IMMACULATE CONCEPTION ACADEMY OF MANILA

HIGH SCHOOL DEPARTMENT

BUSINESS FINANCE CURRICULUM
School Year: 2022 – 2023

CHAPTER 3 Part 2:

SOURCES AND
USES OF LONG-
TERM FUNDS
 CHAPTER OBJECTIVES:

At the end of the chapter, the students are expected to:

1. define long-term fund and its sources and uses;

2. identify bank and non-bank institutions;
3. enumerate and differentiate the different types of long-term borrowing and classes of shares of
stocks;
4. compute for the value of bonds, interest, and periodic payments; and
5. prepare an amortization table.

LONG-TERM FUNDS

Long-term funds, are funds use by the company to support its long-term operations. In some instances,
they can also be used for day-to-day operations. However, in general, long-term funds are reserved for
capital acquisition for the purpose of expansion, improvement of company facilities, or repayment of
currently maturing long-term obligations. They are obtained by means of long-term loans or issuances of
shares of stocks. Long-term funds can be procured from bank and non-bank institutions that act as
financial intermediary.

As discussed earlier, under Republic Act No. 7653, otherwise known as “The New Central Bank Act”, bank
institutions are classified into the following categories:

1. banking Institutions
a. Private banking institutions
i. Commercial banks
a. Universal banks
b. Commercial banks
ii. Thrift banks
a. Savings and mortgage banks
b. Stocks savings and loan associations
c. Private development banks
iii. Rural banks
iv. Cooperative banks
v. Islamic banks
vi. Other classifications of banks as determined by the Monetary Board of the
Bangko Sentral ng Pilipinas
b. Government banks
i. Development Bank of the Philippines
ii. Land Bank of the Philippines

Chapter 3 Part 2: Sources and Uses of Long-term Funds 2

 2. Non-bank Financial Institutions
a. Private Non-bank Financial Institutions
i. Investment banks
ii. Investment companies
iii. Securities dealers/brokers
iv. Insurance companies
v. Credit unions
vi. Pawnshops
b. Government Non-bank Financial Institutions
i. Government Service Insurance System (GSIS)
ii. Social Security System (SSS)

ACTIVITY 5.1

What is financial intermediary? What role do financial intermediaries play in the economy?

FINANCIAL INTERMEDIARY
UNIVERSAL BANKS
It has the authority to exercise as a
commercial bank and has the power of an
investment house to invest in non-allied
enterprises.

COMMERCIAL BANKS
In terms of capitalization, it is next to a universal bank. Common functions of a commercial bank are to

a. accept drafts and issue letters of credit;

b. discount and negotiate promissory notes, bills of exchange, and other evidences of debts;
c. accept or create demand deposits;
d. receive other types of deposits and deposit substitutes;
e. buy and sell foreign exchange and gold or silver bullion;
f. acquire marketable bonds and other debt securities; and
g. extend credit, subject to such rules as the Monetary Board may promulgate.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 3

THRIFT BANKS
This bank is primarily concerned with the mobilization of savings and loans. It provides short-term working
capital, medium- and long-term financing, and diversified financial and allied services for its chosen
market and constituencies especially for small and medium enterprises and individuals (RA 7906 – Thrift
Act of 1995).

COOPERATIVE BANKS
It is retail and commercial bank organized for a cooperative basis. a cooperative bank, just like a thrift
bank, accepts deposits and provides loans to individuals who will undertake ventures in accordance with
the principles of the cooperative.

ISLAMIC BANK
It has the function and purpose for conventional banking. However, adherence to Islamic law and ensuring
fair pay are at its core. Islam forbids lending money for the purpose of interest. The basic principle of
Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer, as seen
in conventional banking. Islamic banking introduces concepts such as profit sharing, safekeeping, joint
venture, cost plus, and leasing.

GOVERNMENT BANK
It is a financial institution controlled by the government. This kind of bank plays a special role in the
economic development of a country.

INVESTMENT BANK
It is an enterprise whose function is to underwrite securities of another person or enterprise, including
securities of government and private companies. It also offers planning, consultancy, fund management,
and fund raising through equity financing and borrowings.

INVESTMENT COMPANY
This company is engaged in the buying and selling of securities. Most often, the trust is engaged in the
business of investing the pooled capital of investors in financial securities. The way conducting its business
is either through a closed-end fund or open-end fund.

An open-end fund, also known as mutual funds, does not have restrictions on the amount of shares to be
issued. It is redeemable anytime and on day-today basis. it has no fixed amount of paid-in capital. If
demand is high enough, the fund will continue to issue shares no matter how many investors there are.
Pen-end also allows the investors to buy back shares anytime that wanted.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 4

SECURITIES DEALER/BROKER
Securities dealers are companies that buy and sell stocks of other companies for the purpose of reselling
them for a profit. They do not receive commission since they are generating profits based on their trading.
Securities brokers are individuals or firms engaged in the buying and selling of stocks for the purpose of
commission.

INSURANCE COMPANIES
It is a company that provides insurance in case of loss to the insured individuals and firms. Insurance is a
transfer of the risk of a loss from one entity to another in exchange for payment called premium. It is a
way of risk management, that is to hedge against the risk of an uncertain loss. Insurance may cover life,
real estate, fire, accident, and even credit cards.

CREDIT UNION
It is composed of member-owned producers and consumers. It is operated for the purpose of promoting
thrift, offering short-term credit ay competitive rates, and providing other financial services to its
members. Most credit unions provide services in order to support community development or sustainable
international development on a local level.

PAWNSHOP
It is a financial institution that caters financing to relatively low-income individuals. Borrowing requires
collateral to guarantee payment. Collateral may take the form of jewelry, gadgets, or any small valuable
items.

ACTIVITY 5.2

If X Company wants to raise money for the purpose of obtaining long-term funds, to which
institution should the corporation go?

