Financing Options: Long-term Financing

Question 1

Long-term (Capital) Financing Defined:

Answer 1

Long-term Financing: long-term, or capital, financing provided by funding which does not become due within one year.

• It’s the primary source of funding for most firms
• The cost associated with each source used will determine firm’s weighted average cost of capital (WACC).

Primary Forms of Long-term Financing:

1. Long-term notes
2. Financial (capital) leases
3. Bonds
4. Preferred Stock
5. Common Stock

Question 2

Long-term Notes:

Answer 2

Long-term Notes: They result from acquiring cash through borrowing with repayment due in more than one year.

• Typically a promissory note is required
• Borrowings are commonly from one to ten yrs, but may be longer
• Repayment is usually in periodic installments
• Note may be secured (collateral) by a mortgage on property or real estate
• Promissory note often containes restrictive covenants.

Common Restrictive Covenants - (to reduce risk)

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

Cost of Long-Term Notes: It will depend on:

• General level of interest
• Creditworthiness of borrowing firm
• Nature and value of collateral, if any

Interest rate is likely to be expressed as a function of a macroeconomic benchmark.

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

Advantages:

• Commonly available to creditworthy firms
• Provides long-term financing, often w periodic repayment

Disadvantages:

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

Question 3

Financial (Capital) Leases:

Answer 3

Financial Leases: Leasing is a common way of acquiring use of certain assets. In some cases leasing may be less costly than buying.

When leasing of assets is possible, the acquisition of assets should be evaluated under both purchase and lease options:

• Is proposed project economically feasible if assets are purchased?
• Is proposed project economically feasible if assets are leased?

Possible Outcomes:

• Reject project, if neither alternatives shows the project is feasible
• Purchase assets, if the purchase alternative is feasible and leasing alternative is not; or if both are feasible, but purchase has higher return.
• Lease assets, if the leasing alternative is feasible and purchasing alternative is not; or if both are feasible, but leasing has higher return.

Cost of Leasing: may be less than cost of buying because:

• Lessor has buying power or efficiencies that lessee does not have.
• Lessor has lower interest rate than the lessee
• Lessor has tax advantages the the lessee does not

*Non-cost reasons may be:

• Flexibility
• Convenience

Lease Terms:

1. Net Lease: Lessee assumes cost associated w ownership (executory costs):
   
   • Maintenance
   • Taxes
   • Insurance

• Net-net Lease: Lessee assumes cost associated w ownership (executory costs) like above and responsibility for residual value at end of lease.

Question 4

Advantages and Disadvantages of Financial Leases:

Answer 4

Advantages:

• Limited immediate cash outlay;
• Possible lower cost than purchasing;
• Possible scheduling of payments to coincide with cash flows;
• Debt (lease payments) is specific to amount needed.

Disadvantages:

• Not all assets available for leasing;
• Lease terms may prove different than the period of asset usefulness;
• Often chosen over buying for noneconomic reasons (e.g., convenience).

Question 5

Which of the following long-term notes would best facilitate financial leverage for the borrowing firm?

Variable Rate Long-term Note Fixed Rate Long-term

Answer 5

Variable Rate Long-term Note: NO

Fixed Rate Long-term: YES

Financial leverage derives from the use of debt with a fixed or determinable cost (rate of interest) for capital financing. Therefore, financial leverage would be possible with either fixed rate or variable rate debt (notes); however, fixed rate debt would better facilitate financial leverage because the cost of the use of debt-financed capital would not change over the life of the financing. The cost of variable rate debt can change, thereby making the degree of leverage more uncertain over the life of the debt.

Question 6

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

A. To cause the price of the company’s stock to rise.

B. To lower the company’s credit rating.

C. To reduce the risk of existing debt holders.

D. To reduce the interest rate on the debt being issued.

Answer 6

D. To reduce the interest rate on the debt being issued.

The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.

Question 7

Bonds Defined and Features:

Answer 7

Bonds: Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.

Bond Features:

• Bond Indenture = Bond contract
• Par/Face Value = Bond principal, commonly $1,000 per bond
• Coupon rate (Stated rate)= Annual rate of interest stated on the face of the bond.
• Maturity= Time at which issuer repays the bondholder principal and extinguishes debt.
• Debenture Bonds = Unsecured bonds, no specific assets are desginated as collateral. Riskier and higher return and cost than secured bonds.
• Secured Bonds = Have specific assets designated as collateral like:
  
  • Mortgage Bonds: secured by real property like land or buildings

Question 8

Bond Selling Price and Value:

Answer 8

Bond Selling Price and Value: They depend on the relationship between the rate of interest the bonds pay (coupon or stated rate) and the rate of interest in the market for comparable risk when bond is issued.

