Advanced Corporate Finance

Long Term Financing

 Features of Common Stock
• Voting rights
– Board of Directors Election: Cumulative vs. Straight
– Other matters such as M&A
• Proxy voting
• Classes of stock
• Other rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets during
liquidation
– Preemptive right – first right of refusal at new stock
issue to maintain proportional ownership if desired
 Cumulative Voting
• Allows minority shareholders to guarantee (as long as
they are above a certain threshold) some level of board
representation.
• With cumulative voting, the directors are elected all at
once.
• If there are N directors up for election, then 1/(N + 1)
percent of the stock plus one share will guarantee you
a seat.
• The more seats that are up for election at one time,
the easier (and cheaper) it is to win one.
𝑺𝑫
𝑿= +𝟏
𝑵+𝟏
D = number of directors you want elected
N = Total number of Directors
S = Total Number of Shares
X = Shares Required
 Cumulative Voting – Example
• Stock in Corporation X sells for $20 per share
and features cumulative voting. There are
10,000 shares outstanding. If three directors
are up for election, how much does it cost to
ensure yourself a seat on the board?
• The question here is how many shares of stock
it will take to get a seat. The answer is 2,501,
so the cost is 2,501 × $20 = $50,020.
𝑺𝑫
𝑿= +𝟏
𝑵+𝟏
D = number of directors you want elected
N = Total number of Directors
S = Total Number of Shares
X = Shares Required
 Straight Voting
• With straight voting, the directors are elected
one at a time
• The only way to guarantee a seat is to own 50
percent plus one share. This also guarantees
that you will win every seat
• Straight voting can “freeze out” minority
shareholders
• Straight voting makes it too hard for minority
representation, cumulative makes it too easy
 Staggered Elections
When cumulative voting is mandatory, devices have
been worked out to minimize its impact
• Only a fraction of the directorships are up for
election at a particular time.
• If only two directors are up for election at any
one time, it will take 1/(2 + 1) = 33.33 percent of
the stock plus one share to guarantee a seat.
• Staggering has two basic effects:
– Makes it more difficult for a minority to elect a
director when there is cumulative voting because
there are fewer directors to be elected at one time.
– Staggering makes takeover attempts less likely to be
successful because it makes it more difficult to vote in
a majority of new directors.
 Proxy voting
• A proxy is the grant of authority by a shareholder to
someone else to vote his/her shares.
• Large companies have hundreds of thousands or even
millions of shareholders. Shareholders can come to the
annual meeting and vote in person, or they can
transfer their right to vote to another party
• Management always tries to get as many proxies as
possible transferred to it.
• If shareholders are not satisfied with management, an
“outside” group of shareholders can try to obtain votes
via proxy. They can vote by proxy in an attempt to
replace management by electing enough directors. The
resulting battle is called a proxy fight
 Classes of Stock
• Created with unequal voting rights.
• Google has two classes of common stock, A and
B.
– The Class A shares are held by the public, and each
share has one vote.
– The Class B shares are held by company insiders, and
each Class B share has 10 votes.
– As a result, Google’s founders and management
control the company
• Primary reason for creating dual or multiple
classes of stock has to do with control of the firm.
• If such stock exists, management of a firm can
raise equity capital by issuing non-voting or
limited-voting stock while maintaining control
 Dividends
• Represent a return on the capital
• The payment of dividends is at the discretion of
the board of directors.
• 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 (go bankrupt) on an
undeclared dividend
• Dividends are paid out of after-tax profits
• Dividends received by individual shareholders are
taxable
 Features of Preferred Stock
• Has preference over common stock in the payment of
dividends and in the distribution of corporation assets
in the event of liquidation
• Dividends
– A preferred dividend is not like interest on a bond. The
board of directors may decide not to pay the
dividends on preferred shares
– Dividends are not a liability of the firm, and preferred
dividends can be deferred indefinitely.
– Most preferred dividends are cumulative (vs. non-
cumulative) – any missed preferred dividends have to
be paid before common dividends can be paid.
– Preferred dividend must be paid before dividends can
be paid to common stockholders.
• Preferred stock generally does not carry voting rights.
 Corporate Long Term Debt
• Debt is the result of borrowing money.
• All long-term debt securities/loans are promises
made by the issuing firm/borrowers to pay principal
when due and to make timely interest payments on
the unpaid balance
• Debt is not an ownership interest in the firm. Creditors
do not usually have voting power.
• Unpaid debt is a liability of the firm. If it is not paid, the
creditors can legally claim the assets of the firm.
• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully tax-
deductible.
 Debt versus Equity
• Equity
• Debt
– Not an ownership interest
– Creditors do not have voting
rights
– Interest is considered a cost of
doing business and is tax
deductible
– Creditors have legal recourse if
interest or principal payments
are missed
– Excess debt can lead to
financial distress and
bankruptcy
– Ownership interest, a residual
claim
– Common stockholders vote for
the board of directors and
other issues
– Dividends are not considered a
cost of doing business and are
not tax deductible
– Dividends are paid out of after-
tax profits
– Dividends received by
individual shareholders are
taxable
– Dividends are not a liability of
the firm, and stockholders have
no legal recourse if dividends
are not paid
– An all-equity firm cannot go
bankrupt
 Is It Debt or Equity?
• Corporations are very adept at creating exotic,
hybrid securities that have many features of
equity but are treated as debt.
• The distinction between debt and equity is
very important for tax purposes.
• One reason that corporations try to create a
debt security that is really equity is to obtain
the tax benefits of debt and the bankruptcy
benefits of equity
• Courts and taxing authorities would have the
final say.
 Long Term Debt Basics
• Maturity of a long-term debt instrument is the
length of time the debt remains outstanding with
some unpaid balance
• Bond refers to all kinds of secured and unsecured
debt
• The main difference between public-issue and
privately placed debt is that the latter is directly
placed with a lender and not offered to the
public.
• Other dimensions: Security, call features, sinking
funds, ratings, and protective covenants
 The Bond Indenture
• Contract or a written agreement (a legal document) between
the company and the bondholders that includes:
– The basic terms of the bonds
• Face Value (or Par Value)

