Chapter 5_Long-term Financing New SV.pptx

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1. CHAPTER 5: LONG-TERM FINANCING

2. Watson, D., & Head, A. (2010).  Corporate finance: principles and practice . Pearson Education. Chapter 4: Long-term finance: Equity Finance Chapter 5: Long-term finance: Debt finance, Hybrid and leasing Atrill , P. (2020).  Financial management for decision makers . Pearson. Chapter 6: Financing a business 1: Sources of Finance Chapter 7: Financing a business 2: Raising Long-term Finance Ross, S. A., Jaffe, J., & Kakani , R. K. (2019).  Corporate Finance, 10e . McGraw-Hill Education. Chapter 15: Long-Term Financing: An Introduction. Lecture notes and Supplementary documents LEARNING MATERIALS

3. 5.1 Equity Finance 5.2 Debt Finance 5.3 Hybrid Finance and Leasing 5.4 CONTENT Long-term Financing Sources of Finance: Introduction

4. 5.1 Source of Finance: Introduction

5. 5.1 Source of Finance: Introduction Internal Finance Retained Earnings Cash generated by more efficient management of working capital (See chapter 4 on working capital management) External Finance Equity Finance Debt Finance

6. 5.1 Source of Finance: Introduction Sources of Finance

7. 5.1 Source of Finance: Introduction Short-term finance & Long-term finance Short-term finance: expected to provide finance for less than a year (or a business cycle) (See Chap 4 on short-term finance) Long-term finance: expected to finance for one year (or one business cycle) and more

8. 5.1 Source of Finance: Introduction Long-term finance Equity Finance Ordinary shares Preference shares Debt Finance Term loan Loan notes (loan stock, bonds )… Hybrid Finance and Leasing

9. 5.2 Equity Finance Ordinary shares Preference shares

10. Dividend: when, how? Risk and Rate of Return? Tax savings? Voting right? From the business’s perspective, ordinary shares can be a useful source of financing when compared with borrowing. Why? Ordinary shares – Common stocks

11. Dividend: no fixed rate of dividend, available for distribution after other investors (preference shareholders and lenders) High risks, high expected rate of return for ordinary shareholders Limited potential losses based on the amount that they have invested, the potential returns are unlimited. A business does not obtain tax relief on dividends paid to shareholders, whereas interest on borrowings is tax deductible. Ordinary shareholders control the business through their voting rights, which give them the power to important company issues such as electing BOD, M&A... Ordinary shares can be a useful source of financing when compared with borrowing. It may be possible to avoid paying a dividend, whereas it is not usually possible to avoid interest payments. Ordinary shares – Common stocks

12. Shareholder Rights Control the corporation through the right to elect the directors ”One share, one vote” (NOT one shareholder, one vote) The “golden rule”: “Directors are elected at an annual shareholders’ meeting by a vote of the holders of a majority of shares who are present and entitled to vote” Ordinary shares – Common stocks

13. Shareholder Rights Voting procedures Cumulative voting Straight voting How to be assured of a directorship How many votes are needed to win to guarantee a director seat Ordinary shares – Common stocks

14. Shareholder Rights Voting procedures Cumulative voting: permit minority participation The total number of votes (each shareholder may cast is determined first) = Number of shares x Number of directors to be elected To guarantee a ”director” seat , = 1/(N+1) percent of stock plus ONE, in which N – no of directors up for election The directors are elected all at once Top N vote getters will be the new director A shareholder can distribute votes Ordinary shares – Common stocks

15. Shareholder Rights Voting procedures Straight voting: “freeze out” minority participation The directors are elected one at a time Percent of stock to guarantee a ”director” seat = 50% + ONE share Ordinary shares – Common stocks

16. Shareholder Rights Voting procedures Stagger the voting – basic effects more difficult for a minority to elect a director deters takeover attempts because of the difficulty of voting in a majority of new directors provides “institutional memory” from continuity on the board of directors Ordinary shares – Common stocks

17. Shareholder Right Classes of Stock With unequal voting rights E.g Google has 2 classes of common stock Class A shares held by the public, one share one vote Class B shares held by company insiders, one share ten votes. Limited voting stock allows management to raise equity while maintaining control Ordinary shares – Common stocks

18. Shareholders Rights The right to share proportionally in dividends. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation. The right to vote on stockholder matters of great importance, such as a merger. The preemptive right to sell stock to its existing stockholders before offering to the general public >>protect his proportionate ownership in the corporation. Ordinary shares – Common stocks

19. Preference shares What are the differences between preferred shares and ordinary shares Dividend? Risk and Rate of Return? Tax savings? Voting right?

