Short-term and long-term financing
Letter of credit
A conditional commitment by a bank to pay a third party in accordance with specified terms and commitments
Zero-coupon bonds
A debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. -provide a profit to investors by selling at a deep discount and paying full face value when redeemed at maturity
Inverted yield curve
A downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates.
How is preferred stock different from common stock
A firm can have different classes or types of preferred stock with different characteristics and different preferences Cumulative/noncumulative feature to distinguish whether dividends no paid in any year accumulate and require payment before payment of common dividends Participating/nonparticipating feature to distinguish whether preferred shareholders receive dividends in excess of the stated preference rate Protective provisions to protect preferred shareholders' interest Convertible/nonconvertible feature to distinguish whether PS shareholders can exchange PS for CS according to specified exchange rate Call provision, which gives the firm the right to buy back the PS, normally at a premium
Inventory secured loan
A firm pledges all or part of its inventory as collateral for a short term loan. The amount that can be borrowed depends on the value and marketability of the inventory -cost of using inventory secured loans for financing will depend of nature of inventory used as collateral, credit standing of borrower, specific type of security agreement
Cost of financing with common stock
CAPM Arbitrage pricing model Bond-yield plus approach
Market rate of interest
Changes cause price of bonds to change inversely, investors in bonds face a market interest rate risk -longer-term fixed-rate debt has greater risk than short-term debt because there is a greater possibility that an increase in the market rate of interest will occur and result in a decline in the value of the debt -longer the term of bonds, greater the maturity premium and the higher the required rate of return
Bond yield measures
Current yield and yield to maturity
Maturity face value
Discounted as the present value of a single amount
Crowdfunding
raising money for a project or venture by obtaining many small amounts of money from many people
Mortgage bonds
secured by a lien on real property typically, the value of the real property is greater than that of the bonds issued, providing bondholders a margin of safety
Advantages and disadvantages of long-term note payable
Commonly available, long-term financing Poor credit ratings = higher interest rates, greater security requirements and more restrictive covenants, violation of restrictive covenants triggers serious consequences
How is preferred stock like common stock
Grants ownership interest, has no maturity date, does not require dividends be paid, provides that dividends paid are not an expense and are not tax deductible, has liability that is limited to the amount of the investment
Secured bonds
Have specific assets designated as collateral for the bonds
Cost of bond financing
Interest rate less the tax savings from the tax deductibility of interest expense -market interest rate x (1.0 - marginal tax rate) -when bonds are issued at par value, the coupon or stated rate of interest is the effective rate of interest and is the basis for determining the cost of debt --bonds will be issued at a discount when the bonds have a coupon rate of interest rate less than the market rate of interest ay the issue date; bonds will be issued at a premium when the bonds have a coupon rate of interest more than the market rate of interest at the date of issue
Retained earnings
Largely residual income -cost of capital for this would be less than the cost of capital for issuing new common stock due to floatation costs of issuing new securities
Finance lease
Legally enforceable, non-cancelable contract under which the lessee commits to making a series of payments to the owner of the asset for the use of the asset over the period of the lease
Net lease
Lessee assumes the cost associated with ownership during the period of lease -costs are referred to in accounting as executory costs and include maintenance, taxes, and insurance
Financial lease
Lessor buys equipment on behalf of the lessee, its usually for the life of the asset and is cheaper than operating -analysis would need to determine if proposed project is economically feasible if assets are purchased or leased
Investor related regulations
Limit the amount an individual investor may invest in offerings to: -if the investor's annual income or net worth is less than 107k, the greater of 2,200 or 5% of the lesser of their annual income or net worth -if both investor's annual income and net worth are equal to or greater than 107k, 10% of the lesser of their annual income or net worth, not to exceed 107k Limit maximum amount an investor may invest in all crowdfunding equity offerings during 12 month period to 107k Generally impose a one-year holding requirement before the securities may be resold
Advantages and disadvantages of leasing
Limited immediate cash outlay, possible lower cost than purchasing, debt is specific to amount needed, possibility of scheduling payments coincide with cash flows, no restrictive agreements than incurring certain other debt Not all assets are commonly available for lease, leasing financing is asset specific, lease terms may prove different than period of asset usefulness, often chosen for reasons other than economic justification
Hedging Principle of Financing
Long-term or permanent investments in assets should be financed with long-term or permanent sources of capital and short-term needs should be financed with short-term sources of financing -objective is to match cash flows from assets with cash requirements needed to satisfy the related financing
Bonds
Long-term promissory notes wherein the borrower, in return for buyers'/lenders', promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity
Why might leasing be better alternative
Lower cost
Floating lien agreement
The borrower gives a lien against all of its inventory to the lender but retains control of its inventory, which it continuously sells and replaces.
Chattel mortgage agreement
The borrower gives a lien against specifically identified inventory and retains control of the inventory, but cannot sell it without the lender's approval.
Tax rate benefit effect
The higher the tax rate, the greater the benefit of debt financing -the higher the tax rate faced by firm, the greater amount of tax saved from the use of debt financing compared to equity financing
Terminal warehouse agreement
The inventory used as collateral is moved to a public warehouse where it is held as security.
Field warehouse agreement
The inventory used as collateral remains at the firm's warehouse, placed under the control of an independent third-party and held as security.
Net-net lease
The lessee is responsible for not only executory costs but also pre-established residual value -particular nature will affect the cost of the lease to the lessee and the viability and benefits of leasing
Common stock
The most basic form of ownership, including voting rights on major issues, in a company -limited liability, residual claim to income and assets, right to vote, preemptive right
Yield to maturity
The rate of return required by investors in the market for owning a bond -the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today -similar to calculating IRR
Current yield
The ratio of annual interest payments to the current market price of the bond -annual coupon interest / current market price
Maturity
The time at which the issuer repays the par value to the bondholders
Structured note
Type of short-term NP where one whose cash flows are contingent on changes in the value of an underlying interest rate, stock index, commodity price, or other factor
Long-term notes
Typically used for borrowings normally from one to ten years, but some may be of longer duration -usually repaid in periodic installments over life of loan, and usually secured by mortgage on equipment or real estate -often contain restrictive covenants that impose restrictions on the borrower as to reduce likelihood of default -depends on general level of interest in market, creditworthiness of firm borrowing and nature and value of any collateral -expressed as function of prime interest rate
Debenture bonds
Unsecured; no specific asset is designated as collateral. These bonds are considered to have more risk and, therefore, must provide a greater return than secured bonds.
Pledging accounts receivable
Uses a current asset as security for short term borrowings -pledge all or some of AR as collateral for short term loan from commercial bank or finance company. if terms of agreement provide that all accounts receivable are pledged without regard to or an analysis of the collectability of individual accounts, the lender will lend a smaller portion of the face value of receivables than if only specific accounts with known risk are pledged
APR
[(Discount lost / principal) x 1] / time fractiopn of year -discount lost in percentage -principal = 1 - discount lost -- what would have been paid if discount is taken -time fraction of year = days between discount and due date / 360 days
Preferred stock
a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock
Revolving credit agreement
a guaranteed line of credit in which a bank makes a binding commitment to provide a business with funds up to a specified credit limit at any time during the term of the agreement -unsecured and have the same interest, maturity, and compensating balance as a regular line of credit
Flat yield curve
a yield curve that indicates that interest rates do not vary much at different maturities
Line of credit
an informal agreement between a borrower and a bank as to the maximum amount of funds the bank will provide at any one time -good only for the borrower's fiscal year and is not legally binding on financial institution -unsecured, has interest rate indexed to prime rate, and may require compensating balance -not arranged for specific purpose, it is for feneral use
Short-term financing
money that will be used for one year or less -trade accounts payable, accrued accounts payable, short-term NP, line of credit, commercial paper, pledging AR, factoring AR, inventory secured loans
Par value or face value
the "principal" that will be returned at maturity, most commonly $1,000 per bond
Coupon rate of interest
the annual interest rate printed on the bond and paid on par value
Floatation costs
the costs associated with issuing new stocks or bonds
With recourse
The seller retains the risk of uncollectibility
Common stock expected return
(Dividend in next year / market price) + growth rate
Indenture
The bond contract
Without recourse
A receivables-factoring transaction in which the purchaser assumes the risk of collectibility and absorbs any credit losses. The transfer of receivables in such a transaction is an outright sale of the receivables both in form (transfer of title) and substance (transfer of control).
Operating lease
A rental agreement; Lessee recognizes rental expense each period and an operating cash outflow; Lessor does not remove asset from balance sheet, recognizes rental income and continues to depreciate the asset
Compensating balance
Amount that the borrower maintains in a demand deposit account with the lender as a condition of the loan -amount required is usually expressed as a percentage of the loan and increases the effective cost of loan
Normal yield curve
An upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates.