LONG-TERM LOAN
It is an obligation that matures for more than a year and is usually paid in installment. Firms who do not
have an access to the financial market would rather go to commercial banks, insurance companies, or
other financial institutions where interest are considerably higher. Like short-term funds, long-term funds
may also be secured or unsecured. Some example of long-term loans includes term loan, mortgage loan,
bonds and leasing.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 5

TERM LOAN
It is an obligation whose maturity is more than a year. The borrower generally negotiates with the creditor
rather than go to an investment banker to act as an intermediary. Term loans are obtained for the purpose
of purchasing capital assets such as land, buildings, machinery, and equipment. It may also be obtained
for the purpose of expansion or repayment of currently maturing obligations. A term loan my or may not
have collateral.

The advantage of term loan is that it is flexible to the needs of the borrower in terms of manner of
payment, collateral to be used, and interest rate to be charged. Normally, the collateral used in term loan
is machinery, equipment, land, inventory, shares of stocks, or receivables, the price of the collateral
offered must be higher by 20% or more than the amount of the term loan.

Interest payment is made on a periodic basis during the life of the term loan followed by a lump-sum
payment at the maturity date. However, in some cases, a term loan may pay interest and principal on a
regular periodic payment monthly, quarterly, semi-annually or annually.

Example

Joyce Ganda arranged long-term financing with RCBC for its expansion program. RCBC offers to lend Ms.
Ganda the required funds on a loan whose interest must be paid annually at the end of the year. The
borrowing rate is 9% for a term loan of ₱2,500,000 for five years. How much is the interest payment per
year for five years and how much must be paid at the end of the fifth year?

Answer

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑅𝑎𝑡𝑒

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱2,500,000 × 0.09

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱225,000
Outstanding
Year Total payment Interest payment Principal payment
balance
₱2,500,000
1 ₱225,000 ₱225,000 2,500,000
2 225,000 225,000 2,500,000
3 225,000 225,000 2,500,000
4 225,000 225,000 2,500,000
5 2,725,000 225,000 2,500,000
At the end of five years, Ms. Ganda must pay ₱2,725,000.

TERM LOAN PROCEDURE

The borrower should submit an application form to an account officer of the financial institution. The
application form must contain all the necessary information and documents like the name and
background of the company, the articles of incorporation, the by-laws, the stockholders, the board of
directors, the purpose of the loan, the cost of the projects, the means of financing, marketing, and the
projected cash flow of the project.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 6

The account officer, upon receipt of the application form, reviews its viability and completeness. If it is
viable and complete, the account officer requests for a credit investigation. The credit investigation
verifies the authenticity of the information provided by the borrower. Appraisal of collaterals is also maid
to ascertain that properties offered is enough to cover the loan should the borrower default on its
payment. Upon completion and submission of the report made by the credit investigator and appraiser
to the account officer, a Credit Approval Memorandum (CAM) is prepared.

The loan application has to e presented by the account officer to the approving committee of the financial
institution. If it is approved by the committee, a letter is issued to the borrower stating the terms and
conditions of the loan. The acceptance of the terms and conditions of the loan should be communicated
to the financial institutions within a stipulated time.

The financial institutions, after receiving the letter of acceptance from the borrower, sends the draft of
agreement to the borrower for the signature of the authorized officers. The draft of the agreement, once
properly executed, is returned to the financial institution.

If everything is in order as required by the financial institution, a credit advice or issuance of a manager’s
check shall be made in favor of the borrower.

MORTGAGE
Mortgage is an obligation granted by the creditors that
uses real estate or movable assets as collateral. The
borrower is termed as the mortgagor and the lender as the
mortgagee. A mortgage takes place when the owner of the
property conveys the title to the mortgagee by means of
signing a deed of assignment. When real estate is used as
collateral, it is called real estate mortgage; when it is an
automobile or equipment, it is called chattel mortgage.

A mortgage may have a closed-end provision that prevents

the firm from issuing additional debt of the same priority against the mortgaged property. If the mortgage
is open-ended, the company can issue additional first-mortgage binds against the property.

In general, in a mortgage, principal and interest are paid on a monthly, quarterly, semi-annual, or annual
basis. However, most of the time, it is on a monthly basis.

Example

A real estate loan has a mortgage of ₱1,000,000. It is to be amortized by equal payments at the end of
each quarter for two years starting March 31, 2015. I the interest is 9% compounded quarterly, find the
periodic payment. Construct an amortization table.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 7

Answer

Monthly payment
𝐹𝑉
𝑃𝑀𝑇 =
1 − (1 + 𝑖)−𝑛

where
FV = amount of the loan
i = Interest rate
PMT = Quarterly payment

𝑖 = 0.09/4

= 0.0225
𝑛 = 2×4

=8
₱1,000,000
𝑃𝑀𝑇 =
1 − (1 + 0.0225)−8
0.0225
₱1,000,000
=
7.2472
= ₱137,984.33 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
Amortization Schedule
Period Periodic Payment Interest Payment Principal Outstanding
Payment Balance
1-Jan-15 1,000,000.00
31-Mar-15 137,984,33 22,500.00 115,484.33 884,515.67
30-Jun-15 137,984,33 19,901.60 118,082.73 766,432.94
30-Sep-15 137,984,33 17,224.74 120,739.59 645,693.35
31-Dec-15 137,984,33 14,528.10 123,456.23 522,237.12
31-Mar-16 137,984,33 11,750.34 126,233.99 396,003.13
30-Jun-16 137,984,33 8,910.07 131,978.43 266,928.87
30-Sep-16 137,984,33 6,005.90 131,978.43 134,950.44
31-Dec-16 137,984,33 3,036.38 134,950.44 (0)

Note: at the early stage of the amortization, the interest is high and constantly decreases as it approaches
its maturity. On the other hand, the principal payment is constantly increasing as it approaches maturity
until the outstanding balance becomes zero.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 8

 ACTIVITY 5.3

A debt of ₱750,000 with interest at 6% compounded semi-annually is amortized for two years.
What is the periodic payment every six months?

