CHAPTER TWO: LONG-TERM CAPITAL

At the inception, the firm should be supported by the capital. These are contributions
(cash and in-kind contributions) brought by shareholders in order to start a business.
The capital will be used in acquiring assets that will, prospectively, generate
additional value (referred hereto as net worth). As such, capital is essential in setting
but also in operating a business. Any decision to acquire a new asset should
necessitate the raising of new capital. And consistently, long-term assets are financed
with long-term capital. Long-term capital refers to any liability (in a broad sense)
that is accompanied with a probable sacrifice of funds but expected to yield economic
benefits in periods generally greater than one year in the future.
In principle, capital is fuelled by owners, but the practice allowed another category
of backers to finance the firm without being qualified as owners but benefiting of
perks all the same. They are debtholders. In that respect, we are considering in some
details, related modes of long-term financing: Equity and debt. Then, our second
concern will be to appreciating the relevance of each mode of financing as well as
the associated costs.

1. Equity Financing
Companies often raise money for projects by selling (issuing) ownership interests
(e.g., corporate common stock or partnership interests). Although these equity
instruments legally represent ownership in companies rather than loans to the
companies, selling equity to raise capital is simply another mechanism for moving
money from the future to the present. When shareholders or partners contribute
capital to a company, the company obtains money in the present in exchange for
equity instruments that will be entitled to distributions in the future. Although the
repayment of the money is not scheduled as it would be for loans, equity instruments
also represent potential claims on money in the future.

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1.1. Equity instruments
There are several types of equity instruments as described below.

1.1.1. Common stocks

The common stockholders are the owners of the corporation. In Private partnerships
and sole proprietorships, they are liable to the payment of the corporation debts.
Whenever the firm’s assets could not settle the debts, partners or owners will be
collectively bound to pay those debts from their personal assets. in Public limited
companies and public partnerships, the liability of owners is limited to their
contributions in the firm capital. By no means, their assets cannot be seize for the
payment of the firm debts.
In exchange of funds provided, owners expect dividends if there is profit (or if there
are available retained earnings). They are residual owners because they assume the
risk of receiving a fluctuating income after all suppliers are paid. Even in case of
liquidation, they are paid only if liabilities are settled.

Stockholders control the firm through the right to elect and dismiss the firm’s
directors. The firm directors in turn select officers to manage the business. In a small
firm, the major stockholder typically assumes the position of president and chairman
of the Board of Directors (BOD). In publicly owned firms, stockholders exercise
control through voting rights associated to their stocks. Voting rights are based on
the principle: one share – one vote.

Although many firms only have a single type of common stocks, in some firms,
special classification of stocks are created to meet the special needs of the company.
For instance, Class A may be affordable by insiders and the general public; it pays a
dividend and have full voting rights; Besides, a second class can be designated as
Class B. This class may be retained by organises of the company, and the legal terms
may provide that dividends will not be paid on it until the company has established
its earning power by building up retained earnings to a prespecified level.
Going public induces the following advantages:
- diversification facility;
- liquidity improvement;
- ease of cash collection by corporations.
Still, disadvantages are still related:
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- cost of reporting;
- disclosure of operations;
- self-dealing behaviour;
- inactive market / low price;
- control.

1.1.2. Preferred stocks

A preferred stock is a hybrid; it is similar to bonds in some respects and to common
stocks in other ways. Preferred stocks pay out a dividend as percentage of the par
value. Once the dividend is set at the stock issuance, it will not change in the future.
However, if the preferred stock is not earned, the company does not have to pay it.
Preferred stocks are akin to perpetual bonds but subordinated to bonds in cate of
liquidation. However, most preferred issues are cumulative; otherwise, the
cumulative total of all unpaid preferred dividends must be paid before dividends can
be paid on common the stock. Unpaid preferred dividends are called arrearages. In
fact, dividends in arrears do not earn interest. Thus, arrearages do not increase in a
compound interest sense. They only grow from continued nonpayment of the
preferred dividend.
Normally, preferred stocks do not have voting rights, but most preferred issues do
not stipulate that the preferred stockholders can elect a minority of directors if the
dividend is passed. Even though the payment of preferred dividends will not
bankrupt a company, corporations issue preferred dividends with every intention of
paying the dividends. Even if passing the dividend does not give the preferred
stockholders control of the company, a failure to pay a preferred dividend precludes
the payment of common dividends; and virtually, makes impossible for the firm to
raise capital from selling bonds, more preferred and common stocks.
However, having preferred stocks outstanding does not give a firm that experiences
temporary problems a chance to overcome its difficulties. Had bonds been used
instead of preferred stocks, the company might have been forced to bankruptcy
before it could straighten out its problems. Thus, from the standpoint of the issuing
corporation, preferred stocks are less risky than bonds. Conversely, investors regard
preferred stocks as being riskier than bonds for two reasons. First of all, preferred
stockholders’ claims are subordinated to bond holders in the event of liquidation.
And bondholders are more likely to continue receiving income during hard time than

