Financial Management 2

Sources of Long-Term Financing

Carren T. Payad, Evangeline M. Payumo,
Jayson Lester M. Pineda, Patrick

I. Rivera,

and Jester Aries A. Sagun

Group II- BSA IV
I.

Rationale
Firms finance their existing and new assets with
capital. Some capital used to finance assets come from
equity financing (ownerships shares that the firms
sells), debt financing (borrowed funds, usually loans
and bonds) and retained earnings (profits that firms
retain and reinvest, also considered as part of ownerprovided). As business firms grow bigger, the demand
for more capital likewise intensifies (Cabrera, 2012).
A firm will choose its preferred type of capital
funding upon its size, its stage in its life cycle and
as a related issue, its prospects for future growth
(Cabrera, 2012).

II.

Objectives
1. Determine the sources of capital for business firms.
2. Discuss the nature of debt financing, its advantages
and disadvantages, general terms, maturity,
collateral restructure covenants and repayment
schedule.
3. Identify the different features of bonds, prices,
credit risk and ratings; types and methods of
retirement.
4. Know the features, advantages and disadvantages of
issuing preferred shares, and calculating its
intrinsic value.
5. Understand the nature of ordinary (common) equity
share and calculate its valuation using the Finite
and Infinite-Period valuation methods.
6. Understand how leases are utilized as source of long
term capital.

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III. Pre-test

IV.

What are the sources of capital for business firms?

What is Long-Term Financing?
Identify and explain the nature of debt financing
and equity financing.
What is bond?
What are the major features of preferred and
ordinary shares?
How is the valuation of preferred shares? For
ordinary shares?
Why leasing is a form of debt?

Learning Cell
Sources of Long-Term Financing

Equity Financing, which include capital funds invested by

venture capitalists.

Debt Financing, which include capital funds borrowed from

personal savings of friends or relatives, financial
institutions such as commercial bank loans or venture
capitalists.

Types of Debt Financing

Short Term debt financing

Long Term debt financing

Short Term Debt Financing

As it is obvious in the name, short term debt financing
is a form of financing involving financial obligations that
must be fulfilled usually within a year to two at most. It
is more often used for working capital requirements, or dayto-day operations of the business.

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Advantages

Short term debt financing is a source of 'quick'

liquidity for the business, in particular SMEs, who do
not have large pool of reserve funds for emergency uses.

Small enterprises are more prone to short term shocks

from their operating environment such as a large debtor
declaring bankrupt, or an abruptly ceased partnership
with a major supplier. Hence, short term debt financing
provides almost immediate funds to tide over such
difficult situations that could otherwise impact the
going concern of SMEs.

Short term debt financing is usually easier to negotiate

(compared to long term debts and equity financing), as
the financier faces relatively lower credit risk.

Due to the ease of negotiation, short term debt financing

can be used to free up funds in the business for good
investment opportunities that would otherwise have been
foregone.

Disadvantages

Short term debt financing has to be monitored closely to

avoid bad relationships with suppliers and bankers, or a
bad reputation in the industry for not paying debts on
time.

Short-term debts only meet working capital or immediate

business needs. They are not useful for servicing any
long term plans with larger capital requirements, higher
risk, and longer payback horizons.

Long Term Debt Financing

In contrast to short-term borrowings, long-term debt is
used to finance business investments that have longer
payback periods
Advantages

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Long term debt financing is usually less prone to short

term shocks as it is secured by formally established
contractual terms. Hence, they are relatively more stable
than short-term debt.

Long term debt financing is directly linked to the

growth of the company's operating capacity (purchase of
capital assets such as machinery).

Long-term debt is normally well structured and defined.

Thus fewer resources have to be channeled to monitor and
maintain long-term debt financing accounts (compared to
short term debt financing such as supplier credit which,
changes overtime and need to be monitored on a regular
basis).

Long-term debt financing options such as leases offer a

certain degree of flexibility, compared to having to
purchase the asset (E.g. machinery).

Disadvantages

Long term debt is often costly to service (interest

charges are higher).

Long term debt financiers usually demand a great amount

of information from the company to perform its credit
evaluation.

Start-ups usually find it more difficult to obtain long

term debt financing, or if they do, at unfavorable terms,
as they have almost no proven track record, low cash
flow, and small asset base.

Long-term debt financing contracts normally contain a

lot of restrictive clauses and covenants, including the
scope of business operations that the company is allowed
to engage in, capital and management structure
limitations, etc.

Term Loans
Term Loans are the standard commercial loan, often used
to pay for a major investment in the business or an

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acquisition. Term loans usually last between more than one

and ten years, but may last as long as 30 years in some
cases. The loans often have fixed interest rates, with
monthly or quarterly repayment schedules and a set maturity
date.
Characteristics of Term Loans:

Have maturities of more than 1-10 years;

Are repaid in periodic installments over life of the

loan; and
Are usually secured by a chattel mortgage on equipment or
mortgage on real property.
Commercial Banks- usually offer more than 1 to 10 years
of maturity.
Insurance Companies- 5-15 years of maturity.

