Chapter I Long Term Financing Introduction
When Companies decides to acquire long-term assets it must also decide how to finance them. In this regard there are two roads available, namely, internal financing or external financing. Internal funds are primarily in the form of cash flow from operations plus the liquidation of marketable securities. Because firms typically pay some portion of net income to shareholders in the form of dividends, this limits the amount of operating cash flow available for reinvestment purpose to retained earnings plus depreciation.
In a Pecking Order Theory; firms first finance themselves through their retained earnings. When a firm is not able to secure sufficient cash from its internal source, it will finance itself through issuing debt; finally the last resort will be issuing stocks.
Though the firm can rely on internal sources, to a certain extent, these are usually insufficient to meet the investment needs. This compels the firm to look out for external funding so as to not abandon profitable projects. In this chapter the main external sources of long term finance that are generally employed by business firms: Equity capital, Preference capital, Debenture capital, Term loans and venture capital and the prime source of internal financing, retained earning are explored.
I. Internal Financing:
Retained Earnings
Retained earnings represent profits that have been ploughed back into the business. It shows internal sources of finance available to the company, which can be used for expansion and growth. Benefits of retained earnings from the firm’s point of view:
Readily available finance within the company
It eliminates issue costs (like brokerage costs )and losses on account of under pricing No dilution of control
From the shareholder’s point of view:
When there is appreciation in the capital due to retained earnings, there is a lower rate of tax compared to dividend income.
Shareholders are also freed of the responsibility of re-investing earnings on shares. Disadvantage of retained earning financing
The amount of retained earning is limited by the firms profit
It is usually considered as unreliable source of financing. This is basically because firms usually try to avoid reducing the level of dividend payments even if earnings have declined temporarily and therefore mostly possible incase where there is stable earning.
II. External Financing
Ordinary Shares
dividends only after the income claims of others have been satisfied. At time of wound up, they can exercise claims on assets after the claims of other suppliers of capital have been meet.
Basic Features of Ordinary Common Stocks
These are special characteristics, which distinguish it from other securities.
1. Claim on income- shareholders do have a residual claim after earnings has been apportioned to paying expenses, interest charges, taxes and preference dividend. The residual income is either directly distributed to shareholders or indirectly in the form of capital gains on the ordinary shares. Dividends payable depend on the discretion of the company board of directors and capital gains on future market value of ordinary shares which then makes an ordinary share a risky security form investors point of view
2. Claims on assets –at time of liquidation it is the debt holders which has a priority claim on the realized value of the asset being followed by preference share holders and it is the remaining balance to be paid for the ordinary ones
3. Voting right and right to control- usually each ordinary shares caries one vote. Share holders may vote in person or proxy. A proxy gives a designated person to vote on behalf of a shareholder at annual general meetings.
4. Pre-emptive rights- it is an entitlement given to a shareholder to maintain his proportionate share of ownership in the company. The share holder’s option to purchase a stated number of new shares at a specified price during an issue is called a right.
5. Limited liability-the liabilities is limited to the extent of their investments in shares
Advantages
There is no liability for payments, as it is permanent capital
It also enhances the creditworthiness of the company –the issuance of ordinary shares would increase its financial capability and it can borrow based on it
There is no capital obligation for payment of dividends- at the time of financial distress the company either can reduce or suspend the payment of dividend
Dividend received from domestic corporations is usually freed to the extent of 70% while interest income, which is fully taxed.
Disadvantage
Cost-the non deductibility of dividends and floatation costs would make them more costly then debt.
Dividends are paid out of after tax earning where as interest payments are tax deductible Risk-the uncertainty of dividend and capital gain make it riskier form investors perspective Earning diluting- every new issuance of shares water down the existing share holder’s
earning unless profits do increase in proportion to the increase in the number of ordinary shares
Ownership dilution-unless the pre-emptive rights are exercised the issuance of an ordinary shares weaken the ownership and control of the existing shareholders
Long-term Debt
sector companies. An indenture is a written agreement between the corporation (the borrower) and a trust company. It is also called deed of trust. It includes the following provisions:
The Basic terms of the bonds- the face value (par value), coupon rate, issue and maturity date etc.
A description of property used as a security or collaterals.
Details of the protective covenants; is that part of the indenture or loan agreement that limits certain actions of the borrowing company. Such as
o Limitations placed on the amount of dividends a company may pay.
o The firms cannot pledge any of its assets to other lenders.
o The firms cannot merge with another firm.
o The firm may not sell or lease its major assets without approval by the lender.
o The firm cannot issue additional long-term debt.
The sinking fund arrangements: a sinking fund account managed by the bond trustee for the purpose of repaying bonds.
The call provision; lets the company repurchase or call the entire bond issue at a predetermined price over a specified period.
