Chapter 20 LongTerm Debt Preferred Stock and Common

Chapter 20 Long-Term Debt, Preferred Stock, and Common Stock 20 -1 © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph. D. Carroll College, Waukesha, WI

After studying Chapter 20, you should be able to: u u 20 -2 Understand the terminology and characteristics of bonds, preferred stock, and common stock. Explain how the retirement (repayment) of bonds and preferred stock may be accomplished in a number of different ways. Explain the differences between various types of long -term securities in terms of claims on income and assets, maturities, security holders' rights, and the tax treatment of income from the securities. Discuss the advantages and disadvantages of issuing/buying the three different types of long-term securities from both the perspective of the issuer and investor.

Long-Term Debt, Preferred Stock, and Common Stock Bonds and Their Features u Types of Long-Term Debt Instruments u Retirement of Bonds u Preferred Stock and Its Features u Rights of Common Shareholders u Dual-Class Common Stock u 20 -3

Bonds and Their Features Bond -- A long-term debt instrument with a final maturity generally being 10 years or more. Basic Terms 20 -4 Par Value Coupon Rate Maturity Bond Ratings

Trustee and Indenture Trustee -- A person or institution designated by a bond issuer as the official representative of the bondholders. Typically, a bank serves as trustee. Indenture -- The legal agreement, also called the deed of trust, trust between the corporation issuing bonds and the bondholders, establishing the terms of the bond issue and naming the trustee. 20 -5

Types of Long-Term Debt Instruments Debenture -- A long-term, unsecured debt instrument. 20 -6 u Investors look to the earning power of the firm as their primary security. u Investors receive some protection by the restrictions imposed in the bond indenture, particularly any negative-pledge clause u A negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors.

Types of Long-Term Debt Instruments 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. u In this case, subordinated debenture holders rank behind debenture holders but ahead of preferred and common stockholders in the event of liquidation. u Frequently, the security is convertible into common stock to lower the yield required by subordinated debenture holders (often less than regular debentures). 20 -7

Types of Long-Term Debt Instruments Income Bond -- A bond where the payment of interest is contingent upon sufficient earnings of the firm. u 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. u The bonds are unpopular with investors (usually limited to reorganizations), but are still senior to preferred and common shareholders in the event of liquidation. 20 -8

Types of Long-Term Debt Instruments Junk Bond -- A high-risk, high-yield (often unsecured) bond rated below investment grade. u These are bonds with a rating of Ba (Moody's) or lower. u Principal investors are pension funds, high-yield bond mutual funds, and some individual investors. u Liquidity varies depending on investor sentiments. u Junk bonds were used frequently in the 1980 s as a means of financing leveraged buyouts (LBOs). 20 -9

Types of Long-Term Debt Instruments Mortgage Bond -- A bond issue secured by a mortgage on the issuer’s property. u The issue is secured by a lien on specific assets of the corporation. u The market value of the collateral should exceed the amount of the bond issue by a reasonable margin of safety to help protect bondholders. 20 -10

Types of Long-Term Debt Instruments Mortgage Bond (Continued) 20 -11 u 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. u 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.

Types of Long-Term Debt Instruments 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. Let us look at an example using a railroad. u A railroad arranges with a trustee to purchase equipment from a manufacturer. u The railroad signs a contract with the manufacturer for the construction of specific equipment. u When the equipment is delivered, equipment trust certificates are sold to investors. 20 -12

Types of Long-Term Debt Instruments Equipment Trust Certificates (Continued) u u 20 -13 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.

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 – Debt securities whose interest and principal payments are provided by the cash flows coming from a discrete pool of assets. u u 20 -14 Purpose: To reduce financing costs Firm picks assets to “package” and use cash flows Assets removed from the balance sheet and sold to bankruptcyremote entity (special-purpose vehicle -- SPV) SPV raises money by selling asset-backed securities

Retirement of Bonds 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: 20 -15 u The corporation makes a cash payment to the trustee, which calls the bonds. u The corporation purchases bonds in the open market and delivers them to the trustee.

