Ch 20- Long-Term Debt, Preffered Stock and Common Stock


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Financial Management by Van Horne
Ch 20- Long-Term Debt, Preffered Stock and Common Stock

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Ch 20- Long-Term Debt, Preffered Stock and Common Stock

  1. 1. 0-1Chapter 20Chapter 20Long-Term Debt,Long-Term Debt,Preferred Stock, andPreferred Stock, andCommon StockCommon Stock© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
  2. 2. 0-2Long-Term Debt, PreferredLong-Term Debt, PreferredStock, and Common StockStock, and Common StockBonds and Their FeaturesTypes of Long-Term DebtInstrumentsRetirement of BondsPreferred Stock and Its FeaturesRights of Common ShareholdersDual-Class Common Stock
  3. 3. 0-3Bonds and Their FeaturesBonds and Their FeaturesBasic TermsBasic TermsPar Value Coupon RateMaturity Bond RatingsBondBond -- A long-term debt instrumentwith a final maturity generally being10 years or more.
  4. 4. 0-4Trustee and IndentureTrustee and IndentureTrusteeTrustee -- A person or institution designatedby a bond issuer as the officialrepresentative of the bondholders.Typically, a bank serves as trustee.IndentureIndenture -- The legal agreement, also calledthe deed of trustdeed of trust, between the corporationissuing bonds and the bondholders,establishing the terms of the bond issue andnaming the trustee.
  5. 5. 0-5Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsInvestors look to the earning power of the firm astheir primary security.Investors receive some protection by therestrictions imposed in the bond indenture,particularly any negative-pledge clausenegative-pledge clause.A negative-pledge clausenegative-pledge clause precludes the corporationfrom pledging any of its assets (not alreadypledged) to other creditors.DebentureDebenture -- A long-term, unsecured debtinstrument.
  6. 6. 0-6Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsIn this case, subordinated debenture holders rankbehind debenture holders but ahead of preferred andcommon stockholders in the event of liquidation.Frequently, the security is convertible into commonstock to lower the yield required by subordinateddebenture holders (often less than regular debentures).Subordinated DebentureSubordinated Debenture -- A long-term,unsecured debt instrument with a lower claimon assets and income than other classes ofdebt; known as junior debt.
  7. 7. 0-7Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsFrequently, there is a cumulative feature,cumulative feature, whichprovides that any unpaid interest in a particular yearaccumulates. The cumulative obligation is usuallylimited to no more than three years.The bonds are unpopular with investors (usuallylimited to reorganizations), but are still senior topreferred and common shareholders in the event ofliquidation.Income BondIncome Bond -- A bond where the payment ofinterest is contingent upon sufficientearnings of the firm.
  8. 8. 0-8Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsThese are bonds with a rating of Ba (Moodys) or lower.Principal investors are pension funds, high-yield bondmutual funds, and some individual investors.Liquidity varies depending on investor sentiments.Junk bonds were used frequently in the 1980s as ameans of financing leveraged buyouts (LBOs).Junk BondJunk Bond -- A high-risk, high-yield (oftenunsecured) bond rated below investmentgrade.
  9. 9. 0-9Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsThe issue is secured by a lienlien on specificspecificassetsassets of the corporation.The market value of the collateral shouldexceed the amount of the bond issue by areasonable margin of safety to help protectbondholders.Mortgage BondMortgage Bond -- A bond issue secured by amortgage on the issuer’s property.
  10. 10. 0-10Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsIf the corporation defaults, the trustee canforeclose on behalf of the bondholders. Thebondholders become general creditors for anyresidual amount after the sale of the collateral.The corporation may have a first mortgageand a second mortgage on the same assets.The first mortgage has a senior claim on theassets.Mortgage BondMortgage Bond (Continued)
  11. 11. 0-11Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsA railroad arranges with a trustee to purchaseequipment from a manufacturer.The railroad signs a contract with the manufacturerfor the construction of specific equipment.When the equipment is delivered, equipment trustcertificates are sold to investors.Equipment Trust CertificateEquipment Trust Certificate -- An intermediate- tolong-term security, usually issued by a transportationcompany such as a railroad or airline, that is used tofinance new equipment.Let us look at an example using a railroadLet us look at an example using a railroad..
