McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Lecture 4

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.

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Financial MarketsCompetition 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 True value – a price that incorporates all the information currently

available to investors

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Corporate FinancingFirms have three broad sources of cash.

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

New equity issuesNew debt issues

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Internally Generated Funds

Historical sources of funds for FedEx1995-2010

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Why Internal Funds?Managers prefer to reinvest internal funds for a number of reasons:Cost of issuing securitiesNew 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.

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Corporate FinancingWhat happens when the firm cannot finance all of its

activities from plowed-back funds?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.

New Equity IssuesNew Debt Issues

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Equity IssuesMost 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?

The investor owns: , or 0.000000085% of Dow

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Equity Terminology

Treasury stock• Stock that has been repurchased by the company and held in its

treasury.

Issued shares and Outstanding Shares• Shares that have been issued by the company; shares that have

been issued by the company and are held by investors.

Authorized Share Capital• The maximum number of shares that the company is permitted to

issue without additional shareholder approval.

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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 the number of shares outstanding?

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Equity TerminologyWhen a firm issues new equity, it records each

new share in its books at par value.

Additional Paid-in Capital• The difference between the issue price and the par value

of a stock

Retained Earnings• Earnings not paid out as dividends

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Equity Terminology: Example

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)?

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Net Common Equity

Net CommonEquity =

ParValue

+Additional

Paid-in Capital+

RetainedEarnings -

ShareRepurchases

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

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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?

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Corporate OwnershipA corporation is owned by its common stockholders.

Owners are entitled to: 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

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Corporate OwnershipShareholders exercise control over the firm by voting for its

board of directors.

• Majority Voting• Voting system in which each director is voted on separately

• 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

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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

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Preferred Stock

Preferred Stock Advantages:• Dividends• Tax Advantages:– If one corporation buys another’s stock, only 30% of

the dividends it receives is taxable.•Disadvantages:

Potential Disadvantages:• Interest rate fluctuations: 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

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Corporate Debt

When issuing debt, companies promise to make payments and repay principal. But they have limited liability; debt

is not always repaid.

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Debt Characteristics Interest rate fluctuations

Coupon vs. Zero-coupon Bonds• Prime Rate – Benchmark interest rate charged by banks.• LIBOR – London Interbank Offered Rate; the rate at which international banks lend to

one another.

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?

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Debt Characteristics Funded and Unfunded Debt

• Debt with more than 1 year remaining to maturity; debt due in less than one year.

Sinking Fund• A fund established to retire debt before maturity.

Callable Bond• A 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?

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Debt Characteristics Seniority

• Subordinated Debt – Debt that may be repaid in bankruptcy only after senior debt is paid.

Security• Secured Debt – Debt that has first claim on specified collateral in the event of default.

Currency and Country of Origin• Eurodollars – Dollars held on deposit in a bank outside the United States.• Eurobond – Bond that is marketed internationally.

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Debt Characteristics 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.

Protective Covenants

• Restrictions on a firm to protect bondholders

Leases

• Long-term rental agreements

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Convertible Securities

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

Warrant• The right to buy shares from a company at a stipulated

price before a set date

Convertible Bond• A bond that the holder may exchange for a specified

amount of another security

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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?

Without conversion:

With conversion: