Long-term financing

Review item When a firm creates value through a

financial transaction, who gets the increase?

Answer Old equity means the shareholders at

the time the decision is made. Old equity gets the gains. Why? Old equity has no competitors.

Everyone else is competitive and must accept a market return.

Chapter 14 Long-Term Financing: An Introduction

Common Stock Corporate Long-term Debt: The Basics Preferred Stock Patterns of Financing Recent Trends in Capital Structure

Shareholders rights Preemptive right to a proportionate

share of any new stock sold. Proportionate share in dividends. Proportionate share in liquidation. Voting rights … of some kind

Straight voting Each seat on the board of directors is a

separate election. In each election, the shareholder has

votes in proportion to her shares. A thin majority can freeze out minority

directors.

Cumulative voting All directors are elected in a single

election. The n highest vote getters are elected. Each shareholder has votes in

proportion to her shares. A minority can elect at least one

director.

How many votes are needed to elect one director?

n directors. Minority has fraction x of all votes. Assume the worst, your opponent plays

optimally. He votes (1-x)/n for each of n seats (no

cheap seats). You need x > (1-x)/n, that is, x > 1/(n+1) (plus one vote)

Example Smith and Marshall Four seats. Smith is the minority. Fraction of votes needed to elect is 1/5. Smith needs only 1/5 + 1 vote. Marshall

can muster 3/5 of the total votes for 3 candidates and 1/5 – 1 votes for the fourth.

Dividend facts Dividends are not tax deductible to the

corporation that pays them. Corporations owning other corporations

are exempt from 70% of the tax that would otherwise fall on dividends.

Skipping dividends does not put a firm in default.

Debt Contractual relation with the firm, via

the indenture. No voting rights. Interest is deductible from corporate

taxes. Missing any interest payment puts the

firm in default.

Notes, debentures, bonds Notes are shorter term, unsecured. Debentures are long term, unsecured. (Mortgage) bonds are secured.

Sinking funds Debt is gradually extinguished. Money in the fund buys back the bonds

steadily.

Call provisions Specified in the indenture. Call price is above par … but is below market when called. Call protection for 5 or 10 years

Indenture Among creditors, a coordination

problem. Prisoner’s dilemma. Free rider problem.

Solution: trustee (a law firm) Restrictive covenants -- new debt, size

of dividends, minimum working capital

Default of bonds If the firm misses a debt payment to

any bond, repayment of all other bonds is immediately due, an impossible task.

Bondholders get control of the firm. Bankruptcy proceedings or

reorganization.

Preferred stock Stated percentage dividends. No voting rights. Preferred dividends can be skipped but

are rarely, and only if common dividends are skipped.

Contingent voting rights when the firm is near bankruptcy.

Corporations hold preferred stock

Not individuals, because taxes are higher to them.

Individuals hold preferred by holding common in firms that hold preferred.

Corporations pay tax on interest from the debt of other corporations but only 30% on preferred dividends.

Financing Decisions by U.S. Non-financial Corporations

-30

0

30

60

90

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Internal financingNew debtNew stock

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.

Year

Percent

Convertible debt – an option Can be traded for shares at a fixed

price. Need not be traded. Rationale: cash in on success if the firm

becomes vary valuable Retain rights of debt if the firm fails.

Debt-to-Asset Ratio (Book Value) for U.S. Non-financial Firms from 1979 to 1994

0

10

20

30

40

50

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Year

Percent

Source: OECD data from the 1995 edition of Financial Statements of Nonfinancial Enterprises.

Debt-to-Asset Ratio (Market Value) for U.S. Non-financial Firms from 1980 to 1994

0

10

20

30

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Year

Percent

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.

Review Item Two assets have the same expected

return. Each has a standard deviation of 2%. The correlation coefficient is .5. What is the standard deviation of an

equally weighted portfolio?

Answer Var P

= .5x.5x4+.5x.5x4+2x.5x.5x.5x2x2 = 3 Standard deviation = sq. root of 3 =1.732