• Coupon Rate > Market Effective Rate = Sells at Premium
• Coupon Rate < Market Effective Rate = Sells at Discount
• Coupon Rate = Market Effective Rate = Sells at Par

Bond Selling Price or Fair Value - is detertmined as the PV of cash flows from the bonds:

1. Periodic interest: discounted ast PV of annuity at market effective rate.
2. Face Value: discounted ast PV of single amount at market effective rate.

• Discount using the market rate of interest.
• Sum of present values = selling price of bonds and reflects any premium or discount.

Question 9

Market Rate of Interest and Market Price of Bonds:

Answer 9

Market Rate of Interest and Market Price of Bonds: The market price of bonds changes inversely with changes in the market rate of interest:

• Market rate of int goes up = Market price of bond goes down.
• Market rate of int goes down = Market price of bond goes up.

Example:

• Assume $1,000 bonds outstanding that pay 4% - that rate doesn’t change (coupon)
• The market rate goes up to 5%
• As a consequence, the value of 4% bonds goes down, no one will buy a 4% bond for $1,000 when they can get a better rate of interest (5%) on the new bonds. So your 4% bonds will sell in the market only if the price is such that they earn 5%.
• What’s the price? Market price of the $1,000 bond would be $800:
  
  • The bond would have to sell in the market for $800 in order for the buyer to earn 5% interest:
    
    • $1,000x.04 = $40 / .05 = $800

Bondholders face what is called “Market Interest Rate” Risk:

• The risk that market will go down due to interest rates going up.
• The longer the maturity of the bonds, the greater the risk of that happening (because of longer holding period) and the higher the required (stated) interest rate.

Question 10

Describe the calculation of the Current Yield on a bond:

Answer 10

Current Yield of Bond:

The ratio of annual interest payments to the current market price of the bond. It is computed as:

Annual interest payment/Current market price

Question 11

Describe the Yield to Maturity for Bonds (also called the expected rate of return).

Answer 11

Yield to Maturity for Bonds:

The rate of return required by investors as implied by the current market price of the bonds; determined as the discount rate that equates present value of cash flows from the bonds with the current price of the bonds.

• It’s the current cost of capital for the firm’s bond.

Question 12

Advantages and Disadvantages for Bonds:

Answer 12

Advantages:

• A source of large sums of capital;
• Does not dilute ownership or earnings per share;
• Interest payments are tax deductible.

Disadvantages:

• Required periodic interest payments-default can result in bankruptcy;
• Required principal repayment at maturity-default can result in bankruptcy;
• May require security and/or have restrictive covenants.

Question 13

Which of the following statements concerning debenture bonds and secured bonds is/are correct?

I. Debenture bonds are likely to have a greater par value than comparable secured bonds.

II. Debenture bonds are likely to be of longer duration than comparable secured bonds.

III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.

A. I only.
B. II only.
C. III only.
D. I, II, and III.

Answer 13

C. III only. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.

Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.

Question 14

Which of the following types of bonds is most likely to maintain a constant market value?

A. Zero-coupon.
B. Floating-rate.
C. Callable.
D. Convertible.

Answer 14

B. Floating-rate.

Floating-rate bonds are most likely to maintain a constant market value. The rate of interest paid on floating-rate bonds (also called variable-rate bonds/debt) varies with the changes in some underlying benchmark, usually a market interest rate benchmark (e.g., LIBOR or the Fed Funds Rate). Because the interest rate changes with changes in the market rate of interest, they maintain a relatively stable (constant) market value.

Question 15

Preferred Stock Defined:

Answer 15

Preferred Stock Defined: ownership interest with preference claims (over common stock)

It has characteristics of both bonds and stock.

• It is like bonds because:
  
  • Usually does not have voting rights
  • Dividends usually are limited in amount and expected (like bond interest)
• It is like common stock because:
  
  • 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.

Question 16

Preferred Stock Characteristics I:

Answer 16

Preferred Stock Characteristics:

Question 17

Preferred Stock Characteristics II:

Answer 17

Question 18

Preferred Stock Valuation:

Answer 18

PS Valuation: PV of expected cash flows.

• Preferred cash flow is preferred dividends
• Elements use to value P/S are:
  
  • Estimated future annual dividends
  • Investors’ required rate of return
  • An assumption that dividend stream will exist in perpetuity
• Cost of P/S: Annual Dividends / Net Proceeds of Stock Issuance

Example:

Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen’s tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen?

• Annual Dividend: $10
• Net Proceeds of Stock Issuance: $101 - $5 underwriting fee = $96
• $10 / $96 = 10.4%

Preferred Value Theoretical Value (PSV) Calculation:

• PSV: Annual Dividend / Required Rate of Return
• Example:
  
  • Annual Dividend: $4
  • P/S Investors’ required rate of return: 8%
  • PSV: $4 / .08 = $50

Preferred Stock Expected Rate of Return (PSER) Calculation:

• PSER: Annual Dividend / Market Price
• Example:
  
  • Annual Dividend: $4
  • Market Price: $52
  • PSER: $4 / $52 = 7.7%
• Current cost of P/S = 7.7%
• As the current price changes, so does the expected rate of return.

