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Chapter 20Chapter 20

Long-Term Debt, Long-Term Debt, Preferred Stock, Preferred Stock,

and Common Stockand Common Stock

Long-Term Debt, Long-Term Debt, Preferred Stock, Preferred Stock,

and Common Stockand Common Stock

© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI

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After studying Chapter After studying Chapter 20, you should be able 20, you should be able to:to:

Understand the terminology and characteristics of bonds, preferred stock, and common stock.

Explain how the retirement (repayment) of bonds and preferred stock may be accomplished in a number of different ways.

Explain the differences between various types of long-term securities in terms of claims on income and assets, maturities, security holders' rights, and the tax treatment of income from the securities.

Discuss the advantages and disadvantages of issuing/buying the three different types of long-term securities from both the perspective of the issuer and investor. School.edhole.com

Long-Term Debt, Preferred Long-Term Debt, Preferred Stock, and Common StockStock, and Common Stock

Bonds and Their Features Types of Long-Term Debt Instruments Retirement of Bonds Preferred Stock and Its Features Rights of Common Shareholders Dual-Class Common Stock

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Bonds and Their FeaturesBonds and Their Features

Basic Terms Basic Terms Par Value Coupon RateMaturity Bond Ratings

Bond Bond -- A long-term debt instrument with a final maturity generally being

10 years or more.

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Trustee and IndentureTrustee and Indenture

Trustee Trustee -- A person or institution designated by a bond issuer as the official

representative of the bondholders. Typically, a bank serves as trustee.

Indenture Indenture -- The legal agreement, also called the deed of trustdeed of trust, between the corporation

issuing bonds and the bondholders, establishing the terms of the bond issue and

naming the trustee.School.edhole.com

Types of Long-Term Debt Types of Long-Term Debt InstrumentsInstruments

Investors look to the earning power of the firm as their primary security.

Investors receive some protection by the restrictions imposed in the bond indenture, particularly any negative-pledge clausenegative-pledge clause.

A negative-pledge clause negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors.

Debenture Debenture -- A long-term, unsecured debt instrument.

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In this case, subordinated debenture holders rank behind debenture holders but ahead of preferred and common stockholders in the event of liquidation.

Frequently, the security is convertible into common stock to lower the yield required by subordinated debenture holders (often less than regular debentures).

Subordinated Debenture Subordinated Debenture -- A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of

debt; known as junior debt.

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Frequently, there is a cumulative feature, cumulative feature, which provides that any unpaid interest in a particular year accumulates. The cumulative obligation is usually limited to no more than three years.

The bonds are unpopular with investors (usually limited to reorganizations), but are still senior to preferred and common shareholders in the event of liquidation.

Income Bond Income Bond -- A bond where the payment of interest is contingent upon sufficient

earnings of the firm.

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These are bonds with a rating of Ba (Moody's) or lower.

Principal investors are pension funds, high-yield bond mutual funds, and some individual investors.

Liquidity varies depending on investor sentiments.Junk bonds were used frequently in the 1980s as a

means of financing leveraged buyouts (LBOs).

Junk Bond Junk Bond -- A high-risk, high-yield (often unsecured) bond rated below investment

grade.

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The issue is secured by a lienlien on specific specific assets assets of the corporation.

The market value of the collateral should exceed the amount of the bond issue by a reasonable margin of safety to help protect bondholders.

Mortgage Bond Mortgage Bond -- A bond issue secured by a mortgage on the issuer’s property.

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If the corporation defaults, the trustee can foreclose on behalf of the bondholders. The bondholders become general creditors for any residual amount after the sale of the collateral.

The corporation may have a first mortgage and a second mortgage on the same assets. The first mortgage has a senior claim on the assets.

Mortgage BondMortgage Bond (Continued)

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A railroad arranges with a trustee to purchase equipment from a manufacturer.

The railroad signs a contract with the manufacturer for the construction of specific equipment.

When the equipment is delivered, equipment trust certificates are sold to investors.