Features of Long-term debt
The fact that lenders are not owners of the firms has three important consequences. Lenders ordinarily have no voting power.
Their returns are limited to interest plus principal repayments, no matter how profitable the firm’s investments turn out to be.
Interest payments are considered as a cost of business and so are taxes deductible.
Benefits from the firm’s point of view:
It is cost effective because the interest on debentures is tax deductible and also because investors consider debentures as a relatively less risky investment alternative requiring a lower rate of interest
It does not cause dilution of ownership, as debenture holders do not have voting rights. During periods of high inflation, the fixed monetary burden associated with debenture
financing, irrespective of changes in the price level benefits the company.
As debenture holders do not contribute to extraordinary earnings of the company, the payments are limited to interest.
Benefits from the investor’s point of view: They earn a stable rate of return
They enjoy a high order of priority in the event of liquidation. They are protected by various provisions of the debenture trust deed. They generally have a fixed maturity period
Disadvantage of debt financing
Greater use of debt financing increases the firm’s financial risk, possibly leading to bankruptcy and eventual liquidation
The real cost of debt will be greater than expected if the rate of inflation turns out to be unexpectedly low
Certain terminologies related to debentures/bonds
Face Value: It is also called par value or nominal value. The value is stated on the face of the bond.
Maturity Value and Maturity Period: The amount that the debt holder gets at the time of the maturity is called as the maturity value. The maturity value may be same as par value, or may be more (i.e. at premium), or less (i.e. at discount) than the par value as the case may be. The period outstanding for the repayment of the bond issued is termed as the maturity period. Coupon Rate: Bonds pay interest periodically at a pre-specified rate of interest. The rate of interest at which the bonds are issued is known as the coupon rate or coupon. E.g.: a bond of face value 2000, with a 10% coupon payable semi-annually will pay 100 as interest every 6 months.
Call option: Internationally many bonds contain a call option, which entitles the issuer to call back the bonds and redeem them even before the maturity. E.g.: a company issues a bond in the year 2000 with a coupon rate of 11%, maturing in 2010, with a call option after 5 years. Suppose the interest rate in 2005 goes down by 2% i.e. to 9%, if there is no call option, company has to pay interest at 11%, although the prevailing market interest rate is 9%. A call option in this case will allow the company to call back the bonds and redeem them. The company can then issue new bonds at 9%.
Put option: Internationally many bonds contain a put option, which entitles the bondholder to put the bonds to the issuer for redeeming even before the maturity date. E.g.: continuing the above example, suppose the interest rate goes up to 13% in 2005, the investor will put back his bonds for redeeming and invest the proceeds in other bonds giving a return of 13% prevailing at that time.
Classification of Bonds
1. Secured and Unsecured Bonds:
Bonds, where whole or part of the principal amount is secured by the tangible assets of the issuing company as collateral is called secured bonds. The holder can lay a claim on the assets in the event of default by the issuer. Holders of unsecured bonds have no charge on any tangible assets of a company.
2. Senior and subordinate bonds:
In case of liquidation of a company, holders of senior debt are paid before the holders of subordinate debt. That means if there are not enough funds, holders of senior debt get their funds first. If any funds are left then they are distributed to the holders of subordinate debt.
3. Registered and unregistered bonds:
Unregistered debentures are also called as bearer debentures and are payable to the bearer. They are negotiable and can be transferred by simple endorsement. Registered debentures are payable only to the registered holder whose name appears on the debenture. Only on executing a transfer deed and filing a copy of it with the company, they can be transferred.
4. Convertible and Non-convertible Bonds:
Bond Ratings
Firms frequently pay to have their date rated. The two leading bond-ratings firms are Moody’s and Standard & Poor’s. The debt ratings depend upon the likelihood that the firm will default and the protection afforded by the loan contract in the event of default.
Bond Ratings Very High Quality High Quality Speculative Very Poor
Standard & Poor’s AAA AA A BBB BB B CCC CC C D Moody’s Aaa Aa A Baa Ba B Caa Ca C D
Types of Bonds
Zero coupon Bonds/Deep Discount Bonds: No interest is paid on such bonds prior to maturity. Instead, they are sold at discounts to their Par Value. A bond that pays no coupon must be offered at a price that is much lower than the face value.
Junk Bonds: The investment community has labeled bonds with a Standard and Poor’s rating of BB and below or a Moody’s ratings of Ba and below as junk bonds. These bonds are also called high yield or low grade bonds. These are corporate bonds that are treated below investment grade or investment bonds.
Preference Capital
It is similar to an ordinary share in the following ways:
The preference dividend is not an obligatory payment. The non-payment of dividends does not force the company into insolvency
The preference dividend is payable only out of distributable profits Preference dividends are not deductible for tax purpose.
