Long-term Financing Flashcards
Long-term Financing
Capital financing - Primary source of financing for most firms
Long-term notes
Require collateral and often contain restrictive covenant that impose restrictions on borrower so as to reduce likelihood of default
LT Covenants
1) Maintaining certain working capital conditions - Maintain minimum dollar amount of working capital or ratio
2) Additional incurrence of debt - Lender approval before taking on additional long-term debt
3) Frequency and nature of financial information
4) Management changes
Financial Leases
Leasing, rather than buying, is an alternative way of financing the acquisition of certain assets. When leasing is an option for acquiring assets in a capital budgeting project, evaluation of the project has to take into account
A financial lease is a legally enforceable, noncancelable contract under which the lessee commits to making a series of payments to the owner of the asset (lessor) for the use of the asset over the period of the lease. Thus, for financial analysis purposes, whether the lease is, in effect, a sale - the concept underlying the designation for capital lease in accounting—is not relevant. Practically, however, both categories (financial and capital) reflect the same consequence for financing—the use of an asset is acquired at the present with the cost being incurred over multiple future periods. (In both finance and accounting, operating leases are considered more like renting than a means of financing asset acquisition and are not particularly relevant here).
Net Leases vs Net-net Leases
In finance, leases are described as being net leases or net-net leases to identify which costs of the asset are the responsibility of the lessee. In a net lease, the lessee assumes the cost associated with ownership during the period of the lease. Normally, these costs are referred to in accounting as executory costs and include maintenance, taxes, and insurance. In a net-net lease, the lessee is responsible for not only the executory costs, but also a pre-established residual value. The particular nature—lease, net lease, or net-net lease—will affect the cost of the lease to the lessee and, therefore, the viability and benefits of leasing.
Bonds
Long-term promissory notes wherein promises are to pay a fixed amount of interest each year and to repay face value @ maturity
Characteristics of Bonds
Indenture - Bond contract, states terms of the bond
Par value or face value - the “principal” that will be returned @ maturity, most common $1,000 per bond
Coupon rate of interest - the annual interest rate printed on the bond and paid on par value
Maturity - the time at which the issuer repays the par value to the bondholders
Bond MAJOR DIFFERENCES
Major difference in bonds is whether bond issue is secured by collateral;
Debenture bonds - Unsecured
Secured bonds - specific sets designated as collateral
Mortgage bonds - secured by a lien on real property
CALLABILITY -
Callable bonds are most commonly used to enable issuing firm to call in outstanding bonds if market rate declines
Bonds with a callable feature usually pay a higher rate of interest
CONVERTIBILITY - Bond holder has the option of converting bonds into specific equity; usually pay a lower rate of interest
ZERO COUPON BONDS - Does not pay interest during its life; sell at deep discounts and paying full value @ maturity
Floating rate bonds - Pay a rate of interest that fluctuates over the life of the instrument; rate of interest paid is tied to macroeconomic benchmark rate
Bond Values
Bond’s selling price determined by Periodic Interest and Maturity Face Value;
Both cashflows would be discounted using market required rate of return
Bond Yields
Current Yield - Ratio of annual interest payments to current market price of the bond
CY = Annual Coupon Interest / Current Market Price
Yield to Maturity - Expected Rate of Return - Rate of return required y investors as implied by the current market price of the bonds ; Determining the yield to maturity is done by determining the discount rate that equates the present value of future cash flows from the bond issue with the current price of the bonds
Term Structure of Interest Rates
Term structure of interest rates (yield curve) shows current yield to maturity (rate of return) on bonds of similar quality. Commonly plotted with interest rates on vertical axis and time until maturity on horizontal axis
Preferred Stock
Has characteristics of bonds and stock;
Like bonds because no voting rights, dividends (like interest)
Like common stock because (not tax deductible)
Preferred Stock Valuation
PS value is the resent value of expected cash flows - Preferred cash flow is Preferred dividends
Elements used to value preferred stock are:
Estimated future annual dividends, Investors’ required rate of return, An assumption that dividend stream will exist in perpetuity
PSV = Annual Dividend/Required Rate of Return;
Preferred stock expected rate of return (PSER)
Annual dividend/Market Price = PSER
Preferred Stock Cost Equation
The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares
Common Stock
Regulatory limits usually limit to one class of common stock;
Liability of shareholder limited to amount of investment; Residual claim on earnings and assets; Has right to vote
