2.  Learning Objectives 
Identify how business firms issue debt securities and negotiate loans in order to raise funds in the financial markets
Examine the key factors affecting the volume of funds that businesses seek to raise in the financial system
Consider the often powerful impact that business borrowing has upon market interest rates and credit conditions

3. Introduction
Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment
In 2008, nonfinancial business firms in the U.S. raised nearly $1.4 trillion, of which approximately $551 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments

4. Factors Affecting Business Activity in the Financial Markets
Many factors affect the extent to which business firms draw on the financial markets for external funds:
Total funding demands of business firms
Level and expected growth of internally generated funds
Condition of the economy
Credit availability and interest rates

5. Characteristics of Corporate Notes and Bonds
Maturity definition:
A note has an original maturity of five years or less
A bond carries an original maturity of more than five years
General characteristics:
An amount equal to the par value at maturity
Interest payments at specified intervals
Generally issued in units of $1,000
Accompanied by indentures

6. Characteristics of Corporate Notes and Bonds
Corporate bonds tend to be issued with longer maturities when both interest rates and inflation are low
Some corporate bonds are backed by sinking funds
A considerable proportion of corporate bonds that are outstanding today carry call privileges

7. Characteristics of Corporate Notes and Bonds
During rapid economic expansion:
The supply of credit is relatively scarce
The cost of borrowing rises
Yield movements:
Yields on the highest-grade bonds tend to move closely with government bond yields
Yields carried by lower-grade corporate bonds:
Are tied more to conditions in the economy
Also tied more to factors specifically affecting the risk position of the borrower

8. Characteristics of Corporate Notes and Bonds
For a bond that matures in 10 years:
Interest charges on debt are tax deductible, so k’ = k (1 – t)

9. Characteristics of Corporate Notes and Bonds
Signals Corporate Bond Issues May Send
A bond issue that appears to be driven by an unanticipated cash-flow shortage:
Tends to lower bond prices of the issuer
Tends to lower equity prices of the issuer
A new bond sold to expand a firm’s capitalization tends to send a positive signal to the market

10. Characteristics of Corporate Notes and Bonds
Common types of corporate bonds:
Debentures – unsecured by a specific asset
Subordinated debentures – junior securities
Mortgage bonds – closed end or open end
Income bonds – interest is paid only when income is actually earned
Equipment trust certificates – resemble leases
Industrial development bonds (IDBs) – issued by a local government borrowing authority

11. Characteristics of Corporate Notes and Bonds
Innovations in corporate debt include:
Discount bonds – including zero coupon bonds
Floating-rate bonds
Commodity-backed bonds – face value is tied to the market price of an internationally traded commodity
Inflation-linked corporate notes
Medium-term notes (MTNs) – carry maturities of one to ten years

12. Asset-Backed Securities Issued by Corporations
Securitization:
The process that gives rise to the creation of asset-backed securities (ABSs)
Example: Packaging group of home mortgages:
Usually with federal agency guarantees
Removed from the lenders’ balance sheets
Placing them in a separate trust account
Selling securities backed by mortgages
With the help of an investment bank

13. Asset-Backed Securities Issued by Corporations

14. Asset-Backed Securities Issued by Corporations
Securitization may:
Reduce the cost of raising funds
Grant companies greater control over their balance sheets
Help a company avoid the issuance of additional balance-sheet debt
Improve the apparent financial strength of an issuing firm
Permit greater asset diversification
Provide a new source of company earnings

15. Asset-Backed Securities Issued by Corporations

16. Investors in Corporate Debt
The market is institution dominated:
Pension funds prefer public corporate debt
Insurance companies frequently prefer private placement
Foreign institutions are a very dynamic sector of the market:
Many dealers are international
Many of the debt instruments are for foreign takeovers of U.S. companies
Many more are ways to access dollars

17. Investors in Corporate Debt
Rapid growth in debt instruments in the United States:
Not matched by the rise of U.S. resident bond holdings
Differential filled by foreign investors
Bonds by U.S. companies between 1995 and 2006:
Tripled from $2.5 trillion to $8.2 trillion
Foreign investment went from $461 billion to $2.7 trillion

