Chapter 15

Long-Term Financing: An
Introduction
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Chapter Outline

15.1 Common Shares

15.2 Corporate Long-Term Debt: The Basics
15.3 Preferred Shares
15.4 Income Trusts
15.5 Patterns of Long-Term Financing
15.6 Summary and Conclusions

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Common Shares (1 of 3)
• Common shares or common stock – ownership in
a corporation.
– Stock that has no special preference either in dividends or
in bankruptcy.
– Common shareholders have limited liability.
– Common shareholders receive residual value of firm on
liquidation or bankruptcy.

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Section 15.1
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Common Shares (2 of 2)
• Par and No-Par Value Shares
• Authorized Versus Issued Common Shares
• Retained Earnings
• Market Value, Book Value, and Replacement Value
• Shareholders’ Rights
• Dividends
• Classes of Shares

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Section 15.1
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Par and No-Par Stock

• The stated value on a stock certificate is called the
par value.
– Par value is an accounting value, not a market value.
– On the balance sheet,
Value of = par value × number of
common stock outstanding shares
• Typically in Canada, most shares have no par value.

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Section 15.1
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Authorized Vs. Issued Common
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Stock
• The articles of incorporation of a new corporation
must state the number of common shares the
corporation is authorized to issue.
• The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares.
– Authorizing a large number of shares may worry
investors about dilution because authorized shares can be
issued later with the approval of the board of directors
but without a vote of the shareholders.
– There is no requirement that all authorized shares ever be
issued.
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Section 15.1
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Retained Earnings and
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Contributed Surplus
• The earnings that are not paid out as dividends are
referred to as retained earnings.
– A component of the shareholders’ equity on the balance
sheet.
• Contributed surplus: when a company issues and
sells shares at a price greater than their par
value.

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Section 15.1
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Market Value, Book Value, and
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Replacement Value (1 of 2)
• Market Value is the price of the share multiplied
by the number of shares outstanding.
– Also known as Market Capitalization
– Common shares of Canadian corporations may trade on
the Toronto Stock Exchanges (TSX) and U.S. stock
exchanges (NYSE, NASDAQ).
• Book Value (per share)
– The sum of par value of common stock, contributed
surplus, accumulated retained earnings, and adjustments
to equity is the common shareholders’ equity of the firm,
also referred to as the book value or net worth of the
firm.
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Section 15.1
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Market Value, Book Value, and
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Replacement Value (2 of 2)
• Replacement Value
– The current cost of replacing the assets of the firm.

• At the time a firm purchases an asset, market value,

book value, and replacement value are equal.
– The market-to-book ratio of common stock and Tobin’s
Q (market value of assets / replacement value of assets)
are indicators of the success of the firm.
– If these ratios are greater than one, the firm has done well
with its investment decisions.

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Section 15.1
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Common Stock of Enbridge

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Section 15.1
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Shareholders’ Rights (1 of 2)
• The right to elect the directors of the corporation by
vote constitutes the most important control device
of shareholders.
– Voting rights may be modified in dual or multi-voting
share structures.
• Directors are elected each year at an annual meeting
by a vote of the holders of a majority of shares who
are present and entitled to vote.
– The exact mechanism varies across companies.

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Section 15.1
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Shareholders’ Rights (2 of 2)
• Assuming only one class of common shares,
shareholder’s rights include the right to:
– share proportionately in dividends;
– share proportionately in net assets on liquidation;
– vote at the annual meeting or a special meeting;
– share proportionately in any new shares sold
(“preemptive right”).

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Section 15.1
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Cumulative Versus Straight
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Voting (1 of 2)
• The effect of cumulative voting is to permit
minority participation.
– Under cumulative voting, the total number of votes that
each shareholder can cast is determined first. The number
is typically equal to the number of shares × the number of
directors to be elected.
– All seats are elected at one time
– If there are N directors up for election, then 1/(N + 1)
percent of the stock plus one share will guarantee you a
seat.
– With cumulative voting, the more seats that are up for
election at one time, the easier it is to win one.

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Section 15.1
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Cumulative Versus Straight
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Voting (2 of 2)
• Straight voting
– Shareholders have as many votes as shares.
– Each position on the board has its own election.
– Tends to freeze out minority shareholders.

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Section 15.1
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Cumulative Vs. Straight Voting:
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Example 15.1
• Imagine a firm with two shareholders: Mr.
MacDonald and Ms. Laurier.
– Mr. MacDonald owns 25 shares and Ms. Laurier owns 75
shares.
– There are four seats up for election on the board.

• Under straight voting, Ms. Laurier gets to pick all

four seats.
• Under cumulative voting, Ms. Laurier has 300 votes
( = 75 shares × 4 seats) and Mr. MacDonald 100
votes.
– Mr. MacDonald can elect at least one board member.
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Section 15.1
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Proxy Voting
• A proxy is the legal grant of authority by a
shareholder to someone else to vote his or her
shares.
• For convenience, the actual voting in large public
corporations is usually done by proxy.
• If shareholders are not satisfied with management, an
outside group of shareholders can try to obtain as
many votes as possible via proxy.
• Proxy battles are often led by large pension funds like
the Ontario Teachers’ Pension Board or the British
Columbia Investment Management Corporation.
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Section 15.1
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Dividends
• 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.
• The payment of dividends by the corporation is not
a business expense.
– Therefore, they are not tax-deductible but paid from
after-tax dollars.
• Dividends received by individual shareholders are
partially sheltered by a dividend tax credit.
– There is an intra-corporate dividend exclusion for
Canadian corporations to avoid the double taxation of
dividends. 15-17
Section 15.1
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Classes of Shares (1 of 2)
• When more than one class of shares exists, they are
usually created with unequal voting rights.
• Many companies issue dual classes of common
shares. The reason has to do with control of the
firm.
– Amoako-Adu and Smith (2001) show that firms going
public with dual classes of shares in Canada are often
family controlled.

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Section 15.1
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Classes of Shares (2 of 2)
• Lease, McConnell, and Mikkelson (1983) found the
market prices of U.S. stocks with superior voting
rights to be about 5% higher than the prices of
otherwise identical stocks with inferior voting
rights.
• Restricted shares may allow managers to
expropriate benefits from the minority shareholders.
• Coattail provisions give non-voting shareholders
the right to vote in certain situations.

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Section 15.1
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Corporate Long-Term Debt: The
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Basics
• Interest Versus Dividends
• Is It Debt or Equity?
• Basic Features of Long-Term Debt
• Different Types of Debt
• Repayment
• Seniority
• Security
• Indenture
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Section 15.2
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Interest Versus Dividends

• Debt is not an ownership interest in the firm.
Creditors do not usually have voting power.
• The device used by creditors to protect themselves is
the loan contract (i.e., indenture).
• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully tax-
deductible.
• Unpaid debt is a liability of the firm. If it is not paid,
the creditors can legally claim the assets of the firm.
– One of the costs of issuing debt is the possibility of
financial failure.

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Section 15.2
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Is It Debt or Equity?
• Some securities blur the line between debt and
equity.
• Corporations are very adept at creating hybrid
securities that look like equity but are called debt.
– Obviously, the distinction is important for accounting and
tax purposes.
– A corporation that succeeds in creating a debt security
that is really equity obtains the tax benefits of debt while
eliminating its bankruptcy costs.

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Section 15.2
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Basic Features of Long-Term Debt

• The bond indenture usually lists
– Amount of Issue, Date of Issue, Maturity
– Denomination (Face value)
– Annual Coupon, Dates of Coupon Payments
– Security
– Sinking Funds
– Call Provisions
– Covenants
• Features that may change over time
– Credit rating
– Yield-to-maturity
– Market price
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Section 15.2
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Different Types of Debt

• A debenture is an unsecured corporate debt,
whereas a bond is secured by a mortgage on the
corporate property.
• A note usually refers to an unsecured debt with a
maturity shorter than that of a debenture, perhaps
under seven years.
• Debentures and bonds are long-term debt, i.e.,
payable more than one year from the date they are
originally issued.

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Section 15.2
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Repayment
• Bonds can be repaid at maturity or earlier through
the use of a sinking fund.
• A sinking fund is an account managed on behalf
of the issuer by a bond trustee for the purpose of
retiring all or part of the bonds prior to their
stated maturity.
• Debt may be extinguished before maturity through a
call provision giving the firm the right to pay a
specific amount (call price) to retire the debt before
the stated maturity date.

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Section 15.2
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Seniority
• Seniority indicates preference in position over other
lenders.
• Some debt is subordinated. In the event of default,
holders of subordinated debt must give preference
to other specified creditors who are paid first.
• Debt cannot be subordinated to equity.

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Section 15.2
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Security
• Security is a form of attachment to property.
– It provides that the property can be sold in event of
default to satisfy the debt for which the security is given.
– A mortgage is used for security on tangible property.
– For example, debt can be secured by mortgages on plant
and equipment.
• Debentures are not secured.
– If mortgaged property is sold in the event of default,
debenture holders will obtain something only if the
mortgage bondholders have been fully satisfied.

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Section 15.2
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Indenture

The written agreement between the corporate debt

issuer and the lender.
• Sets forth the terms of the loan:
– Maturity
– Interest rate
– Protective covenants
– Examples:
• restrictions on further indebtedness,
• a maximum on the amount of dividends that can be paid,
• a minimum level of working capital.

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Section 15.2
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Preferred Shares (1 of 2)
• Represents equity of a corporation, but is different
from common shares because it has preference over
the common in the payments of dividends and in the
distribution of corporate assets in the event of
bankruptcy.
• Typically, they have no voting rights.
• Preferred shares have a stated liquidating value.
• For example, CIBC “$2.25 preferred” translates into
a dividend yield of 9% of the stated $25 value.

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Section 15.3
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Preferred Shares (2 of 2)
• Preferred dividends are either cumulative or
noncumulative.
• Firms may have an incentive to delay preferred
dividends, since preferred shareholders receive no
interest on the cumulated dividends.

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Section 15.3
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Are Preferred Shares Really
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Debt?
• A good case can be made that preferred shares are
really debt in disguise.
– The preferred shareholders receive a stated dividend.
– In the event of liquidation, the preferred shareholders are
entitled to a fixed claim.
• Some preferred shares have adjustable dividends.
– Example: CARP (cumulative, adjustable rate, preferred).

• In Canada, corporate investors have an incentive to

hold preferred shares issued by other corporations,
since 100% of the dividends they receive are
exempt from income taxes.
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Section 15.3
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Preferred Shares and Taxes
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(1 of 2)
• In Canada, a tax loophole encourages corporations
that are lightly taxed to issue preferred shares.
– Low-tax companies can make little use of the tax
deduction on interest.
– They can issue preferred shares and enjoy lower
financing costs since preferred dividends are significantly
lower than interest payments.

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Section 15.3
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Preferred Shares and Taxes
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(2 of 2)
• There are several reasons beyond taxes why
preferred shares are issued:
– Regulated public utilities can pass the tax disadvantage of
issuing preferred shares on to their customers.
– Firms issuing preferred shares can avoid the threat of
bankruptcy that might otherwise exist if debt were relied
on.
– A means of raising equity without surrendering control.

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Section 15.3
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Income Trusts (1 of 2)
• Income trust: non-corporate form of business
organization.
• The business income trust is a partnership and its
income is not subject to corporate income tax.
– Structured so that income was taxed only once in the
hands of trust unitholders.
– The operating entity is taxed as a corporation.
– Usually, the operating entity pays all earnings to unit
holders before paying taxes thus practically paying no
tax.
– Owners have limited liability protection.
– Typically, traded publicly
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Section 15.4
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Income Trusts (2 of 2)
• The business income trust sector experienced
significant growth starting in 2001 due to the tax
advantage.
• In the fall of 2006 the government announced plans
to eliminate this tax advantage by applying
corporate tax rates to income trusts.
• Effective in 2011, income trusts became taxable at
31.5% and distributions are taxed as dividends.
– Real Estate Investment Trusts (REITs) are exempt.

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Section 15.4
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Patterns of Long-Term Financing

• For Canadian firms, internally generated cash flow
dominates as a source of financing.
• Firms usually spend more than they generate
internally - the gap is financed by new issues of debt
and equity.
• Net new issues of equity are dwarfed by new sales of
debt.
• This is consistent with the pecking order hypothesis
– firms use predominantly internally generated cash
flow for long-term financing; issuing new equity is
least important source of corporate financing.
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Section 15.5
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The Long-Term Financial Gap
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(Fig. 15.1)
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)

Capital Internal cash

spending flow (retained
earnings plus Internal
depreciation) cash flow
+ 68.3%
Financial
deficit
Net
working Short-term and
capital plus Long-term External
other uses debt + shares cash flow
31.7%

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Section 15.5
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Summary and Conclusions

• The basic sources of long-term financing are:
– Long-Term Debt
– Common Shares
– Preferred Shares
• Common shareholders have voting rights, limited
liability, and a residual claim on the corporation.
• Bondholders have a contractual claim against the
corporation.
• Preferred shares have some of the features of debt and
equity.
• Firms need financing - most of it is generated
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Section 15.6
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Quick Quiz
• Describe the basic characteristics of the three
primary sources of long-term financing:
– Long-Term Debt
– Common Stock
– Preferred Stock

• Identify the rights of shareholders and bondholders.

• Why are preferred shares issued by corporations?

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