  12. 12. 0-12Types of Long-TermTypes of Long-TermDebt InstrumentsDebt InstrumentsProceeds plus the railroad downpayment are usedto pay the manufacturer.Title of the equipment is held by the trustee, andthe trustee leases the equipment to the railroad.Lease payments are used to pay a fixed dividend tothe certificate holders and to retire a specifiedportion of the certificates at regular intervals.After the final lease payment (all certificates areretired), title to the equipment passes to therailroad.Equipment Trust CertificatesEquipment Trust Certificates (Continued)
  13. 13. 0-13Asset SecuritizationAsset SecuritizationPurpose: To reduce financing costsFirm picks assets to “package” and use cash flowsAssets removed from the balance sheet and sold to bankruptcy-remote entity (special-purpose vehicle -- SPV)SPV raises money by selling asset-backed securitiesAsset SecuritizationAsset Securitization – The process of packaging apool of assets and then selling interests in the pool inthe form of asset-backed securities.Asset-backed SecurityAsset-backed Security – Debt securities whoseinterest and principal payments are provided by thecash flows coming from a discrete pool of assets.
  14. 14. 0-14Retirement of BondsRetirement of BondsThe corporation makes a cash payment to thetrustee, which calls the bonds.The corporation purchases bonds in the openmarket and delivers them to the trustee.Sinking FundSinking Fund -- Fund established to periodicallyretire a portion of a security issue beforematurity. The corporation is required to makeperiodic sinking-fund payments to a trustee.Two forms for the sinking-fundTwo forms for the sinking-fundretirement of a bondretirement of a bond::
  15. 15. 0-15Sinking Fund and theSinking Fund and theRetirement of BondsRetirement of BondsWhen bonds are called for redemption, thebondholders will receive the sinking-fundsinking-fundcall pricecall price.The bonds are called on a lottery basis (bytheir serial numbers) and published inperiodicals like The Wall Street JournalWall Street Journal.Bonds should be purchased in the openmarket if the market price is less than thesinking-fund call pricesinking-fund call price.
  16. 16. 0-16Sinking Fund and theSinking Fund and theRetirement of BondsRetirement of BondsVolatility in interest rates or a decline in thecredit quality of the firm could lower themarket price of the bond and enhance thevalue to the firm of having this option.Bondholders may benefit from the orderlyretirement of debt (amortization effect),which reduces the default risk of the firmand adds liquidity to bonds outstanding.
  17. 17. 0-17Sinking Fund and theSinking Fund and theRetirement of BondsRetirement of BondsMany bond issues are designed to have a largerfinal payment to pay off the debt.For example, a corporation may undertake a $10million, 15-year bond issue. The firm isobligated to make $500,000 sinking-fundpayments in the 5ththrough 14thyears. The finalballoon payment in the 15thyear would be for theremaining $5 million of bonds.Balloon PaymentBalloon Payment -- A payment on debt thatis much larger than other payments.
  18. 18. 0-18Serial BondsSerial BondsFor example, a $10 million issue of serialbonds might have $500,000 of predeterminedbonds maturing each year for 20 years.Investors are able to choose the maturity thatbest fits their needs (wider investor appeal).Serial BondsSerial Bonds -- An issue of bonds withdifferent maturities, as distinguished froman issue where all bonds have identicalmaturities (term bonds).
  19. 19. 0-19Call ProvisionCall ProvisionNot all bonds are callable. In periods of lowinterest (hence, low coupon) rates, firms aremore likely to issue noncallable bonds.When a bond is callable, the call pricecall price isusually above the par value of the bond andoften decreases over time.Call ProvisionCall Provision -- A feature in an indenture thatpermits the issuer to repurchase securities ata fixed price (or series of fixed prices) beforematurity; also called call featurecall feature.
  20. 20. 0-20Call PriceCall PriceFor example, the call price for the first yearmight equal the bond par value plus one-year’sinterest.According to when they can be exercised, callprovisions can be either immediate or deferred.The call provision provides financing flexibilityfor the firm as conditions change.Call PriceCall Price -- The price at which a security witha call provision can be purchased by theissuer prior to the security’s maturity.
  21. 21. 0-21Value of the Call PrivilegeValue of the Call PrivilegeThe call privilege is valuable to the firm to thedetriment of bondholders. As such, bondholdersrequire a premiumpremium for this additional risk in theform of a higher yield.The greater the volatility of interest rates, thegreater the probability that the firm will call thebonds. Thus, the call-optioncall-option is more valuable allelse equal.Callable-bondCallable-bondvaluevalueNoncallable-Noncallable-bond valuebond valueCall-optionCall-optionvaluevalue= -
  22. 22. 0-22Preferred StockPreferred Stock -- A type of stock thatpromises a (usually) fixed dividend, butat the discretion of the board of directors.Preferred StockPreferred Stockand Its Featuresand Its FeaturesBasic TermsBasic TermsPar ValueDividend RateMaturity
  23. 23. 0-23CumulativeCumulativeDividends FeatureDividends FeatureFor example, if the board of directors omits a $6preferred dividend for two years, it must pay preferredshareholders $12 per share ($100 par value) beforeany dividend can be paid to common shareholders.The corporation does not have to make up thedividend even if it is profitable, as long as the firm hasno plans to pay dividends to common shareholders.Cumulative Dividends FeatureCumulative Dividends Feature -- A requirementthat all cumulative unpaid dividends on thepreferred stock be paid before a dividend maybe paid on the common stock.
