We now begin our analysis of long-term financing decisions—an undertaking we will not complete until Chapter 25. This chapter provides an introduction to corporate financing. It reviews, with a broad brush, several topics that we will explore more carefully later on.
We start the chapter by looking at aggregate data on the sources of financing. Most of the money for new investments comes from profits that companies retain and reinvest. The remainder comes from selling new debt or equity securities. These financing patterns raise several interesting questions. Do companies rely too heavily on internal financing rather than on new issues of debt or equity? Are debt ratios of U.S. corporations dangerously high?
Our second task in the chapter is to review some of the essential features of debt and equity. Lenders and stockholders have different cash-flow rights and also different control rights. The lenders have first claim on cash flow because they are promised definite cash payments for interest and principal. After the lenders have been paid, whatever cash is left over belongs to the stockholders. Stockholders, on the other hand, have complete control of the firm, providing that they keep their promises to lenders. As owners of the business, they have the ultimate say over what assets the company buys, how the assets are financed, and how they are used. Of course, in large public corporations, the stockholders delegate these decisions to the board of directors, who in turn appoint senior management. In these cases, effective control often ends up with the company’s management.
The simple division of cash flow among debt and equity glosses over the many different types of debt that companies issue. Therefore, we close our discussion of debt and equity with a brief canter through the main categories of debt. We also pause to describe certain less common forms of equity, particularly preferred stock.
The financial manager is the link between the firm and the financial institutions that provide much of the funds that the companies need, together with help in making payments, managing risk, and so on. We, therefore, introduce you to the major financial institutions and look at the roles that these institutions play in corporate financing and in the economy at large. The financial crisis that started in the summer of 2007 demonstrated the importance of healthy financial markets and institutions. We will review the crisis and its aftermath.
14-1Patterns of Corporate Financing
Corporations invest in long-term assets, such as property, plant, and equipment, and in current assets, such as inventory and accounts receivable. Figure 14.1 shows where U.S. corporations get the cash to pay for these investments. Most of the cash is generated internally. That is, it comes from cash flow allocated to depreciation and from retained earnings (earnings not paid out as cash dividends).1 U.S. corporations, together with those in other Anglo-Saxon countries, are unusual in their very heavy reliance on internal finance. However, in most industrial countries depreciation and retained earnings remain the largest source of finance. Shareholders are happy for the cash to be plowed back into the firm, provided that it is invested in positive-NPV projects. Every positive-NPV outlay increases shareholder value.
FIGURE 14.1 Sources of funds for U.S. nonfinancial corporations expressed as a fraction of the total
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F103 at www.federalreserve.gov/ releases/z1/current/default.htm.
If internal cash flow is not sufficient to pay for the investments, the company faces a financial deficit. To cover the deficit, the company must cut back on dividends in order to increase retained earnings, or it must raise new debt or equity capital from outside investors. So there are two basic financing decisions. First, what fraction of profits should be plowed back into the business rather than paid out to shareholders? Second, what fraction of the financial deficit should be met with debt rather than equity? Thus, the firm needs a payout policy (Chapter 16) and a debt policy (Chapters 17 and 18).
Take a look at U.S. equity issues in Figure 14.1. Net issues were negative in almost every year. This means that companies paid out more to shareholders by repurchasing shares than they raised by share issues. (Corporations can buy back their own shares, or they may purchase and retire other firms’ shares in the course of mergers and acquisitions.) The choice between cash dividends and repurchases is another aspect of payout policy.
Stock repurchases in the U.S. have typically been larger than new issues of shares. They were especially large in 2006 and 2007, which accounts for the large negative net equity issues in those years. By contrast, debt issues were positive in almost every year.
Do Firms Rely Too Much on Internal Funds?
We have seen that, on average, internal funds (retained earnings plus depreciation) cover most of the cash needed for investment. It seems that internal financing is more convenient than external financing by stock and debt issues. But some observers worry that managers have an irrational or self-serving aversion to external finance. A manager seeking comfortable employment could be tempted to forgo a risky but positive-NPV project if it involved launching a new stock issue and facing awkward questions from potential investors. Perhaps managers take the line of least resistance and dodge the “discipline of capital markets.”
We do not mean to paint managers as loafers. They sometimes have good reasons for relying on internally generated funds. They may seek to avoid the cost of issuing new securities, for example. Moreover, the announcement of a new equity issue is usually bad news for investors, who worry that the decision signals lower future profits or higher risk.2 If issues of shares are costly and send a bad-news signal to investors, companies may be justified in looking more carefully at those projects that would require a new stock issue.
How Much Do Firms Borrow?
The mix of debt and equity financing varies widely from industry to industry and from firm to firm. Debt ratios also vary over time for particular firms. These variations are a fact of life: There is no constant, God-given debt ratio, and if there were, it would change. But a few aggregate statistics will do no harm.
