CH05 Long Term Sources of Financing

CHAPTER 5 Strategic Financial Planning 187
Strategic Financial
Decision
AFTERTHESTUDYINGTHISCHAPTER,READERSHOULDBEABLETO:
Understandthefeatures,advantagesanddisadvantagesofcommonstock.
Explainthefunctionsofinvestmentbanker.
Describetheinvestmentbankingprocess.
Understandthespecificdebtcontractfeatures .
Understandtheadvantagesanddisadvantagesofdebt.
Explainthefactorsinfluencinglongtermfinancingdecisions.
Defineandexplainthefeaturesofpreferredstock.
Rankthedifferenttypesofsecurities.
Understandtheadvantagesanddisadvantagesofpreferredstock.
188 Corporate Finance
Purpose
his chapter is more descriptive than analytical, but financial managers do need a
working knowledge of the issued covered. The focus in this chapter is on
common stock, debt, and preferred stock. We discussed the specific characteristics of
common stock, debt and prefereed stock and the issuing process of such securities. We
examine some of the characteristics of different equities, and of the many different types of
debt, and we will discuss how firms actually raise long term capital.
Concept of Common Stock

Common stock Common stock is a source of long term financing. Common stock certificates are
Securities that legal documents that evidence ownership (or equity) in a company that is
represent the ultimate organized as a corporation; they are also marketable financial instruments. Sole
ownership (and risk)
position in a proprietorship and partnership firm cannot issue the common stock, but only
corporation. corporation can issue common stock.
The owners of a corporation are called stockholders. Common stock shares
issued by a corporation are claims to a share of the assets of a corporation as well
as to a share of the corporation's net income -- i.e., the corporation's income after
subtraction of taxes and other expenses, including the payment of any debt
obligations. This implies that the return that holders of common stock receive
depends on the economic performance of the issuing corporation.
Holders of a corporation's common stock typically participate in any upside
performance of the corporation in two ways: by receiving a share of net income
in the form of dividends; and by enjoying an appreciation in the price of their
stock shares. However, the payment of dividends is not a contractual or legal
requirement. Even if net earnings are positive, a corporation is not obliged to
distribute dividends to shareholders. For example, a corporation might instead
choose to keep its profits as retained earnings to be used for new capital
investment (self-financing of investment rather than debt or equity financing).
On the other hand, corporations cannot charge losses to their common stock
shareholders. Consequently, these shareholders at most risk losing the purchase
price of their shares, a situation which arises if the market price of their shares
declines to zero for any reason. An example of a common stock share is a share
of International Business Machine (IBM) and share of Himalayan Bank Limited
(HBL).
Authorized shares The corporate charter of a company specifies the number of authorized shares of
Maximum number of common stock. Authorized shares represent the maximum amount of stock the
shares that the
company is permitted
to issue.
company can issue according to the corporate charter. The firm cannot sell more
shares than the charter authorizes without obtaining approval from its owners
through a shareholder vote or without amending its charter. Because it is
difficult to amend the charter to authorize the issuance of additional shares, firm
generally issues shares less than the authorized shares. These unissued share
allow flexibility in granting stock option and splitting the stock. Issued shares
represent the number of authorized shares which have been sold by the firm.
Issued shares When share of common stock are sold, they become issued shares. All or some
Shares that have been portion of these share are purchased and actually held by the investors, which
issued by the company.
are called outstanding shares. If firm repurchases any of its outstanding shares,
Outstanding shares these shares are recorded as treasury stock and shown as a deduction from
Shares that have been shareholders equity in the firms balance sheet. Treasury stock is stock that has
issued by the company
and are held by
been reacquired by the firm. It is not retired but , rather, held for possible future
investors. resale, a stock option plan, to use in purchasing another company, or to prevent
Treasury stock
a takeover by an outside group. Treasury stock does not pay dividend and has
Common stock that has no voting rights. Total treasury stock can not exceed five percent of total
been repurchased and capitalization. Outstanding shares are therefore equal to the issued shares less
is held by the issuing
company. the treasury shares. Dividends are based on the outstanding shares.
The par value of a stock is a stated amount of value per share specified in the
corporate charter. The firm typically cannot sell stock at a price below par value
since stockholders would be liable to creditors for the difference between par
value and the amount received.
A closely held corporation is one having only a few stockholders. They keep full
control and are not acquired to publicly disclose financial information about the
company. However, a company having 50 or more stockholders must file an
annual financial statement with the Security Board of Nepal (SEBON). The
common stock of a firm can be closely owned by a small group of investors, or
publicly owned by a broad group of unrelated individuals and /or institutional
investors. Small corporations are privately or closely owned where as large
corporation are publicly owned.
A company may issue different classes of common stock. Class A is stock issued
to the public and usually has no dividends specified. However, it does have
voting rights. Class B stock is usually kept by the companys organizers.
Dividends are not paid on it until the company has generated sufficient
earnings.
Features of Common Stock

Common stock has the following features:
Par value stock or no par value stock

Owners of common stock in a corporation are referred to as shareholders or
stockholders. They receive stock certificates for the shares they own. There is
often a stated value on each stock certificate called the par value. The par value
of each share of most common stock in Nepal is Rs.100.
Maturity
The capital obtained from this source is called as fixed capital. This cannot be
redeemed in the mid life of the organization.
Priority to Assets and Earnings

Common stockholders have a residual claim on the earnings and assets of their
corporation. This means that if the corporation goes bankrupt, the law says that
all bills (such as employees wages; suppliers bills, and bondholders interest)
must be paid before common stockholders are entitled to divide up whatever
assets remain from the bankrupt operation.
Voting Rights
The common shareholders enjoy right to vote in the affairs of the company. In
most of the common stock each shareholder casts one vote in one share.
Typically, common stockholders receive one vote per share to elect the
companys board of directors (although the number of votes is not always
directly proportional to the number of shares owned).
Preemptive Right
The preemptive right gives the current shareholders the right to purchase any
new shares issued in proportion to their current holdings. When the preemptive
right granted, the preemptive right enables current owners to maintain their
proportionate share of ownership and control of the business. It also prevents
the sale of shares at low prices to new stockholders which would dilute the
value of the previously issued shares.
Limited Liability
If a corporation goes bankrupt and does not have enough assets to pay all it bills,
the common stock holders cannot be forced to participate in the payment of
unpaid bills. Stockholders cannot lose more than the cost of their investment.
Balance Sheet Accounts and Definitions

Common equity Common equity: Common equity is the sum of the firms common stock, paid
The sum of the firms in capital, and retained earnings, which equals the common stockholders total
common stock, paid in
capital and retained investment in the firm stated at book value.
earnings. Par value: Common stock may be sold with or without a par value. The par
Par value value of a share of stock is merely a recorded figure in the firms corporate
The nominal or face
charter, which has no significant use. According to Company Act 2063, the
value of a stock or
bond. company can set a par value of Rs 50 per share or higher amount that must be
divisible by ten as provided in the memorandum of association and articles of
association. A company should not issue common stock at a price less than par
value, because any discount from par value is considered to be a contingent
liability of the owner to the creditors of the company. In the event of liquidation,
the shareholders would be legally liable to the creditors for any discount from
par value. But in Nepal, company cannot issue share at discount.
Retained earninngs Retained earnings: The balance sheet account that indicates the total amount of
Earnings not paid out the earnings the firm has not paid out as dividends throughout its history; these
as dividends.
earnings have been reinvested in the firm.
Additional paid in Additional paid in capital: Funds received in excess of par value when a firm
capital sells stock is called additional paid in capital. If shares are issued at a price in
Difference between
issue price and par excess of par value, the difference is credited to contribute surplus. It is also
value of stock . Also known as share premium or excess capital.
called capital surplus.
Book value
Book value: Book value is an accounting concept, amount of book value the
Book value equals to firms equity records/includes common stock, share premium (paid in capital)
firms equity. and retained earning. It may be called net worth of the firm. Book value per
share is simply the amount per share of common stock to be received if all of the
firms assets are sold for their exact book value and all liabilities (included
preference stock) are paid.
Book value per share Book value per share: The accounting value of a share of common stock; equal
Book value divided by to the common equity (common stock plus additional paid in capital plus
number of shares.
retained earnings) divided by the number of shares outstanding.
Consider the following example. Lumbini Sugar Mill has had one stock issue in
which it sold 100,000 shares to the public at Rs. 15 per share. The par value of
common stock is Rs 1 per share. The retained earnings is Rs 3,000,000. The total
book value is equals to Rs 4,500,000 and book value per is Rs 45 per share.
Common shares (Rs. 1.00 par value per share) Rs. 100,000
Additional paid in capital 1,400,000
Retained earnings 3,000,000
Net common equity Rs. 4,500,000
Book value per share =
= = Rs. 45 per share
Where,
Common shares = Par value per share Number of shares
= Rs. 1.00 100,000 = Rs. 100,000
Additional paid in capital = (Market price per share Par value per share)
Number of shares
= (Rs. 15 Rs. 1.00) 100,000
= Rs. 1,400,000
Legal Rights and Privileges of Common Stockholders

