Team Members

Long-Term Finance

Long-term financing is financing that is provided for a period of more than one
calendar year.
Examples
• A 30-year Mortgage
or
• A 10-year Treasury note.
or
• Equity, such as when a company issues stock to raise capital for a new project.
 Purpose of Long Term Finance

• To finance fixed assets.

• To finance the permanent part of working capital.
• Expansion of companies.
• Provide capital for funding the operations. This helps in adjusting the cash
flow.
 Sources of Long Term Financing
Long Term Finance

Internal Source External Source

Retained Different Non-Security Segment

Security Segment  Commercial Banks
Earnings Reserves  Common Stock
 Preferred Stock
 Insurance/Leasing Companies
 Bonds or Debentures  Investment Bank
 Specialized Financial Institutions
 Security Segment
Long-term Bond/Debenture

A Bond is typically a loan that is secured by a specific physical asset.

A Debenture is secured only by the issuer’s promise to pay the interest

and loan principal.
Bonds or debentures are similar in all respect except bond is a secured debt whereas, debenture
is unsecured.
 Long-term Bond/Debenture(Contd.)
Who and Why Bond/Debenture issue
When companies or other entities (like government) need to raise
money to finance new projects, maintain ongoing operations, or
refinance existing debts, they may issue bonds directly to investors
instead of obtaining loans from a bank.
 Long-term Bond/Debenture(Contd.)

POINTS TO KNOW
• Bond/Debenture can be issued by companies or governments and generally pay a stated
interest rate.
• The market value of a bond/Debenture changes over time as it becomes more or less
attractive to potential buyers.
• Bonds that are higher-quality generally offer lower interest rates.
• Bonds that have shorter maturities tend to offer lower interest rates.
 Long-term Bond/Debenture(Contd.)
Par value or Face value The principal amount of a bond that is repaid at the end of the term. Also called par
value.
Coupon rate (CR) Coupon rate is the rate of interest paid by bond issuers on the bond’s face value.

Coupon The annual interest paid on a debt security.

Features
of Maturity date Maturity date refers to the final payment date of a bond or other financial facilities,
at which point the principal (and all remaining interest) is due to be paid.
Long-
term Time to Maturity The time remaining until a financial contract expires.
Bond/D Yield or Yield to
ebenture The rate required in the market on a bond
maturity
Interest rate calculated based on the supply of credit in the market and the demand
Market Interest Rate
for that credit.
Current Yield (CY) A bond’s annual coupon divided by its price
Long-term Bond/Debenture(Contd.)
Bond/Debenture Indenture
 Long-term Bond/Debenture(Contd.)
Bond/Debenture Indenture
Contract between the company and the bondholders that includes:
 The basic terms of the bonds
 The total amount of bonds issued
 A description of property used as security
 Sinking fund provisions
 Call provisions
 Details of protective covenants
 How To Determine The Cost of Bond

As we know, a bond is a debt instrument: it pays periodic interest payments based on

the stated (coupon) rate and return the principal at the maturity.
The price of a bond is given by the following formula:

r is the interest rate prevailing in the market

c is the coupon rate on the bond
t is the time periods occurring over the term of the bond
F is the face value of the bond
 How To Determine The Cost of Bond(Contd.)
Example :01

Bond with annual coupon payments

Company A has issued a bond having face value of $100,000 carrying annual
coupon rate of 8% and maturing in 10 years. The market interest rate is 10%.
The price of the bond is calculated as the present value of all future cash flows:
1 − (1 + 10%)-10 $100,000
Price of Bond = 8% × $100,000 × +
10% (1 + 10%)10
Price of Bond = $87,711
 How To Determine The Cost of Bond(Contd.)
Example :02

Bond with semiannual coupon payments

Company S has issued a bond having face value of $100,000 carrying coupon rate of 9% to be
paid semiannually and maturing in 10 years. The market interest rate is 8%.
Since the interest is paid semiannually the bond interest rate per period is 4.5% (= 9% ÷ 2), the
market interest rate is 4% (= 8% ÷ 2) and number of time periods are 20 (= 2 × 10). Hence,
the price of the bond is calculated as the present value of all future cash flows as shown below:
1 − (1 + 4%)-20 $100,000
Price of Bond = 4.5% × $100,000 × +
4% (1 + 4%)20
Price of Bond = $106,795
 Security Segment
Common Stock
Financial securities that represent the ultimate ownership position in a corporation.
Key Features
 The common stock holders own the company and assume the ultimate risk associated with the
company.
 In the event of liquidation, common stockholders have the residual claim on the assets of the
company after all other claims have been paid.
 Common stock has no maturity date.
 Common Stock (Contd.)
Basic Terms
 Authorized Shares: Maximum number of share that can be issue under its charter.
 Issued Shares: Number of shares the company has issued to its stockholders. The number
of issued shares is always less than (or equal to) the authorized number of shares.
 Outstanding Shares: Number of shares that the stockholders own. (The number of
issued share minus number of treasury stock). The number of outstanding shares is always
less than or equal to the number of issued shares.
 Treasury stock: The company may repurchase its common shares, these shares are known
as treasury stock.
 Common Stock (Contd.)
Basic Terms
Par or Face Value:
i. Stated value of the common sharers.
ii. A common share can be with or without par value.
iii. A common stock without par value is known as no-par-stock.
 Common Stock (Contd.)
Basic Terms
Additional Paid-in-capital or Paid-in-surplus:
i. The positive difference between issue price and par or face value of
common stock.
 Common Stock (Contd.)
Different Rights of Common Stock
Voting Rights: Because the stockholders are owners of the firm, they are entitled to
elect the boards of directors.
Voting Methods
Cumulative
Under cumulative voting, total number of votes
that a stockholder may cast is determined by the
straight / majority-rule
number of directors to be elected multiplied by
Under straight or majority-rule voting, maximum
the number of shares owned by the stockholder.
of 100 votes can be given to each of the
Example :if there are three directors to be
directors.
nominated and a particular shareholder owns 100
shares, then 3 x 100 = 300 votes can be given in
whatever manner desired.
 Common Stock (Contd.)
Voting Rights
Proxy voting: A proxy is the grant of authority by a shareholder to
someone else to vote his/her shares.
For convenience, much of the voting in large corporations
is actually done by proxy.
 Common Stock (Contd.)
Other Rights
 Right to share proportionally in dividends.
 Right to share proportionally in assets remaining after liabilities have been
paid in liquidation.
 Right to vote on stockholder matters of great importance.
 Right to share proportionally in any new shares issued. This is known as
preemptive right.
How To Determine The Cost of Common Stock

