BBA 3005

CORPORATE FINANCE

KHOO YU TING

921227015896

200080

MR. LOH YONG CHIANG

NOVEMBER 2013
 TOPIC PAGES

1 Contents 2

2 Task 1 3-12

-direct and indirect costs of bankruptcy

-Continental airline in the United States once filed for

bankruptcy

-Steps can stockholders take to reduce the cost of debt

3 Task 2 13-15

-process whereby the owners control the firms

management

-suppose the financial manager of a not-for-profit

business

-corporate ownership varies around the world

Task 3
4 16-19
-the differences between preference stock and debt
-preferred stock doesnt offer corporate tax shield on the
dividends paid
Task 4
5 20-27
-the major advantages and disadvantages of the corporate
form of organization as compared to sole proprietorship
and partnership
-factors affecting corporate dividend policy

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 Coursework
6 28-34

TABLE OF CONTENT

2.0 Task 1

1.1 Direct and indirect costs of bankruptcy

One limit to the amount of debt a firm might use comes in the form of bankruptcy costs.3

As the debtequity ratio rises, so does the probability that the firm will be unable to pay

its debtholders what was promised to them. When this happens, ownership of the firm's

assets is ultimately transferred from the shareholders to the debtholders.

In principle, a firm becomes bankrupt when the value of its assets equals the value of its

debt. When this occurs, the value of equity is zero and the shareholders turn over control

of the firm to the debtholders. At this point, the debtholders hold assets whose value is

exactly equal to what is owed on the debt. In a perfect world, there are no costs

associated with this transfer of ownership, and the debtholders do not lose anything.

This idealised view of bankruptcy is not, of course, what happens in the real world.

Ironically, it is expensive to go bankrupt. As we will discuss, the costs associated with

bankruptcy may eventually offset any tax-related gains from leverage.

DIRECT BANKRUPTCY COSTS

When the value of a firm's assets equals the value of its debt, the firm is economically

bankrupt in the sense that the equity has no value. However, the formal turning over of

the assets to the debtholders is a legal process, not an economic one. There are legal and

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administrative costs to bankruptcy, and it has been remarked that bankruptcies are to

lawyers what blood is to sharks.

Because of the expenses associated with bankruptcy, debtholders will not get all that

they are owed. Some fraction of the firm's assets will disappear in the legal process of

going bankrupt. These are the legal and administrative expenses associated with the

bankruptcy proceeding. We call these costs direct bankruptcy costs The costs that are

directly associated with bankruptcy, such as legal and administrative expenses..

INDIRECT BANKRUPTCY COSTS

Because it is expensive to go bankrupt, a firm will spend resources to avoid doing so.

When a firm is having significant problems in meeting its debt obligations, we say that it

is experiencing financial distress. Some financially distressed firms ultimately file for

bankruptcy, but most do not because they are able to recover or otherwise survive.

The costs of avoiding a bankruptcy filing incurred by a financially distressed firm are

called indirect bankruptcy costs The costs of avoiding a bankruptcy filing incurred by a

financially distressed firm.. We use the term financial distress costs The direct and

indirect costs associated with going bankrupt or experiencing financial distress. to refer

generically to the direct and indirect costs associated with going bankrupt or avoiding a

bankruptcy filing.

The problems that come up in financial distress are particularly severeand the

financial distress costs are thus largerwhen the shareholders and the debtholders are

different groups. Until the firm is legally bankrupt, the shareholders control it. They, of

course, will take actions in their own economic interest. Since the shareholders can be

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wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy

filing.

The debt holders, on the other hand, are primarily concerned with protecting the value

of the firm's assets and will try to take control away from the shareholders. They have a

strong incentive to seek bankruptcy to protect their interests and keep shareholders from

further dissipating the assets of the firm. The net effect of all this fighting is that a long,

drawn-out and potentially quite expensive legal battle is started.

Meanwhile, as the wheels of justice turn in their ponderous way, the assets of the firm

lose value, because management is busy trying to avoid bankruptcy instead of running the

business. Normal operations are disrupted and sales are lost. Valuable employees leave,

potentially fruitful programs are dropped to preserve cash, and otherwise profitable

investments are not taken.

