II.2 An Overview of Long-Term Financing
FIN 357: II.2.1 An Overview of Long-Term Financing c 2001 DC
The Sources of Long-Term Financing
There are four main sources of long-term ﬁnancing available to the ﬁrm:
1. Internal funds
– This is the portion of earnings that is not paid out as dividend to the
– It represents an addition to shareholder’s equity (in the ﬁrm’s ﬁnancial
2. Stock issues
– A stock is a claim to fractional ownership of the ﬁrm.
– The maximum number of shares that a corporation can issue (the
authorized share capital ) is speciﬁed in the articles of incorporation and
can be increased only with the permission of the stockholders.
◦ issued shares held by investors: issued and outstanding.
◦ issued shares bought back by the ﬁrm: treasury shares or issued but
– Some companies have issued more than one class of shares, diﬀering in
their rights to vote and receive dividends.
– Dividends to the stockholders are paid out of after-tax earnings.
FIN 357: II.2.2 An Overview of Long-Term Financing c 2001 DC-SG
The Sources of Long-Term Financing (cont’d)
3. Debt issues
– Corporate debt is a promise from a ﬁrm to make regular interest
payments and to repay the principal according to an agreed schedule.
– However, stockholders have limited liability: they have the right to
default on any debt obligation, handing over the corporation’s assets to
– Corporate debt varies in its repayment and interest provisions, as well as
in the rights attributed to the bondholders in the event of a default.
– Interest to bondholders is paid out of pre-tax earnings.
4. Hybrid Securities, such as preferred stock, convertible securities, bonds with
FIN 357: II.2.3 An Overview of Long-Term Financing c 2001 DC
Debt Issues: More Details
• Promise to
– regular interest payment and
– repay principal
according to a pre-speciﬁed schedule.
• This liability is limited in the sense that the shareholders have the right to
default if they hand over the corporation’s assets to the lenders.
– This is done when the value of assets is smaller than the amount of the
• Lenders do not vote.
• Interest payments are deducted from taxable income, i.e. the corporation
eﬀectively receives a tax subsidy by the government for issuing debt (vs
FIN 357: II.2.4 An Overview of Long-Term Financing c 2001 DC-SG
Characteristics of Debt
• Repayment provision:
– usually repaid in a steady ﬂow until maturity.
– sometimes callable: the ﬁrm has an option to repay and retire all the
bonds of a given issue prior to maturity.
• Seniority: rank in which the lenders are considered for interest payments and
for the resale of assets in the case of bankruptcy.
– subordinated debt: junior claim which is paid after the senior creditors
• Security of Collateral: Some bonds may be secured by mortgages on plants
and equipment. These bonds have the ﬁrst claim on these assets if
• Default risk: evaluated by bond rating agencies (Moody’s and Standard and
– investment-grade debt: top four grades.
– junk bonds: worst rating.
FIN 357: II.2.5 An Overview of Long-Term Financing c 2001 DC-SG
Patterns of Corporate Financing in the U.S.
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
(1) Capital expenditures 74 87 87 98 73 81 80 77 81 83
(2) Investment in net working
capital and other uses 26 13 13 2 27 19 20 23 19 17
(3) Total investment 100 100 100 100 100 100 100 100 100 100
(4) Internally generated cash 81 87 90 112 88 88 86 78 89 85
(5) Financial deﬁcit [(3)–(4)] 19 13 10 -12 12 12 14 22 11 15
Financial deﬁcit covered by
(6) Net stock issues -26 -27 -14 3 6 4 -7 -8 -9 -14
(7) Net increases in debt 45 40 24 -14 7 8 21 30 20 30
Source: Board of Governors of the Federal Reserve System.
FIN 357: II.2.6 An Overview of Long-Term Financing c 2001 DC-SG
Patterns of Corporate Financing by Country
The following table summarizes the relative importance of alternative sources of
capital in ﬁnancing gross real investment in diﬀerent countries.
Canada France Germany
1970-92 1970-81 1982-92 1970-92 1970-81 1982-92 1970-92 1970-81 1982-92
Internal 75% 74% 76% 69% 58% 81% 62% 55% 67%
Equity 10% 7% 12% 5% 8% 1% 0% 0% 0%
Bonds 14% 16% 10% 4% 5% 4% -1% -1% -2%
Bank Loans 16% 20% 11% 34% 46% 21% 30% 35% 26%
Other -15% -17% -9% -12% -17% -7% 9% 11% 9%
Japan U.K. U.S.
