Unformatted text preview: LONGTERM FINANCING – AN INTRODUCTION
Chapter 15 of the Textbook 1 Chapter Outline
15.1 Common Stock 15.2 Corporate LongTerm Debt: The Basics 15.3 Preferred Stock 15.4 Patterns of LongTerm Financing 15.6 Summary and Conclusions 2 Methods of Securing Financing 3 15.1 Common Stock Par and NoPar Stock Authorized versus Issued Common Stock Contributed Surplus Retained Earnings Market Value, Book Value, and Replacement Value Shareholders’ Rights Dividends Classes of Stock 4 Par and NoPar Stock The stated value on a stock certificate is called the par value.
Par value is an accounting value, not a market value. The total par value (the number of shares multiplied by the par value of each share) is sometimes called the dedicated capital of the corporation. Some stocks have no par value. Typically in Canada, there is no particular par value assigned to stock. 5 Authorized vs. Issued Common Stock The articles of incorporation must state the number of shares of common stock the corporation is authorized to issue. The board of directors, after a vote of the shareholders, may amend the articles of incorporation to increase the number of shares. Authorizing a large number of shares may worry investors about dilution because authorized shares can be issued later with the approval of the board of directors but without a vote of the shareholders.
6 Contributed Surplus Usually refers to amounts of directly contributed equity capital in excess of the par value. For example, suppose 1,000 shares of common stock having a par value of $1 each are sold to investors for $8 per share. The contributed surplus would be ($8 – $1) × 1,000 = $7,000 7 Retained Earnings Not many firms pay out 100percent of their earnings as dividends. The earnings that are not paid out as dividends are referred to as retained earnings. 8 Market Value, Book Value, and Replacement Value Market Value is the price of the stock multiplied by the number of shares outstanding. Also known as Market Capitalization Common stocks of Canadian corporations trade on the Toronto Stock Exchanges (TSX) and U.S. stock exchanges (NYSE, NASDAQ). Book Value The sum of par value, contributed surplus, accumulated retained earnings, and adjustments to equity is the common equity of the firm, usually referred to as the book value of the firm.
9 Market Value, Book Value, and Replacement Value (continued) Example: Enbridge Inc. Shareholder’s Equity at Book Value, 2003 (in $ thousands) Common stock and other shareholders’ equity $2,897,300 Retained earnings 1,511,400 Reciprocal shareholding (135,700) Foreign exchange adjustment 10 Market Value, Book Value, and Replacement Value (continued) Replacement Value The current cost of replacing the assets of the firm. At the time a firm purchases an asset, market value, book value, and replacement value are equal. The markettobook ratio of common stock and Tobin’s Q (market value of assets / replacement value of assets) are indicators of the success of the firm. If these ratios are greater than one, then this indicates that the firm has done well with its investment decisions.
11 Shareholders’ Rights The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders. Directors are elected each year at an annual meeting by a vote of the holders of a majority of shareswho are present and entitled to vote. The exact mechanism varies across companies. The important difference is whether shares are to be voted cumulatively or voted straight.
12 Cumulative versus Straight Voting The effect of cumulative voting is to permit minority participation. Under cumulative voting, if there are N directors up for election, then 1/(N+1) percent of the stock plus one share will guarantee you a seat. With cumulative voting, the more seats that are up for election at one time, the easier it is to win one. Straight voting works like a U.S. political election. Shareholders have as many votes as shares and each position on the board has its own election.
13 Imagine a firm with two shareholders: Mr. MacDonald and Ms. Laurier. Cumulative vs. Straight Voting: Example Mr. MacDonald owns 60% of the firm ( = 600 shares) and Ms. Laurier 40% ( = 400 shares). There are three seats up for election on the board. Under straight voting, Mr. MacDonald gets to pick all three seats. Under cumulative voting, Ms. Laurier has 1,200 votes ( = 400 shares × 3 seats) and Mr. MacDonald 1,800 votes. Ms. Laurier can elect at least one board 14 A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares. For convenience, the actual voting in large public corporations is usually done by proxy, e.g. BCE Inc. If shareholders are not satisfied with management, an outside group of shareholders can try to obtain as many votes as possible via proxy. Proxy battles are often led by large pension funds like the Ontario Teachers’ Pension Board or the British Columbia Investment Management Corporation. Proxy Voting 15 Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. Dividends The payment of dividends by the corporation is not a business expense. A corporation cannot default on an undeclared dividend. Dividends received by individual shareholders are partially sheltered by a dividend tax credit. (Appendix of Chapter 1) There is a pension for Canadian corporations to avoid the double taxation of dividends. 16 Therefore, they are not taxdeductible. When more than one class of share exists, they are usually created with unequal voting rights. Many companies issue dual classes of common stock. The reason has to do with control of the firm. Classes of Shares Lease, McConnell, and Mikkelson found the market prices of U.S. stocks with superior voting rights to be about 5percent higher than the prices of otherwiseidentical stocks with inferior voting rights.