Collateral is property or other assets that a borrower

offers a lender to secure a loan.

Shorter Maturity Loans- often secured with chattel mortgage.

Longer Maturity Loans- often secured with mortgages on real
estate.
Restrictive covenants are binding legal obligations written
into the deed of a property by the seller. These
covenants can be either simple or complex and can levy
penalties against buyers who fail to obey them.
Illustration: Assuming that a firm borrows P1, 500,000 which
is to be repaid in five annual installments. The loan will
carry an 8% rate of interest, and payments will be made at
the end of the next five years.
Requirements:
1. Determine the annual amortization.
2. Prepare an amortization schedule that will show the
loan will be fully paid in five years.
Computation of Present Value Using the Table
Table 4: Present Value of Ordinary Annuity

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Computation of Present Value Using the Formula

Present Value = (1-(1+r)-n )

r
r= rate of interest
n= number of periods
Solution:
Present Value = (1-(1+.08)-5 )
.08
Present Value = 3.993
Amortization
Amortization

= P 1,500,000
3.93
= P 375,657

Amortization Schedule:
End of
Year

Installment
Payment
Amortization

Interest

Principal

0
1

Remaining
1,500,000

P375,675

120,000

255,667

1,244,343

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2
3
4
5

P375,675

99,547

276,110

968,233

P375,675

77,459

298,198

670,035

P375,675

55,603

322,054

347,981

P375,675

27,839

347,819

162

Bonds

A long term promissory note

A long term contract

Most prevalent example of the interest only loan with

investors receiving exactly the same two sets of cash
flows; (1) the periodic interest payments, and (2) the
principal (par value or face value) returned at maturity.

Advantages & Disadvantages of using Bonds

Advantages:

Long term debt is generally less expensive

Bondholders are limited to the payments of interest

Bondholders do not have voting rights

Flotation costs are generally lower than those of
ordinary (common) equity shares.

Disadvantages:

Results in interest payments

Produces fixed charges

Major out cash flow

May limit the firms future financial flexibility.

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Bond features and Prices

Par value the face value of the bond that is returned

to the bondholder

Coupon Interest Rate the percentage of the par value

that will be paid out annually in the form of interest.

Maturity the length of time until the bond issuer

returns the par value and terminates the bonds.

Current yield the ratio of the annual interest payment

to the bonds market price.

Yield to maturity the bonds internal rate of return.

Types of Bonds
A. Unsecured Long Term Bonds
Debentures unsecured long term debt and backed up only by
the reputation and financial stability of the corporation.
Subordinated Debentures claims are honored only after the
claims of secured debt and unsubordinated debentures have
been satisfied.
Income Bonds- requires interest payments only if earned and
nonpayment of interest does not lead to bankruptcy.
B. Secured Long Term Bonds
Mortgage Bonds a bond secured by a lien on real property.
- should the issuing firm fail to pay the
bonds at maturity; the trustees can foreclose or
sell the mortgaged property and use the proceeds to pay
the bondholders.

Other types of Bonds

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Floating Rate or Variable Bonds is one in which the

interest payments changes with market conditions.

Junk or Low rated Bonds participants of this are new

firms that do not have an established record of
performance.

Eurobonds bonds payable denominated in the borrowers

currency, but sold outside the country of the borrower.

Treasury Bonds carry the full-faith-and-credit

backing of the government and investors consider them
among the safest fixed-income investments in the world.

Methods of Retiring Debt

Serial Payments bonds are paid off in installments over

the life of the issue.

Conversion exercised at the option of the bondholder.

(Conversion into common stock).

Call Provision allows the corporation to retire or

force in the debt issue before maturity.

Bond refunding the process of retiring an old bond

issue before maturity and replacing it with a new issue.

Preferred share is a class of equity shares which has

preference in payment of dividends and distribution of
corporate assets upon liquidation over ordinary equity.
Issuance of Preferred Shares favorable

Control problem in issuance of common stock.

Profit margin is adequate to make of additional leverage
attractive.
Additional debt possess substantial risk
Interest rates advantage
The firm has a high debt ratio

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Features of Preferred Share

1. Par Value- face value that appears on stock certificate.
2. Dividends are stated as a percentage of par value.
3. Cumulative and non-cumulative- the unpaid dividends from
prior years can be accumulated to proceeding years.
4. No definite maturity date.
5. Convertible- it can be converted into common shares.
6. Voting rights- they dont have voting rights.
7. Participating features- the holders are entitled to share
in profits above and beyond declared dividends.
8. Protective features- contain protective covenants to
assure payment of dividends.
9. Call provision- gives the issuer a right to call in the
preferred share for redemption.
Advantages of Financing Preferred Share

Financing Flexibility
Favorable Financial Leverage
No dilution of control
No maturity
Asset preservation
No equal participation in earnings

