FINANCIAL ADMINISTRATION OF THE FIRM FIN 5043930

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Chapter 11
An Overview Of Long-Term Financing
Del HawleyFIN 634
Fall 2003
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Chapter 11 Overview

• 11.1 The Basic Instruments of Long-Term Financing
• Common Preferred Stock
• Long-Term Debt
• 11.2 The Basic Choices in Long-Term Financing
• The Need to Fund a Financial Deficit
• The Choice Between Internal Versus External
  Financing
• 11.3 Financial Intermediaries Role in Corporate
  Finance
• What is a Financial Intermediary (FI) and What
  Does it Do?
• The Role of FIs in American Corporate Finance
• The Role of FIs in non-U.S. Corporate Finance
• 11.4 The Expanding Role of Securities Markets
• The Growth of Securities Issues Worldwide
• The Worldwide Surge in Mergers and Acquisitions
• 11.5 Corporate Governance and Corporate Finance

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Characteristics of Common Stock

• Basic terminology of common stock (refer to IBM
  data)
• Par value denomination little economic
  relevance today
• Shares authorized, outstanding, issued
  shareholders specify maximum amount of shares
  that can be issued
• Additional paid-in capital amount received in
  excess of par value when corporation initially
  sold stock.
• Market value market price/share x number shares
  O/S
• Treasury stock stock purchased on open market by
  corporation. Usually purchased for stock options.
• Stock split two-for-one split issues one new
  share for each already held. Done to reduce per
  share price.
• Common stockholders are residual claimants
• They have no claim to earnings or assets until
  all senior claims are paid in full.
• High risk, but historically also high return

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Book Value Of Stockholders Equity In IBM As Of
December 31, 2001 (In millions)
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Rights Of Common Stockholders

• Voting rights of C/S can be exercised in person
  or by proxy
• Assigning proxy means giving someone else
  (usually mgt) the right to vote your shares at a
  stockholders meeting
• Can change your mind most recent proxy has
  voting right
• proxy fight when a dissident group solicits
  proxies in order to challenge management. Mgt
  usually wins.
• Most US corporations have majority voting
• This gives each share one vote for each
  directors position (one vote for each of ten
  board seats)
• Cumulative voting gives minority S/Hs greater
  chance of electing one or more directors
• Can vote all ten votes for a single director.
• S/Hs do not have a legal right to receive
  dividends
• Dividends paid only at BOD discretion, and only
  if all creditor claims are current.

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Characteristics of Preferred Stock

• Preferred stock is an equity claim, though fixed
  in amount
• Claim on assets and cash flow senior to common
  stock
• As equity security, dividend payments are not tax
  deductible for the corporation and are subject to
  personal income tax.
• For tax reasons, straight P/S held mostly by
  corporations
• Venture capitalists use convertible P/S almost
  exclusively
• Promises a fixed annual dividend payment,
  expressed as dollar amount or percent, but not
  legally enforceable
• However, firm cannot pay C/S dividends if P/S in
  arrears
• In liquidation, P/S claim paid before C/S receive
  anything
• Preferred stockholders usually do not have voting
  rights
• Venture capitalists an exception they have very
  strong control rights and receive BOD seats

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Methods Of Classifying Long-Term Debt

• Maturity Only long-term debt is part of a
  corporations capitalization (permanent
  capital)
• Short, Intermediate, and long-term debt often
  called bills, notes, and bonds, respectively.
• Seniority Rank in priority of claims to assets
  cash flow
• Senior versus subordinated debt
• Security Is debt secured by explicit collateral?
• Mortgages are secured by real estate
  transportation equipment secured by equipment
  trust receipts
• Most corporations issue debentures no explicit
  collateral
• Callability Most US corporate debt is callable
  by firm
• Allows firm to retire reissue debt if interest
  rates fall
• Must compensate investors with call premium and
  higher interest rate on bonds

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Methods Of Classifying L-T Debt (Continued)

• Interest payment method Floating or fixed rate
  debt
• Most US bonds pay fixed coupon interest payments
• Virtually all bank loans are floating rate debt,
  based on prime rate or LIBOR (London Inter-Bank
  Offered Rate)
• Method of principal repayment Bullet vs
  amortized loans
• Most corporate bonds are bullet loans principal
  repaid in a lump sum at maturity
• Sinking fund purchases reduce default risk by
  reducing amount O/S over bond issues life
• Most personal loans (homes, cars), some corporate
  debts are amortized equal periodic principal
  interest payments
• Security versus loan product Is debt
  securitized?
• Capital market instruments--bonds, notes,
  bills--are securities (commercial paper is
  economically, but not legally)
• Syndicated bank loans the most important loan
  products

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Basic Choices In Long-Term Financing

• Corporations are almost always net dis-savers
  they consume more capital (savings) than they
  generate
• Their capital investments exceed their retained
  earnings
• Thus ongoing need to fund financial deficit by
  tapping external sources of capital
• Individual corporations (and corporate sector)
  face four key decision variables each year
• How much capital is needed for investment, other
  purposes?
• How much capital to raise externally vs
  internally?
• Should external funds be raised on capital
  markets or via financial intermediaries?
• Fraction of external capital raised as debt
  versus equity?
• Internal financing roughly equal to cash flow
  from operations minus cash dividends
• Amount not fixed firm can vary dividends
  capital structure

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Sources Of Funds For Non-Financial U.S.
Corporations, 1980-2000
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External Financing Patterns For G-7 Countries
Averages For 1984-1991
Source Rajan and Zingales, What do We Know
About Capital Structure Some Evidence from
International Data, Journal of Finance 50
(1995).
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Composition Of Net External Financing, G-7
Countries Average 1984-1991
Source Rajan and Zingales, What do We Know
About Capital Structure Some Evidence from
International Data, Journal of Finance 50
(1995).
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Annual Global Securities Issuance Patterns

• Record 4.07 Trillion Securities Issued On Public
  Capital Markets Worldwide During 2001 and 3.9
  trillion in 2002
• Compared to only 504 bn in 1990
• Over 500bn More In Private Placements (417bn in
  2002)
• Almost 20 Trillion Total Public Offers During
  1990s
• Another 3-4 trillion in private placements
• Rule 144A issues very popular with US, non-US
  issuers
• Each Year, US Issuers Account For Two-Thirds Of
  Total Public Issue Volume, Most Private Issues
• Over 70 of public issues in 2001and 2002
• Debt Issues Are Over Three-Fourths Of US Total
  Every Year
• Account for 91 and 94 of issues in 2001 and
  2002
• Equity Issues Play Small Financing Role Everywhere

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Number Value (US Billions) Of U.S. Public
Security Offerings, 2002
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Value of Global Mergers Acquisitions, 1991-2002
(US Billions)
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Pension Funds And Capital Markets
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Pension Funds And Capital Markets (Cont)