1. CHAPTER 15: LONG-TERM FINANCING – AN INTRODUCTION
Topics:
15.1 Common Stock
Long-term Debt
Preferred Shares
Patterns of Long-Term Financing

2. Methods of Securing Financing

3. 15.1 Common Stock: Some terms (1)
Common stockholders are owners of the corporation and assume the ultimate risk associated with the ownership
Different terms of Value
Par value - stated face value of share
Typically in Canada, stocks do not have a par value
Book-value - net worth of firm from balance sheet- limited economic significance
Market value - going-concern value - current investor expectations about firm’s future prospects
Replacement value - current costs of replacing assets of the firm
Market value / book value (M/B) M/B is usually > 1
positive NPV projects
inflation has driven the value of assets above what they originally cost
Tobin’s Q - market value of assets / replacement value of assets

4. Common stock: Some terms (2)
Share capital structure
authorized shares - approved by shareholders - no legal limit on no. of authorized shares
issued shares - shares actually sold
contributed surplus (aka additional paid-in capital):
selling price - par
retained earnings

5. Example: Share capital structure of RBC (1)
RBC (TSE/NYSE: RY), 2006 Annual Report
Question: Find authorized shares, outstanding shares, and Tobin’s Q for RBC FY 2006.

6. Shareholder Rights (1) Easy transfer of shares Limited liability
Residual claimants—Dividends
Dividends at board’s discretion
Dividends paid by firm - taxable
Dividends received by investors - partial tax shelter
Dividends received by corporations-100% tax shelter
Elect directors who hire management
Most important control mechanism of shareholders

7. Shareholder Rights (2) Voting rights
straight voting -one vote per share for each position
50% + can control board
minority freeze-out
cumulative voting - permits minority participation; no. of votes = no. of shares * no. of positions on board; cumulate votes and cast for any position
proxy voting
Delegate vote to another party by proxy

8. Proxy fight: Hewllet vs. Fiorina
2002 Acquistion of Compaq by HP
Hewllet and Packard families, controlling 18% of equity, opposed to it;
Proxy fights to get shareholder support
Most expensive proxy fights
Approved by 51% of the votes.
“ Whew. After a rancorous eight-month proxy fight, a three-day trial in Delaware, countless speeches, a blizzard of regulatory filings, and a bitter boardroom squabble, Hewlett-Packard on Friday completed the largest technology merger in history by acquiring Compaq Computer.”
-from CNET.com

9. Dual-class share is a common scene in North America
Dual-class of shares
unequal voting rights (subordinate voting / restricted voting / multiple voting)
Examples:
Google: Each of the class-B shares reserved for Google insiders (founders and top executives) would carry 10 votes, while ordinary class-A shares sold to the public would get just one vote.
Ford: The Ford family controls 40% of shareholder voting power with only about 4% of the total equity in the company.
Bombardier: (see text p. 426) founder’s family has about 2/3 of the votes, but only 22% of the shares.
Empirical evidence suggests that shares with superior voting rights are worth more than those with inferior voting rights.

10. Example: Cumulative voting

11. Example: Straight vs. cumulative voting
The shareholders of the ABC company need to elect seven new directors. There are two million shares outstanding. How many shares do you need to be certain that you elect at least one director if
If ABC has straight voting:
2. If ABC has cumulative voting
Suppose you have x shares
-votes that you cast on 1 candidate (“concentrate”) > the 7th largest vote excluding your candidate.
Thumb rule for your one candidate:
Does it work?
Suppose you have 250,001 shares, then you have votes.
Your opponents have shares and votes.
You choose one director with votes. If the others choose seven different people with say votes each, your choice will prevail.