Common stockholders are the real owners of a corporation, and as such they
have certain rights and privileges. There are two types of rights of common
stockholders.
Collective Rights
Certain collective rights are usually given to the common stock holders. Some of
the more important rights allow stockholders (1) to amend the charter with the
approval of the appropriate officials in the state of incorporation. (2) to adopt
and amend bylaws, (3) to elect the directors of the corporation, (4) to authorize
the sale of fixed assets, (5) to enter into mergers, (6) to change the amount of
authorized common stock, and (7) to issue preferred stock, debentures, bonds,
and other securities.
Specific Rights
Common stockholders also have specific rights as individual owners. (1) Right
to income (2) Right to share residual assets (3) Right to inspect the corporate
books (4) Right to sell their stock certificates; (5) Right to information, (6) Right
to vote, and (7) Preemptive right.
Right to Income
A corporation may distribute profits to shareholders in the form of dividends,
and indeed, many growth companies re-invest profits for greater growth rather
than distribute them to shareholders, but if the company does declare a
dividend, which is equal to a specific amount for each share of stock, then
common shareholders are entitled to the dividend amount times the number of
shares that they own. However, common shareholders have inferior rights to
dividends than preferred shareholders, if the company has preferred
shareholders.
Right to Share Residual Assets

If a company liquidates, common stockholders have a claim to the residue
what is left after all creditors and all preferred stockholders have been paid.
Right to Inspect the corporate books

Stockholders has the right to obtain information from management regarding
the firms operations. It is applied only if the release of such information will not
have negative impact in the competitive position of the firm. This limitation is
imposed in order to protect the other stockholders.
Right to Sell their Stock Certificates

Shareholders can sell their shares without taking permission from the
management or other shareholders. The company continuous to exist regardless
of any changes in ownership because of transfers of stock by shareholders. In
Nepal, shares must be transferred through a stock broker. When ownership of
the shares transferred, new shareholders are entitled to receive dividends on the
shares and has all the rights and privileges associated with stock ownership.
Right to Information
In addition to the reports that a shareholder receives, which includes an audited
financial statements every year, he also has the right to the minutes of the
meetings of the board of directors and to examine the list of stockholders,
although these rights are not usually exercised.
Right to Vote
Common stockholders, unlike preferred stockholders, have the right to vote for
the corporate board of directors, who, in turn, have complete control of the
company. Each stock gives the stockholder one vote for each director position
that is up for voting, but that vote may be apportioned in 2 different ways.
Statutory voting (also known as majority voting or straight voting or non-
cumulative voting) allows using all votes for each of the vacancies for the board
of directors; cumulative voting increases the number of votes that a stockholder
can use for a particular candidate. For instance, if there are 4 different vacancies
on the board and a stockholder owns 500 shares, then a statutory voting
privilege allows the stockholder to cast 500 votes for each of 4 candidates for the
4 vacancies for a total of 2,000 votes, but no more than 500 can be cast for any
candidate. Cumulative voting would give the shareholder 2000 votes (500 4)
that could be apportioned in any way: all 2000 votes for one candidate, or 1,000
for one, 500 to each of two others, and none to the others, for instance.
Cumulative voting system gives minority shareholders an opportunity to elect
some directors. The number of shares required to elect desired number of
directors is given by the following formula.
req = .(5.1)
Where,
req = Number of shares required to elect desired number of directors.
des = Desired number of directors
n = Total number of shares outstanding .
# = Total number of directors to be elected.
des = (5.2)
Majority voting system gives majority shareholders to elect all directors. The
number of shares required to elect all directors is calculated as follows:
= +1 ...(5.3)
If a stockholder cannot attend a meeting to vote, then he can cast his vote by
proxy through the mail, or having someone else at the meeting to cast his vote.
Consider the following example. Mr. X is a shareholder in the ABC Corporation.

He feels that if he could be elected to the board of directors, changes could be
made to improve the firm's operations. Mr. X owns 85,000 shares of the 500,000
shares outstanding. Five directors will be elected at the next annual meeting.
If voting is non-cumulative, Mr. X can not be elected because Mr. X can cast only
85,000 votes for himself, while other shareholders can cast 415,000 votes. It
would be possible for Mr. X to be elected if he had 250,000 plus 1 shares.
If voting is cumulative, Mr. X will be able to elect himself to the board of

directors because required shares is lower than 85,000 shares.
Number of shares required to one director (req) =
=
= 83,334 shares
Preemptive right
If a corporation wants to raise more money, it will frequently do so by issuing
more shares from the authorized, but unissued shares. However, existing
shareholders have the right to maintain their proportionate ownership of the
company, so the company provides existing shareholders with rights that allow
them to buy the new shares at a specified price known as the subscription price
which is usually lower than the market price. The main reasons to make a rights
issue by a company are as follows:
In times of inflation, the replacement costs of assets will be high, unless
the company can retain cash from substantial profits, the only
alternative is to raise cash from a fresh issue of shares.
For funding expansion projects, a company may make rights issue.
If a company has a proportion of interest bearing loan capital, the
company can suffer from a squeeze on profits. The company can
improve the capital structure position by obtaining extra share capital.
At a time when the share prices were relatively high, companies found
it easy to persuade their shareholders to subscribe cash for new issues
with a view to expansion by takeover.
A benefit for the company of selling to existing shareholders is that marketing
costs will be less than selling to the general public and benefit to the
shareholders is they are able to maintain their original proportion of share
ownership.
For instance, if shareholder X owns 10% of the company, and the company
issues 100,000 new shares of stock, then the company must allow X to buy at
least 10,000 shares of stock before the stock is presented to the public, so that he
can maintain his proportionate ownership of the company. He/she can refuse to
buy any new issues, or only some of them, but then his ownership percentage in
the company will decline, and along with it, the number of pre-emptive rights
received in any future rights offering.
A stockholder always receives 1 right for each stock owned at the rights record
date, when the rights are created. This gives the stockholder the right, but not
the obligation, to buy additional shares of stock at the subscription price. To buy
an additional share of stock requires a certain number of rights, and the number
of rights required will be the quotient of the number of issued shares divided by
the number of newly issued shares. If there is a remainder, then there will be a
rupee amount added to the number of rights required to purchase each share.
This will allow the shareholder to buy enough shares to maintain proportionate
ownership, but no more.
The right provides the privilege, so it must have a value. The value of right can
be calculated in two bases:
Right on: With the privilege of receiving rights, a share of stock is rights-on if it
entitle its owner to a right that is about to be issued by the firm. In this case
value of one right can be found by using the following formula.
Value of right (vr) = (5.4)
Exrights: Without the privilege of receiving rights, a share of stock is ex-rights
if it no longer entitles it owner to right that is about to be issued by the firm. In
this case value of one right can be found by using the following formula.
Value of one right (vr) = (5.5)
Where,
Pe = Market value of stock, ex-rights, equal to P0 vr
P S
= Subscription price
# = Number of rights required to purchase one new share
Stockholders have the choice of exercising their rights or selling them. If they
have sufficient funds and want to buy more shares of the company's stock, they
will exercise the rights. If they do not have sufficient money or do not want to
buy more stock, they will sell the rights. In either case, provided that the formula
value of the rights holds true, stockholders will neither benefit nor lose by the
rights offering. A stockholder may suffer a loss if he forgets to exercise or sell his
rights or brokerage cost of selling the rights are excessive. Shareholders wealth
position can be calculated as follows:
When all rights are exercised:
Wealth position = Pe (Number. of old shares + Number of new share)
(Subscription price Number of new shares) + Cash balance (if any) (5.6)
When all rights are sold:
Wealth position = Pe (Number of old shares) + (v r Number. of rights sold) +
Cash balance (if, any) (5.7)
When some rights are sold and some are exercised:
Wealth position = Pe (Number of old share + Number of new share) + v r
Number of rights sold Ps Number of new share purchased. + Cash (if any)
(5.8)
When all rights discards:
Wealth position = Pe (Number of old shares) + Cash (if any) (5.9)
For example, Laxaman is a shareholder in ABC Corporation. At the time of the
rights offering, Laxamans total assets consist of 320 shares of ABC Corporation
(purchase price was Rs.37.50 per share) and Rs.3,000 in cash. Prepare a statement
showing Laxamans position before and after the rights offering for each of the
four alternatives below. Notice is given that shareholders may purchase one new
share at a cost of Rs.30 for each four shares currently held.
The value of right is Rs 1.50 which is calculated as follows:
Value of right (vr) = = = Rs 1.50
The ex right market price per share is Rs 36 per share.

