Finansal Tablolar Analizi Dersi 1. Ünite Özet

Açıköğretim ders notları öğrenciler tarafından ders çalışma esnasında hazırlanmakta olup diğer ders çalışacak öğrenciler için paylaşılmaktadır. Sizlerde hazırladığınız ders notlarını paylaşmak istiyorsanız bizlere iletebilirsiniz.

Açıköğretim derslerinden Finansal Tablolar Analizi Dersi 1. Ünite Özet için hazırlanan  ders çalışma dokümanına (ders özeti / sorularla öğrenelim) aşağıdan erişebilirsiniz. AÖF Ders Notları ile sınavlara çok daha etkili bir şekilde çalışabilirsiniz. Sınavlarınızda başarılar dileriz.

Medium And Long Term Financing

Introduction

The uses of cash flows are for net working capital and others and also for capital expenditures. In order to fund those uses, there exist two types of cash sources. Internal cash flow is generated from retained earnings and depreciation. External cash flow is generated from shortterm borrowings and long-term debt and equity finance. As a general principle, short-term uses are proposed to be financed by short-term sources and vice versa. Long-term uses of cash are basically for funding the future of the company by new investments.

For funding investments and/or other cash uses by medium and long-term sources, the companies have four different alternatives. These are generally in the forms of bank borrowing, borrowing from special institutions, debt issuance and equity finance, securitization. Furthermore, depending on the peculiarities of the funding needs leasing can be another source of medium and long-term financing. Additionally, the internal sources such as Retained Earning and Depreciation provide financing to the corporate. Each of the alternatives has impacts on the balance sheet and income statement of the company. Some of the important factors affecting the decision amongst those alternatives are:

  • Peculiarities of the fund use (whether machinery or equipment purchase financing or construction, etc.)
  • Bank lending capacity and relation with banks,
  • Availability of security,
  • Existing capital structure of the company,
  • Capital market depth,
  • Financial climate (Boom or boost financial market conditions),
  • Legal and tax issues,
  • The approach of top management with regards to equity sharing.

Long-term financial requirement is also called fixed capital requirements. Fixed capital is the capital, which is used to purchase the fixed assets of firms such as land and building, furniture and fittings, plant and machinery, etc.

Medium and Long Term Bank Borrowing

Bank lending is the most common source of external finance for many companies, especially Small and Medium Sized Enterprises (SMEs) and entrepreneurs, which are often heavily reliant on straight debt to fulfill their start-up, cash flow, and investment needs. Mediumterm and long-term loans are used for financing business or municipal investments. Sometimes they are a combination of financing investments and operational costs related to these investments.

The funding provided by the banks are classified into short-term loans (payback period up to 1 year), mediumterm loans (payback period 1 to 5 years) and long-term loans (payback period over 5 years, up to about 30 years such as for mortgage credits.

Bank Loan Types : According to the type of drawing and paying back, the loans are categorized as classical, revolving credits, bank overdraft, project loans, and syndication loans. With “classical” loans , after the drawing phase, the principal is paid gradually or by a single payment until a zero balance is achieved together with the interest for the period. With revolving credits , a limit of credit is set on the credit account of the borrower and both limits of credit and the due date are determined in a loan agreement. From concluding a loan contract till maturity date the borrower can draw the credit repeatedly within the limit. The bank overdraft is based on the same principle as the revolving loans, but the limit of the credit is set as a debit of a company’s current account. If the limit is overdrawn, the borrower pays a penalty interest rate. Project finance is the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself.

Cost of Bank Loans : The main type of cost applicable to Bank loans is interest on the owed amount. The most common types of interest rate will be fixed or variable (a margin over base rate or London Interbank Offered Rate [LIBOR] or EURIBOR depending on the currency of loan). Arrangement fees are commitment or administration charges payable to the lender to reserve the funds. Fees will vary depending on the complexity of the business, its size, and risk. Interest is charged and will vary depending on risk of default. Better rates can normally be obtained when the bank loan is secured, as the risk to the lender will generally be lower. Legal fees will vary depending on if other services are provided, the complexity of the business, its size, and risk to the lender. Fees are likely to apply when a personal asset, such as a jointly owned property, is provided as security.

Syndication Loans : Syndication loans are credits granted by a group of banks to a borrower. In a syndication loan, two or more banks agree jointly to make a loan to a borrower. Every syndicate member has a separate claim on the debtor, although there is a single loan agreement contract. The creditors can be divided into two groups. The first group consists of senior syndicate members and is led by one or more lenders, typically acting as mandated arrangers, arrangers, lead managers or agents. These senior banks are appointed by the borrower to bring together the syndicate of banks prepared to lend money at the terms specified by the loan.

