Corporate Financing Decisions Long-Term Financing

1. Corporate Financing DecisionsLong-Term Financing Finance - Pedro Barroso

2. Long-Term Debt • Corporate debt can be short-term (maturity less than one year) or long-term • Different from common stock: • Creditor’s claim on corporation is specified • Promised cash flows • No voting rights • Over half of outstanding bonds are owned by life insurance companies & pension funds Corporate Finance - Pedro Barroso

3. Features of Long-Term Debt • Bond indenture (written agreement between the corporate debt issuer and the lender) usually lists • Amount of Issue, Date of Issue, Maturity • Denomination (Par value) • Annual Coupon, Dates of Coupon Payments • Security (Collateral) • Sinking Funds • Call Provisions • Covenants • Features that may change over time • Rating • Yield-to-Maturity • Market price Corporate Finance - Pedro Barroso

4. Seniority • Seniority indicates preference in position over other lenders – senior or junior debt • Some debt is subordinated; In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first Corporate Finance - Pedro Barroso

5. Security - Collateral • Security is a form of attachment to property • It provides that the property can be sold in event of default to satisfy the debt for which the security is given • A mortgage is used for security in tangible property • Debentures are not secured by collateral Corporate Finance - Pedro Barroso

6. Protective Covenants • Agreements to protect bondholders • Negative covenant: Shall not: • pay dividends beyond specified amount • sell more senior debt & amount of new debt is limited • refund existing bond issue with new bonds paying lower interest rate • buy another company’s bonds • Positive covenant: Shall: • use proceeds from sale of assets for other assets • allow redemption in event of merger or spinoff • maintain good condition of assets • provide audited financial information Corporate Finance - Pedro Barroso

7. Bond Ratings • What is rated: • The likelihood that the firm will default • The protection afforded by the loan contract in the event of default • Who pays for ratings: • Firms pay to have their bonds rated • The ratings are constructed from the financial statements supplied by the firm • Ratings can change, and raters can disagree Corporate Finance - Pedro Barroso

8. Moody's S&P's Credit Rating Description Aaa AAA Highest credit rating, maximum safety Aa1 AA+ Aa2 AA High credit quality, investment - grade bonds Aa3 AA - A1 A+ A2 A Upper - medium quality, inve stment grade bonds A3 A - Baa1 BBB + Baa2 BBB Lower - medium quality, investment grade bonds Baa3 BBB - Bond Ratings: Investment Grade Corporate Finance - Pedro Barroso

9. Moody's S&P's Credit Rating Description Speculative - Grade Bond Ratings Ba1 BB+ Low credit quality, speculative - grade bonds Ba2 BB Ba3 BB - B1 B+ Very low credit quality, speculative - grade bonds B2 B B3 B - Extrem ely Speculative - Grade Bond Ratings Caa CCC Extremely low credit + standing, high - risk bonds CCC CCC - Ca CC Extremely speculative C C D Bonds in default Bond Ratings: Below Investment Grade Corporate Finance - Pedro Barroso

10. Junk Bonds • Anything with S&P “BB+” or Moody’s “Ba1” or below is a junk bond • A polite euphemism for junk is high-yield bond • There are two types of junk bonds: • Original issue junk • Fallen angels—rated • Yield premiums versus default risk Corporate Finance - Pedro Barroso

11. Different Types of Bonds • Callable Bonds • Puttable Bonds • Convertible Bonds • Pure Discount Bonds • Floating-Rate Bonds Corporate Finance - Pedro Barroso

12. Preferred Stock • Represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy • Preferred shares have a stated liquidating value • Preferred dividends are either cumulative or noncumulative • No voting rights • Similar to debt Corporate Finance - Pedro Barroso

13. Corporate Financing DecisionsIssuing Securities to the Public Corporate Finance - Pedro Barroso

14. Public Issue • The Basic Procedure • Management gets the approval of the Board. • The firm prepares and files a registration statement with the SEC. • The SEC studies the registration statement during the waiting period. • The firm prepares and files an amended registration statement with the SEC. • If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway. Corporate Finance - Pedro Barroso

15. An Example of a Tombstone Corporate Finance - Pedro Barroso

16. Alternative Issue Methods • There are two kinds of public issues: • General cash offer (IPOs, SEOs) • Rights offer (SEOs) • Almost all debt is sold in general cash offerings Corporate Finance - Pedro Barroso

17. Firm Commitment Underwriting • The issuing firm sells the entire issue to the underwriting syndicate • The syndicate then resells the issue to the public • The underwriter (fee) makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold • The syndicate bears the risk of not being able to sell the entire issue for more than the cost • This is the most common type of underwriting in the United States Corporate Finance - Pedro Barroso

