Long-Term Sources of Funds: Debt, Preferred, and Common Stock

LONG-TERM SOURCES OF FUNDS
Debt, Preferred, and Common Stock
Bond
Bond: A long-term debt instrument issued by a corporation or government. Par Value: Also called Face Value or Principal represents the amount to be paid at maturity. Coupon Rate: Stated rate of interest on a Bond. Issuer pays on every par value bond annually.
Trustee: A person or institution designated by a bond issuer as the official representative of bondholders. Typically, a bank serves as trustee. Indenture: The legal agreement between the corporation issuing bonds and bondholders, establishing the terms of bond issue and naming the trustee. Bond Ratings: Where creditworthiness is often judged by investment rating agencies. Opinions are given in the form of letter grades.
Long-Term Debt Instruments: Types

DEBENTURES A long-term, unsecured instrument of a corporation. Debenture holders become general creditors of the firm in the event of company liquidation. Therefore, investors look to the earning power of the firm as their security.
INCOME BONDS Bond where payment of interest is contingent on sufficient earnings of the firm. If firm generates earnings in future, it will have to pay the cumulative interest to the extent that earnings permit. Cumulative obligation limited to 3 years.
JUNK BONDS A high-risk, high-yield (often unsecured) bond rated below investment grade. MORTGAGE BONDS A bond issue secured by a mortgage on the issuers property fixed assets. If the corporation defaults, the trustee has the power to foreclose. In a foreclosure, trustee takes over the property and sells it. The proceeds are paid to the bondholders.
EQUIPMENT TRUST CERTIFICATES A security, usually issued by a transportation company, that is used to finance new equipment. For example, the railways arranges with a trustee to purchase equipment from a manufacturer. When the equipment is delivered, the ETCs are sold to investors. The proceeds of this sale, together with down payment by railways, are used to pay the manufacturer.
ASSET SECURITIZATION Process of taking a cash-flow producing asset, packaging it into a pool of similar assets, and then issuing securities backed by the asset pool. For example, if a firm needs cash but doesnt have a high enough credit rating to make a bond issue economical. So it picks assets to package, removes them from its balance sheet, and sells them to a SPV. In this way, if the firm ever went bankrupt, its creditors couldnt seize the packaged assets. The SPV, in turn, raises money by selling securities backed by the assets just purchased from the firm.
Retirement of Bonds
The retirement (repayment) of bonds may be accomplished in a number of different ways. By making single-sum payment at maturity. By conversion if bonds are convertible. By calling the bonds (subject to call feature). By periodic repayment (sinking funds).
Preferred Stock
Is a hybrid form of financing, combining features of debt and common stock. Such stockholders, in the event of liquidation, have claim on assets after the creditors but before the common stockholders. This claim is restricted to par value of the stock.
VOTING RIGHTS (Special Situations) Because of their prior claim on assets and income, PSs are not normally given voice in management. Under such circumstances PSs would be entitled to elect a specific number of directors.
Common Stock
The common stockholders of a company are its ultimate owners. Collectively, they own the company and assume the ultimate risk associated with ownership. Their liability, however, is restricted to the amount of their investment. They have a residual claim on the assets. CS has no maturity date. But can liquidate by selling their stocks in the secondary market.
Features
AUTHORIZED, ISSUED, & OUTSTANDING The corporate charter specifies the number of authorized shares of CS. When authorized shares are sold, they become issued shares. The number of shares issued and actually held by the public refers to outstanding shares. The company can buy back part of its issued stock and hold it as treasury stock.
PAR VALUE A share of CS can be authorized either with or without par value. The par value of CS is merely a recorded figure in the corporate charter and is of little economic significance. CS that is authorized without par value (no-par stock) is carried on the books at the original market price or at some assigned (or stated) value. Assigned value refers to a no-par CS usually far below the actual issuing price.
BOOK VALUE & LIQUIDATING VALUE The BV per share is the shareholders equity total assets minus liabilities. Often assets are sold for less than their book values, particularly when liquidating costs are involved. For the company involved, LV may be higher than the BV.
MARKET VALUE MV per share is the current price at which the stock is traded. MV of a common stock is a function of the current and expected future dividends and the perceived risk of the stock on the part of investors. Typically, shares of a newer company are traded in the OTC market, where one or more security dealers maintain an inventory in the common stock and buy & sell it at the bid and ask prices that they quote.
VOTING RIGHTS Entitled to elect board of directors. Usually exercise indirect control through the BODs they elect. When goals differ (mgt. V/s shrholders), the shareholders can effect management through the BODs. Voting can be done either in person or by proxy at the annual meetings.
Proxy refers to a legal document giving one person the authority to act for another. In business, in generally refers to the instructions given by a shareholder with regard to voting shares of common stock. BODs are elected under a majority-rule voting system. These depend on the corporate charter.
Majority-Rule System Stockholders have one vote for each share of stock that they own, and they must vote for each director position that is open. A stockholder who owns 100 shares will be able to cast 100 votes for each directors position open. Management can select entire BODs if it can obtain proxies for over 50% of shares voted.
Cumulative Voting System A stockholder is able to accumulate votes and cast them for less than the total number of directors being elected. The total number of votes for each stockholder is equal to the number of shares owned times the number of directors being elected. A stockholder who owns 100 shares and 12 directors are to be elected, then 100 x 12 = 1200 votes may be cast for one director.
Term Loans
Also refers to long-term debt or term finance. Historically, TLs given by FI and banks have been the primary source of longterm debt for private and most public firms. Employed to finance acquisition of fixed assets and working capital margin.
Features of Term Loans

Currency: Given domestic currency and foreign currency term loans. Security: Term loans typically represent secured borrowing. Interest payment & Principal repayment: They are definite obligations that are payable irrespective of the financial situation of the firm.
Comparative Picture
Cost Equity RE Preference Term Loan Debentures high high high low low Dilution of Control Risk yes no no no no nil nil neg. high high Restraint on MF no no no moderate some
MF = Managerial Freedom

Long-Term Sources of Funds: Debt, Preferred, and Common Stock

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LONG-TERM SOURCES OF FUNDS

Debt, Preferred, and Common Stock

Long-Term Debt Instruments: Types

Features of Term Loans

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