Financial Management 14 Edition

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Chapter 20Chapter 20
Long-Term Debt,Long-Term Debt,
Preferred Stock, andPreferred Stock, and
Common StockCommon Stock
Instructor: Ajab Khan Burki

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Long-Term Debt, PreferredLong-Term Debt, Preferred
Stock, and Common StockStock, and Common Stock
Bonds and Their Features
Types of Long-Term Debt
Instruments
Retirement of Bonds
Preferred Stock and Its Features
Rights of Common Shareholders
Dual-Class Common Stock

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Bonds and Their FeaturesBonds and Their Features
Basic TermsBasic Terms
Par Value Coupon Rate
Maturity Bond Ratings
BondBond -- A long-term debt instrument
with a final maturity generally being
10 years or more.

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Trustee and IndentureTrustee and Indenture
TrusteeTrustee -- A person or institution designated
by a bond issuer as the official
representative of the bondholders.
Typically, a bank serves as trustee.
IndentureIndenture -- The legal agreement, also called
the deed of trustdeed of trust, between the corporation
issuing bonds and the bondholders,
establishing the terms of the bond issue and
naming the trustee.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
Investors look to the earning power of the firm as
their primary security.
Investors receive some protection by the
restrictions imposed in the bond indenture,
particularly any negative-pledge clausenegative-pledge clause.
A negative-pledge clausenegative-pledge clause precludes the corporation
from pledging any of its assets (not already
pledged) to other creditors.
DebentureDebenture -- A long-term, unsecured debt
instrument.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
In this case, subordinated debenture holders rank
behind debenture holders but ahead of preferred and
common stockholders in the event of liquidation.
Frequently, the security is convertible into common
stock to lower the yield required by subordinated
debenture holders (often less than regular debentures).
Subordinated DebentureSubordinated Debenture -- A long-term,
unsecured debt instrument with a lower claim
on assets and income than other classes of
debt; known as junior debt.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
Frequently, there is a cumulative feature,cumulative feature, which
provides that any unpaid interest in a particular year
accumulates. The cumulative obligation is usually
limited to no more than three years.
The bonds are unpopular with investors (usually
limited to reorganizations), but are still senior to
preferred and common shareholders in the event of
liquidation.
Income BondIncome Bond -- A bond where the payment of
interest is contingent upon sufficient
earnings of the firm.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
These are bonds with a rating of Ba (Moody's) or lower.
Principal investors are pension funds, high-yield bond
mutual funds, and some individual investors.
Liquidity varies depending on investor sentiments.
Junk bonds were used frequently in the 1980s as a
means of financing leveraged buyouts (LBOs).
Junk BondJunk Bond -- A high-risk, high-yield (often
unsecured) bond rated below investment
grade.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
The issue is secured by a lienlien on specificspecific
assetsassets of the corporation.
The market value of the collateral should
exceed the amount of the bond issue by a
reasonable margin of safety to help protect
bondholders.
Mortgage BondMortgage Bond -- A bond issue secured by a
mortgage on the issuer’s property.

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
If the corporation defaults, the trustee can
foreclose on behalf of the bondholders. The
bondholders become general creditors for any
residual amount after the sale of the collateral.
The corporation may have a first mortgage
and a second mortgage on the same assets.
The first mortgage has a senior claim on the
assets.
Mortgage BondMortgage Bond (Continued)

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
A railroad arranges with a trustee to purchase
equipment from a manufacturer.
The railroad signs a contract with the manufacturer
for the construction of specific equipment.
When the equipment is delivered, equipment trust
certificates are sold to investors.
Equipment Trust CertificateEquipment Trust Certificate -- An intermediate- to
long-term security, usually issued by a transportation
company such as a railroad or airline, that is used to
finance new equipment.
Let us look at an example using a railroadLet us look at an example using a railroad..

