VI. SOURCES OF CORPORATE FINANCE

 1 Common Stock

    Some definitions

      treasury stock

        The shares which is bought back by the issuing company (reducing the amount of outstanding stocks on the open market)

        held in the company’s treasury.

      issued and outstanding shares

        The shares held by investors.

      authorized share capital

        The maximum number of shares that can be issued (without getting the approval of the current shareholders)

      The share's par value

        The price at which each share is recorded

      additional paid-in capital or capital surplus

        The difference between the price at which new shares are sold to investors and  the par value is entered into the company’s accounts

    Book value versus Market value

      Book value

        is a backward-looking measure.

        tells us how much capital the firm has raised from shareholders in the past.

      The market value

        is forward-looking;

        depends on the future dividends that shareholders expect to receive.

      Market value is usually greater than book value.

        Partly, inflation has driven the value of many assets above what they originally cost.

        Also, firms raise capital to invest in projects with present values that exceed initial cost.

        These positive-NPV projects made the shareholders better off.

      Market value can fall below book value.

        projects do go awry

        companies fall on hard times

    Dividends

      A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.

      The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share - DPS).

      It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

      Dividends are not considered to be a business expense, so companies are not allowed to deduct dividend payments when they calculate their taxable income.

    Stockholders' Rights

      Common stockholder exercise control by electing a board of directors and voting on corporate policy.

      Common stockholders are on the bottom of the priority ladder for ownership structure.

      In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debtholders have been paid in full.

    Voting Procedures

      In most companies, stockholders elect directors by a system of majority voting. Each director is voted on separately and stockholders can cast one vote for each share they own.

      In some companies directors are elected by cumulative voting. The directors are then voted on jointly and the stockholders can cast all their votes for just one candidate.

    Classes of Stock

      Most companies issue just one of common stock.

      Sometimes, however, a firm may have two or more classes outstanding, which differ in their right to vote or receive dividends.

      Owners of companies that have been privately owned and go public often create class A and B share structures with different voting rights in order to maintain control and/or to make the company a more difficult target for a takeover. Obviously, it's the original owners that end up with the preferential voting class of stock.

        Class A mutual fund shares charge a front-end load, have lower 12b-1 fees and a below-average level of operating expenses.

        Class B mutual fund shares charge a back-end load and have higher 12b-1 fees and operating expenses.

        Class C mutual fund shares: there's no front-end load but a low back-end load applies, as do 12b-1 fees and relatively higher operating expenses.

    Corporate Government in the United States and Elsewhere

 2 Preferred Stock

    A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock.

    It generally has a dividend that must be paid out before dividends to common stockholders

    The shares usually do not have voting rights.

    It is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation).

    Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation

    Preferred shareholders have a fixed dividend and give up their voting rights and less potential for appreciation.

 3 Corporate Debt

    Interest Rate

      The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.

      Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR).

      The interest payment, or coupon, on most long-term loans is fixed at the time of issue

      Most loans from a bank and some long-term loans carry a floating interest rate

      The prime rate is the benchmark interest rate charged by banks to large customers with good to excellent credit

      When the prime rate changes, the interest on your floating-rate loan also changes.

    Maturity

      The length of time until the principal amount of a bond must be repaid.

      The end of the life of a security.

      It is the date the borrower must pay back the money he or she borrowed through the issue of a bond.

      Funded debt is any debt repayable more than 1 year from the date of issue.

      Funded debt is described as long-term

      Debt due in less than a year is termed unfunded

      Unfunded debt is carried on the balance sheet as a current liability.

      Unfunded debt is often described as short-term debt

    Repayment Provisions

      Long-term loans are commonly repaid in a steady regular way, perhaps after an initial grace period.

      For bonds that are publicly traded, this is done by means of a sinking fund.

      Each year the firm puts aside a sum of cash into a sinking fund

        that is then used to buy back the bonds (a portion of the issue) annually, usually at a fixed par value or at the current market value of the bonds.

      Sinking-fund provisions allow a firm to lessen the interest rate risk of its bonds

      From the investor's point of view,

        a sinking fund adds safety to a corporate bond issue

        When there is a sinking fund, investors are prepared to lend at a lower rate of interest.

      Most firms issuing debt to the public also reserve the right to call the debt - that is, issuers of callable bonds may buy back the bonds before the final maturity date

        This option to call the bond is attractive to the issuer.

          If interest rates decline and bond prices rise, the issuers may repay the bonds at the specified call price and borrow the money back at a lower rate of interest.

        The call provision comes at the expense of bondholders, for it limits investors’ capital gain potential.

          If interest rates fall and bond prices rise, holders of callable bonds may find their bonds bought back by the firm for the call price.

    Seniority

      Some debts are subordinated.

      In the event of default,

        The subordinated lender gets in line behind the firm’s general creditors.

        The subordinated lender holds a junior claim and is paid only after all senior creditors are satisfied

    Security

      When you borrow to buy your home, the Savings and Loan Company will take out a mortgage on the house.

        The mortgage acts as security for the loan.

          If you default on the loan payments, the S&L can seize your home.

      When companies borrow, they also may set aside certain assets as security for the loan

        These assets are termed collateral and the debt is said to be secured

        In the event of default,

          the secured lender has first claim on the collateral;

          unsecured lenders have a general claim on the rest of the firm’s assets but only a junior claim on the collateral.

    Default Risk

      The risk that companies or individuals will be unable to make the required payments on their debt obligations.

      Lenders and investors are exposed to default risk in virtually all forms of credit extensions.

      To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk.

      The higher the risk, the higher the required return and vice versa.

    Country and Currency

    Public versus Private Placement

      Publicly issued bonds

        are sold to anyone who wishes to buy

        can be freely traded in the securities markets

      In a private placement, the issue is sold directly to a small number of banks, insurance companies, or other investment institutions.

      Privately placed bonds

        cannot be resold to individuals in the United States but only to other qualified institutional investors

    Protective Covenants

      Revenue bonds often have protective covenants written into their indentures.

      These often require

        that sinking funds be established,

        that any future debt related to the project be subordinate to the issue in question

        or that the bondholders have recourse to the physical assets in case of default.

    A debt by any other Name

  3Convertible Securities

    We have seen that companies sometimes have the option to repay an issue of bonds before maturity.

    The most dramatic case is provided by a warrant

      A legal document that is signed by the judge, allowing the police to take a particular action

    Companies often issue warrants and bonds in a package

    A convertible bond gives its owner the option to exchange the bond for a predetermined number of common shares.

    investors value this option to keep the bond or exchange it for shares

    Companies may also issue convertible preferred stock.

      The investor receives preferred stock with fixed dividend payments

      The investor has the option to exchange this preferred stock for the company’s common stock.

  4.Patterns of Corporate Financing

    Firms have two broad sources of cash.

      They can raise money from the external sources by an issue of debt or equity.

      they can plow back part of their profits.

      When the firm retains cash rather than paying the money out as dividends, it is increasing shareholders’ investment in the firm.

    Do firms rely too heavily on Internal Funds

    External Sources of Capital

  For Class Discussion

  Special Terms

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