Ø B3- introduction to long-term financial management :
Long-term financial management covers
how a firm finances its assets over the long term and is defined as more than a
year.
Capital structure:
The permanent/long-term sources
of financing that a company uses are referred to collectively as the company's capital structure. The source of permanent and long-term financing may be broken
down into external and internal sources. A firm's capital structure includes the long-term liabilities and equity sections of its balance sheet.
External fund:
External funds may be raised through
the issuance of debt securities, equity securities, long-term financing, or
other types of financing such as leasing.
Internal fund:
Internal funds are available from
profit, which the company generates but not distributes to the stockholders.[ retained
earnings]. The advantage of internal sources of capital is that there is no
cash cost. [ interest or dividend] to the company associated with these funds.
Ø Determined
the capital structure issuing debt or equity:
Affirm capital structure is the
mixture of capital that it uses to finance its assets.
The following factors should consider,
1.
The future prospects of the company.
2.
The equity market.
3.
The amount of risk, the companies are willing to
aspects.
4.
Reputations of the issuer.
5.
The cost of each source of capital.
6.
Usually capital structure is expressed in the terms
of percentage.
Example: debt, equity.
Ø Debt
financing ( bonds):
Bonds are means of financing in which
a company borrows money by selling debt securities [bonds] to investors. A bond
issue represents the bondholder's [ investors] loan to the issuing
company.
By selling the bonds, the company promises to pay the investors a certain amount of interest every period until the bond matures. On the maturity date, the company promises to pay the
investors the face amount of the bond.
Ø How
bonds work:
A bond represents a contract between
the issuer ( the borrower) and the bondholders ( the lenders) the legal contract is called the indenture (agreement, rules, and conditions) and it contains all
the terms and conditions.
On the face of the bond itself is a set of information, this information includes,
Bonds par value: it is started amount
[ the face value] of the bond.
Started interest rate; it is the
interest rate printed on the board.
Issue date: it is the on which
the bond was first issued by the company.
Maturity date: it is the date on
which the issuer will retire the bond by paying the face amount of the bond to
the bondholders.
The sale price of the bond: bonds
are valued and sold at the present value of all of the future cash payments the
company. The company will make the interest payment and the final
principal repayments. The present value is calculated by using the market rate
of interest on the sale date for bonds of similar terms and risk.
Ø Types
of bonds:
1. Convertible
bonds:
Beneficial to the holder of the
bond can be converted by the bondholder into a stated number of shares of the
issuer's common stock at any time during the bond's life. It is advantageous for bondholders
if the price of the firm's common stock increases.
2. Debenture
bond:
Riskier for the holder of the
bonds unsecured, meaning they are not backed by any specific assets as collateral.
The only backing to the bond is the credit worthless of the company itself.
3. Mortgage
bond:
Less risky for the shareholders
of the bond to have specific assets or assets pledged as collateral for the loan.
4. Subordinated
debenture:
More risk for the holder of the
bond. Are bonds that will not have the first claim to the asset of the company.
In case of bankruptcy because the bonds are subordinated to other debt.
In case of bankruptcy, all
superior debt will be settled before subordinated debentures.
5. Income
bond:
Riskier for the holder of the
bond. Pay interest only if the company achieves a certain level of income.
6. Serial
bonds:
Serial bonds allow investors to choose the term that fits their needs.
7. Indexed
bonds:
Having an interest rate is indexed
to some other measures, such as a price indexed or general economic indicators instead of playing a fixed interest rate they pay a variable interest rate.
8. Zero
coupon bond:
Do not pay any interest, but they
sell at a price significantly less than the face value.
9. Participating
bond:
Beneficial to the holder of the
bond. Can participate in dividends the company's profit distribution during
a period of high profit.
The terms international bonds include,
1.
Foreign bond
2.
Euro bond
Both are sold outside of the issuing company’s home country.
Ø
Foreign bonds: Are issued in a country that is
denominated in a currency that is different from the currency of the country In
which they are sold.
Example: a US company may issue bonds in Japan that are denominated
in yen.
Ø
Euro bonds are international bonds that are
different from the currency of the country in which they are sold. Example:
euro bond denominated in Japanese yen could be issued in Canada by an Australian
company.
Ø
Bond and rating agency:
A firm that issues bonds must have its debts issues related
by outside agencies for which pay them a fee. The primary rating agencies are moody’s
investor’s service standard and flitch rating.
The top four categories of each agency’s rating system are
considered investment grade quality, while bonds rated that are considered
speculative grade or junk bonds.
Euro bonds are less expensive because of the absence of
government regulations.
Ø
Special features that bond may have:
Bonds may also be sold with special features. The most
common provisions for bonds are,
a.
A call provision: gives the issuer the option of
buying back the bond before its maturity at a given price. If interest rates
are expected to decline a call provision would be advantageous for the issuer
but not advantageous for the investor on the bond. Call provision bond investors’
risk increases return also increase.
b.
A put provision:
If certain events occur or if the issuing company violates any
bond covenants an investor can require that the issuer repurchase the bonds
from him. A put provision beneficial to the investor. Risk decreases return
also decreases.
c.
A convertible clause:
Allows an investor to convert the bond into common stock at
a specified conversion rate. It is a benefit to investors because risk decreases
return also decreases.
Restrictive covenants: limit the company’s activities that
could be determinantal to the bondholder. Example:
1.
Sinking fund: may be required.
A mortgage bond covenant may include,
A negative pledge clause starts that the issuer will not
pledge any of its assets as security for other debts.
Ø
Benefits of issuing bonds:
The bond issuer has no loss of control or ownership. The total
cost of the bonds is limited and known. Interest paid on a bond is limited and
known. Interest paid on a bond is tax deductible as a business expense. If the
bonds are collab or can otherwise be retired early.
Ø
Limitations of issuing bonds:
Debt as a source of capital creates less flexibility for the
company than equity. the issuing company assumes increased risk because of the possibility
of default. As the level of debt grows the interest rate on the next loan or bond
and the return required by not only the debt holder but also the company’s shareholders
will increase. The maturity of the debt will result in a large future cash
payout. the terms of the bond issue may include restrictive terms and consonants
that must be adhered to by the issuer.
Ø
Duration:
All bonds will change in value in value as the market rate
of interest changes. Market interest rate increases bond value also increases. Market
interest rate decreases bond value also decreases.
This change in the value of the bond is the interest rate change
in interest rate risk. The best measure of this interest rate risk for bonds is
their duration. A bond’s duration is a measure of how much the value of a bond
changes when the interest rate changes.
For example: when the market interest rate increase by 1%
then the bond market value will decrease by 2.74% and vice versa.