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are preferred stockholders. For such considerations, investors should reasonably
receive a higher rate of return on a given firm’s preferred stock than on its bonds.

1.1.3. Retained earnings

Retained earnings are part of the result that have decided by the firm to be reinvested
in the firm. instead of contracting new debts or raising a new capital, an alternative
could well be to use the profit generated in order to self-finance the business. The
reason why retained earnings must be regarded as equity stems form the opportunity
cost principle but also the liability involved. The firm’s after-tax earnings literally
belong to the stakeholders. Bondholders are compensated by interest payments,
while earnings belong to common stockholders and serve to pay the rent on
stockholders’ capital. Management may either pay out earnings in form of dividends
or retain and reinvest earnings in the business. Whenever management decides to
retain earnings, there is an opportunity cost involved: stockholders could have
received earnings as dividends and invested this money in other stocks, in binds, in
real estate or in any other investment. Thus, the firm should earn on retained
investment at least as much as stockholders could earn themselves in alternative
investment. Put otherwise, retained earnings and common stock have the same
features relative to opportunity costs but also the embedded liability.

2. Debt financing
A long-term debt is often called funded debt. Whenever a firm is planning to fund its
floating debt, it is planning to replace short-term debt with securities of longer
maturity. Funding does not imply placing money with a trustee or a repository. Three
debt financing instruments are selected for the purpose of this course: term loans,
bonds and leasing.

2.1. Term loans

A term loan is a contract under which a borrower agrees to make a series of payments
(interests and principal included) on specified dates to a lender. Term loans are
usually negotiated directly between the borrowing firm and a financial institution or
a private lender. In the latter case, formal documentation is minimised. Referring to
the long-term nature of the loan, the maturity should be at least 2 years. Although,
some loans can afford a maturity of 30 years, the common practice is the have long-
term loans maturity ranging from 3 to 15 years. Term loans have three main

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advantages: speed, flexibility and low issuance cost. The interest rate on a term loan
can be either fixed for the life of the loan or variable.

2.2. Bonds
Bonds are contractual promises made by a company (or other borrowing entity) to
pay cash, in exchange for receiving cash in the present, interest and principal on
specified dates in the future to its lenders (i.e., bondholders). The terms of a bond
contract are contained in a document called an indenture. The cash or sales proceeds
received by a company when it issues bonds is based on the value (price) of the
bonds at the time of issue; the price at the time of issue is determined as the present
value of the future cash payments promised by the company in the bond agreement.
Ordinarily, bonds contain promises of two types of future cash payments: the face
value of the bonds and periodic interest payments. The face value of the bonds is the
amount of cash payable by the company to the bondholders when the bonds mature.
The face value is also referred to as the principal, par value, stated value, or maturity
value. The date of maturity of the bonds (the date on which the face value is paid to
bondholders) is stated in the bond contract and typically is a number of years in the
future. Periodic interest payments are made based on the interest rate promised in the
bond contract applied to the bonds’ face value. The interest rate promised in the
contract, which is the rate used to calculate the periodic interest payments, is referred
to as the coupon rate, nominal rate, or stated rate. Similarly, the periodic interest
payment is referred to as the coupon payment or simply the coupon. For fixed rate
bonds (the primary focus of our discussion here), the coupon rate remains unchanged
throughout the life of the bonds. The frequency with which interest payments are
made is also stated in the bond contract. For example, bonds paying interest semi-
annually will make two interest payments per year.
The future cash payments are discounted to the present to arrive at the market value
of the bonds. The market rate of interest is the rate demanded by purchasers of the
bonds given the risks associated with future cash payment obligations of the
particular bond issue. The market rate of interest at the time of issue often differs
from the coupon rate because of interest rate fluctuations that occur between the time
the issuer establishes the coupon rate and the day the bonds are actually available to
investors. If the market rate of interest when the bonds are issued equals the coupon
rate, the market value (price) of the bonds will equal the face value of the bonds.
Thus, ignoring issuance costs, the issuing company will receive sales proceeds (cash)

