Topic 8: Sources of intermediate and Long-term Financing

Topic Learning Outcomes

After this topic, you should be able to:
1. Know the various sources of capital for business firms.
2. Explain the nature, advantages and disadvantages, terms, maturity, collateral restructure covenants and
repayment schedule of debt financing.
3. Understand the nature of bonds, their trading process, features, and prices, credit risks and ratings, types and
methods of retirement.
4. Understand the nature of preferred shares, features, advantages and disadvantages and calculate its intrinsic
value thereof
5. Understand the nature of ordinary shares, their features, types, advantages and disadvantages and calculate its
value using finite and infinite-valuation methods.
6. Understand how leases are utilized as source of long term capital

Be Engaged
Read:
Converge ICT plans P35.9-B IPO
Riding on strong demand for connectivity especially with the lockdowns prompted by the coronavirus pandemic, fiber
internet and other digital services provider Converge ICT Solutions Inc. filed an application at the Securities and
Exchange Commission (SEC) for an initial public offering (IPO) worth as much as P35.9 billion.
The SEC announced on Friday that it had received the registration statement of Converge ICT’s IPO of up to 1.496 billion
primary and secondary common shares at a maximum offer price of P24 a share.

Converge ICT, led by Pampanga-based businessman Dennis Anthony Uy, plans to sell shares and list on the main board
of the Philippine Stock Exchange by October this year, subject to regulatory approvals.
The offer consists of 1.3 billion common shares consisting of 425.68 million primary shares and 885.61 million secondary
shares together with an offer of up to 195.19 million option shares.
About 70 percent of the firm shares will be offered for sale to foreign investors.

The stock debut will bring about a quarter of the company’s shares to public hands.
Proceeds from the primary offering will be used for the company’s capital expenditure requirements to accelerate its
nationwide fiber network rollout and other general corporate purposes.

Morgan Stanley and UBS AG are the joint global coordinators and joint bookrunners, while BPI Capital is the sole local
coordinator, joint local underwriter and joint bookrunner. BDO Capital is a joint local underwriter and book runner.
Converge ICT operates the fastest-growing end-to-end finer network in the Philippines with over 30,000 kilometers of
fiber as of end-March serving about 4.1 million homes.
The company’s residential business captured over 50 percent of the market for new subscriptions from Jan. 1, 2018, to
March 31, according to the prospectus.
“We believe that the Philippine fixed broadband market is currently at an inflection point, with Converge in particular,
serving as a catalyst for market growth as it continues to lead efforts to address current unserved demand,” the
prospectus said.

Source: https://business.inquirer.net/301656/converge-ict-plans-p35-9-b-ipo#ixzz6SPjamXux

Think:
1. Are familiar with the company on the above article? Are you availing is services?
2. What is your first impression when you hear “stock market”? Do you think this is only for really rich people?
3. What do you think is the objective of people who buys shares of a company? What do these shares have that
make it so attractive?
Let’s Discuss
1. Sources of funds for business firms
2. Debt financing
a. Term loans
b. Bonds
c. Methods for retiring debt
3. Equity financing
a. Preferred share
b. Ordinary share
4. Leasing as a form of debt

Sources of funds for business firms

Funding or financing is an act of contributing resources to finance a program, project, or a need. Corporations often
need to raise external funding or capital, after exhausting all internal financing thru Retained Earnings, in order to
expand their businesses into (1) new markets or locations or (2) to fund research & development. Funding can be
initiated for either short-term or long-term purposes. The different sources of funding include:

1. Retained earnings – The retained earnings can be either be

a. distributed to shareholders as dividends
b. used to invest in projects and grow the business.

2. Debt capital
• Companies that initiate debt issues are borrowers because they exchange securities for cash needed for
certain operations. The companies will repaying the debt i.e. principal and interest in accordance with
the specified debt agreement that lays the repayment schedule and contracts underlying the issued debt
securities.
• This can be done privately through bank loans, or it can be done publicly through issuance of
instruments known as corporate bonds, which allows investors to become creditors of the company.
• The considerations for borrowing money are:
a. the principal and interest must be paid and any failure to pay interest or repay the principal can
result in default or bankruptcy.
b. the interest paid on debt is typically tax-deductible and interest costs are mostly to be less
expensive than other sources of capital.

3. Equity capital
• Companies can raise capital from the public in exchange for a proportionate ownership in the company
in the form of shares and investors will become shareholders after purchasing those securities.
• The considerations for issuances of shares or stocks are:
a. Compared to debt financing, equity funding does not require making periodic interest payments to a
borrower
b. one disadvantage of equity capital funding is sharing profits among all shareholders in the long
term. Shareholders dilute a company’s ownership control as long as it sells more shares.

