Sources of Long-term Financing

Types of Bonds
Part 2
 Learning Outcomes:
●
Identify the sources of business capital
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Understand the nature, features, pros and cons, of these
sources
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Calculate the intrinsic value of preferred shares
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Compute the ordinary shares valuation using the finite
and infinite period methods
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Understand leases as source of capital
 Sources of capital for Businesses
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Equity
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Debt
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Debentures
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Retained Earnings
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Term loans
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Working capital loans
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Letter of credit
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Euro Issue
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Venture funding
-THEY ARE GROUPED BASED ON TIME PERIOD, OWNERSHIP CONTROL, AND SOURCE
GENERATION
 Time-period Financing
●
Classified into three
1. Long-term sources of finance
2. Medium-term sources of finance
3. Short-term sources of finance
 Time-period Financing
●
Long-term sources of finance
-capital needed for a period of more than 5 years to
10 to 15 and 20 years or even more
-Examples: share capital, preference shares,
retained earnings, bonds, term loans from financial
institutions, international financing by means of euro
issue, foreign currency loans.
 Time-period Financing
●
Medium-term financing
-Financing for a period of three to five years
-Examples: preference shares, bonds, medium term
loans from financial institutions, ,lease
 Time-period Financing
●
Short-term sources of financing
-financing is funding for a short period of less than one year
-this usually funds current assets like inventory of materials,
debtors etc.
- In the form of trade credits
short-term loan from commercial banks, advances received from
customers, creditors, factoring services and bill discounting
 Finances categorized as to
Ownership and Control
●
1. Owned capital or ownership shares
-Referred to as equity capital
-Preference capital
-Retained Earnings
Convertible debentures (long-term debt that can be converted into
shares of equity stock)
-bonds
-private equity (investors directly invest into the business)
 Finances categorized as to
Ownership and Control
●
2. Borrowed capital
-Also called debt financing
-sourced from outside including loans from family,
relatives, and friends, financing institutions,
commercial banks and the general public in the
form of debentures/bonds
 Features of borrowed capital:
●
The company-borrower will pay the creditors first in case
of liquidation
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Regular payment of interest and repayment of capital
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There is no reduction in ownership and business control
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Interest or the cost borrowed funds is a deduction for tax
purposes resulting to decrease in taxes for the company
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It provides the firm a leverage benefit
Disadvantages of borrowed capital:
●
Principal and interest obligations have to be paid
regardless of the economic condition of the company
●
Some restrictions in the indenture agreement may
be a burden on the firm
●
Debt may weaken outstanding ordinary shares if
used in a long period
 Finance Source Origin
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1. Internal Sources
-capital is generated internally which have the same
characteristics of owned capital, include retained earnings,
reduction or controlling working capital, sale of assets
●
2. External sources
-one in which the capital is generated from outside or third
party
 Major sources of long-term
financing:
●
1. Bonds
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2. Preference shares
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3. Ordinary or common shares
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4. Lease
 Bond
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Is a promise in writing under seal, to pay a definite sum of money with a fixed rate
of interest thereon
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Evidenced by a bond certificate issued by a corporation or a government body
representing the loan made by the investor to the issuer of bonds.
●
Bond certificate shows the name of the company-issuer, the principal amount the
firm borrowed from the bondholder, the bond’s face value, interest rate to be paid
by the issuer, dates of payment, maturity date and value.
●
Issuance of bonds usually requires the services of a security underwriter, which
can be a an investment bank or other financial institutions. The underwriter
purchases the bonds from the issuing company and resells them to prospective
clients.
 Other agreements between the
underwriter and the issuing firm in
trading bonds
●
The Investment bank can negotiate directly with the issuer
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The underwriter can participate in bidding for the purchase of bonds
●
An investment bank can be a sole underwriter by acquiring exclusive
right to sell the bonds.
●
The investment bank can make an agreement with the issuer to sell the
bonds at the best market price it can for issuing company, not
guaranteeing a fixed price with the selling firm.
 Advantages of using bonds in the
capital structure
●
Long-term debts are less expensive and the interest payments
are deductible for tax purposes
●
Many investors considered these as a relatively safe investment
●
Bondholders are paid interest and do not share in the
extraordinary earnings of the firm
●
Bondholders are not corporate voters
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Bond’s flotation costs are lower than those of ordinary
 Disadvantages of Utilizing bonds
are:
●
Long-term debts can cause the firm’s bankruptcy if it fails to meet
interest payments.
