Introduction to corporate financing

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Introduction to corporate financing
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Back to the principles of corporate finance

• The Financing Principle Choose a financing mix
  that minimizes the hurdle rate and matches the
  assets being financed
• What are the firms choices with respect to
  financing its investments?
• Retained earnings
• Equity
• Debt
• The mix of debt and equity used by a firm is
  called the firms capital structure. Is there an
  optimal external financing mix (capital
  structure) and, if so, what is it?

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Trends in FinancingSources of Funds for
Investment for U.S. Non-Financial
Corporations(expressed as a percent of each
years total investment)
Internal funds are net income plus depreciation
less cash dividends paid to shareholders. Source
Board of Governors of the Federal Reserve System
Flow of Funds Accounts
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Trends in FinancingSources of Funds for
Investment for U.S. Non-Financial
Corporations(expressed as a percent of each
years total investment)
Internal funds are net income plus depreciation
less cash dividends paid to shareholders. Source
Board of Governors of the Federal Reserve System
Flow of Funds Accounts
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Patterns of firm financing

• Publicly traded firms in the US finance their
  investments mostly with funds generated
  internally rather than with external funds
• 70-90 of financing is internal
• Notice that in almost every year there exists a
  financing gap (difference between cash needed to
  finance investments and cash generated
  internally)
• When using external financing, firms are more
  likely to use debt rather than equity even though
  there are variations in the debt-equity mix from
  year to year

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Do firms rely too much on internal funds?

• The data show a heavy reliance of firms on
  internal funds
• Are managers averse to external financing? Do
  they forego positive NPV projects if they involve
  external financing?
• There are some good reasons for relying on
  internal funds
• Cost of issuing new securities is avoided
• Announcement of new equity is usually bad news
  for investors who worry that the decision signals
  lower future profits or higher risk

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The distinction between debt and equity

• The difference between debt and equity is not one
  between bonds and stocks, but is determined by
  the nature of each assets claims on the firms
  cash flows
• Debt and equity are distinguished based on the
  following characteristics
• Nature of claim
• Priority of cash flows
• Tax treatment
• Maturity
• Management control

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Characteristics of debt and equity
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The firms financing choices

• The range of financing choices available to firms
  has expanded greatly in recent decades
• Firms can choose among the following instruments
  to finance their investments
• Common stock
• Preferred stock
• Debt
• Convertible securities
• The firms choice of financing depends on its
  needs and the reception of the firms securities
  by investors not on securities laws

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Common stock

• Common stockholders are the owners of the firm
  they hold the residual claim on the earnings of
  the firm (i.e., they receive whatever is left
  after all debts are paid)
• In 2000, over 60 of common stock in the US was
  held by financial institutions (banks, pension
  and mutual funds, insurance companies)
• Pension and mutual funds each held about 20 of
  all common stock
• Common stock is the conventional way for a firm
  to raise equity capital either through an IPO or
  through seasonal offerings

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• The maximum number of shares that can be issued
  is known as the authorized share capital
• If management wants to increase the number of
  authorized shares, it needs to receive approval
  by the firms shareholders
• The firms shares held by investors are said to
  be issued and outstanding
• When a firm repurchases its outstanding shares,
  these shares are held in the Treasury until they
  are cancelled or resold and are called issued but
  not outstanding

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• Common stockholders have the right to vote to
• Elect the Board of Directors
• Approve mergers
• Increase the number of shares of stock that the
  firm can issue
• In the US and the UK, firm ownership is widely
  dispersed, meaning that it is rare to find
  shareholders who own more than 5-10 of the
  outstanding shares of a firm
• In many countries, firm ownership is more
  concentrated and large shareholders may own 20
  or more of shares this is less common in the US
  (e.g. Microsoft)

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Classes of common stock

• If existing shareholders do not wish to
  relinquish control, they can attach inferior
  voting rights to newly-issued shares
• Thus, firms may have several classes of stock
  with different voting rights
• For example, a firm may have class A shares and
  class B shares where A shares have 10 votes each
  and B shares have 1 vote each
• Shares with superior voting rights trade, on
  average, at a small premium in the US

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• Firms may also issue different classes of stock
  that differ in terms of dividend payments
• One class of shares receives cash dividends
• A second class of shares receives stock dividends
• Possible explanations of this difference are
• The firm is trying to attract investors in
  different tax brackets
• The firm may be trying to compensate investors
  who hold shares with inferior voting rights by
  offering higher dividend payments

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Preferred stock

• Preferred stock is a form of a hybrid security
  and is typically a small proportion of a firms
  financing
• Preferred stock pays a fixed dividend like debt,
  but does not have a final repayment date (firm
  often buys back the stock)
• A firm can choose not to pay dividend, but
  skipped dividends are accumulated and must
  eventually be repaid (cumulative vs.
  non-cumulative preferred stock)
• Dividends must be paid to preferred stockholders
  before common stockholders receive any cash flows

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• Preferred stockholders are paid after
  bondholders, but before common stockholders
• Major advantage of preferred stock is that it
  does not dilute shareholder ownership, but a
  disadvantage is that payments to preferred
  shareholders are not tax deductible
• Variants of preferred stock are convertible
  preferred stock and adjustable rate preferred
  stock

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Why do firms issue preferred stock?

• Preferred stock is more expensive than debt and
  is not tax deductible
• However, firms issue preferred stock because
• Preferred stock is calculated as equity when
  determining a firms leverage
• Firms dont have to pay taxes on 70 of dividends
  from preferred stock investments in other
  companies

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Debt

• Stockholders issue debt promising to make regular
  interest payments and repay the principal
• Debt comes with limited liability stockholders
  can default on debt and turn over the
  corporations assets to creditors
• Lenders do not generally have voting power or
  control on management
• Interest payments are viewed as a cost for the
  firm and are, thus, deductible from taxable
  income

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Debt characteristics

• Debt maturity
• Short-term vs. long-term debt (most corporate
  bonds have maturities between 5-20 years)
• In general, maturity should match the horizon of
  the investment
• Larger firms can issue short-term debt
  (commercial paper) while smaller firms rely on
  bank financing for short-term needs
• Fixed vs. floating interest rate
• Typically, rates are fixed, even though rates can
  also be floating and linked to an interbank rate
  such as LIBOR

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• Choice of currency
• Debt can be issued domestically in US dollars or
  issued as dollar-denominated bonds abroad
  (eurobonds)
• Firms with large operations overseas may issue
  bonds in a foreign currency
• Debt security
• Secured debt has the highest priority in terms of
  payment (mortgage bonds, collateral bonds)
• This debt is backed by collateral (inventory,
  accounts receivable, equipment, etc.)
• Unsecured bonds backed by the firms general
  credit are called debentures, if they have
  maturity greater than 15 years, and notes if
  their maturity is less than 15 years

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• Debt seniority
• Some debt is subordinated (junior claim) in case
  of default
• Subordinated debt holders get paid after other
  creditors, but before preferred and common stock
• Debt may have a call provision this allows the
  firm to repay and retire debt before its maturity
  date
• Moodys and Standard Poors rate bonds on a
  regular basis
• Bonds below investment grade (BBB for SP, Baa
  for Moodys) are referred to as junk bonds and
  must offer a risk premium to investors

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Convertible securities

• Firms issue securities that give investors the
  option to convert them into other securities
  called convertible securities
• Thus, the option that these securities include
  may have a significant impact on their value
• There are three types of convertible securities
  issued by firms
• Warrants
• Convertible bonds
• Stock options

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• Warrants give their holders the right to buy
  shares in a firm at a fixed price within a
  certain period of time, in exchange for paying
  for the warrants today
• Warrants are attractive because
• Their value increases with the variance of the
  firms stock
• They create no financial obligations for the firm
  in terms of dividends at the time of their issue
• They avoid ownership dilution while allowing the
  firm to raise equity capital

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• Convertible debt (bonds) gives its owner the
  option to exchange the bond into common stock at
  a pre-determined exchange ratio
• Convertible bonds are attractive because
• Firms can offer a lower yield because the
  conversion option has value
• Convertible bonds are an attractive alternative
  to firms with high growth that do not currently
  have high operating cash flows
• Convertible debt can reduce conflicts between
  equity and debt holders in a firm

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• A couple of examples
• Amazon.com raised 1.25 billion in February 1999
  by selling convertible debt with conversion
  prices of 78 and offering yield of 4.75, which
  was 500-600 basis points below junk bond yield
• From 1994 to third quarter of 1999, convertible
  debt comprised 5-10 of total public debt
  issuance for non-financial corporations, while in
  Q4 1999 Q1 2000 it jumped to 20-25 due to the
  soaring NASDAQ