On the other hand, it is similar to debentures in the following ways: The dividend rate on preference capital is fixed
Preference shareholders do not share residual earnings. They greater claim on income and assets compared shareholders
Preference shareholders do not usually enjoy the right to vote
Benefits from the firm’s point of view:
As a company does not face any legal consequences if it skips preference dividend, there is no legal obligation to pay the preference dividend either
Preference shares provide advantages of financial leverage since the preference dividend is a fixed obligation
Preference shares enhance the credit worthiness of the firm as it is generally regarded as part of the net worth
Preference shareholders do not have voting rights except when dividend arrears exist. Thus, the ordinary shareholders’ span of control is preserved
Preference shareholders do not benefit from the excess profits accruing to the company as ordinary shareholders do because dividend payments are restricted to the stated amount
Disadvantage of preferred stocks
Preferred dividends are not tax deductible, in contrast with interest expense that are tax deductible. This is not a disadvantage if the firm is not paying taxes, however
The claim of preferred stock on the firm’s earning and assets take priority over the common stock holders claims
The fixed dividend payment son preferred add to financial leverage which is unfavorable if earrings decline
The failure to meet preferred dividends could force the company to grant voting rights to preferred shareholders
Leasing
Long-term leasing is a method of financing equipment, property or plant. A lease is a contractual agreement between a lessee and lessor, the lessee is the user of the equipment and the lessor is the owner. The agreement establishes that the lessee has the right to use an asset and in turn make periodic payments to the lessor.
The lessor is either the assets manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy asset from a manufacturer.
Operating Leases
This form of leasing has several characteristics:
Operating leases are usually not fully amortized: this means the payment required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. The term of the life of the operating lease is usually less than the economic life of the asset. Operating leases are usually require the lessor to maintain and insure the leased asset. An operating lease has a cancellation option: this option gives the lessee the right to cancel
the lease contract before the expiration date.
Operating leases are treated off-balance sheet items.
Financial Leases
Financial leases are the exact opposite of operating leases, as is seen from their important characteristics:
Financial leases do not provide for maintenance or service by the lessor. Financial leases are fully amortized.
The lessee usually has a right to renew the lease on expiation.
Generally, financial leases cannot be cancelled. in other words the lessee must make all payments or face the risk of bankruptcy.
Valuation of Lease
To value lease, need to identify two unknowns
Cost of Capital; which is cost of debt after tax (Kd(1-Tc) Cash Flows
Lease or Buy Decisions
Net Advantage of Leasing = Cost of new asset – Net Cost of Leasing
Example: Your company wants to purchase a new network file sever for its wide area computer network. The server costs Br. 500,000. It will be completely obsolete in 5 yeas. Your options are to borrow the money at 7% (Kd after tax) or to lease the machine. If you lease, the payments will be Br. 125,000 at the end of every year. The maintenance cost is Br. 10,500 per year. If you buy the server you can depreciate it using straight line over the five years. The tax rate is 30%. Should you lease or buy, assuming it is a financial lease?
NAL = 500,000 – [87,500(ADF) + 30,000(ADF)] =500,000 – [87,500(4.1) + 30,000(4.1)] = 500,000 – 481,750
= Br.18, 250; Leasing the asset is the best decision.
If it was operating lease
NAL = 500,000 – [87,500(ADF) + 30,000(ADF) + 10,500*0.7(ADF)] NAL = ?
Exercise: Your company wants to purchase a new network file sever for its wide area computer network. The server costs Br. 75,000. It will be completely obsolete in 3 years. Your options are to borrow the money at 10% or to lease the machine. If you lease, the payments will be Br. 27,000 at the end of every year. The maintenance cost is Br. 10,500 per year. If you buy the server you can depreciate it using straight line over the 3 years. The tax rate is 34%. Should you lease or buy, assuming it is a financial lease?
Key figure: NAL = Br. 5,420.09
Capital Markets
Primary Market
A market for new issues of shares, bonds, where investors apply directly to the issuer for allotment and pay application money to the issuer’s account. The transactions in the primary market result in new capital formation.
Players in a Primary Market:
1. Issuers may be Corporations, the Government or Mutual Funds. They start the whole process of raising funds. Funds are raised through public issues, rights issues, or through private placement, and preferential allotments.
2. Instruments are the means through which issuers raise funds, such as debentures, equity shares, warrants, etc.
3. Intermediaries are those who facilitate the flow of funds from a person who has excess funds to the person who needs it. They help the issuer to raise funds by issuing securities through selected instruments. Examples of financial intermediaries are banks, investment companies, insurance companies, development financial institutions, Mutual Funds, pension funds, etc.
Secondary Market
It is a market for the secondary sale of securities. In other words, the market where existing securities are traded is referred to as the secondary market or stock market. In the stock market, securities of government, semi government, and other public bodies as well as shares and debentures issued by joint stock companies are traded. This market provides liquidity to the investor, since he can trade his securities at any time.