Ex right market price of a share (Pe) = P0 vr
= Rs. 37.50 Rs. 1.50
= Rs. 36 per share
Total assets (before right offering) of Laxman is Rs 15,000
Wealth position (Before right offering) = Po (Number of old shares) + Cash
= Rs.37.50 ( 320 ) + Rs.3,000
= Rs.15,000
Total assets (After right offering) of Laxman is calculated as follows:
Total assets if he exercise all rights
Wealth position = Pe (Number of old shares + Number of new share)
(PS Number of new shares) + Cash
= Rs.36 ( 320 + 80) (Rs.30 80) + Rs.3,000
= Rs.15,000
Where,
Number of new shares = = 80 shares
Total assets if he sell all rights.
Wealth position = Pe (Number of old shares) + (vr Number of rights) + Cash
= Rs.36 (320) + (1.5 320) + Rs.3,000 = Rs.15,000
Total assets if he sells 220 rights and exercises 100 rights.

Wealth position = Pe (Number of old shares + Number of new share)
(PS Number of new shares) + (vr Number of rights) + Cash
= Rs.36 ( 320 + 25) (Rs.30 25) + Rs.1.5 (220) + Rs.3,000
= 15,000
Working notes:
Number of new shares = = 25 shares
Total assets if he neither sells nor exercises the rights
Wealth position = Pe (Number of old shares) + Cash
= Rs.36 (320) + Rs.3,000
= Rs.14,520
The stockholder's position is unchanged by rights offering except when the
rights are neither exercised nor sold, in which case a loss is suffered.
Advantages and Disadvantages of Common stock

From Issuer's Viewpoint
Advantages:
1. Maturity: Common stock carries no fixed maturity date. It represents
permanent capital. Hence, there is no liability for repayment.
2. No fixed burden of dividend: The dividend on common stock is not fixed. It

depends on the profits generated. Dividends are not the burden as in the case
of preference share.
3. Increase in borrowing capacity: Common stock increases the future
borrowing capacity of the firm. If the equity capital is more, it becomes easier
to borrow fund in future. The more the firm sells common stock, the more is
its equity base. Hence it can take long term finance more easily and cheaply
then that of other alternatives.
4. Sold easily: Common stock can be sold more easily than debt because it has
higher expected rate of return and it represents ownership of the firm.
5. Lower tax: Returns from common stock, in the form of capital gains, are
subject to lower personal income tax rates.
Disadvantages
1. High cost of capital: The cost of common stock is high, usually the highest.
The rate of return required by common stockholders is generally higher than
the rate of return required by other investors.
2. High cost: The cost of issuing common stock is generally higher than the cost
of issuing other types of securities. Underwriting commission, brokerage
costs, and other issue expenses are high in case of common stock.
3. Tax facility: Common stock dividends are not tax-deductible payments and
are riskier than both the debt and the preferred stock.
4. Dilution of control: The control of the firm is shared with the new
shareholders.
5. Dilution of earnings: The new shares participate fully in earnings and
dividends.
From Investor's Viewpoint

Advantages:
1. More income: Dividend in the case of equity shares is not fixed. It depends
on the profits generated by the company. If the company is progressive it can
be a good source of income to investors.
2. Participation in management: Common stockholders have the right to
participate in management. They can take part in the general meetings with
voting rights. They elect the board of directors.
3. Best for investment: The person who enjoys taking risks, investment in
equity share is good investment.
4. Capital profit: In case of progress and profit to the company the market
value of the share increases. In this case the shareholders can sell the shares
at higher prices to get the capital gains.
5. Interest in company's activities: Common stockholders are the owners of the
company. They take a lot of interest in the company's affairs.
Disadvantages:
1. Low priority in the liquidation: Common stockholders have a residual claim
to income and assets of the company. They suffer the lowest priority.
2. Irregular income: Payment of dividend is dependent on the profits of the
company. Many times when there is larger profit the dividends are very
little.
3. Capital loss: At the time of reduction of share prices it is not in favor of
investors to sell the shares. If one shareholder has the urgency to sell his
shares he has to incur capital loss.
4. Less attractive to modest investors: Those investors, who want regular and
consistent income on their investment, the investment in equity shares is not
very attractive.
The Market for Common Stock

Some companies are so small that their common stocks are not actively traded;
they are owned by only a few people, usually the companies managers. Such
firms are said to be closely held, or privately owned, corporations. In contrast,
Over the counter
market the stocks of most larger companies are owned by a large number of investors,
The network of dealers most of whom are not active in management. Such companies are said to be
that provides for trading publicly held corporations.
securities not listed on
organized exchanges. The stock of smaller publicly owned firms are not listed on an exchange; they
trade in the over the counter market, and the companies and their stocks are said
to be unlisted. However, larger publicly owned companies generally apply for
listing on an organized security exchange, and they and their stocks are said to
be listed.
Stock market transactions may be separated into three distinct categories:
Organized security The secondary market deals with trading in previously issued, or outstanding,
exchange
shares of established, publicly owned companies. The company receives no new
A formal organization,
having a tangible money when sales are made in the secondary market.
physical location, that
facilitates tranding in
The primary market handles additional shares sold by established, publicly
designated securities. owned companies. Companies can raise additional capital by selling in this
market.
The primary market also handles new public offerings of shares in firms that
were formerly privately held. Capital for the firm can be raised by going public,
the act of selling stock to the public at large by a closely held corporation or its
principal stockholders. This market is termed the initial public offering (IPO)
market, the market consisting of stocks of companies that have just gone public.
Stocks traded on organized stock exchanges are called listed stocks. While the
decision go to public is significant, the decision to list is not a major event. In
order to have a stock listed, a company must apply to an exchange, pay a
relatively small fee, and meet the exchanges minimum requirements. The
company will have to file a few new reports with an exchange. It will have to
abide by the rules of the exchange. Firms benefit from listing their stocks by
gaining liquidity, status, and free publicity. These factors may cause the value of
the stock to be increased.
Investment Banker
When a corporation/firm sells new securities to raise cash, the offering is called
a primary issue. The agent responsible for finding buyers for these securities is
called the investment banker or underwriter. The name investment banker is
Investment banker
A financial institution unfortunate because those people are not investors and they are not bankers.
that underwrites new Essentially, investment bankers purchase primary issues from security issuers
securities for resale. such as companies and governments, and, then, arrange to immediately resell
these securities to the investing public. The investment banker act as the
middleman in channeling driblets of individuals savings and funds into the
purchase of business securities.
Issue of Common Stock

Company can issue common stock in the primary market by using different
methods: They are:
(1) Private placements; (2) Public offerings; (3) Right offerings
Private Placements
Private placement A corporation can sell the entire issue to a single purchaser (generally a financial
The sale of an entire institution or wealthy individual) or a group of such purchasers. This type of
issue of unregistered
sale is known as a private placements. Private placement also known as direct
securities directly to
one purchaser or a placement, because the company negotiates directly with the investors over the
group of purchasers. terms of the offering, eliminating the underwriting function of the investment
banker. Equity and debt securities may be issued either publicly or privately. A
consideration in determining whether to issue securities publicly or privately is

the type and amount of the needed financing.
Advantages of private placement:

Flexible: In a private placement, there is greater flexibility in working out the
terms of the issue. Private placement is more flexible on timing, amount of funds
to be raised, certainty of commitments and other features. The issuing company
may collect desired funds as scheduled. Company need not fulfill the legal
formalities concerning preparation and issue of prospectus and its registration.
The repayment terms can be made according to the situation of the company. If
the company is in financial difficulty, it is easier to make one, two investors
adjust the terms. They can offer greater flexibility in the writing of the terms of
the contract between the borrower and the lender.
Speed: The time required for completing a public issue cycle is usually 6 months
or more because of the several formalities that have to be gone through. On the
other hand, a private placement requires lesser time, perhaps a month or two
months. Therefore, private placement offer can avoid the time delays associated
with the preparation of registration statements with the waiting period.
Lower issue costs: A public issue entails several expenses with underwriting,
brokerage, printing, mailing, announcements, promotion, and so on. These costs
can be quite high. The issue cost for a private placement is substantially less.
Under private placement, there is no administration, issuing, underwriting fees.
Advantageous for low credit rating company: The companys credit rating may
be low, and as a consequence investment may not be interested in buying
securities when the money supply is limited.
Advantageous to small company: It may not be practical to issue securities in
the public market when a company is so small that an investment banker would
not find it profitable.
Disadvantages of private placement:

