Debt Financing and Instruments Quiz

Chapter 8: Long Term Financing

• This chapter covers various methods of long-term financing, including bonds, preferred shares, and common stock.
• The content includes types of bonds, characteristics of financial instruments, advantages and disadvantages of these instruments, and cost of financing.
• The objective is for learners to determine a firm's cost of debt, equity capital, overall cost of capital, identify pitfalls of overall cost of capital and how to manage them.
• Capital is essential for a firm to operate, and firms need various financing sources (debt to equity) especially when large capital expenditures are involved.

Chapter Content

• Types: Bonds, Preferred Shares and Common Stock.
• Characteristics of Bonds, Preferred Shares and Stock.
• Advantages and disadvantages of these instruments.
• Cost of Financing.

Chapter Objective

• Know how to determine a firm's cost of debt.
• Know how to determine a firm's cost of equity capital.
• Know how to determine a firm's overall cost of capital.
• Understand pitfalls of overall cost of capital and how to manage them.

Introduction

• Capital is a necessary element of production for a firm.
• Firms need to secure proper financing (from debt to equity) to support operations, especially during large capital expenditures.
• The cost of capital is the minimum rate of return needed by investors to satisfy their required rate of return on the firm's investments.

Debt

• Debt creates a fixed obligation that must be serviced regardless of financial conditions.
• Debt is a source of financing for capital investments.
• Long-term debt instruments can be convertible or non-convertible. Convertible bonds allow holders to exchange the debt for a specific number of common shares, while non-convertible bonds do not.

Features of Long-Term Debts

• Fixed interest rate: fixed obligations that need servicing when due
• Fixed maturity date: the date set for final payment, fixed at issuance

Preference of Debt Financing over Equity Financing

• Management control: Debt holders do not participate in company management decisions.
• Cost of funds: Interest paid to debt holders is tax deductible.

Types of Debt

• Term Loans: can be obtained quickly, flexible, low issuance costs, more than 5 years maturity, from banks, insurance companies, or pension funds. Interest rates can be fixed or variable.
• Bonds: long-term promissory notes issued by governments or businesses. Obligates the issuer to make periodic interest payments and principal payment to the bondholder.

Bond Characteristics/ Features

• Par Value: The face value of the bond, usually RM1,000.
• Coupon/Interest Rate: The percentage of par value paid to bondholders. Usually paid annually or semi-annually.
• Yield to Maturity (YTM): The rate a bondholder earns if bought, held, and interest is reinvested until maturity.
• Call Provision: Gives the issuing firm the right to call in the bond before maturity.
• Bond Ratings: Qualitative guide to default probability.
• Bond Maturities: The date the par value is repaid. Maturities typically range from 5 to 40 years.

Bond Categories

• Issued with convertible e Bonds
• Bonds with stock purchase warrants
• Zero Coupon Bonds
• Subordinated Debentures
• Index Bonds
• Income Bonds

Secured Bonds

• Convertible Bonds: Exchangeable for shares of common stock.
• Bonds with Stock Purchase Warrants: Similar to convertible bonds, allow holders to buy stock at a predetermined price.
• Indexed Bonds: Interest rates linked to a price index.
• Zero Coupon Bonds: Sold at a deep discount, no interest or principal payments until maturity.
• Debentures: Long-term claims not secured by company assets. The bondholders receive payment after senior creditors are settled.
• Subordinated Debentures: Junior debt, claims settled after senior creditors.
• Income Bonds: Pay interest only when the firm earns enough profit

Bond Valuation

• Present Value Equation: Calculation of present value of bond.

Illustration (Example of bond valuation calculation)

• Example of calculating bond value from TM Afic Inc.

Exercise

• KUAT Public Utilities examples.
• TM Afiq example of preferred stock valuation.
• Royan Industries examples of preferred stock and common stock costs

Common Equity

• Ownership of the firm.
• Ownership proportion depends on the number of common shares held versus total outstanding common shares.
• Common stockholders are the real owners

Cost of Equity

• Return required by equity investors for the risk associated with cash flows.
• Major methods: - Dividend growth model
  • SML (Security Market Line) or CAPM (Capital Asset Pricing Model)

The Dividend Growth Model Approach

• Formula for calculating cost of equity using a dividend growth model.

Dividend Growth Model Example

• Calculation of the cost of equity when given dividend, growth rate, and current price.

The SML Approach

• Method for calculating cost of equity, using risk-free rate, market risk premium, and systematic risk (beta) of assets.

SML Example

• Calculation of the cost of equity capital with risk-free rate, market risk premium, and beta provided

Cost of Equity Example

• Calculation approach using SML and DGM when given relevant financial information.
• Examples using given information to calculate cost of equity
• Calculate the cost of equity for different situations.

Cost of Capital

• Crucial to evaluating projects before investment.
• Correlated with the share price of the firm. Higher rate of return projects lead to higher share prices

The Weighted Average Cost of Capital (WACC)

• Computation of cost of capital by considering the proportion of total capital structure.
• Function of individual cost of capital and percentage of funds provided by debt, preferred stock and common stock.

Illustration (Example of WACC calculation)

• Calculation of WACC when considering different financing options.

Exercise (example)

• Dynamic Corporation financing options, calculating costs and choosing the best alternative.
• Suk Berhad capital structure, calculating costs, and recommend financing structure

References

• List of references used in the chapter with authors and the source