Long-term Debt and Preferred Stock Financing
Long-term debt means replacing short debt with securities of longer maturity. Long-term debt often is called funded debt. It is one of major long-term source of financing.
The big firm can raise fund by selling long-term bonds/debenture in the open market. Debt-holders becomes the creditor of the debt issuing company.
There is a claim on the firm’s income and assets as started in the bond contract is called indenture. The rights, facilities, obligation of investors are indicated in the indenture. There are many types of long-term debt instruments i.e. term loan, bond, secured and unsecured notes, marketable and non-marketable debt and so on.
The loan can be raised from the public by issuing a bond or debentures by public limited companies. Bonds are normally issued in different denominations ranging from $100 to $1000 and carry a different rate of interest.
As compared with preference shares, bonds provide a more convenient mode long term funds. The cost of capital raised through the bond is quite low since the interest payable on bonds can be charged as an expense before tax.
From the investor’s point of view, bond offers a more attractive, prospect the preference share. Interest on bonds is payable whether or not the company making a profit.
Features of Long-term debts are as follows:
- The debt holder usually does not have the right view.
- If the bonds go into default, the debtholder is taken control of the company.
- The debtholder does not participate in supervisor profit.
- Interest payment on a debt is deductible as tax expenses.
- Debt usually has a fixed maturity date.
- Debts are either secured or unsecured.
- In the debt issue, there is a sinking fund provision.
- Debt Instrument
There are many types of long-term debt instrument: term loans, bonds, secured and unsecured notes, marketable and non-marketable debt and so on we consider some innovations in long-term debt financing.
Tradition Debt Instruments
Term Loan: A term loan is a contract under which a borrower agrees to make a service of interest and principal payment on specific dates to the lender.
A term loan usually is negotiated directly between the borrowing firm and financial institution-generally bank an insurance company or pension fund. Although term loan maturities vary from 2 to 30 years, most are for the period in the 3 years to 15 years range.
The term loan has three major advantages over public offering:
- Speed, Flexibility and low issuance costs.
- They are negotiated directly between the lender and the borrower, formal documentation is minimized.
- The key provisions of term loan can be worked out much more quickly than those for a public issue and it is not necessary for the loan to go through the securities and exchange commission registration process.
When the term loan is scheduled to be repaid in equal periodic installments(payments), it is known as an amortized loan.
Lenders use a loan amortizations schedule to determine periodic equal installment and the allocation of each payment to interest and principal. The annual amount of periodic installment to be paid off that includes both principal and interest. The annual payment is calculated by the following formula:
Example: Prepare an amortization schedule for a $1 million 3 – years 9 % loan.
Loan Amount (PVA) = $ 10, 00, 000
No. of Years (n) = 3 Years
Interest Rate (k) = 9 %
Annual Payment (PMT) = ?
Annual payment (PMT) = Loan Amount / (PVIFA k n)
= 10, 00, 000 / (PVIFA 9%,3)
= $10, 00, 000 / 2.5313
= $ 395053.92
The end of year 3, the remaining balance should be zero. Here, the reason for remaining balance different from zero is due to rounding off error in computing the PVIFA. If we use a financial calculator remaining balance would be zero at the end of the third year.
Bound: A bond is a long term contract under which a borrower agrees to make payments of interest and principal, on a specific date, to the holders of the bond.
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it is issued by a corporation or government sector to meet the financing needs or budget deficit. The borrower or company aggress to make a series of interest payments until the maturity period and principal payments at the end of the maturity period.
Bonds may be classified as treasury bonds, corporate bonds, municipal bond, foreign bond, etc. Treasury bonds issued by the government such as National Banks.
The corporate bond issued by a corporation and they may be secured or unsecured. A secured bond is secured by the pledge of Mortgages or collateral. The unsecured bond is known as a debenture. Municipal bonds are issued by local government and foreign bonds are issued by foreign corporation or government.
The various types of corporate bonds are available in the capital market. Some of them are as follows:
Mortgage Bond: With a mortgage bond, the corporation pledges certain assets as a security for the bond. In the event of liquidation, first mortgages bonds are senior in priority to claim of second mortgage bonds.
Debenture: A debenture is an unsecured and such it provides no line against specific property as security for the obligation. Therefore debenture holders are general creditors whose claims are protected by property not otherwise pledged.