4. Other Funding Sources

• Funding sources also include private equity, venture capital, donations, grants, and subsidies that do not
have a direct requirement for return on investment, except for private equity and venture capital. They
are also called “crowdfunding” or “soft funding.”
• Example of a crowdfunding in the Philippine is the SeedIn platform:
Debt financing
• Debt financing is when the company obtains a loan, and promises to repay it over a period of time, with an
agreed interest. The loan can come from a lender, like a bank, or from selling bonds to the public.
• Debt financing also occurs when a firm sells fixed income products or securities, such as bonds, bills, or notes, to
investors to get a capital needed to expand its activities and operations.
• The amount of the investment known as principal must be paid back at an agreed date in the future.
• Advantages of Debt financing:
(1) Interest paid is tax deductible, whereas dividends are not deductible.
(2) The return on debt is fixed, so stockholders do not have to share the firm’s profits if the company turns
out to be extremely successful.
• Disadvantages of Debt financing:
(1) Using more debt increases the firm’s risk which further raises the costs of both its debt and equity.
(2) If the company falls on hard times and its operating income is insufficient to cover interest charges, the
company may on the verge of bankruptcy.

A. TERM LOANS OR BANK LOANS

• The most common type of debt financing is a bank loan.
• Types of Bank loans may include the following but not limited to, secured business loans, equipment loans, or
even unsecured business loans.
• Most loans have a provision that lender expects the borrower to promise some security or assets as a collateral
which indicate the loan will be repaid even if cash to repay it doesn't exist in the future. This is a required for a
"secured" business loan. A secured business loan often has a lower interest rate since the lender accepts the
collateral that securing the loan.
• An unsecured business loan requires no collateral but requires a 'financial assessment.' The lender may also
want to see a specific income for a set period of time to be assured that borrower have the ability to repay the
loan.
• Example of a bank loan application:
B. Bonds
• A long-term debt instrument issued to raise capital
• Issued by either by
o Government
o Corporation
• A contract that is long-term that stipulates that holders will receive Coupon Payment on stipulated period and
the Face Value or principal on the Maturity date.

The Philippine domestic bond market consists of short- and long-term bonds, mainly issued by the national government.
The Philippine bond market is dominated mainly by Treasury notes and bonds. Although the size of the Philippine
corporate bond market is still small relative to government bonds, it has been growing rapidly over the years. Types of
Securities issued by Philippine government:

• Issued by the National Government through the Bureau of the Treasury (BTr)
• Treasury bills (fixed-rate)
• Treasury bonds (fixed-rate coupon-bearing and zeroes)
• Retail treasury bonds (RTBs, fixed-rate coupon-bearing)Multi-currency retail treasury bonds (MRTBs, fixed-rate
coupon-bearing)
• Dollar-linked peso notes (fixed-rate)
• Issued by the National Government through Other Entities
• Debt securities issued by government-owned and -controlled corporations (GOCCs)
• Debt securities issued by government agencies

Here is one of the platforms where the public can invest or buy bonds from the Philippine government:

Types of Bonds based on who issued them

Treasury Bonds
• Bonds issued by the government
 • generally called treasuries or simply government bonds
Corporate Bonds
• Bonds issued by corporations.
• A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and
promise to repay it in the future under clearly defined terms
• These bonds are exposed to default risk
Municipal Bonds or Munis
• Bonds issued by state and local governments.
Foreign Bonds
• Bonds issued by foreign governments or by foreign corporations.
• All foreign corporate bonds are exposed to default risk

Bond Markets
• Most bonds are owned by and traded among large financial institution
• Corporate bonds are traded over the counter most of the time
• it is relatively easy for bonds to be traded over the counter as compared to shares or stocks, since there is a
transfer of large blocks of bonds among the relatively few holders while stock market is trading among the
literally millions of large and small stockholders.
• In the Philippines, the reports on the Bond Market, even other financial market securities, are available on the
Bureau of Treasury website (treasury.gov.ph) under the supervision of the Department of Finance.

Key Characteristics of Bonds

Even though all bonds have common characteristics, different types of bonds can have different contractual features

Common Characteristics
Face Value
• Also known as the Par Value
• It is the amount borrowed by the issuer to be paid at the maturity date
Maturity Value
• A specified date on which the par value of a bond must be repaid.
Coupon Payment
• The percentage of a bond’s par value that will be paid annually, typically in two equal semiannual payments, as
interest
• Computed by multiplying the interest rate with the face value of the bond
Coupon Interest Rate
• Also known as the nominal rate or stated rate in the bond
• The rate used to compute the coupon payment

Other Characteristics
Call Provision
• A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to
the normal maturity date.
• Bonds with call provision are called Callable Bond.
Put Provision
• A provision that gives right to the bond holder to “put back” or require the issuer to repurchase the said bond at
a certain price before the maturity.
• Bonds with call provision are called Puttable Bond.
Issued with Warrants
• This gives the bond holders the option to buy shares of common stock from a company at a predetermined
price.
Issued with Convertible Feature
• This gives the bond holders the option to convert the bond into number of shares of common stock at a
predetermined price.
• Bonds with this provision are called Convertible Bond.

