Chapter 15
LONG-TERM FINANCING: AN INTRODUCTION
SLIDES
CHAPTER WEB SITES
Section Web Address
15.2 www.investinginbonds.com
www.nasdbondinfo.com
www.sifma.org
www.sec.gov
CHAPTER ORGANIZATION
15.1 Some Features of Common and Preferred Stocks
Common Stock Features
Preferred Stock Features
15.2 Corporate Long-Term Debt
Is It Debt or Equity?
Long-Term Debt: The Basics
The Indenture
15.3 Some Different Types of Bonds
Floating-Rate Bonds
15.1 Key Concepts and Skills
15.2 Chapter Outline
15.3 Features of Common Stock
15.4 Features of Preferred Stock
15.5 Debt versus Equity
15.6 The Bond Indenture
15.7 Bond Classifications
15.8 Required Yields
15.9 Zero Coupon Bonds
15.10 Pure Discount Bonds
15.11 Pure Discount Bonds: Example
15.12 Floating Rate Bonds
15.13 Other Bond Types
15.14 Bank Loans
15.15 International Bonds
15.16 Patterns of Financing
15.17 The Long-Term Financial Deficit
15.18 Recent Trends in Capital Structure
15.19 Quick Quiz
Other Types of Bonds
15.4 Bank Loans
15.5 International Bonds
15.6 Patterns of Financing
15.7 Recent Trends in Capital Structure
Which Are Best: Book or Market Values?
ANNOTATED CHAPTER OUTLINE
Slide 15.0 Chapter 15 Title Slide
Slide 15.1 Key Concepts and Skills
Slide 15.2 Chapter Outline
1. Some Features of Common and Preferred Stocks
A. Common Stock Features
Slide 15.3 Features of Common Stock
Shareholders have the right to elect corporate directors who set corporate
policy and select operating management.
1. Cumulative voting –the directors are all elected at once. Total votes that
each shareholder may cast equal the number of shares times the number of
directors to be elected. In general, if N directors are to be elected, it takes
[1 / (N+1)] percent of the stock + 1 share to assure a deciding vote for one
directorship. It is good for getting minority shareholder representation on
the board.
2. Straight (majority) voting – the directors are elected one at a time, and
every share gets one vote. It is good for freezing out minority
shareholders.
3. Staggered elections – directors’ terms are rotated so they aren’t elected
at the same time. This makes it harder for a minority shareholder group to
elect a director, and it complicates takeovers. This is often referred to as a
classified board.
4. Proxy voting – grant of authority by a shareholder to someone else to
vote his or her shares. A proxy fight is a struggle between management
and outsiders for control of the board, waged by soliciting shareholders’
proxies.
Lecture Tip: Large institutions, such as mutual funds and pension funds,
used to remain on the sidelines when it came to corporate control.
However, several institutions have become much more active in recent
years and have worked to force companies to operate in the shareholders’
best interests. CalPERS, the pension plan for California public employees,
has been at the forefront of the corporate governance movement.
Management for the fund takes their job as “shareowners” so seriously
that they
have a section of their web site devoted to corporate governance issues.
For more information, see http://www.calpers-
governance.org/principles/home. This issue has become even more
important in recent years, given the number of scandals related to
corporate management by Boards of Directors and executive officers.
Other rights usually include:
1. Sharing proportionately in dividends paid
2. Sharing proportionately in any liquidation value
3. Voting on matters of importance (e.g., mergers)
4. The right to purchase any new stock sold – the preemptive right
Lecture Tip: The importance of the preemptive right was driven home in
November, 1996 to the shareholders of Marvel Entertainment Group, the
company that produces Marvel Comics. (Marvel’s stable of characters
includes Spider–Man, the Fantastic Four, and the Incredible Hulk, among
others.) Despite Marvel’s dominance of the comic book market, the
declining size of the market, as well as a heavy debt load, caused Marvel
to run the risk of default. In order to obtain needed funds, Ron Perelman,
who (through his other firms) owned approximately 80% of the
outstanding shares, proposed that Marvel issue 410 million new shares at
a price of $0.85 per share. The effect of the announcement was to drive
the price of the outstanding 20% of the shares Perelman didn’t own from
$4.625 to less than $2.50. To add insult to injury, according to The Wall
Street Journal, Perelman had the power, as the majority shareholder, to
force the plan through.
Subsequently, Marvel filed for bankruptcy reorganization and Carl
Icahn sought to gain control of the firm. Ultimately, Marvel merged with
Toy Biz, much to Icahn’s displeasure. The combined company was called
Marvel Enterprises.
Dividends – return on shareholder capital.
1. Payment of dividends is at the discretion of the board. A firm cannot
default on an undeclared dividend, nor can it be forced to file for
bankruptcy because of nonpayment of dividends.
