The last article showed the importance of short-term money management in relation to current business operations. A company must also plan for the financing of its long-term assets (land, buildings, equipment, and fixtures) and for the basic levels of its operating assets (inventory and receivables). To start or expand a business requires substantial investments in these relatively permanent assets. Because it is virtually impossible to finance these assets with short-term credit, long-term financial planning is necessary if the company is to maintain normal operation. This chapter deals with the major sources of long-term financing-bonds, common stock, preferred stock, and long-term leases and the markets for them.
The basic financial fact of a company’s existence is that it must maintain an acceptable level of earnings. Otherwise, the bond investor will consider the company a poor risk, and the stockholder will look elsewhere for a better return. The investor is interested in a firm’s stability, and in the amount, rate, and potential of its earnings The firm is interested in obtaining capital at the lowest possible cost in order to maximize the return to its owners. Borrowing capital at a fixed rate of interest in the hope of earning more than that rate is known as trading on the equity A company hopes by this means to apply favorably the principle of leverage That is, if it can borrow at an interest rate of 7 per cent and employ these funds in such a way as to earn more than 7 per cent, then the excess will be profit for the owners. A savings and loan association, for example, pays its depositors 5 to 6 per cent on savings accounts, and lends the same money on home and apartment mortgages at 7 to 9 per cent.
A bond is a security representing money furnished to the corporation by the investing public. It must be repaid at a certain time, together with periodic payments of interest. Bonds must not be confused with stocks. Stocks are rights of ownership. Bonds are promises to pay (1) a definite sum of money, (2) a definite rate of interest. (3) At specified dates.
A bond issue is made up of a number of bonds. For example, a $1,000,000 bond issue may consist of one thousand $1,000 bonds. Since these may be held by many investors, the corporation usually enters into a supplementary agreement with a trustee, usually a trust company, which defines the rights, privileges, restrictions, and limitations of the owners of the bonds. This supplementary agreement is called the bond indenture. The trustee, according to the terms of the indenture, certifies the genuineness of the bonds, collects money from the corporation to pay the interest and eventually the principal, holds any collateral that may be used as security for the issue, and in general, looks after the interests of the bond holders.
The face value or denomination of the bound is $1,000 for most bond issues although other denominations are used. The date when a bond must be repaid is known as the maturity date. The length of time between issue and maturity varies. But since bonds are usually means of raising long term debt, it is rarely shorter than 10 years, and may be as long as 100 years. Most bond issues nature in 20 30, or 40 years. The interest rate on bonds is always a fixed rate and is usually paid twice a year.
Bonds may or may not be issued in the name of the holder. A registered bond shows the name of the owner. The issuing corporation records the name of the owner and sends the interest payments directly to him. A coupon bond on the other hand is not issued in a particular name and does not show the name of the owner. Since the corporation does not know who the owner is, the owner must clip dilated coupons which are attached to the bonds and present them in order to receive the interest. Coupon bonds are assumed to be the property of the bearer, and are therefore easy to transfer. Banks prefer them as security for loans. Registered bonds are also easy to transfer. The owner endorses the bond to a purchaser and sends it to the corporation so that the transfer can be recorded. If a registered bond is stolen, the owner is protected against loss because of the record of his ownership.
As with many kinds of debt, the bondholder usually wants some kind of protection or security in case the issuer is not able to pay interest or principal on the due dates, Common types of security are real estate for real estate mortgage bonds, machinery and equipment for chattel mortgage bonds, and stocks, bonds, and other securities for collateral trust bonds. When a company has such excellent credit that it can borrow money by issuing bonds simply on its good name, the bonds are called debenture bonds.
Another variable to consider when dealing with bonds is how the company will retire them, that is pay them off. There must be a plan for accumulating the millions of dollars which are necessary to repay most bond issues when they mature. The repayment plan is nearly always written into the bond indenture. The two most common methods of repayment are through the use of sinking funds and serial bonds. Most sinking fund plans call for the deposit by the borrowing corporation of a fixed sum each year with a trustee. The annual deposit is computed so that the total deposits plus the interest they will earn while with the trustee equal the amount which must be repaid at maturity. Serial bonds call for the retirement of the total bond issue over a period of years, For instance, a company may have a thirty-year, $10,000,000 bond issue which calls for the maturity of $500,000 worth of bonds each year from year eleven through year thirty. Instead of making a deposit to a sinking fund, a portion of the total issue is retired each year.
In industries such as utilities and railroads, which have substantial investments in long-term fixed assets financed by bonds, there is often no intention of repaying the total debt at maturity. Instead these companies often use the proceeds of one bond issue to retire another. This process is called refunding.
Most bond issues contain a provision which enables a company to pay them before maturity. This provision provides flexibility to the issuing corporation if it becomes desirable for the corporation to retire the bonds. Most bond indentures specify a call price, at which they can repay the bonds before the maturity date. The call price is usually 2 to 6 per cent above the original issue price, the attractiveness of most bonds to the investor is the fixed rate of interest over a set number of years. People and institutions who want a fixed income from investments usually select bonds. Some bonds, called convertible bands, not only pay fixed interest but add a speculative feature: they can be converted into common stock if the investor wishes. An investor, for example, may buy a $1,000, 5 per cent bond which can be converted into forty shares of common stock in the same company. If the investor exercises his conversion option immediately, he will have forty shares at $25 each ($1,000+40). At the time of issue, however, the price of the common stock is likely to be only $15 or $20 a share. The bond investor will probably hold the bonds and 5 per cent interest, and wait for the common stock to appreciate. If it goes above $25, he can exercise his conversion option and sell the stock for a capital gain.
The advantage of convertible bonds to the company is that investors are usually willing to accept a lower rate of interest for the conversion privilege. For instance, the bonds in the example above might carry a 7 per cent rate without the conversion option. Also, if the company does well and the price of its common stock goes up, significant conversion may take place, thus red ting the amount of debt which has to be repaid and increasing the amount of common stock.
