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CHAPTER 15: LONG-TERM FINANCING – AN INTRODUCTION

Topics:

• 15.1 Common Stock

• 15.2 Long-term Debt

• 15.3 Preferred Shares

• 15.5 Patterns of Long-Term Financing

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Methods of Securing Financing

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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

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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

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Example: Share capital structure of RBC (1)• RBC (TSE/NYSE: RY), 2006 Annual Report

2006 2005 2004

Question: Find authorized shares, outstanding shares, and Tobin’s Q for RBC FY 2006.

2006 2005 2004

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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

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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

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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

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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.

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Example: Cumulative voting

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Example: Straight vs. cumulative votingThe 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

1. If ABC has straight voting:

2. If ABC has cumulative votingSuppose 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.

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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)

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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

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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

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Is it Debt or Equity?

Feature Equity Debt

Income

tax status

default and priority

management control

maturity

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Related knowledge: Gov’t bonds

– Treasury bills - maturity < 1 year - no coupons

– Treasury notes - medium maturity 1 - 10 yrs - semi-annual coupons

– Treasury bonds - maturity > 10 years - semi-annual coupons

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

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Yield comparison of bonds with repayment provisions

Yield

> or < ? Yield

Regular Bond Callable Bond

Regular Bond Extendable Bond

Regular Bond Retractable Bond

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Example: RBC debentures (2006 Annual report)

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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

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Example: RBC preferred shares

Par: $25/share

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15.4 Patterns of Long -Term Financing

• Pecking order theory: internal cash then debt then equity

The Long-Term Financial GapSources of Cash Flow

(100%)

Internal cash flow (retained earnings plus depreciation)

68.3%

Long-term debt and

equity 31.7%

Uses of Cash Flow (100%)

Capital spending

Net working

capital plus other uses

Internal cash flow

External cash flow

Financial deficit

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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.

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2. 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 + 11.16% 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?

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Solution to RQ 2Step 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:

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• Assigned Problems # 15.1, 2, 4, 7, 8, 12