●
The fixed charges on bonds,other than income bonds, increase the
company’s financial leverage, This is unfavorable for firms with
unstable income
●
Bond repayment at maturity (principal amount)involves a huge cash
outflow.
●
Bonds’ restricting agreements may hamper the firm’s future financial
flexibility
 Bond attributes and Prices
●
Par value-refers to the face value of the bonds that is returned to the the
bondholder at maturity date
●
Contract interest rate or stated interest rate-pertains to the interest rate
that determines the amount of interest to be paid by the issuer and to be
received by the bondholder each year. The contract rate is stated in the
bond certificate or contract and does not change during the duration of
the bonds
●
Coupon interest rate-refers to the percentage of par value that will be paid
annually in the form of interest. Computed by dividing stated interest
payment by par value.
 Bond attributes and Prices
●
Market interest rate or effective interest rate-is
the interest rate that investors demand for
lending their money to the bond issuer
●
Maturity (date) -date or time that the bond
issuer returns the par value of the bond and
terminates it.
 Bond attributes and Prices
●
Market price of the bonds- bond’s present value
which is the total of the present value of the
principal amount/payment and the present value
of the cash interest payments
●
Present value- is the amount that an investors
would invest now to receive a greater amount at
a future date.
 Bond attributes and Prices
●
Yield to maturity-refers to the bonds internal rate of return (IRR). It is
the discount rate that equates the present value of the interest and
principal payments with the current market price of the bonds.
●
Current yield-pertains to the ratio of the annual interest payment to the
market price of the bonds.
●
Indenture-the arrangements between the issuer and the bond trustee
who represents the bondholders. It includes the specific terms of the
loan agreement, description of the bonds, the bondholders’ rights, the
issuing firm’s rights and the responsibilities of the trustee.
 Bond attributes and Prices
●
Bond premium-is the excess of the bond’s issue price over its
maturity or par value
●
Bond Discount-is the excess of the bond’s maturity or par
value over its issue price
●
Credit quality risk-refers to the possibility that the issuer of the
bonds will not be able to meet timely payments.
●
Bond ratings-relate to the opinions or perceptions about the
future risk potential of the bond,
 Factors affecting the bond ratings:
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Profitable operations
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Little inconsistencies of previous earnings
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Firm’s size
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Less usage of subordinated debt
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Less application of financial leverage
 Types of Bonds
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Unsecured Long-term bonds
-Income bonds usually issued during the reorganization of a company facing
problems. This requires interest payments only if earned and nonpayment of
interest does not precede insolvency. Accumulated unpaid interest must be
paid prior to payment of dividends to shareholders
- Debenture bonds-bonds are backed only by the good faith of the bond
issuer
- Subordinated Debenture – bondholders’ claims are honored only after the
claims of the secured debt and un subordinated debentures have been
satisfied.
●
2. Secured-Long – term bonds
Mortgage bonds- this type of bonds is secured
by a lien on real property. The value of the real
property should be greater than the value of the
mortgage bonds issued. If the issuer fails to pay
the bonds at maturity, the trustees can foreclose
or sell the mortgaged property in order to pay
the bondholders
 Sub – classifications of mortgage
bonds
●
First mortgage bonds-bondholders of first mortgage bonds are prioritized first in
claims if the same property has been pledge on more than one mortgage bonds
●
Second mortgage bonds-is next to first mortgage bonds on claim and will be
paid only after the first mortgage bonds are met
●
Blanket or general mortgage bonds- all the assets of the company are utilized
as security in this type of mortgage bonds.
●
Closed-end mortgage bonds
●
Open-end mortgage bonds
●
Limited open-end mortgage bonds
 3. Other types of bonds
●
Eurobonds – these are bonds payable in the borrower’s
currency and sold outside the country of the issuer by an
international consortium of investment banker
●
Floating rate bonds – also called Variable rate bond, this
interest payment changes with market conditions.
●
Treasury bonds-safest fixed-income investment as
perceived by the investors is backed up by the government.
 Retiring debts
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Repayment of debts can be done in the following ways:
●
1. Serial payments-paid in installments, each bond has its own maturity date and receives
interest only up to that point.
●
2. Conversion-reducing debts by converting debt into ordinary shares as a prerogative of the
bondholders
●
3. Call provision – callable bonds are bonds that the issuer may call or pay off at a specified
price whenever the issuer wants. These bonds give the issuer the benefit of low interest rates.
