Long-term financing

Review item  When a firm creates value through a financial transaction, who gets the increase?

Answer  Old equity means the shareholders at the time the decision is made.  Old equity gets the gains.  Why? Old equity has no competitors. Everyone else is competitive and must accept a market return.

Chapter 14 Long-Term Financing: An Introduction  Common Stock  Corporate Long-term Debt: The Basics  Preferred Stock  Patterns of Financing

Shareholders rights  Preemptive right to a proportionate share of any new stock sold.  Proportionate share in dividends.  Proportionate share in liquidation.  Voting rights … of some kind

Straight voting  Each seat on the board of directors is a separate election.  In each election, the shareholder has votes in proportion to her shares.  A thin majority can freeze out minority directors.

Cumulative voting  All directors are elected in a single election.  The n highest vote getters are elected.  Each shareholder has votes in proportion to her shares.  When can a elect at least one director?

How many votes are needed to elect one director?  n directors.  Minority has fraction x of all votes.  The majority plays optimally.  Majority votes (1-x)/n for each of n seats (no cheap seats).  Minority needs x > (1-x)/n, that is, x > 1/(n+1)  x = 1/(n+1) plus one vote

Example  Adam Smith and Alfred Marshall  Four seats.  Smith is the minority, needs 1/5 of the votes to elect one director.  Check: Smith has 1/5 + 1 vote. Marshall can muster 3/5 of the total votes for 3 candidates and 1/5 – 1 votes for the fourth. The fourth loses. Smith gets a director.

Example: majority lacks discipline  Hamas has 40% of the voters.  Fatah has 60%.  6 seats to be filled.  Hamas runs 4 candidates, gets 10% per candidate  Fatah runs 10 candidates, gets 6% per candidate.  Hamas gets 4 of the 6 seats.  Fatah could have had 4 of 6.

Dividend facts  Dividends are not tax deductible to the corporation that pays them.  Corporations owning other corporations are exempt from 70% of the tax that would otherwise fall on dividends.  Skipping dividends does not put a firm in default.

Debt  Contractual relation with the firm, via the indenture.  No voting rights.  Interest is deductible from corporate taxes.  Missing any interest payment puts the firm in default.

Notes, debentures, bonds  Notes are shorter term, unsecured.  Debentures are long term, unsecured.  (Mortgage) bonds are secured.

Sinking funds  Debt is gradually extinguished.  Money in the fund buys back the bonds steadily.

Call provisions  Specified in the indenture.  Call price is above par …  but is below market when called.  Call protection for 5 or 10 years

Indenture  Among creditors, a coordination problem. Prisoner’s dilemma. Free rider problem.  Solution: trustee (a law firm)  Restrictive covenants -- new debt, size of dividends, minimum working capital

Default of bonds  If the firm misses a debt payment to any bond, repayment of all other bonds is immediately due, an impossible task.  Bondholders get control of the firm.  Bankruptcy proceedings or reorganization.

Preferred stock  Stated percentage dividends.  No voting rights.  Preferred dividends can be skipped but are rarely, and only if common dividends are skipped.  Contingent voting rights when the firm is near bankruptcy.

Corporations hold preferred stock  Not individuals, because taxes are higher to them.  Individuals hold preferred by holding common in firms that hold preferred.  Corporations pay tax on interest from the debt of other corporations but only 30% on preferred dividends.

The Long-Term Financial Deficit (2002) Sources of Cash Flow (100%) Internal cash flow (retained earnings plus depreciation) 97% Long-term debt and equity 3% Uses of Cash Flow (100%) Capital spending 98% Net working capital plus other uses 2% Internal cash flow External cash flow Financial deficit

Financing Decisions by U.S. Non-financial Corporations Internal financing New debt New stock Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. Year Percent

Convertible debt – an option  Can be traded for shares at a fixed price.  Need not be traded.  Rationale: cash in on success if the firm becomes vary valuable  Retain rights of debt if the firm fails.

Debt-to-Asset Ratio (Book Value) for U.S. Non-financial Firms from 1979 to Year Percent Source: OECD data from the 1995 edition of Financial Statements of Nonfinancial Enterprises.

Debt-to-Asset Ratio (Market Value) for U.S. Non-financial Firms from 1980 to Year Percent Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.