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LONG-TERM LONG-TERM FINANCING FINANCING

– AN – AN INTRODUCTIONINTRODUCTIONChapter 15 of the TextbookChapter 15 of the Textbook

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Chapter OutlineChapter Outline

15.1 Common Stock15.1 Common Stock

15.2 Corporate Long-Term Debt: The 15.2 Corporate Long-Term Debt: The BasicsBasics

15.3 Preferred Stock15.3 Preferred Stock

15.4 Patterns of Long-Term Financing15.4 Patterns of Long-Term Financing

15.6 Summary and Conclusions15.6 Summary and Conclusions

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Methods of Securing Methods of Securing FinancingFinancing

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15.1 Common Stock15.1 Common Stock

Par and No-Par StockPar and No-Par Stock Authorized versus Issued Common StockAuthorized versus Issued Common Stock Contributed SurplusContributed Surplus Retained EarningsRetained Earnings Market Value, Book Value, and Market Value, Book Value, and

Replacement ValueReplacement Value Shareholders’ RightsShareholders’ Rights DividendsDividends Classes of StockClasses of Stock

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Par and No-Par StockPar and No-Par Stock

The stated value on a stock certificate is The stated value on a stock certificate is called the called the par valuepar value.. Par value is an accounting value, not a market Par value is an accounting value, not a market

value.value. The total par value (the number of shares The total par value (the number of shares

multiplied by the par value of each share) is multiplied by the par value of each share) is sometimes called the sometimes called the dedicated capitaldedicated capital of the of the corporation.corporation.

Some stocks have no par value.Some stocks have no par value. Typically in Canada, there is no particular par Typically in Canada, there is no particular par

value assigned to stock.value assigned to stock.

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Authorized vs. Issued Authorized vs. Issued Common StockCommon Stock

The articles of incorporation must state the The articles of incorporation must state the number of shares of common stock the number of shares of common stock the corporation is authorized to issue.corporation is authorized to issue.

The board of directors, after a vote of the The board of directors, after a vote of the shareholders, may amend the articles of shareholders, may amend the articles of incorporation to increase the number of incorporation to increase the number of shares.shares. Authorizing a large number of shares may worry Authorizing a large number of shares may worry

investors about investors about dilutiondilution because authorized shares because authorized shares can be issued later with the approval of the board can be issued later with the approval of the board of directors but without a vote of the shareholders.of directors but without a vote of the shareholders.

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Contributed SurplusContributed Surplus

Usually refers to amounts of directly Usually refers to amounts of directly contributed equity capital in excess contributed equity capital in excess of the par value.of the par value. For example, suppose 1,000 shares of For example, suppose 1,000 shares of

common stock having a par value of $1 common stock having a par value of $1 each are sold to investors for $8 per each are sold to investors for $8 per share. The contributed surplus would share. The contributed surplus would be be

($8 ($8 – $1) × 1,000 = $7,000– $1) × 1,000 = $7,000

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Retained EarningsRetained Earnings

Not many firms pay out 100-percent Not many firms pay out 100-percent of their earnings as dividends.of their earnings as dividends.

The earnings that are not paid out as The earnings that are not paid out as dividends are referred to as dividends are referred to as retained retained earningsearnings..

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Market Value, Book Value, Market Value, Book Value, and Replacement Valueand Replacement Value

Market Value is the price of the stock multiplied Market Value is the price of the stock multiplied by the number of shares outstanding. by the number of shares outstanding. Also known as Market Capitalization Also known as Market Capitalization Common stocks of Canadian corporations trade Common stocks of Canadian corporations trade

on the Toronto Stock Exchanges (TSX) and U.S. on the Toronto Stock Exchanges (TSX) and U.S. stock exchanges (NYSE, NASDAQ).stock exchanges (NYSE, NASDAQ).

Book ValueBook Value The sum of par value, contributed surplus, The sum of par value, contributed surplus,

accumulated retained earnings, and accumulated retained earnings, and adjustments to equity is the adjustments to equity is the common equitycommon equity of of the firm, usually referred to as the book value of the firm, usually referred to as the book value of the firm.the firm.

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Market Value, Book Value, Market Value, Book Value, and Replacement Value and Replacement Value

(continued)(continued)Example:Example: Enbridge Inc.Enbridge Inc.

