bond issue: the issuer, the bondholders, and
the trustee. The trustee is largely responsible for enforcing the provisions of the
bond indenture on behalf of the bondholders.

5. Bonds may be either secured or unsecured. Secured bonds are backed by a

pledge of certain types of property whereas unsecured bonds are not secured by
specific property.

6. The major advantages of bond financing include relatively low cost, no dilution
of control, financing flexibility, financial leverage, lower risk than short-term
debt, and an inflation hedge.

7. The disadvantages of bonds include increased financial and default risk,

restrictions on operations, a definite maturity date, and limits of debt in the
firm’s financial structure.

8. Preferred stock is a hybrid security because it has characteristics of both debt

and equity.

9. The basic advantages for the use of preferred stock financing include the ability
to increase financial leverage, the flexibility of the issue, the absence of control
dilution, and the preservation of assets for collateral.

10. Disadvantages of preferred stock include its relatively high cost and its
preference over the common stockholders.
18-2 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations

11. Common stockholders have numerous rights including voting rights, the right to
dividends (if declared), the right to any remaining assets upon liquidation, the
right to transfer their ownership, and the preemptive right.
12. The basic advantages of common stock stem from the fact that this source of
financing places minimum constraints on the firm. Common stock gives a firm
flexibility because it has no fixed charges and no maturity date.

13. Disadvantages of common stock include its high cost, potential dilution of
control and earnings, and loss of leverage.

II. True or False

1. False 6. True 11. False

2. True 7. True 12. True
3. True 8. True 13. False
4. False 9. False 14. True
5. True 10. True 15. True

III. Practical Problems

PROBLEM 1

(a) The total amount of semiannual interest is: (0.09 x P2,000,000) / 2 = P90,000.

(b) The after-tax cost of the semiannual interest payments is: P90,000 x (1 – 0.34)
= P59,400.

PROBLEM 2

The following computations show that Supreme Hotel has a net investment of
P1,252,600 in the refunding.

Initial cash outflows

Cost of calling old bonds (P1,120 x 10,000 bonds)......................... P11,200,000
Overlapping interest on old bonds
[(2 / 12) x 0.15 x P10,000,000]................................................... 250,000
Flotation costs of new bonds.............................................................. 350,000
Initial cash outflows........................................................................... P11,800,000

Initial cash inflows

Proceeds from new bonds.................................................................. P10,000,000
Tax savings
Call premium on old bonds (0.12 x P10,000,000 x 0.34)........... 408,000
Unamortized flotation costs on old bonds
[(20 / 30) x P240,000 x 0.34].............................................. 54,400
 Long-term Financing 18-3
Overlapping interest on old bonds
[(2 / 12) x 0.15 x P10,000,000 x 0.34]................................ 85,000
Initial cash inflows............................................................................. P10,547,400

Initial net cash inflows

Initial cash outflows........................................................................... P11,800,000
Initial cash inflows............................................................................. 10,547,400
Initial net cash outflows (net investment).......................................... P 1,252,600

PROBLEM 3

Northpark Noodles Company has issued 140,000 shares (0.70 x 200,000 shares)
and repurchased 14,000 (0.10 x 140,000) of these shares. Hence, the total number
of shares outstanding is the number of issued shares less treasury stock or 126,000
shares (140,000 – 14,000).

PROBLEM 4

The P3,200,000 (P16 x 200,000 shares) is recorded from the stock sale and is
separated into two accounts: common stock and additional paid-in capital. The
common stock account is P200,000 (P1 par x 200,000 shares) and the additional
paid-in capital account is P3,000,000 (P15 x 200,000 shares). The balance sheet
accounts are shown below:

Stockholders’ Equity
Common stock
(500,000 shares authorized and
200,000 shares issued and outstanding at P1 par)...................... P 200,000
Additional paid-in capital.................................................................. 3,000,000
Total stockholders’ equity.......................................................... P 3,200,000