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BEC III > 5. Long-Term (Capital) Financing > Flashcards

5. Long-Term (Capital) Financing Flashcards

1
Q

What is the primary source of funding for most firms?

A

Capital financing.

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2
Q

What is LT or capital financing?

A

Provided by funding which does not become due within one year.

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3
Q

What are primary forms of LT financing?

A
  • LT notes
  • Financial (capital) leases
  • Bonds
  • Preferred stock
  • Common stock
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4
Q

How is the weighted average cost determined?

A

By using the cost of LT financing.

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5
Q

LT notes and Financial Leases: What is LT notes?

A

Result from acquiring cash through borrowing with repayment due inmate than one year.

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6
Q

LT notes and Financial Leases: LT notes: what does it typically require? Length of borrowing? How is the repayment done? How can the note be secured?

A
  • A promissory note (often with restrictive covenant)
  • Commonly one to ten years, but may be longer
  • Usually in periodic installments
  • By a mortgage on property or real estate
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7
Q

LT notes and Financial Leases: LT notes: What are common restrictive covenants?

A
  • Maintain a certain working capital condition (e.g. a minimum working capital ratio)
  • Restrictions on incurrence of additional debt without the lender’s approval
  • Specification of required frequency and nature of financial info provided to lender, perhaps audited
  • Restrictions on management changes without lender approval
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8
Q

LT notes and Financial Leases: LT notes: What elements impact cost of financing?

A
  • General level of interest in the market
  • Creditworthiness of the borrowing firm
  • Nature and value of collateral, if any
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9
Q

LT notes and Financial Leases: LT notes: Interest rate is likely to be expressed as what?

A

A function of a macroeconomic benchmark

  • For example, the prime rate
  • Interest rate on note changes as the benchmark changes
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10
Q

LT notes and Financial Leases: LT notes: advantages?

A
  • Commonly available to creditworthy firms

* Provides LT financing often with periodic repayment

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11
Q

LT notes and Financial Leases: LT notes: disadvantages?

A
  • Poor credit rating results in higher interest rate, greater security required, and more restrictive covenants
  • Violation of covenants can trigger serious consequences, including technical default
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12
Q

LT notes and Financial Leases: What is leasing?

A

A common way of acquiring use of certain assets.

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13
Q

LT notes and Financial Leases: Leases: What should a firm do when leasing of assets is possible?

A

Should evaluate the acquisition of assets under both purchase and lease options;
*Is proposed project economically feasible if assets are purchased or leased?

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14
Q

LT notes and Financial Leases: Leases: What are possible outcomes?

A
  • Reject project = if neither alternative shows the project is feasible
  • Purchase assets = if the purchase alternative is feasible and the leasing alternative is not; or if both are feasible, but purchase has a higher return.
  • Lease assets = opposite of above
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15
Q

LT notes and Financial Leases: Leases: Why can the cost of leasing may be less than the buying?

A
  • Lessor has buying power or efficiencies that the lessee does not
  • Lessor has lower interest rates than the lessee
  • Lessor has tax advantages that the lessee does not
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16
Q

LT notes and Financial Leases: Leases: What are 2 non-cost related reasons for leasing rather than buying?

A

Flexibility and convenience.

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17
Q

LT notes and Financial Leases: Leases: What are ways leases may be described?

A
  • Net lease

* Net-net lease

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18
Q

LT notes and Financial Leases: Leases: What is net lease?

A

Lessee assumes cost associated with ownership

*Maintenance, taxes, insurance = Executory costs in accounting

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19
Q

LT notes and Financial Leases: Leases: What is net-net lease?

A

Lessee assumes cost associated with ownership (same as net lease) and responsibility for residual value at end of the lease.

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20
Q

LT notes and Financial Leases: Leases: Advantages?

A
  • Limited immediate cash outlay required
  • Possible lower cost than purchasing
  • Related obligation specific to amount needed; that is, the cost of the asset leased
  • Possibility of scheduling lease pmts to pattern cash inflows from use of the leased asset
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21
Q

LT notes and Financial Leases: Leases: Disadvantages?

A
  • Not all assets are commonly available for lease
  • Lease financing is asset specific; no funds are provided for other uses
  • Lease terms may prove different than asset usefulness to the lessee
  • Leasing may be chosen for non-economic reasons (e.g. convenience)
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22
Q

Bonds: What is it?

A

LT promissory notes; In return of proceeds (cash), the issuer of the bonds (borrower) promises to pay bondholder (the investor) a fixed amount of interest each period and repay the face or principal of the bond at maturity.