BONDS
A bond is a long-term obligation issued by public or private corporations for the purpose of obtaining
funds. The issuer of the bonds is obliged to repay the principal at its face value on the maturity date ad
make periodic interest payments until such time the principal value has been paid. Market participants
normally use bonds for large issues offered to a wide public.

For smaller issues to a limited number of investors, long-term notes payable is used instead. There are
also “bills” which usually denote fixed income securities with three years or less, from the issue date to
maturity. Bonds have the highest risk, notes have the second highest risk, and bills have the least risk.
These risks are due to a statistical measure called duration, in which lower durations pose less risks and
are associated with shorter term obligation.

When a firm needs large amounts to finance its activities, the enterprise may have to borrow from the
general investing public through the use of a bond issue. Prior to the issuance, it requires the approval of
the Securities and Exchange Commission (SEC). bonds are used primarily by corporations and government
units. In the case of the issuer’s insolvency, a bondholder has a priority of claim to the firm’s assets before
the preferred and common stockholders. Also, bondholders are the first to receive principal and interest
before dividends are distributed to the stockholders.

FEATURES OF BOND ISSUE

a. A bond indenture or deed of trust is the document that shows the full details of the bond issue.
It also includes the rights and duties of the borrower and other parties to the contract.

b. Bond certificates are used. Each bond certificate represents a portion of the total loan. The usual
minimum denomination in business practice is ₱1,000 although smaller denominations are issued
occasionally.

c. If property is pledged as security for the bond issue, a trustee is named to hold title to the property
serving as security. The trustee acts as the representative of the bondholders and is usually a bank
or a trust company.

d. A bank or trust company is usually appointed as a registrar or as a disbursing agent. The issuing
firm deposits the interest and principal payments to the disbursing agents, who then distribute

Chapter 3 Part 2: Sources and Uses of Long-term Funds 9

 the funds to the bondholders. In other words the trust company is the one that ensures that all
the terms and conditions indicated in the indentures are executed by the issuing firm.

BONDS INDENTURES
The terms and conditions in a bond issuance are determined in the bond indenture. It describes the
features of the bond issuances. Bond indenture is sometimes called a deed of trust. A financial
intermediary, normally banks, acts as a trustee to represent the bondholders. Thus, the trustee must make
sure that the stipulations in the bond indenture are diligently followed, manage the sinking fund, and
represent the bondholders in case the issuing company defaults on its payments.

DETAILS OF THE TERMS OF BOND ISSUANCE

Listed below are the details of the terms of bond issuance.

a. Nominal rate, principal or face amount. It is the agreement as regards nominal rate to be used in
computing interest, and the amount of the principal to be paid on the maturity date.

b. Issue price. It is the price at which investors buy the bonds when they are first issued. The net
proceeds that the issuer received are calculated as the issue price less the issuance fees. The issue
price comprises the present value of the face value of the bond plus the present value of all
coupon payments.

c. Maturity date. It I the date on which the issuer has to repay the nominal amount. As long as all
payments have been made, the issuer will no longer have further obligations to the bondholders
after the maturity date.

SALE OF BONDS
Bonds are usually too expensive to sell to a few investors. Thus, a borrower may split bond issuance into
many small units, of say ₱1,000, ₱10,000, or ₱100,000, so that many investors can afford to buy the bonds.
Each of these units is essentially a note payable to investors who bought the bonds and as an effect, grants
loan to the issuing company. More often, bonds are sold in equal denominations for simplicity. Each of
the bonds issued is evidenced by a certificate called a bond certificate.

Bonds issued may be either an interest-bearing bond or non-interest-bearing bond. An interest-bearing

bond is a bond that earns interest on specific periodic intervals, normally a period of six months. The
interest payment to the bondholder is called nominal interest, which is the interest on the face of the
bond. The interest on bonds is tax deductible. To compute for the value of the bond, the formula is
1 − (1 + i)−n
Vb = FV(1 + i)−n + CP [ ]
i

where VB = Value of the bond at the time of issuance

FV = Face value of the bonds
CP = Coupon or interest payment
i = Required rate of return or discount rate

Chapter 3 Part 2: Sources and Uses of Long-term Funds 10

 n = Total no. of conversion period for the whole term

Example

On January 1, 2015, M & M, Inc. sold ₱1,000,000.00 face value bonds with a required rate of return of
12%. The bonds will mature in 20 years with 12% interest payable annually every January 1. What is the
value of the bond?

Answer
Given: FV = ₱1,000,000
CP = ₱1,000,000 × 12% = ₱120,000
i = 12%
n = 20

1 − (1 + i)−n
Vb = FV(1 + i)−n + CP [ ]
i
1 − (1.12)−20
Vb = 1,000,000(1.12)−20 + 120,000 [ ]
0.12

Vb = 1,000,000(0.1037) + 120,000(7.4694)

Vb = 103,700 + 896,328

Vb = ₱1,000,028 or ₱1,000,000 (the ₱28 is a rounding − off difference)

When a bond is sold below its face value, it I said that the bond is sold at a discount. Meanwhile, a bond
sold above its face value is said to be issued at a premium.

ACTIVITY 5.4

Allan Uy Group of Companies issued a ₱1,000,000 face value bond. It has a coupon rate of
10% paid annually and has a ten-year life. If investors are willing to accept a 12% rate of
return on bonds of similar quality, what is the value of the bond?

