Long-Term Debt and Preferred Stock Financing – Financial Management | BBA Notes

Long-Term Debt and Preferred Stock Financing| Complete Chapter Notes | Financial Management | BBA Notes


Long-Term Debt Instrument

Long-term debt is the fixed income securities that have a maturity time of more than one year. Long-term debts are issued by the companies to finance fixed assets like machinery, land and buildings, furniture and vehicles, etc. Generally, long-term debt has a maturity between 5 to 20 years. Bonds and Term loans are the major sources of long-term debt. These securities are often called fixed-income securities because these securities yield fixed interest. Long-term debt holders have no control over the company. They are considered as the creditor for the company rather than the investor but in the liquidation of the company, they are given priority to pay off the debt.

Term Loan

The term loan is a type of loan in which repayment is made on a periodic installment basis which includes principals and interests that have a maturity period of more than 1 year but generally less than 10 years. It is a formal loan that means a loan arranged from formal negotiation with banks and financial institutions. Formal negotiation includes a formal contract having required information and term and conditions like; maturity period, interest rate, collateral, and payment process along with the date. A series of payments are made periodically on this type of loan until the loan is fully amortized. Term loan funds are normally used for purchasing fixed assets or discharging other loans.


A bond is a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond. It is long-term debt security or long-term promissory note having a maturity period of more than one year. Bonds are issued by corporations and government agencies that are looking for long-term debt capital. The borrower of the securities promises to pay fixed periodic interest till the maturity period and at the end maturity value or face value as well. The interest payment is called coupon payment. In the issuance of a bond the legal document indenture is prepared which specifies the right and duties and all the terms and conditions related to bonds. The indenture also specifies the rights and responsibilities of the trustee. 

Note:   Based on maturity period, some textbooks classify as (i) short-term (ii) Intermediate-term, and (iii) long-term. Some say a bond is a long-term debt instrument with a final maturity generally being 10 years or more. If the security has a final maturity shorter than 10 years, it is usually called a note. But here we assume debts with maturities greater than one year are considered long-term.

Key Characteristics of Bonds

To fully understand bonds, we must be familiar with certain basic terms and common features. These features and characteristics help to analyze and make decisions related to bonds.

Par value

The par value is the value of the bond that is to be paid at the time of maturity of the bond to the bondholder. It is also called the face value of a bond. The Par value of a bond is stated at the indenture of bond on the multiple of Rs.1000 but in Nepal par value of a bond must be Rs.1000. The amount of interest is calculated over the par value of bonds.

Coupon Interest Rate

The stated rate of interest on a bond is referred to as the coupon rate. For example, a 10 percent coupon rate indicates that the issuer will pay bondholders Rs.100 per annum for every Rs.1, 000-par-value bond that they hold. The coupon rate is determined in a way so the investors get motivated to invest in that security. The coupon interest rate generally constant till the maturity date but some bond’s coupon rate is adjusted according to market interest. The bonds’ coupon rate adjusted according to market interest is called floating rate bonds. Some bonds that are issued at discount, below the par value, are called discount bonds that have not coupon rate and are paid face value at the maturity period. Discounted bonds having no coupon rate are called zero-coupon bonds.


Bonds almost always have a stated maturity. This is the time when the company is obligated to pay the bondholder the par value of the bond. For example, the bond has a maturity period of 10 years means that the bond is redeemed at the end of 10 years paying all the interest and par value of bonds.


The legal agreement between the corporation issuing the bonds and the trustee, who represents the bondholders, is defined in the bond indenture. The indenture contains the terms of the bond issue as well as any restrictions placed on the company. These restrictions, known as protective covenants, are very similar to those contained in a term loan agreement. The terms contained in the indenture are established jointly by the borrower and the underwriter along with the trustee. If the corporation defaults under any of the provisions of the indenture, the trustee, on the behalf of the bondholders, can take action to correct the situation. If not satisfied, the trustee can then call for the immediate repayment of all outstanding bonds.