These are all indirect bankruptcy costs, or costs of financial distress. Whether or not the

firm ultimately goes bankrupt, the net effect is a loss of value because the firm chose to

use debt in its capital structure. It is this possibility of loss that limits the amount of debt

that a firm will choose to use.

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1.2 Continental airline in the United States once filed for bankruptcy

Continental Airlines filed for protection from its creditors under bankruptcy laws

yesterday, attributing the step to the jump in fuel prices and the cost of interest on its huge

debts.

The airline, the nation's fifth largest, has been flirting with bankruptcy for months. Since

the crisis in the Persian Gulf sent fuel costs sharply higher, Continental's $2.2 billion in

debt -- a legacy of a high-growth strategy in the 1980's under its former chairman, Frank

Lorenzo -- suddenly loomed as a far greater burden.

Eastern Airlines, also acquired by Mr. Lorenzo under that strategy, filed for

reorganization under the bankruptcy laws in March 1989. It is now operating under the

direction of a trustee.

Continental's bankruptcy filing will give the airline a reprieve from paying its debts so

that it can continue its regular flights as it tries to work out a way to pay its bills and

return to financial health. In the filing, Continental said that it had $138 million in cash.

Whereas bankruptcies once gave companies a cash buffer, by allowing them to stop

payment on unsecured debts, today, most debt is secured which is to say, collateralised

(for airlines, with their planes, facilities and landing rights). This leaves debtors reliant on

debtor-in-possession (DIP) lenders for cash. These lenders, typically large investment

banks like JP Morgan, get priority over other creditors and can make all sorts of demands

on the company. And increasingly, DIP lenders have learned to leverage this position to

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reshape corporate governance according to their whims: sometimes in preparation to

purchase the bankrupt company themselves, sometimes for complete liquidation.

Since Frank Lorenzo's big union bust of 1983, bankruptcy has been for the airlines a

super trump card in labor negotiations, used to void contracts and impose conditions

unilaterally. It's also a nice way for the company to pass the buck, if cuts are demanded

by lenders as terms of the bankruptcy. American's cash reserves, not to mention its hefty

executive compensation and recent purchase of 460 new planes from Boeing and Airbus

for $38bn, show how much this filing is a matter of careful strategy and not sudden

financial calamity. That makes it harder for the company to plead poverty, either to its

employees or the bankruptcy judge, when demanding yet another round of concessions.

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1.3 Steps can stockholders take to reduce the cost of debt

Protective Covenants

Because the stockholders must pay higher interest rates as insurance against their own

selfish strategies, they frequently make agreements with bondholders in hopes of lower

rates These agreements, called protective covenants, are incorporated as part of the loan

document (or indenture) between stockholders and bondholders. The covenants must he

taken seriously because a broken covenant can lead to default. Protective covenants can

be classified into two types: negative covenants and positive covenants.

A negative covenant limits or prohibits actions that the company may take. I lere are

some typical negative covenants:

1. Limitations are placed on the amount of dividends a company may pay

2. The firm may not pledge any of its assets to other lenders.

3. The firm may not merge with another firm.

4. The firm may not sell or lease its major assets without approval lender.

5. The firm may not issue additional long-term debt.

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A positive covenant specifies an action that the company agrees to take or a condition the

company must abide by. Here are some examples:

1. The company agrees to maintain its working capital at a minimum level.

2. The company must furnish periodic financial statements to the lender.

Consolidation of Debt

One reason bankruptcy costs are so high is that different creditors (and their lawyers)

contend with each other. This problem can be alleviated by proper arrangement of

bondholders and stockholders. For example, perhaps one, or at most a few, lenders can

shoulder the entire debt. Should financial distress occur, negotiating costs are minimized

under this arrangement. In addition, bondholders can purchase stock as well. In this way,

stockholders and debt holders are not pitted against each other because they are not

separate entities.

This appears to be the approach in Japan, where large banks generally take significant

stock positions in the firms to which they lend money. Debt equity ratios in Japan are far

higher than those in the United States.

There are six basic strategies that can help you out of excessive debt:

1. Reduce Costs

There are two principle ways to reduce costs:

looking for big savings, or

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 make small reductions across the board

To find big costs savings, concentrate on large savings first.

To make savings across the board, set a savings target (say, 10%) and reduce each budget

by that amount. Then take small steps to reduce costs, eg: reduce train costs by travelling

"standard" instead of "business"/"first" class, opting for cheaper equipment when

purchasing, etc..

2. Increase Income

There are various ways of increasing the amount of money flowing into your business,

such as:

Increase sales

eg: through increased marketing, cross-selling to existing customers, offering

special deals to get additional or advance orders, getting referrals with other

organizations/affiliates

Raise your prices

Find alternative sources of income

eg: renting out unused office space, assessing your waste or unused products and

seeing if it has any value, selling advertising space on your website (eg: Google

Adsense, YPN, MSN Adcenter, affiliates) or in physical spaces you have

available, obtaining commissions from other organisations

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3. Restructure liabilities

Your 'liabilities' are all the amounts of money that you owe to other people. Restructuring

your liabilities doesn't necessarily reduce the overall amount you owe, but it can give you

more cash, more disposable income and/or reduce the amount of debt you need to

provide working capital.

Examples of ways that you can restructure your liabilities to reduce your debt include:

Agree longer or scheduled payment terms with suppliers

Replace existing loans with, for example:

o loans that have a lower interest rate

o secured ones (replacing unsecured loans) to reduce the interest rate

o guaranteed loans (guaranteed by shareholders) to reduce the interest rate

o repayments over a longer period of time

o consolidated loans

o shareholder funds

Defer tax liabilities (this requires specialist tax advice)

4. Restructure Assets

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Your 'assets' are all the things your business owns. This section on restructuring your

assets also includes disposing of assets. Examples include:

Sell unnecessary assets (eg: surplus/old equipment, cars)

Convert necessary assets into liabilities: sell to a finance company and lease them

back

Factor invoices (this can reduce the asset value of the invoice, but raish cash)

Use investments or cash to pay off loans

5. Raise more capital

You can raise more capital by:

finding more investors, eg: venture capitalists

issuing more shares to current investors

obtaining grants

Also, take a look at your asset list and assess whether it can be converted into assets of

greater value. For example, if you own land, can you build more offices or houses on that

land?

6. Exit the business

To exit the business, options include:

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 Selling the business as a going concern

Going into receivership

Selling off all the business assets (including the business goodwill, eg: the client

base) and using the proceeds to pay off the liabilities

3.0 Task 2

2.1 Process whereby the owners control the firms management

In the corporate form of ownership, the shareholders are the owners of the firm. The

shareholders elect the directors of the corporation, who in turn appoint the firm's

management.

This separation of ownership from control in the corporate form of organization is what

causes agency problems to exist.

Management may act in its own or someone else's best interests, rather than those of the

shareholders.

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If such events occur, they may contradict the goal of maximizing the share price of the

equity of the firm.

The upper-middle and upper class own about 40% of all stocks, bonds, and mutual funds.

The middle and lower middle class own another 9%. The bottom 50% of all income

earners own one half of one per cent.

Now for the disturbing part: the top 1% of American income earners own just over 50%

of all corporate stocks, bonds and mutual funds. This degree of ownership effectively

gives 1% of our population unfettered control over the corporations and financial

institutions that are at the centre of our national way of life. The rest of us may have some

interest in their profitability, but a very elite class of persons decide what those

companies do.

The law recognizes a corporation as a wholly separate legal entity. It means the business

is actually viewed as being separate and distinct from the individuals who run the

corporation. A shareholder is a person who own stock in a corporation. A shareholder

with 51 per cent of the stock owns a controlling interest in the corporation and can

significantly influence decisions. The shareholders own a corporation. This can range

from a single shareholder in a closely held corporation to hundreds of thousands of

shareholders in a publicly traded company. Stockholders may be individuals or what are

called "institutional investors," such as mutual funds, retirement plans and insurance

companies. There are a variety of types of shares that can be issued by a corporation, e.g.,

common and preferred, and within these shares there are different classes as well. Shares

can be voting or non-voting, have dividends paid out to them or not. Although the rights

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attached to the shares may vary, all of the shares have one thing in common - they

represent an ownership interest in the corporations. The daily operations of the

corporation are overseen by the board of directors but there must be an annual meeting of

the shareholders to elect the board, and often to ratify the actions taken by the board on

their behalf. At this meeting the shareholders also have the opportunity to question the

board as well as having the financials presented and explained to them.

2.2 Suppose the financial manager of a not-for-profit business

Since such organizations frequently pursue social or political missions, many different

goals are conceivable.

One goal that is often cited is revenue minimization; i.e. providing their goods and

services to society at the lowest possible cost.

Another approach might be to observe that even a not-for-profit business has equity.

Thus, an appropriate goal would be to maximize the value of the equity.

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2.3 Corporate ownership varies around the world

We would expect agency problems to be less severe in other countries, primarily due to

the relatively small percentage of individual ownership. Fewer individual owners should

reduce the number of diverse opinions concerning corporate goals. The high percentage

of institutional ownership might lead to a higher degree of agreement between owners

and managers on decisions concerning risky projects. In addition, institutions may be

better able to implement effective monitoring mechanisms on managers than can

individual owners, based on the institutionsu2019 deeper resources and experiences with

their own management. The increase in institutional ownership of stock in the United

States and the growing activism of these large shareholder groups may lead to a reduction

in agency problems for U.S. corporations and a more efficient market for corporate

control.

4.0 Task 3

3.1 The difference between preferred stock and debt

Preferred Stock

In contrast to bonds, a share of preferred stock entails actual ownership of a corporation.

The proportion of ownership depends on how many shares of stock the corporation has

released into the market. But unlike common shareholders, preferred shareholders

typically don't get involved in running the company. They don't vote on corporate director

or make similar corporate decisions.

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Debt

Debt can be "purchased" from a company in the form of a bond.

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is

a debt security, under which the issuer owes the holders a debt and, depending on the

terms of the bond, is obliged to pay them interest and/or to repay the principal at a later

date, termed the maturity. Therefore, a bond is a form of loan or IOU: the holder of the

bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the

coupon is the interest. Bonds provide the borrower with external funds to finance long-

term investments, or, in the case of government bonds, to finance current expenditure.

Different in two key aspects

First, preferred stockholders have a greater claim to a company's assets and earnings.

This is true during the good times when the company has excess cash and decides to

distribute money in the form of dividends to its investors. In these instances when

distributions are made, preferred stockholders must be paid before common stockholders.

However, this claim is most important during times of insolvency when common

stockholders are last in line for the company's assets. This means that when the company

must liquidate and pay all creditors and bondholders, common stockholders will not

receive any money until after the preferred shareholders are paid out.

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Second, the dividends of preferred stocks are different from and generally greater than

those of common stock. When you buy a preferred stock, you will have an idea of when

to expect a dividend because they are paid at regular intervals. This is not necessarily the

case for common stock, as the company's board of directors will decide whether or not to

pay out a dividend. Because of this characteristic, preferred stock typically don't fluctuate

as often as a company's common stock and can sometimes be classified as a fixed-income

security. Adding to this fixed-income personality is the fact that the dividends are

typically guaranteed, meaning that if the company does miss one, it will be required to

pay it before any future dividends are paid on either stock.

To sum up: a good way to think of a preferred stock is as a security with characteristics

somewhere in-between a bond and a common stock.

3.2 Preferred stock doesnt offer corporate tax shield on the dividends paid

Each stock are stated as a percentage known as the par value.

There is no direct tax advantage to the issuing of preferred shares when compared to

other forms of financing such as common shares or debt. The reason for this is that

preferred shares, which are a form of equity, are paid fixed dividends with after-tax

dollars. This is the same case for common shares. If dividends are paid out, it is in after-

tax dollars.