High interest cost: Interest rates for private placements are higher than they are
for debt and preferred stock issues sold through underwriters.
Less liquid: Securities issued through private placement are less liquid such
issue cannot be resold in the public market.
Difficulty to raise large money: It is more difficult to obtain significant amounts
of money privately compared to publicly.
Poor financial position: Large investors usually employ stringent credit
standards requiring the company to be in a strong financial position.
Voting control: Most management does not want to block of voting shares into
the hands of a single investors. Large institutional investors are more capable of
obtaining voting control of the company.
Close watching: Large institutional investors may watch more closely the
companys activities than smaller investors in a public issue.
Public Issue
Public issue Public issue is the sale of stock or bonds to the general public. With a public
Sale of bonds or stock issue, securities are sold to hundreds, and often thousands, of investors under a
othe general public. formal contract overseen by regulatory authorities.
When a company issues securities to the public, it usually uses the services of an
investment banker. There are three primary means by which companies offer
securities to the public: a traditional underwriting, a best efforts offering, and a
shelf registration.
A public issue is an offer of new common stock to the general public and then
letting the stock trade in public markets. Centra Software, John Hancock
Financial Services, Krispy Kreme Doughnuts, Siddhartha Bank limited, Lumbini
Bank Limited are the examples of pubic issue.
Advantages of Public Issue

Increases liquidity: The stock of the private corporation is illiquid. It has no
ready market. In one of the owners wants to sell some shares, it is hard to find a
ready buyer and price on which base the transaction. These problems do not
exist with publicly owned firms.
Permits founders to diversify: By selling some of their stock in a public offering,
they can diversify their holdings, thereby reducing the riskiness of their personal
portfolios.
Facilities raising new corporate cash: If the private corporation wants to raise
cash by selling new stock, it must either go to its existing owners, who may not
have any money or may not want to invest more. Usually it is difficult to get
outsiders to put money into a private corporation. Public issue reduces these
problems. Public issue brings with public disclosure of information and
regulation of security exchange which makes people more willing to invest in
the company, therefore it makes easier for the firm to raise capital.
Establishes a value for the firm: A company that is publicly owned has an
established value. If a company wants to give incentive stock options to key
employees, it is useful to know the exact value of those options, and employees
much prefer to own stock, or options on stock, that is publicly traded and thus
liquid.
Sets up merger negotiations: If there is an established market price, this helps
when a company is either being acquired or seeking to acquire another company
where it will pay for the acquisition with stock.
Increases potential markets: Many companies report that it is easier to sell their
product and services to potential customers after they become a publicly traded
company.
Disadvantages of Public Issue

Cost of reporting : Publicly owned company must provide quarterly and annual
reports to the regulatory agencies and other government agencies. These reports
can be a costly for the small firms.
Disclosure: Management may not like the idea of reporting operating data,
because these data will then available to competitors. Similarly, the owners of
the company may not want people to know their net worth, and since a publicly
owned company must disclose the number of shares owned by its officers,
directors, and major stockholders, it is easy to anyone to estimate the net worth
of the insiders.
Self dealings: The ownersmanagers of closely held companies have many
opportunities for various types of questionable but legal self-dealings, including
the payment of high salaries, nepotism, personal transactions with the business.
Such self dealings often used to minimize the personal tax liabilities, which are
much difficult to arrange if the company is publicly owned.
Inactive market/low price: If the firm is very small, and if its shares are not
traded frequently, its stock will not really be liquid, and the market price may
not represent the true stock value. Under this condition, security analysts and
stockbrokers will not follow the stock, because there will not be sufficient
trading activities to generate enough brokerage commissions to cover the costs
of following the stock.
Control: The managers of publicly owned firms do not have voting control due
to possible tender offers and proxy flights. Further, there is pressure for the
managers to produce annual earnings gains.
Investor relations: Public companies must keep investors abreast of current
developments. Most of CFOs of newly public firms report that they spend two
full days a week talking with investors and analysts.
Right Offerings
If the preemptive right is contained in a firm's charter, the firm must offer any
new common stock to existing stockholders. If the charter does not prescribe a
preemptive right, the firm has a choice of making the sale to its existing
stockholders or to an entirely new set of investors. If it sells to the existing
shareholders, the stock flotation is called rights offering. Each stockholder is
issued an option to buy a certain number of the new shares, the terms of such
the option contained on a piece of paper an called rights. Each stockholder
receives one right for each share of stock owned. Right offering is very popular
in Nepal.
Investment Banking Process

The financial manager must have a knowledge of the investment banking
process, the process by which new securities are issued. Investment banking
decisions take place in three stages.
Stage I: Decision
At stage I, the firm makes some preliminary decisions, the firm makes.
Rupees to be raised. The rupee amount of new capital required is established.
Types of securities used. The type of securities to be offered is specified. Stock,

bonds, or a combination can be used. If stock is to be issued, should it be offered
to existing stockholders or sold directly to the general public.
Competitive bid versus negotiated deal. The basis on which to deal with the
investment bankers, either by a competitive bid or a negotiated deal, is
determined.
Selection of an investment banker. Finally, the investment-banking firm must
be selected. In case of Nepal, there are nine investment bankers. One can select
the any one or two investment bankers.
Stage II: Decision

The stage II decisions are made jointly by the firm and the selected investment
banker.
Reevaluating the initial decisions. First, the two parties will reevaluate the
Stage I decisions.
Best efforts or underwritten issues. The firm and its investment banker must
decide whether the banker will work on a best efforts basis or will
underwrite the issue.
In a best efforts sale, the investment banker is only committed to making every
effort to sell the stock at the offering price. In this case, the issuing firm bears the
risk that the new issue will not be fully subscribed. If the issue is underwritten,
the investment banker agrees to buy the entire issue at a set price, and then
resells the stock at the offering price. Thus, the risk of selling the issue rests with
the invesment banker.
Issuance costs. The costs associated with a new security issue are termed
flotation costs. These costs include compensation to the investment banker plus
legal, accounting, printing, and other costs borne by the issuer. Flotation costs
depend on the type of security issued and the size of the issue.
Setting the offering price. Several factors must be considered when setting the
offering price.
If the firm is already publicly owned, the offering price will be based upon the
existing market price.
The investment banker will have an easier job if the issue is price relatively low,
while the issuer naturally wants as high a price as possible.
Investors must be attracted to new issues. This can be done by reducing the price
or by promoting the issue.
If the pressure from a new stock issue drives down the price of the stock, all
shares outstanding are affected, not just the new shares. This loss in firm value is
also a flotation cost. However, it may not be a permanent loss; however, if the
companys prospects really were poorer than investors had thought, then most
of the price decline would have occurred sooner or later.
Selling Procedures
Because of potential losses from price declines caused by a failing market,
underwriters doe not generally handle issues single handedly. Groups of
investment bankers form an underwriting syndicate to spread the risk and
minimize individual losses. Syndicates are also useful because an individual
bankers clients may not be able to absorb a large issue.
Underwriting Syndicate: A syndicate of investment firms formed to spread the
risk associated with the purchase and distribution of a new issuance of securities
Lead or Managing Underwriter: The member of an underwriting syndicate who
actually manages the distribution and sale of a new security offering
Selling Group: A group (network) of brokerage firms formed for the purpose of
distributing a new issuance of securities . A selling group may handle the
distribution of securities to individual investors. Thus, the underwriters act as
wholesalers, and the members of the selling group act as retailers.
Shelf Registrations
A shelf registration is a procedure used by large, well established firms to issue
new securities on very short notice.
Maintenance of the Secondary Market

When a company is going public for the first time the investment banker is
obligated to maintain a market for the shares after the issue has been completed.
This is done in order to provide liquidity for the shares and to maintain a good
relationship with both the issuer and the investors who purchased the shares.
The lead underwriter agrees to make a market in the stock and keep it
reasonably liquid
Long Term Debt

