Long-term financing. Review item When a firm creates value through a financial transaction, who...
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Transcript of Long-term financing. Review item When a firm creates value through a financial transaction, who...
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.
Chapter 14 Long-Term Financing: An Introduction
Common Stock
Corporate Long-term Debt: The Basics
Preferred Stock
Patterns of Financing
Recent Trends in Capital Structure
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
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.
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. A minority can elect at least one
director.
How many votes are needed to elect one director?
n directors. Minority has fraction x of all votes. Assume the worst, your opponent plays
optimally. He votes (1-x)/n for each of n seats (no
cheap seats). You need x > (1-x)/n, that is, x > 1/(n+1) (plus one vote)
Example
Smith and Marshall Four seats. Smith is the minority. Fraction of votes needed to elect is 1/5. Smith needs only 1/5 + 1 vote. Marshall
can muster 3/5 of the total votes for 3 candidates and 1/5 – 1 votes for the fourth.
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.
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.
Notes, debentures, bonds
Notes are shorter term, unsecured. Debentures are long term, unsecured. (Mortgage) bonds are secured.
Call provisions
Specified in the indenture. Call price is above par … but is below market when called. Call protection for 5 or 10 years
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
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.
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.
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.
Financing Decisions by U.S. Non-financial Corporations
-30
0
30
60
90
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Internal financingNew debtNew stock
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.
Year
Percent
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.
Debt-to-Asset Ratio (Book Value) for U.S. Non-financial Firms from 1979 to 1994
0
10
20
30
40
50
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
Percent
Source: OECD data from the 1995 edition of Financial Statements of Nonfinancial Enterprises.
Debt-to-Asset Ratio (Market Value) for U.S. Non-financial Firms from 1980 to 1994
0
10
20
30
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
Percent
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.
Review Item
Two assets have the same expected return.
Each has a standard deviation of 2%. The correlation coefficient is .5. What is the standard deviation of an
equally weighted portfolio?