Long Term Financing

Question 1

Describe the concept of long-term financing.

Answer 1

Long-term financing involves obtaining funding through sources for which repayment is not due within one year, including sources which do not require any “repayment” (e.g., common or preferred stock). These sources of funding constitute the capital structure of a firm.

Question 2

Identity major forms of long-term financing.

Answer 2

Long-term notes;
Financial (Capital) leases;
Bonds;
Preferred stock;
Common stock

Question 3

Describe the use of long-term notes, for long-term financing purposes.

Answer 3

Long-term notes are used for borrowings normally of from one to ten years, but some may be of longer duration. Such borrowings usually require collateral, and may have restrictive covenants, but often permit repayment in installments of some period of time.

Question 4

Identify the disadvantages of long-term notes, for financing purposes.

Answer 4

Poor credit rating results in higher interest rate, greater security requirements, and more restrictive covenants.

Violation of restrictive covenants can trigger serious consequences.

Question 5

Define “long-term financing”.

Answer 5

Financing provided by those sources of capital funding that do not mature within one year (e.g., long-term notes, financial leases, bonds, preferred stock and common stock).

Question 6

Identify the advantages of leasing, for long-term financing purposes.

Answer 6

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

Question 7

Identify the disadvantages of leasing, for long-term financing purposes.

Answer 7

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

Question 8

Define a “net lease”.

Answer 8

Lessee (using party) assumes the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, etc.

Question 9

Define a “net-net lease”.

Answer 9

Lessee (using party) assumes not only the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, etc., but also obligation for a residual value at the end of the lease.

Question 10

Define “bonds”.

Answer 10

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.

Question 11

Define a “bond indenture”.

Answer 11

The bond contract, setting forth such terms as face amount of bond, coupon or stated interest rate, maturity date, etc. (indenture means contract)

Question 12

Define “bond maturity”.

Answer 12

The time at which the issuer repays the par value to the bondholders.

Question 13

How is the selling price of a bond determined?

Answer 13

As the sum of the present value of future cash flows from:

1. Periodic interest - PV of an annuity.
2. Maturity face value - PV of $1.

Both discounted using market rate of return.

Question 14

Describe the calculation of the current yield on a bond.

Answer 14

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 15

Describe the yield to maturity for bonds (also called the expected rate of return).

Answer 15

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.

Question 16

Define “market rate risk”.

Answer 16

The risk of loss in the market value of outstanding bonds and other fixed rate instruments as a result of an increase in the market rate of interest during the life of the outstanding instrument. If the market rate of interest increases after an instrument is issued, the market value of the instrument will decrease.

Question 17

Define “preferred stock”.

Answer 17

Ownership interest in a corporation which has certain preferences over common stock; often described as have characteristics of both bonds and common stock.

Question 18

Distinguish between Cumulative Preferred Stock and Noncumulative Preferred Stock

Answer 18

1. Cumulative Preferred Stock = Dividend preference amount not paid in any year accumulates and must be paid before common dividends are paid.
2. Noncumulative Preferred Stock = Dividend preference amount not paid in any year does not accumulate; it is “lost” to the Preferred Shareholder for that period.

Question 19

Distinguish between Participating Preferred Stock and Nonparticipating Preferred Stock

Answer 19

1. Participating Preferred Stock = Preferred shareholders can “participate” with common shareholders in receiving dividends in excess of the preferred preference rate.
2. Nonparticipating Preferred Stock = Preferred shareholders cannot “participate” with common shareholders in receiving dividends in excess of the preferred preference rate; each period they receive only their preference rate of dividends.

Question 20

Distinguish between Convertible Preferred Stock and Nonconvertible Preferred Stock.

Answer 20

1. Convertible Preferred Stock = Preferred shareholders can exchange (convert) preferred stock for common stock according to a specified exchange plan.
2. Nonconvertible Preferred Stock = Preferred shareholders cannot exchange (convert) their preferred stock to common stock.

Question 21

Define “callable preferred stock”.

Answer 21

The issuing firm has the right to buy back the preferred stock, normally at a premium.

Question 22

How is the theoretical value of a share of Preferred Stock (PSV) determined?

Answer 22

PSV = Annual Preferred Dividend/Investors’ Required Rate of Return. Note:

1. The annual dividend is assumed to exist in perpetuity.
2. The investors’ required rate of return is a “discount rate.”

Question 23

How is the currently expected rate of return on Preferred Stock (PSER) determined?

Answer 23

PSER = Annual Preferred Dividend/Market Price of preferred stock.

Note: This expected rate of return is the current cost of Preferred Stock capital.

Question 24

List the advantages of using preferred stock (for long-term financing).

Answer 24

1. No legally required periodic payments (i.e., dividends);
2. Lower cost of capital than Common Stock;
3. Does not dilute Common Stock voting strength;
4. No maturity date;
5. No security required.

Question 25

Describe the limited liability of common stock.

Answer 25

Common shareholders’ liability is limited to their investment in a corporation.

Question 26

Describe the preemptive right of common stock.

Answer 26

The right of first refusal to acquire a proportionate share of any new common stock issued by a corporation.

Question 27

How is the theoretical value determined for a share of Common Stock (CSV) that is to be held for multiple periods?

Answer 27

CSV = Dividend in 1st Year/(Investors’ Required Rate of Return - Dividend Growth Rate)

Note: Dividends are assumed to grow at a constant rate indefinitely.

Question 28

Identify the advantages of using common stock for long-term financing.

Answer 28

1. No legally required periodic payments (i.e., dividends);
2. No maturity date;
3. No security required.

Question 29

Identify the disadvantages of using common stock for long-term financing.

Answer 29

1. Higher cost of capital that other sources;
2. Dividends paid are not tax deductible;
3. Additional shares issued dilute ownership and earnings per share.