  24. 24. 0-24Participating FeatureParticipating FeaturePreferred stockholders have a prior claim on incomeand an opportunity for additional return if thedividends to common stockholders exceed a certainamount.A 6% participating preferred issue ($100 par) allowsholders to share equally in any dividend in excess of$6. A $7 common dividend results in an extra $1dividend to the participating preferred shareholders.Participating Preferred StockParticipating Preferred Stock -- Preferred stock wherethe holder is allowed to participate in increasingdividends if the common stockholders receiveincreasing dividends.
  25. 25. 0-25Voting Rights inVoting Rights inSpecial SituationsSpecial SituationsPreferred stockholders are not normally given a voicein management unless the company is unable to paypreferred stock dividends during a specified period.If such a situation presents itself, the class ofpreferred stockholders would be entitled to elect aspecified number of directors.Any situation in which the company defaults underrestrictions in the agreement (similar to bondindenture) may lead to voting power for preferredshareholders.Preferred shareholders cannot force the immediaterepayment of obligations (like debt obligations).
  26. 26. 0-26Retirement ofRetirement ofPreferred StockPreferred StockCall ProvisionCall Provision -- almost all issues carry a call provisionbecause of the infinite maturity. It is often a cheapermethod of retirement than open market purchases,inviting tenders, or an exchange of securities.Sinking FundSinking Fund -- like bonds, many preferred issuesprovide for this method of retirement.ConversionConversion -- certain issues are convertible intocommon stock at the option of the preferredstockholder. Used most frequently in the acquisition ofother companies (the transaction is not taxable to theshareholders of the acquired firm).
  27. 27. 0-27Use of PreferredUse of PreferredStock in FinancingStock in FinancingThe corporate issuercorporate issuer uses irregularly because thepreferred dividend is not tax deductible. Utilities usemore frequently as the preferred dividend can beaccounted for when setting customer rates.The corporate investorcorporate investor is attracted to preferred stock asgenerally 70% of dividends can be excluded from taxes.Flexibility in paying dividends and an infinite maturity(similar to a perpetual loan) are significant advantagesto the corporate issuercorporate issuer.The after-tax cost of preferred financing is greater thanthat of long-term debt financing to the corporate issuercorporate issuer.
  28. 28. 0-28Common StockCommon Stockand Its Featuresand Its FeaturesBasic TermsBasic TermsAuthorized SharesIssued SharesOutstanding SharesCommon StockCommon Stock -- Securities thatrepresent the ultimate ownership(and risk) position in a corporation.
  29. 29. 0-29Types ofTypes ofCommon Stock ValueCommon Stock ValueIt is merely a recorded figure in the corporatecharter and is of little economic consequence.Stock should never be issued below par value asshareholders would be legally liable for anydiscount from par if the firm is liquidated.Common stock that is authorized without par value(no-par stock) is carried on the books at the originalmarket price or at some assigned (or stated) value.The difference between the issuing price and the paror stated value is additional paid-in capitaladditional paid-in capital.A.A. Par ValuePar Value -- The face value.
  30. 30. 0-30Example of ValueExample of ValueFunFinMan, Inc.FunFinMan, Inc.Common stock ($1 par value$1 par value; 100,000shares issued and outstanding) $ 100,000Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000The par valuepar value of FunFinMan, Inc.,FunFinMan, Inc., is $1 per share$1 per share.This value is not likely to change over time fromnormal day-to-day operations.
  31. 31. 0-31Types ofTypes ofCommon Stock ValueCommon Stock ValueC.C. Liquidating Value (per share)Liquidating Value (per share) -- The value pershare if the firm’s assets are sold separatelyfrom the operating organization.This value may be less (or greater) thanbook value. Rarely are the two valuesidentical.B.B. Book Value (per share)Book Value (per share) -- Shareholders’ equity(as listed on the balance sheet) divided by thenumber of shares outstanding.
  32. 32. 0-32Example of BookExample of BookValue (per share)Value (per share)FunFinMan, Inc.FunFinMan, Inc.Common stock ($1 par value; 100,000100,000sharesshares issued and outstanding) $ 100,000Additional paid-in capital 400,000Retained earnings 650,000Total shareholders’ equity $1,150,000$1,150,000The book valuebook value (per share) of FunFinMan, Inc.,FunFinMan, Inc., isdetermined by dividing total shareholders’ equitytotal shareholders’ equity($1,150,000) by the shares outstanding (100,000100,000),which yields a book value of $11.50 per sharebook value of $11.50 per share. Thisvalue is not likely to change over time from normalday-to-day operations.
