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Long-term financing

Long-term financing. Review item. When a firm creates value through a financial transaction, who gets the increase?. Answer. Old equity means the shareholders at the time the decision is made. Old equity gets the gains.

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Long-term financing

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  1. Long-term financing

  2. Review item • When a firm creates value through a financial transaction, who gets the increase?

  3. Answer • Old equity means the shareholders at the time the decision is made. • Old equity gets the gains. • Why? Old equity has no competitors. Everyone else is competitive and must accept a market return.

  4. Chapter 14 Long-Term Financing: An Introduction • Common Stock • Corporate Long-term Debt: The Basics • Preferred Stock • Patterns of Financing

  5. Shareholders rights • Preemptive right to a proportionate share of any new stock sold. • Proportionate share in dividends. • Proportionate share in liquidation. • Voting rights … of some kind

  6. Straight voting • Each seat on the board of directors is a separate election. • In each election, the shareholder has votes in proportion to her shares. • A thin majority can freeze out minority directors.

  7. Cumulative voting • All directors are elected in a single election. • The n highest vote getters are elected. • Each shareholder has votes in proportion to her shares. • When can a elect at least one director?

  8. How many votes are needed to elect one director? • n directors. • Minority has fraction x of all votes. • The majority plays optimally. • Majority votes (1-x)/n for each of n seats (no cheap seats). • Minority needs x > (1-x)/n, that is, x > 1/(n+1) • x = 1/(n+1) plus one vote

  9. Example • Adam Smith and Alfred Marshall • Four seats. • Smith is the minority, needs 1/5 of the votes to elect one director. • Check: Smith has 1/5 + 1 vote. Marshall can muster 3/5 of the total votes for 3 candidates and 1/5 – 1 votes for the fourth. The fourth loses. Smith gets a director.

  10. Example: majority lacks discipline • Hamas has 40% of the voters. • Fatah has 60%. • 6 seats to be filled. • Hamas runs 4 candidates, gets 10% per candidate • Fatah runs 10 candidates, gets 6% per candidate. • Hamas gets 4 of the 6 seats. • Fatah could have had 4 of 6.

  11. Dividend facts • Dividends are not tax deductible to the corporation that pays them. • Corporations owning other corporations are exempt from 70% of the tax that would otherwise fall on dividends. • Skipping dividends does not put a firm in default.

  12. Debt • Contractual relation with the firm, via the indenture. • No voting rights. • Interest is deductible from corporate taxes. • Missing any interest payment puts the firm in default.

  13. Notes, debentures, bonds • Notes are shorter term, unsecured. • Debentures are long term, unsecured. • (Mortgage) bonds are secured.

  14. Sinking funds • Debt is gradually extinguished. • Money in the fund buys back the bonds steadily.

  15. Call provisions • Specified in the indenture. • Call price is above par … • but is below market when called. • Call protection for 5 or 10 years

  16. Indenture • Among creditors, a coordination problem. Prisoner’s dilemma. Free rider problem. • Solution: trustee (a law firm) • Restrictive covenants -- new debt, size of dividends, minimum working capital

  17. Default of bonds • If the firm misses a debt payment to any bond, repayment of all other bonds is immediately due, an impossible task. • Bondholders get control of the firm. • Bankruptcy proceedings or reorganization.

  18. Preferred stock • Stated percentage dividends. • No voting rights. • Preferred dividends can be skipped but are rarely, and only if common dividends are skipped. • Contingent voting rights when the firm is near bankruptcy.

  19. Corporations hold preferred stock • Not individuals, because taxes are higher to them. • Individuals hold preferred by holding common in firms that hold preferred. • Corporations pay tax on interest from the debt of other corporations but only 30% on preferred dividends.

  20. Uses of Cash Flow (100%) Sources of Cash Flow (100%) Capital spending 98% Internal cash flow (retained earnings plus depreciation) 97% Internal cash flow Financial deficit Net working capital plus other uses 2% Long-term debt and equity 3% External cash flow The Long-Term Financial Deficit (2002)

  21. Internal financing New debt New stock Financing Decisions by U.S. Non-financial Corporations Percent 90 60 30 0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 -30 Year Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.

  22. Convertible debt – an option • Can be traded for shares at a fixed price. • Need not be traded. • Rationale: cash in on success if the firm becomes vary valuable • Retain rights of debt if the firm fails.

  23. Debt-to-Asset Ratio (Book Value) for U.S. Non-financial Firms from 1979 to 1994 Percent 50 40 30 20 10 0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Year Source: OECD data from the 1995 edition of Financial Statements of Nonfinancial Enterprises.

  24. Debt-to-Asset Ratio (Market Value) for U.S. Non-financial Firms from 1980 to 1994 Percent 30 20 10 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Year Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.

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