4-1 Business Finance (MGT 232) Lecture 29

4-2 Long-Term Debt, Preferred Stock, and Common Stock

4-3 Overview of the Last Lecture Private Placement Initial Financing Signaling Effects The Secondary Market

4-4 Long-Term Debt, Preferred Stock, and Common Stock Bonds and Their Features Types of Long-Term Debt Instruments Retirement of Bonds Preferred Stock and Its Features Rights of Common Shareholders Dual-Class Common Stock

4-5 Bonds and Their Features Basic Terms Par ValueCoupon Rate MaturityBond Ratings Bond Bond -- A long-term debt instrument with a final maturity generally being 10 years or more.

4-6 Trustee and Indenture Trustee Trustee -- A person or institution designated by a bond issuer as the official representative of the bondholders. Typically, a bank serves as trustee. Indenture deed of trust Indenture -- The legal agreement, also called the deed of trust, between the corporation issuing bonds and the bondholders, establishing the terms of the bond issue and naming the trustee.

4-7 Types of Long-Term Debt Instruments Investors look to the earning power of the firm as their primary security. negative- pledge clause Investors receive some protection by the restrictions imposed in the bond indenture, particularly any negative- pledge clause. negative-pledge clause A negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors. Debenture Debenture -- A long-term, unsecured debt instrument.

4-8 Types of Long-Term Debt Instruments In this case, subordinated debenture holders rank behind debenture holders but ahead of preferred and common stockholders in the event of liquidation. Frequently, the security is convertible into common stock to lower the yield required by subordinated debenture holders (often less than regular debentures). Subordinated Debenture Subordinated Debenture -- A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of debt; known as junior debt.

4-9 Types of Long-Term Debt Instruments cumulative feature, Frequently, there is a cumulative feature, which provides that any unpaid interest in a particular year accumulates. The cumulative obligation is usually limited to no more than three years. The bonds are unpopular with investors (usually limited to reorganizations), but are still senior to preferred and common shareholders in the event of liquidation. Income Bond Income Bond -- A bond where the payment of interest is contingent upon sufficient earnings of the firm.

4-10 Types of Long-Term Debt Instruments These are bonds with a rating of Ba (Moody's) or lower. Principal investors are pension funds, high-yield bond mutual funds, and some individual investors. Liquidity varies depending on investor sentiments. Junk Bond Junk Bond -- A high-risk, high-yield (often unsecured) bond rated below investment grade.

4-11 Types of Long-Term Debt Instruments claimspecific assets The issue is secured by a claim on specific assets of the corporation. The market value of the collateral should exceed the amount of the bond issue by a reasonable margin of safety to help protect bondholders. Mortgage Bond Mortgage Bond -- A bond issue secured by a mortgage on the issuer’s property.

4-12 Types of Long-Term Debt Instruments If the corporation defaults, the trustee can foreclose on behalf of the bondholders. The bondholders become general creditors for any residual amount after the sale of the collateral. The corporation may have a first mortgage and a second mortgage on the same assets. The first mortgage has a senior claim on the assets. Mortgage Bond Mortgage Bond (Continued)

4-13 Types of Long-Term Debt Instruments A railroad arranges with a trustee to purchase equipment from a manufacturer. The railroad signs a contract with the manufacturer for the construction of specific equipment. When the equipment is delivered, equipment trust certificates are sold to investors. Equipment Trust Certificate Equipment Trust Certificate -- An intermediate- to long-term security, usually issued by a transportation company such as a railroad or airline, that is used to finance new equipment.

4-14 Types of Long-Term Debt Instruments Proceeds plus the railroad downpayment are used to pay the manufacturer. Title of the equipment is held by the trustee, and the trustee leases the equipment to the railroad. Lease payments are used to pay a fixed dividend to the certificate holders and to retire a specified portion of the certificates at regular intervals. After the final lease payment (all certificates are retired), title to the equipment passes to the railroad. Equipment Trust Certificates Equipment Trust Certificates (Continued)

4-15 Asset Securitization Purpose: To reduce financing costs Firm picks assets to “package” and use cash flows Assets removed from the balance sheet and sold to bankruptcy-remote entity (special-purpose vehicle -- SPV) SPV raises money by selling asset-backed securities Asset Securitization Asset Securitization – The process of packaging a pool of assets and then selling interests in the pool in the form of asset-backed securities. Asset-backed Security Asset-backed Security – Debt securities whose interest and principal payments are provided by the cash flows coming from a discrete pool of assets.

4-16 Retirement of Bonds The corporation makes a cash payment to the trustee, which calls the bonds. The corporation purchases bonds in the open market and delivers them to the trustee. Sinking Fund Sinking Fund -- Fund established to periodically retire a portion of a security issue before maturity. The corporation is required to make periodic sinking-fund payments to a trustee. Two forms for the sinking-fund retirement of a bond:

4-17 Sinking Fund and the Retirement of Bonds sinking-fund call price When bonds are called for redemption, the bondholders will receive the sinking-fund call price. Wall Street Journal The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street Journal. sinking-fund call price Bonds should be purchased in the open market if the market price is less than the sinking-fund call price.

4-18 Sinking Fund and the Retirement of Bonds Volatility in interest rates or a decline in the credit quality of the firm could lower the market price of the bond and enhance the value to the firm of having this option. Bondholders may benefit from the orderly retirement of debt (amortization effect), which reduces the default risk of the firm and adds liquidity to bonds outstanding.

4-19 Sinking Fund and the Retirement of Bonds Many bond issues are designed to have a larger final payment to pay off the debt. For example, a corporation may undertake a $10 million, 15-year bond issue. The firm is obligated to make $500,000 sinking-fund payments in the 5 th through 14 th years. The final balloon payment in the 15 th year would be for the remaining $5 million of bonds. Balloon Payment Balloon Payment -- A payment on debt that is much larger than other payments.

4-20 Serial Bonds For example, a $10 million issue of serial bonds might have $500,000 of predetermined bonds maturing each year for 20 years. Investors are able to choose the maturity that best fits their needs (wider investor appeal). Serial Bonds Serial Bonds -- An issue of bonds with different maturities, as distinguished from an issue where all bonds have identical maturities (term bonds).

4-21 Call Provision Not all bonds are callable. In periods of low interest (hence, low coupon) rates, firms are more likely to issue noncallable bonds. call price When a bond is callable, the call price is usually above the par value of the bond and often decreases over time. Call Provision call feature Call Provision -- A feature in an indenture that permits the issuer to repurchase securities at a fixed price (or series of fixed prices) before maturity; also called call feature.

4-22 Call Price For example, the call price for the first year might equal the bond par value plus one-year’s interest. According to when they can be exercised, call provisions can be either immediate or deferred. The call provision provides financing flexibility for the firm as conditions change. Call Price Call Price -- The price at which a security with a call provision can be purchased by the issuer prior to the security’s maturity.

4-23 Summary Bonds and Their Features Types of Long-Term Debt Instruments Debentures Subordinated Debentures Junk Bonds Income Bonds Mortgage Bonds Retirement of Bonds Sinking funds Serial Bonds Call provision and Call price