Chapter - 3

Long-term financing
• Long-Term Financing Defined
– A long-term source of finance indicates external cash,
such as a loan, that a company receives to fund
activities, with a maturity of a year or more. Simply put,
a firm is not required to repay a long-term debt within a
year.
• Significance
– Long-term financing is important because it provides a
company with capital needed to fund projects in the
short term and long term. For instance, a firm may
borrow to expand activities in a new market or region.
 Sources of raising long term Finance
 The long- term finance available to a company
for raising capital includes:
Equity shares (ordinary/common share)
Hybrid sources of finance (preference share)
Term loans and bonds
Lease and hire-purchase financing
 Ordinary/common shares
• Ordinary shares represent the ownership
position in a company. The holders of ordinary
shares, called shareholders or stockholders are
the legal owners of the company.
• Ordinary shares (common shares) are the
sources of permanent capital since they do not
have a maturity date.
• The owners of common stock of a corporation
can be thought of as the true owners of the
business.
 Cont’d
• Represents the personal investment of the
owner(s) in the business
• Is called risk capital because investors assume
the risk of losing their money if the business
fails
• Does not have to be repaid with interest like a
loan does
 Features of ordinary shares
• Ordinary/common share has a number of
special features which distinguishes it from
other securities. These features mainly relate to
the rights and claims of ordinary shareholders.
A. claim on income
Ordinary share holders have a residual
ownership claim. They have a claim to the
residual income, w/h is earnings after paying
expenses and preference dividends.
 Cont’d

o The net income of a company may be split into

two parts: dividend and retained earnings.
• Retained earnings are reinvested in the
business and shareholders stand to benefit in
future in the form of the firm’s enhanced value
and earning power and ultimately enhanced
dividend and capital gain.
• Dividends payable depends on the discretion of
the company’s board of directors. A company is
not under a legal obligation to distribute
dividend out of the available earnings.
 Cont’d

• Capital gains depend on the future market value of

ordinary shares. Thus, an ordinary share is a risky
security from the investor’s point of view.
• Dividends paid on ordinary shares are not tax
deductible in the hands of company.
B. Claim on assets
Ordinary shareholders also have a residual claim on
the company’s assets in the case of liquidation. Out of
the residual value of assets, first the claim of debt-
holders and then preference shareholders are
satisfied and remaining balance, if any is paid to
ordinary shareholders.
 Cont’d

C. Right to Control
• Control in the context of a company means the
power to determine its policies, to appoint
directors (mgt).
• The company’s major policies and decisions are
approved by the board of directors while day-to-
day operations are carried out by managers
appointed by the board.
• Ordinary shareholders are able to control mgt of
the company through their voting right and right
to maintain proportionate ownership.
 Cont’d

D. Voting Rights
• Ordinary shareholders are required to vote on a
number of important matters; election of
directors and change in the memorandum of
association.
E. Pre-emptive Right
• The law grants shareholders the right to purchase
new shares in the same proportion as their
current ownership. Thus, if a shareholder owns
2% of the company’s ordinary shares, he has pre-
emptive right to buy 2% of new shares issued.
 Cont’d

F. Limited Liability
• Ordinary shareholders are the true owners of
the company, but their liability is limited to
the amount of their investment in shares.
• If a shareholders has already fully paid the
issue price of shares purchased, he has
nothing more to contribute in the event of
financial distress or liquidation.
 Pros and Cons of Equity Financing
Advantages:
i. permanent capital: it is a permanent capital, and is available for use
as long as the company survives.

ii. Borrowing base: the equity capital increases the company’s financial
base, and thus its borrowing limit. Lenders generally lend in
proportion to company’s equity capital. By issuing ordinary shares,
the company increases its financial capability. It can borrow when it
needs additional funds

iii. Dividend payment discretion: a company is not legally obligated to

pay dividend. In times of financial difficulties, it can reduce or
suspend payment of dividend. Thus, it can avoid cash outflow
associated with ordinary shares.
 Cont’d

