20-1
Long-Term Debt,
Preferred Stock,
and Common Stock
u Bonds and Their Features
u Types of Long-Term Debt
Instruments
u Retirement of Bonds
u Preferred Stock and Its
Features
u Rights of Common
Shareholders
u Dual-Class Common
Stock
20-2
Bonds and Their
Features
Basic Terms Basic Terms
Par Value
Coupon Rate
Maturity Bond
Ratings
Bond Bond -- A long-term debt instrument
with a final maturity generally being
10 years or more.
20-3
Trustee and
Indenture
Trustee Trustee -- A person or institution designated
by a bond issuer as the official
representative of the bondholders.
Typically, a bank serves as trustee.
Indenture Indenture -- The legal agreement, also called
the deed of trustdeed of trust, between the corporation
issuing bonds and the bondholders,
establishing the terms of the bond issue and
naming the trustee.
20-4
Types of Long-
Term Debt
Instruments
u Investors look to the earning power of the firm as
their primary security.
u Investors receive some protection by the
restrictions imposed in the bond indenture,
particularly any negative-pledge clausenegative-pledge clause.
u A negative-pledge clause negative-pledge clause precludes the
corporation from pledging any of its assets (not
already pledged) to other creditors.
Debenture Debenture -- A long-term, unsecured debt
instrument.
20-5
Types of Long-
Term Debt
Instruments
u In this case, subordinated debenture holders rank
behind debenture holders but ahead of preferred and
common stockholders in the event of liquidation.
u Frequently, the security is convertible into common
stock to lower the yield required by subordinated
debenture holders (often less than regular
debentures).
Subordinated Debenture Subordinated Debenture -- A long-term,
unsecured debt instrument with a lower claim
on assets and income than other classes of
debt; known as junior debt.
20-6
Types of Long-
Term Debt
Instruments
u Frequently, there is a cumulative feature, cumulative feature, which
provides that any unpaid interest in a particular year
accumulates. The cumulative obligation is usually
limited to no more than three years.
u The bonds are unpopular with investors (usually
limited to reorganizations), but are still senior to
preferred and common shareholders in the event of
liquidation.
Income Bond Income Bond -- A bond where the payment of
interest is contingent upon sufficient
earnings of the firm.
20-7
Types of Long-
Term Debt
Instruments
u These are bonds with a rating of Ba (Moody's) or
lower.
u Principal investors are pension funds, high-yield bond
mutual funds, and some individual investors.
u Liquidity varies depending on investor sentiments.
u Junk bonds were used frequently in the 1980s as a
means of financing leveraged buyouts (LBOs).
Junk Bond Junk Bond -- A high-risk, high-yield (often
unsecured) bond rated below investment
grade.
20-8
Types of Long-
Term Debt
Instruments
u The issue is secured by a lienlien on specific specific
assets assets of the corporation.
u The market value of the collateral should
exceed the amount of the bond issue by a
reasonable margin of safety to help
protect bondholders.
Mortgage Bond Mortgage Bond -- A bond issue secured by a
mortgage on the issuer’s property.
20-9
Types of Long-
Term Debt
Instruments
u If the corporation defaults, the trustee can
foreclose on behalf of the bondholders. The
bondholders become general creditors for
any residual amount after the sale of the
collateral.
u The corporation may have a first mortgage
and a second mortgage on the same assets.
The first mortgage has a senior claim on the
assets.
Mortgage BondMortgage Bond (Continued)
20-10
Types of Long-
Term Debt
Instruments
u A railroad arranges with a trustee to purchase
equipment from a manufacturer.
u The railroad signs a contract with the manufacturer
for the construction of specific equipment.
u When the equipment is delivered, equipment trust
certificates are sold to investors.
Equipment Trust Certificate Equipment Trust Certificate -- An intermediate- to long
-term security, usually issued by a transportation
company such as a railroad or airline, that is used to
finance new equipment.
Let us look at an example using a railroadLet us look at an example using a railroad..
20-11
Types of Long-
Term Debt
Instruments
u Proceeds plus the railroad downpayment are used
to pay the manufacturer.
u Title of the equipment is held by the trustee, and
the trustee leases the equipment to the railroad.
u Lease payments are used to pay a fixed dividend
to the certificate holders and to retire a specified
portion of the certificates at regular intervals.
u After the final lease payment (all certificates are
retired), title to the equipment passes to the
railroad.
