Corporate Finance
Why Cost of Capital Is Important
- provides us with an Indication of how the market views the risk of our assets
- can also help us determine our required return for capital budgeting projects
Difference between Debt and Equity
Debt Equity
- Not an ownership interest - Ownership interest
- Creditors do not have voting rights - Common stockholders vote for the board
of directors and other issues
- Interest is considered a cost of doing
business and is tax deductible - Dividends are not considered a cost of
doing business and are not tax deductible
- Creditors have legal recourse if interest or
principal payments are missed - Dividends are not a liability of the firm
and stockholders have no legal recourse if
- Excess debt can lead to financial distress dividends are not paid
and bankruptcy
- An all equity firm can not go bankrupt
merely due to debt since it has no debt
• Bonds- When a Corporation or Government wishes to borrow money from the
public on a long-term basis, it usually does so by issuing or selling debt securities that
are called bond
• Indenture: The written agreement between the corporation and the lender detailing the
terms of the debt issue including: The basic terms of the bonds, The total amount of
bonds issued, A description of property used as security, if applicable, The repayment
arrangement, Call provisions, Details of protective covenants
Bond Classifications:
• registered form: payment is made directly to the owner of record.
• bearer form : payment is made to whoever holds the bond
Bond Classifications Based on Security
• Collateral : secured by financial securities
• Mortgage: secured by real property, normally land or buildings
• Debentures: unsecured 10 years or more.
• Notes: unsecured debt with original maturity less than 10 years.
• Seniority indicates preference in position over other lenders, and debts are sometimes
labeled as senior or junior to indicate seniority
, Government Bonds
Treasury Securities:
- Federal government debt:
• T-bills – pure discount bonds with original maturity of one year or less
• T-notes – coupon debt with original maturity between one and ten
years
• T-bonds – coupon debt with original maturity greater than ten years
Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to corporate debt
• Interest received is tax-exempt at the federal level
Bond Ratings – Investment Quality
High Grade
- Moody’s Aaa and S&P AAA – capacity to pay is extremely strong
- Moody’s Aa and S&P AA – capacity to pay is very strong
Medium Grade
- Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in
circumstances
- Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have
more impact on the firm’s ability to pay
Low Grade-
Moody’s Ba and B/ S&P BB and B
- Considered possible that the capacity to pay will degenerate.
Very Low Grade:
Moody’s C (and below) and S&P C (and below)
- income bonds with no interest being paid, or in default with principal and interest in arrears
If you buy a share of stock, you can receive cash in two ways:
Why Cost of Capital Is Important
- provides us with an Indication of how the market views the risk of our assets
- can also help us determine our required return for capital budgeting projects
Difference between Debt and Equity
Debt Equity
- Not an ownership interest - Ownership interest
- Creditors do not have voting rights - Common stockholders vote for the board
of directors and other issues
- Interest is considered a cost of doing
business and is tax deductible - Dividends are not considered a cost of
doing business and are not tax deductible
- Creditors have legal recourse if interest or
principal payments are missed - Dividends are not a liability of the firm
and stockholders have no legal recourse if
- Excess debt can lead to financial distress dividends are not paid
and bankruptcy
- An all equity firm can not go bankrupt
merely due to debt since it has no debt
• Bonds- When a Corporation or Government wishes to borrow money from the
public on a long-term basis, it usually does so by issuing or selling debt securities that
are called bond
• Indenture: The written agreement between the corporation and the lender detailing the
terms of the debt issue including: The basic terms of the bonds, The total amount of
bonds issued, A description of property used as security, if applicable, The repayment
arrangement, Call provisions, Details of protective covenants
Bond Classifications:
• registered form: payment is made directly to the owner of record.
• bearer form : payment is made to whoever holds the bond
Bond Classifications Based on Security
• Collateral : secured by financial securities
• Mortgage: secured by real property, normally land or buildings
• Debentures: unsecured 10 years or more.
• Notes: unsecured debt with original maturity less than 10 years.
• Seniority indicates preference in position over other lenders, and debts are sometimes
labeled as senior or junior to indicate seniority
, Government Bonds
Treasury Securities:
- Federal government debt:
• T-bills – pure discount bonds with original maturity of one year or less
• T-notes – coupon debt with original maturity between one and ten
years
• T-bonds – coupon debt with original maturity greater than ten years
Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to corporate debt
• Interest received is tax-exempt at the federal level
Bond Ratings – Investment Quality
High Grade
- Moody’s Aaa and S&P AAA – capacity to pay is extremely strong
- Moody’s Aa and S&P AA – capacity to pay is very strong
Medium Grade
- Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in
circumstances
- Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have
more impact on the firm’s ability to pay
Low Grade-
Moody’s Ba and B/ S&P BB and B
- Considered possible that the capacity to pay will degenerate.
Very Low Grade:
Moody’s C (and below) and S&P C (and below)
- income bonds with no interest being paid, or in default with principal and interest in arrears
If you buy a share of stock, you can receive cash in two ways:
