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500 SECTION FIVE


Like common stock dividends, preferred dividends are paid from after-tax income. For
most industrial firms this is a serious deterrent to issuing preferred. However, regulated
public utilities can take tax payments into account when they negotiate with regulators
the rates they charge customers. So they can effectively pass the tax disadvantage of
preferred on to the consumer. A large fraction of the dollar value of new offerings of or-
dinary preferred stock consists of issues by utilities.
Preferred stock does have one tax advantage. If one corporation buys another™s
stock, only 30 percent of the dividends it receives is taxed. This rule applies to dividends
on both common and preferred stock, but it is most important for preferred, for which
returns are dominated by dividends rather than capital gains.
Suppose that your firm has surplus cash to invest. If it buys a bond, the interest will
be taxed at the company™s tax rate of 35 percent. If it buys a preferred share, it owns an
asset like a bond (the preferred dividends can be viewed as “interest”), but the effective
tax rate is only 30 percent of 35 percent, .30 — .35 = .105, or 10.5 percent. It is no sur-
prise that most preferred shares are held by corporations.
If you invest your firm™s spare cash in a preferred stock, you will want to make sure
that when it is time to sell the stock, it won™t have plummeted in value. One problem
with garden-variety preferred stock that pays a fixed dividend is that the preferreds™
market prices go up and down as interest rates change (because present values fall when
rates rise). So one ingenious banker thought up a wrinkle: Why not link the dividend on
FLOATING-RATE
the preferred stock to interest rates so that it goes up when interest rates rise and vice
PREFERRED Preferred
versa? The result is known as floating-rate preferred. If you own floating-rate pre-
stock paying dividends that
ferred, you know that any change in interest rates will be counterbalanced by a change
vary with short-term interest
in the dividend payment, so the value of your investment is protected.
rates.


A company in a 35 percent tax bracket can buy a bond yielding 10 percent or a pre-
Self-Test 3
ferred stock of the same firm that is priced to yield 8 percent. Which will provide the
higher after-tax yield? What if the purchaser is a private individual in a 35 percent tax
bracket?




Corporate Debt
When they borrow money, companies promise to make regular interest payments and
to repay the principal (that is, the original amount borrowed).

However, corporations have limited liability. By this we mean that the promise
to repay the debt is not always kept. If the company gets into deep water, the
company has the right to default on the debt and to hand over the company™s
assets to the lenders.

Clearly it will choose bankruptcy only if the value of the assets is less than the amount
of the debt. In practice, when companies go bankrupt, this handover of assets is far from
straightforward. For example, when the furniture company Wickes went into bank-
ruptcy, there were 250,000 creditors all jostling for a better place in the queue. Sorting
out these problems is left to the bankruptcy court.
Because lenders are not regarded as owners of the firm, they don™t normally have any
An Overview of Corporate Financing 501


voting power. Also, the company™s payments of interest are regarded as a cost and are
therefore deducted from taxable income. Thus interest is paid out of before-tax income,
whereas dividends on common and preferred stock are paid out of after-tax income.
This means that the government provides a tax subsidy on the use of debt, which it does
not provide on stock.


DEBT COMES IN MANY FORMS
Some orderly scheme of classification is essential to cope with the almost endless va-
riety of debt issues. We will walk you through the major distinguishing characteristics.

Interest Rate. The interest payment, or coupon, on most long-term loans is fixed at
the time of issue. If a $1,000 bond is issued with a coupon of 10 percent, the firm con-
tinues to pay $100 a year regardless of how interest rates change. As we pointed out-
earlier, you sometimes encounter zero-coupon bonds. In this case the firm does not
make a regular interest payment. It just makes a single payment at maturity. Obviously,
investors pay less for zero-coupon bonds.
Most loans from a bank and some long-term loans carry a floating interest rate. For
example, your firm may be offered a loan at “1 percent over prime.” The prime rate is
PRIME RATE
the benchmark interest rate charged by banks to large customers with good to excellent
Benchmark interest rate
credit. (But the largest and most creditworthy corporations can, and do, borrow at less
charged by banks.
than prime.) The prime rate is adjusted up and down with the general level of interest
rates. When the prime rate changes, the interest on your floating-rate loan also changes.
Floating-rate loans are not always tied to the prime rate. Often they are tied to the
rate at which international banks lend to one another. This is known as the London In-
terbank Offered Rate, or LIBOR.


Would you expect the price of a 10-year floating-rate bond to be more or less sensitive
Self-Test 4
to changes in interest rates than the price of a 10-year maturity fixed-rate bond?


Maturity. Funded debt is any debt repayable more than 1 year from the date of issue.
Debt
FUNDED DEBT
Debt due in less than a year is termed unfunded and is carried on the balance sheet as
with more than 1 year
a current liability. Unfunded debt is often described as short-term debt and funded debt
remaining to maturity.
is described as long-term, although it is clearly artificial to call a 364-day debt short-
term and a 366-day debt long-term (except in leap years).
There are corporate bonds of nearly every conceivable maturity. For example, Walt
Disney Co. has issued bonds with a 100-year maturity. Some British banks have issued
perpetuities”that is, bonds which may survive forever. At the other extreme we find
firms borrowing literally overnight.

Repayment Provisions. Long-term loans are commonly repaid in a steady regular
way, perhaps after an initial grace period. For bonds that are publicly traded, this is done
by means of a sinking fund. Each year the firm puts aside a sum of cash into a sinking
Fund
SINKING FUND
fund that is then used to buy back the bonds. When there is a sinking fund, investors are
established to retire debt
prepared to lend at a lower rate of interest. They know that they are more likely to be
before maturity.
repaid if the company sets aside some cash each year than if the entire loan has to be
repaid on one specified day.
Firms issuing debt to the public sometimes reserve the right to call the debt”that is,
502 SECTION FIVE


issuers of callable bonds may buy back the bonds before the final maturity date. The
CALLABLE BOND
Bond that may be price at which the firm can call the bonds is set at the time that the bonds are issued.
repurchased by firm before This option to call the bond is attractive to the issuer. If interest rates decline and
maturity at specified call bond prices rise, the issuer may repay the bonds at the specified call price and borrow
price. the money back at a lower rate of interest.3
The call provision comes at the expense of bondholders, for it limits investors™ cap-
ital gain potential. If interest rates fall and bond prices rise, holders of callable bonds
may find their bonds bought back by the firm for the call price.


Suppose Heinz is considering two issues of 20-year maturity coupon bonds; one issue
Self-Test 5
will be callable, the other not. For a given coupon rate, will the callable or noncallable
bond sell at the higher price? If the bonds are both to be sold to the public at par value,
which bond must have the higher coupon rate?


Seniority. Some debts are subordinated. In the event of default the subordinated
SUBORDINATED DEBT
lender gets in line behind the firm™s general creditors. The subordinated lender holds a
Debt that may be repaid in
junior claim and is paid only after all senior creditors are satisfied.
bankruptcy only after senior
When you lend money to a firm, you can assume that you hold a senior claim unless
debt is paid.
the debt agreement says otherwise. However, this does not always put you at the front
of the line, for the firm may have set aside some of its assets specifically for the pro-
tection of other lenders. That brings us to our next classification.

Security. When you borrow to buy your home, the savings and loan company will
take out a mortgage on the house. The mortgage acts as security for the loan. If you de-
fault on the loan payments, the S&L can seize your home.
When companies borrow, they also may set aside certain assets as security for the
loan. These assets are termed collateral and the debt is said to be secured. In the event
Debt
SECURED DEBT
of default, the secured lender has first claim on the collateral; unsecured lenders have a
that has first claim on
general claim on the rest of the firm™s assets but only a junior claim on the collateral.
specified collateral in the
event of default.
Default Risk. Seniority and security do not guarantee payment. A debt can be senior
and secured but still as risky as a dizzy tightrope walker”it depends on the value and
the risk of the firm™s assets. Earlier, we showed how the safety of most corporate bonds
can be judged from bond ratings provided by Moody™s and Standard & Poor™s. Bonds
that are rated “triple-A” seldom default. At the other extreme, many speculative-grade
(or “junk”) bonds may be teetering on the brink.
As you would expect, investors demand a high return from low-rated bonds. We saw
evidence of this in Section 3, where Figure 3.9 showed yields on default-free U.S. Trea-
sury bonds as well as on corporate bonds in various rating classes. The lower-rated
bonds did in fact offer higher promised yields to maturity.

Country and Currency. These days capital markets know few national boundaries
and many large firms in the United States borrow abroad. For example, an American
company may choose to finance a new plant in Switzerland by borrowing Swiss francs
from a Swiss bank, or it may expand its Dutch operation by issuing a bond in Holland.