The cost of common equity can be measured using the following methods
 Capital Asset Pricing Model (CAPM)
 Dividend Discount Model
 Debt plus Risk Premium Model (D+RP)
 How To Determine The Cost of Common Stock (Cont.)
Capital Asset Pricing Model (CAPM)

It is used to determine the expected rate of return of a risky asset.

CAPM Equation
rs = RF + [RM − RF] × β
Where,
Example:
RF is the risk free rate,
RM is the market Falcons Footwear wants to calculate rs using the CAPM.
β is beta. If our company has yet to issue stock, t They estimate the risk free rate (RF) to be 4%. The firm’s
beta is 1.3 and the market return is 9%.
hen beta will need to be estimated rs = 0.04 + [0.09 − 0.04] * (1.3) = 0.105 = 10.5%
 How To Determine The Cost of Common Stock (Cont.)
Dividend Discount Model

According to the dividend discount model, the intrinsic value of a stock is equal to the present value
of all the expected cash flows (dividends) from the stock.
DDM Equation
Example:
Where, Falcons Footwear has 12 million shares of common
stock. The stock is currently selling for $60/share. It
P0 is the price of the share of stock now pays a dividend of $3 this year and the dividend is
D1 is our expected next dividend growing at 4%. What is rs?
rs is the required return on common stock
g is the growth rate of the dividends of common stock.
 How To Determine The Cost of Common Stock (Cont.)
Debt plus Risk Premium Model (D+RP)

This approach assumes that the common equity is costlier than the debt, and estimates the cost of
equity as a premium over the cost of debt.
D+RP Equation
rs = rd + Risk Premium
Example:
Current Falcons Footwear bonds are yielding 7%. If we know that comparable companies have
cost of equity about 4% higher than their cost of debt, what is a good estimate of Falcons
Footwear’s cost of equity?
rs = 0.07 + 0.04 = 0.11 = 11%
 Common Stock (Contd.)
Dividends
A dividend is a payment made by a corporation to its shareholders, usually as a
distribution of profits.
Key Features
 Dividends are not a liability of the firm until it declared by the Board.
 A firm cannot go bankrupt for not declaring dividends.
 Dividend are not considered a business expense.
 hey are not tax deductible
 Common Stock (Contd.)
Difference between Debt and Equity
Debt
 Not an ownership interest
 Creditors do not have voting rights
 Interest is considered a cost of doing
business and is tax deductible
 Creditors have legal recourse if interest or
principal payments are missed
 Excess debt can lead to financial distress and
bankruptcy
Equity
 Ownership interest
 Common stockholders vote for the board of
directors and other issues
 Dividends are not considered a cost of doing
business and are not tax deductible
 Dividends are not a liability of the firm and
stockholders have no legal recourse if
dividends are not paid
 An all equity firm can not go bankrupt
 Security Segment
Preferred Stock
A type of financial security or asset that usually promises a fixed dividend but at
the discretion of the board of directors.
Key Features
 Omission of preferred dividends will not result in a default of the obligation.
 It has preference of claims over common stockholders.
 The preferred stockholders do not get any voting right.
 Preferred Stock(Contd.)
Types of Preferred Stock

Preferred Stock

Cumulative Non-cumulative
If the dividend is not paid in a if dividends are not given in any
particular year, it will accumulate year they will not be paid in the
for future payment. future.
 How To Determine The Cost of Preferred Stock

Formula
Rps = Dps/Pnet
where:
Dps = preferred dividends
Pnet = net issuing price
Example:
Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share.
If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1%

 Preferred Stock(Contd.)
Advantage of Preferred Stock
This allows the holder to participate in additional dividends if common
stockholders receive increasing dividend.
 Reasons for Using in Financing

 About 70% of the dividends received by corporations are not subject to tax.
 Unlike debt, it has no maturity date or legal obligation.
 It increases equity base of the firm.