1. Long-Term Financing:

2. Corporate Long-Term Debt:

3. Why issue debt?
If the asset return is greater than the cost of debt, then the higher debt ratio, the higher ROE
ROE = ROA + (ROA – Cost of Debt) x Financial Leverage
The use of debt increases the volatility in ROE (and EPS)
Usually when economy is good (thus, the firm’s earnings is sound), a levered firm’s equity would have better return (than it is un-levered); otherwise when economy is poor, a levered firm’s equity would have poorer return (than it is un-levered).

4. Assets
Debt and Equity
Assets (100%)
(ROA = 20%)
Debt (50%)
Cost of Debt = 10%
Equity (50%)
Return on Equity = 30%
Assets
Debt and Equity
Assets (100%)
(ROA = 20%)
Debt (75%)
Cost of Debt = 10%
Equity (25%)
Return on Equity = 50%

5. Un-levered (Equity $175,000）
50% debt (debt $87,5000, Kd=10%, Equity $87,500)
If Expected EBIT is $35,000 (before tax ROA =20%)
Expected EBIT
$35,000
Interest Exp.
8,750
Profit before Taxes
$26,250
Income Taxes (40%)
14,000
10,500
Profit after Taxes
$21,000
$15,750
Expected ROE
$21,000/$175,000=12%
$15,750/87,500=18%
If the actual EBIT is ONLY $5,000 (before tax ROA =2.86%)
Actual EBIT
$5,000
($3,750)
2,000
1,500+
$3,000
($2,250)
Actual ROE
$3,000/$175,000=1.7%
($2,250)/87,500=-2.6%

6. Different Types of Debt
A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property.
A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years.

7. Different Types of Bonds
Callable Bonds
Put-table Bonds
Convertible Bonds
Deep Discount Bonds
Income Bonds
Floating-Rate Bonds

8. Protective Covenants Agreements to protect bondholders
Negative covenant: Thou shalt not:
pay dividends beyond specified amount
sell more senior debt & amount of new debt is limited
refund existing bond issue with new bonds paying lower interest rate
buy another company’s bonds
Positive covenant: Thou shalt:
use proceeds from sale of assets for other assets
allow redemption in event of merger or spin-off
maintain good condition of assets
provide audited financial information

9. Bond Ratings What is rated? Who pays for ratings?
The likelihood that the firm will default.
The protection afforded by the loan contract in the event of default.
Who pays for ratings?
Firms pay to have their bonds rated.
The ratings are constructed from the financial statements supplied by the firm.
What are the most important financial ratios in rating?
Interest coverage ratio and leverage ratio.
Ratings can change, and raters can disagree.

10. Bond Ratings: Investment Grade
Moody's
Duff &
Phelps
S&P's
Credit Rating
Description
Aaa 1
AAA
Highest credit rating,
maximum safety
Aa1 2
AA+
Aa2 3 AA
High credit quality,
investment -
grade bonds
Aa3 4 A1 5 A+ A2 6 A
Upper
medium quality,
investment grade bonds A3 7
Baa1 8
BBB +
Baa2 9
Lower
Baa3 10

11. Bond Ratings: Below Investment Grade
Moody's
Duff &
Phelps
S&P's
Credit Rating
Description
Speculative -
Grade Bond Ratings
Ba1 11
BB+
Low credit quality,
speculative
grade bonds
Ba2 12 BB
Ba3 13 B1 14 B+
Very low credit quality, B2 15 B B3 16
Extremely
Caa 17
CCC +
Extremely low credit
standing, high
risk bonds Ca CC
Extremely speculative C D
Bonds in default

12. Junk bonds
Anything less than an S&P “BB” or a Moody’s “Ba” is a junk bond.
A polite euphemism for junk is high-yield bond.
There are two types of junk bonds:
Original issue junk—possibly not rated
Fallen angels—rated
Current status of junk bond market
Private placement
Yield premiums versus default risk

13. Convertible Bonds Why are they issued? Why are they purchased?
Conversion ratio:
Number of shares of stock acquired by conversion
Conversion price:
Bond par value / Conversion ratio
Conversion value:
Price per share of stock x Conversion ratio
In-the-money versus out-the-money

14. Convertible Bond Prices

15. Preferred Stock

16. Preferred Stock
Represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy.
Preferred shares have a stated liquidating value, usually $100 per share.
Preferred dividends are either cumulative or noncumulative.