Sub-ordinate Debenture: As its name implies, subordinated debentures are inferior debenture. In the event of liquidation, subordinated debenture holders have a claim on assets only after senior debenture holder’s claim is satisfied.
Convertible Bond: Convertible bonds are exchangeable into common stock of the option of the holder and under specified terms and conditions. Once converted into stock, the stock can’t be exchanged again for a bond. The ratio of exchange between the convertible bond and the common stock can be stated in-term of either on conversion price or a conversion ratio.
Warrant: Warrant is a long term option which gives the holder right purchase specified no of shares at a pre-determined price within or on certain future date. It is attached with a bond or preferred with a bond or preferred stock.
Put-able bond: Put-able bond may be turned in and exchanged for cash at the holder’s option. Generally, the put option is exercised only if the firm takes some specified action such as acquiring a weak company or increasing its outstanding debt by a bulk amount.
Income bond: Income bonds provide that interest must be paid only if the earnings of the firm are sufficient to meet the interest obligations. A company is obligated to pay interest on an income bond only when the interest is earned.
Contemporary Bond or Bond Innovation
Zero-Coupon Bond: A bond that pays on annual interest bit is sold at a discount below par, thus providing compensation to investors in the form of capital appreciation.
Floating rate bond: A bond whose interest rate fluctuates with shifts in the general level of interest rates is set for say the initial six-month period, after which it is adjusted every six months, based on the same market interest rate.
Indexed Bond: Index or purchasing power bonds have their interest rate payments tied to an inflation index, such as the consumer price index; thus protecting the bondholders against inflation.
Junk Bond: A high risk, high yield bond and generally used finance mergers, leveraged buyouts, and troubled companies are called junk bond. High rated bonds are called investment grade bonds; low rated bonds are called speculative grade bonds or less formally called a junk bond.
Specific Debt Contract Features
The managers of the firm are concerned with the debt cost as well as the restrictions imposed on the debt contract that might in the actions of the firm in the future period. The debt capital carries special characteristic that affects either in the cost or in the firm’s future flexibility. Let’s discuss specific debt contract features.
- Bond Indentures: All mortgage bond are written subject to an indenture, which is a legal document that spells out in detail the rights of both holder and corporation.
- Call Provision: A call provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. The call provision states that the company must pay the bondholder’s an amount greater than par value for the bonds when they are called. The call price may be higher than par value and this difference represents the call premium.
- Refunding: A company sells bonds/preferred stock at the time when interest rates are relatively high provided the issue is callable, as may are, the company can sell a new issue of low-yielding securities if and when interest rates drop and use the precedes to retire the high rate issue, this is called a refunding operation.
- Sinking funds: A sinking fund is a provision that facilitates the orderly retirement of a bond issue. Typically, the sinking fund provision requires the firm to retire a portion of the bond issue each year.
The might be required to deposit money with a trustee, which invest the funds and there uses the accumulated sum to retire the bonds when they mature the firms are given to handle the sinking bond in either of two ways:
- The company can call in for redemption a certain percentage of the bond each year.
- The company might buy the required amount of bonds in the open market.
What are the Advantages of Long-term Debt
Advantages of long-term debt company’s point of views
- The specific cost of debt is less expensive.
- No interference in management and control.
- The interest payment is tax-deductible, the company will able to save tax.
- In the case of overcapitalization, the company can redeem the debt.
- A provision a bond contract that gives the issuer the rights to redeem the bonds under specified terms prior to the maturity date.
Advantages of preferred stocks from investor’s point of views
- It earns a fixed and stable rate of return.
- It has a high order of priority in the event of a liquidation.
- It has low risk than other securities.
- Debt can sell easily in the open market.
Disadvantages of Long-term Debt
Disadvantages of long-term debt company’s viewpoints
- At the end of the maturity period, the company has to return the principal.
- Reduction in the company’s goodwill.
- The company has earned or not, it has to keep on paying interest on time.
- After the issue of debt, if there is a decrease in interest rate, then the company will suffer.
- Its possibility of insolvency.
Disadvantages of Preferred stocks from an investor’s viewpoint
- If the company earns a huge profit, the debt holder is received a fixed rate of coupon interest.
- The debt holder does not have a right to participate in shareholders meeting and voting rights.
- The rate of return on debt is less than other securities.
