Corporate Finance Ross Westerfield Jaffe

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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

14Chapter Fourteen

Long-Term Financing: An Introduction

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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Chapter Outline

14.1 Common Stock

14.2 Corporate Long-Term Debt: The Basics

14.3 Preferred Stock

14.4 Patterns of Financing

14.5 Recent Trends in Capital Structure

14.6 Summary and Conclusions

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14.1 Common Stock

• Par and No-Par Stock• Authorized versus Issued Common Stock• Contributed Surplus• Retained Earnings• Market Value, Book Value, and Replacement Value• Shareholders’ Rights• Dividends• Classes of Stock

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Par and No-Par Stock

• The stated value on a stock certificate is called the par value.– Par value is an accounting value, not a market value.

– The total par value (the number of shares multiplied by the par value of each share) is sometimes called the dedicated capital of the corporation.

• Some stocks have no par value.– Typically in Canada, there is no particular par value

assigned to stock.

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Authorized vs. Issued Common Stock

• The articles of incorporation must state the number of shares of common stock the corporation is authorized to issue.

• The board of directors, after a vote of the shareholders, may amend the articles of incorporation to increase the number of shares.– Authorizing a large number of shares may worry

investors about dilution because authorized shares can be issued later with the approval of the board of directors but without a vote of the shareholders.

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Contributed Surplus

• Usually refers to amounts of directly contributed equity capital in excess of the par value.– For example, suppose 1,000 shares of common stock

having a par value of $1 each are sold to investors for $8 per share. The contributed surplus would be

($8 – $1) × 1,000 = $7,000

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Retained Earnings

• Not many firms pay out 100-percent of their earnings as dividends.

• The earnings that are not paid out as dividends are referred to as retained earnings.

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Market Value, Book Value, and Replacement Value

• Market Value is the price of the stock multiplied by the number of shares outstanding. – Also known as Market Capitalization

– Common stocks of Canadian corporations trade on Canadian stock exchanges (TSE, MSE, ASE, VSE) and U.S. stock exchanges (NYSE, NASDAQ).

• Book Value– The sum of par value, contributed surplus, accumulated

retained earnings, and adjustments to equity is the common equity of the firm, usually referred to as the book value of the firm.

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Market Value, Book Value, and Replacement Value (continued)

Example:TransCanada Pipelines Limited

Shareholder’s Equity at Book Value, 2000

(in $ thousands)

Common stock and other

shareholders’ equity $5,898,000

Retained earnings 414,000

Contributed surplus 263,000

Foreign exchange adjustment 13,000

Total shareholders’ equity $6,588,000

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Market Value, Book Value, and Replacement Value (continued)

• Replacement Value– The current cost of replacing the assets of the firm.

• At the time a firm purchases an asset, market value, book value, and replacement value are equal.– The market-to-book ratio of common stock and Tobin’s

Q (market value of assets / replacement value of assets) are indicators of the success of the firm.

– If these ratios are greater than one, then this indicates that the firm has done well with its investment decisions.

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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.

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Cumulative versus Straight Voting

• The effect of cumulative voting is to permit minority participation.– Under cumulative voting, if there are N directors up for

election, then 1/(N+1) percent of the stock plus one share will guarantee you a seat.

– With cumulative voting, the more seats that are up for election at one time, the easier it is to win one.

• Straight voting works like a U.S. political election.– Shareholders have as many votes as shares and each

position on the board has its own election.

– A tendency to freeze out minority shareholders.

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Cumulative vs. Straight Voting: Example

• Imagine a firm with two shareholders: Mr. MacDonald and Ms. Laurier. – Mr. MacDonald owns 60% of the firm ( = 600 shares)

and Ms. Laurier 40% ( = 400 shares).

– There are three seats up for election on the board.

• Under straight voting, Mr. MacDonald gets to pick all three seats.

• Under cumulative voting, Ms. Laurier has 1,200 votes ( = 400 shares × 3 seats) and Mr. MacDonald 1,800 votes.

• Ms. Laurier can elect at least one board member.

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Proxy Voting

• A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares.

• For convenience, the actual voting in large public corporations is usually done by proxy, e.g. BCE Inc.

• If shareholders are not satisfied with management, an outside group of shareholders can try to obtain as many votes as possible via proxy.

• Proxy battles are often led by large pension funds like the Ontario Teachers’ Pension Board or the Caisse de Dépôt.

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Dividends

• Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. – A corporation cannot default on an undeclared dividend.

• The payment of dividends by the corporation is not a business expense. – Therefore, they are not tax-deductible.

• Dividends received by individual shareholders are partially sheltered by a dividend tax credit. (Appendix of Chapter 1)

• There is a pension for Canadian corporations to avoid the double taxation of dividends.

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Classes of Shares

• When more than one class of share 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.– Amoako-Adu and Smith show that firms going public

with dual classes of shares in Canada are often family controlled.

