Medium and Long-Term Financing Section 20.

1 Medium- and Long-term Debt financing presents the commercial term credit and leasing as sources of medium- and long-term finance. It examines the basic features and decisions involved in those financing sources. Section 20.2 Equity Financing - presents the features of preferred and common stocks as financing sources. Section 20.3 Long-term Financing presents the considerations which a company must take into account while raising capital through the securities market

Section 20.1 Medium- and Long-term Debt Financing The primary sources of long-term debt financing in the Philippines are commercial bank loans and leases. Management negotiates with banks and leasing companies to obtain these funds. The unique features, advantages or disadvantages for each type of debt financing are the focus of the succeeding discussions. Financial analysis addresses the need to evaluate and choose the most advantageous source of debt financing. Term Loan is a written commitment, issued by a company in favor of a lending institution, to repay the loan under a specified payment schedule and conditions. The lending institution has a claim on the assets of the company and control over management decisions as specified in a loan contract called the term loan agreement. Term Loans differ according to the terms and conditions. Medium-term Loans A company resorts to medium-term loans depending on the following: 1. Medium-term financing need 2. Availability of medium-term loan products 3. Managements negotiating ability

Long-term Loans Management seeks long-term loans to finance investment projects and to supplement equity capital. It depends on the following factors: 1. Availability of funding sources 2. Collateral 2 categories of Collateral 1. Real State - for residential and commercial properties 2. Chattel for goods, machines, vehicles and other movable assets 3. Managements negotiating ability 4. Nature of financing need Types of repayment plans 1. Repayment in tranches 2. Periodic amortization 3. Balloon Repayment 5. Performance requirements 5 Cs of Credit 1. Character 2. Capacity to repay the loan 3. Conditions that influence the company 4. Collateral 5 Capital 2 types of Covenants 1. Positive Covenants - are actions and performance standards to be maintained by the company. 2. Negative Covenants - under these covenants the company agrees to desist from taking actions without the banks approval because they are detrimental to the claims of the bank. These actions increase the risk of default on the long-term loan.

Evaluating the Cost of Term Financing Term financing has financial and non financial costs. The financial cost consists of transaction cost and compensation for the funder of the term loan. The non financial costs include the loss of flexibility by management and increased monitoring of management and operations by creditors. Financial Cost of Term Loans To evaluate the financial cost of a term financing proposal, a financial manager calculates its effective cost. The effective cost of a term financing plan is the discount rate that equates the present values of the net proceeds of the financing and the future debt service cash outflows, shown in equation 20-1 (20.1) Proceeds of Term Loan = PV of (Future debt service cash outflows) Where: Discount rate is the rate that equates the two terms. (20.2) Least Cost Financing Plan = Minimum {IRR1, IRR2 IRRn} Where: IRRi = effective cost of financial plan i I = 1, 2, . . ., n financial plans Basic principle of Least Cost Financing When choosing among alternative financing plans with similar conditions, the finance manager should choose the financing plan with the lowest effective cost. Non-financial Cost of Term Loan Loan covenants and other non financial terms of financing schemes may differ especially when proposals come from various lending institutions. The differences are due to differences in the credit policies and lending strategies of banks. They result in a non-financial cost to the company. Non-financial cost means more risk and pressure on management due to the term loan

Leasing Leasing is another way of acquiring and financing the asset. Finance companies and universal banks are the predominant institutions that provide lease financing to companies. Types of Leasing 1. Operating Lease The company providing the asset, or lessor, retains ownership of the asset. The company that uses the asset, or lessee, makes periodic lease payments to the lessor. Operating leases require the lessor to maintain, provide insurance and service the leased property or equipment. Such costs are built into a lease payment. 2. Financial or Capital Lease The lessee assumes all the rights of ownership although it has no legal title to the leased asset. It differs from an operating lease for four reasons, namely: It is not cancelable. It transfers to the lessee the responsibility for maintaining, providing insurance, and servicing the asset. The total value of the lease payments approximately equals the cost of the leased asset at the initiation of the lease agreement. It is a true alternative to borrowing and then purchasing the asset. Deciding Whether to Lease or Own A company evaluates whether to borrow and own or to lease an asset by applying present value analysis on after-tax cash flows and opportunity costs of leasing the asset. The costs of leasing are the periodic lease payments and the depreciation tax shield that the company would have gained if it owned the asset. The benefit of leasing to the company is equal to the cost of the asset.

(20-3) Evaluation formula Advantage of Leasing (AL) = Benefit of Leasing Cost of Leasing AL = Cost of asset Present value of (after tax lease payments + depreciation tax shield) = A0 PV(d, n) [ Li x (1 - t) + D x t ] Where: A0 = cost of asset Lt = lease payment in time t Dt = depreciation expense in time t t = tax rate I = time, 1, 2, . . . . ,n d = discount rate An alternative approach is to calculate the IRR for the financial lease proposal. This method finds the effective cost, in percentage basis, of a lease proposal. The effective lease financing rate is the rate i that solves equation 20-4 (20.3) AL = 0 A0 = PV(d, I) [ (Li x (1 t) + Di x t ] The result is interpreted as follows: a. If the rate I is less than the debt interest rate, kd, lease financing is better than owning b. If the rate i is greater than kd, owning is better than leasing.

Section 20.2 Equity Financing Equity financing is a permanent source of funds for a company because equity securities have no stated maturity. As permanent funds, equity security holders incomes depend on the success or failure of the company. The basic types of equity securities are the preferred and common stocks. Preferred Stock - Is a security that is subordinate to the creditors claim but is senior to the claim of common stockholders. - Is called quasi-equity securities because they have the features of both debt and equity securities. Features of Preferred Stocks -Dividends -Cumulative -Participating -Retirement or call feature -Voting rights Common Stock A company builds up equity capital by retaining earnings and issuing new common stocks. A high rate of earnings enables a company to raise capital by simply retaining the cash earned and controlling the payment of dividends. A companys build up of equity capital lays the foundation for growth and expansion of the business. A company with ambitious expansion plans often has to issue new common stock because its profits would not be enough to finance its growth. Creditors exert pressure on a company to maintain an equity position that strongly supports its debt. Features of Common Stock -Ownership -Claim on assets -Voting Rights