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AN OVERVIEW OF CORPORATE FINANCING
14 AN OVERVIEW OF CORPORATE FINANCING McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
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14-1 patterns of corporate financing
How Firms Raise Funds Plowing back profits Seeking external financing Debt sources Equity sources Firms may raise funds from external sources or plow back profits, i.e., internal funds. External financing involves the choice between debt and equity.
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Figure 14.1 sources of funds, u.s. nonfinancial corporations
This shows that a major part of financing for firms in the USA is from internally generated funds.
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TABLE 14.1 U.s. manufacturing, third quarter, 2011 ($ billions)
These are aggregate figures for manufacturing corporations in the U.S.
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14-1 patterns of corporate financing
How Do We Define Debt? There are two ways to calculate the debt ratio. The first definition is total debt (includes short-term and long-term liabilities) to total assets ratio. The second definition is total long-term liabilities to total capitalization ratio. In the second case, analysts focus on the long-term financing.
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Figure 14.2 debt to net worth, nonfinancial corporations, 1955-2010
This graph provides a comparison of book debt ratio and market debt ratio. Market debt ratio is more volatile.
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14-2 common stock Common Stock Residual claim on assets and cash flow
Mostly held by financial institutions Stockholders have ultimate right of control There is no law of nature that says residual cash-flow rights and residual control rights have to go together. For example, one could imagine a situation where the debtholder gets to make all the decisions. But this would be inefficient. Since the benefits of good decisions are realized mainly by the common stockholders, it makes sense to give them control over how the firm’s assets are used.
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Figure 14.3 corporate equity holdings, third quarter, 2011
Households, pension funds, and mutual funds hold a large part of the corporate equity in the U.S.
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14-2 common stock Voting Procedures
Board of directors comes up for re-election every year Classified board of directors One-third of directors come up for re-election every year Entrenches management For many U.S. companies, the entire board of directors comes up for re-election each year. However, approximately half of large companies have classified boards, in which case only a third of the directors come up for re-election each year. Shareholder activists complain that such staggered elections make it more difficult for a dissident group of shareholders to replace the board and therefore help to entrench management. Consequently, in recent years many companies have been pressured by their shareholders into declassifying their boards.
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14-2 common stock Dual-Class Shares and Private Benefits
Some companies have two classes of stock Same cash-flow rights, different control rights Greater control rights grant private benefits If everyone gains equally from better management, why do shares with superior voting power typically sell at a premium? The only plausible reason is that there are private benefits captured by the owners of these shares. For example, a holder of a block of voting shares might be able to obtain a seat on the board of directors or access to perquisites provided by the company.
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14-2 common stock Equity in Disguise Partnerships
Avoid corporate income tax Limited life span Trusts Passive ownership of asset Real Estate Investment Trust (REIT) Not taxed Limited to real estate REITs are tightly restricted to real estate investment. You cannot set up a widget factory and avoid corporate taxes by calling it a REIT.
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14-2 common stock Preferred Stock
Takes priority over common stock when receiving dividends Gains some voting rights if corporation fails to pay preferred dividend Like debt, preferred stock offers a series of fixed payments to the investor. The company can choose not to pay a preferred dividend, but in that case it may not pay a dividend to its common stockholders.
