BUSINESS AND FAITH INTEGRATION

BUSI 530

Chapter 14: Introduction to Corporate Financing

Chapter 14 Learning Objectives

1. Explain why managers should assume that the securities they issue are fairly priced.
2. Summarize the changing ways that U.S. firms have financed their growth.
3. Interpret shareholder equity accounts in the firm’s financial statements.
4. Describe voting procedures for the election of a firm’s board of directors and other matters.
5. Describe the major classes of securities sold by the firm.

Introduction to Corporate Financing

Firms have three sources of cash from which to finance their activities.
This chapter provides an overview of debt, equity, and internally generated funds.

Chapter 14 Outline

· Financial Market Competition
· Corporate Financing
· 3 Sources of Cash
· Internally Generated Funds
· Why Internal Funds?
· Equity
· Equity Terminology
· Understanding Stock Issues
· Net Common Equity
· Corporate Ownership
· Two Owner Entitlements:
· Profits
· Corporate Control
· Voting Procedures
· Majority vs. Cumulative Voting
· Proxy Contests
· Equity
· Preferred Stock
· Advantages & Disadvantages
· Corporate Debt
· Limited Liability & Default Risk
· Debt Characteristics
· Interest Rate Fluctuations
· Funded vs. Unfunded Debt
· Sinking Funds
· Callable Bonds
· Subordinated Debt
· Secured Debt
· Foreign Debt
· Public vs. Private Placements
· Protective Covenants
· Leases
· Convertible Securities
· Warrants
· Convertible Bonds

Financial Markets

Competition in financial markets is fierce–much more so than in product markets.

· Few protected niches (ex: cannot patent the structure of a new security)
· Securities sell for their true values

· Unlike in product markets, there are few protected niches in financial markets.
· Example: You can’t patent the design of a new security.
· Financial markets are highly efficient and securities generally sell for their true values:
· True value – a price that incorporates all the information currently available to investors

Corporate Financing

Firms have three broad sources of cash.

· Internally generated funds
· New equity issues
· New debt issues

Internally generated funds
– Cash reinvested in the firm: depreciation plus earnings not paid out as dividends.

Internally Generated Funds

Historical sources of funds for FedEx 1995-2010

Just as with most firms, FedEx’s largest source of cash by far came from internally generated funds.

Why Internal Funds?

Managers prefer to reinvest internal funds for a number of reasons:

· Cost of issuing securities
· New equity announcement implications

· The announcement of a new equity issue is usually bad news for investors.
· Can be perceived as an attempt by management to sell overpriced stock.

Raising capital internally avoids the costs and bad omens associated with new equity issues.

Corporate Financing

What happens when the firm cannot finance all of its activities from plowed-back funds?

· Financial Deficit
· New Equity Issues
· New Debt Issues

Financial Deficit – The difference between the cash a company needs and the amount generated internally.
· To fix this deficit, firms either issue new equity or issue new debt.

Equity Issues

Most corporations are too large to be owned by one investor; therefore they issue stock to many investors.
· Example:
Dow is owned by 650,000 different investors. If it has 1.167 billion shares outstanding, how much of Dow does an investor who holds one share own?

, or 0.000000085% of Dow
The investor owns:

Equity Terminology

Treasury Stock
–Stock that has been repurchased by the company and held in its treasury.

Issued Shares
– Shares that have been issued by the company.

Outstanding Shares
– Shares that have been issued by the company and are held by investors.

Authorized Share Capital – Maximum number of shares that the company is permitted to issue without additional shareholder approval.

Equity Terminology: Example

Imagine a firm has 100 million shares currently trading on the NYSE. The firm issues 20 million new shares, and repurchases 5 million shares one month later.

What is the total change in treasury stock?

What is the total change in the number of issued shares?

What is the total change in the number of shares outstanding?

Equity Terminology

When a firm issues new equity, it records each new share in its books at par value.

Par Value
– Value of security shown in the company’s accounts.

Note: par value has little economic significance.

Additional Paid-in Capital
– Difference between issue price and par value of stock.
Also called capital surplus

Retained Earnings
– Earnings not paid out as dividends.

Equity Terminology

Suppose a firm has recently issued 10 million new shares at $15 per share; the par value of each is $1.50.

What is the value of additional paid-in capital (APIC)?

Net Common Equity

Represents the total amount contributed directly by shareholders when the firm issued new stock, and contributed indirectly when it plowed back part of its earnings

Net Common

Equity

=
Par
Value
+
Additional
Paid-in Capital
+
Retained
Earnings
–
Share
Repurchases

Net common equity – represents the total amount contributed directly by shareholders when the firm issued new stock, and indirectly when it plowed back part of its earnings.

Net Common Equity: Example

What is the book value per share of equity for a firm with $1 million in net common equity; $50,000 in authorized share capital; 25,000 shares issued; and 20,000 shares outstanding?

Net Common Equity: Example

What is the book value per share of equity for a firm with $1 million in net common equity; $50,000 in authorized share capital; 25,000 shares issued; and 20,000 shares outstanding?

