1. 14 Real Firms and Their Financing: Stocks and Bonds A bargain that is going to become a greater bargain is no bargain. MARTIN SHUBIK, YALE UNIVERSITY Real Firms and Their Financing: Stocks and Bonds A bargain that is going to become a greater bargain is no bargain. MARTIN SHUBIK, YALE UNIVERSITY

2. ●Corporations and Their Financing ●Financing Corporate Activity: Stocks and Bonds ●Buying Stocks and Bonds ●Stock Exchanges and Their Functions ●Speculation ●Corporations and Their Financing ●Financing Corporate Activity: Stocks and Bonds ●Buying Stocks and Bonds ●Stock Exchanges and Their Functions ●Speculation Contents Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

3. ●U.S. firms are of three types: ♦Proprietorships (largest number of firms) ♦Partnerships ♦Corporations (have largest amount of business) ●U.S. firms are of three types: ♦Proprietorships (largest number of firms) ♦Partnerships ♦Corporations (have largest amount of business) Corporations and Their Financing

4. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●The largest U.S. firms are corporations, which are treated by law as entities separate from their owners. Corporations and Their Financing

5. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Corporations and Their Financing ●Advantages: ♦Limited liability ♦Access to large amounts of capital ♦Ease of operation with help of hired management ♦Remain permanent even when the owners change ●Advantages: ♦Limited liability ♦Access to large amounts of capital ♦Ease of operation with help of hired management ♦Remain permanent even when the owners change

6. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Corporations and Their Financing ●Disadvantages: ♦Double taxation ♦Hired managers may act against the interest of the owners ●Disadvantages: ♦Double taxation ♦Hired managers may act against the interest of the owners

7. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●The Effect of Double Taxation of Corporate Earnings ♦Reduces the extent of corporate activities ♦Does not reduce the net returns to individual investors ●The Effect of Double Taxation of Corporate Earnings ♦Reduces the extent of corporate activities ♦Does not reduce the net returns to individual investors Corporations and Their Financing

8. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Why do corporations need additional funds? ♦To add to plant or equipment ♦To finance other types of real investment ●Why do corporations need additional funds? ♦To add to plant or equipment ♦To finance other types of real investment Financing Corporate Activity: Stocks and Bonds

9. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●How does a corporation get additional funds? ♦Take out a loan ♦Print and sell new stock certificates or new bonds ♦Reinvest its own earnings (rather than paying them out as dividends to stockholders) ●How does a corporation get additional funds? ♦Take out a loan ♦Print and sell new stock certificates or new bonds ♦Reinvest its own earnings (rather than paying them out as dividends to stockholders) Financing Corporate Activity: Stocks and Bonds

10. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Loans ♦A company can obtain money by borrowing from banks, insurance companies, other private firms, or a U.S. government agency. ●Sell Stocks ♦Common stock conveys an ownership claim and entitles the stockholder to a proportionate share of the dividends, if any. ●Loans ♦A company can obtain money by borrowing from banks, insurance companies, other private firms, or a U.S. government agency. ●Sell Stocks ♦Common stock conveys an ownership claim and entitles the stockholder to a proportionate share of the dividends, if any. Financing Corporate Activity: Stocks and Bonds

11. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Sell bonds ♦A bond purchase is like a loan. ♦It conveys no ownership stake, and entitles the bondholder to be repaid a certain fixed amount if the bond is held to maturity. ♦Bondholders have a prior claim to stock- holders. ●Sell bonds ♦A bond purchase is like a loan. ♦It conveys no ownership stake, and entitles the bondholder to be repaid a certain fixed amount if the bond is held to maturity. ♦Bondholders have a prior claim to stock- holders. Financing Corporate Activity: Stocks and Bonds

12. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stock “ownership” may be an illusion since large blocks are needed to exert influence ●Bonds can be a very risky investment due to fluctuations in market price and inflation. ●Stock “ownership” may be an illusion since large blocks are needed to exert influence ●Bonds can be a very risky investment due to fluctuations in market price and inflation. Financing Corporate Activity: Stocks and Bonds

13. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●From the point of view of the corporation, bonds are typically (not always) cheaper than stocks, in terms of expected interest payments versus return to the stockholders; they are, however, riskier because they establish a fixed obligation. Financing Corporate Activity: Stocks and Bonds

14. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stockholders usually demand a higher return than bondholders do because, to them, stocks are riskier. ●In other words, bonds are a way of transferring some (not all) of the risk from the investor to the company. ●Stockholders usually demand a higher return than bondholders do because, to them, stocks are riskier. ●In other words, bonds are a way of transferring some (not all) of the risk from the investor to the company. Financing Corporate Activity: Stocks and Bonds

15. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Plowback or Retained Earnings ♦As well as issuing stocks and bonds, firms can finance their investments through plowback or retained earnings. ♦Firms often find this preferable and, in fact, in 1996, plowback constituted about 62 percent of total U.S. corporate financing. ●Plowback or Retained Earnings ♦As well as issuing stocks and bonds, firms can finance their investments through plowback or retained earnings. ♦Firms often find this preferable and, in fact, in 1996, plowback constituted about 62 percent of total U.S. corporate financing. Financing Corporate Activity: Stocks and Bonds

16. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●What Determines Stock Prices? The Role of Expected Company Earnings ♦Since most bonds carry a fixed nominal return, their current market value fluctuates inversely with interest rates. ♦The market price of bond is equal to the coupon divided by the current market interest rate. ●What Determines Stock Prices? The Role of Expected Company Earnings ♦Since most bonds carry a fixed nominal return, their current market value fluctuates inversely with interest rates. ♦The market price of bond is equal to the coupon divided by the current market interest rate. Financing Corporate Activity: Stocks and Bonds

17. FIGURE 14-2 Sources of New Funds for U.S. Corporations Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 18.9 –12.9 21.2 Percent New stocks Other external sources New bonds and other debt Plowback –20 –10 0 10 20 30 40 50 60 72.8 70 80

18. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Selecting a Portfolio: Diversification ♦Investors reduce their risk by acquiring a variety of assets. ♦An easy way for an individual investor to diversify is to invest money in an index fund. ●Selecting a Portfolio: Diversification ♦Investors reduce their risk by acquiring a variety of assets. ♦An easy way for an individual investor to diversify is to invest money in an index fund. Buying Stocks and Bonds

19. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Selecting a Portfolio: Diversification ♦Index funds ■Buy the securities used in one of the standard stock price indexes ■Return reflects the performance of the whole market ●Selecting a Portfolio: Diversification ♦Index funds ■Buy the securities used in one of the standard stock price indexes ■Return reflects the performance of the whole market Buying Stocks and Bonds

20. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stocks are bought and sold on stock exchanges, the largest and most important of which is the New York Stock Exchange. Stock Exchanges and Their Functions

21. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Regulation of the Stock Market ♦Stock exchanges are regulated internally and by the Securities and Exchange Commission. ●Regulation of the Stock Market ♦Stock exchanges are regulated internally and by the Securities and Exchange Commission. Stock Exchanges and Their Functions

22. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stock Exchanges and Corporate Capital Needs ♦A special type of bank called an investment bank usually handles new stock issues. ♦Stock exchanges deal in previously issued stock; they do not provide capital to firms directly. ●Stock Exchanges and Corporate Capital Needs ♦A special type of bank called an investment bank usually handles new stock issues. ♦Stock exchanges deal in previously issued stock; they do not provide capital to firms directly. Stock Exchanges and Their Functions

23. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Stock Exchanges and Their Functions ●Stock Exchanges and Corporate Capital Needs ♦Stock exchanges have two critically important functions for corporate financing: ■By providing a second-hand market for stocks, they make individual investment in a company much less risky. ■The stock market determines the current price of the company’s stock. ●Stock Exchanges and Corporate Capital Needs ♦Stock exchanges have two critically important functions for corporate financing: ■By providing a second-hand market for stocks, they make individual investment in a company much less risky. ■The stock market determines the current price of the company’s stock.

24. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stock Exchanges and Corporate Capital Needs ♦A high price of its stock on the exchange is important to a firm because it allows the issuance of new stock at a good price. ♦If a firm has a promising future, its stock will tend to command a high price on the stock exchanges. ●Stock Exchanges and Corporate Capital Needs ♦A high price of its stock on the exchange is important to a firm because it allows the issuance of new stock at a good price. ♦If a firm has a promising future, its stock will tend to command a high price on the stock exchanges. Stock Exchanges and Their Functions

25. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Stock Exchanges and Their Functions ●Stock Exchanges and Corporate Capital Needs ♦The stock market helps to allocate the economy’s resources to firms that can best use those resources. ●Stock Exchanges and Corporate Capital Needs ♦The stock market helps to allocate the economy’s resources to firms that can best use those resources.

26. ●Takeover = group of outside financiers buys a sufficient amount of company stock to gain control of the firm. ♦There has been an increase in takeovers, including “hostile takeovers,” through the buying of stock. ♦Opinion is divided as to whether this is good or bad for the economy. ●Takeover = group of outside financiers buys a sufficient amount of company stock to gain control of the firm. ♦There has been an increase in takeovers, including “hostile takeovers,” through the buying of stock. ♦Opinion is divided as to whether this is good or bad for the economy. The Surge in Takeovers Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

27. ●Speculators get bad press, but they usually perform important, socially useful tasks. ●They protect other people against risk and they help to smooth out price fluctuations. ●In some circumstances, they may even prevent famine. ●Speculators get bad press, but they usually perform important, socially useful tasks. ●They protect other people against risk and they help to smooth out price fluctuations. ●In some circumstances, they may even prevent famine. Speculation

28. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Even skilled analysts cannot accurately predict individual stock prices. ●Rather, they move in a random fashion, around a long-run market trend for stocks in general. ●The reason for this may be the great skill and foresight of investors or, alternately, their irrational behavior. ●Even skilled analysts cannot accurately predict individual stock prices. ●Rather, they move in a random fashion, around a long-run market trend for stocks in general. ●The reason for this may be the great skill and foresight of investors or, alternately, their irrational behavior. Unpredictable Stock Prices as “Random Walks” ?