Advantages and disadvantages of factoring receivables
Available, flexible (as AR occur, more are available for sale), compensating balance not required, provides cash for general use, buyer generally assumes billing and collection responsibilities Cost may be greater than other sources, if sold with recourse firms may have ongoing risk, sale of accounts may alienate customers
Advantages and disadvantages of inventory secured loans
Available, flexible, compensating balance not required, provides cash for general use Pledged inventory may not be available when needed, cost can be greater than certain other sources of short term financing, requires repayment in the short term, not available for certain inventory
Advantages and disadvantages of pledging AR
Available, flexible, compensating balance not required, provides cash for general use, lender may assume billing and collection services Accounts are committed to lender, cost may be greater than certain other sources of short term financing, requires repayment in short term
Advantages and disadvantages of line of credit
Available, flexible, unsecured, general use for cash High interest, fee, require satisfaction in short term, lacks flexibility of extension or other accommodation available in bank loans
Advantages of short term notes payable
Available, flexible, unsecured, provides cash, short maturity permits refinancing at lower cost if interest rate declines Poor credit rating results in high interest, requires satisfaction in short term, compensating balance increases cost and reduces effective funds available, refinancing at higher rates may be needed if interest rates increase
Convertibility
Convertible bonds that the bond holder has the option of converting the bonds into a specified number of shares of equity of the issuing company -convertible bonds will exercise the option to convert if the market price of the stock increases -usually pay lower interest rate than bonds without this. may also contain a call provision
Eurobonds
Debt security payable in the borrower's currency but sold outside the borrower's country -registration and disclosure requirements are less than in the US, so the bond can be issued at lower costs
Floating rate bonds
Debt security that pays a rate of interest that fluctuates over the life of the instrument. Typically, the rate of interest paid is tied to a macroeconomic benchmark rate -because the rate of interest paid floats with changes in a macroeconomic benchmark, the bonds tend to maintain their market value as the market rate of interest changes
Periodic interest
Discounted as the present value of an annuity
How is preferred stock like bonds
Dividend (like interest) is expected and limited in amount and generally preferred stock does not have voting rights
Advantages and disadvantages of trade accounts payable
Ease of use, flexible, interest not charged, unsecured, discount offered for early payment Requires payment in short term, higher effective cost if discounts not taken, use-specific (only assets acquired, not cash)
Advantages and disadvantages of accrued accounts payable
Ease of use, flexible, unsecured Requires satisfaction in short term, certain sources are use specific
Structured bonds
Either the periodic interest payment or the value at maturity varies with changes in one or more underlying, which might include specified stock or bond market indexes, commodity prices, currency exchange rates, or other factors -derivative instruments, so they derive their value from the value of the underlying -ex. callable bonds because the call option embedded in the bond which may provide for payment of a call premium based on an underlying -convertible as well because holder has option to convert bonds to stock
PSER
Expected rate of return for PS annual dividend / market price
Relationships with cost of capital
Macroeconomic conditions - market conditions and expectations concerning economic factors such as interest rates, tax rates, inflation/deflation rates Past performance of firm - reflects management operating and financial decisions and the riskiness associated with those decisions Amount of financing - recognized that the larger the absolute amount of financing sought, the higher the cost of capital Relative level of debt financing - recognizes that at some level of debt financing increasing financing sought through debt will increase the cost of marginal debt and result in increasing cost of capital Debt maturity - recognizes that the longer the maturity of debt, the higher the cost of capital Debt security - recognizes that the greater the value of collateral, the lower the interest rate and cost of capital
What are restrictions on long term notes
Maintaining certain working capital conditions Additional incurrence of debt Frequency and nature of financial information Management changes
Operating leverage
Measures the degree to which a firm incurs fixed cost in its operations -if fixed cost is high, a significant decrease in sales can dramatically affect operating results % change in operating income / % change in unit volume
Financial leverage
Measures the extent to which a firm uses debt financing -as more debt is issued, risk increases % change in EPS / % change in EBIT
Advantages and disadvantages of preferred stock
No legally required periodic payments (no default), generally lower cost of capital than common stock, generally does not bestow voting rights, no maturity date, no security required Dividend expectations are high, dividend payments are not tax deductible, protective provisions may be onerous if triggered, a higher cost of capital than bonds
Advantages and disadvantages of common stock
No legally required periodic payments, no maturity date, no security required Generally a higher cost of capital, dividends paid are not tax deductible, and addition shares issued dilute ownership and earnings
Trade accounts payable
Occurs in the normal course of business as a firm routinely buys goods or services on credit from its suppliers. The credit derived from this is not normally secured, in that no assets are pledged as collateral, but rather depend on borrowers ability and willingness to pay the obligation when due -highly flexible source of short term financing -trade credit is extended with the offer of a cash discount for early payment of obligation -annual effective rate of interest implicit in cash discount shows that effective cash management would take advantage of most cash discounts
Cost of financing with PS
Outstanding preferred stock - since the annual dividend is fixed and the market price will change to reflect changes in market perceptions of the stock, the expected rate of return reflects the rate investors currently require to invest in the stock. That rate is a measure of the firm's current cost of outstanding preferred stock capital New preferred stock - the cost of newly issued preferred stock is determined by dividing the annual dividend by the issue price, including any premium or discount
Regulations of crowdfunding
Preclude companies that have no specific business plan, companies that plan to merge with or acquire another unspecified company, certain investment companies, and companies that fail to comply with SEC Require all crowdfunding transaction take place through an SEC dealer or funding portal Limit the amount a company may raise through crowdfunding during any 12 month period to a maximum of 1 million Require certain reporting by the company the intended use of funds raised, the security price, and the total offering amount, a discussion of company's financial condition and disclosure of its financial statements
Common stock value
Present value of expected cash flows (expected dividends and stock price appreciation) -if only held for a year, the value is the sum of the present value of dividends expected at investor rate of return AND present value of expected stock market price at end of period discounted at investor rate of return -if multiple holding periods, expectations about future dividends and future stock prices become less certain. -dividend in first year / (required rate of return - growth rate)
Preferred stock values
Present value of expected future cash flows -dividends are only primary stream of future cash flows for preferred stocks -elements used to determine is estimated future annual dividends, discount rate in the form of investors' required rate of return, an assumption that the dividend stream will exist in perpetuity -annual dividend / required rate of return
Callability
Provide that bonds can be redeemed (bought back) by the issuer prior to maturity -used to enable the issuing firm to call in outstanding bonds if market rate of interest declines significantly below the interest being paid on the outstanding bonds to reduce interest expense -usually pay a higher rate of interest than comparable bonds without a call feature. the higher interest rate compensates the holder for the risk that the bonds will be called before maturity and the investor will be faced with reinvesting at a lower interest rate -may also provide that the issuer pay a premium at the time it calls the bond
Business risk constraint
Recognizes that a firm with higher variability in its operating results should limit the extent to which it uses debt financing -firms with higher risk have an increased change that operating results may cause default on fixed obligations and therefore should use less debt financing than a firm with steady operating results
Options after analyzing economic feasibility
Reject - if neither analysis shows economically feasible Purchase - traditional capital budgeting analysis shows the project to be feasible, but leasing-based analysis does not. both analyses show the project to be feasible but the traditional purchase analysis shows a better return Lease - leasing-based analysis shows the project to be feasible but traditional capital budgeting does not, both analyses is feasible but leading shows better return
Accrued accounts payable
Result from benefits or cash received for the related unpaid obligation -salaries and wages payable, taxes payable, unearned revenue
Short term notes payable
Result from borrowing, usually from commercial bank, with repayment due in one year or less. Typically for designated purpose require a promissory note to be given, and carry a rate of interest determined by the credit rating of the borrower -still unsecured unless borrower's credit rating dictates the lender require security -borrower may also be required to maintain compensating balance with lending institution
Factoring accounts receivable
Sake of AR to a commercial bank or other financial institution (factor) actual payment to the firm for its AR may occur at various times between date of sale and collection of AR -factor charges fee based on creditworthiness and length of maturity of receivables, and the extent to which the factor assumes risk of uncollectible
Bond characteristics
Security, callability, convertibility, zero-coupon bonds, floating rate coupons, eurobonds
Optimum capital structure objective
Seeks to minimize a firm's aggregate cost of permanent capital financing by using an optimum mix of debt and equity components. Since a corporation will have common stock, a major issue is how much debt financing it should use relative to its equity financing -objective is to determine the set or sets of capital sources that result in the lowest composite cost of capital for the firm
Term structure of interest rates
Shows the current yield to maturity on bonds of similar quality that have different lengths of times until maturity -commonly plotted with interest rates on the vertical axis and time until maturity on the horizontal axis
Advantages or disadvantages of bonds
Source of large sums of capital, does not dilute ownership or earnings per share, interest payments are tax deductible Required periodic interest payments (bankruptcy), required principal repayment at maturity (bankruptcy), may require security and/or restrictive covenants
Long-term financing
Sources of funds used by a firm that do not mature within one year -major source of funding for most firms with long length of commitment -long term notes, financial leases, bonds, preferred stock, common stock