Financing Options: Long-term Financing Flashcards
(38 cards)
Long-term (Capital) Financing Defined:
Long-term Financing: long-term, or capital, financing provided by funding which does not become due within one year.
- It’s the primary source of funding for most firms
- The cost associated with each source used will determine firm’s weighted average cost of capital (WACC).
Primary Forms of Long-term Financing:
- Long-term notes
- Financial (capital) leases
- Bonds
- Preferred Stock
- Common Stock
Long-term Notes:
Long-term Notes: They result from acquiring cash through borrowing with repayment due in more than one year.
- Typically a promissory note is required
- Borrowings are commonly from one to ten yrs, but may be longer
- Repayment is usually in periodic installments
- Note may be secured (collateral) by a mortgage on property or real estate
- Promissory note often containes restrictive covenants.
Common Restrictive Covenants - (to reduce risk)
- Maintaining a certain working capital condition (e.g. a minimum working capital ratio)
- Restrictions on incurrence of additional debt without lender’s approval.
- Specification of required frequency and nature of financial information provided to lender, perhaps audited FS.
- Restrictions on management changes without lender approval.
Cost of Long-Term Notes: It will depend on:
- General level of interest
- Creditworthiness of borrowing firm
- Nature and value of collateral, if any
Interest rate is likely to be expressed as a function of a macroeconomic benchmark.
- For example, the prime rate
- Interest rate on note changes as the benchmark changes
Advantages:
- Commonly available to creditworthy firms
- Provides long-term financing, often w periodic repayment
Disadvantages:
- Poor credit rating results in higher interest rate, greater security requirements, and more restrictive covenants.
- Violation of restrictive covenants can trigger serious consequences, including technical default.
Financial (Capital) Leases:
Financial Leases: Leasing is a common way of acquiring use of certain assets. In some cases leasing may be less costly than buying.
When leasing of assets is possible, the acquisition of assets should be evaluated under both purchase and lease options:
- Is proposed project economically feasible if assets are purchased?
- Is proposed project economically feasible if assets are leased?
Possible Outcomes:
- Reject project, if neither alternatives shows the project is feasible
- Purchase assets, if the purchase alternative is feasible and leasing alternative is not; or if both are feasible, but purchase has higher return.
- Lease assets, if the leasing alternative is feasible and purchasing alternative is not; or if both are feasible, but leasing has higher return.
Cost of Leasing: may be less than cost of buying because:
- Lessor has buying power or efficiencies that lessee does not have.
- Lessor has lower interest rate than the lessee
- Lessor has tax advantages the the lessee does not
*Non-cost reasons may be:
- Flexibility
- Convenience
Lease Terms:
-
Net Lease: Lessee assumes cost associated w ownership (executory costs):
- Maintenance
- Taxes
- Insurance
- Net-net Lease: Lessee assumes cost associated w ownership (executory costs) like above and responsibility for residual value at end of lease.
Advantages and Disadvantages of Financial Leases:
Advantages:
- Limited immediate cash outlay;
- Possible lower cost than purchasing;
- Possible scheduling of payments to coincide with cash flows;
- Debt (lease payments) is specific to amount needed.
Disadvantages:
- Not all assets available for leasing;
- Lease terms may prove different than the period of asset usefulness;
- Often chosen over buying for noneconomic reasons (e.g., convenience).
Which of the following long-term notes would best facilitate financial leverage for the borrowing firm?
Variable Rate Long-term Note Fixed Rate Long-term
Variable Rate Long-term Note: NO
Fixed Rate Long-term: YES
Financial leverage derives from the use of debt with a fixed or determinable cost (rate of interest) for capital financing. Therefore, financial leverage would be possible with either fixed rate or variable rate debt (notes); however, fixed rate debt would better facilitate financial leverage because the cost of the use of debt-financed capital would not change over the life of the financing. The cost of variable rate debt can change, thereby making the degree of leverage more uncertain over the life of the debt.
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A. To cause the price of the company’s stock to rise.
B. To lower the company’s credit rating.
C. To reduce the risk of existing debt holders.
D. To reduce the interest rate on the debt being issued.
D. To reduce the interest rate on the debt being issued.
The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.
Bonds Defined and Features:
Bonds: Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
Bond Features:
- Bond Indenture = Bond contract
- Par/Face Value = Bond principal, commonly $1,000 per bond
- Coupon rate (Stated rate)= Annual rate of interest stated on the face of the bond.
- Maturity= Time at which issuer repays the bondholder principal and extinguishes debt.
- Debenture Bonds = Unsecured bonds, no specific assets are desginated as collateral. Riskier and higher return and cost than secured bonds.
-
Secured Bonds = Have specific assets designated as collateral like:
- Mortgage Bonds: secured by real property like land or buildings
Bond Selling Price and Value:
Bond Selling Price and Value: They depend on the relationship between the rate of interest the bonds pay (coupon or stated rate) and the rate of interest in the market for comparable risk when bond is issued.
- Coupon Rate > Market Effective Rate = Sells at Premium
- Coupon Rate < Market Effective Rate = Sells at Discount
- Coupon Rate = Market Effective Rate = Sells at Par
Bond Selling Price or Fair Value - is detertmined as the PV of cash flows from the bonds:
- Periodic interest: discounted ast PV of annuity at market effective rate.
- Face Value: discounted ast PV of single amount at market effective rate.
- Discount using the market rate of interest.
- Sum of present values = selling price of bonds and reflects any premium or discount.
Market Rate of Interest and Market Price of Bonds:
Market Rate of Interest and Market Price of Bonds: The market price of bonds changes inversely with changes in the market rate of interest:
- Market rate of int goes up = Market price of bond goes down.
- Market rate of int goes down = Market price of bond goes up.
Example:
- Assume $1,000 bonds outstanding that pay 4% - that rate doesn’t change (coupon)
- The market rate goes up to 5%
- As a consequence, the value of 4% bonds goes down, no one will buy a 4% bond for $1,000 when they can get a better rate of interest (5%) on the new bonds. So your 4% bonds will sell in the market only if the price is such that they earn 5%.
- What’s the price? Market price of the $1,000 bond would be $800:
- The bond would have to sell in the market for $800 in order for the buyer to earn 5% interest:
- $1,000x.04 = $40 / .05 = $800
- The bond would have to sell in the market for $800 in order for the buyer to earn 5% interest:
Bondholders face what is called “Market Interest Rate” Risk:
- The risk that market will go down due to interest rates going up.
- The longer the maturity of the bonds, the greater the risk of that happening (because of longer holding period) and the higher the required (stated) interest rate.
Describe the calculation of the Current Yield on a bond:
Current Yield of Bond:
The ratio of annual interest payments to the current market price of the bond. It is computed as:
Annual interest payment/Current market price
Describe the Yield to Maturity for Bonds (also called the expected rate of return).
Yield to Maturity for Bonds:
The rate of return required by investors as implied by the current market price of the bonds; determined as the discount rate that equates present value of cash flows from the bonds with the current price of the bonds.
- It’s the current cost of capital for the firm’s bond.
Advantages and Disadvantages for Bonds:
Advantages:
- A source of large sums of capital;
- Does not dilute ownership or earnings per share;
- Interest payments are tax deductible.
Disadvantages:
- Required periodic interest payments-default can result in bankruptcy;
- Required principal repayment at maturity-default can result in bankruptcy;
- May require security and/or have restrictive covenants.
Which of the following statements concerning debenture bonds and secured bonds is/are correct?
I. Debenture bonds are likely to have a greater par value than comparable secured bonds.
II. Debenture bonds are likely to be of longer duration than comparable secured bonds.
III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.
A. I only.
B. II only.
C. III only.
D. I, II, and III.
C. III only. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.
Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.
Which of the following types of bonds is most likely to maintain a constant market value?
A. Zero-coupon.
B. Floating-rate.
C. Callable.
D. Convertible.
B. Floating-rate.
Floating-rate bonds are most likely to maintain a constant market value. The rate of interest paid on floating-rate bonds (also called variable-rate bonds/debt) varies with the changes in some underlying benchmark, usually a market interest rate benchmark (e.g., LIBOR or the Fed Funds Rate). Because the interest rate changes with changes in the market rate of interest, they maintain a relatively stable (constant) market value.
