LONG TERM FINANCIAL
MANAGEMENT
Introduction
Every firm has the need to raise capital to finance the necessary purchase of assets
to run its business. The more permanent or long-term sources of financing that a
company uses are referred to collectively as the company’s capital structure. The
capital structure of a firm includes the long-term liabilities and equity sections of its
balance sheet.
Long-term liabilities and equity indicate how the company obtained the necessary
money to buy the assets the company holds. capital structure is usually expressed in
%. Example - 40% of debt and 60% equity.
Bonds
Bonds are the long-term financial debt security. By selling bond, the company making
promise to pay the investors a certain amount of interest every period until the bond
get matures. On the maturity date the company promises to pay the face value of the
bond to the investors.
Bond Indenture
A bond represents a contract between issuer and bond holder. The legal contract or
agreement is called bond indenture. It contains all necessary information and
condition including interest rate, stated value, payment date maturity etc.
Bond PAR Value is stated amount of bond. This is the amount that is used to calculate
how much interest is paid each time.
Stated Interest rate is the interest rate on the bond, and it issued to calculate the
amount of interest that will be paid each time.
Issue date, which is the date on which the bonds were first issued by the company.
Maturity date, which is the date on which the issuer will “retire” the bond by paying
the face amount of the bond and the final amount of interest due to the bondholders.
Special Features
Call Provision
If the bond is callable bond, The company had the right to call back the bond before
maturity, Thus it is negative for the investors, therefore it posses' high interest rate.
Put Provision
If the bond is putable bond, the investor has the right to redeem the bond before
maturity. It is because the company make default in interest payment, Or violate any
covenants, the investors can redeem this, it’s possess low coupon rate.
Convertibility Clause
It is the right of bond holder to convert bond into common stock at a specific conversion
rate. It is beneficial to the investors, But it decreases the rate of return.
Covenants
Protective covenants set limits or restrictions on certain actions the company might be
taking during the term of the agreement. They are a particularly important feature in a
bond indenture.
There are two types of covenants: negative and positive.
1. Negative covenants limit or prohibit the borrower from certain actions. Paying
too much in dividends, pledging assets to other lenders, selling major assets,
merging with another firm, and acquiring more long-term debt are all examples
of actions that a negative covenant may require.
2. Positive (affirmative) covenants specify actions that the borrower promises to
perform. Examples of positive covenants include maintaining certain ratios,
preserving collateral in good condition, and making timely interest and principal
payments.
Types of Bonds
Convertible Bonds
It can be converted by the bondholder into a stated number of shares of the issuer’s
common stock at anytime during the bond’s life. A convertible bond can be
advantageous to the issuer too, because if it is converted by the bondholder into
common stock, the financing becomes equity financing instead of debt financing.
Debenture Bonds
Debenture bonds (greater risk for the holder of the bond) are unsecured, meaning they
are not backed by any specific asset as collateral.
Because of the lack of specific assets pledged as collateral, only a company that has
a very high credit rating and enjoys a large amount of public confidence an issue
debenture bonds.
Subordinated Debentures
These bonds are for which the holders will not have the first claim to the assets of the
company in case of a bankruptcy because these bonds are subordinated (inferior) to
other debts the company owes. In case of bankruptcy, all superior debts will be settled
before subordinated debentures.
Mortgage Bonds
These are less risky for the holder of the bond, have a specific asset or assets pledged
as collateral for the debt.
Income Bonds
It is greater risk for the holder of the bond, pay interest only if the company achieves
a certain level of income.
Serial Bonds
These bonds are issued with varying maturity dates so that some of the bonds mature
each year. The issuer of the bonds is thereby able to retire the bonds a little at a time
over a period of years without the need for a single, large cash payment. Serial bonds
offer investors the ability to choose the term that fits their needs.
Zero-coupon Bonds
This type of bond do not pay any interest, but they sell at a price significantly less than
the face value.
Participating Bond
Participating bonds can participate in dividends (the distributions of profits) of the
company during a period of high profits.
Indexed Bonds
These bond have an interest rate that is indexed to some other measure, such as a
price index or a general economic indicator. Instead of paying a fixed interest rate,
they pay a variable interest rate.
Types of Bonds - International Bond
It include two types of bonds: foreign bonds and Eurobonds. Both
International are sold outside of the issuing companies’ home countries (for a
Bond U.S.-based company, the bonds are sold outside the U.S.), but they
differ in the currency in which they are denominated.