Bonds are long term fixed income securities. Debentures are also long term fixed
income securities. The two terms, however, are often used interchangeably. Both
of these are debt securities. Long-term debt is the major long-term sources of
financing. The big firms can raise fund by selling long-term bonds / debentures
in the open market. But long-term loan may be suitable for both small and big
firm. Debtholder becomes the creditor of the debt issuing company. There is a
claim on firm's income and assets as stated in the bond contract called indenture.
The rights, facilities, obligation of the investors are indicated in the indenture.
Debt Instruments
Debt The words' used for long-term debt instruments are bond and debenture. The
Long term loan. bond and debenture are used synonymously. In Britain bond is also a debenture.
There is no difference between secured and unsecured bond. In USA bond may
be secured or unsecured. The term debenture is used in the sense of unsecured
bond. In India, debt securities issued by the government and public sector units
are generally referred to as bonds, while debt securities issued by private sector
joint stock companies are called debentures. In this book bond and debenture
have been used in the same meaning. There are many types of long-term debt
instruments: term loans, bonds, secured and unsecured notes, marketable and
non- marketable debt, and so on.
Term loan
Term Loan A term loan is a contract under which a borrower agrees to make a series of
A debt contract with a interest and principal payments on specific dates to the lender. The financial
financial intermediary
having a specified institution which lends the funds is usually a bank, an insurance company, or a
schedule of principal pension fund. The maturity of a term loan is generally from 3 to 15 years, but it
and interest payments. may be as short as 2 or as long as 30 years. Term loans have three major
advantages over public offerings: speed, flexibility, and low issuance costs. The
interest rate on a term loan can either be fixed for the life of the loan or be variable.
Bonds
Bonds A bond is a long-term contract under which a borrower agrees to make
A long term debt
instrument. payments of interest and principal on specific dates to the holder of the bond. A
bond is a debt security, in which the issuer owes the holders a debt and is
obliged to repay the principal and interest (the coupon). A bond is just a loan,
but in the form of a security, although terminology used is rather different. The
issuer is equivalent to the borrower, the bond holder to the lender and the
coupon to the interest. A bond is issued by a corporation, therefore this is also
known as corporate bond. Sometimes, the term corporate bonds is used to
include all bonds except those issued by governments in their own currencies,
although, it only applies to those issued by corporations. Corporate bonds are
often traded in major stock exchanges. Compared to government bonds, they
generally have a higher risk of default.
Mortgage bonds
Mortgage Bonds Mortgage bonds are collateralized by assets such as power plants or factories.
A bond backed by fixed Should the corporation be liquided, the bondholders have a direct claim on
assets. First mortgage
bonds are senior in those assets. A mortgage bond can be open ended or closed ended. An opend
proiority to claims of ended mortgage bond allows the corporation to issue more bonds backed by the
second mortgae bonds.
same collateral and of equal seniority. This means the bondholders claim on the
collateral can be diluted. With a closed end mortgage bond, the corporation may
issue more bond backed by the same collateral, but bonds are divided into
classes according to the order in which they were issued. The classes are called
the first mortgage, second mortgage, etc. Earlier classes have higher seniority
than later classes. In a liquidation, claims are satisfied in the order of seniority.
First mortgage claims must be paid in full before subordinate claims can be paid.
Debentures
Debenture A debenture is a long term debt instrument used by governments and large
Unsecured long term companies to obtain funds. It is similar to a bond except the securitization
bond.
conditions are different. A debenture is unsecured in the sense that there are no
liens or pledges on specific assets. It is however, secured by all properties not
otherwise pledged. In the case of bankruptcy debenture holders are considered
general creditors. The advantage of debentures to the issuer is they have specific
assets unencumbered, and thereby leave them open for subsequent financing. In
practice the distinction between bond nad debenture is not always maintained.
Bonds are sometimes called debentures and vice versa.
Subordinated debentures
Subordinated Subordinated debenetures are those that have a lower priority than other bonds
Debentures of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of
A bond having a claim
on assets only after the creditors. First the liquidator is paid, then government taxes, etc. The first bond
senior debt has been holders in line to be paid are those holding what is called senior bonds. After
paid off in the event of
liquidation. they have been paid, the subordinated bond holders are paid. As a result, the
risk is higher. Therefore, subordinated bonds usually have a lower credit rating
then senior bonds. The main examples of subordinated bonds can be found in
bonds issued by banks, and asset backed securities. The latter are often issued in
tranches. The senior trances get paid back first, the subordinated tranches later.
Convertible bonds
Convertible Bonds Convertible bonds are securities that can be converted into a fixed number of
A bond that is shares of common stock at the option of the bondholder. Examples of
exchangeable, at the
option of the holder, for convertibles are convertible bonds and convertible preferred stock.
common stock of the
issuing firm. Convertible securities are bonds or preferred stocks that can be converted into
stated number of common stock at the option of the holder within specified
time. A bond can be converted into preferred stock and common stock while
preferred stock can be converted into common stock only. Conversion feature
increases the marketability of the security. Unlike the exercise of warrants,
conversion of the security does not provide additional capital. Debt or preferred
stock is simply replaced by common stock.
A specified number of shares of stock are received by the holder of the
convertible security when he/she makes the exchange. This is referred to as the
coversion ratio. The conversion price applies to the effective price the holder
pays for the common stock when the conversion is effected. The conversion
price and the conversion ratio are set at the time the convertible security is
issued. The conversion price should be tied to the growth potential of the
company. The greater the potenatial, the greater the conversion price should be.
Generally, the conversion ratio and conversion price are fixed for the life of the
bond. Conversion period is the period of time during which conversion of a
security is permitted. It is set by the issuer to suit the firm's forecast for the long
run financial needs.
A convertible bond is a quasi-equity security because its market value is tied to
its value if converted rather than as a bond. This value is referred to as
conversion value and it is the product of common stock price and conversion
ratio.
When a convertible security is issued, it is priced higher than its conversion
value. The difference is referred to as the conversion premium.
Warrants
Warrants A warrant refers to the option of purchase a given number of shares of stock at a
A long term option to given price. Warrants can be either detachable or nondetachable. A detachable
buy a stated number of
shares of common warrant may be sold separately from the bond with which it is associated. Thus,
stock at a specified the holder may exercise the warrant but not redeem the bond if he/she wishes.
price.
A nondetachable warrant is sold with its bond to be exercised by the bondholder
simultaneously with the convertible bond.
To receive common stock the warrant must be given up along with the payment
of cash is called the exercise price. Although warrants typically expire on a given
date, some are perpetual, that is, never expire. A holder of a warrant may
exercise it by purchasing the stock, sell it on the market to other investors, or
continue to hold it. The company cannot force the exercise of a warrant. An
investor may wish to hold a warrant rather than exercise or sell it because there
exists a possibility of achieving a high rate of return. But there are several
drawbacks to warrants, including a high risk of losing money, no voting rights,
and no receipt of dividends.
If desired, a company may have the exercise price associated with a warrant
vary over time. If there is a stock split or stock dividend before the warrant is
exercised, the option price of the warrant is typically adjusted for it.
Through warrants additional funds are received by the issuer. When a bond is
issued with a warrant, the warrant price is typically set between ten to twenty
percent above the stocks market price. If the companys stock price goes above
the option price, the warrants will, of course, be exercised at the option price.
The closer the warrants are to their expiration date, the greater chance is that
they will be exercised.
Income bonds
Income Bonds Income bonds provide that interest must be paid only if the earnings of the firm
A bond that pays are sufficient to meet the interest obligations. The principal, however, must be
interest to the holder
only if the interest is paid when the bond is due. Therefore, the interest itself is not a fixed charge
earned by the firm. under this condition. Income bonds have been issued because a firm has been in
financial difficulties and it may be unable to meet a substantial level of fixed
charges in the future. However, income bonds provide flexibility to the firm in
the event that earnings do not cover the amount of interest that would otherwise
have to be paid. Income bonds are like preferred stock in that the firm will not
be in default if current payments on the obligations are not made. They have an
additional advantage over preferred stock in that the interest is a deductible
expense for corporate income tax computations, while the dividends on
preferred stock are not.
The main advantages of income bond is that interest is payable only if the
company achieves earnings. Since the earnings calculations are subject to
different interpretations, the indenture of the income bond carefully defines
income and expenses. If it did not, litigation might result. Some income bonds
are cumulative indefinitely; others are cumulative for the first three to five years,
after which they become noncumulative.
Income bonds usually contain sinking fund provisions to provide for their
retirement. The annual payments to the sinking funds range between half and
one percent of the face amount of the original issue. Because the sinking fund
payment requirements are typically contingent on earnings, a fixed cash drain
on the company is avoided. Generally, income bondholders do not have voting
rights when the bonds are issued. Sometimes bondholders are given the right to
elect some specified number of directors if interest is not paid for a certain
number of years. Sometimes income bonds are convertible.
Putable bonds
Putable Bonds Putable bonds may be turned in and exchanged for cash at the holders option;
A bond that can be generally, the option to turn in the bond can be exercised only if the firm takes
redeemed at the
bondholders option. some specified action, such as being acquired by a weaker company or
increasing its outstanding debt by a large amount.
Index (Purchasing Indexed, or Purchasing Power Bonds

