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RossCF8ce PPT Ch15
RossCF8ce PPT Ch15
Long-Term Financing: An
Introduction
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Chapter Outline
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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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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.
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Section 15.1
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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.
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
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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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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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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
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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).
(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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(Fig. 15.1)
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)
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Section 15.5
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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
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