Bonds, Preferred Stocks & Common Stocks

Chapter Structure

Bonds
Preferred Stocks Common Stocks

Topic Layout Bonds

Basic Terms and Concepts Classification of Bonds Security Issuer Interest Payment Retirement of Bonds Sinking Fund Serial Bonds Call Provision

Basic Terms and concepts

Bond A security through which the issuer promises to pay principal when due and to make timely interest payments on the principal amount. Its a long-term debt instrument with a final maturity of 10 years or more. In common usage, the word bond refers to all kinds of debt.

Basic Terms and concepts

Note An unsecured debt, usually with a maturity under 10 years. Par Value It represents the amount to be paid to the bondholder at bonds maturity It is also called as face value or principal.
Coupon Rate The stated rate of interest on a bond.

Basic Terms and concepts

Coupon Payment The periodic payment made by the issuer of the bond to the holder. The payment can be semi-annual or annual.
Maturity The time at which the issuer is obligated to pay the bondholder the par value of the bond. Registered Form and Bearer Form

Basic Terms and concepts

Seniority It indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority.
Protective Covenant A part of the indenture limiting certain actions (of the issuer) that might be taken during the term of the loan, usually to protect the bondholders interest.

Negative Covenants Positive Covenants

Basic Terms and concepts

Trustee A person or institution (usually a bank) designated by a bond issuer as the official representative of the bondholders. The trustee must:
1) make sure the terms of the indenture are obeyed 2) manage the sinking fund 3) represent the bondholders in default, that is, if the company defaults on its payments to them. 4) to watch over the financial condition of the borrower

The trustee is directly compensated by the issuer

Basic Terms and concepts

Indenture The legal agreement between the issuer of the bond and the bondholders, establishing the terms of the bond issue and naming the trustee. The bond indenture is a legal document. It generally includes the following provisions:
1) The basic terms of the bonds 2) The total amount of bonds issued 3) A description of property used as security 4) The repayment arrangements 5) The call provisions 6) Details of the protective covenants

Basic Terms and concepts

Bond Ratings The debt ratings are an assessment of the creditworthiness of the corporate issuer. The definitions of creditworthiness is, how likely the firm is to default and the protection creditors have in the event of a default. It is important to recognize that bond ratings are concerned only with the possibility of default. The two leading bond-rating firms are Moodys and Standard & Poors (S&P).

Basic Terms and concepts

Investment Grade Bonds Bond that have a relatively low risk of default are considered investment grade bonds 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade.
Junk Bond A high-risk, high-yield (often unsecured) bond rated below investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds".

Classification of Bonds

On the basis of Security Secured Mortgage Bonds Equipment Trust Certificates Unsecured Debenchers Subordinated Debenchers Income Bonds On the basis of coupon payments Zero Coupon Bonds Fixed-Rate Bonds Floating-Rate Bonds On the basis of issuer Government Bonds Municipal Bonds Corporate Bonds

Types of Bonds Secured

Mortgage Bond
A bond issue secured by a mortgage on the issuers property. The issue is secured by a lien on specific assets of the corporation. The market value of the collateral should exceed the amount of the bond issue by a reasonable margin of safety to help protect bondholders. If the corporation defaults, the trustee can foreclose on behalf of the bondholders. The bondholders become general creditors for any residual amount after the sale of the collateral. The corporation may have a first mortgage and a second mortgage on the same assets. The first mortgage has a senior claim on the assets.

Types of Bonds Secured

Equipment Trust Certificate

An intermediate to long-term security, usually issued by a company, that is used to finance new equipment. A issuer arranges with a trustee to purchase equipment from a manufacturer. The issuer signs a contract with the manufacturer for the construction of specific equipment and pays a downpayment. When the equipment is delivered, equipment trust certificates are sold to investors. Proceeds plus the downpayment are used to pay the manufacturer.

Types of Bonds Secured

Equipment Trust Certificate (cont )

Title of the equipment is held by the trustee, and the trustee leases the equipment to the issuer. Lease payments are used to pay a fixed interest payment to the certificate holders and to retire a specified portion of the certificates at regular intervals. After the final lease payment (all certificates are retired), title to the equipment passes to the issuer.