Preferred shares are considered to be like debt in that they pay a fixed rate like a bond (a

debt investment). It is because interest expenses on bonds are tax deductible, while

preferred shares pay with after-tax dollars, that preferred shares are considered a more

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expensive means of financing. Issuing preferred shares does have its benefits over bonds

in that a company can stop making payments on preferred shares where they are unable

to stop making payments on bonds without going into default.

There are a few reasons why issuing preferred shares are a benefit for companies. One

benefit of issuing preferred shares, is that for financing purposes they do not reflect added

debt on the company's financial books. This actually can save money for the company in

the long run. When the company looks for debt financing in the future, it will receive a

lower rate since it will appear the company's debt load is lower - causing the company to

in turn pay less on future debt. Preferred shares also tend to not have voting rights, so

another benefit becomes that issuing preferred shares does not dilute the voting rights of

the company's common shares.

Preferred Stock is stock which is preferred over common stock in any number of

different ways. For example:

Preferred stock may have a liquidation preference, which is a right to be paid first

a certain fixed or formulaic amount of money before the common stock or other

junior series of preferred stock are entitled to receive any portion of the proceeds

from a liquidation or sale or merger of the company into another company;

Preferred stock may have purchase price anti-dilution protection, which means

that if the company issues additional stock in the future at a price per share lower

than the price per share at which the preferred stock was sold, the preferred stocks

purchase price will in effect be reduced as a result of the subsequent stock sale at the

lower price;

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 Preferred stock may have special voting rights (including protective provisions,

such as the right to block a subsequent financing or sale transaction);

Preferred stock may be entitled to dividends before any dividends may be paid on

the common stock or other junior series of preferred stock; or

Preferred stock may have redemption rights, meaning the holders will have the

right to have their preferred shares redeemed after a certain period of time.

5.0 Task 4

4.1 The major advantages and disadvantages of the corporate form of organization as

compared to sole proprietorship and partnership

It is important to understand the different types of business organizations types such as a

sole proprietorship, partnership, and corporation. A businesss organizational structure

influences issues, legal issues, financial concerns, and personal concerns.

A Sole Proprietorship is a business with one owner who operates the business on his or

her own or employ employees. It is the simplest and the most numerous form of business

organization in the United States, however it is dangerous as the sole proprietor has total

and unlimited liability. Self contractor is one example of a sole proprietorship.

Advantages of a sole proprietorship

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1. Simplest and least expensive form of business to establish and to dissolve.

2. The owner is making all the decisions and controlling the whole operations.

3. All profit flows directly to the owner.

4. It is subject to fewer regulations.

5. It has tax advantage: any income is declared as the owners personal income tax

return, therefore there are no corporate income taxes.

Disadvantages of a sole proprietorship

1. The owner is responsible for all the obligations of the business.

2. It is difficult to raise capital: it can only use the owners personal saving and

consumer loans.

A Partnership is a business with two or more individuals owns and manages the

business. Partners share the unlimited liabilities of the business and operate the business

together. There are three classification of partnerships: general partnership (partner divide

responsibility, liability and profit or loss according to their agreement), limited

partnership (in additional at least one general partner, there are one or more limited

partner who have limited liability to the extent of their investment), and limited liability

partnership (all of the partners have limited liability of the business debts; it has no

general partners).

Advantages of a partnership

1. It is relatively easy to form but considerable amount of time should be invested in

developing the partnership agreement.

2. It is easier to raise capital compared to a sole proprietorship as there is more than

one investor.

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3. Any income is declared as the partners personal income tax returns, therefore

there are no corporate income taxes.

4. Employees may be motivated and attracted to the business by the inventive to

become a partner

Disadvantages of a partnership

1. Partners are jointly responsible for all the obligations of the business.

2. Partners must make decision together therefore disputes or conflicts may occur. It

may eventually lead to dissolving the partnership.

A corporation is a limited liability entity doing business owned by multiple shareholders

and is overseen by a board of directors elected by the shareholders. It is distinct from its

owners and can borrow money, enter into contracts, pay taxes and be sued. The

shareholders gain from the profit through dividend or appreciation of the stocks but are

not responsible for the companys debts.

Advantages of a corporation

1. It can raise additional funds through the sale of stock.

2. Shareholders can easily transfer the ownership by selling their stock.

3. Individual owner liability is limited to the value of stock they are holding in the

corporation.

Disadvantages of a corporation

1. It is restricted by more regulations, more closely monitored by governmental

agencies and are more costly to incorporate than other forms of the organizations.

2. Profit of the business is taxed by the corporate tax rate. Dividends paid to

shareholders are not deductible from corporate income, so this part of income is taxed

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 twice as the shareholders must declare dividends as their personal income and pay

personal income taxes too.

4.2 Factors affecting corporate dividend policy

1. Stability of Earnings. The nature of business has an important bearing on the dividend

policy. Industrial units having stability of earnings may formulate a more consistent

dividend policy than those having an uneven flow of incomes because they can predict

easily their savings and earnings. Usually, enterprises dealing in necessities suffer less

from oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend

policy. A newly established company may require much of its earnings for expansion and

plant improvement and may adopt a rigid dividend policy while, on the other hand, an

older company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an

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important factor in dividend decisions. A dividend represents a cash outflow, the greater

the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity

of a firm depends very much on the investment and financial decisions of the firm which

in turn determines the rate of expansion and the manner of financing. If cash position is

weak, stock dividend will be distributed and if cash position is good, company can

distribute the cash dividend.

4. Extent of share Distribution. Nature of ownership also affects the dividend decisions.

A closely held company is likely to get the assent of the shareholders for the suspension

of dividend or for following a conservative dividend policy. On the other hand, a

company having a good number of shareholders widely distributed and forming low or

medium income group, would face a great difficulty in securing such assent because they

will emphasise to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for

strengthening their financial position. The income may be conserved for meeting the

increased requirements of working capital or of future expansion. Small companies

usually find difficulties in raising finance for their needs of increased working capital for

expansion programmes. They having no other alternative, use their ploughed back profits.

Thus, such Companies distribute dividend at low rates and retain a big part of profits.

6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend

policy is adjusted according to the business oscillations. During the boom, prudent

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management creates food reserves for contingencies which follow the inflationary period.

Higher rates of dividend can be used as a tool for marketing the securities in an otherwise

depressed market. The financial solvency can be proved and maintained by the

companies in dull years if the adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is widely affected by the

change in fiscal, industrial, labour, control and other government policies. Sometimes

government restricts the distribution of dividend beyond a certain percentage in a

particular industry or in all spheres of business activity as was done in emergency. The

dividend policy has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and consequently

the rate of dividend is lowered down. Sometimes government levies dividend-tax of

distribution of dividend beyond a certain limit. It also affects the capital formation. N

India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legal

requirements too into consideration. In order to protect the interests of creditors an

outsiders, the companies Act 1956 prescribes certain guidelines in respect of the

distribution and payment of dividend. Moreover, a company is required to provide for

depreciation on its fixed and tangible assets before declaring dividend on shares. It

proposes that Dividend should not be distributed out of capita, in any case. Likewise,

contractual obligation should also be fulfilled, for example, payment of dividend on

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preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep

in mind the dividend paid in past years. The current rate should be around the average

past rat. If it has been abnormally increased the shares will be subjected to speculation. In

a new concern, the company should consider the dividend policy of the rival organisation.

11. Ability to Borrow. Well established and large firms have better access to the capital

market than the new Companies and may borrow funds from the external sources if there

arises any need. Such Companies may have a better dividend pay-out ratio. Whereas

smaller firms have to depend on their internal sources and therefore they will have to

built up good reserves by reducing the dividend pay out ratio for meeting any obligation

requiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is so far as

dividends are concerned. If the directors want to have control on company, they would

not like to add new shareholders and therefore, declare a dividend at low rate. Because by

adding new shareholders they fear dilution of control and diversion of policies and

programmers of the existing management. So they prefer to meet the needs through

retained earing. If the directors do not bother about the control of affairs they will follow