Shareholder’s Equity at Book Shareholder’s Equity at Book Value, 2003Value, 2003

(in $ thousands)(in $ thousands)

Common stock and other Common stock and other

shareholders’ equityshareholders’ equity$2,897,300$2,897,300

Retained earningsRetained earnings 1,511,4001,511,400

Reciprocal shareholdingReciprocal shareholding (135,700)(135,700)

Foreign exchange adjustmentForeign exchange adjustment(147,000)(147,000)

Total shareholders’ equityTotal shareholders’ equity $4,126,000 $4,126,000

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Market Value, Book Value, and Market Value, Book Value, and Replacement Value (continued)Replacement Value (continued)

Replacement ValueReplacement Value The current cost of replacing the assets of the The current cost of replacing the assets of the

firm.firm. At the time a firm purchases an asset, market At the time a firm purchases an asset, market

value, book value, and replacement value are value, book value, and replacement value are equal.equal. The market-to-book ratio of common stock and The market-to-book ratio of common stock and

Tobin’s Q (market value of assets / replacement Tobin’s Q (market value of assets / replacement value of assets) are indicators of the success of value of assets) are indicators of the success of the firm.the firm.

If these ratios are greater than one, then this If these ratios are greater than one, then this indicates that the firm has done well with its indicates that the firm has done well with its investment decisions.investment decisions.

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Shareholders’ RightsShareholders’ Rights

The right to elect the directors of the The right to elect the directors of the corporation by vote constitutes the most corporation by vote constitutes the most important control device of shareholders.important control device of shareholders.

Directors are elected each year at an annual Directors are elected each year at an annual meeting by a vote of the holders of a majority meeting by a vote of the holders of a majority of shares who are present and entitled to of shares who are present and entitled to vote. vote. The exact mechanism varies across companies.The exact mechanism varies across companies.

The important difference is whether shares The important difference is whether shares are to be voted cumulatively or voted are to be voted cumulatively or voted straight.straight.

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Cumulative versus Straight Cumulative versus Straight VotingVoting

The effect of cumulative voting is to permit The effect of cumulative voting is to permit minority participation.minority participation. Under cumulative voting, if there are N directors Under cumulative voting, if there are N directors

up for election, then 1/(N+1) percent of the stock up for election, then 1/(N+1) percent of the stock plus one share will guarantee you a seat.plus one share will guarantee you a seat.

With cumulative voting, the more seats that are With cumulative voting, the more seats that are up for election at one time, the easier it is to win up for election at one time, the easier it is to win one.one.

Straight voting works like a U.S. political Straight voting works like a U.S. political election.election. Shareholders have as many votes as shares and Shareholders have as many votes as shares and

each position on the board has its own election.each position on the board has its own election. A tendency to freeze out minority shareholders.A tendency to freeze out minority shareholders.

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Cumulative vs. Straight Cumulative vs. Straight Voting: ExampleVoting: Example

Imagine a firm with two shareholders: Imagine a firm with two shareholders: Mr. MacDonald and Ms. Laurier. Mr. MacDonald and Ms. Laurier. Mr. MacDonald owns 60% of the firm ( = 600 Mr. MacDonald owns 60% of the firm ( = 600

shares) and Ms. Laurier 40% ( = 400 shares).shares) and Ms. Laurier 40% ( = 400 shares). There are three seats up for election on the board.There are three seats up for election on the board.

Under straight voting, Mr. MacDonald gets to Under straight voting, Mr. MacDonald gets to pick all three seats.pick all three seats.

Under cumulative voting, Ms. Laurier has Under cumulative voting, Ms. Laurier has 1,200 votes ( = 400 shares 1,200 votes ( = 400 shares × 3 seats) and Mr. × 3 seats) and Mr. MacDonald 1,800 votes.MacDonald 1,800 votes.

Ms. Laurier can elect at least one board Ms. Laurier can elect at least one board member.member.

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Proxy VotingProxy Voting A proxy is the legal grant of authority by a A proxy is the legal grant of authority by a

shareholder to someone else to vote his or her shareholder to someone else to vote his or her shares.shares.

For convenience, the actual voting in large For convenience, the actual voting in large public corporations is usually done by proxy, public corporations is usually done by proxy, e.g. BCE Inc.e.g. BCE Inc.

If shareholders are not satisfied with If shareholders are not satisfied with management, an outside group of shareholders management, an outside group of shareholders can try to obtain as many votes as possible via can try to obtain as many votes as possible via proxy.proxy.

Proxy battles are often led by large pension Proxy battles are often led by large pension funds like the Ontario Teachers’ Pension Board funds like the Ontario Teachers’ Pension Board or the British Columbia Investment or the British Columbia Investment Management Corporation.Management Corporation.

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DividendsDividends Unless a dividend is declared by the board Unless a dividend is declared by the board

of directors of a corporation, it is not a of directors of a corporation, it is not a liability of the corporation. liability of the corporation. A corporation cannot A corporation cannot defaultdefault on an undeclared on an undeclared

dividend.dividend. The payment of dividends by the The payment of dividends by the

corporation is not a business expense. corporation is not a business expense. Therefore, they are not tax-deductible.Therefore, they are not tax-deductible.

Dividends received by individual Dividends received by individual shareholders are partially sheltered by a shareholders are partially sheltered by a dividend tax credit. (Appendix of Chapter 1)dividend tax credit. (Appendix of Chapter 1)

There is a pension for Canadian There is a pension for Canadian corporations to avoid the double taxation of corporations to avoid the double taxation of dividends.dividends.

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Classes of SharesClasses of Shares When more than one class of share exists, When more than one class of share exists,

they are usually created with unequal they are usually created with unequal voting rights.voting rights.

Many companies issue dual classes of Many companies issue dual classes of common stock. The reason has to do with common stock. The reason has to do with control of the firm.control of the firm. Amoako-Adu and Smith show that firms going Amoako-Adu and Smith show that firms going

public with dual classes of shares in Canada public with dual classes of shares in Canada are often family controlled.are often family controlled.

Lease, McConnell, and Mikkelson found Lease, McConnell, and Mikkelson found the market prices of U.S. stocks with the market prices of U.S. stocks with superior voting rights to be about 5-superior voting rights to be about 5-percent higher than the prices of percent higher than the prices of otherwise-identical stocks with inferior otherwise-identical stocks with inferior voting rights.voting rights.

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15.2 Corporate Long-Term 15.2 Corporate Long-Term Debt: The BasicsDebt: The Basics

Interest versus DividendsInterest versus Dividends Is It Debt or Equity?Is It Debt or Equity? Basic Features of Long-Term DebtBasic Features of Long-Term Debt Different Types of DebtDifferent Types of Debt RepaymentRepayment SenioritySeniority Security Security IndentureIndenture

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Interest versus DividendsInterest versus Dividends Debt is not an ownership interest in the Debt is not an ownership interest in the

firm. Creditors do not usually have firm. Creditors do not usually have voting power.voting power.

The device used by creditors to protect The device used by creditors to protect themselves is the loan contract (i.e., themselves is the loan contract (i.e., indenture).indenture).

The corporation’s payment of interest on The corporation’s payment of interest on debt is considered a cost of doing debt is considered a cost of doing business and is fully tax-deductible. business and is fully tax-deductible. Dividends are paid out of after-tax Dividends are paid out of after-tax dollars.dollars.

Unpaid debt is a liability of the firm. If it Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally is not paid, the creditors can legally claim the assets of the firm.claim the assets of the firm. One of the costs of issuing debt is the One of the costs of issuing debt is the

possibility of financial failure.possibility of financial failure.

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Is It Debt or Equity?Is It Debt or Equity?

Some securities blur the line between debt Some securities blur the line between debt and equity.and equity.

Corporations are very adept at creating Corporations are very adept at creating hybrid securities that look like equity but hybrid securities that look like equity but are called debt. are called debt. Obviously, the distinction is important at tax Obviously, the distinction is important at tax

time.time. A corporation that succeeds in creating a debt A corporation that succeeds in creating a debt

security that is really equity obtains the tax security that is really equity obtains the tax benefits of debt while eliminating its benefits of debt while eliminating its bankruptcy costs.bankruptcy costs.

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Basic Features of Long-Term Basic Features of Long-Term DebtDebt The bond indenture usually listsThe bond indenture usually lists

Amount of Issue, Date of Issue, MaturityAmount of Issue, Date of Issue, Maturity Denomination (Par value)Denomination (Par value) Annual Coupon, Dates of Coupon PaymentsAnnual Coupon, Dates of Coupon Payments SecuritySecurity Sinking FundsSinking Funds Call ProvisionsCall Provisions CovenantsCovenants

Features that may change over timeFeatures that may change over time RatingRating Yield-to-MaturityYield-to-Maturity Market PriceMarket Price

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Different Types of DebtDifferent Types of Debt A A debenturedebenture is an unsecured corporate is an unsecured corporate

debt, whereas a debt, whereas a bondbond is secured by a is secured by a mortgage on the corporate property.mortgage on the corporate property.

A A notenote usually refers to an unsecured usually refers to an unsecured debt with a maturity shorter than that of debt with a maturity shorter than that of a debenture, perhaps under seven years.a debenture, perhaps under seven years.

Debentures and bonds are long-term Debentures and bonds are long-term debt, i.e., payable more than one year debt, i.e., payable more than one year from the date they are originally issued.from the date they are originally issued.

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RepaymentRepayment Bonds can be repaid at maturity or earlier Bonds can be repaid at maturity or earlier

through the use of a through the use of a sinking fundsinking fund. . A A sinking fundsinking fund is an account managed on is an account managed on

behalf of the issuer by a bond trustee for behalf of the issuer by a bond trustee for the purpose of retiring all or part of the the purpose of retiring all or part of the bonds prior to their stated maturity.bonds prior to their stated maturity.

Debt may be extinguished before maturity Debt may be extinguished before maturity through a call provision giving the firm through a call provision giving the firm the right to pay a specific amount to retire the right to pay a specific amount to retire the debt before the stated maturity date.the debt before the stated maturity date.

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SenioritySeniority

Seniority indicates preference in Seniority indicates preference in position over other lenders.position over other lenders.

Some debt is Some debt is subordinated.subordinated. In the In the event of default, holders of event of default, holders of subordinated debt must give subordinated debt must give preference to other specified preference to other specified creditors who are paid first.creditors who are paid first.

Debt cannot be subordinated to Debt cannot be subordinated to equity.equity.

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Security Security Security is a form of attachment to property.Security is a form of attachment to property.

It provides that the property can be sold in event It provides that the property can be sold in event of default to satisfy the debt for which the of default to satisfy the debt for which the security is given.security is given.

A mortgage is used for security in tangible A mortgage is used for security in tangible property.property.

For example, debt can be secured by mortgages For example, debt can be secured by mortgages on plant and equipment.on plant and equipment.

Debentures are not secured by a mortgage.Debentures are not secured by a mortgage. If mortgaged property is sold in the event of If mortgaged property is sold in the event of

default, debenture holders will obtain something default, debenture holders will obtain something only if the mortgage bondholders have been fully only if the mortgage bondholders have been fully satisfied.satisfied.

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IndentureIndenture The written agreement between the The written agreement between the

corporate debt issuer and the lender.corporate debt issuer and the lender. Sets forth the terms of the loan:Sets forth the terms of the loan:

MaturityMaturity Interest rateInterest rate Protective covenantsProtective covenants

Examples: Examples:

- restrictions on further indebtedness,- restrictions on further indebtedness,

- a maximum on the amount of dividends - a maximum on the amount of dividends that can be paid,that can be paid,

- a minimum level of working capital.- a minimum level of working capital.

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15.3 Preferred Shares15.3 Preferred Shares Represents equity of a corporation, but is different Represents equity of a corporation, but is different

from common stock because it has preference from common stock because it has preference over common in the payments of dividends and in over common in the payments of dividends and in the assets of the corporation in the event of the assets of the corporation in the event of bankruptcy.bankruptcy.

Preferred shares have a stated liquidating value. Preferred shares have a stated liquidating value. For example, CIBC “$2.25 preferred” translates For example, CIBC “$2.25 preferred” translates into a dividend yield of 9% of the stated $25 value.into a dividend yield of 9% of the stated $25 value.

Preferred dividends are either cumulative or Preferred dividends are either cumulative or noncumulative.noncumulative.

Firms may have an incentive to delay preferred Firms may have an incentive to delay preferred dividends, since preferred shareholders receive dividends, since preferred shareholders receive no interest on the cumulated dividends.no interest on the cumulated dividends.

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Is Preferred Stock Really Is Preferred Stock Really Debt?Debt?

A good case can be made that preferred A good case can be made that preferred stock is really debt in disguise.stock is really debt in disguise. The preferred shareholders receive a stated The preferred shareholders receive a stated

dividend.dividend. In the event of liquidation, the preferred In the event of liquidation, the preferred

shareholders are entitled to a fixed claim.shareholders are entitled to a fixed claim. Some preferred shares have adjustable Some preferred shares have adjustable

dividends. An example is the CARP dividends. An example is the CARP (cumulative, adjustable rate, preferred).(cumulative, adjustable rate, preferred).

In Canada, corporate investors have an In Canada, corporate investors have an incentive to hold preferred shares issued by incentive to hold preferred shares issued by other corporations, since 100% of the other corporations, since 100% of the dividends they receive are exempt from dividends they receive are exempt from income taxes.income taxes.

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The Preferred Shares and The Preferred Shares and TaxesTaxes In Canada, a tax loophole encourages In Canada, a tax loophole encourages

corporations that are lightly taxed to issue corporations that are lightly taxed to issue preferred shares.preferred shares.

Low-tax companies can make little use of Low-tax companies can make little use of the tax deduction on interest.the tax deduction on interest.

They can issue preferred shares and enjoy They can issue preferred shares and enjoy lower financing costs since preferred lower financing costs since preferred dividends are significantly lower than dividends are significantly lower than interest payments.interest payments.

There are several reasons beyond taxes There are several reasons beyond taxes why preferred shares are issued:why preferred shares are issued:

Regulated public utilities can pass the Regulated public utilities can pass the tax disadvantage of issuing preferred tax disadvantage of issuing preferred shares on their customers.shares on their customers.

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The Preferred Shares The Preferred Shares and Taxes (continued)and Taxes (continued) Firms issuing preferred shares can Firms issuing preferred shares can

avoid the threat of bankruptcy that avoid the threat of bankruptcy that might otherwise exist if debt were might otherwise exist if debt were relied on.relied on.

Issuing preferred shares may be a Issuing preferred shares may be a means of raising equity without means of raising equity without surrendering control.surrendering control.

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15.4 Patterns of Long-15.4 Patterns of Long-Term FinancingTerm Financing

For Canadian firms, internally generated cash For Canadian firms, internally generated cash flow dominates as a source of financing.flow dominates as a source of financing.

Firms usually spend more than they generate Firms usually spend more than they generate internally—the gap is financed by new sales of internally—the gap is financed by new sales of debt and equity.debt and equity.

Net new issues of equity are dwarfed by new Net new issues of equity are dwarfed by new sales of debt.sales of debt.

This is consistent with the pecking order This is consistent with the pecking order hypothesis (later in details).hypothesis (later in details).

Leverage ratios for Canadian firms are Leverage ratios for Canadian firms are considerably higher than they were in the 1960s.considerably higher than they were in the 1960s.

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The Long-Term Financial The Long-Term Financial GapGapSources of Cash Flow

(100%)

Internal cash flow (retained earnings plus depreciation)

68.3%

Long-term debt and

equity 31.7%

Uses of Cash Flow (100%)

Capital spending

Net working

capital plus other uses

Internal cash flow

External cash flow

Financial deficit

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15.5 Summary and 15.5 Summary and ConclusionsConclusions

The basic sources of long-term financing are:The basic sources of long-term financing are: Long-Term DebtLong-Term Debt Common StockCommon Stock Preferred StockPreferred Stock

Common shareholders have voting rights, Common shareholders have voting rights, limited liability, and a residual claim on the limited liability, and a residual claim on the corporation.corporation.

Bondholders have a contractual claim Bondholders have a contractual claim against the corporation.against the corporation.

Preferred stock has some of the features of Preferred stock has some of the features of debt and equity.debt and equity.

Firms need financing—most of it is Firms need financing—most of it is generated internally.generated internally.

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Review Questions #Review Questions #

Review Questions: 15.1, 15.2, 15.3, Review Questions: 15.1, 15.2, 15.3, 15.5, 15.615.5, 15.6

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Assigned Questions #Assigned Questions #

Assigned Questions # 15.4, 15.7, Assigned Questions # 15.4, 15.7, 15.8, 15.10 15.8, 15.10