Treasury bond 1 f. First mortgage bond—with sinking fund 2 g. Subordinated debentures—callable 6 i. Term loan 4 From the corporation's viewpoint, one important factor in establishing a sinking fund is that its own bonds generally have a higher yield than do government bonds; hence, the company saves more interest by retiring its own bonds than it could earn by buying government bonds.
This factor causes firms to favor the second procedure. Investors also would prefer the annual retirement procedure if they thought that interest rates were more likely to rise than to fall, but they would prefer the government bond purchases program if they thought rates were likely to fall. In addition, bondholders recognize that, under the government bond purchase scheme, each bondholder would be entitled to a given amount of cash from the liquidation of the sinking fund if the firm should go into default, whereas under the annual retirement plan, some of the holders would receive a cash benefit while others would benefit only indirectly from the fact that there would be fewer bonds outstanding.
On balance, investors seem to have little reason for choosing one method over the other, while the annual retirement method is clearly more beneficial to the firm. The consequence has been a pronounced trend toward annual retirement and away from the accumulation scheme. The average investor in a listed firm is not really interested in maintaining his or her proportionate share of ownership and control. An investor could increase ownership by simply buying more stock on the open market.
Consequently, most investors are not concerned with whether new shares are sold directly at about market prices or through rights offerings. However, if a rights offering is being used to effect a stock split, or if it is being used to reduce the underwriting cost of an issue by substantial underpricing , the preemptive right might well be beneficial to the firm and its stockholders. Clearly, the preemptive right is important to the stockholders of closely-held firms whose owners are interested in maintaining their relative control positions.
From the standpoint of the firm, preferred stock is like equity in that it cannot force the firm into bankruptcy, but it is like debt in that it causes fluctuations in earnings available to the common stockholders. Consequently, if the firm is concerned primarily with survival, it probably would classify preferred stock as equity.
However, if there is essentially no danger of bankruptcy, management would view preferred stock as simply another fixed charge security and treat it internally as debt. Equity investors would have a similar viewpoint, and in general they should treat preferred stock in much the same manner as debt.
For creditors, the position is reversed. They take preference over preferred stockholders, and the preferred issues act as a cushion. Consequently, a bond analyst probably would want to treat preferred as equity. Obviously, in all these applications, there would have to be some qualifications; in a strict sense, preferred stock is neither debt nor equity, but a hybrid. The firm can use convertible bonds if it is believed that the price of the stock will rise sufficiently in the future to make conversion attractive.
Then, if conversion takes place when the stock price is higher, the firm will have essentially issued its stock at a price higher than existed when the convertible bond was issued. We know the expected capital gain must be at least 3 percent, because the total expected return on the convertible must be at least equal to that on the nonconvertible bond, 12 percent.
In all likelihood, the expected return on the convertible would be higher than that on the straight bond, because a capital gains yield is riskier than an interest yield. The convertible would, therefore, probably be regarded as being riskier than the straight bond. However, the convertible, with its interest yield, probably would be regarded as being less risky than common stock.
Most firms have a continuing need for long-term debt to finance operations at least as long as they are still in business. It would make sense for a firm to issue bonds like the Canadian bonds. If you think about it, the most significant difference between a 30—year bond and a perpetual bond that is callable is that there is a refinancing requirement for the regular bond at the end of 30 years.
This refinancing requirement probably will change the cost of the bond, because refinancing takes place at existing market rates. The default risk will be negligible for each bond. The interest rate risk, however, will be greatest for the bond with the longest term to maturity. Because the Canadian bond will be called only if interest rates decline, it is considered the riskiest, and thus will have the highest expected interest rate. The order of the expected interest rate from lowest to highest would be: 5-year bond year bond regular perpetual bond Canadian perpetual bond c.
Probably not. If rates had dropped so that bonds with a coupon rate equal to 3 percent could be sold, the Canadian government probably would have issued the 3-percent bonds to replace the more expensive bonds. At the same time, some might argue that the Canadian government has a moral obligation to ensure that any false information that it knows about is not passed on to investors.
The conversion feature would add some flexibility to the bonds as an investment. Investors might find it attractive to buy the bonds because they can later decide whether they prefer to remain bondholders or to convert and become stockholders.
But because the debt is a zero-coupon bond, there will no interest payments in the meantime. Therefore, it would be beneficial to exercise the option. Therefore, it would not be beneficial to exercise the option.
Meyer issued bonds, not stock, so it has 20, shares of common stock outstanding. We will discuss this concept further in later chapters in the book. Original Alt. Each alternative permits Charles Cox to maintain control of the firm more than 50 percent ownership. In addition, each alternative results in an increase in EPS.
But, because Plan 2 results in the greatest increase in EPS, it would be preferred. Today, the amount Fibertech has to pay today is known with certainty because the current exchange rate is known. The primary advantage to waiting to pay the bill is that Fibertech can use the funds for other purposes.
In addition, it can avoid the high cost of borrowing funds to pay the bill today. Financing with stock offers several advantages over debt, but there are also disadvantages. The major advantages and disadvantages are discussed below. If Gonzales sells bonds, it will be required to make interest payments on fixed dates. If some stock is sold to the public, the stock will then be publicly held. Classified stock is stock that is given some special designation. Those designations typically are Class A, Class B, and so on, but any designation can be used.
Then, Class B stock, which would have the right to receive dividends but not to vote, would be sold to the public. Still, it is not at all uncommon for founding stockholders to sell some of their shares as a part of the initial offering in order to diversify their personal holdings. Indeed, some companies go public using only already-issued shares, that is, where the company receives none of the money raised.
Part II: Subsequent Expansions a. Bonds and term loans both are long-term debt contracts under which a borrower agrees to make a series of interest and principal payments on specified dates to the lender s. The main difference is that a term loan usually is placed with one or more financial institutions a bank, an insurance company, or a pension fund , while a bond typically is sold to the public.
Because this is secured debt, the interest rate on mortgage bonds is lower than on most other types of long-term debt. One of the most important changes in finance during the past century has been that the techniques used to make financial decisions have become much more sophisticated.
The electronic revolution, especially with respect to computers, has fueled this change. In addition, financial decision making has become much more concerned with value, especially with how a firm can maximize its value. Industries such as financial services, transportation, and utilities have become much less regulated and thus much more competitive than previously. However, Congress typically is reactive rather than proactive when passing legislation that affects business.
As a result, we generally expect that new legislation will be passed or reregulation will be imposed when Congress believes particular events harm the economy and business. For example, the Sarbanes Oxley Act of was passed in response to the downfall of Enron, WorldCom, and others that resulted from unethical, and in some cases illegal, accounting actions.
As the time we write this book, the economy is performing poorly, which some believe is the direct result of unethical practices that occurred in the real estate and mortgage markets during the past few years. Congress is currently considering legislation that will restrict how mortgage companies originate mortgages for individuals.
Value refers to the amount that should be paid for an asset investment today, and it is determined by computing the amount an investor must invest today at a particular rate of return to generate the same cash flows that the asset is expected to generate during its life.
In other words, an investor should never pay more for an investment than what he or she would need today to produce the same cash flow pattern that the investment is expected to produce in the future. Firms focus on the values of their common stocks; thus, they maximize value by maximizing the market prices of their stocks. Individuals maximize value in a similar fashion—that is, individuals maximize the total values of the combinations of investments that they hold. Sustainability refers to the process by which we live and interact with businesses, governments, other humans, and so forth, and how both the current environment and the future environment are affected by the actions of all of these stakeholders.
To remain a going concern, a firm must be concerned with sustainability. If a firm does not consider the effects of its decisions on sustainability, then it might find itself in bankruptcy in the future because one or more of the stakeholder groups employees, customers, environment, and so forth was irreparably harmed.
Ethical dilemma: There are a few of factors that should be considered here. Second, if Sunflower is not granted the loan for the requested amount, the company might take its banking business to a competitor of The Democrat. Third, The Democrat is having financial difficulties that might result in future layoffs.
As a result, it might be in her best interest to grant Sunflower the loan it requested even though her analysis suggests that such an action is not rational. It appears that Sheli would be making a decision that she does not favor in an effort to help her division meet its loan quota and perhaps to save her job with the bank. If Sheli bases her decision on her own best interests—that is, keeping her job—at the expense of the bank, then she probably is making an unethical decision.
If, on the other hand, her decision is based on the best interests of the bank, then her decision is justified. To answer this question, other questions should be asked. Do you believe that customer loyalty is an important factor when making financial decisions?
If so, how important of an input should loyalty be in such decisions? It appears that Henry believes loyalty is a very important factor that should be considered when making decisions about loans.
Thus, Henry considers intangibles when making loan decisions. How should such factors as loyalty and previous business relationships be incorporated into financial decisions? How important are these factors? Most people would agree that loyalty and previous credit history are important factors to consider when making loan decisions. The fact that Sunflower Manufacturing has been a loyal customer of The Democrat for many years must be considered when making the decision about how much the company should be allowed to borrow.
Because one of the most important inputs to a loan decision is the character of the borrower, loyalty should be considered when deciding how much to lend to Sunflower.
In this case, both the lender and the borrower might go bankrupt. Like any other investment, lending money is risky. Because The Democrat has been losing business to competing banks, Henry would like to find a way to lend Sunflower the money it has requested. It appears that Sheli is amenable to lending the money to Sunflower, but her motives might not be appropriate. At least she is willing to reconsider her initial recommendation. Commercial lending is a very competitive business.
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