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23
Q

Bonds: What are characteristics?

A
  • Bond indenture = bond contract
  • Par/Face value = bond principal, commonly $1,000 per bond
  • Coupon rate of interest = annual rate of interest stated on face of bond (“stated rate”)
  • Maturity = Time at which the issuer repays the bondholder principal and extinguishes debt
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24
Q

Bonds: what is debenture bonds?

A

Unsecured bonds;

  • No specific assets are designated as collateral
  • They carry more risk and have higher cost than secured bonds
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25
Q

Bonds: What is secured bonds?

A

Have specific assets designated as collateral.

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26
Q

Bonds: How is the bond selling price determined?

A

Depends on the relationship between the rate of interest the bonds pay (coupon rate) and the rate of interest in the market for comparable risk when the bond is issued.

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27
Q

Bonds: What does discount and premium, and at par mean for sale?

A
  • Discount: sells at less than par if coupon rate is less than the market rate.
  • Premium: sells at more than par if coupon rate is more than the market rate.
  • At par: sells at par if coupon rate is equal to the market rate at the time of issue.
28
Q

Bonds: Practically how is the bond selling price determined?

A

As PV of cash flows from the bonds

29
Q

Bonds: What are 2 cash flows?

A
  • Periodic interest: discounted as the PV of annuity using current interest rate
  • Face value: discounted as the PV of a single amount using current interest rate
30
Q

Bonds: What re 2 measures of rate of return?

A
  • Current yield (CY)

* Yield to maturity

31
Q

Bonds: what is current yield? Formula? What happens to CY when market price changes?

A
  • Ratio of annual interest pmts to current price of the bonds in the market.
  • CY = annual coupon rate / current market price.
  • CY changes as well
32
Q

Bonds: CY ex:

$1,000, 6% bond, currently selling for $900. CY?

A

(1,000 x 6%) / 900 = 6.67% = CY

33
Q

Bonds: what is yield to maturity?

A

Determines the discount rate that equates the PV of future cash flows from the bonds with the current price of the bonds.

  • It is the rate of return required by investors as implied by the current price of bonds in the market
  • It is computed like IRR (internal rate of return) and is best done with a financial calculator or computer program
34
Q

Bonds: What is the relationship between the market price of bond and market rate of interest?

A

Inverse relationship.
If market rate goes up, no one will want to buy the bond with lower interest rate (value goes down).
Bond can be sold only if the price is such that it earns 5%.

35
Q

Bonds: How much would bond ($1,000) selling price be if the stated interest rate is 4% and market rate increases to 5%?

A

Using CY formula, $1,000 x 4% = $40 / ? = 5%.

? = $800 = Bond selling price.

36
Q

Bonds: What is market interest rate risk?

A

Bond holders face the risk;

  • The risk that the market value will go down due to interest rates going up
  • The longer the maturity of the bonds, the greater the risk of that happening and the higher the required face (stated) interest rate
37
Q

Bonds: Advantages?

A
  • Source of large sums of capital
  • Issuance does not dilute ownership or earnings per share
  • Interest payments are tax deductible
38
Q

Bonds: Disadvantages?

A
  • Require periodic interest pmts and principal repayments - if missed can result in default and bankruptcy.
  • May require security and/or have restrictive covenants
  • Generally not available to small, privately held entities.
39
Q

Preferred stock: what is it?

A

Ownership interest with preference claims (over common stock.

40
Q

Preferred stock: what characteristics does it have?

A

Of both bonds and stock.
Like bonds;
*Usually doesn’t have voting rights
*Dividends usually are limited in amount and expected (like bond interest)

Like common stock;

  • Grants ownership interest
  • Has no maturity date
  • Does not require dividends be paid though they are expected
  • Dividends are not an expense and are not tax deductible
41
Q

Preferred stock: what are characteristics?

A
  • Possibility of having different classes or types of pref. stock with different preferences
  • May be cumulative or noncumulative - to distinguish whether or not dividends not paid accumulated
  • May be participating or nonparticipating - to distinguish whether or not dividends in excess of preference claim can be paid
  • May have protective provision - to protect pref. shareholders’ interest (e.g. right to vote in certain circumstances)
  • May be convertible or nonconvertible - to distinguish whether or not pref. stock can be exchanged for common stock (and under what circumstances)
  • May be callable - the fight of the firm to buy back pref. shares, usually at pre-established price
42
Q

Preferred stock: what is stock value?

A

PV of expected cash flows.

Pref. cash flow = pref. dividends.