Foreign bonds are issued in a country that is different from the
Foreign
issuing corporation’s home country and are usually denominated in
Bond
the currency of the country in which they are sold.
Eurobonds are international bonds that are denominated in a
Euro Bonds
currency that is different from the currency of the country in which
they are sold. The main advantage of issuing Eurobonds is that the
issuer can choose the market that has the most favorable interest
rates available to them.
Often, this allows the company to find a lower interest rate than may
be available to them in their home country.
Bond duration considers how the price of a bond changes in response to yield
changes. The best interpretation of duration is the approximate percentage price
changes for a 1% change in yield to maturity.
Term Structure of Interest Rate & Yield Curve
The term structure of interest rate describes the relationship between interest rate on
bond and maturity of bond.
Short term bond have lower yield, because an investor has less risk with a shorter
yield bond. When the rates and terms for the various securities are graphed, the
resulting line is called Yield curve.
Yield curve will be upsloping because long-term bond required greater return for
investors to be compensated for greater risk they are taken.
Bond Rating
A bond rating allows an investor to assess the general risks of buying a bond before
making the actual purchase.
Bond issues often are rated by credit agencies based on numerous factors including:
• Current financial status of the issuer
• Future financial prospects
• Collateral (if any) securing the bond
Some key points to understand about bond ratings are listed next.
• Bond ratings apply to the bond issue, not the company.
• U.S. Treasury bonds are rated AAA, because they are backed by the full faith
and credit of the U.S. government.
• Ratings may be adjusted either up or down during the lifetime of a bond; a
downgraded rating means that future issues will need to offer higher interest
rates to attract buyers.
• Bonds with Aaa and AAA ratings have the lowest rates of interest.
• Because of the default risk associated with junk bonds, they are higher-yield
bonds.
• Junk bonds have a greater chance of default, but in some circumstances they
also may be an emerging entity and provide a highly profitable return.
Bond Valuation
The value of a bond is the sum of its discounted cash flows. The discount rate used is
the market rate of interest. The market rate is also called the effective rate, the yield
rate, or the required rate of return. The steps to determine the value of a bond are:
• Calculate the PV of interest payments at the market rate.
• Calculate the PV of the face value at the market rate.
• Add the two PVs.
The next formula can be used to determine the value of a bond.
V = In (PVIFA) + F (PVIF)
V: Value of Bond
In: Interest in each time period
F: Principal or face value of the bond
PVIFA: PV interest factor of an annuity
PVIF: PV interest factor
Illustration
A company issued a 15-year annual pay bond that has five years before maturity. At
issuance, the bond had a 10% coupon and a face value of $1,[Link] an
8% return on bonds of similar risk. The value of the bond is calculated as shown:
• Determine the annual interest (10% × $1,000 = $100).
• Use the PV annuity table in Appendix A to discount the annual interest of $100
at the required rate of 8% for five years. The discount factor is 3.993.
• Use the PV tables in to discount the face value of $1,000 at the required rate
of8% for five periods (years). The discount factor is 0.681.
• Add the two PVs.
Vb = In (PVIFA) + F(PVIF)
$100(3.993) + $1,000(0.681)
$399.30 + $681.00 = $1,080.30
The value of the bond is $1,080.30 and represents the price an investor would pay for
the bond.
Valuation of Semi -Annual Pay Bond
If the Bond are annual pay bond, following changes is made.
Coupon rate /2 = 10/2 = 5%
MKT rate /2 = 8/2 = 4%
Num years × 2 =5×2 = 10 years
Illustration
Calculate the value of bond if the PAR value of the bond is 100$ and coupon rate is
10% and the market rate of interest is:
• 8%
• 10%
• 12%
• If the coupon rate is lower than market rate - Issued at discount
• If the coupon rate is equal to market rate - Issued at PAR
• If the coupon rate is more /higher than market rate - Issued at premium
Benefit of Company while Issuing Bond
• The bond issuer has no loss of control or ownership.
• Interest paid on bonds is tax deductible as a business expense.
• If the bonds are callable or can otherwise be retired early, the company has the
flexibility to retire the bonds and eliminate the interest payment if it no longer has
a need for the financing.
• The total cost of the bonds is limited and known because the interest rate that is
used to calculate the cash to be paid for interest is constant throughout the life
of the bond.
Limitations of Issuing Bond
• The issuing company assumes increased risk because of the possibility of
default.
• The maturity of the debt will result in a large future cash payout that will need to
be made at one time.
• The terms of the bond issue may include restrictive terms and covenants that
must be adhered to by the issuer.