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equal to the face value of the bonds. When a bond is issued at a price equal to its face
value, the bond is said to have been issued at par.
If the coupon rate when the bonds are issued is higher than the market rate, the market
value of the bonds – and thus the amount of cash the company receives – will be
higher than the face value of the bonds. In other words, the bonds will sell at a
premium to face value because they are offering an attractive coupon rate compared
to current market rates. If the coupon rate is lower than the market rate, the market
value and thus the sale proceeds from the bonds will be less than the face value of
the bonds; the bond will sell at a discount to face value. The market rate at the time
of issuance is the effective interest rate or borrowing rate that the company incurs on
the debt. The effective interest rate is the discount rate that equates the present value
of the two types of promised future cash payments to their selling price. For the
issuing company, interest expense reported for the bonds in the financial statements
is based on the effective interest rate.
On the issuing company’s statement of cash flows, the cash received (sales proceeds)
from issuing bonds is reported as a financing cash inflow. On the issuing company’s
balance sheet at the time of issue, bonds payable normally are measured and reported
at the sales proceeds. In other words, the bonds payable is initially reported at the
face value of the bonds minus any discount, or plus any premium.

2.3. Lease
A company wishing to obtain the use of an asset can either purchase the asset or lease
the asset. A lease is a contract between the owner of an asset (the lessor) and another
party seeking use of the asset (the lessee). Through the lease, the lessor grants the
right to use the asset to the lessee. The right to use the asset can be for a long period,
such as 20 years, or a much shorter period, such as a month. In exchange for the right
to use the asset, the lessee makes periodic lease payments to the lessor. A lease, then,
is a form of financing to the lessee provided by the lessor that enables the lessee to
obtain the use of the leased asset.
There are several advantages to leasing an asset compared to purchasing it. Leases
can provide less costly financing; they usually require little, if any, down payment
and often are at lower fixed interest rates than those incurred if the asset was
purchased. This financing advantage is the result of the lessor having advantages
over the lessee and/or another lender. The lessor may be in a better position to take
advantage of tax benefits of ownership, such as depreciation and interest. The lessor

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may be better able to value and bear the risks associated with ownership, such as
obsolescence, residual value, and disposition of asset. The lessor may enjoy
economies of scale for servicing assets. As a result of these advantages, the lessor
may offer attractive lease terms and leasing the asset may be less costly for the lessee
than owning the asset. Further, the negotiated lease contract may contain less-
restrictive provisions than other forms of borrowing.
3. Determinant of long-term financing decisions
It would be soundless to rank those factors that may influence a firms’ long-term
financing decisions. Their relative importance varies among firms at any point in
time and for any given firm over time. We can afford to list some hereto: the target
capital structure, the maturity matching and interest rates.

3.1 The target Capital structure

In any financing decision, the firm must compare its actual capital structure to its
target structure. In practice, firms establish an optimal or target capital structure; and
over time raise finance in accordance with this target. Setting a target capital structure
does not preclude the firm from deviating. Smaller issues of new securities have
proportionally larger flotation costs, so firms tend to use debt one year and stock the
next. In fact, small fluctuation about optimal capital structure has little effect on a
firm weighted average cost of capital. Besides, investors would recognise that this
action is prudent. And the firm would save substantial amount of flotation costs by
financing in this manner.

3.2. The Maturity matching

The least risky approach to financing is to match the maturities of liabilities with the
maturity of the assets being financed. Any mismatching between both maturities may
give rise to illiquidity issues whenever the project may be profitable. However, the
rule is not so stringent. There are still situations where long-term capital levels can
be allowed below fixed assets.

