Long-Term Financing

Long-term (capital) expenditures have a time frame of greater than one year — buildings, machinery, major equipment. Three sources of long-term financing: debt financing, equity financing, and hybrid financing (preferred stock). The mix of debt and equity a firm uses is its capital structure.

How It Appears Per Course

ADMN 201

graph TD
    A[Long-Term Financing] --> B[Debt Financing]
    A --> C[Equity Financing]
    A --> D[Hybrid: Preferred Stock]
    B --> B1[Long-Term Loans]
    B --> B2[Bonds]
    B2 --> B2a[Callable]
    B2 --> B2b[Serial]
    B2 --> B2c[Convertible]
    C --> C1[Common Stock]
    C --> C2[Retained Earnings]
    C1 --> C1a[Par Value]
    C1 --> C1b[Book Value]
    C1 --> C1c[Market Value]
    D --> D1[Fixed dividend\nbefore common]
    D --> D2[No voting rights]
    D --> D3[Never matures]

(diagram saved)

Debt Financing

Debt financing = raising money to meet long-term expenditures by borrowing from outside the company. Best for companies with predictable profits and cash flows (e.g., hydroelectric utilities).

Two primary forms:

Long-Term Loans

Usually from chartered banks, credit companies, insurance companies, or pension funds
Typically matched with long-term assets
Interest rates: fixed or floating (tied to the prime rate — the rate banks charge their most creditworthy customers)
- Example: a firm might negotiate “prime + 1%.” If prime = 3%, the firm pays 4%.

Advantages of long-term loans:

Arranged quickly
Duration easily matched to borrower’s needs
Terms can be renegotiated if the firm’s situation changes

Disadvantages:

Large borrowers may struggle to find enough lenders
Restrictions placed on borrower (e.g., can’t take on more debt, must pledge assets as collateral)

Bonds (Corporate Bonds)

A corporate bond is a contract — a promise by the issuing company to pay the bondholder:

A specific amount of money (the principal) on a specified date
Plus stated interest payments in the interim

The bond indenture is the legal document spelling out all bond terms: interest rate, maturity date, which assets (if any) are pledged as collateral.

Bond types by registration:

Type	How it works
Registered bond	Holder’s name registered with the company; cheques mailed automatically
Bearer (coupon) bond	Anonymous; holder clips coupons and submits for payment; redeemable by anyone

Bond types by security:

Type	What it means
Secured bond	Borrower pledges specific assets as collateral; bondholders can sell those assets if default occurs
Debenture	Unsecured bond; no specific property pledged; holders have inferior claims (last after secured creditors)

Bond types by maturity:

Type	How it works
Callable bond	Issuer can call (retire) early at a specified call price (face value + premium). Usually cannot call for the first 5 years. Firms call when interest rates fall below the bond’s rate.
Serial bond	Firm retires portions of the issue in a series of preset stages. E.g., $5 M / ye a ro f a$ 100M issue over 20 years.
Convertible bond	Holder can convert the bond to the issuing company’s common stock at a specified ratio. Offers potential stock upside plus bond safety.

Bond ratings — measure default risk (chance that promised payments will be missed):

Rating Agency	High Grade	Medium/Investment Grade	Speculative	Poor/Junk
Moody’s	Aaa, Aa	A, Baa	Ba, B	Caa, C
Standard & Poor’s	AAA, AA	A, BBB	BB, B	CCC, D

Low rating → issuer must pay higher interest to attract investors (“junk bonds”)
Rating agencies: Moody’s, S&P. Example: Moody’s downgraded Enbridge after its $37B Spectra Energy acquisition due to execution risk.

Bond price and yield:

Bond price expressed as % of face value (e.g., quote of 85 = 85% of $1, 000 =$ 850)
Bond yield = annual interest paid ÷ current market price
If stated rate > market rate → bond sells at a premium (above face value)
If stated rate < market rate → bond sells at a discount (below face value)

Advantages of bonds (vs equity):

Interest is tax-deductible (dividends are not)
Bonds do not dilute ownership/control

Disadvantages:

Expensive administrative and selling costs
Companies with poor credit ratings pay high interest
Default → firm in serious trouble (creditors can force bankruptcy)

Equity Financing

Equity financing = raising money by issuing common stock or retaining earnings. Puts owners’ capital to work.

