Long-Term Financing:. Corporate Long-Term Debt: Why issue debt? If the asset return is greater than the cost of debt, then the higher debt ratio, the.

Long-Term Financing:

Corporate Long-Term Debt:

Why issue debt? If the asset return is greater than the cost of debt,

then the higher debt ratio, the higher ROEROE = 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).

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%

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 $35,000

Interest Exp. 0 8,750

Profit before Taxes $35,000 $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 $5,000

Interest Exp. 0 8,750

Profit before Taxes $5,000 ($3,750)

Income Taxes (40%) 2,000 1,500+

Profit after Taxes $3,000 ($2,250)

Actual ROE $3,000/$175,000=1.7% ($2,250)/87,500=-2.6%

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.

Different Types of Bonds

Callable Bonds Put-table Bonds Convertible Bonds Deep Discount Bonds Income Bonds Floating-Rate Bonds

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 int

erest 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

Bond Ratings What is rated?

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.

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 AA - A1 5 A+ A2 6 A Upper -medium quality,

investment grade bonds A3 7 A - Baa1 8 BBB

+

Baa2 9 BBB Lower -medium quality, investment grade bonds

Baa3 10 BBB -

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 BB - B1 14 B+ Very low credit quality,

speculative -grade bonds B2 15 B B3 16 B -

Extremely Speculative -Grade Bond Ratings Caa 17 CCC

+ Extremely low credit standing, high -risk bonds

CCC CCC - Ca CC Extremely speculative C C D Bonds in default

Junk bonds Anything less than an S&P “BB” or a Moody’s “B

a” 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

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

Convertible Bond Prices

50

60

70

80

90

100

110

120

130

140

150

50 70 90 110 130 150

Conversion value (% of par)

Bo

nd

pri

ce (

% o

f p

ar)

Convertible bond price

Nonconvertible bond price

Stock price

Preferred Stock

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.

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.

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.

Common Stock

Common Stocks

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

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.

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.

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.

The Process of A Public Offering

Steps in Public Offering Time1. 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

The Process of A Public Offering

Two methods for issuing securities for cash:Firm CommitmentBest Efforts

Two methods for selecting an underwriterCompetitiveNegotiated

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.

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.

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 InformationSince the managers are the insiders, perhaps they are selling new stock because they think it is overpriced.

Debt CapacityIf 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

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.

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.