1970-92 1970-81 1982-92 1970-92 1970-81 1982-92 1970-92 1970-81 1982-92
Internal 60% 55% 66% 86% 78% 100% 90% 79% 99%
Equity 3% 2% 3% -1% -3% 2% -6% -2% -10%
Bonds 8% 7% 9% -0% 0% -0% 16% 14% 17%
Bank Loans 51% 57% 45% 31% 39% 17% 11% 14% 8%
Other -22% -21% -23% -16% -14% -19% -11% -5% -14%
Source: OECD National Accounts.
FIN 357: II.2.7 An Overview of Long-Term Financing c 2001 DC
How Corporations Issue Securities
• There are several ways in which a ﬁrm can issue new securities. These are
summarized by the following diagram:
Public General Oﬀer
Oﬀering Privileged Subscription (Rights
• A private placement occurs when the new issue is purchased and held by a
small group of investors. On the contrary, public oﬀerings are directed to a
larger public, and are subject to registration with the SEC.
– Private placement is typically used for smaller debt issues. Its main
advantages lie in a more direct relationship with the lender and lower
• In the case of a public oﬀering, the new securities can be directly oﬀered to
the public at large (general oﬀer ), or existing shareholders can be given a
preemptive right to subscribe the new securities (privileged subscription).
This preemptive right is sometimes established by the articles of
FIN 357: II.2.8 An Overview of Long-Term Financing c 2001 DC
• After the Great Crash of 1929, the Securities and Exchange Commission
(SEC) was set up with the purpose, among other things, of regulating new
issues and protecting the public from unscrupulous promoters.
– The issuers of new securities must ﬁle a registration statement with the
SEC. This statement provides information about the proposed ﬁnancing,
the ﬁrm’s history, existing business, and plans for the future. A
prospectus included in the statement summarizes this information: this is
the documentation actually used in marketing the securities. The selling
price is not speciﬁed in the registration statement.
– Following the ﬁling of the statement, there is a 20-day waiting period
during which the SEC staﬀ can check the documentation for any
omissions of misrepresentation of the facts. During this period, the
company is not permitted to oﬀer the securities for sale. However, they
can distribute copies of the preliminary prospectus to potential investors.
This is called a red herring, since it must state in red ink on the cover
that the SEC has yet to approve the issue.
– If no exception is ﬁled by the SEC during the waiting period, then a ﬁnal
prospectus including the ﬁnal oﬀering price is issued, and the company
can proceed with the sale.
FIN 357: II.2.9 An Overview of Long-Term Financing c 2001 DC
Disclosure Requirements (cont’d)
• There are a number of exceptions to the registration procedure:
– A ﬁrm that issues less than $1.5 million per year in new securities is
– Debt instruments with maturities shorter than 270 days are exempt.
– Securities issued in exchange for outstanding stock in a merger are
– Private placements to large institutional investors are exempt.
• Moreover, since 1982 the SEC allows issuers to ﬁle a single registration
statement covering issues up to 2 years into the future. This process of shelf
registration allows a company to issue securities promptly without having to
wait for the SEC approval.
• In addition to the SEC registration requirements, new issues are subject to
the state blue-sky laws passed in 1911 to prevent “speculative schemes which
have no more basis than so many feet of blue sky” (Hall v. Geiger-Jones Co.,
U.S. 539, 1917).
FIN 357: II.2.10 An Overview of Long-Term Financing c 2001 DC
The Role of Investment Banks in a General Oﬀer
• A very important role in the issuance of new securities through a general
oﬀer is played by an investment bank, the underwriter. Besides providing
advice, the most important function of the underwriter is selling the
securities to the public.
– In an underwritten arrangement the underwriter buys the securities from
the issuing company and then proceeds to reselling them to the public.
This means that the proceeds of the issue to the ﬁrm are guaranteed and
the underwriter bears the risk of price changes while the securities are
being sold to the public. This is the most common arrangement.
– In a best eﬀorts arrangement the underwriter does not actually buy the
new securities, but simply agrees to use his best eﬀorts to sell them. This
arrangement is usually reserved to issues that are perceived as
FIN 357: II.2.11 An Overview of Long-Term Financing c 2001 DC
The Role of Investment Banks in a General Oﬀer (cont’d)
• For larger issues, a group of investment banks, security dealers and brokers
will get together to form an underwriting syndicate to handle the sale. In
this case, one investment bank will act as the leading managing underwriter .
