CMA USA Part 2 section B introduction to long term financial management notes and free classes

Ø  B3- introduction to long-term financial management :

Long-term financial management covers how a firm finances its assets over the long term and is defined as more than a year.


Capital structure:

The permanent/long-term sources of financing that a company uses are referred to collectively as the company's capital structure. The source of permanent and long-term financing may be broken down into external and internal sources. A firm's capital structure includes the long-term liabilities and equity sections of its balance sheet.


External fund:

External funds may be raised through the issuance of debt securities, equity securities, long-term financing, or other types of financing such as leasing.


Internal fund:

Internal funds are available from profit, which the company generates but not distributes to the stockholders.[ retained earnings]. The advantage of internal sources of capital is that there is no cash cost. [ interest or dividend] to the company associated with these funds.


Ø  Determined the capital structure issuing debt or equity:

Affirm capital structure is the mixture of capital that it uses to finance its assets.

The following factors should consider,

1.      The future prospects of the company.

2.      The equity market.

3.      The amount of risk, the companies are willing to aspects.

4.      Reputations of the issuer.

5.      The cost of each source of capital.

6.      Usually capital structure is expressed in the terms of percentage.

Example: debt, equity.


Ø  Debt financing ( bonds):

Bonds are means of financing in which a company borrows money by selling debt securities [bonds] to investors. A bond issue represents the bondholder's [ investors] loan to the issuing company.

By selling the bonds, the company promises to pay the investors a certain amount of interest every period until the bond matures. On the maturity date, the company promises to pay the investors the face amount of the bond.


Ø  How bonds work:

A bond represents a contract between the issuer ( the borrower) and the bondholders ( the lenders) the legal contract is called the indenture (agreement, rules, and conditions) and it contains all the terms and conditions.

On the face of the bond itself is a set of information, this information includes,

Bonds par value: it is started amount [ the face value] of the bond.

Started interest rate; it is the interest rate printed on the board.

Issue date: it is the on which the bond was first issued by the company.


Maturity date: it is the date on which the issuer will retire the bond by paying the face amount of the bond to the bondholders.

The sale price of the bond: bonds are valued and sold at the present value of all of the future cash payments the company. The company will make the interest payment and the final principal repayments. The present value is calculated by using the market rate of interest on the sale date for bonds of similar terms and risk.


Ø  Types of bonds:

1.      Convertible bonds:

Beneficial to the holder of the bond can be converted by the bondholder into a stated number of shares of the issuer's common stock at any time during the bond's life. It is advantageous for bondholders if the price of the firm's common stock increases.


2.      Debenture bond:

Riskier for the holder of the bonds unsecured, meaning they are not backed by any specific assets as collateral. The only backing to the bond is the credit worthless of the company itself.

3.      Mortgage bond:

Less risky for the shareholders of the bond to have specific assets or assets pledged as collateral for the loan.

4.      Subordinated debenture:

More risk for the holder of the bond. Are bonds that will not have the first claim to the asset of the company. In case of bankruptcy because the bonds are subordinated to other debt.

In case of bankruptcy, all superior debt will be settled before subordinated debentures.

5.      Income bond:

Riskier for the holder of the bond. Pay interest only if the company achieves a certain level of income.

6.      Serial bonds:

Serial bonds allow investors to choose the term that fits their needs.

7.      Indexed bonds:

Having an interest rate is indexed to some other measures, such as a price indexed or general economic indicators instead of playing a fixed interest rate they pay a variable interest rate.

8.      Zero coupon bond:

Do not pay any interest, but they sell at a price significantly less than the face value.

9.      Participating bond:

Beneficial to the holder of the bond. Can participate in dividends the company's profit distribution during a period of high profit.


The terms international bonds include,

1.      Foreign bond

2.      Euro bond

Both are sold outside of the issuing company’s home country.

Ø  Foreign bonds: Are issued in a country that is denominated in a currency that is different from the currency of the country In which they are sold.

Example: a US company may issue bonds in Japan that are denominated in yen.

Ø  Euro bonds are international bonds that are different from the currency of the country in which they are sold. Example: euro bond denominated in Japanese yen could be issued in Canada by an Australian company.


Ø  Bond and rating agency:

A firm that issues bonds must have its debts issues related by outside agencies for which pay them a fee. The primary rating agencies are moody’s investor’s service standard and flitch rating.

The top four categories of each agency’s rating system are considered investment grade quality, while bonds rated that are considered speculative grade or junk bonds.

Euro bonds are less expensive because of the absence of government regulations.

Ø  Special features that bond may have:

Bonds may also be sold with special features. The most common provisions for bonds are,

a.      A call provision: gives the issuer the option of buying back the bond before its maturity at a given price. If interest rates are expected to decline a call provision would be advantageous for the issuer but not advantageous for the investor on the bond. Call provision bond investors’ risk increases return also increase.

b.      A put provision:

If certain events occur or if the issuing company violates any bond covenants an investor can require that the issuer repurchase the bonds from him. A put provision beneficial to the investor. Risk decreases return also decreases.

c.      A convertible clause:

Allows an investor to convert the bond into common stock at a specified conversion rate. It is a benefit to investors because risk decreases return also decreases.

Restrictive covenants: limit the company’s activities that could be determinantal to the bondholder. Example:

1.      Sinking fund: may be required.

A mortgage bond covenant may include,

A negative pledge clause starts that the issuer will not pledge any of its assets as security for other debts.

Ø  Benefits of issuing bonds:

The bond issuer has no loss of control or ownership. The total cost of the bonds is limited and known. Interest paid on a bond is limited and known. Interest paid on a bond is tax deductible as a business expense. If the bonds are collab or can otherwise be retired early.


Ø  Limitations of issuing bonds:

Debt as a source of capital creates less flexibility for the company than equity. the issuing company assumes increased risk because of the possibility of default. As the level of debt grows the interest rate on the next loan or bond and the return required by not only the debt holder but also the company’s shareholders will increase. The maturity of the debt will result in a large future cash payout. the terms of the bond issue may include restrictive terms and consonants that must be adhered to by the issuer.


Ø  Duration:

All bonds will change in value in value as the market rate of interest changes. Market interest rate increases bond value also increases. Market interest rate decreases bond value also decreases.

This change in the value of the bond is the interest rate change in interest rate risk. The best measure of this interest rate risk for bonds is their duration. A bond’s duration is a measure of how much the value of a bond changes when the interest rate changes.

For example: when the market interest rate increase by 1% then the bond market value will decrease by 2.74% and vice versa.

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