Assessing a Bond’s Riskiness

Various Types of Corporate Bonds
Two key factors that impact a bond’s riskiness

a. Price Risk
• risk of a decline in a bond’s price due to an increase in interest rates.
• increase in interest rates hurts bondholders because it leads to a decline in the current value of a bond
portfolio; when interest rate rise, the value of outstanding bonds decline
b. Reinvestment Risk
• The risk that a decline in interest rates will lead to a decline in income from a bond portfolio.
• It is obviously high on callable bonds and on short-term bonds

Default Risk
the quoted interest rate includes a default risk premium to compensate for the probability of default. Default risk on
Treasuries is zero.

Mortgage Bonds
• A bond backed by fixed assets.
Indenture
• a legal document that spells out in detail the rights of the bondholders and the corporation
Debentures
• an unsecured bond and quite risky
• provides no specific collateral as security for the obligation
• debenture holders
o general creditors whose claims are protected by property not otherwise pledged
Subordinated Debentures
• Bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation.

Bond Ratings
Investment-Grade Bonds
• are the lowest-rated bonds that many banks and other institutional investors are permitted by law to hold
• examples are Single-A and triple-B bonds
Junk Bonds
• speculative-grade bonds and
• High-risk, high-yield bonds
• Examples are Double-B and lower bonds are

Bond Rating Criteria

Determinants of bond ratings include the following:
a. Financial Ratios
b. Qualitative Factors: Bond Contract Terms
c. Miscellaneous Qualitative Factors
Bond transactions

1.

Bond
Bond
Holder
Issuer
1

Observation:
• Bond Holder 1 holds the bond until maturity
• The Total expected Return that Bond Holder 1 receives equal to the Yield to Maturity (YTM)

2.

Bond Issuer

Bond
...Bond Holder 1
Holder 2 sells the
bond to...

Observation:
• Scenario
o Bond Holder sells the bond to another holder (Bond Holder 2)
• Bond Holder 1
o Will sell the bond when market interest rates decline to take advantage of the increase in Bond price
o Expected total return is the Current Yield plus the capital gains
• Bond Holder 2
o Expected total return is the Yield to maturity
3.

Bond Holder
Bond Issuer
1
•issued callable
bonds •Issuer exercised
its right to call

Observation:
• Scenario
o Bond with call provision was issued to Bond holder 1 and Bond issuer exercise its right to call and pays a
call premium.
• Bond Holder 1
o Expected total return is the Yield to call
• Bond issuer
o Expects to call the callable bond when the market interest rate drops below or equal to the projected
Yield to Call

4.
Observation:
• Bond issuer issues new bonds to new investors after the bond issuer
Bond exercise its right to call due to decrease in the market interest rate
Holder 1 • Newly issued bonds have higher price because of the decrease in
market interest rate.
• Lower interest rate: higher bond price; higher interest rate: lower bond
price

Bond
Issuer

New
investor
Methods for retiring debt
• Debt retirement is when a borrower repays the principal associated of a the debt, be it a note, loan, or
bond.
• A conservative way to realize debt retirement is to establish a sinking fund when a debt is initially
recognized, and make contributions to the sinking fund so that on maturity date of the debt, the amount
in the sinking fund is sufficiently enough to pay for the debt or most of it.
• Debt may also be retired by incurring a new debt and using it to pay off the old debt.
• Another approach is to issue serial bonds, where the bonds mature on different periodic dates, allowing
for a staggered or in instalment repayment scheme.

Equity financing
It is the process of raising capital through selling of shares in which they sell ownership of the company in return for
cash, non-cash assets, or services. The company needs money because they might have a short-term need to fund
operation or for a long-term goals and require funds to invest in their growth.

Equity
• equity financing is obtained from investors – part owners of the firm
• investors have only an expectation of being repaid unlike creditors who are entitled for periodic payments
• payment to equity holders are subject to the firm’s performance.

Legal Rights and Privileges of Common Stockholders

1. Control of the Firm
• the right to elect its directors, who in turn elect the officers who manage the business
2. The Preemptive Right
• To purchase on a pro rata basis any additional shares sold by the firm
• A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on
a pro rata basis new issues of common stock (or convertible securities).

Common vs Preferred Stock

Summary Table for differences of Common and Preferred Stock:
Feature Preferred Common

Ownership of Company Yes Yes

Voting Rights No Yes

Dividends Fixed Varies

Order Paid if Company Defaults First Second

Price of Security Is Based on: Earnings Earnings

Common Stock
• true owners of a corporate business are the common or the ordinary stockholders.
• sometimes referred to as residual owners since they receive what is left after all other claims on the firm’s
income and assets have been satisfied – debt and preferred stockholder.
• They are assured that they cannot lose any more than they have invested in the firm.