Selling securities to the public – the basic procedure
Management must first obtain approval from the board of directors.
The firm must prepare a registration statement and file it with the securities exchange commission (SEC). The registration statement contains financial information including financial history, details of the existing business, proposed financing and plans for the future.
The SEC examines the registration statement during a waiting period. During this time, the firm may distribute copies of a preliminary prospectus. The prospectus is a business document describing details of the issuing corporation and the proposed offering to potential investors. The prospectus contains much of the information put into the registration statement, and it is given to potential investors by the firm. The preliminary prospectus is also called a red herring, because bold red letters are printed on the cover. The company can not sell its securities during the waiting period. However oral offers can be made.
On the effective date of the registration statement, a price is determined and a full fledged selling effort gets underway.
A final prospectus must accompany the delivery of securities or confirmation of sale, whichever comes first.
Methods of Floating New Issues
Public issue:
The Company directly offers the shares to the public through an offer document called a prospectus. The offer is for fixed number of shares at a stated price.
Private Placement:
In this, the Issue House or Share brokers purchase all the shares with the intention of selling them to their clients only. These intermediaries act like a wholesaler who purchases from the company and then sell the same to their clients.
Initial Public Offerings
The first public offer of securities by a company after its inception is known as an Initial Public Offering (IPO). IPO’s are also called unseasoned new issue. IPO dilutes the ownership stake and diffuses corporate control as it provides ownership to investors in the form of equity shares. It can be used both as an exit strategy and a financing strategy. As a financing strategy, its main purpose is to raise funds for the company. When used as an exit strategy, existing investors can offload their equity holdings to the public.
Reasons for Going Public
To raise funds for financing capital expenditure needs like expansion, diversification etc.
To finance increased working capital requirement As an exit route for existing investors
For debt financing Advantages
The IPO provides avenues for funding future needs of the company. It provides liquidity for the existing shares.
The reputation and visibility of the company increases.
Additional incentive for employees in the form of the company’s stocks. This also helps to attract potential employees.
It commands better valuation for the company. Disadvantages
The profit earned by the company should be shared with its investors in the form of dividends.
An IPO is a costly affair. Around 15-20%of the fund realized is spent on raising the same.
In an IPO, the company has to disclose results of operations and financial position to the public and the Securities and Exchange Board.
The company has to invest substantial management time and effort.
A. CASH OFFER: Stock is sold to all interested investors in a cash offer. if the cash offer is a public one, investment bankers are involved. Investment bankers provide advice in formulating the method used to issue the securities, pricing the new securities and selling the new securities.
There are two methods of issuing securities for
cash:- Firm commitment –Under this method the investment banker buys the securities for less than the offering price and accepts the risk of not being able to sell them. Because this function involves risk, we say that the investment banker underwrites the securities in a firm commitment.
To summarize the risks here, investment bankers combine to form an underwriting group (syndicate) to share the risk and to help sell the issue.
The difference between the underwriters buying price and the offering price is called the spread or discount. it is the basic compensation received by the underwriter.
Firm commitment underwriting is really just a purchase – sale arrangement, and the investment banker’s fee is the spread.
Cost of New Issue
The cost of issuing Securities
1. spread The spread consists of direct fees paid by the issuer to the underwriting syndicate – the difference between the price the issuer receives and the offer price
2. other direct expenses These are direct expenses incurred by the issuer that are not part of the compensation to underwriters. These costs include filing fees, legal fees, and taxes – all reported in the prospectus.
3. indirect expenses These costs are not reported on the prospectus and include the cost of management time spent on working on the new issue 4. abnormal returns In a seasoned new issue of stock, the price of the existing
stock drops on average by 3% upon the announcement of the issue. This drop is called the abnormal return
5. under pricing For initial public offerings, losses arise from selling the stock below the true value.
6. green shoe provision The green shoe option gives the underwriters the right to buy additional shares at the offer price
B. RIGHTS: If a preemptive right is contained in the firm’s article of incorporation, then the firm must first offer any new issue of common stock to existing share holders. If the articles of incorporation do not say anything the firm has a choice of offering the issue of common stock directly to existing shareholders or to the public.
An issue of common stock offered to existing shareholders is called a rights offer or a privileged subscription. In a rights offer each shareholder is issued rights to buy a specified number of new shares from the firm at a specified price with in a specified time, after which time the rights are said to expire. To execute a rights offering, the financial manager should have to answer the following
questions:- What should the price per share be for the new stock? How many shares will have to be sold?
How many shares will each shareholder be allowed to buy?
What is likely to be the effect of the rights offering on the per share value of the existing stock?
The value of a right equals the difference in the price of the issuer’s outstanding shares before and after the rights offering, and is determined by three factors:
