Overview of Long-Term Financing

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					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
         not outstanding.
     – 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
     the lenders.
   – 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
   warrants, etc.

                 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
        are satisfied.
  • Security of Collateral: Some bonds may be secured by mortgages on plants
    and equipment. These bonds have the first claim on these assets if
    bankrupcy occurs.
  • 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
     Issue                                        Offer)
                          Private Placement
 • 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
      flotation costs.
 • 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
                       Disclosure Requirements

• 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
     particularly risky.

                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
  standby underwriting.

                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             –      –
    Other direct
    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