Chapter 14 Long-Term Financing: An Introduction by  Ross, Westerfield, Jaffe,

CHAPTER 14 IS A DEFINITIONS CHAPTER, IT WILL DEFINITELY CLEAR UP ANY CONFUSION, IF THERE IS ANY, OF THE BASIC TERMS USED IN THE FINANCE WORLD.  We will not be spending a great dealof time on it in class.

14.1 Definitions pertaining to Common Stock

Common Stock:  applied to stock that has no special preference either in dividends or in bankruptcy, owners of common stock are referred to as shareholders or stockholders, they receive certificates for the shares they own, the stated value on the stock certificate is called the par value .  The total par value is the number of shares issued multiplied by the par value of each share, can be referred to as dedicated capital

Authorized Shares:  the amount of shares of common stock that can be issued, decided upon incorporation, by the board of directors, no limit to the # of shares that can be authorized, number of shares authorized can be increased by a vote of the board of directors, not all shares are required to be issued

Capital surplus:  the amount of directly contributed equity capital in excess of the par value, # of shares sold x  (selling price-par value)

Retained Earnings: Net income - dividends paid to shareholders; $$$ that is retained within a corporation

Book value/common equity of a firm =  par value + capital surplus + accumulated retained earnings

Treasury stock:  When a firm buys back shares of stock these shares are known as treasury stock

Market value: The selling price of a share of stock

Replacement value:  The cost of replacing assets of a firm

 
Shareholder's Rights

Ideally;  Shareholders elect directors who in turn elect managers to carry out the shareholders "wishes", usually directors are elected once/year, all firms are different however in the way the election is carried out.

Cumulative voting: # of votes each shareholder can cast is determined first, (usually the # of shares held x the number of directors to be elected), the shareholder can distribute their votes as they wish, this type of voting encourages minority participation

Straight voting:  the # of shares a share holder owns = the # of votes a shareholder has, obviously making it tougher for minority shareholders to voice their opinion.

(Some states have mandatory cumulative voting)

Proxy voting:  legal grant of authority by a shareholder to someone else to vote his/her shares.

Other rights:

1. The right to share proportionally in dividends paid

2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation

3. The right to vote on matters of great importance i.e.; mergers

4. The right to share proportionally in any new stock sold, preemptive right

Dividends:  represents a return on the capital contributed by the shareholders, payment is at the discretion of the board, corporations are authorized by law to pay dividends to shareholders

• unless a dividend is declared, it is not a liability, amount to be paid is determined by board

• payments of dividends are not a business expense, not tax deductible, paid out of after tax profits

• dividends received by shareholders are considered ordinary income by the IRS, taxed on 30% of dividends received

14.2 Corporate Long Term Debt:  The Basics

Long term debt is any obligation payable more than 1 year from the date of issue

Comparison of Debt vs Equity:  debt is something that must be repaid, is not an ownership or interest in the firm, creditors do not have voting power, interest paid on debt is fully tax deductible, dividends are paid after taxes, and are considered a return on shareholders contributed capital, unpaid debt is a liability, dividends are not a liability as discussed above.  (IRS provides a tax subsidy when debt is used v equity)

Different types of debt:

Notes: unsecured debt with maturity shorter than 10 years

Debenture: unsecured corporate debt; (funded debt)

Bond:   secured by a mortgage on corporate property, (funded debt) commonly can also be referred to as unsecured debt

Unfunded debt:  debt that is due in less than a year; current liability

Consol:  debt that is perpetual and has no specific maturity

 

Types of Debt defined by Repayment

Amortization:  The payment of long term debt by installments, at the end of amortization, debt is said to be extinguished

Callable debt:  debentures or bonds that the firm has a right to pay a specific price in order to extinguish before maturity

Seniority:  indicates preference in position over other lenders, some debt is subordinated, in the event of default, holders of subordinated debt, must give preference to other specified lenders

Security:  form of attachment to property, it provides that property can be sold in the event of default, in order to satisfy the debt for which the security is given i.e.; mortgage

Indenture:  The written agreement between the corporate debt issuer and the lender, setting the maturity date, interest rate, and all other terms.

Restrictive covenants:  listed in the indenture, all restrictions placed on the firm by the lender; i.e.;, restrictions on further indebtedness, maximum on the amount of dividends paid, minimum level of working capital.

14.3 Preferred Stock

Preferred Stock:  Represents equity of a corporation, preference over common stock, in terms of payment of dividends, (preferred is paid first), have a stated liquidating value, usually $100/share, dividend preference is described in terms of $/share, i.e.; $5 preferred = dividend yield of 5% of stated value

Dividends payable on preferred stock are either cumulative or no cumulative , if cumulative and dividends are not paid in a certain year then the payment will be carried over to the following year., can be delayed indefinitely,

Some argue that Preferred Stock is really debt in disguise (see class discussionof income bonds), preferred shareholders receive a stated dividend only, have no voting rights, (unless dividends are not paid), if corporations are liquidated preferred shareholders receive a stated value.,  however unlike debt preferred stock dividends cannot be deducted like an interest expense., but when a corporation issues preferred stock, 70% of dividends received are exempt from corporate taxation.

Why issue preferred stock?

1. Because of the way utility rates are determined, utility companies can pass tax disadvantage of issuing preferred stock onto their customers, consequently a substantial amount of preferred stock is issued by the utility companies

2. companies reporting losses to the IRS may issue preferred stock, they have no taxable income from which taxes on interest can be deducted, preferred stock poses no penalty relative to debt

3. Firms issuing preferred stock can avoid issue of bankruptcy, dividends are not a liability.

14.4 Patterns of financing

See Table 14.1 Historical US Financing patterns

In the US only about 25% of financing comes from new debt and new equity

Historically US firms spent 80% of cash flow on capital spending, and 20% on net working capital

Figure 14.1 suggests a Pecking order to long term financing strategy:  First;  Internal Financing, Second; New Debt, Third; New stock

 However, the existence of a pecking order is a subject of much debate and research.  We will cover it more in class.

Need more sources?

Definition of common stock and other links

Definition of Preferred Stock and other links

Stock Basics Tutorial

Take QUIZ from this chapter

A special thank you to Cortney Minarik for putting these notes together!