The call price is higher than the bond’s par value. The difference is termed call premium
●
4. Bond refunding - the process of retiring old bond issue prior to maturity and replacing it by a
new bond issue. It occurs when interest rates have gone low. The decision can be arrived at
after comparing the present value of the benefits from refunding versus the present value of the
costs using the after-tax cost of borrowing as the discount rate
 Preferred shares
●
A kind of equity that gives its owners some
advantages over ordinary shareholders.
●
Benefits include:
-Right to receive dividends before ordinary
shareholders
-Right to receive assets of the company before
ordinary shares in the event of the firm’s liquidation.
 Conditions when issuing preferred
shares is favorable
●
Some problems in issuing ordinary shares
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Earnings or profits are huge to make additional leverage
appealing to investors
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Additional loans create considerable risks
●
Low interest rates lowering the cost of preferred shares
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The company’s high debt ratio proposing a mixture of
equity financing
●
 Attributes of preferred shares
●
Par value- the face value of the preferred share that
appears on the stock certificate
●
Dividends-states as a percentage of par values
●
Cumulative and noncumulative dividends –
Cumulative are those dividends not paid for a
particular year. Non cumulative, if dividends are are
not declared in any particular year and are forfeited.
●
Call feature and sinking fund provision. Preferred shares have
no maturity date. This allows the firm to buy back the shares
directly from its holders or owners but at a price higher than its
par value.
●
Convertibility- have the choice of converting preferred shares to
ordinary shares
●
Voting rights- no voting rights
●
Participating features-give its owners the right to share in the
profits above and beyond the declared dividends
●
Maturity- most preferred shares have a sinking fund and
therefore an effective maturity date.
 Pros and cons of the preferred
shares
●
Can be easily sold to investors who are very cautious for the safety of
their capital and want to receive a regular and fixed return
●
When the company’s profit is not sufficient, dividends can be postponed.
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Do not bear voting rights
●
Do not establish any mortgage or charge on the assets of the company,
so, the company can use their fixed assets in raising future loans
●
A company can issue redeemable preference shares for a fixed period.
The risk of over-capitalization is eliminated and the capital structure
remains flexible
 Disadvantages of preferred shares
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Preferred shares have no minimal voting rights
●
Preferred shares have bigger after-tax costs of capital
than debt. This is because dividends on preferred share
are not deductible while interest is for tax purposes.
●
The preferences of preferred shares when it comes to
dividends and assets in case of the company’s
liquidation may put at risk the ordinary shares’ return
 Valuation of Preferred Shares
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Is considered a hybrid investment or security
●
It has the qualities of a share and debt (bond)
●
Shareholder is a part owner of the firm just like an
ordinary shareholder. It has fixed payment in the form
of dividend
●
The value of the preferred shares can be calculated by
discounting each of the dividend payment
 Valuation of Preferred Shares
●
The fixed dividend payments can be treated in
perpetuity and be discounted using the investors
required rate of return.
●
Perpetuity is an annuity with an infinite life span.
●
The concept of perpetuity is also used the
dividend discount model.
●
EBC Company pays an annual 10.00 dividend on
its issue of preferred share. The investor require
an 8% rate of return on this preferred share.
●
Solution:
●
V=D/r
●
V=10/.08
●
V=125
 Ordinary (Common) Equity Share
●
Known as common stock is the common form of capital stock or
share. The word stock is meant to be common stock or ordinary
share unless designated otherwise .
●
Investors of ordinary shares take the ultimate risk with the
issuing firms as the company makes no promises to pay them.
●
If the company is successful and earns profits, it will pay
dividends but if the company’s net income is too low, it may opt
not to distribute dividends.
 Valuation Methods of Ordinary
Equity shares
●
Based on holding periods
1. Finite-Period Dividend valuation
2. Infinite-Period Dividend Valuation
●
Value of Ordinary Equity share Finite period
dividend model
●
Mr. A intends to buy ordinary equity share of
LMN corporation on January 1, 2017 and sell
them at the end of the year. He expecting that
the corporation will pay 8.50 cash dividend per
share. He also plans to sell the shares at 60.00
each. His required rate of return is 12%
●
What is the value of an ordinary equity share to
Mr A?
●
Po= 8.5 + 60.00
(1+.12) (1 + .12)

=68.50/1.12

= 61.16
●
Mr. A. intends to buy ordinary equity shares of
LMN corporation on January 1, 2017 and hold
them indefinitely. He is expecting that the
corporation will pay 8.50 cash dividend per
share and his required rate of return is 12%.
●
What is the value of an ordinary equity share to
Mr. A?
●
Solution:
Po= Dp/Ks

●
=8.50/.12
●
=70.83