17. Is Preferred Stock Really Debt?
A good case can be made that preferred stock is really debt in disguise.
The preferred shareholders receive a stated dividend.
In the event of liquidation, the preferred shareholders are entitled to a fixed claim.
Unlike debt, preferred stock dividends cannot be deducted as interest expense when determining taxable corporate income.
Most U.S. preferred stock are held by corporations.
They get a 70-percent income tax exemption on dividend received.

18. Angel Investors and Preferred Stock
Preferred stock are often used by start-up firms, which are hesitated to issue common equity and are unable to use debt.
Preferred stocks have fixed dividends at the beginning, and sometimes they are able to be converted into common stocks (convertible preferred) if the firms that issued preferred have upside potential.
Issuing preferred can avoid right dilution that caused by issuing common. It can also be done by setting a high conversion price for a convertible preferred.

19. Common Stock

20. Common Stocks
Common shareholders have voting rights, limited liability, and a residual claim on the corporation.

21. Shareholders’ Rights
The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders.
Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote.
The exact mechanism varies across companies.
The important difference is whether shares are to be voted cumulatively or voted straight.

22. Classes of Stock
When more than one class of stock exists, they are usually created with unequal voting rights.
Many companies issue dual classes of common stock. The reason has to do with control of the firm.
Lease, McConnell, and Mikkelson found the market prices of stocks with superior voting rights to be about 5 percent higher than the prices of otherwise-identical stocks with inferior voting rights.

23. The Public Issue -- The Basic Procedure
Management gets the approval of the Board of Directors.
The firm prepares and files a registration statement with the SEC.
The SEC studies the registration statement during the waiting period.
The firm prepares and files an amended registration statement with the SEC.
If everything is completely satisfactory with the SEC, a price is set and a full-fledged selling effort gets underway.

24. The Process of A Public Offering
Steps in Public Offering Time
1. Pre-underwriting conferences
2. Registration statements
3. Pricing the issue
4. Public offering and sale
5. Market stabilization
Several months
20-day waiting period
Usually on the 20th day
After the 20th day
30 days after offering

25. The Process of A Public Offering
Two methods for issuing securities for cash:
Firm Commitment
Best Efforts
Two methods for selecting an underwriter
Competitive
Negotiated

26. Firm Commitment
Under a firm commitment underwriting, the investment bank buys the securities outright from the issuing firm.
Obviously, they need to make a profit, so they buy at “wholesale” and try to resell at “retail”.
To minimize their risk, the investment bankers combine to form an underwriting syndicate to share the risk and help sell the issue to the public.

27. Best Efforts
Under a best efforts underwriting, the underwriter does not buy the issue from the issuing firm.
Instead, the underwriter acts as an agent, receiving a commission for each share sold, and using its “best efforts” to sell the entire issue.
This is more common for initial public offerings than for seasoned new issues.

28. The Announcement of New Equity and the Value of the Firm
The market value of existing equity drops on the announcement of a new issue of common stock.
Reasons include
Managerial Information
Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced.
Debt Capacity
If the market infers that the managers are issuing new equity to reduce their debt-equity ratio due to the specter of financial distress, the stock price will fall.
Falling Earnings

29. The Private Equity Market
For start-up firms and firms in financial trouble, the public equity market is often not available.
Avoid the costly procedures associated with the registration requirements that are a part of public issues.
The SEC restricts private placement issues to no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds.
The biggest drawback is that the securities cannot be easily resold.

30. Venture Capital
The limited partnership is the dominant form of intermediation in this market.
There are four types of suppliers of venture capital:
Old-line wealthy families.
Private partnerships and corporations.
Large industrial or financial corporations have established venture-capital subsidiaries.
Individuals, typically with incomes in excess of $100,000 and net worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.