Corporate Ownership

A corporation is owned by its common stockholders.

· Owners are entitled to:
· Profits
· Control of the firm

· Profits:
· The shareholders are entitled to whatever profits are left over after the lenders have received their dues.
· A portion of profits are usually paid out in dividends and the rest is plowed back into the firm.
· Plowed back profits should allow the company to earn higher profits and pay higher dividends in the future.
· Control of the firm:
· Shareholders retain all residual rights of control over the operation of the firm

Shareholders exercise control over the firm by voting for its board of directors.

Majority Voting
– Voting system in which each director is voted on separately.

Most companies use a system of majority voting.

Cumulative Voting
– Voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors.

Proxy Contest
– Takeover attempt in which outsiders compete with management for shareholders’ votes.

Note: Corporations sometimes issue multiple classes of common stock, some with different voting rights than others.

Corporate Ownership: Example

A shareholder owning 100 shares of stock is voting for the board of directors who are elected by cumulative voting. How many votes did the shareholder cast for Director ‘A’ if four directors are to be elected and the shareholder cast his/her maximum number of votes for ‘A’?

400

Preferred Stock

n

Preferred Stock – Stock that takes priority over common stock in regards to dividends.

Net Worth – Book value of common stockholders’ equity plus preferred stock.
· Advantages:
· Dividends – Preferred stock dividends must be paid to shareholders before common shareholders can receive anything.
· Tax Advantages – If one corporation buys another’s stock, only 30% of the dividends it receives is taxable.
· Disadvantages:
· Interest rate fluctuations – As interest rates rise, the present value of the preferred securities falls. This problem is solved with floating-rate preferred shares.
·
Floating-Rate Preferred – Preferred stock paying dividends that vary with short-term interest rates.

Corporate Debt

When issuing debt, companies promise to make payments and repay principal. But they have limited liability; debt is not always repaid.

· Limited Liability – The promise to repay a firm’s debt is not always kept.
· The company has the right to default on the debt and to hand over the assets to the firm’s lenders.

Debt Characteristics

· Interest rate fluctuations
· Coupon vs. Zero-coupon Bonds
· Prime Rate
· LIBOR

Would you expect the price of a 10-year floating-rate bond to be more or less sensitive to changes in interest rates than the price of a 10-year fixed-rate bond?

· A bond’s interest payment, its coupon, is usually fixed at time of issue.
· The present value of the bond changes with fluctuations in the interest rate.
· A zero coupon bond pays no regular payments; it simply makes a single payment at maturity.
· Most loans carry a floating interest rate, usually tied to the prime rate or the LIBOR.
·
Prime Rate
– Benchmark interest rate charged by banks.
·
LIBOR
– London Interbank Offered Rate; the rate at which international banks lend to one another.

Debt Characteristics

Funded Debt – Debt with more than 1 year remaining to maturity

Unfunded Debt – Debt due in less than one year.
· Carried on the balance sheet as a current liability.

Sinking Fund – Fund established to retire debt before maturity.
· When a sinking fund exists, investors are prepared to lend at a lower rate of interest.

Callable Bond – Bond that may be repurchased by a firm before maturity at a specified call price.

If interest rates rise, would holders of callable bonds expect the firm to buy back the debt?

Debt Characteristics

· Seniority

· Subordinated Debt
· Security

· Secured Debt
· Currency and Country of Origin

· Eurodollars
· Eurobond

· In the event of default, a subordinated lender gets repaid only after the firm’s general creditors are paid.
·
Subordinated Debt – Debt that may be repaid in bankruptcy only after senior debt is paid.
· If a loan is backed by collateral (assets held as security for a loan), the loan is said to be secured.
·
Secured Debt – Debt that has first claim on specified collateral in the event of default.
· Financial markets know few national boundaries; many U.S. firms often borrow abroad.
·
Eurodollars – Dollars held on deposit in a bank outside the United States.
·
Eurobond – Bond that is marketed internationally.

Debt Characteristics

· Public vs. Private Placements
· Protective Covenants
· Restrictions on a firm to protect bondholders

· Leases
· Long-term rental agreements

· Public vs. Private Placements:
· Publicly issued bonds are sold to anyone who wishes to buy, and are resold and traded in securities markets.
·
Private Placement
– Sale of securities to a limited number of investors without a public offering.
· Bondholders sometimes place restrictions on the company to prohibit it from taking unreasonable risks.
·
Protective Covenant
– Restriction on a firm to protect bondholders.
·
Lease
– Long-term rental agreement.

Convertible Securities

Give investors the option to alter their investments if they so choose.

·
Warrant
– Right to buy shares from a company at a stipulated price before a set date.
·
Convertible Bond
– Bond that the holder may exchange for a specified amount of another security.

Convertible Securities: Example

An investor owns a bond selling for $1,000. This bond can be converted to 20 shares of stock that are currently selling for $55 per share. Should the investor convert his bond into shares?

With conversion:

Without conversion:

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