3.3. Interest rates

Financial managers consider interest rates levels when making financing decisions.
When long-term interest rates are high with respect to historic standards, many
managers will be reluctant issue long-term debt. Long-term contracting will
definitely lock term in those costs over a long period. Indeed, a solution would be to

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 use a call provision which permit calling off the debt if interest drop. There is still a
cost because the firm must pay a for anticipated payments. Alternatively, the firm
may finance with short term-debt instruments when long-term debt financing is
costly. Subsequently, when interest rates on long-term debt fall, they sell long-term
issues to replace the short-term debt. Of course, this strategy is still risky. If interest
rates move higher, the firm will be forced to renew the debt at higher and higher
short-term rates, or to replace the short-term debt with long-term bond which costs
more than it would have when the original decision was made.

4. Loan amortisation schedules

Once the firm has envisaged the option to issue a loan, it should also prospect the
amortization method to gradually settle a debt.

4.1. Amortisation of a loan

The amortization schedule is given as follows:
Periods (years, Opening Payment Interests Repayment Remaining
months, etc.) balance (PMT) of principal balance
1
2
3
.
Totals
It is worthwhile noticing that:
PAYMENT = REPAYMENT OF THE PRINCIPAL + INTERESTS
Otherwise: REPAYMENT OF THE PRINCIPAL = PAYMENT - INTERESTS

INTERESTS = OPENING BALANCE x INTEREST RATE

REMAINING BALANCE = OPENING BALANCE - REPAYMENT OF THE PRINCIPAL

Among the wide range of methods, we are going to consider some methods that are
commonly used in killing off the loan over time: constant annuities, constant
amortisation and sinking fund.

Application: MITACCUL granted a loan to Mrs CHICK at the following conditions:

- Nominal value of the loan: CFAF500,000
- interest rate: 16 % per year;
- payable in 5 annual instalments;
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- the first payment is expected within one year.
You are required to provide the loan amortisation schedule according to each
method.
4.1.1. Constant annuities method
This method assumes that all instalments are constant over time. These instalments
encompass the principal amortized and the related interest.
Periods Opening Payment Interests Repayment of Remaining
balance (PMT) principal balance
1
2
3
4
5
Totals

4.1.2. Constant amortization method

The method consists in repaying constant amounts of the principal. Here, the
principal amount repaid is constant, interests are variable, and overall, instalments
are variable.
Periods Opening Payment Interests Repayment of Remaining
balance (PMT) principal balance
1
2
3
4
5
Totals

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4.1.3. The sinking fund method
This method has been implemented by USA. Its principle is simple too: over the
periods, the borrower only pays interests, and at the maturity, he pays both interests
and principal. Knowing that the last year will be heavier, the borrower will provide
a constant amount each year so as to meet the payment during the last year.
Periods Opening Payment Interests Repayment of Remaining
balance (PMT) principal balance
1
2
3
4
5
Totals

4.2. Amortisation of a bond

The amount at which bonds are reported on the company’s balance sheet is referred
to as the carrying amount, carrying value, book value, or net book value. If the bonds
are issued at par, the initial carrying amount will be identical to the face value, and
usually the carrying amount will not change over the life of the bonds. For bonds
issued at face value, the amount of periodic interest expense will be the same as the
amount of periodic interest payment to bondholders.
If, however, the market rate differs from the bonds’ coupon rate at issuance such that
the bonds are issued at a premium or discount, the premium or discount is amortised
systematically over the life of the bonds as a component of interest expense. For
bonds issued at a premium to face value, the carrying amount of the bonds is initially
greater than the face value. As the premium is amortised, the carrying amount
(amortised cost) of the bonds will decrease to the face value. The reported interest
expense will be less than the coupon payment. For bonds issued at a discount to face
value, the carrying amount of the bonds is initially less than the face value. As the
discount is amortised, the carrying amount (amortised cost) of the bonds will increase
to the face value. The reported interest expense will be higher than the coupon
payment.
The accounting treatment for bonds issued at a discount reflects the fact that the
company essentially paid some of its borrowing costs at issuance by selling its bonds
at a discount. Rather than there being an actual cash transfer in the future, this

