Corporate Finance MLI28C060 Lecture 4 Thursday 15 October 2015

Capital structure I: Financial instruments and capital structure Structure: - Introduction to principal financial instruments used in firm financing - The implications of financing on decision-making and firm strategy Reading: Brealey & Myers: Chapters 13, 14, and 15

Introduction to principal financial instruments used in firm financing

Types of Securities: Debt securities Debt Securities: Firms borrow money by selling debt securities in the debt market. – If the debt has a maturity of less than one year, it is typically called notes, and is traded in the money market. – If the debt has a maturity of more than one year, it is called bond and is traded in the capital market. Most bonds pay a fixed interest rate on the face or par value of bond. Example: A bond with a face value of $1,000 and semi-annual coupon rate of 9% will pay an interest of $45 every 6 months or $90 per year, which is 9% of $1,000. When the bond matures, the owner of the bond will receive $1,000.

Figure: Bond certificate with coupons

Types of Securities: Equity securities Equity securities represent ownership of the corporation. Common stock is a security that represents equity ownership in a corporation, provides voting rights, and entitles the holder to a share of the company’s success in the form of dividends and any capital appreciation in the value of the security. – Common stockholders are residual owners of the firm. They earn a return only after all other security holder claims (debt and preferred equity) have been satisfied in full. – Dividend on common stock are neither fixed nor guaranteed. Thus, a company can choose to reinvest all of the profits in a new project and pay no dividends. Preferred stock is an equity security. However, preferred stockholders have preference with regard to: – Dividends: They are paid before the common stockholders. – Claim on assets: They are paid before common stockholders if the firm goes bankrupt and sells or liquidates its assets.

Figure: Share Certificate ( “Ordinary” CERTIFICATES)

Preferred stock Preferred stock is also referred to as a hybrid security as it has features of both common stock and bonds. Preferred stock is similar to common stocks in that: – It has no fixed maturity date, – The nonpayment of dividends does not result in bankruptcy of the firm, and – The dividends are not deductible for tax purposes. Preferred stock is similar to corporate bonds in that: – The dividends are typically a fixed amount, and – There are no voting rights.

Futures and Options

The implications of financing on decision-making and firm strategy

So…….there are 2 questions: 1: where (location) do we raise finance? 2: what type of finance do we use?

Firms almost always exhaust internal sources of capital first before considering external sources – why? Answer: Internal sources draw on ”Internal Capital Market” within firm and it’s network (network in case of business groups or family firms)

Entrepreneurial firms – lifecycle: – Internal sources exhausted by entrepreneur (friends, family and business groups in case of network economies) – Then Business Angels (BA) early stage investors – Then Venture Capital (VC) – The ultimate goal/aim is for firm to achieve a stock market IPO (Intitial Public Offering)

Normally after internal sources bank finance/lending is preferable to external capital markets – why? One answer is ”informational” i.e. – For a firm to issue bonds to external investors there are huge costs in terms of auditing, accounting transparency, issuing prospectuses etc – This is in order to provide investors with confidence through firm incurring ”bonding costs” as in bonding with investors – Alternative is bank lending – with relationship with bank mitigating informational costs

Bank lending is also a useful indicator to investors – i.e. if banks continue to supply credit to firm then given their close relationship – this is a good sign of credit-worthiness of firm – The presence of banking relationships thus impacts positively on value of firm’s equity and debt (bonds)

Now………. Where do firm’s raise finance: This has everything to do with costs of debt and costs of equity – This is the subject of tommorow’s (Friday’s) lecture

The importance of stock markets as a source of capital

Stock Markets A stock market is a public market in which the stocks of companies is traded. Stock markets are classified as either organized security exchanges or over-the-counter (OTC) market. Organized security exchanges are tangible entities; that is, they physically occupy space and financial instruments are traded on their premises. For example, the New York Stock Exchange (NYSE) is located at 11 Wall Street in Manhattan, NY. The total value of stocks listed on the NYSE fell from $18 trillion in 2007 to just over $10 trillion at the beginning of The over-the-counter markets include all security market except the organized exchanges. NASDAQ (National Association of Securities Dealers Automated Quotations) is an over-the- counter market and describes itself as a “screen-based, floorless market”. In 2009, nearly 3,900 companies were listed on NASDAQ, including Starbucks, Google, Intel.

Initial Offering Initial Public Offering (IPO) - First offering of stock to the general public. Underwriter - Firm that buys an issue of securities from a company and resells it to the public. Spread - Difference between public offer price and price paid by underwriter. Prospectus - Formal summary that provides information on an issue of securities. Underpricing - Issuing securities at an offering price set below the true value of the security.

Example of IPO listing process – Manila, Philippines

Motives For An IPO Percent of CFOs who strongly agree with the reason for an IPO

Average Initial IPO Returns

Initial Offering Average Expenses on 1767 IPOs from

General Cash Offers Seasoned Offering - Sale of securities by a firm that is already publicly traded. General Cash Offer - Sale of securities open to all investors by an already public company. Shelf Registration - A procedure that allows firms to file one registration statement for several issues of the same security. Private Placement - Sale of securities to a limited number of investors without a public offering.

Total Direct Costs of Raising Capital