Chapter Ten THE CAPITAL MARKETS

Why Firms Borrow To acquire new assets or replace existing assets These can be financed by internal financing (from retained earnings) external financing (debt or equity issue)

What affects firm borrowing? Economic Conditions Credit Availability and i-rates Level and expected growth among internal fund sources Economic Conditions Business cycle and business optimism and pessimism Credit Availability and i-rates Rising I-rates reduce NVP of projects Make inventories more costly Falling I-rates increase NPV of projects Lead to restocking of inventories Level and expected growth among internal fund sources Internal Fund sources such as firm earnings and CFs tend to be volatile so the use of external funding is also volatile. External funding is often viewed as supplemental to internal funding.

Capital Markets Original maturity is greater than one year. Best known capital market securities: Stocks and Bonds Primary issuers of securities: Federal and Local Governments Corporations Largest purchasers of securities: Households Primary use of K markets is for longer-term investments

Bonds Debenture or debt Issuer Maturity Coupon Rate Face or Par Value

Principal Investors in Bonds Investor Amount Percent of Total Households $465.6 12.9% ROW $558.4 15.8% Commercial Banks $153.0 4.3% Savings Institutions $ 58.2 1.6% Life Insurance Companies $1,039.8 29.3% Property-Casualty Ins $ 150.2 4.2% Private Pension Funds $ 291.2 8.2% Gov’t Pension Funds $ 207.5 5.9% Mutual Funds $ 296.5 8.4% Security Dealers/Brokers $ 102.1 2.9% Other $ 221.6 6.3% TOTAL $3,543.8 100.0%

Bonds Growth of Corporate Bonds and Notes Issued by US Companies Year New Issues 1950 $ 4,920 1960 $ 8,801 1970 $ 30,321 1980 $ 53,199 1990 $ 114,500 1998 $ 428,100

Treasury Bonds Used to finance US Gov’t debt Note the difference between a note and a bond – maturity

Treasury Bond Interest Rates No default risk Very low interest rates

Treasury Bond Interest Rates

Compare 20-Year Treasury Bonds to 90-Day Treasury Bills

STRIPS Separate Trading of Registered Interest and Principal Securities or STRIPS Separates out the CFs of the bond Coupon Payments and Principal

Agency Bonds Quasi-private Government Entities Low risk, backed by Federal Gov’t

Agency Bonds Gov’t National Mortgage Administration Ginnie Mae Student Loan Marketing Association Sallie Mae, SLMA Federal Home Loan Mortgage Corp. Freddie Mac, FHLMC Postal Service PS Tennessee Valley Authority TVA Federal Agricultural Mortgage Corporation Farmer Mac, FAMC Federal National Mortgage Association Fannie Mae, FNMA Federal Farm Credit Banks FFCB

Agency Bond Growth Year-End Agency Debt Outstanding ($ billions) 1961 $ 8.6 1971 $ 50.7 1980 $ 193.2 1990 $ 434.7 1998 $ 1,296.5

Municipal Bonds Issued by local, county, and state governments Used to finance “public interest” projects Two types General obligation bonds Revenue bonds NOT Default-Free Defaults of $1.4 b in 1990 General obligation bonds are backed by “good will” or the :full faith and credit” if the issuing entity. No specific asset or CF is tied to the bond. Revenue bonds are linked to a specific asset of stream of future CFs. As a result the ratio of revenue bond issues to general obligation bond issues is over 1.

“Tax-free Muni’s” Legislation at the federal level subsidizes municipality bond issues through the tax code Tax-free municipal interest rate = taxable interest rate x (1 - marginal tax rate)

Comparing Revenue and General Obligation Bonds

Use of Muni’s Use Percentage Total 100% Other 27% Education 25% Social Welfare 22% Transportation 11% Utilities 10% Industrial Aid 5% Total 100%

Corporate Bonds Face value of $1,000 Most pay interest semi-annually Most are callable – option to be redeemed when the issuer wishes Degree of risk varies with each bond Interest rate varies with level of risk