Question 19

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share, with a par of $20. The cost of issuing the stock was $5 a share. What is the company’s cost of preferred stock?

A. 4.5%

B. 5.1%

C. 9.0%

D. 10.3%

Answer 19

B. 5.1%

Cost of P/S = Annual Dividend / Net Proceeds of Stock Issuance

• Annual Dividend = $20 par x .09 = $1.80 per share
• Net Proceeds of Stock Issuance= $40 - $5 cost of issuance = $35
• $1.80 / $35 = 5.1%

Question 20

Advantages and Disadvantages of Preferred Stock:

Answer 20

Advantages:

• No legally required periodic payments; default cannot result from failure to pay dividends;
• Generally a lower cost of capital than common stock;
• Generally does not bestow voting rights;
• No maturity date;
• No security required.

Disadvantages:

• Dividend expectations are high;
• Dividend payments are not tax deductible;
• If triggered, protective provisions may be onerous;
• Generally, a higher cost of capital than bonds.

Question 21

Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock?

A. 15.6%

B. 12.0%

C. 8.4%

D. 3.6%

Answer 21

B. 12.0%

Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.

Question 22

Common Stock Defined:

Answer 22

Common Stock: Basic ownership interest in a corportation.

• Regulatory requirements limit most companies to one class of CS.
  
  • Some jurisdictions permit more than one class of CS.

Common Share Characteristics:

• Limited liability- liability is limited to amount of investment
• Residual claim on earnings and assets- a claim after creditors and preferred shareholders have been satisfied
• Right to vote for Directors, auditors, and changes to the corporate charter
  
  • A “proxy” is used to delegate that right
• Preemptive right - right of first refusal to acquire a proportionate share of any new CS issue.

Question 23

Common Stock Valuation:

Answer 23

CS Valuation: PV of expected cash flows

• CS has 2 cash flows:
  
  1. Common dividends
  2. CS Appreciation
• Historic Economic Rate of Return on CS:
  
  • (Dividends paid during period + Change in price) / Beginning Price
• Theoretical Value of Common Stock (considering investment for multiple holding periods:
  
  • CSV: Dividend in 1st Yr / (Required Return Rate - Growth Rate)
• Common Stock Expected Rate of Return:
  
  • CSER: (1st Yr Dividend / Market Price) + Growth Rate
  • Return marginal (new investor) will require
  • Current cost of Common Stock capital

Question 24

Common Stock Advantages and Disadvantages:

Answer 24

Advantages:

• No legally required periodic payments. Default cannot result from failure to pay dividends;
• No maturity date;
• No security required.

Disadvantages:

• Generally a higher cost of capital than other sources;
• Dividends paid are not tax deductible;
• Additional shares issued dilute ownership and earnings.

Question 25

Common Stock Comments:

Answer 25

Common Stock Comments:

• CS is the most fundamental source of capital financing for a corporate entity.
• Since common shareholders have only a residual claim to earnings and assets, they face greater risk than preferred shareholders; therefore cost of CS is greater than cost of PS.
• Since common shareholders do have a residual claim to Retained Earnings, the cost of capital for RE is the cost of capital for common shareholders.

Question 26

Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander’s financing requirements?

A. Bonds.

B. Common stock.

C. Long-term debt.

D. Short-term debt

Answer 26

B. Common stock.

Issuing common stock to finance its projects would best meet Bander’s financing strategy. Specifically, issuing common stock would:

1. (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors,
2. (2) not result in a fixed maturity date, since common stock does not mature, and
3. (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.

Question 27

The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm’s cost of common equity?

A. 12.0%
B. 8.4%
C. 7.0%
D. 5.0%

Answer 27

A. 12.0%

CSER: (Div 1st Yr/Market Price) + Growth Rate

• ($4.25/$85) + .07 = 12%

Question 28

Which of the following formulas should be used to calculate the historic economic rate of return on common stock?

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

B. (Net income - preferred dividend) divided by common shares outstanding.

C. Market price per share divided by earnings per share.

D. Dividends per share divided by market price per share.

Answer 28

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

For common stock, expected returns are from dividends and stock price appreciation. Thus, the rate of return on the common stock would be (dividends paid during the period + change in the stock price)/price of the stock at beginning of the period.

Question 29

Cost of Capital and Financing Strategies: Cost of Capital Summary Comments

Answer 29

Cost of Capital of each source is the rate of return required by each source.

