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14-2 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.

14-3 Financial Markets Competition 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

14-4 Corporate Financing Firms have three broad sources of cash.  Internally generated funds – Cash reinvested in the firm: depreciation plus earnings not paid out as dividends.  New equity issues  New debt issues

14-5 Internally Generated Funds Historical sources of funds for FedEx

14-6 Why Internal Funds? Managers prefer to reinvest internal funds for a number of reasons:  Cost of issuing securities  New 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.

14-7 Corporate Financing What 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 Issues  New Debt Issues

14-8 Equity Issues Most 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 billion shares outstanding, how much of Dow does an investor who holds one share own? The investor owns:, or % of Dow

14-9 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.

14-10 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?

14-11 Equity Terminology When 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

14-12 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)?

14-13 Net Common Equity Net Common Equity = Par Value + Additional Paid-in Capital + Retained Earnings - Share Repurchases 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

14-14 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?

14-15 Corporate Ownership A 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

14-16 Corporate Ownership Shareholders 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

14-17 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

14-18 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

14-19 Corporate Debt When issuing debt, companies promise to make payments and repay principal. But they have limited liability; debt is not always repaid.

14-20 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?

14-21 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?

14-22 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.

14-23 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

14-24 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

14-25 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: