Chapter 15: Long-Term Financing

15.1.Common stock: The most popular kind of stock, common stock represents
shares of ownership in a firm. When people talk about stocks, they are usually
referring to common stock. In actuality, this is how the vast majority of stock is
issued.
 Common stock means no special preference either in receiving dividends or
in bankruptcy.
Common shares represent a claim on profits (dividends) and confer voting rights.
Investors most often get one vote per share owned to elect board members who
oversee the major decisions made by management. Stockholders thus have the
ability to exercise control over corporate policy and management issues compared
to preferred shareholders.
Common stock tends to outperform bonds and preferred shares. It is also the type of
stock that provides the biggest potential for long-term gains. If a company does well,
the value of a common stock can go up. But keep in mind, if the company does
poorly, the stock's value will also go down.
Features of Common stock:
Voting right : Shareholders have the right to vote for the board of directors and
other important issues: M&A.
+ Straight voting: directors are elected one at a time; each time, the number of votes
is not cumulated.
+ Cumulative voting: all directors are elected at one time; the number of votes each
shareholder can cast can be cumulated: = number of shares the shareholder holds *
the number of directors up for election. Cumulative voting increases the likelihood
of minority shareholders getting a seat on the board.
+ Staggered voting: only a fraction of directors is up for election at a particular
time.
Overall, staggering has two basic effects:
1. Staggering makes it more difficult for a minority to elect a director under
cumulative voting because fewer directors are elected at one time.

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 2. Staggering deters takeover attempts because of the difficulty of voting in a
majority of new directors.
*Note: 1 share, 1 vote
EX: Peter has 20 shares, 4 directors are up for election.
With straight voting, Peter can cast the maximum of 20 votes for each director.
With cumulative voting, Peter can cast the maximum of 20x4=80 votes for one
director because all directors are elected at the same time and votes can be
cumulated.
To guarantee that you get a seat on the Board of directors, you need to have at
least:
- Straight voting: (50% x number of shares outstanding) + 1 share
- Cumulative voting: [1/(N+1)] x number of shares outstanding + 1 share
N: the number of directors up for election
E.g. A company has 10,000 shares outstanding; 3 directors are up for election.
What’s the minimum number of shares you need to have to guarantee that you get a
seat on the Board of directors?
Straight voting =
Cumulative voting =
Proxy voting: When shareholders are absent at the meeting, they grant the right to
vote their shares to someone else.
Classes of stock: For example, Google has 2 classes of common stock:
+ Class A: 1 share has 1 vote; class A is held by the public.
+ Class B: 1 share has 10 votes; class B is held by founders and insiders  maintain
the control of the company.
=> Creating of different classes of shares allows management of a firm to raise
equity capital while maintaining control.
Other rights
 Share proportionally in declared dividends
 Share proportionally in assets remaining after liabilities have been paid in a
liquidation

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  Preemptive right – first shot at new stock issue to maintain proportional
ownership if desired. ( Preemptive right buộc một công ty phải bán cổ phiếu
cho những người sở hữu cổ phiếu hiện có của mình trước khi chào bán cổ
phiếu ra công chúng. Quyền cho phép mỗi cổ đông bảo vệ quyền sở hữu tương
xứng của mình trong công ty.) SEO, IPO

Some important characteristics of dividends include the following:

1. Unless a dividend is declared by the board of directors of a corporation, it is not
a liability of the corporation. A corporation cannot default on an undeclared
dividend. As a consequence, corporations cannot become bankrupt because of
nonpayment of dividends. The amount of the dividend and even whether it is paid
are decisions based on the business judgment of the board of directors.
2. Dividends are paid out of the corporation’s aftertax cash flow => They are not
business expenses and are not deductible for corporate tax purposes.
3. Dividends received by individual shareholders are taxable.

15.2. Preferred stock: Preferred stock is a form of equity from a legal and tax
standpoint. It is important to note, however, that holders of preferred stock usually
have no voting privileges. Preferred stock pays a cash dividend expressed in terms
of dollars per share. Preferred stock has a preference over common stock in the
payment of dividends and in the distribution of corporation assets in the event of
liquidation. Preference means only that holders of preferred shares must receive a
dividend (in the case of an ongoing firm) before holders of common shares are
entitled to anything. Preferred stock typically has no maturity date.
Fearture of prefferred stock
 Preferred shares have a stated liquidating value. Stated dividend must be paid
before dividends can be paid to common stockholders
 Dividends are not a liability of the firm, and preferred dividends can be
deferred indefinitely
 Most preferred dividends are cumulative – any missed preferred dividends
have to be paid before common dividends can be paid.

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 Note: Unpaid preferred dividends are not debts of the firm. Preferred dividends may
be postponed indefinitely by directors appointed by common shareholders. Common
shareholders must, however, also sacrifice dividends in certain circumstances.
Additionally, if preferred dividends have not been paid for a while, preferred share
holders may be given voting and other privileges.
Similarities between preferred stock and debt:
- Stated dividend
- Stated liquidating value
- Sometimes can be converted to common stock
Differences between preferred stock and debt:
- Preferred stock has no maturity date
- Dividends are not tax deductible
- Dividends are not the obligation of the company

15.3. Debt vs Equity

From a financial point of view, the main differences between debt and equity
are:
1. Debt is not an ownership interest in the firm, creditors generally do not have
voting power. While equity is an ownership interest and common stockholders can
vote for the BOD and others issues
2. The corporation’s payment of interest on debt is considered a cost of doing
business and is fully tax deductible. Dividends paid to stockholders are not tax
deductible.
3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally
claim the assets of the firm. This action can result in liquidation or reorganization,
two of the possible consequences of bankruptcy. Thus, one of the costs of issuing
debt is the possibility of financial failure. This possibility does not arise when equity
is issued.
The bond indenture is a legal document includes the following provisions:
- The basic terms of the bonds.
- The total amount of bonds issued
- A description of property used as security.

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 - Seniority.
- The repayment arrangements.
- Sinking fund: an account managed by the bond trustee and used to repay the
bonds. Each year, the company transfers money to sinking fund to retire the
bonds.
Benefit of sinking fund: Lower default risk, better credit rating
The call provisions: allows the issuing company to repurchase (buy back) the
bond any time prior to maturity at a specified price.
- Details of the protective covenants.
Negative covenant: prohibits some actions, e.g., limits the amount of
dividends a company can pay.
Positive covenant: specifies an action that the company needs to take, e.g.,
requires the company to maintain a minimum level of working capital.

Bond classification
• Registered vs. Bearer Forms (Corporate bonds are usually in registered form)
• Security
• Collateral (tài sản đảm bảo) – secured by financial securities
• Mortgage (thế chấp) – secured by real property, normally land or
buildings
• Debentures (trái khoán tín dụng) – unsecured vì không được bảo đảm
bằng tài sản thế chấp. Các nhà đầu tư mua debentures sẽ có nguy cơ lỗ
và gánh chịu rủi ro lạm phát nếu debentures trả nợ thấp hơn so với mức
lạm phát. Trong trường hợp vỡ nợ thì người nắm giữ debentures sẽ được
trả sau collateral và mortgage nhưng sẽ trước những cổ đông nắm giữ
common stock.
• Notes – unsecured debt with original maturity less than 10 years
• Seniority: thể hiện mức độ ưu tiên của các lenders. Debt có thể được phân loại
như senior, junior hay subordinated. Trong trường hợp vỡ nợ thì những ng giữ
subordinated bond sẽ đc trả nợ sau khi cty trả nợ cho các chủ nợ ưu tiên khác
(vd như senior).

Required Yields

The coupon rate depends on the risk characteristics of the bond when issued
• Which bonds will have the higher coupon, all else equal?
• Secured debt versus a debenture

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 • Subordinated debenture versus senior debt
• A bond with a sinking fund versus one without
• A callable bond (call provision) versus a non-callable bond
Pure discount bond: PV of pure discount bond = F/(1+r)T
Where F (par value)
r: discount rate
T: maturity day

Floating Rate Bond

• Coupon rate floats depending on some index value
• Examples – adjustable rate mortgages and inflation-linked Treasuries
• There is less price risk with floating rate bonds
• The coupon floats, so it is less likely to differ substantially from the
yield to maturity. (less volatility)
• Coupons may have a “collar” – the rate cannot go above a specified “ceiling”
or below a specified “floor”

Other Bond Types:

- Income bonds: coupon payments depend on level of corporate income.
Coupons are paid to bondholders only if the firm’s income is sufficient. If
earnings are not enough to cover the interest payment, it is not owed. =>
higher required return
- Convertible bonds: A type of bond can be swapped for a fixed number of
shares of stock anytime before maturity at the holder’s option => lower
required return
- Put bonds (put provison): bondholder can force the issuer to buy the bond
back prior to maturity => less risky for bondholders=> Lower required
return

15.4. Bank loans

In addition to issuing bonds, a firm may simply borrow from a bank. Two important
features of bank loans are lines of credit and syndication.
Line of credit:
• Provide a maximum amount the bank is willing to lend
• If guaranteed, referred to as a revolving line of credit

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 Ex: A $45 million revolver with a three-year commitment, meaning the company
could borrow all or part of the amount at any point during the following three years.
A commitment fee is typically charged on the revolver's unused portion. If the
commitment charge is 0.5% and the company loans $15 million in a given year,
leaving 30 million unborrowed. The dollar commitment fee would be
30,000,000*0.5%=150,000 for that year, in addition to the interest on the $15 million
actually borrowed.

Syndicated Loan (vay hợp vốn)

• Very large banks frequently have more demand for loans than they have
supply.
• Small regional banks frequently have more funds on hand than they can
profitably lend to existing customers=> they cannot generate enough
good loans with the funds they have available
• As a result, a very large bank may arrange a loan with a firm or country
and then sell portions of the loan to a syndicate of other banks. With a
syndicated loan, each bank has a separate loan agreement with the
borrowers
• A syndicated loan may be publicly traded. It may be a line of credit and
be “undrawn,” or it may be drawn and used by a firm. Syndicated loans
are always rated investment grade (investment grade là điểm đầu tư
xếp hạng chất lượng tín dụng của một trái phiếu.). However, a leveraged
syndicated loan is junk. (low credit rating, below investment grade).
• Syndicated loan (line of credit, L/C, leveraged loan..)

15.5. International bond

+Eurobonds: bonds denominated in a particular currency and issued
simultaneously in the bond markets of several countries
+Foreign bonds: bonds issued in another nation’s capital market by a foreign
borrower

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 1/ A French company issues a bond denominated in U.S. dollar to the U.S. bond
market
2/ A Japanese company issues a bond denominated in Japanese yen to the bond
markets in China, Mexico, Brazil, Canada, the U.S., Korea, etc

15.6. Pattern of financing

Firms need financing for capital expenditures, working capital, and other long-term
uses. Most of the financing is provided from internally generated cash flow. When
uses of cash flow exceed internal financing, stocks and bonds must be issued to fill
the financial deficit

1. The shareholders of the Stackhouse Company need to elect seven new directors.
There are 900,000 shares outstanding currently trading at $41 per share. You would

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 like to serve on the board of directors; unfortunately no one else will be voting for
you. How much will it cost you to be certain that you can be elected if the company
uses straight voting? How much will it cost you if the company uses cumulative
voting?
2. Candle box Inc. is going to elect nine board members next month. Betty Brown
owns 17.4 percent of the total shares outstanding. How confident can she be of
having one of her candidate friends elected under the cumulative voting rule? Will
her friend be elected for certain if the voting procedure is changed to the staggering
rule, under which shareholders vote on three board members at a time?
3. New Business Ventures, Inc., has an outstanding perpetual bond with a 10 percent
coupon rate that can be called in one year. The bond makes annual coupon payments.
The call premium is set at $150 over par value. There is a 60 percent chance that the
interest rate in one year will be 12 percent, and a 40 percent chance that the interest
rate will be 7 percent. If the current interest rate is 10 percent, what is the current
market price of the bond?

Chapter 16. Capital Structure: Basic Concept

16.1 The Capital Structure Question and the Pie Theory

The value of the firm equals the market value of the debt plus the market value of
the equity (firm value identity).

This is just: V = B + E.
B: market value of debt
E: market value of equity
Unleverd firm: all-equity, no debt
Levered firm: with debt
If the goal of the management of the firm is to make the firm as valuable as possible,
then the firm should pick the debt–equity ratio (D/E) that makes the pie—the total
value—as big as possible.
This discussion begs two important questions:
1. Why should the stockholders in the firm care about maximizing the value of the
entire firm?

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 2. What ratio of debt to equity maximizes the shareholders’ interests?
When the market value of debt is given and constant, any change in the value of the
firm results in an identical change in the value of the equity. The key to this reasoning
lies in the fixed nature of debt and the residual nature of stock => Managers should
choose the capital structure that they believe will have the highest firm value because
this capital structure will be most beneficial to the firm’s stockholders.
16.2 Financial Leverage and Firm Value: An Example

A.Leverage and Returns to Shareholders

EPS (Earnings per share) = Net income / Number of shares outstanding
ROE (Return on equity) = Net income / Total equity
ROA (Return on asset) = Net income / Total assets

Example
Current Proposed
Assets $5,000,000 $5,000,000
Debt 0 2,500,000
Equity 5,000,000 2,500,000
D/E ratio 0 1
Share price (assume it does not change with repurchase) $10 $10
Shares outstanding 500,000 250,000
Interest Rate N/A 10%

The firm borrow 2,500,000 and buy back 250,000 share at $10/share

Current capital structure: No debt

Recession Expected Expansion

EBIT $300,000 $650,000 $1,000,000
Interest Expense 0 0 0
Net Income $300,000 $650,000 $1,000,000
ROE 6% 13% 20%
EPS $0.60 $1.30 $2.00

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 Current share outstanding: 500,000

Proposed share outstanding: 250,000

Assume no taxes, we can conclude that

 When there is a bad time, using debt (leverage) gives lower EPS and ROE.
 When there is a good time, using debt (leverage) increases EPS and ROE.
 The effect of financial leverage depends on EBIT.
 The variability of EPS and ROE is increased with leverage

Break-even point:
EBIT/number of shares outstanding under current capital structure
= (EBIT – Interest= debt*interest rate ) / number of shares outstanding under
proposed capital structure
EX: VNM is debating between a leveraged and an unleveraged capital structure.
The all equity capital structure would consist of 50,000 shares of stock. The debt and
equity option would consist of 25,000 shares of stock plus $250,000 of debt with an
interest rate of 7 percent. What is the break-even level of earnings before interest
and taxes between these two options? Ignore taxes.

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 EPS = Net income/Share outstanding.
*Note: If we expect EBIT less than the break-even EBIT (bad time), should not use
debt.
If we expect EBIT greater than the break-even EBIT (good time), should use debt.
B. The choice between debt and equity
At this point, we can see that leverage is beneficial because EPS is expected to be
$1.6 with leverage and only $1.3 without leverage. However, leverage also creates
risk. In a recession, EPS is higher ($0.6 vs $0.2) for the unlevered firm. Thus a risk-
averse investor might prefer the all-equity firm, whereas a risk-neutral (or less risk-
averse) investor might prefer leverage. Given this ambiguity, which capital structure
is better?
Assumption of M&M model
Perfect Capital Markets:
 Perfect competition

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  Firms and investors can borrow/lend at the same rate
 Equal access to all relevant information
 No transaction costs, no agency costs, no bankruptcy costs
 No taxes
16.3 M&M Proposition I (no taxes) – without corporate taxes and bankruptcy
costs, the firm cannot affect its value by altering its capital structure. We can create
a levered or unlevered position by adjusting the trading in our own account.
This homemade leverage suggests that capital structure is irrelevant in determining
the value of the firm:
VL = VU
Homemade leverage (đòn bẩy tự chế): Một nhà đầu tư cá nhân sẽ sử dụng đòn bẩy
tự chế (homemade leverage) để thao túng đòn bẩy của công ty (levered firm). Một
người đầu tư vào một doanh nghiệp mà không sử dụng đòn bẩy có thể mô phỏng tác
động của đòn bẩy bằng cách tạo ra đòn bẩy của riêng họ, bao gồm cả việc vay cá
nhân để đầu tư.

