Sources of Long-Term Financing
Learning objectives:
1. Define “equity financing” and “debt financing”
Evaluate the advantages and disadvantages of “equity financing” and “debt financing” from the corporation’s standpoint
Study and Learn the Words:
| English | English equivalents | Romanian | Russian |
| equity capital | net worth | capital propriu | собственный капитал |
| standpoint | opinion | punct de vedere | точка зрения |
| drawback | disadvantage | dezavantaj | недостаток |
| сlaim (n) | request | cerere, pretenţie | требование, претензия |
| сoncession | a special right or privilege that is given to someone | concesiune | уступка, скидка |
| to redeem | to repay | a răscumpăra | выкупать, погашать |
| pool of | gathering of | adunătura | пул, объединение |
| bylaw | a law made by a local authority and which applies only in their area. | lege locală | уставные нормы, правила |
| amendment | a change of law | amendament | поправка |
| cumulative | keeps increasing steadily in quantity or degree | cumulativ | кумулятивный |
| par value | face value | valoare la paritate, preţ nominal | номинальная стоимость |
| retained earnings | earnings which are not distributed | profituri nerepartizate | нераспределенная прибыль |
| working capital | the part of a company’s capital readily convertible into cash and available for paying bills, wages | capital de rulment | оборотный капитал |
| installments (n) | any of the parts of a debt or other sum of money to be paid at regular times over a specified period | plată parţială, în rate | часть, партия |
Sources of long-term financing vary with the size and type of business. If the business is a sole proprietorship or partnership, equity capital is acquired by the business when the owner or owners invest money in the business. For corporations, equity-financing options include the sale of stock and the use of profits not distributed to owners. The available debt-financing options are the sale of corporate bonds and long-term loans.
Equity Financing
Some equity capital is used to start every business—sole proprietorship, partnership, or corporation. In the case of corporations, equity capital is provided by stockholders who buy shares in the company. There are at least two reasons why equity financing is attractive to large corporations. First, the corporation need not repay money obtained from the sale of stock, and it need not repurchase the shares of stock at a later date. Thus equity financing does not have to be repaid. Occasionally a corporation buys its own stock, but only because such an investment is in its own best interest. In 1989 Mapco, Inc.—a large oil, gas, and energy company—purchased thousands of shares of its own stock with uninvested profits. The firm's top management believed the purchase was the best investment available at that particular time.
A second advantage of equity financing is that a corporation is under no legal obligation to pay dividends to stockholders. A dividendis a distribution of earnings to the stockholders of a corporation. Investors purchase the shares of stock of many corporations primarily for the dividends they pay, However, for any reason (if a company has a bad year, for example), the board of directors can vote to omit dividend payments. Earnings are then retained for use in funding business operations. Thus a corporation need not even pay for the use of equity capital. Of course, the corporate management may hear from unhappy stockholders if expected dividends are omitted too frequently.
There are two types of stock: common and preferred.
Common Stock A share of common stock represents the most basic form of corporate ownership. Owners may vote on corporate matters, but their claims on profits and assets are subordinate to those of preferred-stock owners. In return for the financing provided by selling "common stock, management must make certain concessions to stockholders that may restrict or change corporate policies. By law, every corporation must hold an annual meeting, at which the holders of common stock may vote for directors and approve (or disapprove) major corporate actions. Amongsuch actions are (1) amendments to the corporate charter or bylaws, the sale of certain assets, (3) mergers, (4) the issuing of preferred stock or bonds, and (5) changes in the amount of common stock issued.
Many states require that a provision for pre-emptive rights be included in the charter of every corporation. Pre-emptive rightsare the rights of current stockholders to purchase any new stock that the corporation issues before it is sold to the general public. By exercising their pre-emptive rights, stockholders are able to maintain their current proportion of ownership of the corporation. This may be important when the corporation is a small one and management control is a matter of concern to stockholders.
Money that is acquired through the sale of common stock is thus essentially cost-free, but few investors will buy common stock if they cannot foresee some return on their investment.
Preferred Stock The owners of preferredstock usually do not have voting rights, but their claims on profit and assets precede those of common-stock owners. Thus holders of preferred stock must receive their dividends before holders of common stock are paid, provided dividends are distributed at all. Moreover, they have first claim (after creditors) on corporate assets if the firm is dissolved or declares bankruptcy. Even so, like common stock, preferred stock does not represent a debt that must be legally repaid.
The dividend to be paid on a share of preferred stock is known before the stock is purchased. It is stated, on the stock certificate, either as a percentage of the par value of the stock or as an amount of money. The par valueof a stock is an assigned (and often arbitrary) dollar value that is printed on the stock certificate.
When the corporation exercises a call provision, the investor usually receives a call premium. A call premium isa dollar amount over value that the corporation has to pay an investor for redeeming cither preferred stock or a corporate bond. When considering the two options, management will naturally obtain the preferred stock in the less costly way.
Added Features for Preferred-Stock IssuesTo make their preferred stock particularly attractive to investors, some corporations include cumulative, participating and convertible features in various issues.
Cumulative preferred stockis preferred stock on which any unpaid dividends accumulate and must be paid before any cash dividend is paid to the holders of common stock.
Participating preferred stockis preferred stock whose owners share in the corporation's earnings, along with the owners of common stock. Here's how it works: First, the required dividend is paid to holders of the preferred stock. Then a stated dividend, usually equal to the dividend amount paid to preferred stockholders, is paid to the common stockholders. Finally, any remaining earnings that are available for distribution are shared by both preferred and common stockholders.
Convertible preferred stockis preferred stock that can be exchanged at the stockholder's option for a specified number of shares of common stock. This conversion feature provides the investor with the safety of preferred stock and the hope of greater speculative gain through conversion to common stock.
Retained EarningsMost large corporations distribute only a portion of their after-tax earnings to shareholders. The remainder, the portion of a corporation's profits that is not distributed to stockholders, is called retained earnings. Retained earnings are reinvested in the business. Because they are undistributed profits, they are considered a form of
equity financing.
Retained earnings represent a large pool of potential equity financing that does not have to be repaid. The amount of a firm's earnings that is to be retained in any year is determined by corporate management and approved by the board of directors. For a large corporation, retained earnings can amount to a hefty bit of financing.
Most small and growing corporations pay no cash dividend—or a very small dividend—to their shareholders. All or most earnings are reinvested in the business. Stockholders don't actually lose because of this. Reinvestment tends to increase the value of their stock while it provides essentially cost-free financing. More mature corporations may distribute 40 to 60 percent of their after-tax profits as dividends. Utility companies and other corporations with very stable earnings often pay out as much as 80 to 90 percent of what they earn.
Debt Financing
For a small business, long-term debt financing is generally limited to loans. Large corporations have the additional option of issuing corporate bonds.
Corporate Bonds A corporate bond is a corporation’s written pledge that it will repay a specific amount of money, with interest. It includes the interest rate and the maturity date. The maturity date is the date on which the corporation is to repay the borrowed money. It also has spaces for the amount of the bond and the bond owner’s name.
Large corporations issue bonds in denominations of from $1,000 to $50,000. The total face value of all the bonds in an issue usually runs into the millions of dollars. An individual or firm buys a bond generally through a securities broker. Between the time of purchase and the maturity date, the corporation pays interest to the bond owner—usually every six months—at the stated rate. The method used to pay bondholders their interest depends on whether they own registered or coupon bonds. A registered bond is a bond that is registered in the owner's name by the issuing company. Interest checks for registered bonds are mailed directly to the bondholder of record. When a registered bond is sold, it must be endorsed by the seller before ownership can be transferred on the company books. A coupon bond, sometimes called a bearer bond, is a bond whose ownership is not registered by the issuing company. To collect interest on a coupon bond, bondholders must clip a coupon and then redeem it by following procedures outlined by the issuer. At the maturity date, the bond owner returns the bond to the corporation and receives cash equaling its face value. Coupon bonds are less secure than registered bonds. If coupon bonds are lost or stolen, interest may be collected and the bond may be redeemed by anyone who finds it. For this reason, most corporate bonds are registered.
Maturity dates for bonds generally range from fifteen to forty years after the date of issue. In the event that the interest is not paid or the firm becomes insolvent, bond owners’ claims on the assets of the corporation take precedence over stockholders'. Some bonds are callable before the maturity date. For these bonds, the corporation usually pays the bond owner a call premium. The amount of the premium is specified, along with other provisions, in the bond indenture. The bond indenture is a legal document that details all the conditions relating to a bond issue.
From the corporation's standpoint, financing through a bond issue differs considerably from equity financing. Interest must be paid periodically and in the eyes of the Internal Revenue Service; interest is a tax-deductiblebusiness expense. Furthermore, bonds must be redeemed for their face value at maturity. If the corporation defaults on (does not pay) either of these payments, owners of bonds could force it into bankruptcy.
A corporation may use one of three methods to ensure that it has sufficient funds available to redeem a bond issue. First, it can issue the bonds as serial bonds,which arc bonds of a single issue that mature on different dates. For example, Seaside Productions used a twenty-five-year $50-million bond issue to finance its expansion. None of the bonds matures during the first fifteen years. Thereafter, 10 percent of the bonds mature each year, until all the bonds are retired at the end of the twenty-fifth year. Second, the corporation can establish a sinking fund. A sinking fundis a sum of money to which deposits are made each year for the purpose of redeeming a bond issue. Third, a corporation can pay off an old bond issue by selling new bonds. Although this may appear to perpetuate the corporation's long-term debt, a number of utility companies and railroads have used this repayment method.
A corporation that issues bonds must also appoint a trustee,which is an independent firm or individual that acts as the bond owners' representative. A trustee's duties are most often handled by a commercial bank or other large financial institution. The corporation must report to the trustee periodically regarding its ability to make interest payments and eventually redeem the bonds. In turn, the trustee transmits this information to the bond owners, along with its own evaluation of the corporation's ability to pay.
Most corporate bonds arc debenture bonds. A debenture bondis a bond that is backed only by the reputation of the issuing corporation. To make its bonds more appealing to investors, however, a corporation may issue mortgage bonds. A mortgage bondis a corporate bond that is secured by various assets of the issuing firm. Or the corporation can issue convertible bonds. A convertible bondcan be exchanged, at the owner's option, for a specified number of shares of the corporation's common stock. The corporation can gain in two ways by issuing convertible bonds. They usually carry a lower interest rate than nonconvertible bonds. And once a bond owner converts a bond to common stock, the corporation no longer has to redeem it.
Long-Term Loans Many businesses finance their long-range activities with loans from commercial banks, insurance companies, pension funds, and other financial institutions. Manufacturers and suppliers of heavy equipment and machinery may also provide long-term financing by granting extended credit terms to their customers.
When the loan repayment period is longer than one year, the borrower must sign a term-loan agreement. A term-loan agreementis a promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual installments.
Long-term business loans are normally repaid in three to seven years. Although they may occasionally be unsecured, in most cases the lender requires some type of collateral. Acceptable collateral includes real estate, machinery, and equipment. Lenders may also require that borrowers maintain a minimum amount of working capital. The interest rate and other specific terms are often based on such factors as the reasons for borrowing, the borrowing firm's credit rating, and the collateral.
I. COMPREHENSION
Answer the following questions:
1. What do the sources of long-term financing depend on? In what way is equity capital acquired by a business?
2. Who provides equity capital in the case of corporations?
3. Why is equity financing attractive to large corporations?
4. Define the word “dividend”. What happens if a company has a bad year?
5. What kinds of stock do you know?
6. Describe the advantages and disadvantages of common stocks and preferred stocks.
7. What do some corporations include to make their preferred stock attractive to investors?
8. Compare the cumulative preferred stock and the participating preferred. What do they have in common?
9. What is “returned earnings”? Give examples.
10. Explain the terms: corporate bonds, coupon bonds and bond indenture.
II. FOCUS ON GRAMMAR
A) Insert prepositions:
Long-term business loans are normally repaid (1) .. there (2) … seven years. To make its bonds more appealing (3) …. Investors, however, a corporation may issue mortgage bonds. Serial bonds are bonds (4) … a single issue that mature (6) … different dates. Maturity dates (7) … bonds generally range (8) … fifteen (9) … fifty years after the date (10) … issue. The amount (11) … the premium is specified (12)… (13) …. Other provisions in the bond indenture. (14) …. the eyes (15) … the International Revenue Service, interest is a tax-deductible business expense. Sources of long-term financing vary (16) … the size and type of business. (17) …. Law, every corporation must hold an annual meeting, (18) …. Which the holders of common stock may vote (19) … directors.
B) COMPLEX VERBS
Choose one suitable verb to fill in the gaps so as to form complex verbs with the adverbial particle out.
to carry; come; get; give; go; set; take; turn; wear; wipe; work;
1. This year’s loses have … out last year’s profits. 2. Fixed assets gradually …. out. 3. The factory …. out 5, 000 pairs of shoes a week. 4. He is not at home, he has …. out. 5. One of the plane’s engines … out. 6. I’ll … out some money from my current account. 7. It has … out that you were right. 8. She … out first in the competition. 9. We will …. the new textbook out by October Ist. 10. he will … out early in the morning. 11. Our customer’s order has been … out . 12. I have … out your share at the expenses of our company at $50.
III. VOCABULARY PRACTICE
A) Finish the sentences:
1. The owners of preferred stock usually ……………………
2. The remainder, the portion of a corporation profits …………………..
3. Large corporations …………………………….
4. Maturity dates for bonds generally ……………………………
5. Many businesses finance their long-range activities with ……………………..
B) Supply:
Synonyms Antonyms
1. standpoint - 6. short-range activities -
2. to default - 7. extended credit –
3. trustee - 8. common stock –
4. earnings - 9. loss –
5. to occur - 10. subordinate (adj) -
C) Match the words with their definitions:
Dividend, common stock, pre-emptive rights, preferred stock, par value, call premium, cumulative preferred stock, participating preferred stock, convertible preferred stock, retained earnings, corporate bond, maturity date, registered bond, coupon bond, bond indenture, serial bonds, sinking fund, sinking fund, trustee, debenture bond, mortgage bond, convertible bond, term-loan agreement.
1. Bonds of a single issue that mature on different dates.
2. A bond whose ownership is not registered by the issuing company.
3. The portion of a business profits that is not distributed to stockholders.
4. Preferred stock that may be exchanged at the stockholder’s option for a specified number of shares of common stock.
5. An assigned dollar value printed on the face of a stock certificate.
6. Stock whose owners may vote on corporate matters but whose claims on profit and assets are subordinate to the claims of others.
7. The dollar amount over par value that the corporation has to pay an investor for redeeming either preferred stock or a corporate bond.
8. A distribution of earnings to the stockholders of a corporation.
9. A bond that is registered in the owner’s name by the issuing company.
10. A corporate bond that is secured by various assets of the issuing firm.
11. A legal document that details all the conditions relating to a bond issue.
12. A bond that can be exchanged for a specified number of shares of the corporation’s common stock.
13. A corporation’s written pledge that it will repay a specified amount of money with interest.
14. Preferred stock on which any unpaid dividends accumulate and must be paid before any cash dividend is paid to the holders of common stock.
15. The rights of current stockholders to purchase any new stock that the corporation issues before it is sold to the general public.
16. Preferred stock whose owners share in the car’s earnings, along with the owners of common stock.
17. A sum of money to which deposits are made each year for the purpose of redeeming a bond issue.
18. Stock whose owners usually do not have voting rights but whose claims on profits and assets have precedence over those of common stock owners.
19. An independent firm or individual that acts as the bond owner’s representative.
20. A bond backed only by the reputation of the issuing corporation.
21. A corporation bond that is secured by various assets of the issuing firm.
IV. DISCUSSION
1. Drexel Burnham Lambert helped finance many of the corporate takeovers during the 1980s. By 1986 it was the most profitable firm on Wall Street. Then in 1990 the firm filed for bankruptcy. What factors led to the decline of Drexel Burnham Lambert?
2. What does a financial manager do? How can he monitor a firm’s financial success?
3. Why would a supplier offer both trade credit and cash discounts to its customers?
4. You want to borrow funds to finance next year’s college expenses. Set up a budget showing your expected income and expenses, and determine how much money you will need to borrow. Then outline a plan for repaying the borrowing funds. Provide enough detail to convince your financing source to advance you the money.
ACCOUNTING
Accounting and Accountants
“Accounting is the language of business”
Learning objectives: