corporate financing decisions long-term financing 1finance - pedro barroso
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Corporate Financing DecisionsLong-Term Financing
1Finance - Pedro Barroso
Long-Term Debt• Corporate debt can be short-term (maturity less
than one year) or long-term• Different from common stock:– Creditor’s claim on corporation is specified– Promised cash flows– No voting rights
• Over half of outstanding bonds are owned by life insurance companies & pension funds
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Features of Long-Term Debt• Bond indenture (written agreement between the corporate debt
issuer and the lender) usually lists– Amount of Issue, Date of Issue, Maturity– Denomination (Par value)– Annual Coupon, Dates of Coupon Payments– Security (Collateral)– Sinking Funds– Call Provisions– Covenants
• Features that may change over time– Rating– Yield-to-Maturity– Market price
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Seniority
• Seniority indicates preference in position over other lenders – senior or junior debt
• Some debt is subordinated; In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first
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Security - Collateral
• Security is a form of attachment to property– It provides that the property can be sold in event
of default to satisfy the debt for which the security is given
– A mortgage is used for security in tangible property
– Debentures are not secured by collateral
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Protective Covenants• Agreements to protect bondholders• Negative covenant: Shall 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
interest rate– buy another company’s bonds
• Positive covenant: Shall:– use proceeds from sale of assets for other assets– allow redemption in event of merger or spinoff– maintain good condition of assets– provide audited financial information
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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• Ratings can change, and raters can disagree
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Bond Ratings: Investment GradeMoody's
S&P's Credit Rating
Description
Aaa AAA Highest credit rating, maximum safety
Aa1 AA+ Aa2 AA High credit quality,
investment-grade bonds Aa3 AA - A1 A+ A2 A Upper -medium quality,
inve stment grade bonds A3 A - Baa1 BBB
+
Baa2 BBB Lower -medium quality, investment grade bonds
Baa3 BBB -
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Bond Ratings: Below Investment Grade
Moody's
S&P's Credit Rating Description
Speculative-Grade Bond Ratings
Ba1 BB+ Low credit quality, speculative-grade bonds
Ba2 BB Ba3 BB - B1 B+ Very low credit quality,
speculative-grade bonds B2 B B3 B -
Extremely Speculative-Grade Bond Ratings Caa CCC
+ Extremely low credit standing, high-risk bonds
CCC CCC - Ca CC Extremely speculative C C D Bonds in default
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Junk Bonds• Anything with S&P “BB+” or Moody’s “Ba1” or
below is a junk bond • A polite euphemism for junk is high-yield bond• There are two types of junk bonds:– Original issue junk– Fallen angels—rated
• Yield premiums versus default risk
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Different Types of Bonds
• Callable Bonds• Puttable Bonds• Convertible Bonds• Pure Discount Bonds• Floating-Rate Bonds
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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 • Preferred dividends are either cumulative or
noncumulative• No voting rights• Similar to debt
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Corporate Financing DecisionsIssuing Securities to the Public
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Public Issue• The Basic Procedure– Management gets the approval of the Board.– 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 copasetic with the SEC, a price is set
and a full-fledged selling effort gets underway.
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An Example of a Tombstone
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Alternative Issue Methods• There are two kinds of public issues:– General cash offer (IPOs, SEOs)– Rights offer (SEOs)
• Almost all debt is sold in general cash offerings
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Firm Commitment Underwriting• The issuing firm sells the entire issue to the
underwriting syndicate• The syndicate then resells the issue to the public• The underwriter (fee) makes money on the spread
between the price paid to the issuer and the price received from investors when the stock is sold
• The syndicate bears the risk of not being able to sell the entire issue for more than the cost
• This is the most common type of underwriting in the United States
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IPO Underpricing
• May be difficult to price an IPO because there is not a current market price available
• Private companies tend to have more asymmetric information than companies that are already publicly traded
• Underwriters want to ensure that, on average, their clients earn a good return on IPOs
• Underpricing causes the issuer to “leave money on the table”
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Costs of Equity Public OfferingsProceeds Direct Costs Underpricing
(in millions) SEOs IPOs IPOs 2 - 9.99 2.88% 15.36% 18.18%
10 - 19.99 8.81% 11.63% 10.02%20 - 39.99 7.24% 9.81% 17.91%40 - 59.99 6.20% 9.21% 29.57%60 - 79.99 5.81% 8.65% 39.20%80 - 99.99 5.56% 8.34% 45.36%
100 - 199.99 5.00% 7.67% 37.10%200 - 499.99 4.26% 6.72% 17.72%500 and up 3.64% 5.15% 12.19%
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Private Placements• Private placements 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
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Rights
• If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders
• This allows shareholders to maintain their percentage ownership if they so desire
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Mechanics of Rights Offerings
• The management of the firm must decide:– The exercise price (the price existing shareholders
must pay for new shares)– How many rights will be required to purchase one
new share of stock• These rights have value:– Shareholders can either exercise their rights or sell
their rights
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Rights Offering Example
• Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price
• What is the new market value of the firm?• What is the ex-rights price?• What is the value of a right?
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What is the New Market Value of the Firm?
shares 20$shares 000,10
share 25$shares 000,200000,200,5$
There are 200,000 outstanding shares at
$25 each
There will be 10,000 new shares issued at a $20
subscription price
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What Is the Ex-Rights Price?• There are 210,000 outstanding shares of a firm with a market value of $5,200,000.• Thus the value of an ex-rights share is
• Thus, the value of a right is: $0.2381 = $25 – $24.7619
= $24.7619$5,200,000
210,000 shares
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Private Equity Market
• The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market
• For start-up firms and firms in financial trouble, the public equity market is often not available
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Venture Capital• The limited partnership is the dominant form of
intermediation in this market• There are four types of suppliers of venture capital:
1. Old-line wealthy families2. Private partnerships and corporations3. Large industrial or financial corporations have
established venture-capital subsidiaries.4. 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.
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Long-Term Syndicated Bank Loans
• 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 money center bank may arrange a loan with a firm or country and then sell portions of the loan to a syndicate of other banks
• A syndicated loan may be publicly traded
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Corporate Financing DecisionsLeasing
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Types of Leases
• A lease is a contractual agreement between a lessee and lessor
• The lessor owns the asset and for a fee allows the lessee to use the asset
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Buying versus LeasingBuy Lease
Firm U buys asset and uses asset; financed by debt and equity
Lessor buys asset, Firm U leases it
Manufacturer of asset
Equity shareholders
Firm U1. Uses asset2. Owns asset
Creditors
Manufacturer of asset
Lessor1. Owns asset
2. Does not use asset
Equity shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
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Operating Leases
• Usually not fully amortized• Usually require the lessor to maintain
and insure the asset• Lessee enjoys a cancellation option
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Financial LeasesThe exact opposite of an operating lease
1. Do not provide for maintenance or service by the lessor
2. Financial leases are fully amortized3. The lessee usually has a right to renew the
lease at expiry4. Generally, financial leases cannot be cancelled
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Sale and Lease-Back
• A particular type of financial lease• Occurs when a company sells an asset it
already owns to another firm and immediately leases it from them
• Two sets of cash flows occur:– The lessee receives cash today from the sale– The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset
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