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FINANCING DEBT
AND
ChaptersEQUITY
15, 20
Long Term
Financing An
Introduct
ion
An Introduction - Outline
3
Financing New
Projects - Pecking
Order
Theory
Firms prefer
to fnance with internally
200,00
0
150,00
0
100,00
0
50,00
0
50,00
0
199
1
199
4
199
7
200
0
200
3
200
6
200
9
Comm
on
stocks
Preferre
d
stocks
Corpora
te bonds
-1.44%
Preferred stock
-0.19%
Convertible bonds
-2.07%
-0.26%
0.11%
0.91%
1.93%
0.61%
0.01%
Chapters 15, 20 and 21
3.98%
Common Shareholders
7
Term Financing
- Debt and
Provides for Long
minority
participation.
Equity
Dividends
Book Value
Market Value
Market-to-Book ratio
No voting power.
Interest payments on debt are fully tax
deductible by corporation.
Unpaid debt is liability of a frm.
Preferred Shares
12
Preferred Shares
13
Preferred shares
Canadian
increase leverage
corporations do
marginally.
not pay tax on
They do not dilute
preferred share
control of company.
dividends received
Non payment of
from other
dividends does not push
Canadian
the company into
corporations.
bankruptcy.
Individuals do pay
Expensive, unless they
tax.
are lightly taxed or dont
pay tax at all.
Most preferred
Term Financing - Debt and
Chapters 15, 20 and 21
A Summary of Financing
Instruments
Common Stock
Preferred Stock
Bonds
Ownership
Voting rights.
Generally no
Obligation to
provide return
None
Bankruptcy
Claims
Distn Cost
Risk return
trade off
Lowest
Before
common
dividends
Second
Limited rights
under default
Contractual
Obligation
Tax status of
payment by firm
Tax status of
payment to
holder
Tax status
Chapters
15, 20 of
and 21
payment to
Highest
Highest risk;
highest return
Moderate
Moderate
risk;
moderate
return
None dividends
None dividends
pd from after tax
pd from after tax
income.
income.
Grossed up
Grossed up
dividend tax
dividend tax
credit
credit
Tax exempt
Tax exempt
Long Term Financing
- Debt and
Equity
Highest
Lowest
Lowest risk; lowest
return
Interest payment
is tax deductible
Fully taxable
Fully taxable
15
16
Issuing Equity
Securities
Securities
the underwriter
20
21
Decreasing Regulatory
Drag
Prompt Ofering Prospectus System
Equity
Way for firms
that trade in Canada and US
22
Role of Underwriters in
General Cash Ofering
23
Types of Underwriting
Agreements
Firm Commitment
Best Efforts
Bought deal
24
Other direct
expenses:
The diference
between the price
the issuer receives
and the ofer price.
Indirect expenses:
Underpricing:
Overallotment
(Green Shoe)
option:
Covers excess
demand for issue.
Chapters 15, 20 and 21
26
Term Financing
- Debt
Chaptersissued
15, 20 and 21
If frm had Long
good
news,
it and
would have
Equity
Performance of IPOs
28
Underwriter incentives.
Leave investors with a good taste in
their mouths.
Signalling (Grinblatt and Hwang (1989)).
Asymmetrically informed investors (Rock
Chapters 15, 20 and 21
(1986)). Long Term Financing - Debt and
Equity
29
#
Shares
A
Receive
d
#
Shares
B
Reques
ted
#
Shares
B
Receive
d
31
32
rs
net
P
E
income
estimated
dividend
growth
Then priceLong
per
share
is S/rate
# shares
Term Financing - Debt and
Chapters 15, 20 and 21
issued.
Equity
Example
33
34
Long Term
Debt
35
Bond refunding.
Bond ratings.
Features of a Hypothetical
Bond
Terms
Explanation
Amt of
Issue
Issue Date
$100
million
10/21/10
Maturity
10/21/30
Annu
al
Coup
on
Ofer Price
10.5
100
Yield
10.5
Features of a Hypothetical
Bond
Terms
Explanation
Coupon
12/31, 6/30
Paymt
Dates
Security
None
Sinking Fund Annual
Rating
AAA
Rating Symbols
39
Indenture Agreement
40
Bond Covenants
41
Dividend covenants.
Financing covenants (how a firm can
raise debt in the future)
Financial ratio covenants.
Sinking fund covenants.
Bonding covenants.
Long Term Financing - Debt and
Equity
Financing Covenants
42
Seniority
Security
Collateral pledged to
protect debtholders in
case of default.
Collateral trust bonds:
The order in
which debt
Equity
Bonds that are
Callable Bonds
44
Bond Options
46
Convertible bonds.
Exchangeable bonds.
Example of a Convertible
Bond
LO21.
5
49
PB Par n
Value
(1
k)
PB =Price of the
bond.
n = number of
periods to
maturity.
k = discount
rate or yield to
maturity.
Disadvantage to investor
Pric
e
Coupon
Bond
ZeroCoupon
Bond
Because there
are no
intermediate
payments, zero
coupon bonds
are more
sensitive than
coupon bonds
to changes in
interest rates.
Rate of
Interest
Chapters 15, 20 and 21
52
Treasury rate.
Fed fund rate.
LIBOR.
Commercial paper rate.
Prime rate.
53
New Bond
Old Bond
Retired
Issued Invest
Proceeds
Anniversary of Old
Bond Issue &
Coupon date
Tim
e
Bond could be
retired for face
value plus call
Long Term Financing - Calculated
Debt and
at Chapters
simple 15, 20 and 21
premium Equity
interest
Cost Calculation
Tax
Deducti
ble
No
Yes
(1- TC )
c old Fisthwehelernegth
of overlap period.
1 1 5
E
i issuing
the
Let ETCbe
and u/w expense. If TC
r
5
r
is the frms
tax rate then the p.v. 1of1
the-5
E
i
TC r
tax
shield is
Total
5
i
pF
(1T
)c
F
cost is
C
old
r 15, 20 and 21
Long
Chapters
ETerm
- Financing - Debt and
Equity
Beneft Calculation
Tax
Deducti
ble
Yes
The net invested in the risk free account is FE. If it is invested for the overlap period at a
rate Rf, then the after tax interest earned is
F - E
Rf
1- Tc .
coupon
rate,
the periodic
interest
If F is the
facethen
amount
of the issue,
and cnew is
savings is F(cold- cnew)(1- Tc).
the new
Usually wont have to worry about
unamortized flotation costs from the old
bond, since many bonds have provisions
such
that they cant be called in the first
5
Benefit
-n
1- 1 ri
years.
therefore is
1 C
ne
F - E Rf 1 TC F w T
i
21
Long Term Financing - Debt
and
Chapters 15, 20 and
r
Equity
Example
59
A Second Example
60
issue
after issue
after issue