Borrowing from Special Financial Institutions : A number of special financial institutions have been set up by the governments to provide long-term finance to the corporate. They also offer support services in the launching of the new enterprises and also for expansion and modernization of existing enterprises. Some of the important ones in Turkey are for SMEs KOSGEB, for other corporate, development banks such as Turk Eximbank, Development and Investment Bank. Since these institutions provide developmental finance, they are also known as Development Banks or Development Financial Institutions (DFI).

Security Issuance

Securities issued by corporations may be classified roughly as equity securities or debt securities. Originally, a debt represents something that must be repaid; it is the result of borrowing money through the issuance of notes or bonds. When corporations borrow, they generally promise to make regularly scheduled interest payments and the principal at the end of the maturity. On the other side, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt-holders. As a result of this, the risks and benefits associated with owning debt and equity are different.

The main differences between debt and equity are the following:

  • Debt is not an ownership interest in the firm. Creditors do not generally have voting power.
  • The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not 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. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

Optimal Capital Structure : The decision to issue security in the form of debt or stock depends on the optimal capital structure of a corporate. The capitalization of a company can be defined as the balance sheet value of stocks and bonds outstanding. In this framework, capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans, and retained earnings. Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum. By definition, the optimal capital structure requires maximization the value of the firm and at the same time minimization of the overall cost of capital. Normally the following forms of a capital structure are popular in practice: Equity shares only, Equity and preference shares only, Equity and Bonds only, Equity shares, preference shares, and bonds.

Factors Determining Capital Structure : The following factors are considered while deciding the capital structure of the firm:

  • Desired Level of Leverage: Financially, leverage refers to furnish the ability to use assets or funds with a fixed cost to increase the return to its shareholders. It is the basic and important factor, which affects the capital structure.
  • Cost of Capital: Cost of capital is the main determining factor of the capital structure of a firm. Normally long-term finance such as equity and debt consist of fixed cost security issuance. When the cost of capital increases, the value of the firm will also decrease.

The following factors affect the cost of capital of a company: Nature of the business, Size of the company, Legal requirements, Requirement of investors.

Debt Securities

Debt securities are typically called notes, debentures, or bonds depending on their peculiarities. Despite the fact that a bond is a secured debt, it generally refers to all kinds of secured and unsecured debt. The difference between notes and bonds is the original maturity. Issues with an original maturity of 10 years or less are often called notes, longer-term issues are called bonds. Long-term debt can be issued in two different forms, public-issue and privately-placed. Although the major terms and conditions are the same, under privately placed issues all of the bonds are sold to a single lender, not offered to the public. As this is a private transaction, the specific terms are up to the parties involved. Some of the legal requirements strictly exist in a public issue does not apply. Public issuance of debt is generally realized in domestic or international capital markets.

Characteristics of a Bond

  1. The Indenture : The indenture is the written agreement between the corporation as borrower and its creditors. It is sometimes referred to as the deed of trust. For the privately placed issuances, it is named as loan agreement or loan contract. It generally includes the following provisions: The basic terms of the bonds, the total amount of bonds issued, a description of property used as security, the repayment arrangements, the call provisions, details of the protective covenants.
  2. Face Value (Par Value) of a Bond : Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value and it is stated on the bond certificate. The par value of a bond is almost always the same as the face value, and the terms are used interchangeably.
  3. Registered Versus Bearer Form of Issuance : Corporate bonds are usually in registered form which means that the company has a registrar who will record the ownership of each bond and record any changes in ownership. A corporate bond may be registered and have attached “coupons” whereas to obtain an interest payment, the owner must separate a coupon from the bond certificate and send it to the company registrar (the paying agent). Alternatively, the bond could be in bearer form. This means that the certificate is the basic evidence of ownership, and the corporation will “pay the bearer.”
  4. Security : Debt issues are classified according to the collateral and mortgages used to protect the bondholder. Collateral is a general term that frequently means securities that are pledged as security for payment of debt. However, the term collateral is commonly used to refer to any asset pledged on a debt. Mortgage securities are secured by a mortgage on the real property of the borrower. The legal document that describes the mortgage is called mortgage trust indenture or trust deed. Bonds frequently represent unsecured obligations of the company. A debenture is an unsecured bond for which no specific pledge of the property is made. The term note is generally used for such instruments if the maturity of the unsecured bond is less than 10 years.
  5. Seniority : In general terms, seniority indicates preference in position over other lenders, and debts are sometimes labelled as senior or junior to indicate seniority. In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt can never be subordinated to equity.
  6. Repayment : Bonds are repaid at maturity when the bondholders receive the face value of the bond. However, some bonds are issued with an early repayment option. Early repayment is typically realized through a sinking fund. A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt.
  7. The Call Provision : A call provision allows the company to repurchase, or “call,” part of the bond issue at stated prices over a specific period. Corporate bonds are usually callable and the terms of call should be defined in the indenture. Generally, the call price is above the par value of the bond. The difference between the call price and the stated value is the call premium and it decreases as maturity converges.
  8. Protective Covenants : A protective covenant is a part of the indenture or loan agreement that limits certain actions a company might take during the term of the loan. Protective covenants can be classified into two types as negative covenants and positive (or affirmative) covenants. A negative covenant limits or prohibits actions that the company might take. A positive covenant specifies an action that the company agrees to take or a condition the company must abide.

Special Types of Bonds

  1. Floating-Rate Bonds : The bonds conventionally have fixed interest payments up to maturity as calculated based on the fixed par value. However, by the time the changing interest environment in the international financial markets, floating-rate bonds (floaters) began to be issued in which, the coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate and the value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined.
  2. Securitized Bonds : Asset-backed, or securitized, bonds have been frequently used since the 2000s by the borrowers and for several years, there has been rapid growth in so-called subprime mortgage loans, which are mortgages made to individuals with less than top-quality credit. Bondholders of a securitized bond receive interest and principal payments from a specific asset (or pool of assets) rather than a specific company. Mortgage-backs are the best-known type of asset-backed security.
  3. Eurobonds : A Eurobond is a bond issued in multiple countries but denominated in a single currency and those bonds have become an important way to raise capital for many international companies and governments. A Eurobond was once defined as a debt instrument underwritten by an international syndicate and offered for sale immediately in a number of countries. Eurobonds are issued outside the restrictions that apply to domestic offerings and are syndicated and traded mostly from London.

Other Types of Bonds

  1. Credit Rating Agencies : Credit rating agencies (CRAs) specialize in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. The logic underlying the existence of CRAs is to solve the problem of the informative asymmetry between lenders and borrowers regarding the creditworthiness of the borrower.
  2. Yield Curves : It is accepted that capital markets should incorporate all available information about the future prospects of the borrowers and the willingness of investors to take risks. The process by which prices in fixed income markets adjust to new information and move towards their equilibrium value is more efficient when market participants agree on certain instruments that can serve as references – or benchmarks – for pricing other securities. In recent decades, market participants have relied on government yield curves to assess the cost of funds at different borrowing horizons; price discovery about inflation prospects and other macroeconomic fundamentals have occurred mainly in government securities markets.

Common Stock

Common stock, also named as equity shares, represents equity or an ownership position in a corporation. The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire management to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Common stock has the following important features:

  • The maturity of the shares,
  • Residual claim on income,
  • Residual claims on assets,
  • Right to control,
  • Voting rights,
  • Pre-emptive right,
  • Limited liability.

Advantages of Common Stock :

  • Permanent sources of finance
  • No fixed dividend payment obligation
  • Lower cost of capital
  • Retained earnings

Disadvantages of Common Stock :

  • Irredeemable
  • Obstacles in management
  • Limited income to investor
  • Loss of leverage contributions

Leasing

A lease is a contractual agreement between a lessee and lessor establishing that the lessee has the right to use an asset and in return must make periodic payments to the lessor who is the owner of the asset. The lessor is either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then, the lessor delivers the asset to the lessee, and the lease goes into effect.

Operating Leases : Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. This occurs because the term, or life, of the operating lease, is usually less than the economic life of the asset. Operating leases usually require the lessor to maintain and insure the leased assets. The most interesting feature of an operating lease is the cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Financial Leases : Financial leases do not provide for maintenance or service by the lessor. Financial leases are fully amortized. The lessee usually has a right to renew the lease on expiration. Generally, financial leases cannot be cancelled. The lessee has the sole responsibility to make all payments. Two special types of financial leases are the sale and leaseback arrangement and the leveraged lease arrangement. In a sale and leaseback arrangement, a company sells an asset it owns to another firm and immediately leases it back. By that way, the lessee receives cash from the sale of the asset and makes periodic lease payments, whereby retaining the use of the asset. A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders.

