Chapter-06 Long term financing 6.1 Definitions: Long-term debt consists of loans and financial obligations lasting over one year. Long-term debt fora company would include any financing or leasing obligationsthat are to come due inagreaterthan 12- month period. Long-term debt also applies to governments: nations can also have long-term debt. 6.2 Characteristic: A business can have different types of debt, but not all debt is created equal Unsecured debt refers to debt that is not linked t0 a physical asset. A good example of unsecured debt is a credit card, Many businesses also have short-term debt, which is debt with a repayment period of less than a year. A business also can have long-term debt, which has particular characteristics that distinguish it fiom any other kind. 1. Loan Period The loan period for a long-term debt exceeds 12 months. The length of the term corresponds to the perceived value of the item. A car loan, for instance, would not receive financing, over a 20-year period because the item does not have enough value to sustain such aloan, A mortgage, on the other hand, would because the inherent value of the property can justify such a loan term. Afer the property's appraisal, the value is stretched out for the length of that term minus any upfont downpayment. 2. Collateral Long-term debt is secured by some form of collateral. An example of this would bea mortgage on a building, a loan on construction equipment or a loan on a piece of land. If the borrower defils, the holder of the loan receives the property and can dispose of it in such a way as to allow the holler to recoup some of the money owed by the borrower. 3. Interest Rate The interest rate for a long-term debt is relatively low and remains fixed for the duration of the Joan, The reason for this is because the loan is secured by an asset, unlike unsecured loans, which tend to have a higher interest rate. As such, the payments on the loan remain the same throughout the li of the loan, The amount of interest that the borrower pays is consistently reduced month by month as the original principal becomes smaller. Such predictable payments increase the company’s ability to budget accurately 4. Risk A business with alot of long-term debt is considered risky. Long-term debt is calculated into the companys debt-to-equity ratio, which is the difference between its long-term debt, also known as its abilities, and stockholler’s equity. If the debt-to-equity ratio is low, analysts mayconsider that a good risk for investors, Consequently, if the opposite is true and the company's liabilities are higher than its equity, then most investors would surmise that an investment in it would not prove profitable. Such companies are considered top heavy when it comes to debt, and that is what makes them risky. 6.3 Long Term Sources of Finance: Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years or maybe more depending on other fitctors, Capital expenditures in fixed assets like plant and machinery, land and building etc of a business are funded using long-term. sources of finance. Part of working capital which permanently stays with the business is ako financed with long-term sources of finance. Long term financing, sources can be in form of any of them: Share Capital or Equity Shares Preference Capital or Preference Shares Retained Earnings or Internal Accruals Debenture / Bonds ‘Term Loans from Financial Institutes, Government, and Commercial Banks Venture Funding Asset Securitization International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR ete. 6.4 Instruments: Common stock: Common stock is a security that represents ownership in a corporation. Holders of common stock exereise control by electing a board of directors and voting on corporate policy. Common stockhoklers are on the bottom of the priority ladder for ownership structure; in the event of liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders and other debt holders are paid in full Preferred stock: A preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, and the shares usually do not carry voting rights. Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price, The details of each preferred stock depend on the issue, Debt Capital Debt capital is the capital that a business raises by taking out a loan. It is a Joan made to a company that is normally repaid at some future date.A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt hoklers, or creditors, of the issuer. A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments ffequently issue this type of bond to secure capital. Like other types of bonds, debentures are documented in an indenture. Why Is Preferred Stock a Hybrid Security? Common Stock Features Preferred stock represents partial ownership in a corporation and pays quarterly dividends. Bond Features Preferred stock pays high current income (although in the form of dividends) and can be called (redeemed) at par (face value) under certain conditions. Some preferred stocks are convertible to common stock under certain conditions. Unique Features Preferred stockholders do not have voting rights. Common stocks are perpetual securities, whereas most preferred stocks have call dates. Preferred stocks can be cumulative (entitling its holder to any dividends and arrears), whereas if dividends on common stocks are suspended or omitted, common stockholders have no recourse. Unlike bond interest, preferred dividends can be omitted or suspended without triggering defiult provisions. Worst of Both Worlds Preferred stocks have limited upside potential because of the call feature. Bonds have a priority chim over preferred stocks against corporate assets in bankruptcy or liquidation.