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Types of Long-TermTypes of Long-Term
Debt InstrumentsDebt Instruments
Proceeds plus the railroad downpayment are used
to pay the manufacturer.
Title of the equipment is held by the trustee, and
the trustee leases the equipment to the railroad.
Lease payments are used to pay a fixed dividend to
the certificate holders and to retire a specified
portion of the certificates at regular intervals.
After the final lease payment (all certificates are
retired), title to the equipment passes to the
railroad.
Equipment Trust CertificatesEquipment Trust Certificates (Continued)

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Asset SecuritizationAsset Securitization
Purpose: To reduce financing costs
Firm picks assets to “package” and use cash flows
Assets removed from the balance sheet and sold to bankruptcy-
remote entity (special-purpose vehicle -- SPV)
SPV raises money by selling asset-backed securities
Asset SecuritizationAsset Securitization – The process of packaging a
pool of assets and then selling interests in the pool in
the form of asset-backed securities.
Asset-backed SecurityAsset-backed Security – Debt securities whose
interest and principal payments are provided by the
cash flows coming from a discrete pool of assets.

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Retirement of BondsRetirement of Bonds
The corporation makes a cash payment to the
trustee, which calls the bonds.
The corporation purchases bonds in the open
market and delivers them to the trustee.
Sinking FundSinking Fund -- Fund established to periodically
retire a portion of a security issue before
maturity. The corporation is required to make
periodic sinking-fund payments to a trustee.
Two forms for the sinking-fundTwo forms for the sinking-fund
retirement of a bondretirement of a bond::

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Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
When bonds are called for redemption, the
bondholders will receive the sinking-fundsinking-fund
call pricecall price.
The bonds are called on a lottery basis (by
their serial numbers) and published in
periodicals like The Wall Street JournalWall Street Journal.
Bonds should be purchased in the open
market if the market price is less than the
sinking-fund call pricesinking-fund call price.

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Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
Volatility in interest rates or a decline in the
credit quality of the firm could lower the
market price of the bond and enhance the
value to the firm of having this option.
Bondholders may benefit from the orderly
retirement of debt (amortization effect),
which reduces the default risk of the firm
and adds liquidity to bonds outstanding.

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Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
Many bond issues are designed to have a larger
final payment to pay off the debt.
For example, a corporation may undertake a $10
million, 15-year bond issue. The firm is
obligated to make $500,000 sinking-fund
payments in the 5th
through 14th
years. The final
balloon payment in the 15th
year would be for the
remaining $5 million of bonds.
Balloon PaymentBalloon Payment -- A payment on debt that
is much larger than other payments.

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Serial BondsSerial Bonds
For example, a $10 million issue of serial
bonds might have $500,000 of predetermined
bonds maturing each year for 20 years.
Investors are able to choose the maturity that
best fits their needs (wider investor appeal).
Serial BondsSerial Bonds -- An issue of bonds with
different maturities, as distinguished from
an issue where all bonds have identical
maturities (term bonds).

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Call ProvisionCall Provision
Not all bonds are callable. In periods of low
interest (hence, low coupon) rates, firms are
more likely to issue noncallable bonds.
When a bond is callable, the call pricecall price is
usually above the par value of the bond and
often decreases over time.
Call ProvisionCall Provision -- A feature in an indenture that
permits the issuer to repurchase securities at
a fixed price (or series of fixed prices) before
maturity; also called call featurecall feature.

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Call PriceCall Price
For example, the call price for the first year
might equal the bond par value plus one-year’s
interest.
According to when they can be exercised, call
provisions can be either immediate or deferred.
The call provision provides financing flexibility
for the firm as conditions change.
Call PriceCall Price -- The price at which a security with
a call provision can be purchased by the
issuer prior to the security’s maturity.

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Value of the Call PrivilegeValue of the Call Privilege
The call privilege is valuable to the firm to the
detriment of bondholders. As such, bondholders
require a premiumpremium for this additional risk in the
form of a higher yield.
The greater the volatility of interest rates, the
greater the probability that the firm will call the
bonds. Thus, the call-optioncall-option is more valuable all
else equal.
Callable-bondCallable-bond
valuevalue
Noncallable-Noncallable-
bond valuebond value
Call-optionCall-option
valuevalue= -

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Preferred StockPreferred Stock -- A type of stock that
promises a (usually) fixed dividend, but
at the discretion of the board of directors.
Preferred StockPreferred Stock
and Its Featuresand Its Features
Basic TermsBasic Terms
Par Value
Dividend Rate
Maturity

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CumulativeCumulative
Dividends FeatureDividends Feature
For example, if the board of directors omits a $6
preferred dividend for two years, it must pay preferred
shareholders $12 per share ($100 par value) before
any dividend can be paid to common shareholders.
The corporation does not have to make up the
dividend even if it is profitable, as long as the firm has
no plans to pay dividends to common shareholders.
Cumulative Dividends FeatureCumulative Dividends Feature -- A requirement
that all cumulative unpaid dividends on the
preferred stock be paid before a dividend may
be paid on the common stock.