Internal Sources Medium and Long Term Finance

Depreciation Funds : Depreciation means a decrease in the value of an asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. The purpose of depreciation is the replacement of the assets after the expired period.

Retained Earnings : Retained earnings are another method of internal sources of finance and it is basically an accumulation of profits by a company for its expansion and diversification activities. In many legislations, a required percentage of the net profits after tax of a financial year has to be compulsorily transferred to reserve by a company before declaring dividends for the year.

Introduction

The uses of cash flows are for net working capital and others and also for capital expenditures. In order to fund those uses, there exist two types of cash sources. Internal cash flow is generated from retained earnings and depreciation. External cash flow is generated from shortterm borrowings and long-term debt and equity finance. As a general principle, short-term uses are proposed to be financed by short-term sources and vice versa. Long-term uses of cash are basically for funding the future of the company by new investments.

For funding investments and/or other cash uses by medium and long-term sources, the companies have four different alternatives. These are generally in the forms of bank borrowing, borrowing from special institutions, debt issuance and equity finance, securitization. Furthermore, depending on the peculiarities of the funding needs leasing can be another source of medium and long-term financing. Additionally, the internal sources such as Retained Earning and Depreciation provide financing to the corporate. Each of the alternatives has impacts on the balance sheet and income statement of the company. Some of the important factors affecting the decision amongst those alternatives are:

  • Peculiarities of the fund use (whether machinery or equipment purchase financing or construction, etc.)
  • Bank lending capacity and relation with banks,
  • Availability of security,
  • Existing capital structure of the company,
  • Capital market depth,
  • Financial climate (Boom or boost financial market conditions),
  • Legal and tax issues,
  • The approach of top management with regards to equity sharing.

Long-term financial requirement is also called fixed capital requirements. Fixed capital is the capital, which is used to purchase the fixed assets of firms such as land and building, furniture and fittings, plant and machinery, etc.

Medium and Long Term Bank Borrowing

Bank lending is the most common source of external finance for many companies, especially Small and Medium Sized Enterprises (SMEs) and entrepreneurs, which are often heavily reliant on straight debt to fulfill their start-up, cash flow, and investment needs. Mediumterm and long-term loans are used for financing business or municipal investments. Sometimes they are a combination of financing investments and operational costs related to these investments.

The funding provided by the banks are classified into short-term loans (payback period up to 1 year), mediumterm loans (payback period 1 to 5 years) and long-term loans (payback period over 5 years, up to about 30 years such as for mortgage credits.

Bank Loan Types : According to the type of drawing and paying back, the loans are categorized as classical, revolving credits, bank overdraft, project loans, and syndication loans. With “classical” loans , after the drawing phase, the principal is paid gradually or by a single payment until a zero balance is achieved together with the interest for the period. With revolving credits , a limit of credit is set on the credit account of the borrower and both limits of credit and the due date are determined in a loan agreement. From concluding a loan contract till maturity date the borrower can draw the credit repeatedly within the limit. The bank overdraft is based on the same principle as the revolving loans, but the limit of the credit is set as a debit of a company’s current account. If the limit is overdrawn, the borrower pays a penalty interest rate. Project finance is the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself.

Cost of Bank Loans : The main type of cost applicable to Bank loans is interest on the owed amount. The most common types of interest rate will be fixed or variable (a margin over base rate or London Interbank Offered Rate [LIBOR] or EURIBOR depending on the currency of loan). Arrangement fees are commitment or administration charges payable to the lender to reserve the funds. Fees will vary depending on the complexity of the business, its size, and risk. Interest is charged and will vary depending on risk of default. Better rates can normally be obtained when the bank loan is secured, as the risk to the lender will generally be lower. Legal fees will vary depending on if other services are provided, the complexity of the business, its size, and risk to the lender. Fees are likely to apply when a personal asset, such as a jointly owned property, is provided as security.

Syndication Loans : Syndication loans are credits granted by a group of banks to a borrower. In a syndication loan, two or more banks agree jointly to make a loan to a borrower. Every syndicate member has a separate claim on the debtor, although there is a single loan agreement contract. The creditors can be divided into two groups. The first group consists of senior syndicate members and is led by one or more lenders, typically acting as mandated arrangers, arrangers, lead managers or agents. These senior banks are appointed by the borrower to bring together the syndicate of banks prepared to lend money at the terms specified by the loan.