Power) Bonds
A bond that has interest Indexed, or purchasing power, bonds have their interest rate payment tied to an
payments based on an inflation index, such as the consumer price index; thus, protecting the
inflation index to protect
the holder from
bondholders against inflation.
inflation.
Serial Bonds
Serial Bonds A specified portion of these bonds comes due each year. At the time serial
An issue of bonds with bonds are issued, a schedule is given showing the yields, interest rates, and
different maturities, as
distinguished from an prices applicable with each maturity. The interest rate on the shorter maturities
issue where all the is lower than the interest rate on the longer maturities. Serial bonds are primarily
bonds have identical
maturities. issued by government agencies.. Serial bonds mature periodically until final
maturity. For example, a Rs. 40 million issue of serial bonds might have Rs. 2
million of predetermined bonds maturing each year for 20 years. With a serial
bond issue, the investor is able to choose the maturity that best suits his/her
needs. Therefore, a serial bond might appeal to a wider group of investors than
an issue in which all the bonds have the same maturity.
Specific debt contract features

A firms managers are concerned with both the effective cost of debt and any
restrictions in debt contracts which might limit the firms future actions. There
are a number of features which could affect either the cost of the firms debt or
the firms future flexibility. We discuss specific debt contract features in this
section.
Bond Indenture
Bond Indenture A bond indenture is a legal contract that specifies the terms and conditions
A formal agreement between a bond issuer and bondholders. An indenture typically includes
between the issuer of a
bond and the repayment provisions, call or redemption terms, bond forms, collateral, sinking
bondholders. fund provisions, working capital and /or current ratio restrictions. A trustee,
usually the bond issuers bank or a trust company, monitor the issuer to ensure
compliance with the terms and conditions set forth in the indenture. The
provisions outlined in a bond indenture generally serve to protect the interests
of the bondholders. Specific provisions differ from one issuer to the next,
although there are similarities in provisions among companies in the same
industry.
The legal agreement also called the 'deed of trust'. In the ordinary common stock
or preferred stock certificate or agreement, the details of the contractual
relationship can be summarized in a few paragraphs. The bond indenture,
however, can be a document of several hundred pages that discusses a large
number of factors important to the contracting parties, such as: (1) The form of
the bond and the instrument; (2) A complete description of property pledged;
(3) The authorized amount of the bond issue; (4) Detailed protective clauses, or
covenants, which usually include limits on indebtedness, restrictions on
dividends, and a sinking fund provision; (5) A minimum current ratio
requirement; and (6) Provisions for redemption or call privileges.
A protective covenant is the part of the indenture that limits certain actions a
company might otherwise wish to take during the term of the loan. Protective
covenants can be classified into two types: positive covenants and negative
covenants.
A positive covenant specifies an action that the company agrees to take or a
condition company must abide by. Some of the examples are as follows:
1. The company must maintain its working capital at or above some specified
minimum level.
2. The company must periodically furnish audited financial statements to the
lender.
3. The firm must maintain any collateral or security in good condition.
A negative covenant limits actions that the company might take. Some of the
examples of the negative covenants are as follows:
1. The firm must limit the amount of dividends it pays according to some
formula.
2. The firm cannot pledge any assets to other lenders.
3. The firm cannot merge with another firm.
4. The firm cannot sell or lease any major assets without approval by the lender.
5. The firm cannot issue additional long-term debt.
Trustee
To facilitate communication between the issuer and the numerous bondholders,
Trustee a trustee was appointed to represent the bondholders. The trustee is still
An official who ensures presumed to act at all times for the protection of the bondholders and on their
that the bondholders behalf.
interests are protected
and that the terms of Trustee a person or institution designated by a bond issuer as the official
the indenture are representative of the bondholders. Typically, a bank serves as trustee. Trustees
carried out .
have three main responsibilities:
1. They certify the issue of bonds. This duty involves in making certain that
all the legal requirements for drawing up the bond contract and the
indenture have been carried out.
2. They police the behavior of the corporation in its performance of the
responsibilities set forth in the indenture provisions.
3. They are responsible for taking appropriate action on behalf of the
bondholders if the corporation defaults on payment of interest or principal.
For example, Ace Finance Company and NIDC Capital markets are the
trustees of the debentures issued by Nepal Investment bank and NIC bank
respectively.
Call provision
Call Porvision A call provision gives the issuing corporation the right to call in the bond for
A provision in a bond redemption. The provision generally states that the company must pay an
contract that gives the amount greater than the par value of the bond; this additional sum is defined as
issuer the right to
redeem the bonds the call premium. The call premium is typically equal to one years interest if the
under specified terms bond is called during the first year, and it declines at a constant rate each year
prior to the normal thereafter.
maturity date.
The call privileges are valuable to the firm but potentially detrimental to the
investor, especially if the bond is issued in a period when interest rates are
thought to be cyclically high. The problem for investors is that the call privilege
enables the issuing corporation to substitute bonds paying lower interest rates
for bonds paying higher ones.
Sinking Funds
Sinking Funds A sinking fund is a provision that facilitates the orderly retirement of a bond
A required annual issue. It requires the firm to buy and retire a portion of the bond issue each year.
payment designed to Sometimes the stipulated sinking fund payment is tied to the current years sales
amortize a bond or
preferred stock issue. or earnings, but usually it is a mandatory fixed amount. If it is mandatory, a
failure to meet the payment causes the bond issue to be thrown into default and
can lead the company into bankruptcy. Obviously, then, a sinking fund can
constitute a dangerous cash drain on the firm.
In most cases the firm (the bond trustee) is given the right to handle the sinking
fund in either of two ways:
1. It can call a certain percentage of the bonds at a stipulated price each year
(for example 2 percent of the original amount at a price of Rs. 1,000). The
serial numbers of the actual bonds to be called are determined by a lottery.
2. To retire the required face amount of the bonds, it can buy the bonds on the
open market.
The firm will do whichever results in the required reduction of outstanding
bonds for the smallest outlay. Therefore, if interest rates have risen (and the
price of the bonds has fallen), the firm will choose the open market alternative. If
interest rates have fallen (the bond prices have risen), it will elect the option of
calling bonds.
Bond Innovations
Zero (Or Very Low) Coupon Bonds
Zero Coupon Bonds A zero coupon bond is a bond that does not make any interest payment and is
A bond that pays no sold with a large discount. Zero coupon bonds pay no interest but are offered at
annual interest but is a substantial discount on their par values and hence provide capital
sold at a discount
below par. appreciation. The advantages to the issuer are that no cash outlays are required
until maturity, and these bonds often have a lower required rate of return than
coupon bonds. The advantages for investors are that there is little danger of a
call, and zeros guarantee a "true" yield to maturity since there is no reinvestment
rate risk.
Floating Rate Bonds

Floating Rate Bonds Floating rate bond is a bond whose interest rate fluctuates with shifts in the
A bond whose interest general level of interest rates. The coupon rate is set for, say, the initial six-month
rate fluctuates with
shifts in the general period, after which it is adjusted every six months, based on some market rate.
level of interest rates.
Junk bond
Junk Bond Junk bonds are corporate bonds with low ratings from major credit rating
A high risk, high yield agencies. High rated bonds are called investment grade bonds; low rated bonds
bond used to finance
mergers, leveraged are called speculative grade bonds or less formally called as Junk bond. A bond
buyouts, and troubled may receive a low rating for a number of reasons. If the financial condition or
companies. business outlook of the company is poor, bonds are rated speculative grade.
Bonds are also rated speculative grade if the issuing company already has large
amounts of debt outstanding. Some bonds are rated speculative graded because
they are subordinated to the other debt i.e. their legal claim on the firms assets
in the event of default stands behind the other claim, so called senior debt. Junk
bonds are traded in a dealer market rather than being traded in stock exchanges.
Institutional investors hold the largest share of junk bonds. Firms with low
credit ratings are willing to pay 3 to 5 percent more than the investment grade
corporate debt to compensate for greater risk. Junk bonds are a high yield
security, thus it is widely used as a source of finance in takeovers and leveraged
buy-outs. Junk bonds are riskier than investment grade bonds but less risky than
equity. Junk bonds may have cost or tax advantage that allow for some marginal
increase in debt.
Advantages and Disadvantages of Debt