18. IPO Underpricing • May be difficult to price an IPO because there is not a current market price available • Private companies tend to have more asymmetric information than companies that are already publicly traded • Underwriters want to ensure that, on average, their clients earn a good return on IPOs • Underpricing causes the issuer to “leave money on the table” Corporate Finance - Pedro Barroso

19. Costs of Equity Public Offerings Proceeds Direct Costs Underpricing (in millions) SEOs IPOs IPOs 2 - 9.99 2.88% 15.36% 18.18% 10 - 19.99 8.81% 11.63% 10.02% 20 - 39.99 7.24% 9.81% 17.91% 40 - 59.99 6.20% 9.21% 29.57% 60 - 79.99 5.81% 8.65% 39.20% 80 - 99.99 5.56% 8.34% 45.36% 100 - 199.99 5.00% 7.67% 37.10% 200 - 499.99 4.26% 6.72% 17.72% 500 and up 3.64% 5.15% 12.19% Corporate Finance - Pedro Barroso

20. Private Placements • Private placements avoid the costly procedures associated with the registration requirements that are a part of public issues • The SEC restricts private placement issues to no more than a couple of dozen knowledgeable investors, including institutions such as insurance companies and pension funds • The biggest drawback is that the securities cannot be easily resold Corporate Finance - Pedro Barroso

21. Rights • If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders • This allows shareholders to maintain their percentage ownership if they so desire Corporate Finance - Pedro Barroso

22. Mechanics of Rights Offerings • The management of the firm must decide: • The exercise price (the price existing shareholders must pay for new shares) • How many rights will be required to purchase one new share of stock • These rights have value: • Shareholders can either exercise their rights or sell their rights Corporate Finance - Pedro Barroso

23. Rights Offering Example • Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price • What is the new market value of the firm? • What is the ex-rights price? • What is the value of a right? Corporate Finance - Pedro Barroso

24. What is the New Market Value of the Firm? There are 200,000 outstanding shares at $25 each There will be 10,000 new shares issued at a $20 subscription price Corporate Finance - Pedro Barroso

25. $5,200,000 210,000 shares What Is the Ex-Rights Price? • There are 210,000 outstanding shares of a firm with a market value of $5,200,000. • Thus the value of an ex-rights share is • Thus, the value of a right is: $0.2381 = $25 – $24.7619 = $24.7619 Corporate Finance - Pedro Barroso

26. Private Equity Market • The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market • For start-up firms and firms in financial trouble, the public equity market is often not available Corporate Finance - Pedro Barroso

27. Venture Capital • The limited partnership is the dominant form of intermediation in this market • There are four types of suppliers of venture capital: • Old-line wealthy families • Private partnerships and corporations • Large industrial or financial corporations have established venture-capital subsidiaries. • Individuals, typically with incomes in excess of $100,000 and net worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks. Corporate Finance - Pedro Barroso

28. Long-Term Syndicated Bank Loans • Large money-center banks frequently have more demand for loans than they have supply • Small regional banks are often in the opposite situation • As a result, a larger money center bank may arrange a loan with a firm or country and then sell portions of the loan to a syndicate of other banks • A syndicated loan may be publicly traded Corporate Finance - Pedro Barroso

29. Corporate Financing DecisionsLeasing Corporate Finance - Pedro Barroso

30. Types of Leases • A lease is a contractual agreement between a lessee and lessor • The lessor owns the asset and for a fee allows the lessee to use the asset Corporate Finance - Pedro Barroso

31. Manufacturerof asset Firm U Lessor Lessee (Firm U) • Uses asset 1. Owns asset 1. Uses asset • Owns asset 2. Does not use asset 2. Does not own asset Equity shareholders Creditors Buying versus Leasing Buy Lease Firm U buys asset and uses asset; financed by debt and equity Lessor buys asset, Firm U leases it Manufacturer of asset Equity shareholders Creditors Corporate Finance - Pedro Barroso

32. Operating Leases • Usually not fully amortized • Usually require the lessor to maintain and insure the asset • Lessee enjoys a cancellation option Corporate Finance - Pedro Barroso

33. Financial Leases The exact opposite of an operating lease • Do not provide for maintenance or service by the lessor • Financial leases are fully amortized • The lessee usually has a right to renew the lease at expiry • Generally, financial leases cannot be cancelled Corporate Finance - Pedro Barroso

34. Sale and Lease-Back • A particular type of financial lease • Occurs when a company sells an asset it already owns to another firm and immediately leases it from them • Two sets of cash flows occur: • The lessee receives cash today from the sale • The lessee agrees to make periodic lease payments, thereby retaining the use of the asset Corporate Finance - Pedro Barroso