  33. 33. 0-33Types ofTypes ofCommon Stock ValueCommon Stock ValueThis value is usually greater than bookvalue (per share), but can occasionally beless than book value (per share) for firmsthat have been, are or expected to be infinancial difficulties. Rarely are the twovalues identical.Market value (per share) may be difficult toobtain from thinly traded securities.D.D. Market Value (per share)Market Value (per share) -- The current priceat which the stock is currently trading.
  34. 34. 0-34Types ofTypes ofCommon Stock ValueCommon Stock ValueTypically, the shares of newcompanies are traded in the over-the-counter (OTC) market, where dealersmaintain an inventory of the stock toprovide additional liquidity.D.D. Market Value (per share)Market Value (per share) -- continued.
  35. 35. 0-35Rights ofRights ofCommon ShareholdersCommon ShareholdersRight to IncomeRight to Income -- entitled to share in the earnings ofthe company only if cash dividends are paid (viaapproval by the board of directors).Right to Purchase New Shares (Maybe)Right to Purchase New Shares (Maybe) -- thecorporate charter of state statute may provide currentshareholders with a preemptive right, which requiresthat these shareholders be first offered any new issueof common stock or an issue that can be convertedinto common stock.Voting RightsVoting Rights -- because the shareholders are ownersof the firm, they are entitled to elect the board ofdirectors.
  36. 36. 0-36Two methods of voting: (1) in person or (2) by proxyProxyProxy -- A legal document giving one personauthority to act for another.Voting RightsVoting RightsSEC regulates the solicitation of proxies and requirescompanies to disseminate information to theirshareholders through proxy mailings.Most shareholders, if satisfied with companyperformance, sign proxies in behalf of management.Shareholders are generally geographically widelydispersed.
  37. 37. 0-37Voting ProceduresVoting ProceduresMajority-rule votingMajority-rule voting -- a method of electing corporatedirectors, where each common share held carries onevote for each director position that is open; also calledstatutory votingstatutory voting.Cumulative votingCumulative voting -- a method of electing corporatedirectors, where each common share held carries asmany votes as there are directors to be elected andeach shareholder may accumulate these votes andcast them in any fashion for one or more particulardirectors.The board of directors are elected under either:
  38. 38. 0-38VotingVotingProcedures ExampleProcedures ExampleUnder majority-rule votingUnder majority-rule voting: You may cast 100 votes(1 per share) for each of the 9 director positionsopen for a maximum of 100 votes per position.Under cumulative votingUnder cumulative voting: You may cast 900 votes(100 votes x 9 positions) for a single position ordivide the votes amongst the 9 open positions in anymanner you desire.You are a shareholder ofYou are a shareholder of FunFinMan, Inc.FunFinMan, Inc.You own 100 shares and there are 10 directorYou own 100 shares and there are 10 directorpositions to be filled.positions to be filled.
  39. 39. 0-39Minimum Votes to ElectMinimum Votes to Electa Director -- Cumulativea Director -- CumulativeFor example, to elect 3 directors out of 9 directorpositions at FunFinMan, Inc., (100,000 voting sharesoutstanding) would require 30,001 voting shares30,001 voting shares.(100,000 shares) x (3 directors)10Total number ofvoting sharesSpecific number ofdirectors soughtTotal number of directors to be elected + 1X+ 1+ 1 = 30,001 shares30,001 shares
  40. 40. 0-40Minimum Votes to ElectMinimum Votes to Electa Director -- Cumulativea Director -- CumulativeNotice that slightly over 30% of total voting sharesare necessary to guarantee the election of three ofthe nine director positions -- less than a majority.Management can reduce the influence of minorityshareholders by reducing the number of directors orstaggering the election terms of directors so fewerpositions are open at each vote.Reducing the number of directors up for electionfrom 9 to 4 would increase the votes necessary toelect 3 directors to 60,001 shares (twice as many)!
  41. 41. 0-41Dual-ClassDual-ClassCommon StockCommon StockThis is used to retain control for founders,management, or some other specific group.For example, 80,000 shares of Class A at$20/share and 200,000 shares of Class B at$2/share. Class A puts up 80% of the funds, butClass B has over 70% of the votes.Usually Class B takes a lower claim to dividendsand assets than Class A for this voting control.Dual-class Common StockDual-class Common Stock -- Two classes of commonstock, usually designated Class A and Class B. ClassA is usually the weaker voting or nonvoting class, andClass B is usually the stronger.