From Issuer's Viewpoint
Advantages:
1. Less costly: The specific cost of debt capital is less expensive than that of
the equity and preferred stock. It is because investor considers debt as a
relatively less risky investment and interest payments are tax deductible.
2. Flexibility: Debt provides flexibility in the financial structure of the
corporation. The company can issue debt or repay whenever required to
make financial structure flexible.
3. No interference in management and control: Creditors have no
interference in business operations. The owners may extend the scope of
their operation by using funds furnished by creditors and still maintain
their position of control
4. Facility of trading on the equity: The debt enables the firm to trade in
equity. It increases returns to the shareholders.
5. Tax deductible: The interest paid on debt can be deducted as tax
expenditure. While paying tax, interest can be deducted as expenditure.
6. Remedy for over capitalization: In case of over capitalization the company
can redeem the debenture to balance its capital structure.
Disadvantages
1. Unreliable source: Only well-established companies can take the
advantage of this finance because the people invest their money in
debentures of renowned companies. Small companies and new companies
have difficulty raising the fund from this source.
2. Permanent burden to the company: Company has to pay the interest to
debt holders at a fixed rate whether it earns profit or not. The company is
legally liable to pay that interest.
3. Reduction in company's goodwill: Debt capital may affect company's
goodwill. Because it makes difficulty raising funds from the other sources
of finance.
4. Inappropriate in all situations: According to financial policy the debt ratio
should not cross certain limit. If debt is taken more than this limit, the cost
of the loan rapidly increases.
5. Repayment: The debt has fixed maturity date. Hence, arrangement should
be made for repayment.
6. Increases financial liabilities: Since most of debt issue requires some
security as mortgages, the firm's liability will increase.
7. Possibility of insolvency: Debt is a fixed charge, if the earnings of the
company fluctuate, it may be unable to meet the charges.
From investor's viewpoint

Advantages
1. Fixed and stable income: There is fixed interest rate on the debt. Therefore,
the investors receive stable and definite income regularly.
2. Liquidity: Debts are liquid. They can sell easily in the open market.
3. Security of investment: Money invested in debt is secure because it is the
debt on asset.
4. Maturity: It generally has a fixed maturity period.
5. Priority of income: It has high order of priority in the event of liquidation.
Disadvantages
1. Right to vote: Debt holders do not carry the right to vote.
2. Interest is taxable: The interest on debentures is fully taxable.
3. No right in the share in company's prosperity: Debt holders do not get the
share in the company's prosperity when the company 13.earns
Warrants
huge profits.
return
After tax
Holders get the fixed rate of interest on their investment.

12. Common Stock
11. Convertible Preferred
Stock
Rational for Using Different Types of Securities 10. Non-convertible Preferred
Stock
9. Income Bond
The various types of securities offer different risk/return combinations to
8. Subordinate Bond Callable
investors and hence have different costs to the firm.
7. Subordinate Bond Non-
Callable Term Loan
6. Amortized
FIGURE
5.1 5. Second Mortgage Bond
Rational for using 4. First Mortgage Bond
different types of
securtieis. 3. Floating Rate Note
kRF 2.Treasury Note and Bonds

1. Treasury
Bill
Risk to
The lowest risk securities are Treasury bill; these securities are free of default
risk. The Treasury Notes and Bonds are somewhat riskier than the T-bill
(because of the Treasury notes and bonds are exposed to little default risk due to
longer maturity period). The floating rate note is lowest risk long-term securities
after the Treasury securities; these securities are free of interest rate risk, but they
are exposed to some risk of default. The first mortgage bonds are somewhat
riskier than the notes (because the bonds are exposed to interest rate risk), and
they sell at a somewhat higher required and expected after tax return. The
second mortgage bonds are even riskier, so they have a still higher expected
return. Amortized loan, subordinated debentures non-callable, subordinated
debentures callable, income bonds, and preferred stocks are all increasingly
risky, and their expected returns increase accordingly. The firms convertible
preferred stock is riskier than its straight preferred, but less risky than its
common stock. The riskiest security is a warrant. The riskiest security it issues,
have the highest required return.
Preferred Stock: Nature of Preferred Stock

Preferred stock is the long-term source of financing under which the
stockholders are entitled to get fixed amount of dividend out of the earning of
the company after payment of debenture interest and tax.
Preferred stocks have features similar to those of equity and debt. Like a bond, it
promises to pay to its holder a fixed amount of income each year. In this sense,
preferred stock is similar to an infinite-maturity bond, that is, perpetuity. It also
resembles a bond in that it does not convey voting power. Preferred stock has no
contractual obligation to pay dividends like common stock. Instead, preferred
dividends are usually cumulative, that is, unpaid dividends cumulate and must
be paid in full before any dividends may be paid to holders of common stocks.
In contrast, the firm does have a contractual obligation to make the interest
payments on the debt. Preferred stocks also differ from bonds in terms of their
tax treatment for the firm. Because preferred stock payments are treated as
dividends rather than interest, they are not tax-deductible expenses for the firm.
Features of Preferred Stock

Among the features given below some are common to all types of preferred
stocks while some are specific to certain types of preferred stock only. However,
the basic features are:
1. Fixed dividend: The dividend rate is fixed at the rate expressed as
percentage of par value. The amount of dividend will be equal to rate
multiplied by par value of preferred stock capital.
2. Cumulative dividends: The unpaid dividend in any single year has to be
carried forward and the company must pay the dividends in arrears on its
preferred stock before any ordinary dividends are paid. Hence, this feature
protects the interest of preference shareholders. The company has no legal
obligation to pay preferred dividend and can also omit such dividend if
needed. Since preference shareholders do not have dividend enforcement
power, cumulative feature is needed to protect their interest.
3. Par value: Unlike common stock, preferred stock usually has a par value: this
value has a meaning of full quantity. First, the par value establishes the
amount due to the preferred stockholders in the event of liquidation. Second,
the preferred dividend is frequently stated as percentage of the par value.
4. Participative feature: This allows preferred stockholders to participate in
extraordinary profit or residual earning of the company. If the common
stockholders receive increasing dividend, the preferred stockholders too
participate in increasing dividend equally and thereby get dividend amount
in excess of fixed dividend. E.g.: For 10% preference share, the regular
dividend is 10%. If company pays 16% ordinary dividend then preference
share holders too would get 16% i.e., 6% extra dividend. These stockholders
may also participate in the residual asset while winding up the company.
5. Voting rights: Because of their prior claim on assets and income, preferred
stockholders are normally given a voice in management. But, they may be
provided with contingent voting right when company fails to provide
dividend for certain specific period; normally two or more consecutive
preceding years or for three or more years in preceding six years. Under such
circumstances they can elect or nominate specific number of members on the
board as directors.
6. Claims on income and assets: Preferred stock has prior claim on company's
income and assets. The company must pay the preference dividend before
paying ordinary dividend. At the event of liquidation, the preference
shareholders claim is prior on the residual assets than the ordinary
shareholders claim.
7. Redemption/retirement: Preference shares can be redeemable and

irredeemable (perpetual). The perpetual stocks have no maturity period but
redeemable stocks mature after specified period.
8. Sinking fund: Sinking fund is created for the purpose of redemption of
preference share. That means, it is created to call (buy back) the preference
stock or even to purchase the preference stocks issued in open market.
9. Call provision: Call feature permits the company to buy back the preferred
stock. The call price may be higher than the par value and this difference
represents the call premium. However, with the passage of time call
premium decreases. If there is no call provision, the company has to retire the
issue by inviting tenders from stockholders and purchasing the stock at
higher price above market value or by offering alternative securities.
10. Convertibility: Preference shares may be convertible or non-convertible. If it
is convertible, the preference shares can be converted into debentures or
ordinary shares if dividend provided on preference stock is at low rate than
that on others.
Advantages and disadvantages of preferred stock

Preferred stocks are advantageous from the viewpoint of issuer and the
investors. These advantages and disadvantages can be listed below:
From Companys Viewpoint:

Advantages:
The preferred stock has the following advantages to the company: -
1. Riskless leverage advantage: Preferred shares increase financial leverage
because, first of all, the preferred dividend is a fixed obligation and unlike
debentures there is no default even if the dividend is not paid. That means,
non-payment of dividend doesn't force the company into insolvency. Thus,
there is increased riskless financial leverage.
2. Repayment anxiety and dividend postponability: The maturity period of
perpetual preferred stock is not specified. Thus, there is no obligation to call
(buy back) the preferred stock within specified time. This is a permanent
source of financing, which will not result in liquidation even if the dividend
and par value /stock value is not paid for longer period of time. The firm has
no repaying anxiety and can easily postpone the payment of dividend.
3. Fixed dividend: The preferred dividends are restricted to the stated amount.
Thus, preference shareholders do not participate in excess profit as the
ordinary shareholders do.
4. Control: Preference shareholders do not have voting right unless the
dividend arrears exist. They do not have voice in the management of the
company; therefore the control of ordinary shareholders remains preserved.
5. Flexibility: Preferred stocks are free of maturity period. Besides, the
dividend can be postponed if earning is insufficient or uncertain. Thus, this is
flexible source of financing.
6. Ease in expansion: It facilitates those firms that want to expand their

business because preferred stock secures the interest of the shareholders as
they have prior claim on earning and assets. Hence, the company can raise
higher fund by issuing preferred stock than by issuing common stock.
7. Participation in earning: Ordinary shareholders have equal participation in
the earnings made through additional issuance of ordinary shares. But, such
participation is not there in case of preferred stock. Their claim is restricted to
limited amount per share. Hence, preferred stocks are in favor of the owners.
8. Conserve assets: Unlike debentures, preferred stock can be deposited in bank
or other financial institution as collateral to get loan. Hence, it helps conserve
assets that can be deposited as collateral.
Disadvantages
The preferred stock has following disadvantages to the company:
1. Cost: It is costly because generally dividend rate on such shares is higher
than interest rate payable on debentures. Similarly, preference dividend is
paid out of earning after interest and tax. The higher the tax rate, the higher
the cost of preference share and it will be inefficient to raise fund through
preferred stock issuance. In other words, it is costlier than debentures
because it is not tax deductible.
2. Difficult to sell the stocks: Investors may not like to invest on preferred
stocks because they get only fixed amount of dividend even though firm's
earning is too high. Besides, if the earning of firm is low or unstable they may
not get preferred dividend as such dividend is not an obligation to the firm.
Thus it is difficult to sell the stocks.
3. Seniority claim: The preferred stockholders have prior claim over the
earning and assets of the company. This adversely affects the claim of
ordinary shareholders. Their claim will, however, be lower than that of
preferred stockholders.
4. Commitment to pay dividend: Common stockholders cannot get dividend
unless preferred dividend is paid. Thus it becomes a sort of obligation to pay
preferred dividend.
From Shareholders' Viewpoint

Advantages:
The preferred stock has the following advantages to the shareholders:
1. Stable income: The preference share provides reasonably regular and stable
dividend to the investors. Because, the rate of dividend, which should be
paid on yearly basis, is already fixed.
2. Priority in earnings and assets: There is priority to the preferred
stockholders before common stockholders. They have full claim on the
earnings and assets of the firm.
3. Tax exemption: Many companies like to purchase preferred share, as

investment because, most of the dividend received on preference shares is tax
exempt.
Disadvantages:
The preferred stock has following disadvantages to the shareholders.
1. Limited return: The return of preference share is limited. Therefore the
preference shareholders get only fixed dividend income.
2. More price fluctuation: There is high price fluctuation of preferred stock
than of debentures, but return on debentures is higher than return on
preferred stock.
3. Claim of dividend: There is no legal right to claim dividend if the company
doesn't pay the dividend to preference stockholders.
4. Voting rights: There is no voting right of preferred stockholders. They have
no control over management of company to protect their interest.
Summary
This chapter is more descriptive and knowledge of the issues discussed here is essential to an
understanding of finance. The key concepts covered are listed below.
Stockholders equity consists of the firms common stock, paid in capital, and retained
earnings.
Book value per share is equal to stockholders equity divided by the number of shares of stock
outstanding. A stocks book value often is different from its par value and its market value.
A proxy is a document that gives one person the power to act for another person, typically the
power to vote shares of common stock. A proxy flight occurs when an outside group solicits
stockholders proxies in order to vote a new management team into office.
Stockholders often have the right to purchase any additional shares old by the firm. This right
is called the preemptive right, protects and control of the present stockholders and prevents
dilution of the value of their stock.
The major advantages of common stock financing are as follows: (1) there is no obligation to
make fixed payments, (2) common stock never matures, (3) the use of the common stock
increases the creditworthiness of the firm, and (4) stock often can be sold on better terms than
debt.
The major disadvantages of common stock financing are (1) it extends voting privileges to
new stockholders, (2) new stockholders share in the firms profits, (3) the costs of stock
financing are high, (4) Using stock cans raise the firms cost off capital, and (5) dividends paid
on common stock are not tax deductible.
There are many different types of bonds. They include mortgage bonds, debentures,
convertibles, bonds with warrants, income bonds, putable bonds, and purchasing power
(indexed) bonds. The return required on each type of bond is determined by the bonds
riskiness.
A bonds indenture is a legal document that spells out the right of the bondholders and of the
issuing corporation. A trustee is assigned to make sure that the terms of the indenture are
carried out.
A call provision gives the issuing corporation the right to redeem the bonds prior to maturity
under specified terms, usually at a price greater than the maturity value. A firm typically will
call a bond and refund it if interest rates fall substantially.
A sinking fund is a provision that requires the corporation to retire a portion of the bond issue
each year. The purpose of the sinking fund is to provide for the orderly retirement of the
issue.
Some innovations in long term financing include zero coupon bonds, which pay no annual
interest but which are issued at a discount; floating rate debt, whose interest payments
fluctuate with changes in the general level of interest rates; and junk bonds, which are high
risk, high yield instruments issued by firms.
A firms long term financing decisions are influenced by its target capital structure, the
maturity of its assets, current and forecasted interest rates, the firms current and forecasted
financial condition, restrictions in its existing debt contracts, and the suitability of its assets for
use as collateral.
Refunding is the process of replacing high interest debt with less expensive debt in the event
of a decline in interest rates.
Quiz Questions
Indicate whether the following statements are True or False. Support your answer with reason:
1. A preferred stock is less risky than common stock for an investor.
2. The underwriter guarantees the sale of securities to the issuer of securities.
3. The price of bond approaches toward its maturity value at its maturity.
4. Debenture is more riskier than common stock.
5. The bonds issued by Unilever Nepal Ltd. have more default risk premium than the bonds
issued by Nepal Rastra Bank.
6. Debenture is riskier than mortgage bond.
7. Among common stock, preferred stock and bond, the issue of bond keeps the capital
structure of a firm more flexible.
8. Priority of the income is the last incase of the preferred stock.
9. Investment bankers manages the issue in the primary market.
10. Stock brokers buy and sell securities from their own accounts.
11. Unlisted securities traded in the over the counter market.
12. Preferred stock always issued with maturity.
13. Preferred stockholders never have any voting rights.
14. Public issue is more expensive than private placement.
15. The cost of using debt is lower than preferred stock and common stock.
16. There is sinking fund provision in case of debt and preferred stock.
17. Preferred stockholders are the real owner of the corporation.
. Preferred stockholder can participate in the extra profits.

CH05 Long Term Sources of Financing

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CHAPTER 5 Strategic Financial Planning 187

Concept of Common Stock

Features of Common Stock

Par value stock or no par value stock

Priority to Assets and Earnings

Balance Sheet Accounts and Definitions

Legal Rights and Privileges of Common Stockholders

Right to Share Residual Assets

Right to Inspect the corporate books

Right to Sell their Stock Certificates

Consider the following example. Mr. X is a shareholder in the ABC Corporation.

If voting is cumulative, Mr. X will be able to elect himself to the board of

The ex right market price per share is Rs 36 per share.

Total assets if he sells 220 rights and exercises 100 rights.

Advantages and Disadvantages of Common stock

2. No fixed burden of dividend: The dividend on common stock is not fixed. It

From Investor's Viewpoint

The Market for Common Stock

Issue of Common Stock

consideration in determining whether to issue securities publicly or privately is

Advantages of private placement:

Disadvantages of private placement:

Advantages of Public Issue

Disadvantages of Public Issue

Investment Banking Process

Types of securities used. The type of securities to be offered is specified. Stock,

Stage II: Decision

Maintenance of the Secondary Market

Long Term Debt

Index (Purchasing Indexed, or Purchasing Power Bonds

Specific debt contract features

Floating Rate Bonds

Advantages and Disadvantages of Debt

From investor's viewpoint

Holders get the fixed rate of interest on their investment.

kRF 2.Treasury Note and Bonds

Preferred Stock: Nature of Preferred Stock

Features of Preferred Stock

7. Redemption/retirement: Preference shares can be redeemable and

Advantages and disadvantages of preferred stock

From Companys Viewpoint:

6. Ease in expansion: It facilitates those firms that want to expand their

From Shareholders' Viewpoint

3. Tax exemption: Many companies like to purchase preferred share, as

. Preferred stockholder can participate in the extra profits.

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