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Participating FeatureParticipating Feature
Preferred stockholders have a prior claim on income
and an opportunity for additional return if the
dividends to common stockholders exceed a certain
amount.
A 6% participating preferred issue ($100 par) allows
holders to share equally in any dividend in excess of
$6. A $7 common dividend results in an extra $1
dividend to the participating preferred shareholders.
Participating Preferred StockParticipating Preferred Stock -- Preferred stock where
the holder is allowed to participate in increasing
dividends if the common stockholders receive
increasing dividends.

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Voting Rights inVoting Rights in
Special SituationsSpecial Situations
Preferred stockholders are not normally given a voice
in management unless the company is unable to pay
preferred stock dividends during a specified period.
If such a situation presents itself, the class of
preferred stockholders would be entitled to elect a
specified number of directors.
Any situation in which the company defaults under
restrictions in the agreement (similar to bond
indenture) may lead to voting power for preferred
shareholders.
Preferred shareholders cannot force the immediate
repayment of obligations (like debt obligations).

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Retirement ofRetirement of
Preferred StockPreferred Stock
Call ProvisionCall Provision -- almost all issues carry a call provision
because of the infinite maturity. It is often a cheaper
method of retirement than open market purchases,
inviting tenders, or an exchange of securities.
Sinking FundSinking Fund -- like bonds, many preferred issues
provide for this method of retirement.
ConversionConversion -- certain issues are convertible into
common stock at the option of the preferred
stockholder. Used most frequently in the acquisition of
other companies (the transaction is not taxable to the
shareholders of the acquired firm).

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Use of PreferredUse of Preferred
Stock in FinancingStock in Financing
The corporate issuercorporate issuer uses irregularly because the
preferred dividend is not tax deductible. Utilities use
more frequently as the preferred dividend can be
accounted for when setting customer rates.
The corporate investorcorporate investor is attracted to preferred stock as
generally 70% of dividends can be excluded from taxes.
Flexibility in paying dividends and an infinite maturity
(similar to a perpetual loan) are significant advantages
to the corporate issuercorporate issuer.
The after-tax cost of preferred financing is greater than
that of long-term debt financing to the corporate issuercorporate issuer.

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Common StockCommon Stock
and Its Featuresand Its Features
Basic TermsBasic Terms
Authorized Shares
Issued Shares
Outstanding Shares
Common StockCommon Stock -- Securities that
represent the ultimate ownership
(and risk) position in a corporation.

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Types ofTypes of
Common Stock ValueCommon Stock Value
It is merely a recorded figure in the corporate
charter and is of little economic consequence.
Stock should never be issued below par value as
shareholders would be legally liable for any
discount 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 original
market price or at some assigned (or stated) value.
The difference between the issuing price and the par
or stated value is additional paid-in capitaladditional paid-in capital.
A.A. Par ValuePar Value -- The face value.

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Example of ValueExample of Value
FunFinMan, Inc.FunFinMan, Inc.
Common stock ($1 par value$1 par value; 100,000
shares issued and outstanding) $ 100,000
Additional paid-in capital 400,000
Retained earnings 650,000
Total shareholders’ equity $1,150,000
The par valuepar value of FunFinMan, Inc.,FunFinMan, Inc., is $1 per share$1 per share.
This value is not likely to change over time from
normal day-to-day operations.

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Types ofTypes of
Common Stock ValueCommon Stock Value
C.C. Liquidating Value (per share)Liquidating Value (per share) -- The value per
share if the firm’s assets are sold separately
from the operating organization.
This value may be less (or greater) than
book value. Rarely are the two values
identical.
B.B. Book Value (per share)Book Value (per share) -- Shareholders’ equity
(as listed on the balance sheet) divided by the
number of shares outstanding.