• Lease, McConnell, and Mikkelson found the market prices of U.S. stocks with superior voting rights to be about 5-percent higher than the prices of otherwise-identical stocks with inferior voting rights.

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14.2 Corporate Long-Term Debt: The Basics

• Interest versus Dividends• Is It Debt or Equity?• Basic Features of Long-Term Debt• Different Types of Debt• Repayment• Seniority• Security • Indenture

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Interest versus Dividends

• Debt is not an ownership interest in the firm. Creditors do not usually have voting power.

• The device used by creditors to protect themselves is the loan contract (i.e., indenture).

• The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. Dividends are paid out of after-tax dollars.

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Interest versus Dividends (continued)

• Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm.– One of the costs of issuing debt is the possibility of

financial failure.

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Is It Debt or Equity?

• Some securities blur the line between debt and equity.

• Corporations are very adept at creating hybrid securities that look like equity but are called debt. – Obviously, the distinction is important at tax time.

– A corporation that succeeds in creating a debt security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs.

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Basic Features of Long-Term Debt

• The bond indenture usually lists– Amount of Issue, Date of Issue, Maturity– Denomination (Par value)– Annual Coupon, Dates of Coupon Payments– Security– Sinking Funds– Call Provisions– Covenants

• Features that may change over time– Rating– Yield-to-Maturity– Market Price

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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 seven years.

• Debentures and bonds are long-term debt, i.e., payable more than one year from the date they are originally issued.

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Repayment

• Bonds can be repaid at maturity or earlier through the use of a sinking fund.

• A sinking fund is an account managed on behalf of the issuer by a bond trustee for the purpose of retiring all or part of the bonds prior to their stated maturity.

• Debt may be extinguished before maturity through a call provision giving the firm the right to pay a specific amount to retire the debt before the stated maturity date.

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Seniority

• Seniority indicates preference in position over other lenders.

• Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

• Debt cannot be subordinated to equity.

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Security

• Security is a form of attachment to property.– It provides that the property can be sold in event of

default to satisfy the debt for which the security is given.

– A mortgage is used for security in tangible property.

For example, debt can be secured by mortgages on plant and equipment.

– Debentures are not secured by a mortgage.

– If mortgaged property is sold in the event of default, debenture holders will obtain something only if the mortgage bondholders have been fully satisfied.

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Indenture

• The written agreement between the corporate debt issuer and the lender.

• Sets forth the terms of the loan:– Maturity

– Interest rate

– Protective covenants

Examples:

- restrictions on further indebtedness,

- a maximum on the amount of dividends that can be paid,

- a minimum level of working capital.

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14.3 Preferred Shares

• 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. For example, CIBC “$2.25 preferred” translates into a dividend yield of 9% of the stated $25 value.

• Preferred dividends are either cumulative or noncumulative.

• Firms may have an incentive to delay preferred dividends, since preferred shareholders receive no interest on the cumulated dividends.

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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.

• Some preferred shares have adjustable dividends. An example is the CARP (cumulative, adjustable rate, preferred).

• In Canada, corporate investors have an incentive to hold preferred shares issued by other corporations, since 100% of the dividends they receive are exempt from income taxes.

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The Preferred Shares and Taxes

• In Canada, a tax loophole encourages corporations that are lightly taxed to issue preferred shares.

• Low-tax companies can make little use of the tax deduction on interest.

• They can issue preferred shares and enjoy lower financing costs since preferred dividends are significantly lower than interest payments.

• There are several reasons beyond taxes why preferred shares are issued:

– Regulated public utilities can pass the tax disadvantage of issuing preferred shares on their customers.

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The Preferred Shares and Taxes (continued)

– Firms issuing preferred shares can avoid the threat of bankruptcy that might otherwise exist if debt were relied on.

– Issuing preferred shares may be a means of raising equity without surrendering control.

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14.4 Patterns of Financing

• For Canadian firms, internally generated cash flow dominates as a source of financing.

• Firms usually spend more than they generate internally—the gap is financed by new sales of debt and equity.

• Net new issues of equity are dwarfed by new sales of debt.

• This is consistent with the pecking order hypothesis.• Leverage ratios for Canadian firms are considerably

higher than they were in the 1960s.

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The Long-Term Financial Gap

Sources of Cash Flow (100%)

Internal cash flow (retained earnings plus depreciation)

68.3%

Long-term debt and

equity 31.7%

Uses of Cash Flow (100%)

Capital spending

Net working

capital plus other uses

Internal cash flow

External cash flow

Financial deficit

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14.6 Summary and Conclusions

• The basic sources of long-term financing are:– Long-Term Debt– Common Stock– Preferred Stock

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

• Bondholders have a contractual claim against the corporation.

• Preferred stock has some of the features of debt and equity.

• Firms need financing—most of it is generated internally.