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14-3 Debt Debt Comes in Many Forms Short-term versus long-term
Fixed versus floating rate Dollars versus foreign currency Senior versus junior debt Straight versus convertible bonds Should the company borrow short term or long term? If your company simply needs to finance a temporary increase in inventories ahead of the holiday season, then it may make sense to take out a short-term bank loan. But suppose that the cash is needed to pay for expansion of an oil refinery. Refinery facilities can operate more or less continuously for 15 or 20 years. In that case it would be more appropriate to issue a long-term bond. 2. Should the debt be fixed or floating rate? Most bank loans and some bonds offer a variable, or floating, rate. For example, the interest rate in each period may be set at 1% above LIBOR (London Interbank Offered Rate), which is the interest rate at which major international banks lend dollars to each other. When LIBOR changes, the interest rate on the loan also changes. 3. Should you borrow dollars or some other currency? Many firms in the U.S. borrow abroad. Often they may borrow dollars abroad (foreign investors have large holdings of dollars), but firms with overseas operations may decide to issue debt in a foreign currency. After all, if you need to spend foreign currency, it probably makes sense to borrow foreign currency. 4. What promises should you make to the lender? Lenders want to make sure that their debt is as safe as possible. Therefore, they may demand that their debt is senior to other debt. If default occurs, senior debt is first in line to be repaid. The junior, or subordinated, debtholders are paid only after all senior debtholders are satisfied (though all debtholders rank ahead of the preferred and common stockholders). 5. Should you issue straight or convertible bonds? Companies often issue securities that give the owner an option to convert them into other securities. These options may have a substantial effect on value. Loan Coupon = LIBOR + Spread FLOATING L+400 Bond Coupon = X% FIXED = 8.00%
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Figure 14.4 u.s. bond holdings, third quarter, 2011
This shows how corporate debt is held by various entities.
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14-3 Debt Debt by Any Other Name
Some debts treated differently in accounts Accounts Payable Good received, not yet paid for Very short-term debt Unfunded obligations Senior debt, e.g., employee pensions Special-Purpose Entities (SPEs) Raise cash through equity and debt Do not show up on balance sheet When American Airlines filed for bankruptcy in 2011, it had promised its employees pensions valued at $18.5 billion. However, AMR had set aside only $8.3 billion to help meet this obligation. The unfunded obligation amounted to $10.2 billion. This $10.2 billion was a senior debt of the corporation. Enron was able to borrow $658 million by setting up special-purpose entities (SPEs), which raised cash by a mixture of equity and debt and then used these debts to help fund the parent company. None of this debt showed up on Enron’s balance sheet.
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Figure 14.5 flow of savings to investment
Savings come from investors worldwide. The savings may flow through financial markets or financial intermediaries. The corporation also reinvests on the shareholders’ behalf.
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14-4 financial markets and institutions
Used to raise money through primary issues Allow investors to trade amongst themselves Help firms manage risks Financial Intermediaries Raise money from investors, provide financing Banks, insurance companies, investment funds This slide explains the role of financial markets and financial intermediaries.
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Table 14. 2 financial assets of u. s
Table 14.2 financial assets of u.s. intermediaries, third quarter, 2011 This slide shows the financial assets of the different types of intermediary in the United States. It gives you an idea of the relative importance of different intermediaries. Of course, these assets are not all invested in nonfinancial businesses. For example, banks make loans to individuals as well as to businesses.
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14-4 financial markets and institutions
Investment Funds Mutual Fund Raises money by selling shares to investors Attempts to beat market Money Market Fund Invests in short-term safe securities Closed-End Fund Fixed number of shares This slide explains the different varieties of investment funds.
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14-4 financial markets and institutions
Investment Funds Exchange-Traded Fund (ETF) Portfolio bought or sold in single trade Hedge Fund Restricted access Limited partnership Performance-related fees This slide explains the different varieties of investment funds.
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14-4 financial markets and institutions
Financial Institutions Commercial banks Provide loans, safe money storage Investment banks Assist companies in raising financing Advise on takeovers, mergers, and acquisitions Insurance companies Invest in corporate stocks and bonds A financial institution is an intermediary that does more than just pool and invest savings. Institutions raise financing in special ways, for example, by accepting deposits or selling insurance policies, and they provide additional financial services. Unlike most investment funds, they not only invest in securities but also lend money directly to individuals, businesses, or other organizations.
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14-5 The role of financial markets and intermediaries
Payment Mechanism Allows individuals to make and receive payments quickly and safely over long distances Borrowing and Lending Channels savings towards those who can best use them Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy.
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14-5 The role of financial markets and intermediaries
Pooling Risk Allows individuals to share risk, i.e., insurance companies Information Allows estimation of expected rates of return Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy.
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