Equipment Trust CertificatesEquipment Trust Certificates (Continued)
20-12
Asset
Securitization
u Purpose: To reduce financing costs
u Firm picks assets to “package” and use cash flows
u Assets removed from the balance sheet and sold to bankruptcy
-remote entity (special-purpose vehicle -- SPV)
u SPV raises money by selling asset-backed securities
Asset Securitization Asset Securitization – The process of packaging a
pool of assets and then selling interests in the pool in
the form of asset-backed securities.
Asset-backed SecurityAsset-backed Security – Debt securities whose
interest and principal payments are provided by the
cash flows coming from a discrete pool of assets.
20-13
Retirement of
Bonds
u The corporation makes a cash payment to the
trustee, which calls the bonds.
u The corporation purchases bonds in the open
market and delivers them to the trustee.
Sinking Fund Sinking Fund -- Fund established to periodically
retire a portion of a security issue before
maturity. The corporation is required to make
periodic sinking-fund payments to a trustee.
Two forms for the sinking-fund Two forms for the sinking-fund
retirement of a bondretirement of a bond::
20-14
Sinking Fund and
the Retirement of
Bonds
u When bonds are called for redemption,
the bondholders will receive the sinking-sinking-
fund call pricefund call price.
u The bonds are called on a lottery basis (by
their serial numbers) and published in
periodicals like The Wall Street JournalWall Street Journal.
u Bonds should be purchased in the open
market if the market price is less than the
sinking-fund call pricesinking-fund call price.
20-15
Sinking Fund and
the Retirement of
Bonds
u Volatility in interest rates or a decline in
the credit quality of the firm could lower
the market price of the bond and enhance
the value to the firm of having this option.
u Bondholders may benefit from the orderly
retirement of debt (amortization effect),
which reduces the default risk of the firm
and adds liquidity to bonds outstanding.
20-16
Sinking Fund and
the Retirement of
Bonds
u Many bond issues are designed to have a
larger final payment to pay off the debt.
u For example, a corporation may undertake a
$10 million, 15-year bond issue. The firm is
obligated to make $500,000 sinking-fund
payments in the 5th through 14th years. The
final balloon payment in the 15th year would be
for the remaining $5 million of bonds.
Balloon Payment Balloon Payment -- A payment on debt that
is much larger than other payments.
20-17
Serial Bonds
u For example, a $10 million issue of serial
bonds might have $500,000 of predetermined
bonds maturing each year for 20 years.
u Investors are able to choose the maturity that
best fits their needs (wider investor appeal).
Serial Bonds Serial Bonds -- An issue of bonds with
different maturities, as distinguished from
an issue where all bonds have identical
maturities (term bonds).
20-18
Call Provision
u Not all bonds are callable. In periods of low
interest (hence, low coupon) rates, firms are
more likely to issue noncallable bonds.
u When a bond is callable, the call pricecall price is
usually above the par value of the bond and
often decreases over time.
Call Provision Call Provision -- A feature in an indenture that
permits the issuer to repurchase securities at
a fixed price (or series of fixed prices) before
maturity; also called call featurecall feature.
20-19
Call Price
u For example, the call price for the first year
might equal the bond par value plus one-
year’s interest.
u According to when they can be exercised, call
provisions can be either immediate or
deferred.
u The call provision provides financing flexibility
for the firm as conditions change.
Call Price Call Price -- The price at which a security with
a call provision can be purchased by the
issuer prior to the security’s maturity.
20-20
Value of the Call
Privilege
u The call privilege is valuable to the firm to the
detriment of bondholders. As such, bondholders
require a premiumpremium for this additional risk in the
form of a higher yield.
u The greater the volatility of interest rates, the
greater the probability that the firm will call the
bonds. Thus, the call-option call-option is more valuable all
else equal.
Callable-bondCallable-bond
valuevalue
Noncallable-Noncallable-
bond valuebond value
Call-optionCall-option
valuevalue=
-
20-21
Preferred Stock Preferred Stock -- A type of stock that
promises a (usually) fixed dividend, but at
the discretion of the board of directors.
Preferred
Stock and Its
Features
Basic Terms Basic Terms
Par Value
Dividend Rate
Maturity
20-22
Cumulative
Dividends
Feature
u For example, if the board of directors omits a $6
preferred dividend for two years, it must pay
preferred shareholders $12 per share ($100 par
value) before any dividend can be paid to common
shareholders.
u The corporation does not have to make up the
dividend even if it is profitable, as long as the firm
has no plans to pay dividends to common
shareholders.
Cumulative Dividends Feature Cumulative Dividends Feature -- A requirement
that all cumulative unpaid dividends on the
preferred stock be paid before a dividend may
be paid on the common stock.
20-23
Participating
Feature
u Preferred stockholders have a prior claim on income
and an opportunity for additional return if the
dividends to common stockholders exceed a certain
amount.
u A 6% participating preferred issue ($100 par) allows
holders to share equally in any dividend in excess of
$6. A $7 common dividend results in an extra $1
dividend to the participating preferred shareholders.
Participating Preferred Stock Participating Preferred Stock -- Preferred stock where
the holder is allowed to participate in increasing
dividends if the common stockholders receive
increasing dividends.
20-24
Voting Rights in
Special
Situations
u Preferred stockholders are not normally given a
voice in management unless the company is unable
to pay preferred stock dividends during a specified
period.
u If such a situation presents itself, the class of
preferred stockholders would be entitled to elect a
specified number of directors.
u Any situation in which the company defaults under
restrictions in the agreement (similar to bond
indenture) may lead to voting power for preferred
shareholders.
u Preferred shareholders cannot force the immediate
repayment of obligations (like debt obligations).
20-25
Retirement of
Preferred Stock
uu Call ProvisionCall Provision -- almost all issues carry a call
provision because of the infinite maturity. It is often a
cheaper method of retirement than open market
purchases, inviting tenders, or an exchange of
securities.
uu Sinking FundSinking Fund -- like bonds, many preferred issues
provide for this method of retirement.
uu ConversionConversion -- certain issues are convertible into
common stock at the option of the preferred
stockholder. Used most frequently in the acquisition
of other companies (the transaction is not taxable to
the shareholders of the acquired firm).
20-26
Use of Preferred
Stock in
Financing
u The corporate issuer corporate issuer uses irregularly because the
preferred dividend is not tax deductible. Utilities use
more frequently as the preferred dividend can be
accounted for when setting customer rates.
u The corporate investor corporate investor is attracted to preferred stock
as generally 70% of dividends can be excluded from
taxes.
u Flexibility in paying dividends and an infinite maturity
(similar to a perpetual loan) are significant advantages
to the corporate issuercorporate issuer.
u The after-tax cost of preferred financing is greater than
that of long-term debt financing to the corporate corporate
issuerissuer.
20-27
Common
Stock and Its
Features
Basic Terms Basic Terms
Authorized Shares
Issued Shares
Outstanding Shares
Common Stock Common Stock -- Securities that
represent the ultimate ownership (and
risk) position in a corporation.
20-28
Types of
Common Stock
Value
u It is merely a recorded figure in the corporate
charter and is of little economic consequence.
u Stock should never be issued below par value as
shareholders would be legally liable for any
discount from par if the firm is liquidated.
u Common stock that is authorized without par
value (no-par stock) is carried on the books at the
original market price or at some assigned (or
stated) value.
u The difference between the issuing price and the
par or stated value is additional paid-in capitaladditional paid-in capital.
. Par ValuePar Value -- The face value.
20-29
Example of
Value
FunFinMan, , Inc.
Common stock ($1 par value$1 par value; 100,000
shares issued and outstanding) $
100,000
Additional paid-in capital
400,000
Retained earnings
650,000
Total shareholders’ equity
$1,150,000
The par value par value of FunFinMan, Inc.,FunFinMan, Inc., is $1 per share$1 per share.
This value is not likely to change over time from
normal day-to-day operations.
20-30
Types of
Common Stock
Value
. Liquidating Value (per share)Liquidating Value (per share) -- The value
per share if the firm’s assets are sold
separately from the operating organization.
u This value may be less (or greater) than
book value. Rarely are the two values
identical.