Sinking Fund and the Retirement of Bonds u When bonds are called for redemption, the bondholders will receive the sinking-fund call price u The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street Journal u Bonds should be purchased in the open market if the market price is less than the sinking-fund call price 20 -16

Sinking Fund and the Retirement of Bonds u 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. u 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. 20 -17

Sinking Fund and the Retirement of Bonds Balloon Payment -- A payment on debt that is much larger than other payments. Many bond issues are designed to have a larger final payment to pay off the debt. u 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. u 20 -18

Serial Bonds -- An issue of bonds with different maturities, as distinguished from an issue where all bonds have identical maturities (term bonds). 20 -19 u For example, a $10 million issue of serial bonds might have $500, 000 of predetermined bonds maturing each year for 20 years. u Investors are able to choose the maturity that best fits their needs (wider investor appeal).

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 20 -20 u Not all bonds are callable. In periods of low interest (hence, low coupon) rates, firms are more likely to issue noncallable bonds. u When a bond is callable, the call price is usually above the par value of the bond and often decreases over time.

Call Price -- The price at which a security with a call provision can be purchased by the issuer prior to the security’s maturity. For example, the call price for the first year might equal the bond par value plus one-year’s interest. u According to when they can be exercised, call provisions can be either immediate or deferred. u The call provision provides financing flexibility for the firm as conditions change. u 20 -21

Value of the Call Privilege Callable-bond value 20 -22 Noncallable= bond value - Call-option value u The call privilege is valuable to the firm to the detriment of bondholders. As such, bondholders require a premium for this additional risk in the form of a higher yield. u The greater the volatility of interest rates, the greater the probability that the firm will call the bonds. Thus, the call-option is more valuable all else equal.

Preferred Stock and Its Features Preferred Stock -- A type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors. Basic Terms Par Value Dividend Rate Maturity 20 -23

Cumulative Dividends Feature -- A requirement that all cumulative unpaid dividends on the preferred stock be paid before a dividend may be paid on the common stock. u u 20 -24 For example, if the board of directors omits a $6 preferred dividend for two years, it must pay preferred shareholders $12 per share ($100 par value) before any dividend can be paid to common shareholders. The corporation does not have to make up the dividend even if it is profitable, as long as the firm has no plans to pay dividends to common shareholders.

Participating Feature Participating Preferred Stock -- Preferred stock where the holder is allowed to participate in increasing dividends if the common stockholders receive increasing dividends. u u 20 -25 Preferred stockholders have a prior claim on income and an opportunity for additional return if the dividends to common stockholders exceed a certain amount. A 6% participating preferred issue ($100 par) allows holders to share equally in any dividend in excess of $6. A $7 common dividend results in an extra $1 dividend to the participating preferred shareholders.

Voting Rights in Special Situations u u 20 -26 Preferred stockholders are not normally given a voice in management unless the company is unable to pay preferred stock dividends during a specified period. If such a situation presents itself, the class of preferred stockholders would be entitled to elect a specified number of directors. Any situation in which the company defaults under restrictions in the agreement (similar to bond indenture) may lead to voting power for preferred shareholders. Preferred shareholders cannot force the immediate repayment of obligations (like debt obligations).

Retirement of Preferred Stock u Call Provision -- almost all issues carry a call provision because of the infinite maturity. It is often a cheaper method of retirement than open market purchases, inviting tenders, or an exchange of securities. u Sinking Fund -- like bonds, many preferred issues provide for this method of retirement. u Conversion -- certain issues are convertible into common stock at the option of the preferred stockholder. Used most frequently in the acquisition of other companies (the transaction is not taxable to the shareholders of the acquired firm). 20 -27

Use of Preferred Stock in Financing u u The corporate issuer uses irregularly because the preferred dividend is not tax deductible. Utilities use more frequently as the preferred dividend can be accounted for when setting customer rates. The corporate investor is attracted to preferred stock as generally 70% of dividends can be excluded from taxes. u Money market preferred stock (MMP) is a floatingrate preferred stock with the dividend rate set at auction every 49 days - attractive to corporations. Flexibility in paying dividends and an infinite maturity (similar to a perpetual loan) are significant advantages to the corporate issuer The after-tax cost of preferred financing is greater than that of long-term debt financing to the corporate issuer 20 -28