18. Investors in Corporate Debt

19. The Secondary Market for Corporate Debt
Relatively limited compared to the markets for other long-term securities
The number of active individual investors is small
Institutional investors tend to follow a buy and hold strategy:
Some changes in strategies more recently:
Many institutions are looking at total performance
Have become more aggressive

20. The Marketing of Corporate Debt
Corporate bonds may be offered:
Through a public sale
Privately to a limited number of investors via a private or direct placement
The majority of offerings are public sales:
Popular with firms with unique financing requirements
Private placements are common among smaller companies

21. The Marketing of Corporate Debt
The decision of small firms is often a function of the nature of the market:
Economies of scale in public issuance of debt:
Relatively cheaper for firms with large debt issuances
Relatively more expensive for smaller firms with less debt
The flexibility of private issues:
More easily address potential agency costs
Allow smaller debt issues

22. The Marketing of Corporate Debt
A public sale uses an underwriter:
An investment banking firm or a syndicate of underwriters may do one of two things:
Purchase the securities directly from the issuing company through a bidding process
Guarantee the issuer a specific price
The underwriter carries the risk of losses (or gains) when the securities are marked for sale in the open market

23. The Marketing of Corporate Debt
Private placements have accounted for about 10% of market sales of corporate bonds
Interest rates influence the private versus public decision:
Rising interest rates bring more borrowing companies into the public market
Falling interest rates often bring about a rise in private placements

24. The Volume of Borrowing by Corporations

25. The Volume of Borrowing by Corporations
Growth in corporate borrowing is due to:
Inflation
The increased use of financial leverage to boost returns to corporate stockholders
The development of international capital markets
Recent, relatively low interest rates
The rash of corporate takeovers (leveraged buyouts) and mergers

26. The Volume of Borrowing by Corporations
The growth in borrowing is also partially caused by corporate stock retirements:
A significant growth in popularity
Among larger corporations:
Stock retirements exceeded $400 billion for the year ending in June 2006
Was only $130 billion in 2001
Various factors for the expansion:
More M&A activity
More companies tapping the debt market

27. Bank Loans to Business Firms
Commercial banks are direct competitors with the corporate debt markets:
Make both short-term and long-term loans to businesses
Growing numbers of corporations have turned to selling securities in the open market
The volume of bank credit for business firms remains enormous

28. Bank Loans to Business Firms
The Fed has been carrying out surveys:
Examining business lending practices
Looking at banks across the U.S.
Surveys indicate bank lending tends to be short-term:
Average maturity of commercial and industrial loans (value-weighted) was 524 days in February 2007
Longer term loans averaged 54 months

29. Bank Loans to Business Firms
The prime bank rate, or base rate:
The annual percentage rate that banks quote to their most creditworthy customers
Tends to be unsecured
Often requires compensating balances
Tends to apply to short-term loans
Traditionally, the prime rate was set by one or more of the nation’s leading banks
Now, prime rates are often pegged to the prevailing yields on Treasury bills
19-29

30. Commercial Mortgages Commercial mortgage:
The construction of commercial structure:
Office buildings
Shopping centers
Other commercial structures
Faced with inflation and a volatile economy, new forms have been developed:
Equity kicker
Indexing
Asset-backed securitization

31. Markets on the Net
American Capital Advance at
AmeriMerchant at
Structured Finance News at
Bankrate at
Bond Market Association at
National Association of Small Business Investment Companies at
Small Business Notes at

32. Markets on the Net British Bankers’ Association at www.bba.org.uk
Business.com at
MarketWatch at
CNNMoney.com at
Financial Pipeline at
Mortgage 101 at
St. Louis Federal Reserve Bank research at

33. Chapter Review Introduction to business borrowing
Factors affecting business activity in the money and capital markets
Characteristics of corporate notes and bonds
Principal features
Recent trends in original maturities
Call privileges
Sinking fund provisions
Yields and costs
Signals corporate bond Issues may send
The most common types of corporate bonds
Innovations in corporate debt

34. Chapter Review Asset-backed securities issued by corporations
Investors in corporate debt
The secondary market for corporate debt
The marketing of corporate debt
Public sales
Private placements
The volume of borrowing by corporations

35. Chapter Review Bank loans to business firms Commercial mortgages
The volume of bank credit supplied to businesses
The prime, or base, interest rate on business loans
Other examples of base rates for business loans
Commercial mortgages