Disadvantages

High issuance cost

Seniority of the holders claim

Preferred share valuation

Po = Dp/ Kp
Where:
Po = Intrinsic Value of a Preferred Share

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Dp = Per share cash dividend

Kp = Investors required rate of return on preferred share

Ordinary (common) equity share- also called the residual

owners. It is a form of long-term equity that represents
ownership interest of the firm.
Features of Ordinary Equity Shares

Par Value/No Par Value it can be issued with or without

par.
Is has authorized maximum number of shares can be issued
by the corporation. Issued authorized shares been sold,
two outstanding which are held by the public.
No Maturity date
The holders have the voting rights
It can be measured at book value per share
The holders have numerous rights
- right to vote
- to receive dividends
- to residual assets
- transfer ownership
- to examine corporate books

Advantages of Ordinary shares

No mandatory fixed charges

No definite maturity date
Potentially greater ease of sale
Increase credit worthiness
Avoidance of restrictive provision

Disadvantages of Ordinary Shares

Dilution of control and earnings

Higher issue cost
Causes increase in component cost of capital

Types of ordinary shares

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Class A- share sold to public and paid a dividend

Class B- or Founders Share share retained by the
organizers of the company

Ordinary Share valuation based on Holding Periods

Finite-Period Dividend Valuation- a model which an

investor plans to purchase an ordinary equity share and
hold it for a specific length of time

Infinite-Period Dividend valuation- a model which an

investor plans to purchase an ordinary share and hold it
indefinitely

Ordinary Share Valuation based on Dividend

Growth Rates

Zero Growth Dividend Model- assumes dividend remain a

fixed amount over time
Gordon Constant Growth Dividend model- assumes that
dividends grow at a constant rate each period.
Supernormal Growth Dividend Model- assumes that dividends
grow at an above normal rate over same time period to
back to normal rate thereafter.

Leasing As Form of Debt

A lease is a contractual arrangement calling for the
lessee (user) to pay the lessor (owner) for use of an asset.
Broadly put, a lease agreement is a contract between two
parties, the lessor and the lessee.
Illustration:
When a corporation contracts to lease an oil tanker or a
computer and signs a non-cancelable, long-term agreement,
the transaction has all the characteristics of debt
obligation.
Advantages of Leasing

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No Large Outlay
Security
Tax Advantages
Budgeting

Disadvantages of Leasing
No Ownership
Long Term Expense
Maintenance
Finance Capital Lease versus Operating Lease

Finance capital lease

The transfers ownership of
the asset to the lessee by
the end of the lease term.
The leased assets are of a
specialized nature such
that only the lessee can
use them without major
modifications being made.
The length is for the
major part of the economic
life of the asset even if
the title is not
transferred. A secondary
rental gives the lessee an
option for renewal.

Operating lease
The lease can be cancelled by the lessee
prior to its expiration at a short
notice.
The lessor is responsible for upkeep and
maintenance of the asset,

The lesse is not given any uplift to

purchase the asset at the end of the
lease period.

The lease is for short period,

The lessor has the option to lease out
the asset again to another party.

V.

Conclusion

Financial Management 2

In operating a business, it is substantial to be

knowledgeable with the different sources of capital
financing of the business. Hence, there are two major
sources of long term financing, debt and capital. For debt
financing, generally long term financing comes from issuing
different types of bonds, depending what the company will
issue. For Capital financing, there are two sources which
can be used, the issuance of preferred shares or ordinary
shares. These two capital financing have their own
advantages and disadvantages as well as their types and
features. Before making a decision in which type of
financing to be done by the business, it is important to
know the measures, advantages and disadvantages of each to
fit and maximize the wealth of the owners or shareholders.

VI.

Post Test
1. Discuss the advantages and disadvantages of debt.
2. What is the difference between the following?
Yields Coupon rate
Current Yield rate
Yield to maturity rate
3. What is the purpose of serial repayments and sinking
funds?
4. Preferred share is often referred to as a hybrid
security. What is meant by this term as applied to
preferred share?
5. If common shareholders are the owners of the company, why
do they the last claim on the assets and a residual claim
on income?
6. What do we mean by capitalizing lease payments?

VII. References

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Brigham, E.F., & Houston J.F.(2013). Financial Management

Fundamentals (12th Ed.). Pasig City, Philippines:
Cengage Learing Asia Pte Ltd. 2015-2016 Raffles Comr.
Center.
Cabrera, M. B.(2012). Financial Management Principles and
Applications. Manila, Philippines: GIC Enterprises &
Co., Inc.
Ling, S. (n.d.). Finance. Types of Debt Financing. Retrieved
August 5, 2015, from
http://www.incontextfinance.com/194/types-of-debtfinance
Investopedia. (n.d.). Lease. Definition of 'Lease'
Retrieved August 10, 2015, from
http://www.investopedia.com/terms/l/lease.asp