Disadvantages:
i. Cost: shares have a higher cost at least for two
reasons. Dividends are not tax deductible as
are interest payments, and flotation cost on
ordinary shares are higher than those on debt.
ii. Risk: ordinary shares are risky from investors’
point of view as there is uncertainty regarding
dividend and capital gains. Therefore, they
require a relatively higher rate of return. This
makes equity capital as a highest cost source
of finance.
 Cont’d
iii. Earnings dilution: the issue of new ordinary
shares dilutes the existing shareholders’
earnings per share if the profits do not
increase immediately in proportion to the
increase in the number of ordinary shares.
iv.Ownership dilution: the issuance of new
ordinary shares may dilute the ownership and
control of the existing shareholders.
 Preference Stock Financing
• Preference shares are often considered to be a
hybrid since it has many features of both
ordinary shares and debentures (bonds).
• It is similar to ordinary shares in that:
A. the non-payment of dividend does not force the
company to insolvency.
B. dividends are not deductible for tax purpose,
and
C. it has no fixed maturity date
 Cont’d

 On the other hand, it is similar to debentures

(bonds) in that:
A. Dividend rate is fixed
B. Preference shareholders do not share in the
residual earnings,
C. Preference shareholders have claims in
income and assets prior to ordinary
shareholders, and
D. They usually do not have voting right.
 Types of preferred stock
1.Cumulative: has the right to receive
accumulated dividends before any dividends
may be paid to common stockholders.
• Dividends on cumulative preferred stock that
are passed are referred to as dividends in
arrears.
• And… dividends are not a liability until declared
by the board of directors.
2.Non-cumulative: has no right to “passed”
dividends.
 Cont’d

3. Participating: has claim to a portion of

common dividends after receiving preferred
dividends.
Participating preferred stock issues provide
for additional dividends to be paid to
preferred stockholders after dividends of a
specified amount are paid to common
stockholders.
 Cont’d
4. Convertible: permits the holder to exchange
preferred stock for common stock.
5. Callable: permits the issuing company to
redeem the preferred stock.
Callable preferred stock is preferred stock that is
redeemable at the option of the corporation. C
6. Redeemable: permits the holder to redeem the
stock-usually with some restrictions.
Redeemable preferred stock is preferred stock
that is redeemable at the option of the
stockholders. stssssstockholder.
 Features of Preference Shares
A. Claim on income and assets: preference shares
is a senior security as compared to ordinary
share. It has prior claim on the company’s
income in the sense that the company must first
pay preference dividends before paying ordinary
dividend. It has prior claim on asset in the event
of liquidation. The preference share claim is
honored after that of a debenture and before
that of ordinary shares. Thus, in terms of risk,
preference share is less risky than ordinary
shares, but more risky than debentures.
 Cont’d

B. Fixed dividend: the dividend rate is fixed in

case of preference shares and preference
dividends are not tax deductible. Preference
share is called fixed income security because it
provides a constant income to investors. The
payment of preference dividend is not a legal
obligation.
C. Voting rights: preference shareholders do
not have any voting right.
Pros and Cons of Preference Shares
Advantages:
1. Riskless leverage advantage: it provides financial
leverage advantage since preference dividend is
fixed obligation. This advantage occurs without a
serious risk of default. The non-payment of
preference dividend does not force the company
into insolvency.
2.Dividend post-ponability: preference share
provides some financial flexibility to the company
since it can postpone payment of dividend.
 Cont’d

3.Fixed Dividend: the preference dividend

payment are restricted to the stated amount.
Thus, preference shareholders do not
participate in excess profit, as do the ordinary
shareholders.
4.Limited Voting Right: preference
shareholders do not have voting right except
in case dividend in arrears exist. Thus, control
of ordinary shareholders is preserved.
 Cont’d

Limitations/disadvantages:
1. non-deductibility of dividends: preference
dividends is not tax deductible. Thus, it is
costlier than bonds.
2. Commitment to pay dividend: although
preference dividend can be omitted, they may
have to be paid because of their cumulative
nature. Non-payment of dividends can adversely
affect the image of a company, since equity
holders cannot be paid any dividends unless
preference shareholders are paid dividends.
Debt Financing (Long-term Debt Financing)

