LONG-TERM FINANCING

WEEK 9
Introduction
This is a type of borrowing expected to be paid fully over a one-year period. This financing
could be sourced locally or internationally. In this lesson, you’ll learn about sources of long-term
finance and financing decisions.

Learning Outcomes
By the end of this lesson, you should be able to:
1. Discuss the major classes of securities issued by firms to raise capital.
2. Explain advantages and limitations of Long-term Financing
3. Describe treatment of common stock and preferred stock

Securities Issued by Firms to Raise Capital

Long Term Financing
This is a type of borrowing expected to be paid fully over a one-year period. This financing
could be sourced locally or internationally. Examples of long-term financing are non-convertible
debentures, long-term loans, bonds or private equity. The principle of long-term financing is to
finance strategic capital projects of firm or expand business operations of the firm. The funds are
used for investing in projects going to generate synergies for the firm in future years like a 10-
year mortgage or a 20-year lease.
Sources of Long-Term Financing
1. Equity Capital
Also known as ordinary share capital. This represents the interest free capital raised by private or
public means. Firms may opt to go public through an IPO or raise the amount privately for the
investors to take significant company stake.
Equity financing causes dilution in ownership and controlling stake rests on largest equity
holder. Equity holders/ ordinary shareholders have no preferential rights in dividend earnings of
firm and carries higher risks across all investments they make. The rate of return expected by
equity shareholders is higher than debt holders to compensate for the risks incurred in terms of
repayment of invested capital.

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 2. Preference Capital
This represents funds raised from preference shareholders. Preference shareholders are those
who carry preferential rights over ordinary or equity shareholders in terms of receiving dividends
at a fixed rate and getting back invested capital in the firm in cases of dissolution. This
contributes to the firm net worth thus increasing creditworthiness and improving the leverage
compared to other similar firms or peers in the industry.
3. Debentures
This is a loan taken from the public by issuing debenture certificates under a common company
seal. The loan may also be privately placed. For public company debenture acquisition involves
using a debt IPO where the general public is invited to subscribe and get allotted certificates as
creditors of the firm. For private loans, private major debt investors are approached in the market
and borrowed funds at higher interest rates.
Debenture holders are entitled to a fixed payment of interests according to agreed terms in the
company term sheet. Debentures do not carry voting rights in company affairs and are secured
against the company assets to be sold by debenture holders in case of default in payment.
Debentures may be redeemable, irredeemable, convertible or non-convertible.
4. Term Loans
These are loans generally given by banks or financial institutions for more than a year. They are
often secured loans given by banks against strong collateral assets provided by firm eg. Land or
building, machinery and other fixed assets. They are considered a flexible source of finance to
meet long-term capital needs of the organization. They carry a fixed rate of interest giving
borrowing firm flexibility to structure the repayment schedule over loan life or tenure based on
the firm cash flows. It is faster to acquire compared to issue of equity or preference shares in the
firm due to fewer regulations and less complexity.
5. Retained Earnings
These are profits kept aside over a period of time to meet future capital needs of the company.
They are free company reserves which carry no cost and are available free of cost without
interest repayment burden. It can be safely used for business expansion and growth without
taking an additional debt burden and equity dilution in the business to outside investors. They
form part of company net worth and have an impact directly on equity shares variation.

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Advantages and Limitations of Long-Term Financing
Advantages of Long-Term Financing
1. Debt diversification
2. Growth and expansion
3. Flexible repayment mechanism.
4. Opportunity for equity investors to take controlling ownership in the company.
5. Provision of long-term support to the investors and the firm for building synergies.
6. Align specifically to the long-term capital objectives of the company to effectively
manage the asset liability position of the firm.
Limitations of Long-Term Financing
1. Strict regulations for repayment of interest and principal amounts.
1. High gearing on company that may affect future fund raising and valuations.
2. Difficulty in monitoring financial covenants and commitments.
3. Risks that could lead to bankruptcy.
9.2.3 Treatment of Common Stock and Preferred Stock
 Preferred Stock is an equity security that has the properties of both an equity and debt
instrument and is higher ranking than common stock.
 Common Stock is a form of equity and type of security. Common stock shareholders are
at the bottom of the line when it comes to dividends and receiving compensation in the
case of bankruptcy.
 Common stock and preferred stock are both forms of equity ownership but carry different
rights and claims to income and votes.
 Preferred stock shareholders will have claim to assets over common stock shareholders in
the case of company liquidation.
 Preferred stock also has first right to dividends whether the firm makes profits or not.
 Common stock holds voting rights while preferred stock does not.
 Common stock shareholders can generally vote on issues such as members of the board
of directors, stock splits and the establishment of corporate objectives and policy.
 Voting rights are exercised at annual general meetings of the firm as required by
company law.

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  Preferred stock can gain cumulative dividends, convertibility to common stock and call
ability depending on the preset terms.
 Rights that come with the ownership of preferred stock are detailed in a Certificate of
Designation.
 Companies often keep the right to call back or put back preferred stock at a
predetermined price and terms.
 Sometimes dividends on preferred stock may be negotiated as floating and may change
according to a benchmark interest rate index.
Concept Check
1. Discuss the sources of long-term financing
2. Explain advantages and disadvantages of long-term financing
3. Describe treatment of common stock and preferred stock

References
1. Ross, Westerfield & Jordan. (2010). Fundamentals of corporate finance. 9th ed. Boston:
McGraw-Hill.
2. Brealey, Myers & Marcus. (2003). Principles of corporate finance.3rd ed. Boston:
McGraw-Hill
3. Ross, Stephen A. (2007). Essentials of corporate finance. 5th ed. Boston: McGraw Hill.
4. Brigham, Eugene F, (2004). Intermediate financial management.8th ed. Mason, Ohio:
Thomson.