2. Dividends are not tax deductible for the paying firm.
3. Dividends received by individuals are taxed based on the holding period
of the stock, while dividends received by a corporation are at least 70%
tax-exempt.
Lecture Tip: The tax laws regarding dividends received by individuals
were revised for dividends received after 2002. Qualified dividends are
taxed at the capital gains rate of 15% if the tax rate on ordinary income is
25% or higher and at 5% if the tax rate on ordinary income is less than
25%. According to the Internal Revenue Service, all of the following
requirements must be met:
1. The dividends must have been paid by a U.S. corporation or qualified
foreign corporation.
2. The dividends are not of the type listed under “Dividends that are not
qualified dividends.”
3. The proper holding period is met.
The “proper holding period” requires the stockholder to own the shares
for at least 61 days during the 121 day period surrounding the ex–dividend
date (60 days before, the ex-dividend date, 60 days after). Preferred stock
may have slightly different requirements in certain circumstances.
Dividends that are NOT qualified include:
1. Capital gains distributions
2. Dividends paid on deposits with banks or credit unions that should be
included in interest income
3. Dividends from a tax-exempt corporation or farmer’s cooperative
4. Dividends paid on stock owned through an employee stock ownership
plan
5. Dividends paid on short sale or similar positions where the shareholder
is obligated to make related payments for positions in similar or related
property
6. Payments in lieu of dividends
Resource: www.irs.gov “What are Qualified Dividends?” (article)
B. Preferred Stock Features
Slide 15.4 Features of Preferred Stock
Preferred stock has precedence over common stock in the payment of
dividends and in liquidation. Its dividend is usually fixed, and the stock is
often without voting rights. The stated value is the value paid to preferred
stockholders in the event of liquidation.
Cumulative dividends – current preferred dividend plus all arrearages
(unpaid dividends) to be paid before common stock dividends can be paid.
Non-cumulative dividend preferred stock does not have this feature.
Preferred stock represents equity in the firm, but it has many features of
debt, including a stated yield, preference in terms of cash flows and
liquidation, and some issues are callable and/or convertible into common
shares.
Lecture Tip: Here’s a gruesome-sounding security – the “death spiral.”
Actually, the name refers to convertible preferred shares that have a
floating conversion ratio. That is, the conversion ratio varies with the price
of the firm’s common stock. Also known as “toxic convertibles,” The Wall
Street Journal reports that, when the issuer’s common stock falls, more
shares must be issued to redeem the convertible securities, which pushes
the common stock price down further, hence the “death spiral”
appellation.
2. Corporate Long-Term Debt
A. Is It Debt or Equity?
Slide 15.5 Debt versus Equity
In general, debt securities are characterized by the following attributes:
-Creditors generally have no voting rights.
-Payment of interest on debt is a tax-deductible business expense.
-Unpaid debt is a liability, so default subjects the firm to legal action by
its creditors.
It is sometimes difficult to tell whether a hybrid security is debt or equity.
The distinction is important for many reasons, not the least of which is that
(a) the IRS takes a keen interest in the firm’s
financing expenses in order to be sure that nondeductible expenses are not
deducted and (b) investors are concerned with the strength of their claims
on firm cash flows.
B. Long-Term Debt: The Basics
Major forms are public and private placement.
Long-term debt – loosely, bonds with a maturity of one year or more.
(Intermediate term debt is usually categorized as debt with maturities
between 2 to 10 years.)
Short-term debt – less than a year to maturity, also called unfunded debt.
Bond – strictly speaking, secured debt; but used to describe all long-term
debt.
C. The Indenture
Slide 15.6 The Bond Indenture
Indenture – written agreement between issuer and creditors detailing terms
of borrowing. (Also deed of trust.) The indenture includes the following
provisions:
-Bond terms
-The total face amount of bonds issued
-A description of any property used as security
-The repayment arrangements
-Any call provisions
-Any protective covenants
Terms of a bond – face value, par value, and form
Registered form – ownership is recorded, payment made directly to
owner
Bearer form – payment is made to holder (bearer) of bond
Lecture Tip: Although the majority of corporate bonds have a $1,000 face
value, there are an increasing number of “baby bonds” outstanding, i.e.,
bonds with face values less than $1,000. The use of the term “baby bond”
goes back at least as far as 1970, when it was used in connection with
AT&T’s announcement of the intent to sell bonds with low face values. It
was also used in describing Merrill Lynch’s 1983 program to sell bonds
with $25 face values. More recently, the term has come to mean bonds
issued in lieu of interest payments by firms unable to make the
payments in cash. Baby bonds issued under these circumstances are also
called “PIK” (payment-in-kind) bonds, or “bunny” bonds, because they
tend to proliferate in LBO circumstances.