Common Stock and Its Features Common Stock -- Securities that represent the ultimate ownership (and risk) position in a corporation. Basic Terms Authorized Shares Issued Shares Outstanding Shares 20 -29

Types of Common Stock Value A. u Par Value -- The face value. It is merely a recorded figure in the corporate charter and is of little economic consequence. u Stock should never be issued below par value as shareholders would be legally liable for any discount from par if the firm is liquidated. u Common stock that is authorized without par value (no-par stock) is carried on the books at the original market price or at some assigned (or stated) value. u The difference between the issuing price and the par or stated value is additional paid-in capital 20 -30

Example of Value Fun. Fin. Man, Inc. Common stock ($1 par value; value 100, 000 shares issued and outstanding) Additional paid-in capital Retained earnings Total shareholders’ equity $ 100, 000 400, 000 650, 000 $1, 150, 000 The par value of Fun. Fin. Man, Inc. , is $1 per share This value is not likely to change over time from normal day-to-day operations. 20 -31

Types of Common Stock Value B. Book Value (per share) -- Shareholders’ equity (as listed on the balance sheet) divided by the number of shares outstanding. C. Liquidating Value (per share) -- The value per share if the firm’s assets are sold separately from the operating organization. u This value may be less (or greater) than book value. Rarely are the two values identical. 20 -32

Example of Book Value (per share) Fun. Fin. Man, Inc. Common stock ($1 par value; 100, 000 shares issued and outstanding) Additional paid-in capital Retained earnings Total shareholders’ equity $ 100, 000 400, 000 650, 000 $1, 150, 000 The book value (per share) of Fun. Fin. Man, Inc. , is determined by dividing total shareholders’ equity ($1, 150, 000) by the shares outstanding (100, 000), 100, 000 which yields a book value of $11. 50 per share This value is not likely to change over time from normal day-to-day operations. 20 -33

Types of Common Stock Value D. Market Value (per share) -- The current price at which the stock is currently trading. u u 20 -34 This value is usually greater than book value (per share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical. Market value (per share) may be difficult to obtain from thinly traded securities.

Types of Common Stock Value D. Market Value (per share) -- continued. u 20 -35 Typically, the shares of new companies are traded in the over-the-counter (OTC) market, where dealers maintain an inventory of the stock to provide additional liquidity.

Rights of Common Shareholders u Right to Income -- entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors). u Right to Purchase New Shares (Maybe) -- the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock. u Voting Rights -- because the shareholders are owners of the firm, they are entitled to elect the board of directors. 20 -36

Voting Rights u Shareholders are generally geographically widely dispersed. u Two methods of voting: (1) in person or (2) by proxy Proxy -- A legal document giving one person authority to act for another. u SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings. u Most shareholders, if satisfied with company performance, sign proxies in behalf of management. 20 -37

Voting Procedures The board of directors are elected under either: u Majority-rule voting -- a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory voting u 20 -38 Cumulative voting -- a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors.

Voting Procedures Example You are a shareholder of Fun. Fin. Man, Inc. You own 100 shares and there are 9 director positions to be filled. u Under majority-rule voting: voting You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position. u Under cumulative voting: voting You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire. 20 -39

Minimum Votes to Elect a Director -- Cumulative Total number of Specific number of voting shares X directors sought Total number of directors to be elected + 1 +1 u For example, to elect 3 directors out of 9 director positions at Fun. Fin. Man, Inc. , (100, 000 voting shares outstanding) would require 30, 001 voting shares u (100, 000 shares) x (3 directors) 10 20 -40 + 1 = 30, 001 shares

Minimum Votes to Elect a Director -- Cumulative u Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions -- less than a majority. u Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote. u Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60, 001 shares (twice as many)! 20 -41

Dual-Class Common Stock Dual-class Common Stock -- Two classes of common stock, usually designated Class A and Class B. Class A is usually the weaker voting or nonvoting class, and Class B is usually the stronger. u u u 20 -42 This is used to retain control for founders, management, or some other specific group. For example, 80, 000 shares of Class A at $20/share and 200, 000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes. Usually Class B takes a lower claim to dividends and assets than Class A for this voting control.