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Chapter 15
Long-Term Financing:
An Introduction

Instructor: Fan Yang

ACTSC 372
Winter 2015

© 2011 McGraw–Hill Ryerson Limited

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Chapter Outline
year
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1

over
.

• Long-term Financing Sources:

– Common Stock
– Long-Term Debt
– Preferred Stock

• Patterns of Financing
• Summary and Conclusions

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no special preference
Common Stock →

in dividends or in bankruptcy

• Authorized versus Issued Common Stock

• Shareholders’ Rights owner of common stock :

• Classes of Shares shareholders /

• Dividends stock holders .

• Par and No-Par Stock

they are protected
• Contributed Surplus
• Retained Earnings by limited liability ,

• Market Value, Book Value

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Authorized vs. Issued Common Stock

• The articles of incorporation must state the

number of shares of common stock the
corporation is authorized to issue.
• The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares.
– Authorizing a large number of shares may worry
investors about dilution because authorized shares can be
issued later with the approval of the board of directors but
without a vote of the shareholders.

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Shareholders’ Rights
• The right to elect the directors of the
corporation by vote constitutes the most
important control device of shareholders.
• Directors are elected each year at an annual
meeting by a vote of the holders of a majority
of shares who are present and entitled to vote.
– The exact mechanism varies across companies.
• The important difference is whether shares
are to be voted cumulatively or voted
straight.
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Cumulative vs. Straight Voting: Example
• Imagine a firm has two shareholders: A & B
– A owns 600 shares of the firm and B owns 400 shares.
– Both A and B want to be on the board of directors.
– Assume there are three directors to be elected and each
shareholder can have up to 3 nominations
• Under straight voting, A may cast 600 votes for
each nomination while B may cast 400 votes for
each
– Implication?
• Under cumulative voting, B has 1,200 votes (= 400
shares × 3 seats) and A has 1,800 votes.
– Each shareholder can distribute these votes over one or
more of their nominations.
– Implication? © 2011 McGraw–Hill Ryerson Limited
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Cumulative versus Straight Voting

• In straight voting, shareholders have as many votes

as shares and each position on the board has its own
election.
– A tendency to freeze out minority shareholders.
• Under cumulative voting, if there are N directors up
for election, then 1/(N+1) percent of the stock plus
one share will guarantee you a seat.
– With cumulative voting, the more seats that are up for
election at one time, the easier it is to win one.
– The effect of cumulative voting is to permit minority
participation.
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Proxy Voting
• A proxy is the legal grant of authority by a
shareholder to someone else to vote his or her
shares.
• For convenience, the actual voting in large
public corporations is usually done by proxy.
• If shareholders are not satisfied with
management, an outside group of
shareholders can try to obtain as many votes
as possible via proxy.

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Dividends
• Unless a dividend is declared by the board of
directors of a corporation, it is not a liability of the
corporation.
– A corporation cannot default on an undeclared dividend.
• The payment of dividends by the corporation is not
a business expense.
– Therefore, they are not tax-deductible.
• Dividends received
– by individual investors are partially sheltered by a
dividend tax credit (see Appendix of Chapter 1)
– by corporate investors are 100% exempt from income
taxes
– To avoid the double taxation of dividends.
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Classes of Shares
.

• Some firms have more than one class of

common shares.
• Usually, the classes are created with different
voting rights.
• This is common for family-owned
corporations.
• The fact that the stocks may have unequal
voting rights implies that their selling prices
would differ and the stocks would pay
different dividends.
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Corporate Long-Term Debt: The Basics

• The person or firm making the loan to the
corporation is the creditor or lender
• The corporation borrowing the money is the
debtor or borrower.

• Debt vs Equity (Interest vs Dividends)

• Different Types of Debt
• Security
• Seniority
• Repayment
• Indenture © 2011 McGraw–Hill Ryerson Limited
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Equity vs Debt

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Types of Debt Securities

• Debts can be classified as secured or unsecured
– e.g. notes, debentures, or bonds
• A note usually refers to a short-term borrowings
– Typically less than seven years
• A debenture is an unsecured corporate debt,
• A bond is secured by a mortgage on the corporate
property
– Collateral
– the (mortgaged) property can be sold in event of default
to satisfy the debt for which the security is given.