Common Stock

By selling shares, the company obtains funds for land, buildings, and equipment. Investors buy hoping for:

Capital gains (stock price increases)
Dividend income

Three ways to express stock value:

Value	Definition	Who cares
Par value	Arbitrary value set by board of directors; stated on stock certificate	Accountants
Book value	Total shareholders’ equity ÷ shares outstanding	Analysts
Market value	Current price on the secondary market	Investors (this is the real value)

When market value falls near book value, some investors buy on the principle the stock is underpriced.

Market capitalization = outstanding shares × market price per share. (E.g., Royal Bank of Canada: $153.4B in June 2021.)

Stock price is influenced by:

Objective: company profits and earnings
Subjective: rumours, investor relations (publicizing financial positives), stockbroker recommendations

Equity financing via common stock is expensive because:

Dividends are paid from after-tax profits (not deductible)
Bond interest is tax-deductible → effectively cheaper
Issuing stock may dilute management control

Despite the cost, firms can’t rely entirely on debt — debt carries fixed obligations that must be met regardless of profitability. Default can lead to bankruptcy.

Retained Earnings

Profits not paid out as dividends — reinvested into the firm.

Avoids new borrowing and interest payments
Attractive to some investors if the firm reinvests profitably
Downside: smaller dividends → can reduce demand for the stock → lower stock price

Example: Greenway Gardening earns $50, 000. I t co u l d p a y a$ 50/share dividend on 1,000 shares. But if it retains $30, 000 t o f u n d a re m o d e l, o n l y$ 20,000 is left for dividends ($20/share).

Hybrid Financing: Preferred Stock

Preferred stock has features of both bonds and common stock:

Feature	Like a bond	Like common stock
Fixed dividend	Yes — fixed amount	—
Maturity date	No — never matures	Like equity
Dividends if no profit	No — can skip	Like equity
Voting rights	No	No (unlike common)

Key advantages for the issuing firm:

Secures funds without surrendering control (no voting rights)
No requirement to pay dividends in lean times
No repayment of principal required

Dividends on preferred stock are expressed as a % of par value. E.g., $100 p a r v a l u e a t 6$ 6/share/year.

Some preferred stock is callable — the issuing firm can require shareholders to surrender shares at the call price specified in the original agreement.

Capital Structure: Choosing Between Debt and Equity

Capital structure = the relative mix of a firm’s debt and equity financing.

graph LR
    subgraph Debt
        D1[Fixed deadline for repayment]
        D2[Regular, fixed income claim]
        D3[Creditors first in liquidation]
        D4[No effect on management control]
        D5[Interest is tax-deductible]
        D6[Many constraints on flexibility]
    end
    subgraph Equity
        E1[No repayment limit]
        E2[Only residual income claim]
        E3[Shareholders last in liquidation]
        E4[May challenge management control]
        E5[Dividends not deductible]
        E6[Few constraints on flexibility]
    end

(diagram saved)

Strategies:

All-equity: Safest (no fixed obligations), but expensive
All-debt: Cheapest per dollar, but riskiest (must pay regardless of profit)
Optimal mix: Maximizes shareholders’ wealth — somewhere in between

Key Points for Exam/Study

Three long-term financing sources: debt, equity, hybrid (preferred stock)
Debt = long-term loans + bonds; Equity = common stock + retained earnings
Know the three bond types by maturity: callable, serial, convertible
Know secured vs debenture bonds
Know Moody’s and S&P rating scales — poor rating → junk bonds → higher interest required
Bond yield = annual interest ÷ current market price
Premium bond: stated rate > going rate; Discount bond: stated rate < going rate
Common stock has three values: par, book, market
Market cap = shares × market price
Dividends are not tax-deductible; bond interest is — makes debt cheaper per dollar
Preferred stock = hybrid: fixed dividend priority + no voting rights + no maturity date
Capital structure = the debt/equity mix; goal is to maximize shareholders’ wealth

Cross-Course Connections

ShortTermFinancing — contrast with short-term sources
SecuritiesMarkets — where stocks and bonds are sold
FinancialManager — long-term financing is one of the four core responsibilities

Open Questions

At what point does a firm’s debt load become dangerous? (Related to the debt-to-equity ratio, covered in accounting)
Why would a firm choose callable bonds if they disadvantage bondholders?

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LongTermFinancing