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TOPIC 9: LONG-TERM FINANCING (1. Bonds (Characteristics (Credit rating…
TOPIC 9: LONG-TERM FINANCING
Long-term financing
Definition
Financial obligations
that are committed by the firm for
5-20 years
or longer
Types
Bonds
Common stock
Preferred stock
1. Bonds
Definition
Debt instruments
issued by a
corporation or government
which obligates them to make
periodic payments
to the holder and repay the
principal
at bond's
maturity date
Characteristics
Bond period
Type of collateral
Payment of interst
Credit rating
3rd party rating of issuer's
credit worthiness
Call feature
issue can repay bond
before maturity
Conversion feature
ability to convert bond into
common shares
Advantages
Preserves control of common shareholders (as no
voting rights
)
Fixed interest repayment
Profit of firm shared among shareholders only
Coupon interest is tax deductable
Disadvantages
Legal obligations to pay interest
Fixed maturity date to repay interest
A claim can be lodged on the firm's assets and income (if payments are not payed periodically)
2. Common Stocks
Definition
Holders of common stocks are
shareholders
and
residual owners
of the firm. They have
claims to remaining assets and earnings
after
claims of all creditors and preferred stockholders
have been
satisfied
Special features
Limited liabilities of shareholders
No legal claim on income (ie shareholders cannot sue if company does not pay dividends)
Share in the wealth of the company
Voting rights
Advantages
Financing without default risk (ie no maturity date and dividends not guaranteed)
No stated maturity
(permanent source of financing)
No contractually obligated to pay dividends
Enhanced future borrowing abilities
Improves debt-equity ratio
Disadvantages
Dilution of earnings
Dilution of control
Dividends are paid in after tax dollars
High cost
(most expensive)
Risky position
Dividends not tax-deductable
3. Preferred Stocks
Definition
Claims on assets and earnings are
secondary to bondholders
and
preferred to common shareholders
. It promises a
fixed periodic dividend
that must be
paid before common stock
Special Features
No voting rights
Fixed dividends
Cumulative dividends
Call feature
Conversion feature
Advantages
Leverage without default risk
No voting rights
Preserves control of common shareholders
Fixed cost nature
Disadvantages
Fixed cost payments (cannot cut dividends when earnings are lower unlike common shares)
Preferred dividends are paid with after tax dollars
High cost
Preferred shareholders are in
riskier position
as compared to bondholders since payment of dividends are not guaranteed
Dividends are not tax-deductable