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CHAPTER NO 04
LONG TERM DEBT,
PREFERRED STOCK, AND
COMMON STOCK
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◻ Bonds A long term debt instrument issued by a

corporation or government

◻ A bond is a long- term debt instrument with a final

maturity generally being 10 years or more.
◻ If the security has a final maturity shorter than 10
years, it is usually called a note. To fully understand
bonds, we must be familiar with certain basic terms
and common features.
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◻ COUPON RATE: The stated rate of interest on a

bond. The annual interest payment divided by the
bond’s face value.
◻ Maturity. Bonds almost always have a stated
maturity. This is the time when the company is
obligated to pay the bondholder the par value of the
bond.
◻ Trustee A person or institution designated by a bond
issuer as the official representative of the bondholders
typically, a bank serves as trustee
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◻ Indenture, The legal agreement. Also called the deed

of trust. Between the corporation issuing bonds and
the bondholders. Establishing the terms of the bond
issue and naming the trustee.
❑ The indenture contains the terms of the bond issue
as well as any restrictions placed on the company.
❑ These restrictions, known as protective covenants,
are very similar to those contained in a term loan
agreement.
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◻ Discount and Premium. A bond sells at

premium whenever its market value is above
its par value.
◻ And a bond sells at a discount whenever its
market value is below its par.

◻ Market value > par value= Bond at premium.

◻ Market value< par value=Bond at discount
◻ Market value=par value =Bond at par.
 Conditions Favor issuing Bonds
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◻ Sales and earning are relatively stable.

◻ The firm’s liquidity positions are adequate.
◻ The existing debt ratio is low.
◻ Indenture provisions prior debt issue or the
proposed debt issue are not too burdensome.
◻ The firm’s stock price is depressed.
◻ Control considerations are important.
◻ The firm’s credit rating is satisfactory.
 ◻ BOND
. RATINGS
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The creditworthiness of a publicly traded debt

instrument is often judged in terms of the credit
ratings assigned to it by investment rating
agencies.

The principal rating agencies are Moody’s

Investors Service (Moody’s) and standard &
Poor’s (S & P).
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◻ Based on their evaluations of a bond issue, the

agencies give their opinion in the form of letter
grades, which are published for use by
investors.
◻ In their ratings, the agencies attempt to rank
issues according to the perceived probability of
default.
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◻ The highest grades, issue, whose risk of default is felt

to be negligible, are rated tripe-A, followed by
double –A, single- A,B-Double-A (Moody’s) or
triple- B (S& P), and so forth through C and D,
which are the lowest grades of Moody’s and S&P,
respectively.
◻ The first four grades mentioned are considered to
represent investment- quality issues, whereas the
other rated bonds are considered speculative.
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◻ TYPES OF LONG-TERM DEBT INTRUMENTS

◻ Bonds can be issued on either an unsecured or a
secured (asset- backed) basis.

◻ Debentures, subordinated debentures, and income

bonds from the major categories of unsecured bonds,
whereas mortgage bonds represent the most common
type of secured long- term debt instrument.
 DEBENTURES
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Debenture
The word debenture usually applies to the unsecured
bonds of a corporation. Because debentures are not secured
by any specific company property, the debenture holder
becomes a general creditor of the firm in the event or
company liquidation.

Subordinated debenture A long term, unsecured debt

instrument with a lower claim on assets and income than
other classes of debt: Known as junior debt.
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◻ INCOME BONDS
◻ Income bond A bond where the payment of interest is
contingent on sufficient earnings of the firm.
◻ JUNK BOND A high- risk, high-yield (often
unsecured) bond rated below investment grade.
◻ MORTGAGE BONDS
◻ Mortgage bond a bond issue secured by a mortgage
on the issuer’s property
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◻ EQUIPMENT TRUST CERTIFICATE

◻ An intermediate- to long- term security, usually issued by a
transportation company, such as a railroad or airline, that is
used to finance new equipment.
◻ ASSET SECURITIZATION
◻ The process of packaging a pool of assets- backed securities
(ABS)
◻ ASSET_ BACKED SECURITY (ABS) Debt securities
whose interest and principal payments are provided by the cash
flows coming from a discrete pool of assets.
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◻ SINKING FUNDS
◻ Fund established to period of a security issue before
maturity the corporation is required to make periodic
sinking – fund payments to a trustee.
◻ BALLOON PAYMENT
◻ A payment on debt that is much larger than other
payments the ultimate balloon payment is the entire
principal at maturity.
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SERIAL BONDS An issue of bonds with

different maturities, as distinguished from an
issue where all the bonds have identical
maturities (term bonds).
◻ CALL PROVISION A feature in an indenture

that permits the issuer to repurchase securities at

a fixed price (or a series of fixed prices) before
maturity: also called call feature.
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◻ CALL PRICE The price at which a security with a

call provision can be repurchased by the issuer prior
to the security’s maturity.
◻ Call premium: Additional sum that a firm pays
above the par value in order to repurchase a bond.
◻ Deferred call provision: not to call a bond until after
a specified date.
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◻ PREFERRED STOCK
◻ A type of stock that promises a (usually) fixed
dividend but at the discretion of the board of
directors.
◻ It has preferences over common stock in the
common stock in the payment of dividends and
claims on assets .
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◻ PREFERRED STOCK AND ITS

FEATURES
◻ Preferred stock is a hybrid form of financing,
combining features of debt and common stock.
◻ In the event of liquidation, a preferred
stockholders’ claim on assets comes after that
of creditor’s but before that of common
stockholders. Usually, this claim is restricted
to the par value of the stock.
 COMULATIVE DIVIDENDS FEATURE
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◻ A requirement that all cumulative unpaid dividends

on the preferred stock be paid before a dividend may
be paid on the common stock .
◻ Before the company can pay a dividend on its
common stock, it must pay dividends in arrears on its
preferred stock.
◻ Suppose that a board of directors omits the preferred
stock dividend on the company’s 8 percent
cumulative preferred stock for three consecutive
years.
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◻ If the stock has a $ 100 par value, 8% the

company is $ 24 per share in three years in arrears
on its preferred stock.

◻ Before it can pay a dividend to its common

stockholders, it must pay preferred stockholders $
24 each share of preferred stock held It Should be
emphasized that, just because preferred stock
dividends are in arrears, there is no guarantee that
they will ever be paid.
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◻ If the corporation has no intention of paying a

common stock dividend , there is no need to
clear up the arrearage on the preferred stock

◻ ARREARAGE A late or overdue payment,

which may be cumulative.
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◻ PARTICIPATING FEATURE
◻ A participating feature allows preferred stockholders
to participate in the residual earnings of the
corporation according to some specified formula.
◻ The preferred stock holders might be entitled to share
equally with common stockholders in any common
stock dividend beyond a certain amount.
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◻ RETIREMENT OF PREFERED
STOCK

◻ The fact that preferred stock, like

common stock, has no maturity does not,
however, mean that most preferred stock
issues will remain outstanding forever.
 CALL PROVISION
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◻ Almost all preferred stock issues have a stated

call price, which is above the original issuance
price and may decrease over time.
◻ Like the call provision on bonds, the call
provision on preferred stock offers the
company flexibility.
◻ Long term debt, unlike preferred stock, has a
final maturity that ensures the eventual
retirement of the issue.
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◻ Without a call feature on preferred stock, the

corporation would be able to retire the issue
only by the more expensive and less efficient
methods of purchasing the stock in the open
market inviting tenders of the stock from
preferred stockholders at a price above the
market price .
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◻ SINKING FUND

◻ many preferred stock issues provide for a

sinking fund, which partially ensures the
orderly retirement of the stock.
◻ Like bond issues, a preferred stock sinking
fund may be advantageous to investors because
the retirement process exerts upward pressure
on the market price of the remaining shares.
 CONVERSION SECURITY
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◻ A bond or preferred stock that is convertible

into a specified number of shares of common
stock at the option of the holder.
◻ Certain preferred stock issues are convertible
into common stock at the option of the holder.
◻ Upon conversion, of course, the preferred
stock is retired.
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◻ Because virtually all convertible securities

have a call feature, the company can force
conversion by calling the preferred stock if the
market price of the preferred is significantly
above the call price convertible preferred stock
is used frequently in the acquisition of other
companies.
 COMMON STOCK AND ITS FEATURES
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◻ The common stockholders of a company are its

ultimate owners.

◻ Collectively, they own the company and assume

the ultimate risk associated with ownership.

◻ In the event of liquidation, these stockholders

have a residual claim on the assets of the
company after the claims of all creditors and
preferred stockholders are settled in full.
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◻ Common stock, like preferred stock, has no

maturity date.

◻ Shareholders can still liquidate their

investments by selling their stocks in the
secondary market.
 Rights of common stock holders
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◻ Right to examine the corporation’s books.

◻ Right to vote(electing board of directors, selecting
independent auditor, amending charter and bylaws.ete).
◻ Right to proxy their vote.
◻ Right to receive their dividends if declared.
◻ Right to share in residual assets in the event of default.
◻ Right to transfer their ownership to another party.
◻ Right to share proportionately in the purchase of any new
stock sold.
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◻ COMMON STOCK securities that represent the

ultimate ownership (and risk) position in a
corporation.
◻ AUTHORIZED, ISSUED, AND OUTSTANDING
SHARES
◻ The corporate charter of a company specifies the
number of authorized shares of common stock, the
maximum that the company can issue without
amending its charter, Although amending the charter
is not a difficult procedure, it does require the
approval of existing shareholders, which takes time.
 ◻ TREASURY STOCK
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◻ Common stock that has been repurchased and is held

by the issuing company.
◻ Shares of common stock are sold, they become issue
shares. Outstanding shares refers to the number of
shares issued and actually held by the public.
◻ PAR VALUE The face value of a stock or bond.
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◻ ASSIGNED (or stated value ) a nominal

value assigned to a share of no-par common
stock that is usually far below the actual
issuing price.
◻ ADDITIONAL PAID IN CAPITAL Funds
received by a company in a sale of common
stock that are in excess of the par or stated
value of the stock.
 Advantages of common stock issue
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◻ No fix charges.(no fix dividend or interest)

◻ No fix maturity.
◻ Increased creditworthiness .
◻ Potentially greater ease of sale.
◻ Freedom from restrictive provisions.
 ◻ Plurality voting:
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◻ A method of electing corporate directors, where each

common share held caries one vote of each director
position that is open and the highest “for” vote-
getters for the open position win.
No . of shares No . of votes No . of directors in
◻ owned. the contest.
100 100 12

◻ A B C D E F G H I J K L
100 100 100
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◻ Plurality voting system has historically

been the predominant standard (but, it is
rapidly being replaced with majority
voting,) with plurality voting, directors
are elected by a plurality of the votes
cast.
◻ A “plurality” is generally without regard
to votes “withheld,” “against,” or not
cost.
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◻ CUMULATIVE VOTING

◻ A method of electing corporate directors,

Where each common share held carries as are
directors to be elected, and each share held
carries as many votes as there are directors to
be elected, and each shareholder may
accumulate these votes and cast them in any
fashion for one or more particular directors.
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◻ The total number of votes for each

stockholder is equal to the number of
shares the stockholder owns times the
number of directors being elected.
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◻ If you are a stockholder who owns 100 shares

and 12 directors are to be elected, you may
cast 100 X 12 = 1,200 votes.
◻ All 1,200 of you votes may be cast for one
director, or these votes may be spread over
number of directors you chose.
No . of shares No . of votes No . of directors
owned in the contest.
100 100*12=1200 12
 Majority voting.
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◻ Under majority voting a candidate in an

election would be elected only if they receive
majority of total votes cast(i-e, more than 50%
of “for” votes plus withhold or “against”
votes) for a position.
◻ Thus with majority voting “withhold” or
“against” votes carry real significance.
 ◻ DUAL CLASS COMMON STOCK
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◻ Class A common stock of a company may

have inferior voting privileges but may be
entitled to a prior claim to dividends,
whereas class B common stock may have
superior voting rights but a lower claim to
dividends.
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◻ Dual classes of common stock are common in

new ventures where promotional common
stock usually goes the funders.
◻ Usually, the promoters of a corporation and its
management hold the class B common stock,
while the class A common stock is sold to the
public.
 REFUNDING A BOND ISSUE
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◻ REFUNDING Replacing, an old debt issue

with a new one, usually to lower the interest
cost.
◻ REFUNDING, we mean calling the issue and
replacing it with a new issue of CALL
PREMIUM the excess of the call price of
security over its par value.