Issuance of bonds involves printing and engraving costs, legal and accounting fees, commission,
registration fee, promotional cots, and other similar charges. Bond issue costs are added to the bond
discount or deducted from the bond premium and amortized over the entire life of the bond.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 11

A non-interest-bearing bond is a bond that offers no interest but is sold as a deep discount. The investor’s
expected return is this type of bond is the difference between the acquisition cost and the face value of
the bond. An example of a non-interest-bearing bond is a zero-coupon bond.

Example

On March 1, 2015, M & M, Inc. sold ₱1,000,000.00 face value zero-coupon bond with a required rate of
return of 12% What is the value of the bond?

Answer
VB = FV(1 + i)−n
= 1,000,000(1 + 0.12)−20
= 1,000,000(1.12)−20
= 1,000,000(0.1037)
= ₱103,700
By the end of 20 years, the bondholder will receive an amount equal to the face value of the bond which
is ₱1,000,000.

A non-interest-bearing bond is a bond that offers no interest but is sold as a deep discount. The
investor’s expected return is this type of bond is the difference between the acquisition cost and
the face value of the bond. An example of a non-interest-bearing bond is a zero-coupon bond.

Example

On March 1, 2015, M & M, Inc. sold ₱1,000,000.00 face value zero-coupon bond with a required
rate of return of 12% What is the value of the bond?

Answer

By the end of 20 years, the bondholder will receive an amount equal to the face value of the bond
which is ₱1,000,000.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 12

CURRENT YIELD
The current yield is the amount computed by dividing the bond’s coupon by its current market
price. The current yield changes from time to time because of the changes in the prevailing
market price.

Example

Marsha Enterprises’ bonds currently sell for ₱975. The bonds have a seven-year maturity, pay an
annual coupon of ₱90, and have a par value of ₱1,000. What is its current yield?

Answer

YIELD-TO-MATURITY
The yield-to-maturity (YTM) is the bond’s return to the investors who held the bond from the
time it was bought till its maturity. The return on the bonds depends primarily on the amount
invested and the timing of the cash flow from the bond. The YTM is difficult to derive without
using a financial calculator. However, as an alternative, an approximation formula for YTM is
used. It gives a reasonably close approximation of YTM for low yields but not as accurate for high-
yielding bonds (Shim et al., 2006). The formula states that

Example

Ms. Sale invested in a ₱1,000,000 face value bond selling for ₱1,150,000. The bond will mature
in five years. The bond has a 9% coupon rate. Using the approximation formula, the YTM is:

Chapter 3 Part 2: Sources and Uses of Long-term Funds 13

Answer

CALL PROVISION
It is a provision which gives right to the issuer of the bonds to redeem the same previously issued
before the maturity date. The call provision states that in the case of redemption, the bondholder
must receive an amount more than the par value of the bond. The excess of the call price over
the par value of the bond is referred to as call premium. The terms and conditions of the call
provision must be indicated in the indenture.

Firms do not normally exercise the call provision unless there is a significant drop in the interest
rate from the time the bonds were issued. A call provision works to the advantage of the issuer
because once the interest rate drops, the issuer can immediately redeem the bonds. Upon
redemption, the company has the option to issue a new set of bonds but at a lower interest rate,
thus reducing the issuer’s interest expense. In some cases, the company who previously issued
callable bonds may issue a new set of bonds once the interest rate drops. The proceeds from the
issuance of the bond with a lower interest rate will be used to redeem the previously issued
higher-interest rate bonds.

Some bond issuance may have call protection. In this case, bonds with call provision cannot be
called immediately.

Example

On March 31, 2015, M & M, Inc. sold ₱1,000,000.00 face value callable bonds. The bonds will
mature in 10 years with coupon rate 12% payable annually every April 1. The bonds can be called
after 15 years from the date of issuance. Assume that on March 31, 2020, the interest rate drops
to 10% and M & M called the bonds. What is the decline in the interest payment should M & M
call the bond?

Answer

Before the call, the interest payment is

Chapter 3 Part 2: Sources and Uses of Long-term Funds 14

After the call, the interest payment is

The decline in interest payment is ₱20,000 (₱120,000 – ₱100,000)

CONVERSION PROVISION
In order to make a bond issue more attractive to investors, the issuing corporation gives the
investors the option to convert the bonds purchased to other forms of security like preferred
stock or common stock.

The conversion privilege becomes less attractive as the maturity date approaches. For instance,
a 20-year, ₱100,000 bond may be convertible into 2,000 shares of common stock during the first
five years from the date of issue, 1,000 shares of common stock for the next five years, 500 from
the 10th to the 15th year, and may not be convertible during its last five years.

Convertible bonds issued at a premium or discount is amortized from the time it was issued until
in matures instead of the conversion date. It only makes sense since the conversion of bonds to
its intended security will be too difficult to forecast if ever it will be converted. Moreover, there
is no guarantee that such privilege will be exercised by the bondholder.

SINKING FUND PROVISION

It is a provision that requires the issuing corporation to set aside an amount in order to pay off
its bond issuances. The amount set aside is given to the trustee who then uses the funds to pay
off, in part or in full, the debt. Sinking fund helps reduce default risk.

The sinking fund retirement of bonds may take two forms.

1. The trustee receives cash payment from the corporation who issued the bonds. From the
payment received, the trustee then calls the bonds at the sinking fund call price.
2. The bonds are purchased in the open market.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 15

TYPES OF BONDS
The most common types of bonds and their distinguishing characteristics are as follows:

1. Term bond. It is the type of bon that matures on a single date. It usually requires firms to
establish a sinking fund so that upon maturity, the firm will not encounter any difficulty
in paying its maturing obligation.
2. Serial bond. It is the bond in which the principal amount matures in series rather than in
a single payment. Thus, it allows companies to pay their obligations by installment,
allowing them to pay a minimal fraction of their total issues by the time it reaches final
maturity.
3. Secured bond. This bond is issued with fixed assets pledged as collateral. Lenders or
investors always prefer that the firm’s fixed assets, particularly land and building, be
attached to the bond issuance. An example is the mortgage bonds. At times, firms use the
same property to bond issuance. If one of the issues is favored or mortgaged for the first
time, it is called a first mortgage (also known as close-end mortgage bonds) and the one
less favored or mortgaged for the second time is the second mortgage. At times of default,
the bondholders of the first mortgage bonds have a priority over the property pledged
than the bondholders of second mortgage.
4. Unsecured bond. It is a bond issued with no collateral. An example of this is the debenture
bond. Though security to bond issuance is of prime importance to bondholders, it is the
firm’s liquidity that determines the attractiveness of the bond in the final assessment.
Only firms with high bond rating are allowed to issue debenture bonds.
5. Registered bond. This type of bond requires that the name of the bondholders be
registered in the books of the corporation. A registered bond bears the name of the owner
on its face and states that the corporation promises to make principal and interest
payments. The corporation or the trustee keeps the record of the owners of the
registered bonds that is constantly changing whatever a sale or transfer takes place.
6. Bearer bond. A coupon or bearer bond is a bond where a sheet of coupons is attached in
the bond certificate. Each coupon represents an interest payment to be made from the
date of issue to the date of maturity. Unlike in registered bonds, the issuing company does
not know who the bondholders are when the bonds are sold or transferred.
7. Convertible bond. The holders of a convertible bond can exchange the bond for a
predetermined number of shares of corporation stock. The bondholders of this type has
the option to receive interest payments plus the face value of the bond on its maturity
date or at the instance of a sudden increase in the company’s stock price, the holder may
do well by trading the bonds for the appreciated stock. Investors prefer this kind of
securities and are usually willing to accept interest rates lower than those of non-
convertible bonds.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 16

 8. Callable bond. It is the bond which may be called in for redemption prior to the maturity
date. If interest rates go down, the company may not want to be saddled with the higher
cost obligations; it can escape the obligations by calling the debt.
9. Guaranteed bond. A bond is guaranteed when another company or an individual, other
than the issuing company, accepts a common obligation to pay the interest and principal
in case of default. The one who accepts the guarantee of payment is called the guarantor.
A guaranteed bond is issued in order to make the issuance more attractive to investors.
10. Junk bond. This bond poses high risk and high yield issued by companies that are heavily
in debt or I an otherwise weak financial condition.
11. Floating rate bond. It a type of bond where the interest payment fluctuates due to the
interest rate. A conventional bond has a fixed rate attached to the face of the certificate
which serves as a basis in computing periodic interests. Floating rate bond is normally
used by banks at times when the inflation rate together with the interest rate is relatively
uncertain.

LEASE FINANCING
Lease is an agreement between the lessor and the lessee, in which the former allows by the latter
to use the property in exchange for a payment in cash or other assets for a certain period of time.
The terms and conditions as agreed by the two parties should be stipulated in a contract, i.e.,
payment terms (daily, weekly, monthly, quarterly, or annually), period, duration, and if sub-
leasing is allowable, who will be responsible for the maintenance, insurance, repairs, taxes, etc.

The lessor is the owner or rightful user (if sub-lease is allowed) of the assets subject to lease. On
the other hand, the lessee is the party to whom the lessor gives the right to use the asset.

TYPES OF LEASES
1. Operating lease. It is practically renting an asset provided by the lessor in exchange for
payment. Lease may be in the form of a space of a building, machine, equipment, or
transportation vehicle. The title of the asset under this type of lease is still with the lessor
and normally, the payments made by the lessee do not recover the full amount of the
asset. The lessor is the one benefiting from the recovery of the cost of the asset in the
form of an inflow of cash or other asset as agreed upon by the parties. The lessor
shoulders the depreciation expense of the asset under lease. However, other cost
associated with the lease of an asset such a maintenance cost, insurance and property
taxes shall be determined in the contract stipulated by the lessor and the lessee. A clause
for cancellation of the lease may also be indicated in the contract if found to be beneficial
for both parties.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 17

 2. Financial lease or capital lease. By nature, it is a contract in which the rental payments
approach the cost of the asset under lease. Normally, the contract is non-cancellable and
the lessee is obliged to pay monthly payments until the end f the lease contract, whether
the leased asset is in use or not. Nevertheless, the lessee may opt to sublease the property
as long as there is a clear arrangement with the lessor and it is permitted in their lease
contract. A non-cancellable contract entered with the lessor serves as a hold for the lessee
to commit oneself to the fullest to fixed financial charges over the life of the lease
contract.

Financial lease gives the lessee an option to purchase the asset under lease as well,
provide that it is clearly stipulated in the contract. The title being transferable, the lessee
shall shoulder the risk and cos associated with the lease such as maintenance, property
taxes, and insurance.

Under this kind of financing, the lessee records the transactions as a purchase of an asset
and therefore recognizes an asset on the present value of lease payments and with a
corresponding liability. The lessor, being the other party, shall consider the lease as a sale.
The finance lease shall be amortized and the obligation be reduced over the lease period.

ACTIVITY 5.5

Why may an investor find a zero-coupon bond a more attractive investment than an interest-
bearing bond?

SHARES OF STOCKS
As mentioned at the start of this chapter, long-term financing has two major sources; long-term debt and
equity financing. The creditors and the stockholders’ relationship with regard to the company differs in
several ways. Creditors are always prioritized over the corporate assets in case of bankruptcy; they have
rights to five covenants to the corporation before lending, so as to protect their interest, and are entitled
to receive payments in the form of interest for the amount borrowed. The stockholders, on the other
hand, do not enjoy much privilege as the creditors; they are entitled only to whatever residue the
corporation may have. The stockholders can only claim the remaining assets of the firm after the firm’s
obligations to the creditors have been satisfied. Being stockholders, they are entitled to receive dividends
and exercise rights over the corporation. The stockholders are the corporation’s investors. Corporations
issue stocks to raise funds for the company that will be used to finance the corporate assets in part or in

Chapter 3 Part 2: Sources and Uses of Long-term Funds 18

full. The firm’s equity capital is comprised of the capital stock, subscribed capital stock, additional paid-in
capital, retained earnings, and treasury stock.

