Oct 2 - extra - ORIE 3150 Bonds Oct. 2, 2008 Long-term debt...

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Oct. 2, 2008 Bonds Long-term debt is used to finance the acquisition of fixed assets and to pursue business activities that have long-run earnings potential. A manager needs to decide 1. Whether to have long-term debt or not 2. How much long-term debt to have 3. What types of long-term debt to have Advantages of long-term debt: 1. Common stockholders do not suffer dilution of their ownership stake. 2. Interest on debt is an expense, and thus reduces net income, which may result in a tax benefit. 3. Financial leverage (financing a company partly with borrowed money, rather than with 100% equity) may increase earnings. This “leverage” is sort of like playing at the high stakes blackjack table. While your winnings will be higher if you win, you can also lose more. Disadvantages of long-term debt: 1. Must make interest and principal payments periodically. This can be a real drain on cash flow. 2. Increased debt increases the chance of financial distress. 3. Lenders may demand management concessions and may dictate company policy. 4. The company’s credit rating becomes important, encouraging financial conservatism and stability. 5. Long-term debt is simply not available to many companies. Start-up companies must usually rely on equity alone. Note: The debt market in the USA is relatively lightly regulated and efficient. Other countries, notably Japan, rely on banks for most of their debt financing. Note: many start-up companies must issue participating preferred stock to their venture capital investors. This instrument, while equity, behaves in some ways like long- term debt. It does lack the tax-deductible interest feature. However, start-up companies are not usually profitable anyway, so the tax-deductible interest feature may have negligible value. The most common type of long-term debt is a long-term bond.
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This note was uploaded on 04/05/2009 for the course ORIE 350 taught by Professor Callister during the Summer '08 term at Cornell University (Engineering School).

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Oct 2 - extra - ORIE 3150 Bonds Oct. 2, 2008 Long-term debt...

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