Equipment Trust Certificate Equipment Trust Certificate -- An intermediate- to long-term security, usually issued by a transportation company such as a railroad or airline, that is used to

finance new equipment.

Let us look at an example using a railroadLet us look at an example using a railroad..

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Proceeds plus the railroad downpayment are used to pay the manufacturer.

Title of the equipment is held by the trustee, and the trustee leases the equipment to the railroad.

Lease payments are used to pay a fixed dividend to the certificate holders and to retire a specified portion of the certificates at regular intervals.

After the final lease payment (all certificates are retired), title to the equipment passes to the railroad.

Equipment Trust CertificatesEquipment Trust Certificates (Continued)

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Asset SecuritizationAsset Securitization

Purpose: To reduce financing costs Firm picks assets to “package” and use cash flows Assets removed from the balance sheet and sold to

bankruptcy-remote entity (special-purpose vehicle -- SPV) SPV raises money by selling asset-backed securities

Asset Securitization Asset Securitization – The process of packaging a pool of assets and then selling interests in the pool in

the form of asset-backed securities.

Asset-backed SecurityAsset-backed Security – Debt securities whose interest and principal payments are provided by the cash flows coming from a discrete pool of assets.

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Retirement of BondsRetirement of Bonds

The corporation makes a cash payment to the trustee, which calls the bonds.

The corporation purchases bonds in the open market and delivers them to the trustee.

Sinking Fund Sinking Fund -- Fund established to periodically retire a portion of a security issue before

maturity. The corporation is required to make periodic sinking-fund payments to a trustee.

Two forms for the sinking-fund Two forms for the sinking-fund retirement of a bondretirement of a bond::

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Sinking Fund and the Sinking Fund and the Retirement of BondsRetirement of Bonds

When bonds are called for redemption, the bondholders will receive the sinking-sinking-fund call pricefund call price.

The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street Wall Street JournalJournal.

Bonds should be purchased in the open market if the market price is less than the sinking-fund call pricesinking-fund call price.School.edhole.com


Volatility in interest rates or a decline in the credit quality of the firm could lower the market price of the bond and enhance the value to the firm of having this option.

Bondholders may benefit from the orderly retirement of debt (amortization effect), which reduces the default risk of the firm and adds liquidity to bonds outstanding.

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Many bond issues are designed to have a larger final payment to pay off the debt.

For example, a corporation may undertake a $10 million, 15-year bond issue. The firm is obligated to make $500,000 sinking-fund payments in the 5th through 14th years. The final balloon payment in the 15th year would be for the remaining $5 million of bonds.

Balloon Payment Balloon Payment -- A payment on debt that is much larger than other payments.

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Serial BondsSerial Bonds

For example, a $10 million issue of serial bonds might have $500,000 of predetermined bonds maturing each year for 20 years.

Investors are able to choose the maturity that best fits their needs (wider investor appeal).

Serial Bonds Serial Bonds -- An issue of bonds with different maturities, as distinguished from

an issue where all bonds have identical maturities (term bonds).

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Call ProvisionCall Provision

Not all bonds are callable. In periods of low interest (hence, low coupon) rates, firms are more likely to issue noncallable bonds.

When a bond is callable, the call pricecall price is usually above the par value of the bond and often decreases over time.

Call Provision Call Provision -- A feature in an indenture that permits the issuer to repurchase securities at a fixed price (or series of fixed prices) before

maturity; also called call featurecall feature.

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Call PriceCall Price

For example, the call price for the first year might equal the bond par value plus one-year’s interest.

According to when they can be exercised, call provisions can be either immediate or deferred.

The call provision provides financing flexibility for the firm as conditions change.

Call Price Call Price -- The price at which a security with a call provision can be purchased by the

issuer prior to the security’s maturity.

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Value of the Call PrivilegeValue of the Call Privilege

The call privilege is valuable to the firm to the detriment of bondholders. As such, bondholders require a premiumpremium for this additional risk in the form of a higher yield.

