Introduction to Long-Term Financing Flashcards
What is LT financing?
Long-term, or capital, is provided by funding which does not become due within one year
Primary source of funding for most firms
Primary forms: - LT notes Financing (Capital) leases Bonds Preferred stock Common stock
What is a LT Notes?
Acquiring cash through borrowing with payment due in more than one year
- Typically a promissory note is required
- Borrowing are commonly from one to ten years, may be longer
- Repayment is usually in periodic installments
- Note may be secured by mortgage on property or real estate
- Contain restrictive covenants
COVENANTS:
- Maintain a certain working capital condition
- Restriction on incurrence of additional debt
- Specification of required frequency and nature of financial information
- Restriction on management changes without approval
COST IMPACTS:
- General level of interest
- Creditworthiness of the firm
- Nature and value of collateral
- Interest rate is likely to be expressed, usually a prime rate mortgage
ADVANTGE:
- Common available to creditworthy firms
- Long term financing
DISADVANTAGE-
- Poor rating = Higher interest rate
- Higher restrictions
- Violation of covenants = default
What is financial leases?
Leasing is common way of acquiring use of certain assets
When leasing of asset is possible- the acquisition of asset should be evaluated under both purchase and lease options
- Proposed project economically feasible if assets are purchased
- Proposed projected economically feasible if assets are leased
OUTCOMES:
- Reject project if neither alternative is feasible
- Purchase asset if leased option is not feasible
- Compare the returns from purchase vs lease
NON COST REASONS:
- Flexibility
- Convenience
What is a net-net lease: Lessee assume cost associated with ownership and responsibility for residual value at the end of the lease
ADVANGES:
- 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 payments to pattern cash inflows from use of the leased asset
What is a bond?
Long-term promissory notes (In return for proceeds, the issuer of the bond promises to pay bondholder)
Define bond indenture?
Bond contract
Par= Bond principle, typically $1,000 per bond
Coupon rate of interest= Annual rate of interest stated on the face of the bond (“Stated Rate”)
Maturity= Time in which the issuer repays the principle and extinguishes the debt
What is denture bond?
Denture: Unsecured
Secured= Have specific assets for collateral
How is the selling price determined?
bond selling price depends on the relationship between the rate of interest on the bonds (coupon rate) and the rate o interest in the market for comparable risk when the bond is issued
Bond will sell less than par if the coupon rate is less than the market rate = discount
Sells are more than par if coupon rate is more than the market = premium
What ar et he two cash flows from bonds?
Periodic interest= discounted as present value of an annuity using current interest rates
Face value = discounted as the present value of a single using current interest rates
What is the current yield?
Ratio of annual interest payments TO CURRENT PRICE OF THE BONDS IN THE MARKET
Example: 1,000, 6% bond, currently selling for $900
CY = Annual coupon interest / current market price
$1,000 * .06= $60 / 900 = 6.67%
What is the yield to maturity?
Determines the discount rate that equates the present value 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 and is best done with financial calc or computer program
Not likely to be on the exam
T/F: The market price of bonds changes INVERSELY with changes in the market rate of interest:
TRUE
Market rate of interest goes up = market price of bonds goes down
Market rate of interest goes down= market price of binds goes up
WHY??
What are the advantages of using bonds?
Source of large sums of capital
Issues doe not dilute ownership or EPS
DISADVANTAGES:
- Periodic interest payments, which can result in default or bankruptcy
- Require principal repayment
- May require security or have restrictive covenants
- Generally not available to privately held entities
What is preferred stock? What are the characteristics? What is convertible vs non convertible? What is callable? What is the PSV formula? What are advantages / disadvantages? What is the PSER formula?
Ownership interest with preference claims over common stock
Has characteristics of both bonds and stock
- Bonds- because it doesn’t have voting rights
- Dividends- are expected and limited
It is like common stock:
- Grants ownership
- Has no maturity dates
- Not tax deductible
Preferred stock may include:
- Passibility of having different classes or types of preferred stock with different preferences
- May be cumulative- to distinguish whether or not dividends not paid accumulated
- Participating or nonparticipating- dividends in excess of preference can be paid
Protective provisions- to protect preferred shareholders interest (right to vote in circumstances)
Convertible or nonconvertbile- Can be potentially converted into common stock
Callable- Give the firm the right to buy back preferred shares, usually at a pre-established price
What is the PSV formula? PSV= Annual dividend/required rate of return
What is preferred stock expected rate of return (PSER):
Annual dividend/market price
Advantages:
- No legally required payment of dividends
- Lower cost of capital than common stock
- Usually does not bestow voting rights
- No maturity date required
- No security required
Disadvantages:
- Dividend expectations are high
- Dividend payments are not tax deductible
- If triggered, protective provisions may be onerous
What is common stock?
Common stock- Basic ownership interest * Regulatory requirements limit most companies to one class of common stock
What are the characteristics of common stock?
- Limited liability- liability is limited to the amount of investment
- Residual claim on earnings and assets
- Right to vote for directors, auditors
- Preemptive right- right of first refusal to acquire a proportionate share of any new common stock issue
How is Common Stock valued? Present value of expected cash flows
- Common dividends
- CS appreciation
CSV = PV of dividends expected + PV of expected market price at the end of one year (or less). Both discounted at common investor required rate of return
Assuming common stock is held for multiple periods, what is the CSV formula?
= 1st year dividend / (RRR- Growth Rate)
What is the Common stock Expected Rate of Return (CSER)
= (1st year dividend / Market price) / Assumed growth rate
What is the cost of capital?
Rate of return required by each source
- Rate of return required is determined by other opportunities with comparable risk amiable to investors; it is the investors opportunity cost
- Higher the risk - the higher the return required