Preemptive Rights
• A right that allows common stockholders to maintain their proportionate ownership in the corporation when
new shares are issued

Authorized, Outstanding, and Issued Shares

a. authorized shares
• Shares of common stock that a firm allows it to issue.
b. outstanding shares
• Issued shares of common stock held by investors.
c. treasury stock
• Issued shares of common stock held by the firm or repurchased by the corporation.
d. issued shares
• Shares of common stock that have been put into circulation
• the sum of outstanding shares and treasury stock.

Preferred Stock
• “hybrid” – similar to a bond in some respects and to common stock in others.
• It has a par value and a fixed dividend that must be paid before dividends can be paid on the common stock.
• a preferred stock entitles its owners to regular, fixed dividend payments
• most often issued by public utilities, by financial institutions, by acquiring firms in merger transactions, and by
young firms receiving investment funds from venture capital firms
• Dividends
o Like the dividends on common stock, preferred dividends are not tax deductible for the firm that pays
them.

Types of preferred stock

a. par-value preferred stock

• has a stated face value that is used with the specified percentage of dividend.
b. no-par preferred stock
• no stated face value but with a stated annual dividend amount.

c. cumulative preferred stock

• all unpaid dividends in arrears, including the current dividend, must be paid before dividends can be paid to
common stockholders.
d. noncumulative preferred stock
• unpaid dividends do not accumulate, only current dividends are paid when declared
e. callable feature preferred stock
• allows the issuer to retire the shares at a specified price within a certain period of time and.
f. conversion feature preferred stock
• allows holders to convert each share into a stated number of common stocks.
Leasing as a form of debt – Debt Financing Vs. Lease Financing
• Traditional finance theories typically treat leases and debt as substitutes. However, the empirical findings on the
relation between leases and debt are mixed. A findings suggest that leases and debt are substitutes instead of
complements. The cost of new debt increases to a larger degree with extra lease
• For instance, to finance the purchase of new equipment, there are two main option a company may do, i.e.
obtain a bank loan, or lease the equipment. Leasing equipment works particularly well if you are in a business
where the technology is constantly changing. Purchasing equipment that will become obsolete in a few years
is a problem that can be avoided by short-term leases that allow you to update your equipment at the end of
each lease. If your equipment needs regular maintenance, or breaks down easily, a lease with maintenance
and repair included can be preferable to purchasing the equipment outright using a bank loan, and paying for
maintenance and repair on top of the debt payment.
• Trade-Off Theory
o This theory states that leases and debt have essentially the same effect on a company on the basis
that, over time, any fixed payment become a burden for the company to support during difficult
economic times. The overhang of fixed lease or debt payments will cause the credit of the company to
decline, resulting in higher borrowing costs in the future.
• Benefits of Leasing
a. Convenience – Leasing is the easiest method of financing fixed assets. No mortgage is required.
Formalities involved in leasing are much less than in case of borrowing from financial institutions.
b. Flexibility – Rental schedule can be adjusted to accommodate genuine needs and problems of the
lessee.
c. Time Saving – The asset is available for use immediately without loss of time in applying for the loan.
Lease rentals can be matched with cash flows directly related to the lessee.
d. No Risk of Obsolescence – Any risk of obsolescence the asset is borne by the lessor.
e. Cost Saving – Lease rentals are deductible from taxable income.
f. Liquidity – The lessee can use the asset to earn without investing money in the asset. He can employ
his available funds for other operational needs.
• Disadvantages:
a. The lessee gets only the right to use the asset.
b. The lessee cannot make alterations or improvements in the asset without the prior consent of the lessor
or the lessor may set some restrictions.
References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• Bagayao, I. Y., & et al. (n.d.). Financial Management Volume 1.
• (n.d.). Retrieved from https://www.thestreet.com/personal-finance/debt-financing-14913324
• (n.d.). Retrieved from https://www.investopedia.com/terms/d/debtfinancing.asp
• (n.d.). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/sources-of-funding
• (n.d.). Retrieved from https://www.investopedia.com/ask/answers/03/062003.asp
• (n.d.). Retrieved from https://www.accountingtools.com/articles/2017/5/5/debt-retirement
• (n.d.). Retrieved from https://smallbusiness.chron.com/debt-financing-vs-lease-financing-37266.html
• (n.d.). Retrieved from https://www.jstor.org/stable/27647267?seq=1
• (n.d.). Retrieved from https://www.investopedia.com/terms/e/equityfinancing.asp
• (n.d.). Retrieved from http://cbonds.com/countries/Philippine-bond