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CPA - BEC > Long-term Financing > Flashcards

Flashcards in Long-term Financing Deck (16):

Long-term Financing

Capital financing - Primary source of financing for most firms


Long-term notes

Require collateral and often contain restrictive covenant that impose restrictions on borrower so as to reduce likelihood of default


LT Covenants

1) Maintaining certain working capital conditions - Maintain minimum dollar amount of working capital or ratio

2) Additional incurrence of debt - Lender approval before taking on additional long-term debt

3) Frequency and nature of financial information

4) Management changes


Financial Leases

Leasing, rather than buying, is an alternative way of financing the acquisition of certain assets. When leasing is an option for acquiring assets in a capital budgeting project, evaluation of the project has to take into account

A financial lease is a legally enforceable, noncancelable contract under which the lessee commits to making a series of payments to the owner of the asset (lessor) for the use of the asset over the period of the lease. Thus, for financial analysis purposes, whether the lease is, in effect, a sale - the concept underlying the designation for capital lease in accounting—is not relevant. Practically, however, both categories (financial and capital) reflect the same consequence for financing—the use of an asset is acquired at the present with the cost being incurred over multiple future periods. (In both finance and accounting, operating leases are considered more like renting than a means of financing asset acquisition and are not particularly relevant here).


Net Leases vs Net-net Leases

In finance, leases are described as being net leases or net-net leases to identify which costs of the asset are the responsibility of the lessee. In a net lease, the lessee assumes the cost associated with ownership during the period of the lease. Normally, these costs are referred to in accounting as executory costs and include maintenance, taxes, and insurance. In a net-net lease, the lessee is responsible for not only the executory costs, but also a pre-established residual value. The particular nature—lease, net lease, or net-net lease—will affect the cost of the lease to the lessee and, therefore, the viability and benefits of leasing.



Long-term promissory notes wherein promises are to pay a fixed amount of interest each year and to repay face value @ maturity


Characteristics of Bonds

Indenture - Bond contract, states terms of the bond

Par value or face value - the "principal" that will be returned @ maturity, most common $1,000 per bond

Coupon rate of interest - the annual interest rate printed on the bond and paid on par value

Maturity - the time at which the issuer repays the par value to the bondholders



Major difference in bonds is whether bond issue is secured by collateral;

Debenture bonds - Unsecured

Secured bonds - specific sets designated as collateral

Mortgage bonds - secured by a lien on real property


Callable bonds are most commonly used to enable issuing firm to call in outstanding bonds if market rate declines

Bonds with a callable feature usually pay a higher rate of interest

CONVERTIBILITY - Bond holder has the option of converting bonds into specific equity; usually pay a lower rate of interest

ZERO COUPON BONDS - Does not pay interest during its life; sell at deep discounts and paying full value @ maturity

Floating rate bonds - Pay a rate of interest that fluctuates over the life of the instrument; rate of interest paid is tied to macroeconomic benchmark rate


Bond Values

Bond's selling price determined by Periodic Interest and Maturity Face Value;

Both cashflows would be discounted using market required rate of return


Bond Yields

Current Yield - Ratio of annual interest payments to current market price of the bond

CY = Annual Coupon Interest / Current Market Price

Yield to Maturity - Expected Rate of Return - Rate of return required y investors as implied by the current market price of the bonds ; Determining the yield to maturity is done by determining the discount rate that equates the present value of future cash flows from the bond issue with the current price of the bonds


Term Structure of Interest Rates

Term structure of interest rates (yield curve) shows current yield to maturity (rate of return) on bonds of similar quality. Commonly plotted with interest rates on vertical axis and time until maturity on horizontal axis


Preferred Stock

Has characteristics of bonds and stock;

Like bonds because no voting rights, dividends (like interest)

Like common stock because (not tax deductible)


Preferred Stock Valuation

PS value is the resent value of expected cash flows - Preferred cash flow is Preferred dividends

Elements used to value preferred stock are:
Estimated future annual dividends, Investors' required rate of return, An assumption that dividend stream will exist in perpetuity

PSV = Annual Dividend/Required Rate of Return;

Preferred stock expected rate of return (PSER)

Annual dividend/Market Price = PSER


Preferred Stock Cost Equation

The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares


Common Stock

Regulatory limits usually limit to one class of common stock;

Liability of shareholder limited to amount of investment; Residual claim on earnings and assets; Has right to vote


CS Valuation

PV of expected cash flows:

Common Dividends
CS stock Appreciation

CSV = PV of dividends expected + PV of expected market price @ end of one year (or less)


Assuming CS is held for multiple periods -

CSV = 1st year dividend/(required rate of return - growth rate)

Common Stock Expected Rate of Return (CSER) - (1st year dividend/market price) + growth rate

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