A stock issue in the financial market for the first time is called initial public offering (IPO). Should the
investors desire to sell the stock, it can be sold in the second market. In the Philippines, selling of
secondary traded stocks is made in the Philippine Stock Exchange (PSE).

Possible returns for stocks are through capital gain and dividends. Capital appreciation refer to the
increase in the price stock from the time it was bought till the time it was sold. For instance, the price of
Philippine Long Distance Telephone Company (PLDT Co.) on May 15, 2015 was ₱17.10 per share. On June
26, 2015, PLDT has a market price of ₱18.90 per share. The capital gain from this is ₱1.80 per share or
10.53% [(18.90 – 17.10)/17.10) x 100]. Dividends, on the other hand, are declared by the board of
directors. They take the form of cash, property, stock, or scrip dividend.

Corporations may have two types of stocks: the common stock and the preferred stocks. If a corporation
issues only one kind of stock, then it must be common stock. In that case, the common stock is also the
firm’s capital stock.

Equity financing is commonly used for long-term investment projects such as investments in property,
plant, and equipment. The proceeds from issuance of shares may be used to pay off the firm’s obligations.

A proof of ownership of stocks of one corporation is called a stock certificate. It shows the name of the
issuing firm, the type of stock (common or preferred), the number of shares, and the name of the
investors. Certificates can be transferred by endorsing at the back of the certificate. Should the investors
desire to sell the stock in the form of a stock certificate in the stock market, the stock certificate has to be
delivered to a stock broker and it will be subjected to clearing before selling. Below is an example of a
stock certificate.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 19

 ACTIVITY 5.6

Mr. Paseo is thinking of buying stocks worth ₱10 per share. He is expecting to receive a
dividend of ₱0.50 per share and that the price of the stock will increase to ₱12 per share after
a year. How much is the expected return (in peso and in percent) should Mr. paseo buy the
stock?

COMPOSITION OF EQUITY
The compositions of the stockholders’ equity are presented in the balance sheet. They are as follows:

1. Capital stock. It represents the amount paid by the stockholders – whether in cash, property, or
service. Stockholders elect the board of directors who in turn shall be responsible in the overall
governance of the corporation. In small firms, the stockholders sometimes assume key positions.
On the other hand, larger firms, especially publicly listed corporations, have a separate set of
officers. The stockholders can always change or terminate key personnel in the company if found
to be ineffective. One is normally considered a majority stockholder if he/she owns more than
50% of the total shares of the company; although at times, control may exist even with less than
50% of the capital stock ownership. Stockholders practically enjoy the benefit of having limited
liability – the firm’s creditors cannot possibly file any litigation case against them.

Authorized capital stock represents the maximum number of shares that the corporation may
issue. This authorized capital stock must be clearly indicated in the articles of incorporation and
subject for approval by the SEC. at any rate, should the corporation raise its maximum shares to
be issued, the articles should be amended and approved by the SEC.

Ownership of a firm’s shares of stock is evidenced by a stock certificate. A subscriber is not entitled
to a certificate unless the full amount for the subscription has been fully paid. However, partial
payments may be issued a certificate at the option of the board of directors by applying the
payments of such number of shares paid for based on the par value.

2. Subscribed capital stock. It represents the portion of the authorized capital stock that has been
subscribed but not yet fully paid. Being not yet fully paid, it is still unissued. The stock subscribed
is indicated in the subscription agreement showing the number of shares being subscribed, the
subscription price, term of payment, and call dates. In the absence of fixed call dates, payment is
made upon call by the board of directors. The subscribed capital stock is reported by deducting
the subscription receivable not collectible currently.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 20

 3. Additional paid-in capital. It is the portion of the paid-in capital representing excess over the par
or stated value. Broadly, the common sources of additional paid-in capital are

a. excess over par value or stated value,

b. resale of treasury stock at more than the cost,
c. donated capital,
d. issuance of detachable stock purchase warrants,
e. distribution of stock dividends, and
f. quasi-reorganization and recapitalization.

4. Retained earnings. It represents the cumulative balance of periodic earnings, dividend

distributions, fundamental errors, and other capital adjustments. The retained earnings may be
appropriated or unappropriated. The appropriated retained earnings are allotted for future
expansion, while the unappropriated retained earnings refer to the portion where the firm has
free hand to declare dividends.

5. Treasury stock. It is the corporation’s own stock that has been issued and then reacquired but not
cancelled. Treasury stock are held for possible future resale, a stock option plan, purchasing of
another company, or prevention of a hostile takeover. In getting the outstanding shares issued,
treasury stock must be deducted.

TYPES OF STOCKS
Companies have two types of stocks to choose from: common stock and preferred stock. The term
“preferred” may lead one to think that preferred stock would be the better choice, but that is not
necessarily true. Digging deeper to the customary features of common and preferred stock will lead to
their differences – providing some advantages and disadvantages for each. Preferred stock, as the term
connotes is in a better position only for dividend declaration and liquidation proceedings as preferred
stockholders are entitled to firs receive such before the common stockholders. However, in some
instances, it can be left behind of significant opportunities for share value appreciation.

A company may issue different classes of common stock. Class A stock is issued to the public and usually
has no specified dividends. However, it does have voting rights. Class B stock is usually kept by company’s
organizers. Dividends are typically not paid on it until the company has generated sufficient earnings.