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Example of BookExample of Book
Value (per share)Value (per share)
FunFinMan, Inc.FunFinMan, Inc.
Common stock ($1 par value; 100,000100,000
sharesshares issued and outstanding) $ 100,000
Additional paid-in capital 400,000
Retained earnings 650,000
Total shareholders’ equity $1,150,000$1,150,000
The book valuebook value (per share) of FunFinMan, Inc.,FunFinMan, Inc., is
determined 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. This
value is not likely to change over time from normal
day-to-day operations.

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Types ofTypes of
Common Stock ValueCommon Stock Value
This value is usually greater than book
value (per share), but can occasionally be
less than book value (per share) for firms
that have been, are or expected to be in
financial difficulties. Rarely are the two
values identical.
Market value (per share) may be difficult to
obtain from thinly traded securities.
D.D. Market Value (per share)Market Value (per share) -- The current price
at which the stock is currently trading.

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Types ofTypes of
Common Stock ValueCommon Stock Value
Typically, the shares of new
companies are traded in the over-the-
counter (OTC) market, where dealers
maintain an inventory of the stock to
provide additional liquidity.
D.D. Market Value (per share)Market Value (per share) -- continued.

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Rights ofRights of
Common ShareholdersCommon Shareholders
Right to IncomeRight to Income -- entitled to share in the earnings of
the company only if cash dividends are paid (via
approval by the board of directors).
Right to Purchase New Shares (Maybe)Right to Purchase New Shares (Maybe) -- the
corporate charter of state statute may provide current
shareholders with a preemptive right, which requires
that these shareholders be first offered any new issue
of common stock or an issue that can be converted
into common stock.
Voting RightsVoting Rights -- because the shareholders are owners
of the firm, they are entitled to elect the board of
directors.

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Two methods of voting: (1) in person or (2) by proxy
ProxyProxy -- A legal document giving one person
authority to act for another.
Voting RightsVoting Rights
SEC regulates the solicitation of proxies and requires
companies to disseminate information to their
shareholders through proxy mailings.
Most shareholders, if satisfied with company
performance, sign proxies in behalf of management.
Shareholders are generally geographically widely
dispersed.

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Voting ProceduresVoting Procedures
Majority-rule votingMajority-rule voting -- a method of electing corporate
directors, where each common share held carries one
vote for each director position that is open; also called
statutory votingstatutory voting.
Cumulative votingCumulative voting -- a method of electing corporate
directors, where each common share held carries as
many votes as there are directors to be elected and
each shareholder may accumulate these votes and
cast them in any fashion for one or more particular
directors.
The board of directors are elected under either:

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VotingVoting
Procedures ExampleProcedures Example
Under majority-rule votingUnder majority-rule voting: You may cast 100 votes
(1 per share) for each of the 9 director positions
open 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 or
divide the votes amongst the 9 open positions in any
manner 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 director
positions to be filled.positions to be filled.

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Minimum Votes to ElectMinimum Votes to Elect
a Director -- Cumulativea Director -- Cumulative
For example, to elect 3 directors out of 9 director
positions at FunFinMan, Inc., (100,000 voting shares
outstanding) would require 30,001 voting shares30,001 voting shares.
(100,000 shares) x (3 directors)
10
Total number of
voting shares
Specific number of
directors sought
Total number of directors to be elected + 1
X
+ 1
+ 1 = 30,001 shares30,001 shares

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Minimum Votes to ElectMinimum Votes to Elect
a Director -- Cumulativea Director -- Cumulative
Notice that slightly over 30% of total voting shares
are necessary to guarantee the election of three of
the nine director positions -- less than a majority.
Management can reduce the influence of minority
shareholders by reducing the number of directors or
staggering the election terms of directors so fewer
positions are open at each vote.
Reducing the number of directors up for election
from 9 to 4 would increase the votes necessary to
elect 3 directors to 60,001 shares (twice as many)!

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Dual-ClassDual-Class
Common StockCommon Stock
This 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, but
Class B has over 70% of the votes.
Usually Class B takes a lower claim to dividends
and assets than Class A for this voting control.
Dual-class Common StockDual-class Common Stock -- Two classes of common
stock, usually designated Class A and Class B. Class
A is usually the weaker voting or nonvoting class, and
Class B is usually the stronger.