. Book Value (per share)Book Value (per share) -- Shareholders’ equity
(as listed on the balance sheet) divided by the
number of shares outstanding.
20-31
Example of
Book Value (per
share)
FunFinMan, , Inc.
Common stock ($1 par value; 100,000 100,000
shares shares issued and outstanding) $
100,000
Additional paid-in capital
400,000
Retained earnings
650,000
Total shareholders’ equity
$1,150,000$1,150,000
The book value book value (per share) of FunFinMan, Inc.,FunFinMan, Inc., is
determined by dividing total shareholders’ equity total shareholders’ equity
($1,150,000) by the shares outstanding (100,000100,000),
which yields a book value of $ per sharebook value of $ per share. This
value is not likely to change over time from normal
day-to-day operations.
20-32
Types of
Common Stock
Value
u This value is usually greater than book
value (per share), but can occasionally be
less than book value (per share) for firms
that have been, are or expected to be in
financial difficulties. Rarely are the two
values identical.
u Market value (per share) may be difficult
to obtain from thinly traded securities.
. Market Value (per share)Market Value (per share) -- The current price
at which the stock is currently trading.
20-33
Types of
Common Stock
Value
u Typically, the shares of new
companies are traded in the over-the-
counter (OTC) market, where dealers
maintain an inventory of the stock to
provide additional liquidity.
. Market Value (per share)Market Value (per share) -- continued.
20-34
Rights of
Common
Shareholders
uu Right to IncomeRight to Income -- entitled to share in the earnings of
the company only if cash dividends are paid (via
approval by the board of directors).
uu Right to Purchase New Shares (Maybe)Right to Purchase New Shares (Maybe) -- the
corporate charter of state statute may provide
current shareholders with a preemptive right, which
requires that these shareholders be first offered any
new issue of common stock or an issue that can be
converted into common stock.
uu Voting RightsVoting Rights -- because the shareholders are
owners of the firm, they are entitled to elect the
board of directors.
20-35
u Two methods of voting: (1) in person or (2) by proxy
ProxyProxy -- A legal document giving one person
authority to act for another.
Voting Rights
u SEC regulates the solicitation of proxies and requires
companies to disseminate information to their
shareholders through proxy mailings.
u Most shareholders, if satisfied with company
performance, sign proxies in behalf of management.
u Shareholders are generally geographically widely
dispersed.
20-36
Voting
Procedures
uu Majority-rule votingMajority-rule voting -- a method of electing corporate
directors, where each common share held carries one
vote for each director position that is open; also
called statutory votingstatutory voting.
uu Cumulative votingCumulative voting -- a method of electing corporate
directors, where each common share held carries as
many votes as there are directors to be elected and
each shareholder may accumulate these votes and
cast them in any fashion for one or more particular
directors.
The board of directors are elected under either:
20-37
Voting
Procedures
Example
uu Under majority-rule votingUnder majority-rule voting: You may cast 100 votes
(1 per share) for each of the 9 director positions
open for a maximum of 100 votes per position.
uu Under cumulative votingUnder cumulative voting: You may cast 900 votes
(100 votes x 9 positions) for a single position or
divide the votes amongst the 9 open positions in
any manner you desire.
You are a shareholder of You are a shareholder of FunFinMan, Inc. FunFinMan, Inc.
You own 100 shares and there are 10 director You own 100 shares and there are 10 director
positions to be to be filled.
20-38
Minimum Votes to
Elect a Director --
Cumulative
u For example, to elect 3 directors out of 9 director
positions at FunFinMan, Inc., (100,000 voting shares
outstanding) would require 30,001 voting shares30,001 voting shares.
u (100,000 shares) x (3 directors)
10
Total number of
voting shares
Specific number of
directors sought
Total number of directors to be elected + 1
X
+ 1
+ 1 = 30,001 shares30,001 shares
20-39
Minimum Votes to
Elect a Director --
Cumulative
u Notice that slightly over 30% of total voting shares
are necessary to guarantee the election of three of
the nine director positions -- less than a majority.
u Management can reduce the influence of minority
shareholders by reducing the number of directors
or staggering the election terms of directors so
fewer positions are open at each vote.
u Reducing the number of directors up for election
from 9 to 4 would increase the votes necessary to
elect 3 directors to 60,001 shares (twice as many)!