A company stock may also be issued at par value or no par value. The par value of a stock is a stated
amount of value per share specified in the certificate of stock and in the articles of incorporation. The firm
typically cannot sell stock at a price below par value since stockholders would be liable to creditors for the
difference between the par value and the amount received. The par value of the stock also serves as the
basis for the legal capital of the firm. The legal capital is on the basis of the “Trust Fund Doctrine” that
protect the interest of the creditors. Knowing that one of the common advantages of stockholders of
corporations is having a limited liability, the creditors can run only after the corporate assets to satisfy
their claims.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 21

A no par value stock is one that has no face value stated in the stock certificate. Nonetheless, such stock
cannot be sold at a price less than ₱5.00, as provided in the Corporation code of the Philippines. All
proceeds of no par value stocks sold are considered legal capital (Section 62 of the Corporation Code). All
corporations established udder the Philippine law can issue no par value stocks except for banks, trust
companies, insurance companies, and building and loan associations.

COMMON STOCK
Some of the typical features of common stock enjoyed by the stockholders are as follows:

1. It provides the right to receive dividends after satisfying the dividend requirements of the
preferred stockholders.

2. It grants holders preemptive right or the right to buy new shares of stock before it can be offered
to the public. This right is given to the current stockholders in order to avoid dilution so that it can
maintain a proportionate percentage of ownership in the company. Dilution of ownership results
in the dilution of net earnings because the present stockholders will have a smaller claim on the
firm’s earnings as compared to before.

3. Holders of common stock have the right to vote in matters like election of the board of directors,
employee stock award plans, and mergers; hence, they can participate in the management.

4. Stockholders have the right to share in the distribution of assets after all preferential claims has
been met.

5. They have the right to periodic financial reports about corporate performance.

6. Holders are given the receipt of a stock certificate which evidences ownership in the firm. The
stock certificate may then be sold by the holder to another in the secondary market.

ADVANTAGES OF ISSUING COMMON STOCK

Should the company decide to raise money by issuing common stock rather than by borrowing, the firm
will have the following advantages:

1. The credit rating of the company will improve due to an increased liquidity. Financing through
borrowing decreases the firm’s financial ratios in relation to financial leverage.

2. The dividend declaration is not required upon by the board of directors, unlike bonds in which the
bondholders are required to receive interest.

3. There is no maturity date on the issued common stock.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 22

 4. Issued common stocks can be repurchased by the company in the form of treasury shares.
Repurchased stocks help the company’s EPS to increase.

5. It will give the company a higher net income because the dividends declared are not deductible.

DISADVANTAGES OF ISSUING COMMON STOCK

Raising money through issuance of common stock has the following disadvantages:

1. It dilutes the EPS of the company. With increase common shares outstanding, the EPS will decline.

2. With increased common shares outstanding, the current stockholders’ interest will decrease if
the preemptive right is not practiced.

3. The dividends declared are not tax deductible, unlike for bonds in which interest expense is
deducted from the income.

4. The retained earnings declared as dividends will be distributed to more stockholders.

5. The flotation costs associated with a common stock issue are higher than with preferred stock
and debt financing.

PREFERRED STOCK
Firms may also choose to offer preferred stock. Some of its common features are as follows:

1. Preferred stock has preferential rights over dividends. It means that preferred stockholders are
paid first before the distribution to the common stockholders. The amount of the dividend is
usually fixed or stated as a percentage of the preferred stock’s par value. Preferred stock is
frequently cumulative; if the annual dividend requirement cannot be satisfied, it becomes a
dividend in arrears, and all dividends in arrears must be paid before nay dividends can be paid to
common stockholders. On the other hand, a non-cumulative preferred stock is not required to
receive dividend the that was not declared in the past. Furthermore, a preferred stock may be
participating or non-participating. Holders of participating preferred stocks have the right to
participate in earnings that normally goes to the common stockholders, while holders of non-
participating preferred stocks do not participate on the remaining dividends once the fixed rate
dividends have been received.

2. Preferred stockholders have no voting rights. They do not have any right to participate in any
management-related decision.

3. In case of corporate liquidation, the preferred stockholders have a preferential claim over the
corporate assets before the common stockholders but after the corporate creditors.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 23

 4. A preferred stock may have a call provision feature. It means that the company can buy back the
preferred stock at a call price – oftentimes set at a certain percentage of par values. For instance,
callable at 110 would mean that the company can buy back the preferred stock at 110% of its par
value.

5. A preferred stock may have a convertible feature. It means that the preferred shares can be
exchanged for common stock at a pre-agreed ratio.

6. Issuance of preferred stock does not dilute the ownership of interest of common stockholders.
However, it has an impact with regard to EPS computation since the dividend requirement for
preferred share has to be deducted first from the net income.

7. Preferred dividends are not tax deductible. Dividends declared are taken from the retained
earnings. However, in computing for the earnings per share, the basis for the net income is after
tax.

8. Price fluctuation of preferred stock is greater than that of bonds due to non-existence of a
maturity date. As the bond approaches its maturity date, the price fluctuation is becoming less
and less. Thus, the risk involved is getting smaller and smaller.

ISSUANCE OF ADDITIONAL SHARES

To issue additional shares, the board of directors must determine how much funds the firm will need. The
additional shares to be issued must be offered first to the existing stockholders for their preemptive rights
before it is offered to an outside investor.

Example

MYMP Corporation has been authorized capital stock of 1,000,000 shares. At present. It has outstanding
500,000 shares of common stock. MYMP Corporation is planning to buy a new equipment that will expand
the firm’s operations. The amount needed for the new acquisition is ₱2,500,000.