Borrowing from Special Financial Institutions : A number of special financial institutions have been set up by the governments to provide long-term finance to the corporate. They also offer support services in the launching of the new enterprises and also for expansion and modernization of existing enterprises. Some of the important ones in Turkey are for SMEs KOSGEB, for other corporate, development banks such as Turk Eximbank, Development and Investment Bank. Since these institutions provide developmental finance, they are also known as Development Banks or Development Financial Institutions (DFI).

Security Issuance

Securities issued by corporations may be classified roughly as equity securities or debt securities. Originally, a debt represents something that must be repaid; it is the result of borrowing money through the issuance of notes or bonds. When corporations borrow, they generally promise to make regularly scheduled interest payments and the principal at the end of the maturity. On the other side, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt-holders. As a result of this, the risks and benefits associated with owning debt and equity are different.

The main differences between debt and equity are the following:

  • Debt is not an ownership interest in the firm. Creditors do not generally have voting power.
  • The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not 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. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

Optimal Capital Structure : The decision to issue security in the form of debt or stock depends on the optimal capital structure of a corporate. The capitalization of a company can be defined as the balance sheet value of stocks and bonds outstanding. In this framework, capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans, and retained earnings. Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum. By definition, the optimal capital structure requires maximization the value of the firm and at the same time minimization of the overall cost of capital. Normally the following forms of a capital structure are popular in practice: Equity shares only, Equity and preference shares only, Equity and Bonds only, Equity shares, preference shares, and bonds.

Factors Determining Capital Structure : The following factors are considered while deciding the capital structure of the firm:

  • Desired Level of Leverage: Financially, leverage refers to furnish the ability to use assets or funds with a fixed cost to increase the return to its shareholders. It is the basic and important factor, which affects the capital structure.
  • Cost of Capital: Cost of capital is the main determining factor of the capital structure of a firm. Normally long-term finance such as equity and debt consist of fixed cost security issuance. When the cost of capital increases, the value of the firm will also decrease.

The following factors affect the cost of capital of a company: Nature of the business, Size of the company, Legal requirements, Requirement of investors.

Debt Securities

Debt securities are typically called notes, debentures, or bonds depending on their peculiarities. Despite the fact that a bond is a secured debt, it generally refers to all kinds of secured and unsecured debt. The difference between notes and bonds is the original maturity. Issues with an original maturity of 10 years or less are often called notes, longer-term issues are called bonds. Long-term debt can be issued in two different forms, public-issue and privately-placed. Although the major terms and conditions are the same, under privately placed issues all of the bonds are sold to a single lender, not offered to the public. As this is a private transaction, the specific terms are up to the parties involved. Some of the legal requirements strictly exist in a public issue does not apply. Public issuance of debt is generally realized in domestic or international capital markets.

Characteristics of a Bond

  1. The Indenture : The indenture is the written agreement between the corporation as borrower and its creditors. It is sometimes referred to as the deed of trust. For the privately placed issuances, it is named as loan agreement or loan contract. It generally includes the following provisions: The basic terms of the bonds, the total amount of bonds issued, a description of property used as security, the repayment arrangements, the call provisions, details of the protective covenants.
  2. Face Value (Par Value) of a Bond : Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value and it is stated on the bond certificate. The par value of a bond is almost always the same as the face value, and the terms are used interchangeably.
  3. Registered Versus Bearer Form of Issuance : Corporate bonds are usually in registered form which means that the company has a registrar who will record the ownership of each bond and record any changes in ownership. A corporate bond may be registered and have attached “coupons” whereas to obtain an interest payment, the owner must separate a coupon from the bond certificate and send it to the company registrar (the paying agent). Alternatively, the bond could be in bearer form. This means that the certificate is the basic evidence of ownership, and the corporation will “pay the bearer.”
  4. Security : Debt issues are classified according to the collateral and mortgages used to protect the bondholder. Collateral is a general term that frequently means securities that are pledged as security for payment of debt. However, the term collateral is commonly used to refer to any asset pledged on a debt. Mortgage securities are secured by a mortgage on the real property of the borrower. The legal document that describes the mortgage is called mortgage trust indenture or trust deed. Bonds frequently represent unsecured obligations of the company. A debenture is an unsecured bond for which no specific pledge of the property is made. The term note is generally used for such instruments if the maturity of the unsecured bond is less than 10 years.
  5. Seniority : In general terms, seniority indicates preference in position over other lenders, and debts are sometimes labelled as senior or junior to indicate seniority. In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt can never be subordinated to equity.
  6. Repayment : Bonds are repaid at maturity when the bondholders receive the face value of the bond. However, some bonds are issued with an early repayment option. Early repayment is typically realized through a sinking fund. A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt.
  7. The Call Provision : A call provision allows the company to repurchase, or “call,” part of the bond issue at stated prices over a specific period. Corporate bonds are usually callable and the terms of call should be defined in the indenture. Generally, the call price is above the par value of the bond. The difference between the call price and the stated value is the call premium and it decreases as maturity converges.
  8. Protective Covenants : A protective covenant is a part of the indenture or loan agreement that limits certain actions a company might take during the term of the loan. Protective covenants can be classified into two types as negative covenants and positive (or affirmative) covenants. A negative covenant limits or prohibits actions that the company might take. A positive covenant specifies an action that the company agrees to take or a condition the company must abide.