Preferred share is that share which gets a fixed rate of dividend determined before issuance. A preference share is one of the important sources of long-term financial fund.
Preference shareholders are that kind of owners of the company who have first priority to get the dividend.
Through the preference, shareholders are the owners of the company they have more responsibility toward the company than the debenture bondholders. They get dividend after the bonds and debentures are paid off.
If the company goes insolvency the preference shareholders get a capital return after the debenture and bondholders but before the ordinary shareholders so, it is clear that preference share by its name is the prior right holder than ordinary share.
Preference shareholders have no right in managing and controlling the company as their investment is a risk-free investment. So, they don’t have a voting right except for some special conditions too. Long-term funds from preference shares can be raised through a public issue of shares.
Preference share capital is a hybrid form financing which imbibes within its self some features of equity capital and some attributes of debt capital.
It is similar to equity because preference share dividend, like equity dividend, is not tax-deductible payment. It resembles debt capital because the rate of preference dividend is fixed.
Features of Preferred Stock
Preferred shares have several features. Some of them one common to all types of preferred shares while others are specific to some.
Claims on Income and Assets: Preference share is a senior as compared to common shares. It has a prior claim on the company’s income in the sense that the company must first pay preference dividend before paying an ordinary dividend.
It also has a prior claim on the company’s assets in the event of a liquidation.
Fixed Divided: The dividend rate is fixed in the case of preference share. The preference share dividend rate is expressed as a percentage of the par value. A preference share is called fixed-income security because it provides a constant income to investors.
Cumulative Dividends: Most of the preference shares carry a cumulative feature, requiring that all pat unpaid preference dividend be paid before any dividend is paid.
The feature is a protective device for preference shareholders.
Redemption: On the basis of the maturity period preference shares are two types: First perpetual or irredeemable preference share does not have a maturity date. Second, a redeemable preference share has a specified maturity.
Sinking Fund: Like in the case of debentures, sinking fund provision may be created to redeem preference share.
Call Feature: The call features allow the company to buyback preference share at a stipulated buyback or call price. Call price may be higher than face value.
The difference between the call price and per value of the preference share is called premium.
Participation Features: Preference shares may in some cases have participation features which entitle preference shareholders to participate in extra profit earned by the company. This means that preference shareholders may set a dividend amount in excess of the fixed dividend.
Voting Rights: Preference shareholders ordinary do not have any voting rights. They may be entitled do contingent voting rights.
Convertibility: Preference share may be convertible or non-convertible. A convertible preference share allows preference shareholders to convert their preference shares, fully or partly into share at a specified price during a given period of time.
Types of Preferred Stock
Major types of preferred stock are as follows:
- Cumulative and non-cumulative preferred share
- Convertible and Non-convertible
- Redeemable and irredeemable preferred stock
- Participative and non-participative preferred stock
Advantages of Preferred Stock
Advantages of preferred stocks from the company’s viewpoint
- It has a fixed period.
- It avoids the danger of bankruptcy if earnings are to low to meet these fixed charges.
- High yielding preferred stock may be replaced by low yielding preferred stock.
- There is a legal obligation to pay preference dividend.
- It is a flexible source of financing.
- It avoids control of the company.
- It avoids participation in earnings.
Advantages of preferred stocks from an investor’s viewpoint
- Seventy to eighty percent of the preferred stock dividend received by the corporation’s investor is not taxable.
- It provides a reasonably steady income.
- Preferred stockholders have preference over common stockholder in liquidation.
- It provides a stable dividend rate.
Disadvantages of Preferred Stock
Disadvantages of preferred stocks from the company’s viewpoint
- If the preferred stock is called before the maturity period, the call premium is generally paid.
- No payment of preferred stock dividend can affect the goodwill of the company.
- The dividend can not be generally paid on common stock without paying a dividend on preferred stock.
- If the company were successful, their return would be fixed. Therefore it is difficult to sell the stock.
Disadvantages of Preferred stocks from an investor’s viewpoint
- Preferred stockholders have no legally enforceable right to a dividend.
- For an individual as opposed to corporate investors, after-tax bond yields generally are higher than that on preferred stock, even though the preferred stock is riskier.
- Price fluctuation in preferred stock may be greater than those in bond.
- The return on preference share is limited if the company has earned more profit.
- There are no voting rights.