3 Sometimes callable bonds specify a period during which the firm is not allowed to call the bond if the pur-
pose is simply to issue another bond at a lower interest rate.
An Overview of Corporate Financing 503


Also many foreign companies come to the United States to borrow dollars, which are
then used to finance their operations throughout the world.
In addition to these national capital markets, there is also an international capital
market centered mainly in London. There are some 500 banks in London from over 70
different countries; they include such giants as Citicorp, Union Bank of Switzerland,
Deutsche Bank, Bank of Tokyo“Mitsubishi, Banque Nationale de Paris, and Barclays
Bank. One reason they are there is to collect deposits in the major currencies. For ex-
ample, suppose an Arab sheikh has just received payment in dollars for a large sale of
oil to the United States. Rather than depositing the check in the United States, he may
choose to open a dollar account with a bank in London. Dollars held in a bank outside
Dollars the United States came to be known as eurodollars. Similarly, yen held outside Japan
EURODOLLARS
held on deposit in a bank were termed euroyen, and so on). When the new European currency was named the
outside the United States. euro, the term eurodollars became confusing. Doubtless in time bankers will dream up
a new name for dollars held outside the United States; until they do, we™ll just call them
international dollars.
The London bank branch that is holding the sheikh™s dollar deposit may temporarily
lend those dollars to a company, in the same way that a bank in the United States may
relend dollars that have been deposited with it. Thus a company can either borrow dol-
lars from a bank in the United States or borrow dollars from a bank in London.4
If a firm wants to make an issue of long-term bonds, it can choose to do so in the
United States. Alternatively, it can sell the bonds to investors in several countries. These
Bond that is bonds have traditionally been known as eurobonds, but international bonds may be a
EUROBOND
marketed internationally. less misleading term. The payments on these bonds may be fixed in dollars, euros, or
any other major currency. Companies usually sell these bonds to the London branches
of the major international banks, which then resell them to investors throughout the
world.

Public versus Private Placements. Publicly issued bonds are sold to anyone who
wishes to buy and, once they have been issued, they can be freely traded in the securi-
ties markets. In a private placement, the issue is sold directly to a small number of
PRIVATE PLACEMENT
banks, insurance companies, or other investment institutions. Privately placed bonds
Sale of securities to a limited
cannot be resold to individuals in the United States but only to other qualified institu-
number of investors without
tional investors. However, there is increasingly active trading among these investors.
a public offering.
We will have more to say about the difference between public issues and private
placements later.

Protective Covenants. When investors lend to a company, they know that they might
not get their money back. But they expect that the company will use their money well
and not take unreasonable risks. To help ensure this, lenders usually impose a number
PROTECTIVE of conditions, or protective covenants, on companies that borrow from them. An hon-
COVENANT Restriction est firm is willing to accept these conditions because it knows that they enable the firm
on a firm to protect to borrow at a reasonable rate of interest.
bondholders. Companies that borrow in moderation are less likely to get into difficulties than
those that are up to the gunwales in debt. So lenders usually restrict the amount of extra
debt that the firm can issue. Lenders are also eager to prevent others from pushing
ahead of them in the queue if trouble occurs. So they will not allow the company to cre-
ate new debt that is senior to them or to put aside assets for other lenders.
4 Because the Federal Reserve requires banks in the United States to keep interest-free reserves, there is in ef-
fect a tax on dollar deposits in the United States. Overseas dollar deposits are free of this tax and therefore
banks can afford to charge the borrower slightly lower interest rates.
504 SECTION FIVE


Another possible hazard for lenders is that the company will pay a bumper dividend
to the shareholders, leaving no cash for the debtholders. Therefore, lenders sometimes
limit the size of the dividends that can be paid.
The story of Marriott in the nearby box shows what can happen when bondholders
SEE BOX
are not sufficiently careful about the conditions they impose. In the wake of the large
losses suffered by Marriott bondholders, several observers predicted that investors
would demand more restrictive bond covenants in future transactions.


In 1988 RJR Nabisco, the food and tobacco giant, had $5 billion of A-rated debt out-
Self-Test 6
standing. In that year the company was taken over, and $19 billion of debt was issued
and used to buy back equity. The debt ratio skyrocketed, and the debt was downgraded
to a BB rating. The holders of the previously issued debt were furious, and one filed a
lawsuit claiming that RJR had violated an implicit obligation not to undertake major fi-
nancing changes at the expense of existing bondholders. Why did these bondholders be-
lieve they had been harmed by the massive issue of new debt? What type of explicit re-
striction would you have wanted if you had been one of the original bondholders?


A Debt by Any Other Name. The word debt sounds straightforward, but companies

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