a liberal dividend policy. Thus control is an influencing factor in framing the dividend

policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate

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of retention earnings, unless one other arrangements are made for the redemption of debt

on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders

(mostly institutional lenders) put restrictions on the dividend distribution still such time

their loan is outstanding. Formal loan contracts generally provide a certain standard of

liquidity and solvency to be maintained. Management is bound to hour such restrictions

and to limit the rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another

consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to

distribute dividend at a time when is least needed by the company because there are peak

times as well as lean periods of expenditure. Wise management should plan the payment

of dividend in such a manner that there is no cash outflow at a time when the undertaking

is already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly

because each investor is interested in the regular payment of dividend. The management

should, inspite of regular payment of dividend, consider that the rate of dividend should

be all the most constant. For this purpose sometimes companies maintain dividend

equalization Fund.

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6.0 Coursework

1. Straight Bonds

Straight Bonds A bond is basically a loan whose repayment obligation is represented by a

debt instrument issued by the company in the form of a certificate. A bond certificate is

evidence that the company (issuer) has borrowed a fixed amount of money from the

lenders (investors) with a promise to repay the principal amount at maturity and make

periodic interest payments on the principal. Unlike loan stocks, bonds are negotiable or

transferable.

When an investor buys a bond, he is lending money to the company and becomes a

creditor of the company. The company issuing the bond is the debtor or the borrower. The

amount owed to the creditor is a liability of the company. Failure of the company to pay

interest or principal constitutes a default by the company.

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The following are the features of straight bonds:

I. Principal value or par value: Straight bonds are usually denominated in units of RM

100 (if in Malaysia). This stated face value of a bond is called the principal or par value.

The issuing company promises to repay the principal amount by a certain date called the

maturity date. The price is often expressed as a percentage of the par value. For example,

if the price is quoted at 80, this means that a bond with a par value of RM 100 is selling at

RM8O. In this situation, the bond is selling at a discount became the market price is

lower than the par value.

Bonds can also be sold at a premium with respect to the par value. The issuer of bond

generally pays interest at a rate expressed as a percentage of the par value. For example, a

5 percent bond means that RMS of interest is paid to the holders of the bond, usually in

semiannual installments. These payments are referred to as "coupons" and the 5 percent

is called the coupon rate.

2. Indenture: Most corporate bonds will include an indenture. An indenture is a legal

agreement that lists the obligations of the issuer to the bondholders, including the

payment schedule and features such as call provisions and sinking funds

3. Call provision: This feature gives the issuer the right to call in the bonds before

maturity. Exercising the call provision becomes attractive to an issuer when the market

interest rates drop below the coupon rate on the outstanding bonds. The issuer can save

money by issuing new bonds at lower rates. When a call is issued, the bondholders must

submit the bonds for redemption and the company (issuer) will have to pay back the

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principal and a small premium, the call price, to the bondholders. The call price is always

higher than the principal value of the bond.

For example, bond that is callable at 10S is debt that the company can buy back from the

holder at a price of RM 105 per bond, regardless of what themarket value of the bond

might be. Call prices are always specified when the debt is originally issued.

4. Sinking fund: A sinking fund provision specifies payment the issuer must make to

redeem a given percentage of the outstanding issue prior to maturity. A sinking fund is

required for the orderly retirement of the bond issue during the life of the bond. Long-

term debt is usually repaid in regular amounts over the life of the debt. The payment of

long-term debt by installment is called amortization.

The entire debt is extinguished at the end of the amortization. Amortization is typically

arranged by a sinking fund. Each year the company places money in the sinking fund and

the money is used to buy back the bonds.

5. Collateral: Bonds can have different types of collateral as follows: Secured bonds

These bonds are backed by a legal claim on some specific property of the issuer in the

case of default. In the event of a default, the property can be sold to satisfy the debt for

which the security is given. Holders of such bonds have prior claim on the mortgaged

assets in the case of default.

Unsecured bonds (debentures) These bonds are backed only by the promise of the issuer

to pay interest and principal on a timely basis. As such, they are secured by the general

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credit of the issuer. In the event of a default, the debenture holders will obtain something

only if the secured bondholders have been satisfied.