• Long-Debt Financing
– Debt financing products include bonds and loans.
Long-term loans are due after a year. A buyer of
bonds, also called a bondholder, receives interest
payments at the end of each quarter or year. He
also receives the principal amount invested at the
bond maturity.
– A bond is a long-term promissory note for
raising loan capital. The firm promise to pay
interest and principal.
 Features of Bond Capital
A. Interest Rate: it is fixed and known. It is called
the contractual rate of interest. It indicates the
percentage of par value of the debenture that
will be paid out annually ( or semi-annually) in
the form of interest, regardless of the market
value.
B. Maturity: debentures are issued for a specific
period of time. The maturity of bonds indicates
the length of time until the company
redeems(returns) the par value to debenture
holders and terminates the debentures.
 Cont’d
C. Redemption: bonds are mostly redeemable; they
are redeemed on maturity. Redemption of
debentures can be accomplished either through a
sinking fund or buy back (call) provision.
i. Sinking fund: a sinking fund is cash set aside
periodically for retiring debentures.
ii. Buy-back (call) provision: buy back provisions
enables the company to redeem debentures at a
specified price before the maturity date. The
buy-back (call) price may be more than the par
value of the debentures. This difference is called
call or buy-back premium.
 Cont’d

D. Indentures: an indenture or debenture trust

deed is a legal agreement b/n the company
issuing the debentures and the debenture
trustee who represents the debenture
holders.
E. Security: debentures are either secured or
unsecured. A secured bond is secured by a lien
on a company’s specific assets. When bonds
are not protected by any security, they are
known as unsecured or naked debentures.
 Cont’d

F. Prior Claim on Assets and Income:

 Bond-holders have a claim on the company’s
earnings prior to that of shareholders. Bond
interest has to be paid before paying any
dividend to preference and ordinary
shareholders.
 In liquidation, the bondholders have a claim
on assets prior to that of shareholders.
However, secured debenture holders will have
priority over the unsecured bondholders.
 Pros and Cons of Bond Capital

Bonds have a number of merits as long-term

source of finance.
A. Less Costly: it involves less cost to the firm
than the equity financing because:
i. investor consider bonds as relatively less
risky investment alternative and therefore,
require a lower rate and
ii. Interest payments are tax deductible.
 Cont’d

B. No Ownership Dilution: bondholders do not

have voting right, therefore, bonds issue does
not cause dilution of ownership.
C.Fixed Payment of Interest: debenture
holders do not participate in extraordinary
earnings of the company. Thus the payments
are limited to interest.
D. Reduced Real Obligation: during periods of
high inflation, bond issue benefits the
company. Its obligation of paying interest and
principal which are fixed decline in real terms.
 Cont’d

Limitations/Disadvantages:
A. Obligatory Payments: debenture result in
legal obligation of paying interest and
principal, which if not paid, can force the
company into liquidation.
B. Financial Risk: it increase the firm’s financial
leverage, which may be particularly
disadvantageous to those firms which have
fluctuating sales and earnings.
 Cont’d

C. Cash Outflow: debentures must be paid on

maturity, and therefore, at some points, it
involves substantial cash outflow.
D. Restricted Covenant: debenture indenture
may contain restrictive covenant which may
limit the company’s operating flexibility in the
futures.
 Equity vs. Debt Financing
Advantages
Debt Financing
Advantages:
• Relatively Easy & Quick
• Maintain control & ownership
• Interest & other costs tax deductible
• May be able to save money
Debt Financing
Advantages:
• Relatively Easy & Quick
• Maintain control & ownership
• Interest & other costs tax deductible
• May be able to save money
 Equity vs. Debt Financing
Disadvantages

Debt Financing
Disadvantages:
• Interest Costs Expensive
• Risk of profits not covering repayment
• Easy to abuse & overuse
• Must share financial information
• Lender Restrictions & Limitations
 Cont’d

Equity Financing
Disadvantages:
• Risk of destroying personal relationships
• Give up part of profits
• Give up part of ownership of business
• Give up some control of business
• Personal sacrifices
• Loss of savings
 Term Loan

• Term loan: A loan which is repaid through

regular periodic payments, usually over a
period of one to 15 years.
 Lease Financing

Long-term leasing is a method of financing property,

plant, and equipment. From the lessee’s standpoint,
long-term leasing is similar to buying the equipment
with a secured loan. The principal benefit of long-
term leasing is tax reduction. Leasing allows the
transfer of tax benefits from those who need
equipment but cannot take full advantage of the tax
benefits associated with ownership to a party who
can. If the corporate income tax were repealed,
long-term leasing would virtually disappear
 1. Types of Leases:

I. Direct leases: A contractual financing arrangement in which

the lessor, typically a bank, purchases the property directly
from the manufacturer and leases that property to the lessee.
II. Sales-type lease: the lessor is the manufacturer.
III. Operating leases:
a. Operating leases are usually not fully amortized. Thus, the
lessor must expect to recover the costs of the asset by renewing
the lease or by selling the asset for its residual value.
b. It usually requires the lessor to maintain and insure the leased
assets.
c. It is also the cancellation option. This option gives the lessee the
right to cancel the lease contract before the expiration date
 Cont’d

IV. Financial leases: are the exact opposite of operating leases:

a. they don’t provide for maintenance or service by the lessor.
b. They are fully amortized.
c. The lessee usually has a right to renew the lease on expiration.
d. Generally, they cannot be canceled.
V. Two types of financial leases:
a. Sale and lease-back: It occurs when a company sells an asset
it owns to another firm and immediately leases it back. Two
things happen:
1). The lessee receives cash from the sale of the asset.
2). The lessee makes periodic lease payments, thereby retaining
use the asset.
 Cont’d
b. Leveraged leases: is a three-sided
arrangement among the lessee, the lessor,
and the lenders:
1). The lessor purchases the assets, delivers
them to the lessee, and collects the lease
payments. However, the lessor puts up no
more than 40-50% of the purchase price.
2). The lenders supply the remaining financing
and receive interest payments from the lessor.
 Cont’d
3). The lenders in a leveraged lease typically use a
nonrecourse loan. This means that the lessor is not
obligated to the lender in case of a default. The lender is
protected in two ways:
A. The lender has a first lien on the asset.
B. In the event of loan default, the lease payments are
made directly to the lender.
4). The lessor puts up only part of the funds but gets the
lease payments and all the tax benefits of ownership.
These lease payments are used to pay the debt service of
the nonrecourse loan.
5). The lessee benefits because, in a competitive market, the
lease payment is lowered when the lessor saves taxes.
 Criteria for a Capital Lease
• If one of the following criteria is met, then the lease is
considered a capital lease and must be shown on the
balance sheet
– Lease transfers ownership by the end of the lease
term
– Lessee can purchase asset at below market price
– Lease term is for 75 percent or more of the life of
the asset
– Present value of lease payments is at least 90
percent of the fair market value at the start of the
lease
 Taxes
• Lessee can deduct lease payments for income tax
purposes
– Must be used for business purposes and not to avoid taxes
– Term of lease is less than 80 percent of the economic life of
the asset
– Should not include an option to acquire the asset at the end
of the lease at a below market price
– Lease payments should not start high and then drop
dramatically
– Must survive a profits test
– Renewal options must be reasonable and consider fair
market value at the time of the renewal
 Reasons for leasing

Good reasons:
I. Taxes may be reduced by leasing.
Both parties can gain when tax rates to then
differ. The lessor uses the depreciation and
interest tax shields that cannot be used by the
lessee. The IRS lose tax revenue, and some of
the tax gains to the lessor are passed on to the
lessee in the form of lower lease payments.
 Cont’d
II. The lease contract may reduce certain types of
uncertainty.
When the lease contract is signed, there may be
substantial uncertainty as to what the residual
value of the asset will be. It is common sense
that the party best able to bear a particular risk
should do so. If the user is highly averse to risk,
he should find a third-party lessor capable of
assuming this burden. This situation frequently
arises when the user is a small and/or newly
formed firm.
 Cont’d
III. Transactions costs can be higher for buying an
asset and financing it with debt or equity than for
leasing the asset. The costs of changing an asset’s
ownership are generally greater than the costs of
writing a lease agreement.
Unfortunately, leases generate agency costs as
well. This cost will be implicitly paid by the lessee
through a high lease payment.
Thus, leasing is most beneficial when the
transaction costs of purchase and resale outweigh
the agency costs and monitoring costs a lease.
 Cont’d
 Bad reason: leasing and accounting income: the
firm’s ROA is generally higher with an operating
lease than with either a capitalized lease or a
purchase.
(1). Leased assets do not appear on the balance sheet
with an operating lease. Thus, the total asset value is
less with an operating lease than it is with either a
purchase or a capitalized lease.
(2) usually, yearly lease payment is less than the sum
of yearly depreciation and yearly interest. Thus,
accounting income, the numerator of the ROA is
higher with an operating lease.