• Since established underwriters are in the capital market on a recurring basis,
they are very careful of their reputation and will not handle new issues
unless they believe that the facts have been fairly represented to investors.
Thus, another important role of the underwriter is that of providing its seal
of approval. This can be quite valuable for smaller companies or unseasoned
FIN 357: II.2.12 An Overview of Long-Term Financing c 2001 DC
A Look at Leading Underwriters in the U.S.
• The following table shows the 12 leading managing underwriters of U.S.
securities oﬀerings in 1989. Full credit for an issue is given to the LMU.
Number of Amount Percent
Manager Issues (millions) of Total
Merrill Lynch 428 45,985 14.9
Goldman Sachs 492 42,937 13.9
First Boston 418 37,765 12.2
Salomon Brothers 404 31,805 10.3
Morgan Stanley 293 29,782 9.6
Shearson Lehman Hutton 342 24,745 8.0
Bear Stearns 424 18,186 5.9
Drexel Burnham Lambert 224 16,805 5.5
Prudential-Bache 349 16,426 5.3
Kidder Peabody 196 8,799 2.9
Paine Webber 114 4,745 1.5
Donaldson, Lufkin & Jenrette 100 4,448 1.4
All Others 949 26,924 8.3
Total 4,733 309,352 100.0
FIN 357: II.2.13 An Overview of Long-Term Financing c 2001 DC
The Mechanism of Rights Oﬀers
• In the case of a rights oﬀer, the company gives the existing shareholders a
preemptive right to subscribe the new issue. In practice, this is done by
sending to shareholders a warrant (or right) for each share they own. A
certain number of rights is needed to purchase one new security at the issue
price. Shareholders have the choice to exercise, sell, or throw away these
• Again, the company might ask an investment bank or a syndicate to cover
the risk of the issue not being fully subscribed. This is attained through a
standby underwriting: rather than immediately buying the whole issue, the
underwriter promises to buy all unsubscribed shares at a price equal to the
issue price minus a take-up fee.
• One important diﬀerence between general oﬀers and rights oﬀers is that the
choice of the issue price is largely irrelevant for rights oﬀers: a lower issue
price simply means a higher value for the right, but the total wealth of
existing shareholders is unaﬀected. Therefore, the only thing a ﬁrm ought to
worry about in setting the terms of rights issue is the possibility that the
new securities’ price will fall below the issue price. By setting the issue price
low enough to foreclose the possibility of failure, the ﬁrm can save the cost of
FIN 357: II.2.14 An Overview of Long-Term Financing c 2001 DC
Relative Costs of Securities Issues
• The following table illustrates the typical costs, as a percentage of proceeds,
of underwritten general oﬀers versus rights oﬀers.
General with Rights with Rights w/o
Underwriting Standby Standby
Small Large Small Large Small Large
issues issues issues issues issues issues
Underwriter 10 2–3 4–6 2–3 – –
expenses 5–7 0.15–0.40 4–5 0.15–0.40 5–7 0.5
Total cost 15–17 2–3+ 8–11 2–3+ 5–7 0.5
Large issues are over $100 million, small issues are less than $2 million.
Source: J.F. Weston and T.E. Copeland, Managerial Finance, 1992.
• In an early study, Smith (1977) found that the ﬂotation cost of U.S. common
stock issues during the period 1971–75 was 6.17% for general underwritten
oﬀers compared with 2.45% on the pure rights oﬀers. Yet, during this period
only 38 out of 578 common stock issues were pure right oﬀerings.
FIN 357: II.2.15 An Overview of Long-Term Financing c 2001 DC
Market Reaction to Security Oﬀer Announcements
• An additional hidden cost of a new security issue lies in the impact of the oﬀer
announcement on the company’s stock price. The following table shows the average
two-day abnormal common stock return from studies of announcements of security
Type of issuer
Security Oﬀering Industrial Utility
Common Stock -3.14% -0.75%
Preferred Stock -0.19% 0.08%
Convertible Preferred Stock -1.44% -1.38%
Straight Bonds -0.26% -0.13%
Convertible Bonds -2.07% n.a.
Source: C. Smith, “Raising Capital: Theory and Evidence”.
• The only signiﬁcantly negative impact occurs for issues of common stock or of
securities convertible in common stock. The most likely explanation for this
phenomenon is the potential for management to exploit its inside information by
issuing overvalued equity (or convertibles): investors recognize their vulnerability in
this process and accordingly reduce their estimate of the ﬁrm’s value.
FIN 357: II.2.16 An Overview of Long-Term Financing c 2001 DC