The greater the volatility of interest rates, the greater the probability that the firm will call the bonds. Thus, the call-option call-option is more valuable all else equal.

Callable-bondCallable-bondvaluevalue

Noncallable-Noncallable-bond valuebond value

Call-optionCall-optionvaluevalue= -

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Preferred Stock Preferred Stock -- A type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors.

Preferred Stock and Preferred Stock and Its FeaturesIts Features

Basic Terms Basic Terms Par Value

Dividend RateMaturity

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Cumulative Dividends Cumulative Dividends FeatureFeature

For example, if the board of directors omits a $6 preferred dividend for two years, it must pay preferred shareholders $12 per share ($100 par value) before any dividend can be paid to common shareholders.

The corporation does not have to make up the dividend even if it is profitable, as long as the firm has no plans to pay dividends to common shareholders.

Cumulative Dividends Feature Cumulative Dividends Feature -- A requirement that all cumulative unpaid dividends on the

preferred stock be paid before a dividend may be paid on the common stock.

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Participating FeatureParticipating Feature

Preferred stockholders have a prior claim on income and an opportunity for additional return if the dividends to common stockholders exceed a certain amount.

A 6% participating preferred issue ($100 par) allows holders to share equally in any dividend in excess of $6. A $7 common dividend results in an extra $1 dividend to the participating preferred shareholders.

Participating Preferred Stock Participating Preferred Stock -- Preferred stock where the holder is allowed to participate in increasing dividends if the common stockholders receive

increasing dividends.

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Voting Rights in Voting Rights in Special SituationsSpecial Situations

Preferred stockholders are not normally given a voice in management unless the company is unable to pay preferred stock dividends during a specified period.

If such a situation presents itself, the class of preferred stockholders would be entitled to elect a specified number of directors.

Any situation in which the company defaults under restrictions in the agreement (similar to bond indenture) may lead to voting power for preferred shareholders.

Preferred shareholders cannot force the immediate repayment of obligations (like debt obligations).School.edhole.com

Retirement of Retirement of Preferred StockPreferred Stock

Call ProvisionCall Provision -- almost all issues carry a call provision because of the infinite maturity. It is often a cheaper method of retirement than open market purchases, inviting tenders, or an exchange of securities.

Sinking FundSinking Fund -- like bonds, many preferred issues provide for this method of retirement.

ConversionConversion -- certain issues are convertible into common stock at the option of the preferred stockholder. Used most frequently in the acquisition of other companies (the transaction is not taxable to the shareholders of the acquired firm).School.edhole.com

Use of Preferred Use of Preferred Stock in FinancingStock in Financing

The corporate issuer corporate issuer uses irregularly because the preferred dividend is not tax deductible. Utilities use more frequently as the preferred dividend can be accounted for when setting customer rates.

The corporate investor corporate investor is attracted to preferred stock as generally 70% of dividends can be excluded from taxes.

◦ Money market preferred stock (MMP) is a floating-rate preferred stock with the dividend rate set at auction every 49 days - attractive to corporations.

Flexibility in paying dividends and an infinite maturity (similar to a perpetual loan) are significant advantages to the corporate issuercorporate issuer.

The after-tax cost of preferred financing is greater than that of long-term debt financing to the corporate issuercorporate issuer.

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Common Stock and Common Stock and Its FeaturesIts Features

Basic Terms Basic Terms Authorized Shares

Issued SharesOutstanding Shares

Common Stock Common Stock -- Securities that represent the ultimate ownership (and

risk) position in a corporation.

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Types of Types of Common Stock ValueCommon Stock Value

It is merely a recorded figure in the corporate charter and is of little economic consequence.

Stock should never be issued below par value as shareholders would be legally liable for any discount from par if the firm is liquidated.

Common stock 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.

The difference between the issuing price and the par or stated value is additional paid-in capitaladditional paid-in capital.

A.A. Par ValuePar Value -- The face value.