20. Preference shareholders will offer a lower level of return, lower level of risk than ordinary shareholders. Preference shareholders have priority over ordinary shareholders regarding dividends and, perhaps, capital repayment. Provided there are sufficient earnings available, preference shares will normally be given a fixed rate of dividend Preference dividends will be the first slice of any dividend paid (The business’s own particular documents of incorporation will state the precise rights of preference shareholders in this respect.) Preference shareholders are not usually given voting rights Preference shares

21. Discussion Preference shares are no longer an important source of new finance, why? Would you expect the market price of ordinary shares, or of preference shares, to be the more volatile? Why? Is a preferred stock more like debt or equity Preference shares

22. Is a preferred stock more like debt or equity More like debt Stated dividend regularly, stated value when liquidated Carry credit ratings like bonds Convertible into common stock Callable (allow the issuer to repurchase) Obligatory sinking funds (retired a portion and create a final maturity No voting privileges >> not control right sharing Preference shares

23. Is a preferred stock more like debt or equity More like equity Legal standpoint (equity securities) Tax purpose: preferred dividends are treated like common stock dividends No maturity date Ontime regularly payment on stated dividends is not compulsory, unpaid preferred dividends are not debts No asset guarantee Preference shares

24. 5.3 Debt Finance Discussion: Differences between Equity and Debts Features Equity Debts Income Tax status Control Default Which one is favorable?

25. Debts Differences between debt and equity 5.3 Debt Finance

26. Long-term Debt: The basics Pay due principal and timely interest payment Maturity : short-term (unfunded debt) or long-term Types of Debt securities: notes, debentures, bonds Public or private placed Call features, sinking funds, ratings, protective covenants... Would you expect the returns from loan to be higher or lower than those from preference shares? 5.3 Debt Finance

27. The Indenture The written legal agreement between the corporation (the borrower) and its creditors (deed of trust). Provisions The basic terms of the bonds. A description of property used as security. Seniority The repayment arrangements. The call provisions. Details of the protective covenants. 5.3 Debt Finance

28. The Indenture Terms of a Bond Face value Coupon rate Maturity E.g. The Beck Corporation wants to borrow $1,000 for 5 years by issuing a corporate bond. The interest rate that equals to the interest on similar debt issued by similar corporations is 12 percent.. At the end of 5 years, Beck will repay the $1,000. 5.3 Debt Finance

29. The Indenture Security Collateral and mortgage securities Collateral : securities pledged as security for payment of debt. Mortgage securities: are secured by a mortgage on the real property of the borrower. Unsecured bond (notes, debentures in the US – claim only on property not otherwise pledged) Seniority: preference in position over other lenders senior or junior (subordinated) 5.3 Debt Finance

30. The Indenture Repayment A sinking fund The company makes annual payments to the trustee. The trustee uses the funds to retire a portion of the debt (buying some bonds in the market or calling a fraction of the outstanding bond) 5.3 Debt Finance

31. The Indenture Repayment A sinking fund Start about 10 years after the initial issuance. Establish equal payments over the life of the bond. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue >> a large “ balloon payment ” at maturity. 5.3 Debt Finance

32. The Indenture Call provision Call provision allow the company to repurchase part or all of the bond issue at stated prices over a specific period. Call premium is the difference between the call price and the stated value. >> smaller over time Deferred call provision (prohibited from calling bonds –call protected bond) A make-whole call : bondholders receive what the bonds are worth if be called. The make-whole call price = Present value of the remaining interest and principal payment (at rate specified in the indenture) The call price is higher when interest rates are lower (WHY???) 5.3 Debt Finance

33. The Indenture Protective Covenants Negative Covenant: limit or prohibit the company action ( e.g limit amount of dividend it pays) Positive Covenant: specifies an action that the company must take (e.g. the company must maintain its working capital at or above some specified minimum level) 5.3 Debt Finance

34. 5.3 Debt Finance Form of Debt Finance Term loans Loan notes (or loan stock, bonds- in USA, UK) Mortgages Others: International bonds, Convertible loan notes (or Convertible bonds)…

35. 5.3 Debt Finance Term loan A term loan is a type of loan offered by banks and other financial institutions that can be tailored to the needs of the client business. The amount of the loan, time period, repayment terms and interest rate are all open to negotiation and agreement Interest will be paid only on amounts actually drawn rather than the whole amount borrowed. Term loans tend to be cheap to set up (from the borrower’s perspective) and quite flexible as to conditions Popular in practice.

36. 5.3 Debt Finance Term loan - Types Lines of Credit Syndicated Loans

37. Lines of Credit A line of credit: setting the maximum amount that the bank is willing to lend to the business. The business can then borrow the money (part or all of a line of credit) If the bank is legally obligated, the credit line is generally referred to as a revolving line of credit or a revolver. 5.3 Debt Finance

38. Lines of Credit Example: Imagine a revolver for $75 million with a three-year commitment, Fee includes: Commitment fee (charged on the unused portion of the revolver): 0.2% Interest on the actual borrowings: 5% per year. The corporation borrows $25 million for the 1 st year Total interest charged on the 1 st year? The commitment fee = $0.1 million (=0.20% x $50 million) for that year The interest charged on the actual borrowings= $1.25 million(= 5% x $25 million) Total interest charged on the 1 st year = 0.1 + 1.25 = $1.35 million 5.3 Debt Finance

39. 5.3 Debt Finance Syndicated Loans Before entering into the agreement The arranger receives a mandate from the customer and composes a syndicate group. After entering into the agreement an agent representing each lender intermediates between the lender (participating financial institution) and the borrower (customer) and handles various procedures.

40. 5.3 Debt Finance International bonds Eurobond is a bond issued in multiple countries but denominated in a single currency, usually the issuer’s home currency Foreign bonds are issued in a single country and are usually denominated in that country’s currency

41. 5.3 Debt Finance Convertible loans G ive investors the right to convert loan notes into ordinary shares at a specified price at a given future date (or range of dates). In effect, the investor swaps the loan notes for a particular number of shares.

42. 5.3 Debt Finance Convertible loans

43. 5.3 Debt Finance Attitudes towards the level of borrowings How those f actors affecting owners’ attitudes towards the level of borrowings?

44. 5.4 Hybrid Finance and Leasing Finance Leases Hire – purchase agreements Securitization of assets

45. When a business needs a particular asset, such as a piece of equipment, instead of buying it direct from a supplier, the business may arrange for a bank (or other business) to buy it and then lease it to the business. Finance lease is  a form of mid and long-term financing via asset leasing under a financial leasing contract . The financial leasing company (lessor) uses its capital to purchase assets required by the business (lessee) and leases such assets to the lessee for their use. With finance leasing, legal ownership of the asset remains with the lessor. However, the lease agreement transfers to the lessee virtually all the rewards and risks associated with the item being leased. A finance lease agreement will cover a substantial part of the life of the leased item, and often cannot be cancelled. Finance leases 5.4 Hybrid Finance and Leasing

46. 5.4 Hybrid Finance and Leasing

47. 5.4 Hybrid Finance and Leasing Finance leases

48. Finance leases Ease of borrowing: Leasing may be obtained more easily than other forms of long-term finance. Cost: Leasing agreements may be offered at reasonable cost Flexibility: where there are rapid changes in technology. Cash flows: Leasing, rather than buying an asset outright, means that large cash outflows can be avoided . 5.4 Hybrid Finance and Leasing

49. Finance leases vs operating leases 5.4 Hybrid Finance and Leasing

50. Sale-and-leaseback arrangements involves a business raising finance by selling an asset to a financial institution. The sale is accompanied by an agreement to lease the asset back to the business to allow it to continue to use the asset. The lease rental payment is a business expense that is allowable against profits for taxation purposes. Which type of asset/business is often subject to a sale-and-lease back arrangement 5.4 Hybrid Finance and Leasing Finance leases

51. Hire purchase (HP): a customer pays for an asset by instalments over an agreed period. Normally, the customer will pay an initial deposit (down payment) and then make instalment payments at regular intervals, perhaps monthly, until the balance outstanding has been paid. The customer will usually take possession of the asset after payment of the initial deposit, although legal ownership of the asset will not be transferred until the final instalment has been paid. 5.4 Hybrid Finance and Leasing Hire purchase

52. Figure: The hire purchase process

53. Discussion : In what way is an HP agreement : (a) similar to (b) different from a finance lease? 5.4 Hybrid Finance and Leasing Hire purchase

54. involves bundling together illiquid financial or physical assets of the same type so as to provide backing for an issue of bonds. e.g. US banks, which bundled together residential mortgage loans to provide asset backing for bonds issued to investors. Future cash flows from a variety of illiquid assets are now used as backing for bond issues. The effect of securitisation is to capitalise future cash flows arising from illiquid assets. This capitalised amount is sold to investors, through the financial markets, to raise finance for the business holding these assets. 5.4 Hybrid Finance and Leasing Securitization

55. 5.4 Hybrid Finance and Leasing Securitization

56. Pattern of Financing Pattern of Financing

57. Patterns of Financing Trends in Financing Decisions