Types of Bonds Unsecured

Debenture

A long-term, unsecured debt instrument. Investors look to the earning power of the firm as their primary security. Investors receive some protection by the restrictions imposed in the bond indenture, particularly any negative-pledge clause. A negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors.

Types of Bonds Unsecured

Subordinated Debenture

A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of debt; known as junior debt. In this case, subordinated debenture holders rank behind debenture holders but ahead of preferred and common stockholders in the event of liquidation. Frequently, the security is convertible into common stock to lower the yield required by subordinated debenture holders (often less than regular debentures).

Types of Bonds Unsecured

Income Bond

A bond where the payment of interest is contingent upon sufficient earnings of the firm. Frequently, there is a cumulative feature, which provides that any unpaid interest in a particular year accumulates. The cumulative obligation is usually limited to no more than three years. The bonds are unpopular with investors (usually limited to reorganizations), but are still senior to preferred and common shareholders in the event of liquidation.

Types of Bonds Coupon Payment

Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below.

Types of Bonds Coupon Payment

Fixed Rate Bond

A fixed rate bond is a long term debt paper that carries a predetermined interest rate. The interest rate is known as coupon rate and interest is payable at specified dates before bond maturity.

Floating Rate Bond

A note with a variable interest rate, which interest is pegged to a benchmark, such as the Treasury Bill rate. The adjustments to the interest rate are usually made every six months and are tied to a certain money-market index.

Types of Bonds Issuer

Government Bonds

Government issues notes and bonds to finance its operations. No default risk since the Treasury can print money to payoff the debt. Very low interest rates, often considered the risk-free rate.

Municipal Bonds

Issued by local, county, and state governments. Used to finance public interest projects.

Types of Bonds Issuer

Corporate Bonds

A debt security issued by a corporation and sold to investors. A corporate bond can either be secured or unsecured. Corporate bonds are considered higher risk than government bonds. As a result, interest rates are almost always higher, even for top quality credit rating companies.

Retirement of Bonds

The retirement (repayment) of bonds may be accomplished in a number of ways: Making a final single payment on maturity Converting bonds (if convertible) Periodic repayment through Sinking Fund or Serial Bond issue Calling a bond if there is a call feature.

Retirement of Bonds
Sinking Fund Fund established to periodically retire a portion of a security issue before maturity. The corporation is required to make periodic sinking-fund payments to a trustee. Forms for the sinking-fund retirement of a bond: The corporation makes a cash payment to the trustee, which calls the bonds. The corporation purchases bonds in the open market and delivers them to the trustee.

Retirement of Bonds
Sinking Fund (cont)

When bonds are called for redemption, the bondholders will receive the sinking-fund call price. The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street Journal. Bonds should be purchased in the open market if the market price is less than the sinking-fund call price. Volatility in interest rates or a decline in the credit quality of the firm could lower the market price of the bond and enhance the value to the firm of having this option.

Retirement of Bonds
Sinking Fund (cont)

Bondholders may benefit from the orderly retirement of debt (amortization effect), which reduces the default risk of the firm and adds liquidity to bonds outstanding. Balloon Payment -- A payment on debt that is much larger than other payments. Many bond issues are designed to have a larger final payment to pay off the debt. For example, a corporation may undertake a $10 million, 15year bond issue. The firm is obligated to make $500,000 sinking-fund payments in the 5th through 14th years. The final balloon payment in the 15th year would be for the remaining $5 million of bonds.

Retirement of Bonds
Serial Bonds An issue of bonds with different maturities, as distinguished from an issue where all bonds have identical maturities (term bonds). For example, a $10 million issue of serial bonds might have $500,000 of predetermined bonds maturing each year for 20 years. Investors are able to choose the maturity that best fits their needs (wider investor appeal).