Assume that new shares can be issued at ₱20 a share. To meet the amount needed for the acquisition,
the number of shares to be issued must be

𝐴𝑚𝑜𝑢𝑛𝑡 𝑛𝑒𝑒𝑑𝑒𝑑 ₱2,500,000

= = ₱125,000 𝑠ℎ𝑎𝑟𝑒𝑠
𝐼𝑠𝑠𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ₱20

Chapter 3 Part 2: Sources and Uses of Long-term Funds 24

The new stockholders will now own 20% of the total shares outstanding as computed below.
𝑁𝑒𝑤𝑙𝑦 𝑖𝑠𝑠𝑢𝑒𝑑 𝑠ℎ𝑎𝑟𝑒 ₱125,000
=
𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 500,000 + 125,000
₱125,000
=
625,000
= 20.0%

Again, the new shares to be issued must first be offered to the existing stockholders before they are
offered to interested investors.

MARKET PRICE PER SHARE

It is the current selling price of the stock as perceived by the market. As such, it is the commonly perceived
true value of the stock. This relates to the main objective of the finance manager: to increase the
stockholders’ wealth through the market price per share of the stock.

Example

HET Corporation is planning to raise ₱5,000,000 for its IPO. It is expected that right after issuance, the
total market value of the stocks will be ₱25,000,000. At present, HET Corporation has 2,000,000
outstanding shares that are closely held. In order to raise the ₱5,000,000, how many new shares must be
issued and what is its expected market price per share?

Since the total market value of the overall stock is anticipated at ₱25,000,000, the new shares will have
0.20 (₱5,000,000/₱25,000,000) of the outstanding shares issued. Furthermore, the shareholdings before
the issuance is 0.80 (1.00 – 0.20).
2,000,000
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 =
0.80
= 2,500,000

𝑁𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 = 2,500,000 × 0.20

= 500,000
Right after the stock issuance, the estimated market price per share to sell the securities is
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
₱25,000,000
=
2,500,000
= ₱10.00

Chapter 3 Part 2: Sources and Uses of Long-term Funds 25

COST OF CAPITAL
It is also known as the firm’s minimum required rate of return or hurdle rate. It is defined as the minimum
rate of return on an investment in order to maintain the market value of the firm’s securities. The cost of
capital is useful in determining the value of the stock, whether common or preferred.

VALUATION OF STOCK
For a firm that has been trading in the market, the market price per share with no expectation of growth
is
𝑑1
𝑃𝑜 =
𝑘𝑒
where 𝑃𝑜 = 𝑖𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑟 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑘𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑜𝑟 𝑟𝑒𝑢𝑞𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛)

Example

Golden Corporation expects the dividend for the year to be ₱10 a share. The cost of capital is 10%.
Compute for the issue price per share.
𝑑1
𝑃𝑜 =
𝑘𝑒
₱10
= = ₱100
0.10
For a stock with an expected growth, the formula is
𝑑1
𝑃𝑜 =
𝑘𝑒 − 𝑔

where 𝑃𝑜 = 𝑖𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑟 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑑1 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟

𝑘𝑒 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑔 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 (𝑔 = 𝑟𝑒(1 − 𝑑𝑝𝑜))
where r, is the past rate of return on common stock and dpo is the dividend payout ratio

STOCK RIGHTS
Stock rights represent an option to the existing stockholders to acquire additional shares of stocks at a
specified price in the future (Shim et al. 2007). Most often, the exercise price is less than the fair value of
the shares. The legal term for this stock right is the right of preemption. This gives the existing
stockholders the first option to buy the additional share to be issued by the company. Normally, a letter
is sent to the existing stockholders, informing them that the company is issuing additional shares. The
letter contains a checkbox to be filled in if they like to exercise their right of preemption or not. The letter

Chapter 3 Part 2: Sources and Uses of Long-term Funds 26

is then sent back to the broker. Should the existing stockholders exercise their right, it permits them to
maintain their interests in the company and protects them against dilution of ownership. On the other
hand, if they wish not to exercise their rights, the additional shares will be sold to the interested investors.

ISSUANCES OF BONDS AND STOCKS

One of the functions of the finance manager is to raise money for the firm to support the operations or
future expansion of the company. When they look assistance, they normally go to a financial intermediary
like an investment bank. An investment bank is a middleman engaged in raising long-term funds for
businesses and government agencies. It gives advice to the issuing corporation on the prices and securities
to be issued. The usual functions of investment bankers are as follows:

1. to originate securities issues (a negotiation between the officers of the issuing firm and officers
of the investment bank)
a. initial discussions. It is concerned with determining the amount of capital to be raised,
the security to be issued, and the particular terms and condition of the issue.
b. Investigation. It looks at the financial capability of the firm if issuances of the securities
give satisfaction to the investors. CPAs are hired to look into the books to audit and
develop required financial statements. Lawyers are hired to investigate the legal aspects
of the issue.
c. Negotiation. It finalizes the securities to be issued and their details. The spread is the
difference between the price of the security to be issued and the amount to be permitted
plus out-of-pocket costs incurred by the investment bank.
d. Registration. This is to ensure that all requirements on the new issues are submitted to
the SEC where all material information about the security are disclosed.
2. to underwrite the issues by guaranteeing the sale in the primary capital market.
a. The investment banker assumes that risk and responsibility of remitting the entire
amount to the issuing company less the amount of spread agreed upon on a given closing
date.
b. The underwrite may invite other investment bankers to spread out the risk of selling the
securities to the public through underwriting syndicate. The originating house becomes
the “manager of the underwriting syndicate.”
c. Part of underwriting is market stabilization. The syndicate manager is placing bid in the
secondary market at its offering price to stabilize the market price of the stock.
3. to manage the distribution of these securities to the ultimate investors (members of the
underwriting syndicate will form a selling group comprising of dealers that will reach the ultimate
investors)
4. to give advice to the corporate clients on long-term financial matters.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 27

 ACTIVITY 5.7

5.
6. Do the issuer and investor of bonds or stocks need to meet face to face in order to make the
exchange between two parties valid?
7.

Chapter 3 Part 2: Sources and Uses of Long-term Funds 28