43
Q

Preferred stock: what are elements used to value stocks?

A
  • Estimated future annual dividends
  • Investor’s required rate of return
  • An assumption that dividend stream will exist in perpetuity
44
Q

Preferred stock: what is PSV?

A

Preferred stock theoretical value.

PSV = Annual dividend / Required rate of return

45
Q

Preferred stock: Ex:

Annual dividend = $4, PS investors’ required rate of return = 8%. What is PSV?

A

4/8%=$50

46
Q

Preferred stock: what is PSER?

A

Preferred stock expected rate of return.

47
Q

Preferred stock: EX:

Annual dividend = $4, Market price = $52. PSER?

A

4/52 = 7.7%

48
Q

Preferred stock: Advantages?

A
  • No legally required pmt of dividends or repayment of investment
  • Lower cost of capital than common stock, because it has less risk
  • Usually does not bestow voting rights
  • No maturity date
  • No security required
49
Q

Preferred stock: Disadvantages?

A
  • Dividend expectation are high
  • Dividend pmts are not tax deductible
  • If triggered, protective provisions may be onerous
  • Generally, has a higher cost of capital than bonds
50
Q

How is the cost of debt determined?

Ex: debenture, coupon rate = 9%, issue price = 101 , tax rate = 40%

A

Annual interest pmt / Proceeds received = 100 x 9% = $9.
9 / 101 = 0.0891.
0.089 x (1 - 0.4) = 5.347%

51
Q

Common stock: Define?

A

The basic ownership interest in a corporation.

52
Q

Common stock: Can a firm have more than one common stock?

A

Regulatory requirements limit usually to one.

But some jurisdictions permit more than one class.

53
Q

Common stock: What are characteristics?

A
  • Limited liability - to amount of investment
  • Residual claim on earnings and assets - a claim after creditors and pref. shareholders have been satisfied
  • Rights to vote for directors, auditors, and changes to the corporate charter
  • Proxy
  • Preemptive right
54
Q

Common stock: what is proxy?

A

Used to delegate the right

55
Q

Common stock: what is preemptive right?

A

The right of first refusal to acquire a corporate share of any new common stock issue

56
Q

Common stock: how is stock value (CSV) determined if assumed to be held for one year or less?

A

PV of expected cash flows.
Has 2 cash flows = common dividends and stock appreciation.
CSV = PV of dividends expected + PV of expected market price at end of one year (or less)

57
Q

Common stock: Which rate is used to discount PV?

A

Common investors’ required rate of return

58
Q

Common stock: how is CSV determined when assumed to be held for multiple periods?

A
  • Projecting dividends and future stock price is less certain
  • Possible approach = assume dividends grow at a constant rate and that growth incorporates both dividends and market value appreciation.

CSV = 1st yr dividend / (Required rate of return - Growth rate)

59
Q

Common stock: Multiple period EX:

Expected dividend = $2.10, Expected dividend growth rate = 5%, Investor required rate of return = 8%. CSV?

A

$2.10 / (8% - 5%) = $70

60
Q

Common stock: what is CSER?

A

Common stock expected rate of return.

CSER = (1st yr dividend / Market price) + Growth rate

61
Q

Common stock: EX:

Expected dividend = $2.10, Expected dividend growth rate = 5%, Market price = $70. CSER? Interpretation?

A

(2.10 / 70) + 5% = 8%
Marginal (new) investor will require 8% rate of return.
Or 8% current cost of common stock capital.

62
Q

Common stock: Advantages?

A
  • No legally required periodic pmts
  • No maturity date
  • No security required
63
Q

Common stock: Disadvantages?

A
  • Generally a higher cost of capital than other sources
  • Dividends are not tax deductible
  • Additional shares dilute ownership and earnings per share
64
Q

Common stock: why is the cost higher than other sources?

A

Since com. shareholders can claim the residual claim to earnings and assets, they face a greater risk than pref. shareholders, therefore the cost is high.

65
Q

Common stock: what is the item Com. shareholders can claim a residual claim? What does it mean?

A

Retained earnings.

The cost of capital for Retained earnings = The cost of capital for common shareholders.

66
Q

Common stock: How is expected rate of return computed?

Priced at $50 per share, expected dividend = $5, trade for $60 per share in one year.

A

The dollar return on stock = the dividends received ($5) + the change in stock price ($10) = 15.
The rate of return on stock = the dollar return / the dollar amount of the investment on which the return was earned = 15/50 = 30%

*(Dividends + change in price) divided by beginning price.

BEC III (10 decks)

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