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Seniority

• Seniority indicates preference in position over other

lenders.
• Some debt is subordinated.
– In the event of default, holders of subordinated debt must
give preference to other specified creditors who are paid
first.
• Example: If mortgaged property is sold in the event
of default, debenture holders will obtain something
only if the mortgage bondholders have been fully
satisfied.
• Debt cannot be subordinated to equity.
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Repayment of Loan
• Bonds can be repaid at maturity or earlier through
the use of a sinking fund.
– A sinking fund is an account managed on behalf of the
issuer by a bond trustee for the purpose of retiring all or
part of the bonds prior to their stated maturity.
– From investor’s viewpoint, a sinking fund reduces the
risk that the company will be unable to repay principal at
maturity
• Debt may be extinguished before maturity through a
call provision giving the firm the right to pay a
specific amount to retire the debt before the stated
maturity date.
– Callable bond not required .

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Indenture
• The written agreement between the corporate
debt issuer and the lender.
• The indenture completely describes the
nature of the indebtedness:
– Maturity, Interest rate etc.
– Protective (or Restrictive) covenants such as
• restrictions on further indebtedness,
• a maximum on the amount of dividends that can be
paid,
• a minimum level of working capital.

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Is It Debt or Equity?
• Some securities blur the line between debt
and equity.
• Corporations are very adept at creating
hybrid securities that look like equity but are
called debt.
– Obviously, the distinction is important at tax
time.
– A corporation that succeeds in creating a debt
security that is really equity obtains the tax
benefits of debt while eliminating its bankruptcy
costs.
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Preferred Shares
• Represents equity of a corporation, but is
different from common stock because it has
preference over common in the payments of
dividends and in the assets of the corporation
in the event of bankruptcy.
• no voting privileges
• Preferred shares have a stated liquidating
value. how much to be paid in life dat :
in
.

– For example, CIBC “$2.25 preferred at

$25/share” translates into a dividend yield of 9%
of the stated $25 value.

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Cumulative vs non-cumulative preferred shares

• Preferred dividends are either cumulative or non-
cumulative.
– Most are cumulative
– under “cumulative”, unpaid dividends are carried
forward (without interest)
– Unpaid preferred dividends are not debt
• Directors elected by the common shareholders can
defer preferred dividends indefinitely BUT
– Common shareholders must also forgo dividends
– Holders of preferred shares are often granted voting and
other rights if preferred dividends have not been paid for
some time

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Is Preferred Stock Really Debt?

• A good case can be made that preferred stock is
really debt in disguise.
– The preferred shareholders receive a stated dividend..

– In the event of liquidation, the preferred shareholders

are entitled to the stated value
– Often, preferreds carry credit ratings much like
bonds
– Preferred shares are sometimes convertible into
common shares
– Preferreds are often callable by the issuer
– Preferred shareholders often have the right to sell the
shares back to the issuer at a set price

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Preferred Shares: Issuer’s Viewpoint

• Significantly lower financing cost with
preferred share (relative to debt)
• In Canada a tax loophole encourages
corporations that are lightly taxed to issue
preferred shares.
– Low-tax companies can make little use of the tax
deduction on interest.
– They can issue preferred shares and enjoy lower
financing costs since preferred dividends are
significantly lower than interest payments.

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Preferred Shares: Issuer’s Viewpoint (Cont’d)

• Fully taxed firms may still be interested in issuing
preferred shares:
• Firms issuing preferred shares can avoid the
threat of bankruptcy that might otherwise exist
if debt were relied on.
• Issuing preferred shares may be a means of
raising equity without surrendering control.
• Regulated public utilities can pass the tax
disadvantage of issuing preferred shares on to
their customers because of the way pricing
formulas are set up in regulatory environment
(particularly in US)
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Patterns of Financing

• The Pecking order of long-term financing:

Recent studies have shown that
– the preferred source of financing for firms is
internally generated cash-flow.
– if the firm has insufficient internal cash flow,
then debt is used second and equity third.

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Summary and Conclusions

• The basic sources of long-term financing are:
– Long-Term Debt
– Common Stock
– Preferred Stock
• Common shareholders have voting rights, limited
liability, and a residual claim on the corporation.
• Bondholders have a contractual claim against the
corporation.
• Preferred stock has some of the features of debt and
equity.
• Firms need financing—most of it is generated
internally.

© 2011 McGraw–Hill Ryerson Limited