Retirement of Bonds
Call Provision A feature in an indenture that permits the issuer to repurchase securities at a fixed price (or series of fixed prices) before maturity; also called call feature. Not all bonds are callable; In periods of low interest (hence, low coupon) rates, firms are more likely to issue noncallable bonds. When a bond is callable, the call price is usually above the par value of the bond and often decreases over time. According to when they can be exercised, call provisions can be either immediate or deferred. The call provision provides financing flexibility for the firm as conditions change.

Retirement of Bonds
Call Privilege Value of Call Option
Callable - Bond = Value

Noncallable Bond Value

Call - Option Value

The call privilege is valuable to the firm to the detriment of bondholders. As such, bondholders require a premium for this additional risk in the form of a higher yield. The greater the volatility of interest rates, the greater the probability that the firm will call the bonds. Thus, the call-option is more valuable all else equal.

Topic Layout Preferred Stocks

Basic Terms Features of Preferred Stocks Cumulative Dividend Feature Participating Feature Voting Rights Retirement of Bonds

Call Provision Sinking Fund Conversion

Use

in Financing

Basic Terms - Preferred Stocks

Preferred Stocks Preferred stock is a hybrid form of financing, combining feature of debt and common stock. Like bonds, preferred stock has a par value and a dividend, that must be paid before dividends can be paid on the common stock. However, if the preferred dividend is not earned, the directors can omit it without throwing the company into bankruptcy.

Basic Terms - Preferred Stocks

Dividend The dividend paid on preferred stocks are fixed, in terms of the rate at which it is paid. Holders of the preferred stocks must receive a dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything. Although preferred stock has a xed payment like bonds, which is at the discretion of the board of directors and a failure to make this payment will not lead to bankruptcy

Basic Terms - Preferred Stocks

Par Value Preferred shares have a stated par value. In case of liquidation the claim of preferred stock holders is restricted to the par value of the preferred stock. The claim of preferred stockholders on assets comes after that of creditors but before that of common stockholders.

Features of Preferred Stocks

Cumulative Dividend Feature A requirement that all cumulative unpaid dividends on the preferred stock be paid before a dividend may be paid on the common stock. For example, if the board of directors omits a $6 preferred dividend for two years, it must pay preferred shareholders $12 per share ($100 par value) before any dividend can be paid to common shareholders. The corporation does not have to make up the dividend even if it is profitable, as long as the firm has no plans to pay dividends to common shareholders.

Features of Preferred Stocks

Participating Feature Preferred stock where the holder is allowed to participate in increasing dividends if the common stockholders receive increasing dividends. Preferred stockholders have a prior claim on income and an opportunity for additional return if the dividends to common stockholders exceed a certain amount. A 6% participating preferred issue ($100 par) allows holders to share equally in any dividend in excess of $6. A $7 common dividend results in an extra $1 dividend to the participating preferred shareholders.

Features of Preferred Stocks

Voting Rights Preferred stockholders are not normally given a voice in management unless the company is unable to pay preferred stock dividends during a specified period. If such a situation presents itself, the class of preferred stockholders would be entitled to elect a specified number of directors. Any situation in which the company defaults under restrictions in the agreement (similar to bond indenture) may lead to voting power for preferred shareholders. Preferred shareholders cannot force the immediate repayment of obligations (like debt obligations).

Features of Preferred Stocks

Retirement of Preferred Stocks Call Provision -- almost all issues carry a call provision because of the infinite maturity. It is often a cheaper method of retirement than open market purchases, inviting tenders, or an exchange of securities. Sinking Fund -- like bonds, many preferred issues provide for this method of retirement. Conversion -- certain issues are convertible into common stock at the option of the preferred stockholder. Used most frequently in the acquisition of other companies (the transaction is not taxable to the shareholders of the acquired firm).

Use in Financing

The corporate issuer uses irregularly because the preferred dividend is not tax deductible. Utilities use more frequently as the preferred dividend can be accounted for when setting customer rates. The corporate investor is attracted to preferred stock as generally 70% of dividends can be excluded from taxes. Flexibility in paying dividends and an infinite maturity (similar to a perpetual loan) are significant advantages to the corporate issuer. The after-tax cost of preferred financing is greater than that of long-term debt financing to the corporate issuer.

Common Stock

Securities that represent the ultimate ownership (and risk) position in a corporation. In event of liquidation, these stockholders have a residual claim over the assets. Their claim is limited to amount recovered from the asset of the company. Common stocks has no maturity date.

Basic Terms Common Stocks

Authorized Shares

Issued Shares

Outstanding Shares

Basic Terms Common Stocks

Par Value It is the face value of stock. It is merely a recorded figure in the corporate charter and is of little economic consequence. Stock should never be issued below par value as shareholders would be legally liable for any discount from par if the firm is liquidated. Common stock that is authorized without par value (nopar stock) is carried on the books at the original market price or at some assigned (or stated) value. The difference between the issuing price and the par or stated value is additional paid-in capital.

Basic Terms Common Stocks

Par Value (Example)
FunFinMan, Inc.

Common stock ($1 par value;100,000 shares issued and outstanding) Additional paid-in capital Retained earnings Total shareholders equity

$ 100,000 400,000 650,000 $1,150,000

The par value of FunFinMan, Inc., is $1 per share. This value is not likely to change over time from normal dayto-day operations.

Basic Terms Common Stocks

Book Value It is the shareholders equity It is total assets minus liabilities and preferred stock divided by the number of shares outstanding.
Liquidating Value The value per share if the firms assets are sold separately from the operating organization. This value may be less (or greater) than book value. Rarely are the two values identical.

Basic Terms Common Stocks

Book Value (Example)
FunFinMan, Inc. Common stock ($1 par value;100,000 shares issued and outstanding) Additional paid-in capital Retained earnings Total shareholders equity

$ 100,000 400,000 650,000 $1,150,000

The book value (per share) of FunFinMan, Inc., is determined by dividing total shareholders equity ($1,150,000) by the shares outstanding (100,000), which yields a book value of $11.50 per share. This value is not likely to change over time from normal day-to-day operations.

Basic Terms Common Stocks

Market Value The current price at which the stock is currently trading. This value is usually greater than book value (per share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical. Market value (per share) may be difficult to obtain from thinly traded securities.

Rights of Common Shareholders

Right to Income - entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors). Right to Purchase New Share (Maybe) Income - the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock.

Rights of Common Shareholders

Voting Right - because the shareholders are owners

of the firm, they are entitled to elect the board of directors.

Shareholders are generally geographically widely dispersed. Two methods of voting: (1) in person or (2) by proxy Proxy -- A legal document giving one person authority to act for another.

Rights of Common Shareholders

Voting Right (Cont) SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings. Most shareholders, if satisfied with company performance, sign proxies in behalf of management. Voting Procedure - The board of directors are elected under either: 1. Majority-rule Voting -- a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory voting.

Rights of Common Shareholders

Voting Right (Cont) 2. Cumulative Voting -- a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors.

Rights of Common Shareholders

Voting Procedure Example You are a shareholder of FunFinMan, Inc. You own 100 shares and there are 10 director positions to be filled.

Under Majority-rule Voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position. Under Cumulative Voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire.

Rights of Common Shareholders

Voting Procedure - Minimum Votes to Elect a Director Under Cumulative Voting (Cont)
Total number of voting shares X Specific number of directors sought

+1

Total number of directors to be elected + 1

For example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001* voting shares. *(100,000 shares) x (3 directors) 10

Rights of Common Shareholders

Voting Procedure - Minimum Votes to Elect a Director Under Cumulative Voting Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions -- less than a majority. Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote. Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60,001 shares (twice as many)!

Dual - Class Common Stock

Two classes of common stock, usually designated Class A and Class B. Class A is usually the weaker voting or nonvoting class, and Class B is usually the stronger. This is used to retain control for founders, management, or some other specific group. For example, 80,000 shares of Class A at $20/share and 200,000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes. Usually Class B takes a lower claim to dividends and assets than Class A for this voting control.