17 AmoakoAdu and Smith show that firms going public with dual classes of shares in Canada are often family controlled. 15.2 Corporate LongTerm Debt: The Basics Interest versus Dividends Is It Debt or Equity? Basic Features of LongTerm Debt Different Types of Debt Repayment Seniority Security Indenture
18 Debt is not an ownership interest in the firm. Creditors do not usually have voting power. The device used by creditors to protect themselves is the loan contract (i.e., indenture). The corporation’s payment of interest on debt is considered a cost of doing business and is fully taxdeductible. Dividends are paid out of aftertax dollars. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. Interest versus Dividends One of the costs of issuing debt is the possibility 19 Is It Debt or Equity? Some securities blur the line between debt and equity. Corporations are very adept at creating hybrid securities that look like equity but are called debt. Obviously, the distinction is important at tax time. A corporation that succeeds in creating a debt security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs. 20 The bond indenture usually lists Basic Features of LongTerm Debt Features that may change over time
Rating YieldtoMaturity Market Price Amount of Issue, Date of Issue, Maturity Denomination (Par value) Annual Coupon, Dates of Coupon Payments Security Sinking Funds Call Provisions Covenants 21 A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property. A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under seven years. Debentures and bonds are longterm debt, i.e., payable more than one year from the date they are originally issued.
22 Different Types of Debt Repayment Bonds can be repaid at maturity or earlier through the use of a sinking fund. A sinking fund is an account managed on behalf of the issuer by a bond trustee for the purpose of retiring all or part of the bonds prior to their stated maturity. Debt may be extinguished before maturity through a call provision giving the firm the right to pay a specific amount to retire the debt before the stated maturity date.
23 Seniority Seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first. Debt cannot be subordinated to equity. 24 Security Security is a form of attachment to property. It provides that the property can be sold in event of default to satisfy the debt for which the security is given. A mortgage is used for security in tangible property. Debentures are not secured by a mortgage. If mortgaged property is sold in the event of default, debenture holders will obtain something only if the mortgage bondholders have been fully 5 2 For example, debt can be secured by mortgages on plant and equipment. Indenture The written agreement between the corporate debt issuer and the lender. Sets forth the terms of the loan:
Maturity Interest rate Protective covenants Examples: restrictions on further indebtedness, a maximum on the amount of dividends that can be paid, a minimum level of working capital. 26 Represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy. Preferred shares have a stated liquidating value. For example, CIBC “$2.25 preferred” translates into a dividend yield of 9% of the stated $25 value. Preferred dividends are either cumulative or noncumulative. Firms may have an incentive to delay preferred dividends, since preferred shareholders receive no interest on the cumulated dividends.
27 15.3 Preferred Shares Is Preferred Stock Really Debt? A good case can be made that preferred stock is really debt in disguise.
The preferred shareholders receive a stated dividend. In the event of liquidation, the preferred shareholders are entitled to a fixed claim. Some preferred shares have adjustable dividends. An example is the CARP (cumulative, adjustable rate, preferred). In Canada, corporate investors have an incentive to hold preferred shares issued by other corporations, since 100% of the dividends they receive are exempt from 28 The Preferred Shares and Taxes In Canada, a tax loophole encourages corporations that are lightly taxed to issue preferred shares. Lowtax companies can make little use of the tax deduction on interest. They can issue preferred shares and enjoy lower financing costs since preferred dividends are significantly lower than interest payments. There are several reasons beyond taxes why preferred shares are issued: Regulated public utilities can pass the tax disadvantage of issuing preferred shares on their customers.
29 The Preferred Shares and Taxes (continued) Firms issuing preferred shares can avoid the threat of bankruptcy that might otherwise exist if debt were relied on. Issuing preferred shares may be a means of raising equity without surrendering control. 30 For Canadian firms, internally generated cash flow dominates as a source of financing. Firms usually spend more than they generate internally—the gap is financed by new sales of debt and equity. Net new issues of equity are dwarfed by new sales of debt. This is consistent with the pecking order hypothesis (later in details). Leverage ratios for Canadian firms are considerably higher than they were in the 1960s.
31 15.4 Patterns of LongTerm Financing The LongTerm Financial Gap
Uses of Cash Flow (100%) Capital spending Sources of Cash Flow (100%) Internal cash flow (retained earnings plus depreciation) 68.3% Financial deficit Long-term debt and equity 31.7% External cash flow Internal cash flow Net working capital plus other uses 32 The basic sources of longterm financing are: LongTerm Debt Common Stock Preferred Stock Common shareholders have voting rights, limited liability, and a residual claim on the corporation. Bondholders have a contractual claim against the corporation. Preferred stock has some of the features of debt and equity. Firms need financing—most of it is generated internally.
33 15.5 Summary and Conclusions Review Questions # Review Questions: 15.1, 15.2, 15.3, 15.5, 15.6 34 Assigned Questions # Assigned Questions # 15.4, 15.7, 15.8, 15.10 35 ...
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