Preferred Stock Defined:
Preferred Stock Defined: ownership interest with preference claims (over common stock)
It has characteristics of both bonds and stock.
-
It is like bonds because:
- Usually does not have voting rights
- Dividends usually are limited in amount and expected (like bond interest)
-
It is like common stock because:
- Grants ownership interest
- Has no maturity date
- Does not require dividends be paid, though they are expected
- Dividends are not an expense and are not tax deductible.
Preferred Stock Characteristics I:
Preferred Stock Characteristics:
Preferred Stock Characteristics II:
Preferred Stock Valuation:
PS Valuation: PV of expected cash flows.
- Preferred cash flow is preferred dividends
- Elements use to value P/S are:
- Estimated future annual dividends
- Investors’ required rate of return
- An assumption that dividend stream will exist in perpetuity
- Cost of P/S: Annual Dividends / Net Proceeds of Stock Issuance
Example:
Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen’s tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen?
- Annual Dividend: $10
- Net Proceeds of Stock Issuance: $101 - $5 underwriting fee = $96
- $10 / $96 = 10.4%
Preferred Value Theoretical Value (PSV) Calculation:
- PSV: Annual Dividend / Required Rate of Return
- Example:
- Annual Dividend: $4
- P/S Investors’ required rate of return: 8%
- PSV: $4 / .08 = $50
Preferred Stock Expected Rate of Return (PSER) Calculation:
- PSER: Annual Dividend / Market Price
- Example:
- Annual Dividend: $4
- Market Price: $52
- PSER: $4 / $52 = 7.7%
- Current cost of P/S = 7.7%
- As the current price changes, so does the expected rate of return.
A company recently issued 9% preferred stock. The preferred stock sold for $40 a share, with a par of $20. The cost of issuing the stock was $5 a share. What is the company’s cost of preferred stock?
A. 4.5%
B. 5.1%
C. 9.0%
D. 10.3%
B. 5.1%
Cost of P/S = Annual Dividend / Net Proceeds of Stock Issuance
- Annual Dividend = $20 par x .09 = $1.80 per share
- Net Proceeds of Stock Issuance= $40 - $5 cost of issuance = $35
- $1.80 / $35 = 5.1%
Advantages and Disadvantages of Preferred Stock:
Advantages:
- No legally required periodic payments; default cannot result from failure to pay dividends;
- Generally a lower cost of capital than common stock;
- Generally does not bestow voting rights;
- No maturity date;
- No security required.
Disadvantages:
- Dividend expectations are high;
- Dividend payments are not tax deductible;
- If triggered, protective provisions may be onerous;
- Generally, a higher cost of capital than bonds.
Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock?
A. 15.6%
B. 12.0%
C. 8.4%
D. 3.6%
B. 12.0%
Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.
Common Stock Defined:
Common Stock: Basic ownership interest in a corportation.
- Regulatory requirements limit most companies to one class of CS.
- Some jurisdictions permit more than one class of CS.
Common Share Characteristics:
- Limited liability- liability is limited to amount of investment
- Residual claim on earnings and assets- a claim after creditors and preferred shareholders have been satisfied
-
Right to vote for Directors, auditors, and changes to the corporate charter
- A “proxy” is used to delegate that right
- Preemptive right - right of first refusal to acquire a proportionate share of any new CS issue.
Common Stock Valuation:
CS Valuation: PV of expected cash flows
-
CS has 2 cash flows:
- Common dividends
- CS Appreciation
-
Historic Economic Rate of Return on CS:
- (Dividends paid during period + Change in price) / Beginning Price
-
Theoretical Value of Common Stock (considering investment for multiple holding periods:
- CSV: Dividend in 1st Yr / (Required Return Rate - Growth Rate)
-
Common Stock Expected Rate of Return:
- CSER: (1st Yr Dividend / Market Price) + Growth Rate
- Return marginal (new investor) will require
- Current cost of Common Stock capital
Common Stock Advantages and Disadvantages:
Advantages:
- No legally required periodic payments. Default cannot result from failure to pay dividends;
- No maturity date;
- No security required.
Disadvantages:
- Generally a higher cost of capital than other sources;
- Dividends paid are not tax deductible;
- Additional shares issued dilute ownership and earnings.
