Sources of finance

Sources and Forms of Long-Term Financing

Niladri Das

The Money and Capital Markets

• Two types of external markets for funds:1. Money market• Short-term debt securities: maturity of less than 1 year• T-bills, commercial paper, bankers’ acceptances, and

short-term certificates of deposit2. Capital market • Intermediate-term securities: maturity of

more than 1 but less than 10 years• Long-term securities: maturity of 10 or more years• Equity securities: preferred and common stock have

longest time horizon since they are issued for life of corporation

Intermediate- and Long-Term Debt

• Two primary sources of intermediate- and long-term debt:1. Term loans2. Bonds


1. Term loans– Paid off over some number of years– Usually negotiated with commercial bank,

insurance company, or some other financial institution

– Fully amortized (principal and interest are paid off in installments over life of loan)


2. Bonds– Intermediate to long term debt agreements issued

by governments, corporations, and other organizations

– Issued in units of Rs 1,000 principal value per bond– Two “promises” to:• Repay Rs 1,000 principal value at maturity• Pay stated interest rate (coupon rate) when due

– Most bonds pay interest semiannually at a rate equal to one-half of the annual coupon rate


2. Bonds (continued)– Bond indenture: complete statement of legal

obligations of issuing organization to bondholders• Specifies number of restrictive covenants

– Protect bondholders’ interests– Describe various standards that issuer must meet or action

that issuer must not take• If issuer violates terms of indenture, bond is in default

and trustee must do whatever is necessary to remedy default.

Intermediate- and Long-Term Debt• Different types of bond issues:– Mortgage bonds: bonds that are collateralized by a

mortgage on some fixed asset (e.g. building, land, equipment)

– Debenture: unsecured bond that is baked by full faith and credit of issuer• No specific assets are pledged as collateral• If default or bankruptcy occurs, debenture holders become

general creditors of the issuer– Subordinated debenture: debenture that is

specifically subordinated to some other debt issue• If default or bankruptcy, junior debt has no claim on

issuer’s assets until senior debt is satisfied


• Different types of bonds (continued)– Convertible bonds: corporate bonds that may be

converted into common stock at the option of bondholder• Conversion rate: number of shares of stock into which

bond may be converted

– Income bonds: bonds on which interest is paid only when corporation earns a specified level of income


• Different types of bond issues (continued)– Floating-rate bonds: like regular bullet bonds

except that coupon rate is tied to some variable rate benchmark (e.g. LIBOR: London Interbank Offered Rate)

– Zero coupon bond: sold at substantial discounts from par buy pay no current interest• Investors earn their rate of interest from interest

accreting as bond approaches maturity

Intermediate- and Long-Term Debt• Different types of bond issues (continued)– Call provisions: issuing corporation has the right to “call

in” bond for retirement prior to maturity• May not be called until some number of years after original issue• Must be called at a premium above par value

– Sinking fund: establishes procedure for orderly retirement of a bond over life of issue• Requires periodic (usually annual) repurchase of stated

percentage of outstanding bonds• Repurchasing corporation may either buy bonds in open market or

call in bonds for redemption– Bonds to be called are determined by lottery based on serial numbers of

bonds– When high interest rates drive bond prices down, open-market

purchases at discounts from par value are more attractive


Bond Yields• Three common yield measures:

1. Coupon yield rate2. Current yield3. Yield to maturity (YTM)


Bond Yields1.Coupon yield rate: rate of interest specified

on bond coupons at the time bond is issued– Stated in bond indenture– Does not change once bond is issued– If interest rates rise after issue, then bond price

will fall.– If interest rates fall after issue, then bond price

will rise.


Bond Yields2.Current yield: calculated by dividing coupon

interest in rupees by current market price of bond– Seasoned bond: bond that has been issued and

is traded freely on open market• Interest rates fluctuate and thus, prices of seasoned

bonds also fluctuate.


Bond Yields3. Yield to maturity: average annual compound

rate of return that would be earned if bond were purchased at its current market value and held to maturity– Includes return from interest payments and

capital gain/loss if bond is purchases at discount/premium

Preferred Stock

• Two important preferences over common stock:1. Payment of dividends2. Stockholders’ claims on assets of business in

event of bankruptcy

Preferred Stock• Preferred stock combines some of the

characteristics of bonds and some of the characteristics of common stock – Fixed in amount– Holders do not participate in growth of corporate

earnings, but rather collect only dividends promised in indenture

– Payments must be voted on and approved by board of directors of corporation

– Issues are cumulative (missed dividends accumulate as arrearages and must be paid off before dividends on common stock can be paid)

Preferred Stock

• Payment of preferred dividends is nearly as important as timely payment of bond interest.– It is difficult for corporations with preferred

dividends in arrears to raise other forms of capital.– Nonpayment of bond interest can force

corporation into bankruptcy.– Preferred stockholders cannot legally force

bankruptcy for nonpayment of dividends.

Preferred Stock

• Conversion ratio: specified exchange rate (common for preferred) at which preferred stock is convertible into common stock– If company prospers and price of common stock

rises, conversion becomes attractive.– If convertible preferred stock is callable,

corporation is allowed to call stock and/or force conversion into common stock in the future if advantageous.

Common Stock• Common stockholders: owners of the corporation– Each share of common stock has one vote in electing

members of corporation’s board of directors.– Board is responsible to stockholders.– Board selects president.– President reports to board.– If one person is a majority stockholder, he/she may serve

as both president and chairman.• In large, publicly held corporations, no single individual

or small group holds enough shares to exercise voting control of corporation.

Common Stock

• Directors are elected in annual meetings.• Prior to each meeting, current management

solicits voting proxies of stockholders, which allows management to vote the shares of stockholders who sign proxy.– Dissident stockholder group or outside group

seeking to take over company can also solicit proxies.

– Party with most proxies gains control of corporation.

Common Stock

• Tender offer: another corporation buys up enough stock in market to exert majority control of takeover target– Acquiring corporation publicly announces its

willingness to buy shares at a given price above current market price from all stockholders who tender their shares be specified expiration date.

Common Stock• Common stock serves as corporation’s equity

cushion.– Money paid to corporation for common stock does

not have to be repaid.– Board declares when dividends are paid. – Dividends do not accumulate as arrearages.– Stockholders cannot legally claim any specified

dividend level.– As corporation prospers, board votes to increase

dividend along with increased growth in earnings.– As dividends increase, value of stock increases.

Common Stock

• Some corporations have two classes of common stock:– Class A stock:

• Voting stock– Class B stock:

• Nonvoting stock• Possesses right to participate in earnings and dividends• Cannot vote on corporate matters

• Large, publicly held corporations rarely offer two different classes.

Dividend Policy

• Board of directors is responsible for dividend policy.– Most dividends are paid quarterly.– Board votes on and approved each payment.– Dividend policy requires compromise between:• Stockholders’ desire to receive some of the earnings

through cash dividends• Corporation’s desire to reinvest earnings to finance

future growth.

Dividend Policy• Factors that influence dividend policy:– Growth rate

• High-growth corporations have high demands for funds and pay low dividends.

– Stability of corporation’s earnings• High level of earnings stability reduces corporation’s

business risk• Allows higher dividend payout

– Rate of return earned on equity capital• If ROE is higher than stockholders’ opportunity rate of return

(return stockholders expect to earn on next-best-available investment opportunity), stockholders will benefit if corporation reinvests earnings.

Dividend Policy

• Factors (continued):– Overall liquidity position and access to money and

capital markets• Highly liquid corporation with easy access to capital markets

can pay out a higher percentage of earnings in dividends than less liquid corporation

– Outstanding debt repayment requirements and/or restrictive covenants on long-term debt agreements• Restrictive covenants prohibit dividend payments out of past

retained earnings and place a lower limit on rupee amount of net working capital that must be maintained.

Dividend Policy

Dividend Theory in Practice• Companies in high-growth industries face

attractive investment opportunities.– High demands for equity capital to finance growth– Pay no dividends or very low dividends

• Companies in low-growth industries have high dividend-payout ratios.

Dividend Policy

Dividend Theory in Practice• Firms strive to maintain stable dividend

payment from year to year.– Board considers likelihood that increased dividend

can be maintained in the future.• Constant percentage-payment ratio: firm

pays out same percentage of income to stockholders each year

Dividend PolicyStock Dividends and Stock Splits• Stock dividend: payment of dividend in the form of

additional shares of stock in corporation• Stock split: stock dividend of 25% or more (each existing

share is paid 0.25 or more shares as dividend)• Shareholder gains nothing from either stock dividend or

stock split.– Total number of shares claiming equity position is increased.– Each shareholder increases number of shares held in

proportion to number of shares held before split/dividend• Price of outstanding shares will decline by amount of split

if it is not accompanied by increase in earnings/dividends per share.

Dividend PolicyStock Repurchases• Companies can repurchase their own stock with

excess cash rather than pay dividend.• Stock repurchases (treasury stock) do not share

in future earnings/dividends.• After repurchase, there are fewer shares

outstanding.– Earnings per share increase if aggregate corporate

earnings remain the same.– Value of stock increases.– Stockholders receive capital gain rather than

dividend.

Economy & Finance

Sources of finance