5. Seniority: In general terms, seniority indicates preference in position over other

lenders. Some debts are subordinated. In the event of a default holders of subordinated

debt must give preference to other specified creditors. This means that the subordinated

lenders will be paid off only after the specified creditors have been compensated.

Different Types of Bonds There are many different types of bonds. These are discussed

below.

1. Debentures: A debenture is an unsecured bond. This means that the issuing company

promises to pay principal and interest on the debenture but it pledges no specific assets in

case the company does not fulfill its promise. Therefore, debenture holders depend on the

success of the borrower to make the promised payment. If the issuer does not make an

interest payment, the debenture holders can declare the company bankrupt and claim any

unpledged assets to pay off the debt.

2. Subordinated bonds: Subordinated bonds are similar to debentures. However, in

the event of a default, subordinated bondholders have a claim on the assets of the

company only after it has satisfied the claims of all senior secured bonds and debenture

holders.

3. Income bonds: Income bonds stipulate payment schedules, but the interest is due

and payable I only if the issuer earns an income to make the payments by the stipulated

dates. In the event that the company does not earn sufficient income, it does not have to

make the interest payments and it cannot be declared bankrupt. However, the interest

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payments must be paid subsequently. Income bonds usually offer higher returns to

compensate investors for the added risk of uncertainty in interest payments of the issuer.

4. Variable interest rate bonds: A variable interest rate bond is a long-term bond with

a coupon rate that varies with changes in the short-term interest rates. The variability of

the interest rate A means that if the short-term interest rate rises, the interest rate paid by

the issuer must also increase.

5. Bonds with warrant: In Malaysia, bonds issued with detachable warrants are quite

common. The issuer offers the entire issues of bonds with warrants at face value to a

primary subscriber. The primary subscriber subsequently detaches the warrants and sells

them to shareholders of the issuer in the secondary market. Bonds with warrants have low

coupon rates and are sold at | a discount to yield the rate of return required by investors in

the secondary market. The bonds allow the issuer to first raise money through the sale of

the bonds. Later , when warrants are exercised ,the issuer is able to raise funds again

when new shares are purchased at the new price.

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2.Rules of the Pecking Order

The previous discussion presented the basic ideas behind the pecking-order theory. What

are the practical implications of the theory for financial managers? The theory provides

the following two rules for the real world.

Rule #1 Use Internal Financing For expository purposes, we have oversimplified by

comparing equity to riskless debt. Managers cannot use special knowledge of their firm

to determine if this type of debt is mispriced because the price of riskless debt is

determined solely by the marketwide interest rate. However, in reality, corporate debt has

the possibility of default. Thus, just as managers tend to issue equity when they think it is

overvalued, managers also tend to issue debt when they think it is overvalued.

When would managers view their debt as overvalued? Probably in the same

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situations when they think their equity is overvalued. For example, if the public thinks

that the firm's prospects are rosy but the managers see trouble ahead, these managers

would view their debtas well as their equityas being overvalued. That is, the public

might see the debt as nearly risk-free, whereas the managers see a strong possibility of

default.

Thus, investors are likely to price a debt issue with the same skepticism that they

have when pricing an equity issue. The way managers get out of this box is to finance

projects out of retained earnings. You don't have to worry about investor skepticism if

you can avoid going to investors in the first place. So the first rule of the pecking order is

this: Use internal financing.

Rule #2 Issue Safe Securities First Although investors fear mispricing of both debt and

equity, the fear is much greater for equity. Corporate debt still has relatively little risk

compared to equity because if financial distress is avoided, investors receive a fixed

return. Thus, the pecking-order theory implies that if outside financing is required, debt

should be issued before equity. Only when the firm's debt capacity is reached should the

firm consider equity.

Of course, there are many types of debt. For example, because convertible debt is more

risky than straight debt, the pecking-order theory implies that managers should issue

straight debt before issuing convertibles. So, the second rule of pecking-order theory is

this: Issue the safest securities first.

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