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Example of ValueExample of Value

FunFinMan, Inc.FunFinMan, Inc.

Common stock ($1 par value$1 par value; 100,000 shares issued and outstanding) $ 100,000Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000

The par value par value of FunFinMan, Inc.,FunFinMan, Inc., is $1 per share$1 per share. This value is not likely to change over time from normal

day-to-day operations.

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C.C. Liquidating Value (per share)Liquidating Value (per share) -- The value per share if the firm’s assets are sold separately from the operating organization.◦ This value may be less (or greater)

than book value. Rarely are the two values identical.

B.B. Book Value (per share)Book Value (per share) -- Shareholders’ equity (as listed on the balance sheet) divided by the number of shares outstanding.

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Example of Book Example of Book Value (per share)Value (per share)

FunFinMan, Inc.FunFinMan, Inc.Common stock ($1 par value; 100,000 100,000 shares shares issued and outstanding) $ 100,000Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000$1,150,000

The book value book value (per share) of FunFinMan, Inc.,FunFinMan, Inc., is determined by dividing total shareholders’ equity total shareholders’ equity ($1,150,000) by the shares outstanding (100,000100,000), which yields a book value of $11.50 per sharebook value of $11.50 per share. This value is not likely to change over time from normal

day-to-day operations.School.edhole.com


This value is usually greater than book value (per share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical.

Market value (per share) may be difficult to obtain from thinly traded securities.

D.D. Market Value (per share)Market Value (per share) -- The current price at which the stock is currently trading.

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Typically, the shares of new companies are traded in the over-the-counter (OTC) market, where dealers maintain an inventory of the stock to provide additional liquidity.

D.D. Market Value (per share)Market Value (per share) -- continued.

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Rights of Rights of Common ShareholdersCommon Shareholders

Right to IncomeRight to Income -- entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors).

Right to Purchase New Shares (Maybe)Right to Purchase New Shares (Maybe) -- the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock.

Voting RightsVoting Rights -- because the shareholders are owners of the firm, they are entitled to elect the board of directors.

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Two methods of voting: (1) in person or (2) by proxy

ProxyProxy -- A legal document giving one person authority to act for another.

Voting RightsVoting Rights

SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings.

Most shareholders, if satisfied with company performance, sign proxies in behalf of management.

Shareholders are generally geographically widely dispersed.

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Voting ProceduresVoting Procedures

Majority-rule votingMajority-rule voting -- a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory votingstatutory voting.

Cumulative votingCumulative voting -- a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors.

The board of directors are elected under either:

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Voting Voting Procedures ExampleProcedures Example

Under majority-rule votingUnder majority-rule voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position.

Under cumulative votingUnder cumulative voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire.

You are a shareholder of You are a shareholder of FunFinMan, Inc. FunFinMan, Inc. You own 100 shares and there are 9 director You own 100 shares and there are 9 director

positions to be filled.positions to be filled.

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Minimum Votes to Elect a Minimum Votes to Elect a Director -- CumulativeDirector -- Cumulative

For example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001 voting shares30,001 voting shares.

(100,000 shares) x (3 directors) 10

Total number ofvoting shares

Specific number ofdirectors sought

Total number of directors to be elected + 1

X+ 1

+ 1 = 30,001 shares30,001 sharesSchool.edhole.com

Minimum Votes to Elect a Minimum Votes to Elect a Director -- CumulativeDirector -- Cumulative

Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions -- less than a majority.

Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote.

Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60,001 shares (twice as many)!

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Dual-Class Common Dual-Class Common StockStock

This is used to retain control for founders, management, or some other specific group.

For example, 80,000 shares of Class A at $20/share and 200,000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes.

Usually Class B takes a lower claim to dividends and assets than Class A for this voting control.

Dual-class Common Stock Dual-class Common Stock -- Two classes of common stock, usually designated Class A and Class B. Class A is usually the weaker voting or nonvoting class, and

Class B is usually the stronger.

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