• Rate of return is determined by other opportunites w comparable risk available to investors’ opportunity cost.
• Higher perceived risk = Higher return required

Question 30

Factors Affecting Cost of Capital:

Answer 30

Factors Affecting Cost of Capital:

• Macroeconomic conditions (e.g., interest rates, tax rates and inflation/deflation rates, etc.);
• Past performance of the firm; (greater firm risk, higher cost of capital)
• Amount of total financing used;
• Relative level of debt financing;
• Length of debt maturity; (longer maturity, higher cost of debt)
• Relative level of collateral provided. (greater value of collateral, lower cost of debt)

Question 31

Guidelines for Financing Strategies:

Answer 31

Guidelines for Financing Strategies:

• Hedging Principle of Financing (also Principle of self-liquidating debt): focuses on matching cash flows from assets with the cash requirements needed to satisfy the related financing.
  
  • Thus, long-term assets should be financed with long-term sources of capital and;
  • Short-term assets should be financed with short-term sources of financing.
  • This minimizes risk.
• Optimum Capital Structure Objective: To minimize a firm’s aggregate cost of capital financing by using an optimum mix of debt and equity components; to achieve the lowest possible weighted average cost of capital.

Question 32

Define “Business Risk”:

Answer 32

Business Risk: The risk of loss or other unfavorable outcome that results as variability in operating results increases; the higher the variability in a firm’s expected operating earnings, the greater the business risk (i.e., the increased chance that it may not be able to meet its debt obligations).

Business Risk Constraint:

• Business Risk is inherent in the nature of business operations
• That general risk can be measured as the variability of firm’s expected operating Earnings Before Interest and Taxes - EBIT
• Firms w higher business risk, that is high variability in EBIT, should use less debt financing than firms w steady EBIT.

Question 33

Tax Rate Benefit:

Answer 33

Tax Rate Benefit: The higehr the tax rate faced by a firm, greater amount of tax saved by use of debt financing.

Question 34

Generally, how do the costs compare of financing using long-term debt, Preferred Stock and Common Stock?

Answer 34

Generally, the cost of Long-term Debt is lower than either Preferred Stock or Common Stock and the cost of Preferred Stock is lower than the cost of Common Stock. However, as the level of Long-term Debt increases relative to equity, the cost of marginal debt increases due to the increased risk of default.

Question 35

The cost of debt most frequently is measured as

A. Actual interest rate.
B. Actual interest rate adjusted for inflation.
C. Actual interest rate plus a risk premium.
D. Actual interest rate minus tax savings.

Answer 35

D. Actual interest rate minus tax savings.

The cost of debt most frequently is measured as the actual interest rate minus the tax savings. The tax savings result because the interest expense is deductible for tax purposes and the resulting tax savings reduce the effective cost (and rate) of debt financing. For example, if the stated (actual) interest rate is 10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be 10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.

Question 36

Which of the following statements concerning the use of short-term financing by an entity is/are correct?

I. Short-term financing generally offers greater financial flexibility than long-term financing.

II. Short-term financing generally has a lower interest rate than long-term financing.

III. Short-term financing generally has a lower risk of illiquidity than long-term financing.

A. I only is correct.
B. I and II are correct.
C. II and III are correct.
D. I, II and III are correct.

Answer 36

B. I and II are correct.

In general, short-term financing offers a firm greater financial flexibility than does long-term financing. With short-term financing, the level of borrowing can be more readily expanded or contracted with changes in the need for funds.
With long-term financing, the level of borrowing cannot be readily adjusted with changes in needs, especially when there is a contraction in the need for debt. Short-term financing is generally cheaper than long-term financing.
For a given borrower at a particular point in time, interest rates on short-term borrowings, in general, are lower than interest rates on long-term borrowings.

Finally, III is not correct because short-term financing generally has a higher (not lower) risk of illiquidity than does long-term financing.
By its nature, short-term borrowing must be repaid or refinanced in the near term and, on an on-going basis, more often than long-term debt.
Changes in the economic environment or within the entity, may make it impossible for the firm to either repay or refinance the debt. In that case, the firm would be technically insolvent.

Question 37

Which one of the following sources of new capital usually has the lowest after-tax cost?

A. Bonds.

B. Preferred stock.

C. Common stock.

D. Retained earnings.

Answer 37

A. Bonds.

Bonds usually have the lowest after-tax cost of new capital because investors have less risk when investing in bonds than in equity, and because the interest payments to bondholders is deductible for tax purposes.

Question 38

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

A. The reduced earnings per share possible through financial leverage.
B. The relatively low after-tax cost due to the interest deduction.
C. The increased financial risk resulting from the use of the debt.
D. The reduction of Larson’s control over the company.

Answer 38

B. The relatively low after-tax cost due to the interest deduction.

The issuance of debt results in interest expense, which is deductible for tax purposes. Therefore, the effective cost of debt is less than its stated interest rate by the amount of taxes saved by that interest deduction. The effective cost of debt is its interest cost x (1 - tax rate).