– The total amount of bonds issued

– A description of property used as security, if applicable
– The repayment arrangement
– Call provisions
– Details of protective covenants
 The Bond Indenture
• Registered vs. Bearer
• Security
– Collateral – assets that are pledged as security for
payment of debt; e.g. Bonds, Common Stock
– Mortgage – secured by real property, normally land or
buildings
– Mortgage Securities – secured by mortgages
– Debentures – an unsecured bond (>10 years)
– Notes – unsecured debt with original maturity less
than 10 years
• Seniority
– Preference (in the event of liquidation) in position
over other lenders, debts are labeled as senior or
junior (subordinate) to indicate seniority
– Debt cannot be subordinated to equity.
 The Bond Indenture
Repayment - Sinking fund
• early repayment in some form is more typical and is often
handled through a sinking fund
• is an account managed by the bond trustee for the purpose of
repaying the bonds.
• the company makes annual payments to the trustee, who
then uses the funds to retire a portion of the debt.
• the trustee does this by either buying up some of the bonds in
the market or calling in a fraction of the outstanding bonds
For example:
• Some sinking funds start about 10 years after the initial
issuance.
• Some sinking funds establish equal payments over the life of
the bond.
• Some high-quality bond issues establish payments to the
sinking fund that are not sufficient to redeem the entire issue.
As a consequence, there is the possibility of a large “balloon
payment” at maturity.
 The Bond Indenture
• Sinking Fund may not necessarily be accompanied by
a call. When no call, it’s a reserve account for
payment to bond holders at maturity
• The Call Provision
– A call provision allows the company to repurchase,
or “call,” part or all of the bond issue at stated
prices over a specific period.
– using money (a sinking fund) from the issuer's
earnings saved specifically for security buybacks
– Because it adds doubt for investors over whether
the bond will continue to pay until its maturity
date, a sinking fund call is seen as an additional
risk for investors
• Sinking fund vs. call provision: Sinking fund
established to retire debt at market price or call
(stated) price (directly from holders)
 The Bond Indenture
• Protective Covenants
– A protective covenant is that part of the indenture or
loan agreement that limits certain actions a company
might otherwise wish to take during the term of the
loan.
– A negative covenant limits or prohibits actions that
the company might take. For example, the firm must
limit the amount of dividends it pays according to
some formula
– A positive covenant specifies an action that the
company agrees to take or a condition the company
must abide by. For example, the company must
maintain its working capital at or above some
specified minimum level.
 Required Yields
• The coupon rate depends on the risk characteristics
of the bond when issued.

• Which bonds will have the higher coupon, all else

equal?
– Secured debt versus a debenture
– Subordinated debenture versus senior debt
– A bond with a sinking fund versus one without
– A callable bond versus a non-callable bond
 Zero Coupon Bonds
• Make no periodic interest payments (coupon
rate = 0%)
• The entire yield to maturity comes from the
difference between the purchase price and
the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount
bonds, or original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury
strips are good examples of zeroes
 Pure Discount Bonds
Information needed for valuing pure discount bonds:
 Time to maturity (T) = Maturity date - today’s date
 Face value (F)
 Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

F
PV 
(1  r ) T
 Pure Discount Bonds: Example

Find the value of a 30-year zero-coupon bond

with a Rs.1,000 par value and a YTM of 6%.
Rs 0 Rs.0 Rs.0 Rs .1,000

0 1 2 29 30

F Rs .1,000
PV    Rs .174.11
(1  r ) T
(1.06) 30
 Some Different Types of bonds

• Floating Rate Bonds

– Coupon rate floats depending on some index value vs.
fixed-dollar obligations in conventional bond where the
coupon rate is set as a fixed percentage of the par value.
– Examples – adjustable rate mortgages and inflation-
linked Treasuries
– There is less price risk with floating rate bonds.
– The coupon floats, so it is less likely to differ
substantially from the yield to maturity.
– Coupons may have a “collar” – the rate cannot go above
a specified “ceiling” or below a specified “floor.”
 Other Bond Types
• Income bonds
– Coupon payments are dependent on company income.
Specifically, coupons are paid to bondholders only if the
firm’s income is sufficient.
• Convertible bonds
– swapped for a fixed number of shares of stock anytime
before maturity at the holder’s option
• Put bonds
– Allows the holder to force the issuer to buy the bond back
at a stated price
– Issuer buy the bonds back at 100 percent of face value
given that certain “risk” events happen such as a change in
credit rating from investment grade to lower than
investment grade by Moody’s or S&P.
 Other Bond Types
• There are many other types of provisions that can be added to a
bond, and many bonds have several provisions – it is important to
recognize how these provisions affect required returns.
– Warrant - A bond with warrants attached, the buyers receives
the right to purchase shares of stock in the company at a fixed
price per share over the subsequent life of the bond.
– Valuable if the stock price climbs substantially
– Bonds with warrants differ from convertible bonds because the
warrants can be sold separately from the bond
• Securitized Bonds:
– Mortgage-backs are the best known type of asset-backed
security.
– With a mortgage-backed bond, a trustee purchases mortgages
from banks and merges them into a pool. Bonds are then issued,
and the bondholders receive payments derived from payments
on the underlying mortgages
 Bank Loans
• Lines of Credit
– Provide a maximum amount the bank is willing to
lend
– Referred to as a revolving line of credit, with a
fixed term of up to three years or more.
• Syndicated Loan
– Large money-center banks frequently have more
demand for loans than they have supply.
– Small regional banks are often in the opposite
situation.
– As a result, a larger bank may arrange a loan with
a firm or country and then sell portions of the
loan to a syndicate of other banks.
International Bonds
• Eurobonds:
– A bond issued in a currency other than the currency of the
country or market in which it is issued.
– a bond issued in multiple countries but denominated in a single
currency, usually the issuer’s home currency
– The four main Eurocurrencies are the US dollar, the euro-zone
euro, the British pound and the Japanese yen; the currencies of
the major economies of the world
– important way to raise capital for many international companies
and governments
• Foreign bonds:
– A bond that is issued in a domestic market by a foreign entity, in
the domestic market's currency.
– unlike Eurobonds, are issued in a single country and are usually
denominated in that country’s currency
– Foreign bonds often are nicknamed for the country where they
are issued: Yankee bonds (United States), Samurai bonds
(Japan), Rembrandt bonds (the Netherlands), Bulldog bonds
(Britain).