corporate financing decisions long-term financing 1finance - pedro barroso

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

14Corporate Finance - Pedro Barroso

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


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


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


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


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


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 -


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


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


Different Types of Bonds

• Callable Bonds• Puttable Bonds• Convertible Bonds• Pure Discount Bonds• Floating-Rate Bonds


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


Corporate Financing DecisionsIssuing Securities to the Public


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.


An Example of a Tombstone


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


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


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”


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%


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


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


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


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?


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


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


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


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.


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


Corporate Financing DecisionsLeasing


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


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


Operating Leases

• Usually not fully amortized• Usually require the lessor to maintain

and insure the asset• Lessee enjoys a cancellation option


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


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


corporate financing decisions long-term financing 1finance - pedro barroso

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