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“payment” was made in the form of accepting less than the face value for the bonds
at the date of issuance. The remaining borrowing cost occurs as a cash interest
payment to investors each period. The total interest expense reflects both components
of the borrowing cost: the periodic interest payments plus the amortisation of the
discount. The accounting treatment for bonds issued at a premium reflects the fact
that the company essentially received a reduction on its borrowing costs at issuance
by selling its bonds at a premium. Rather than there being an actual reduced cash
transfer in the future, this “reduction” was made in the form of receiving more than
face value for the bonds at the date of issuance. The total interest expense reflects
both components of the borrowing cost: the periodic interest payments less the
amortisation of the premium. When the bonds mature, the carrying amount will be
equal to the face value regardless of whether the bonds were issued at face value, a
discount, or a premium.
Application:
MULANG Corp. issues a bond dated 1st January 2020 with the following features:
Face value: 1,400,000 CFAF
Number of bonds: 1,400 bonds issued and redeemable at par
Maturity: 4 years
Coupon rate: 5 %
Frequency of annual interest payments: annually
Work required: Set the bond amortisation schedule.
Application:
MELKITCH Finance issues 200 bonds worth 13,000 CFAF as face value. The sales
proceeds are 2,636,000 CFAF. The bonds pay 6 percent interest annually as from 31
December 2019 and the maturity is 8 years.
Work required: Provide the bond amortisation schedule.
Application
RENOVA issues 1,500 bonds worth 10,000 CFAF as face value. The sales proceeds
are 14,722,500 CFAF. Each bond pays 6 percent interest annually as from 31st
December 2019 and the maturity is 6 years.
Work required: Provide the bond amortisation schedule.

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4.3. Amortisation of an asset in lease
Because a finance lease is economically similar to borrowing money and buying an
asset, a company that enters into a finance lease as the lessee reports an asset (leased
asset) and related debt (lease payable) on its balance sheet. The initial value of both
the leased asset and lease payable is the lower of the present value of future lease
payments and the fair value of the leased asset; in many cases, these will be equal.
On the income statement, the company reports interest expense on the debt, and if
the asset acquired is depreciable, the company reports depreciation expense.

Application
An asset can either be acquired on lease or in full ownership. If lease, 5 annual lease
rents amount to 100,000 CFAF by year-end. Still, a deposit guarantee is required at
the initiation of the contract. The deposit guarantee is worth a quarter of the annual
lease value. Were the asset acquired in full ownership, it would cost 400,000 CFAF
and it would be depreciated over a period of 5 years.
Work required: Provided a corporation tax of 33 %, decide on the mode of financing
which cost is preferable.

Application:
GIVEN company has decided to acquire a new truck:
- one alternative is to lease the truck on a 4-year contract for lease payment of
5,000,000 CFAF per year, with payments to be made at the beginning of each year.
The lease would include maintenance;
- alternatively, GIVEN could purchase the truck outright for 20,000,000 CFAF (VAT
excluded), financing the purchase by a bank loan for the net purchase price and
amortising the loan over a 4-year period at an interest rate of 10 % per year. Under
the borrowing-to-purchase arrangement, GIVEN would have to maintain the truck at
a cost of 500,000 CFAF per year, payable at year-end. The truck qualifies for a 6 %
investment tax credit. It falls into the 3-years depreciation class and it has a salvage
value of 5,000,000 CFAF (before tax), which is the expected market value after 4
years, when GIVEN plans to replace the truck irrespective of whether it leases of
buy. The Tax rate is 33 %.
Work required:
1. What id GIVEN’s present value cost of leasing?
2. What is GIVEN’s present value cost of owning?

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3. Should the truck be leased or purchased?

5. The mode of financing selection

The selection of the mode of financing should compare the present value of cash
flows. Meanwhile, another option would be to consider the actual cost of financing.
But the underlying assumptions may have deleterious effects on the assessment.

Application
In order to acquire a new furniture worth 1,000,000 CFAF which life span is 10
years, CAB can opt for:
- a cash payment;
- 2 equal instalments of 750,000 CFAF payable at end-year 3 and 5;
- 7 constant payments of 210,000 CFAF. The first payment is made after the first
year from the acquisition.

Work required:
1. Provided a discount rate of 10 %, which financing option best suits here?
2. From the actual cost of financing standpoint, what will be the best option.

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