Special Types of Bonds

  1. Floating-Rate Bonds : The bonds conventionally have fixed interest payments up to maturity as calculated based on the fixed par value. However, by the time the changing interest environment in the international financial markets, floating-rate bonds (floaters) began to be issued in which, the coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate and the value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined.
  2. Securitized Bonds : Asset-backed, or securitized, bonds have been frequently used since the 2000s by the borrowers and for several years, there has been rapid growth in so-called subprime mortgage loans, which are mortgages made to individuals with less than top-quality credit. Bondholders of a securitized bond receive interest and principal payments from a specific asset (or pool of assets) rather than a specific company. Mortgage-backs are the best-known type of asset-backed security.
  3. Eurobonds : A Eurobond is a bond issued in multiple countries but denominated in a single currency and those bonds have become an important way to raise capital for many international companies and governments. A Eurobond was once defined as a debt instrument underwritten by an international syndicate and offered for sale immediately in a number of countries. Eurobonds are issued outside the restrictions that apply to domestic offerings and are syndicated and traded mostly from London.

Other Types of Bonds

  1. Credit Rating Agencies : Credit rating agencies (CRAs) specialize in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities. The logic underlying the existence of CRAs is to solve the problem of the informative asymmetry between lenders and borrowers regarding the creditworthiness of the borrower.
  2. Yield Curves : It is accepted that capital markets should incorporate all available information about the future prospects of the borrowers and the willingness of investors to take risks. The process by which prices in fixed income markets adjust to new information and move towards their equilibrium value is more efficient when market participants agree on certain instruments that can serve as references – or benchmarks – for pricing other securities. In recent decades, market participants have relied on government yield curves to assess the cost of funds at different borrowing horizons; price discovery about inflation prospects and other macroeconomic fundamentals have occurred mainly in government securities markets.

Common Stock

Common stock, also named as equity shares, represents equity or an ownership position in a corporation. The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire management to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Common stock has the following important features:

  • The maturity of the shares,
  • Residual claim on income,
  • Residual claims on assets,
  • Right to control,
  • Voting rights,
  • Pre-emptive right,
  • Limited liability.

Advantages of Common Stock :

  • Permanent sources of finance
  • No fixed dividend payment obligation
  • Lower cost of capital
  • Retained earnings

Disadvantages of Common Stock :

  • Irredeemable
  • Obstacles in management
  • Limited income to investor
  • Loss of leverage contributions

Leasing

A lease is a contractual agreement between a lessee and lessor establishing that the lessee has the right to use an asset and in return must make periodic payments to the lessor who is the owner of the asset. The lessor is either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then, the lessor delivers the asset to the lessee, and the lease goes into effect.

Operating Leases : Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. This occurs because the term, or life, of the operating lease, is usually less than the economic life of the asset. Operating leases usually require the lessor to maintain and insure the leased assets. The most interesting feature of an operating lease is the cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Financial Leases : Financial leases do not provide for maintenance or service by the lessor. Financial leases are fully amortized. The lessee usually has a right to renew the lease on expiration. Generally, financial leases cannot be cancelled. The lessee has the sole responsibility to make all payments. Two special types of financial leases are the sale and leaseback arrangement and the leveraged lease arrangement. In a sale and leaseback arrangement, a company sells an asset it owns to another firm and immediately leases it back. By that way, the lessee receives cash from the sale of the asset and makes periodic lease payments, whereby retaining the use of the asset. A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders.

Internal Sources Medium and Long Term Finance

Depreciation Funds : Depreciation means a decrease in the value of an asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. The purpose of depreciation is the replacement of the assets after the expired period.

Retained Earnings : Retained earnings are another method of internal sources of finance and it is basically an accumulation of profits by a company for its expansion and diversification activities. In many legislations, a required percentage of the net profits after tax of a financial year has to be compulsorily transferred to reserve by a company before declaring dividends for the year.

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