Long-Term Financing

Basics of Long-Term Financing

Types of Long-Term Financing Common stock Long-term debt Preferred stock Leasing Option-type security Warrant Convertible

Factors Influencing Long-Term Financing Decisions Target capital structure Maturity matching Interest rate The firm’s current and forecasted conditions Other factors

Common Stock

Common stock means different things to different people, but it is usually applied to stock that has no special preference either in receiving dividends or in bankruptcy. The common stockholders are the owners of a corporation.

Legal Rights and Privileges of Common stock Control of the firm The stockholders have the right to elect the firm’s directors, who in turn elect the officers who manage the business. The problem of control has become a central issue in finance in recent years. The Preemptive Right A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rat basis new issues of common stock or convertible securities. Other rights and privileges

Major Advantages of Common Stock Financing There is no obligation to make fixed payments. Common stock never matures. The use of common stock increases the creditworthiness of the firm. Stock often can be sold on better terms than debt.

Major Disadvantages of Common Stock Financing The costs of stock financing are high. Using stock can raise the firm’s cost of capital. Dividends paid on common stock are not tax deductible. It extends voting privileges to new stockholders. New stockholders share in the firm’s profits.

The Market for Common Stock Organized security exchange market Over-the-counter market Types of stock market transaction Trading in the outstanding shares of established, publicly owned companies: the secondary market Additional shares sold by established, publicly owned companies: the primary market New public offerings by privately held firm: the primary market.

The Investment Banking Process Raising capital: Stage I decisions Amount to be raised Types of securities used. Competitive bid vs. negotiated deal. Selection of an investment banker. Raising capital: Stage II decisions Reevaluating the initial decisions Underwritten issues Issuance costs Setting the offering price Selling procedures

Long-Term Debt

Debt Instruments Term loans – a long-term debt contract under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender. Bond – a long-term under which a borrower agrees to make a series of interest and principal payments on specific dates to the holder of the bond.

Bond Rating Bond ratings are based on both qualitative and quantitative factors, including the financial strength of the company as measured by various ratios, collateral provisions, seniority of the debt, restrictive covenants, provisions such as a sinking fund, litigation possibilities, regulation and so on. Bond ratings are important both to firms and to investors. Indicate its default risk and influence the bond’s interest rate and the firm’s cost of debt. Institutional investors are restricted to investment-grade securities. Changes in a firm’s bond rating affect both its ability to borrow long-term capital and the cost of that capital.

Hybrid Financing

Preferred Stock A hybrid security having characteristics of debt and equity. Similar to debt: it has a claim on the firm’s earnings ahead of the claim of the common stockholders. Similar to equity: debtholders have a prior claim on the firm’s income and assets. Major provisions Priority to assets and earnings Par value Dividends Convertibility

Pros and Cons of Preferred Stock Pros Preferred dividends are limited Failure to pay preferred dividends will not bankrupt the firm Cons The cost of preferred stock is higher than that of a debt because preferred dividends payments are not tax deductible.

Leasing A means of obtaining the use of an asset without purchasing the asset. Leasing is similar to a loan and is used by financial managers as an alternative to borrowing to purchase fixed assets. Types of lease Sale and leaseback - an operation whereby a firm sells land, buildings or equipment and simultaneously leases the property back for a specified period under specific terms Operating lease – a lease under which the lessor maintains and finances the property. Financial lease – a lease that does not provide for maintenance services, is not cancellable and is fully amortized over its life.

Option A contract that gives the option holder the right to buy or sell an asset at some predetermined price within a specified period of time. Option features are used by firms to “sweeten” debt offerings. Option-type securities, particularly warrants and convertibles, are attractive to investors because they allow debtholders to acquire common stock at bargain prices and thus to share in the capital gains if a company is especially successful.

Warrant A long-term option to buy a stated number of shares of common stock at a specified price. A warrant will be exercised if it is about to expire and the stock price is above the exercise price.

Convertible A security, usually a bond or preferred stock, that is exchangeable at the option of the holder for the common stock of the issuing firm. Conversion ratio (CR) is the number of shares of common stock that can be obtained by converting a convertible bond or a share of convertible preferred stock. Conversion price = Par value of bond / CR