A trustee is the third party, usually commercial banks or finance company, appointed by the bond issuer when a bond is issued to represent and protect the collective interest of the bondholders. A trustee is considered as a watchdog of the borrower because they have to certify and watch the behavior of borrower over the time. The trustee’s responsibilities are to authenticate the bond issue’s legality at the time of issuance, to watch over the financial condition and behavior of the borrower, to make sure that all contractual obligations are carried out, and to initiate appropriate actions if the borrower does not meet any of these obligations. The trustee is compensated directly by the corporation, a compensation that adds to the effective costs of borrowing.

Call provision

A call provision is a special provision that is stated on indenture of the bonds which gives the issuer of the bond to redeem the bonds before the maturity date. When the issuer calls the bond, they have to pay the call price to the bondholder. A call price is generally above the face value because that price includes a call premium charge for the redemption before maturity. Call provision allows obtaining low debt securities in the market when the cost of debt in the market is lower than the coupon rate of the bonds. But, to the investors call provision adds risk because their investment may be refunded when the cost of debt is low.

Sinking Funds

A sinking fund is a fund created to pay off the debt or bonds of the firm. It is created on a special provision in a bond or debt contract on indenture of a bond. Sometimes, sinking fund provision may be applied to the issuer. Under this provision, the bond issuer firm deposits money with a trustee, which invests the funds and then uses the accumulated sum to redeem the bonds at maturity. If the issuer of the bond fails to pay the sinking funds requirement, the firm will face the bankruptcy problem.

Types of Corporate Bond

There are various types of corporate bonds in practice. Some of them are as follows;

Mortgage Bond

A Mortgage Bond is a type of bond that is issued using specific assets as collateral for the security of the bond. It is also called a secured bond since at the time of default of the bond interest and redemption that specific asset is sold to satisfy their claims. If those specific assets cannot cover the amount of the bond outstanding, the bondholder becomes general creditors for the residual amount.

A company may have more than one bond issue secured by the same property. A bond issue may be secured by a second mortgage on property already used to secure another bond issue under a first mortgage. In the event of foreclosure, the first mortgage bondholders must be paid the full amount owed them before there can be any distribution to the second mortgage bondholders.


Debentures are unsecured long-term debt issued by the company without pledging any specific assets. Debenture holders are the general types of creditors in case of liquidation if a firm fails to pay the interest and meet the principal amount. The debenture holders invest in the debentures by analyzing the profitability future growth rather than the specific collateral. These debts can be secured with the help of covenants in indenture. Debentures are more risk than mortgage bonds. Generally, debenture has a call provision that also adds a risk of calling the bond when market interest decreases.

Subordinate Debenture

A subordinated debenture is a long-term, unsecured debt instrument with a lower claim on assets and income than other classes of debt; known as junior debt. Generally, subordinate debentures have a higher rate of return than mortgage bonds and debentures. Frequently, subordinate bonds are issued with convertible features for better marketability.


Income Bonds

An Income bond pays interest only if a company earns sufficient income to pay the obligation otherwise interest will be accumulated for up to three years. A company can pay the accumulated interest to the income bondholder when sufficient income is earned. These bonds are less secured than regular bonds but more secured compared to preference share and common stock.  The yields on income bonds should be higher than the regular bonds because of the higher risk.


Junk Bonds

A Junk Bond is an unsecured, risky bond issued by weak companies that yield higher than all other types of bonds. Junk bonds are rated below investment grade. When a market is unstable and higher risk is exist and firms issue the bonds at a higher rate, those bonds are called junk bonds. Generally, these junk bonds are issued through private placement which means that through direct negotiation between individual investors rather than a formal investment banking process.


Convertible Bonds

A bond, which can be converted into a specified number of common stock within a specific future date at the investor’s desire is called a convertible bond. Convertible features of bonds may attract the investors of bonds if the company likely to perform well in near future and increase the share price of the company even if the coupon rate is lower than regular bonds. Convertible bonds are a good option for the company too because it reduces the interest expense and flotation cost to issue new common stock in the future.


Callable And Puttable Bonds

Callable bonds are those which can be called by the company before maturity. In contrast to the callable bond, a puttable bond allows the bondholders the option to exchange the bond for cash. Call provision gives the right to the company to call the bonds and puttable bond provision gives the right to the bondholders to exchange the bond for cash.


Zero-Coupon Bond or Zeros

The bond which is issued at discount without any interest payment(less than par value) and paid face value at the maturity is called a Zero-coupon bond. Generally, zero-coupon bonds are issued by companies having irregular cash flow or government. Government bonds and municipal bonds are issued without coupon interest.


Floating Rate Notes/Bonds

Under floating rate notes, the coupon rate is adjusted according to market interest rate change but the minimum floor rate is often specified. These bonds are less risky than regular bonds because yield is adjusted according to the market interest rate. From the company (issuer) perspective too, floating-rate notes proved to be beneficial when the market interest rate decrease.


Advantages and Disadvantages of Bond Financing

Here we see, the advantages and disadvantages of issuing bonds from a firm’s perspective:

Advantages of the use of long-term debt( bond Financing)

  • Bonds are less costly than common stock and preferred stock financing since interest on debt is tax-deductible
  • Helps to maintain control position. The use of ownership capital may decrease the control position of the shareholders.
  • Helps to restructure the financial structure of the company by inserting call provision and conversion features.
  • Controls the dilution of earning of the company.
  • Leverage benefit in net income.

Disadvantages of bond Financing

  • The sale of bond is harder than common stock
  • Bond is the riskiest source of financing in that sense, the failing of any interest payment and principal at a specified time may take the company into bankruptcy.
  • The negative and restrictive covenants may limit the company’s future operating flexibility in the future.
  • The permanent financial burden to the company, since companies have to pay fixed interest for a long time.


Preferred Stock

Preferred stock is a hybrid long-term security- it is similar to debts in some respect and to common stock in other ways.  Preference shares are paid fixed-dividend. Preferred stock is given preference in the income and assets claim after debts but before the common stock. The preferred dividend omitting does not lead to the company bankruptcy. In this sense, preferred stock is similar to the common stock but the fixed-dividend feature is similar to the debts. For accounting and legal purposes, preferred stock is categorized as equity of the company.

From the company perspective, preferred stock is the less risky source of funds because the failure to pay the preferred stock dividend does not expose to bankruptcy but failure to pay interest for debt expose to bankruptcy risk but from the investors’ perspective bonds (debts) are less riskier than preferred stock. The yield on preferred stock is higher than the yield on debt because a preferred stock is riskier than bonds.

As we have mentioned preferred stock is given second preference over bond in income and assets claim in liquidation and interests are paid only when a company is capable of paying interest. You might think that why investors invest in preferred stock? But preferred stocks are cumulative in nature that means the unpaid dividend in any year is carried forward. Cumulative preferred stock requires such past unpaid preferred stock dividends to be paid before any common stock dividends are declared and paid. Generally, preferred stocks are issued with a convertible feature which is the right to convert the preferred stocks into common stocks into a specific number at a specified price. Dividends of preferred stocks are also paid higher than bonds.

The higher yield than bonds, cumulative nature, and conversion features makes the preferred stock attractive to invest to the investors.

Features of Preferred Stock

Preferred stock is not new to the capital market but a new innovative style of issuing the preferred stock added some other features than what is commonly known. Some features of preferred stocks are as follows;



The par value is the stated price of a preferred stock certificate. The dividend preferred stock is calculated using the par value of the preferred stock because the dividend is expressed as a percentage of par values of preferred stock. The Par value of the preferred stock is used in the calculation of the value of preferred stock in the event of liquidation and maturity.


Fixed Dividend

Preferred stockholders are given preferred dividend that is fixed over the period. It is determined as the percentage of par value of the preferred stock. Fixed amount of dividend can be omitted when the company is not capable of paying preferred dividend but that can be carried forward any year. Generally, the dividend on preferred stocks is higher than the coupon rate of bonds and debentures.



Legally preferred stocks are ownership capital and are issued without a maturity date but companies can issue with a maturity date. On the maturity date, preferred stocks could be paid back or converted into common stocks.

Cumulative and Non-Cumulative

If the unpaid dividend in any year is carried forward, that preferred stock is called cumulative preferred stock and if the unpaid dividend in any is not carried forward is called non-cumulative preferred stock. The cumulative and non-cumulative features can be inserted into the preferred stock according to company policy and conditions underlying that particular company.

Claim on Assets and Income

In dividend distribution, preferred stocks are given preference over common stocks. The firm has to satisfy the preferred stockholders before the declaration and payment of dividends to common stockholders. At the time of liquidation too, the preferred stockholders’ claim is satisfied after the bondholders’ claim is satisfied. But they have a prior claim before that of common stockholders.


Participating and Non-participating

Generally, preferred stockholders have not entitled to the residual income but in some cases, a company may insert a special provision of participation of residual income if a common stock dividend is beyond a certain amount or there may be a special formula. The company may specify this special provision of whether the preferred stockholder will receive fixed-dividend only or will receive residual income beyond a certain amount of common stock dividend.


Voting Rights

Although preferred stockholders are legal owners, they have no voting for the management of the company. Preferred stockholders cannot cast their vote for the board of directors. Preferred stockholders are given the right to claim on assets and income over common stock as bondholders but they are not normally given a voice in management. However, in one condition preferred stockholders may give special voting rights that are if the company omits its preferred stock dividends for a specified period. In that condition, preferred stockholders are also considered as common stockholders.

Retirement of Preferred Stock

The fact that preferred stock, like common stock, has no maturity does not, however, mean that most preferred stock issues will remain outstanding forever. Provision for the retirement of the preferred stock invariably is made.

Call Provision

Generally, all preferred stocks are issued stating call price. A call price is that price at that price company can call the preferred stock to restructure the financial structure of the company. It assumed that the preferred stocks have no maturity time, however, some preferred can be called if the company mentioned at the time of issuance of preferred stock. The call price of preferred stocks is set above the original price but that gradually decreases over time. If call provision is not mentioned at the time of issuance of the preferred stock company has to invite tenders for the preferred stocks at the price above the market price to repurchase that preferred stock from the open market or the company can offer another security in its place to the preferred stockholders.

Sinking Fund

Many preferred stock issues provide for a sinking fund, which partially ensures the orderly retirement of the stock. Like bond issues, a preferred stock sinking fund may be advantageous to investors because the retirement process exerts upward pressure on the market price of the remaining shares.


Preferred stock may contain a conversion feature. A convertible preferred stock allows the preferred stockholder to convert preferred stock into a specified number of common stocks at a specified price within a specified period. The conversion feature helps to reduce the cost of preferred stock to the company by paying a lower dividend than the market rate. Investors can be attracted with conversion features if the company is likely to perform well and the price of common stock will increase.


Advantages and Disadvantages of Preferred Stock

Using preferred stock may be advantageous and disadvantageous from the company’s perspective. From the investors’ perspective also there are pros and cons of investing in preferred stock.

The major advantages of preferred stock from the company perspective:

  • Omitting the preferred stock dividend doesn’t lead to bankruptcy whereas failure to pay interest on bonds leads to bankruptcy.
  • Preferred stocks do not affect the control position and return earning of the company.
  • Preferred stock provides flexibility in capital structuring if there is a call provision or conversion feature.
  • Preferred stock is s permanent source of capital.
  • Preferred stock conserves assets that could be used to mortgage the bonds or debts if preferred stock is issued.


The major disadvantages of preferred stock from the company perspective

  • Preferred stock dividends are not tax-deductible. Unlike, interests on bonds are tax-deductible.
  • Preferred stocks are difficult to sell because the preferred stocks are given second preference over bond in income and assets claim in liquidation and interests are paid only when a company is capable of paying interest.
  • Preferred Stocks are a fixed-financial burden for the company since they have no maturity, increase the firm’s financial risk and thus its cost of common equity.

The major advantages of preferred stock from the Investors’ perspective

  • It provides regular and stable dividend income.
  • Preferred stockholders have a preference over common stockholders in income and assets claim.
  • Conversion options can be obtained through preferred stock.


The major disadvantages of preferred stock from the investors’ perspective

  • No control over the management of the company since there are no voting rights to the preferred stockholders.
  • The preferred stockholders have no legally enforceable right to dividends.
  • Preferred stockholders get fixed-dividend although they bear substantial risk.

Ranking of Different Types of Securities

There are various types of securities are available in the market. Risk and return to the securities are also different from each other. Risk and return have a positive relationship which is also called risk-return trade-off. There are various types of risk involved in the investment of those securities: default risk, maturity risk, liquidity risk. The quality of securities does not solely depend on the risk and but on certainty, cumulative features, security seniority, and adjustability too. 

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