Strategy A: Buy 100 share of levered equity

Strategy B: Borrow $2000 at the interest rate 10%. Then use own investment +
borrow = 2000+2000=4000 to buy share of current unlevered equity at the price
$20/share => 200 shares

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 Result: The same net earning and same initial cost in two strategy. Investor receives
the same payoff whether he/she buys shares in a levered corporation or buys shares
in an unlevered firm and borrows on personal account. Her initial investment is the
same in either case. Thus we must conclude that the company is neither helping nor
hurting its stockholders by restructuring (adding debt to capital structure).
Modigliani and Miller showed a blindingly simple result: If levered firms are priced
too high, rational investors will simply borrow on their personal accounts to buy
shares in unlevered firms. As long as individuals borrow (and lend) on the same
terms as the firms, they can duplicate the effects of corporate leverage on their own.
16.4 M&M Proposition II (no taxes)
A. Risk to Equityholders Rises with Leverage

Leverage affects beta. Therefore, we know that increased leverage increases the
risk of equity
Rs = R0 + (B/S)*(R0-RB)
 Rs is the return on (levered) equity (cost of equity)
 R0 is the unlevered cost of equity
 RB is the interest rate (cost of debt)
 B is the value of debt
 S is the value of levered equity
 M&M Proposition II (no taxes): Cost of levered equity increases with
leverage.
Because debt is cheaper than equity, even though cost of levered equity increases
with leverage, the cost of capital (WACC) remains unchanged.

B. Proposition II: Required Return to Equityholders Rises With

Leverage

M&M Proposition II – a firm’s cost of equity capital is a positive linear function

of its capital structure (still assuming no taxes):

RWACC= (S/B+S)*Rs + (B/B+S)*Rb

 RWACC : cost of capital
 Rs: cost of equity
 Rb: cost of debt
 B: market value of debt

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  S: market value of equity
 Cost of capital (WACC) in an all-equity firm:
RWACC = R0

16.5 Proposition I (with Corporate Taxes):

Firm value increases with leverage
VL = VU + TCB where: VU = EBIT(1-Tc) / R0
With taxes, interest expense on debt is tax deductible. Therefore, firm value
increases when firm uses debt.
The tax saving is: BRBTc : interest tax shield
Assume perpetual cash flow. The present value of interest tax shield: BRBTc / RB
= BTc
Conclusion: With taxes, the value of a levered firm increases by the present value
of interest tax shield. This is the M&M proposition I (with taxes).
16.6 Proposition II (with Corporate Taxes):
Some of the increase in equity risk and return is offset by the interest tax
shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)

B SL
RW ACC = ´ RB ´ (1 - TC ) + ´ RS
B+SL B + SL
The optimal capital structure is the debt-equity mix that minimizes the WACC
and, therefore, maximizes firm value.
With taxes, as the firm increases debt, the cost of equity increases, but the
deductibility of interest more than offsets this increase, which reduces the WACC.

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 In the world of taxes, financial leverage has an effect on the firm value. Firm value
is maximized when the firm uses as much debt as possible due to the interest tax
shield

Plan I Plan II
EBIT (1) $1,000,000 $1,000,000
Interest (10%)= Rb*B (2) 0 500,000
EBT (3) = (1) – (2) 1,000,000 500,000
Taxes (Tc=35%) (4) 350,000 175,000
EAT (5) = (3) – (4) 650,000 325,000
Total CF to both stockholders and
650,000 825,000
bondholders = (5) + (2)

Exercise 1: Highland has debt with both a face and a market value of $12,000. This
debt has a coupon rate of 6 percent and pays interest annually. The expected earnings
before interest and taxes are $2,000, the tax rate is 30 percent, and the unlevered cost
of capital is 11 percent. What is the firm's cost of equity?

Exercise 2: Bruce & Co. expects its EBIT to be $180,000 every year forever. The
firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity is
15 percent.

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 a) If the tax rate is 30 percent, what is the value of the firm? What will the value
be if Bruce borrows $130,000 and uses the proceeds to repurchase shares?
b) what is the cost of equity after recapitalization? What is the WACC? What are
the implications for the firm’s capital structure decision?

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