Corporate Bond Interest Rates, 1973-1996

Characteristics of Corporate Bonds Registered Bonds vs. Bearer Bonds Restrictive Covenants Moral hazard, CEOs, and stockholders Call Provisions Higher yield Sinking fund Interests of stockholders Convertible Bonds Today most bonds are “registered” (electronic) rather than “bearer bonds” (paper) Restrictions on the issuers activity to protect the investor. Clauses in the bond debenture to protect bond holders. Usually limit the debt ratio of the firm and payment level of dividends. These restrictions result from the fact that both stockholders and bond holders have the firm beholden to them for providing capital. Yet stockholders have the advantage because they hire and fire CEOs (ostensibly.) The closer relationship of stockholders to the CEO creates moral hazard problems. Restrictive covenants reduce risk to bond holder, so their effect is to lower coupon rate. Call Provisions allow issuer to buy back bonds at will – some restrictions on timing of the call often exist. Higher yield because they put a limit on bond appreciation caused by interest rate risk. Sinking fund requires issuer to pay of a portion of the issue periodically. They typically have lower rates because their risk is lower because exposure lowers each time a chunk is paid off, Interests of stockholders. Stockholder interests may be best served if the firm can remove restrictive covenants by paying off the bonds with the restrictive covenants. Suppose a 30 yr. bond issued by an electric company states no nuclear, and the price of oil quadruples and environmentalists have frozen all hydro-electric generation. Suddenly, nuclear looks attractive. Alter Capital Structure. Firm may want to reduce debt load when flush with cash. Used to finance convertible cars. Conversion – convert into shares of common stock. Written so that the price must rise substantially. Allows bond holders to share in capital appreciation. Conversion is interesting – the market looks at stock issue as a sign the stock is over-valued. Managers issue when they think they can get a high price relative to value per stock certificate. This occurs when the stock is over-valued. Issuing convertible bonds sends the signal that managers feel the stock is currently under-valued. These signals are strong due to asymmetric information.

Types of Corporate Bonds Secured Bonds Mortgage bonds Equipment trust certificates Unsecured Bonds Debentures Subordinated debentures Variable-rate bonds Junk Bonds Secured Bonds - Secured bonds have collateral attached Mortgage bonds - linked to real estate Equipment trust certificates – linked to real assets. Economic capital, plant and equipment, other non-real estate assets Unsecured Bonds Debentures - Subordinated debentures Variable-rate bonds Junk Bonds Speculative-grade bonds with potential of default

Debt Ratings

Trends in the Bond Market

Stocks Represents ownership in a firm Earn a return in two ways Appreciation/Depreciation – the price of the stock rises/falls over time Cash Flows - dividends are paid to the stockholder periodically Stockholders have claim on all assets Right to vote for directors and on certain issues

Stock Common stock Preferred stock Right to vote Receive dividends Receive a fixed dividend Do not usually vote

Valuing a Stock The NPV of the expected cash flows Current Price = NPV of E(Appreciation or Depreciation) + NPV of E(Dividend Cash Flows) Gordon Growth Model P = D1 / (i-g) Gordonm Growth Model D1 – current dividend Assume constant growth rate in dividends i – discount rate g – constant dividend growth rate expected

Preferred Stock Versus Common Stock

Want to be listed on the NYSE? You Will Need at least: 2000 stockholders, each owning at least 100 shares a minimum of 1.1 million shares traded publicly pretax earnings of $2.5 million at the time of listing $1 million in pretax earning in each of the two prior years. net assets of $18 million a total of $18 million in market value of publicly traded shares.

Stock Prices

30 Stocks in the Dow Jones Industrial Average

Stock Market Indexes

Stock Market Indexes Many Others S&P 500 NASDAQ Composite NTSE Composite Russell 3000 Growth Index Lipper Growth Fund Index Russell 3000 Index S&P 500 is a benchmark against which managers are commonly judged

Public Issues of Stocks and Bonds Two principal ways to sell securities to the public Investment bankers Private placement Investment Bankers underwrite the issue and place the issue with the public through private placement. They price the initial issue, handle the SEC requirements, sell the issue, get the issue rated, etc. The top ten investment banks issue 90% of all stocks. Reputation is important for them to maintain. They also guide the entrepreneur through the process of issue. Sometimes the investment bank promises to buy the entire issue – so setting the correct price is crucial. This is called “firm-commitment under writing.” There is also “Best-efforts underwriting” where the issue is sold on a commission basis. This send a signal to the market though – if the investment bank isn’t willing to buy it why should an individual investor buy it? In some cases the risk of issue is handled by diversifying the initial holdings among a group of investment bankers. Private placement: Sell directly to a large investor at a negotiated price. Registration costs are reduced significantly under SEC rules for private placement. This is a particularly attractive option for large institutional investors.