12. 15.2 Long-term Debt
Debt is not an ownership interest in the firm—creditors do not (usually) have voting power
Creditors protect themselves via the loan contract (indenture)
Interest payments are considered a cost of doing business and are fully tax deductible by the corporation
Unpaid debt is a liability. If it is not paid, creditors can legally claim the assets of the firm
Some securities blur the line between debt and equity:
hybrid securities that look like equity but are called debt (basic idea is to obtain the tax advantages of debt while eliminating potential costs of bankruptcy)

13. Long-term debt cont’d
Among the features usually listed in the bond indenture are
amount of issue, date of issue, maturity, par value
annual coupon, dates of coupon payments
security
sinking funds, call provisions
covenants
Debt securities are usually called notes, bonds, or debentures
a note is normally some form of unsecured “short” term debt (e.g. with a maturity less than 7 years)
a debenture is unsecured debt
in legal terms, a bond is secured by a mortgage on corporate property
in practice, “bond” refers to both secured and unsecured debt

14. Cont’d repayment provisions:
bonds can be repaid at maturity or earlier through the use of a sinking fund
some bonds are callable (the issuer has the right to pay a contractually specified amount to retire the debt prior to the stated maturity date)
there are also extendible bonds (the issuer has the right to extend the maturity to a later date) and retractable bonds (the holder has the right to shorten the maturity to an earlier date)
seniority indicates preference in position over other lenders
subordinated debt —in case of default, holders of subordinated debt must give preference to other specified creditors who are paid first
note that debt cannot be subordinated to equity

15. Is it Debt or Equity? Feature Equity Debt Income tax status
default and priority
management control
maturity

16. Related knowledge: Gov’t bonds
Treasury bills - maturity < 1 year - no coupons
Treasury notes - medium maturity yrs - semi-annual coupons
Treasury bonds - maturity > 10 years - semi-annual coupons

17. Yields and rates on Financial Post, Sept. 14, 2007

18. Yield comparison of bonds with repayment provisions
> or < ?
Regular Bond
Callable Bond
Extendable Bond
Retractable Bond

19. Example: RBC debentures (2006 Annual report)

20. 15.3 Preferred Shares Perpetual dividends, usually fixed
Dividends not contractually guaranteed - cumulative or noncumulative
Form of equity financing
No final repayment date
Claims of preferred shareholders ahead of common stockholders but behind creditors
No voting rights - some voting rights if dividend skipped
Preferred more risky than debt but less risky than common stock (Return?)
For firm, payment of preferred dividends is not tax-deductible
Dividend received by a firm tax-deductible
100% of the dividends firms receive are exempt from income taxes
Extra features: callable / retractable / convertible preferred shares

21. Example: RBC preferred shares
Par: $25/share

22. 15.4 Patterns of Long -Term Financing
Pecking order theory: internal cash then debt then equity

23. Review Questions 1. Why are preferred shares issued? Tax reasons
Low-tax companies can make little use of the tax deduction on interest. They can issue preferred shares and enjoy lower financing costs since preferred dividends are significantly lower than interest payments.
Non-tax reasons
Regulated public utilities can pass the tax disadvantage of issuing preferred shares on their customers.
Firms issuing preferred shares can avoid the threat of bankruptcy that might otherwise exist if debt were relied on.
Issuing preferred shares may be a means of raising equity without surrendering control.

24. Canadian Dividend Tax: (Appendix 1A, p28
Canadian Dividend Tax: (Appendix 1A, p28. Note that tax codes keep changing.)
An investor pays tax at a marginal combined federal-provincial rate of 40.16% (29% federal % provincial). Suppose that dividend is taxed as in Appendix 1A.
Long-term corporate bonds currently yield 6%. Because preferred shares issued by the same corporation are riskier, the investor seeks an increase in after-tax yield (for preferred over bonds) of 1%. If a preferred share issue is as attractive as a bond issued by the same company, what dividend yield (before tax) must the preferred shares have for the investor to be indifferent?

25. Solution to RQ 2
Step 1: after-tax yield of preferred = 1% + after-tax yield of bond
After-tax bond yield:
After-tax preferred yield:
Step 2: Before-tax preferred yield = AT yield / (1-Net dividend tax rate)
Step 3: Net dividend rate work sheet
Dividend of $1
Gross up at 45%
Federal tax rate: 29%
Less federal dividend tax credit (19%)
Federal tax payable
Ontario Provincial tax at 11.16%
Less dividend tax credit: 7.16%
Total tax rate:

26. Assigned Problems # 15.1, 2, 4, 7, 8, 12