Table 14.1 shows the aggregate balance sheet of all U.S. manufacturing corporations. If all these businesses were merged into a single gigantic firm, Table 14.1 would be its balance sheet. Assets and liabilities in the table are entered at book values, that is, accounting values. These do not generally equal market values. The numbers are nevertheless instructive. Notice that firms had long-term debt of $2,779 billion and equity of $4,477 billion. The ratio of long-term debt to long-term debt plus equity was, therefore, $2,779/($2,779 + $4,477) = .38.3
TABLE 14.1 Aggregate balance sheet for manufacturing corporations in the United States, fourth quarter, 2017 (figures in $ billions)
a See Table 30.1 for a breakdown of current assets and liabilities.
b Includes deferred taxes and several miscellaneous categories.
Source: U.S. Census Bureau, Quarterly Financial Report Manufacturing, Mining, Trade, and Selected Service Industries, 2017. Fourth Quarter, issued March 2018 (www.census.gov/econ/qfr).
Table 14.1 is, of course, only a snapshot. Figure 14.2 provides a longer-term perspective. The debt ratios are lower when computed from market values rather than book values. This is because the market value of equity is generally greater than the book value.
Figure 14.2 shows that book debt ratios are higher today than 50 years ago. Should we be concerned about this? It is true that higher debt ratios mean that more companies will fall into financial distress when a serious recession hits the economy. But all companies live with this risk to some degree, and it does not follow that less risk is better. Finding the optimal debt ratio is like finding the optimal speed limit. We can agree that accidents at 30 miles per hour are generally less dangerous than accidents at 60 miles per hour, but we do not therefore set the speed limit on all roads at 30. Speed has benefits as well as risks. So does debt, as we see in Chapter 18.
FIGURE 14.2 Ratio of debt to debt plus net worth for nonfinancial corporations, 1965–2017
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table B.103 at www.federalreserve.gov/ releases/z1/current/default .htm.
It is interesting to compare debt levels of U.S. companies with those of their foreign counterparts. However, in those countries that do not have well-developed bond markets debt means principally short-term bank debt. Therefore, rather than focusing on just long-term debt, it is more instructive to compare the ratio of total liabilities to total liabilities plus equity. Figure 14.3 is taken from a study by Claessens, Djankov, and Nenova of 11,000 companies in 46 countries. Korean and Indian companies are among the most highly indebted; those in the United States are relatively conservative in their use of debt.
FIGURE 14.3 Median ratios of total liabilities to total liabilities plus equity in different countries, 1995–1996
Source: S. Claessens, S. Djankov, and T. Nenova, “Corporate Risk Around the World,” World Bank Policy Research Working Paper 2271, 2000, http://documents.worldbank.org/curated/en/907571468739464629/Corporate-risk-around-the-world.
14-2Common Stock
Ownership of the Corporation
A corporation is owned by its common stockholders. You can see from Figure 14.4 that in the United States, 39% of this common stock is held directly by individual investors, and a similar proportion belongs to financial intermediaries such as mutual funds, pension funds, and insurance companies. Mutual funds and exchange traded funds (ETFs) hold 30% and pension funds a further 12%.4
FIGURE 14.4 Holdings of corporate equities, December 2017
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Financial Accounts of the United States—Z1, Table L.223, at www.federalreserve.gov/releases/z1/current/default.htm.
But what do we mean when we say that these stockholders own the corporation? The answer is obvious if the company has issued no other securities. Consider the simplest possible case of a corporation financed solely by common stock, all of which is owned by the firm’s chief executive officer (CEO). This lucky owner-manager receives all the cash flows and makes all investment and operating decisions. She has complete cash-flow rights and also complete control rights.
These rights are split up and reallocated as soon as the company borrows money. If it takes out a bank loan, it enters into a contract with the bank promising to pay interest and eventually repay the principal. The bank gets a privileged, but limited, right to cash flows; the residual cash-flow rights are left with the stockholder. Thus common stock is a residual claim on the firm’s assets and cash flow.
The bank typically protects its claim by imposing restrictions on what the firm can or cannot do. For example, it may require the firm to limit future borrowing, and it may forbid the firm to sell off assets or to pay excessive dividends. The stockholders’ control rights are thereby limited. However, the contract with the bank can never restrict or determine all the operating and investment decisions necessary to run the firm efficiently. (No team of lawyers, no matter how long they scribbled, could ever write a contract covering all possible contingencies.5) The owner of the common stock retains the residual rights of control over these decisions. For example, she may choose to increase the selling price of the firm’s products, to hire temporary rather than permanent employees, or to construct a new plant in Miami Beach rather than Hollywood.6
Ownership of the firm can of course change. If the firm fails to make the promised payments to the bank, it may be forced into bankruptcy. Once the firm is under the “protection” of a bankruptcy court, shareholders’ cash-flow and control rights are tightly restricted and may be extinguished altogether. Unless some rescue or reorganization plan can be implemented, the bank becomes the new owner of the firm and acquires the cash-flow and control rights of ownership. (We discuss bankruptcy in Chapter 32.)
No law of nature says residual cash-flow rights and residual control rights have to go together. For example, one could imagine a situation where the debtholder gets to make all the decisions. But this would be inefficient. Since the benefits of good decisions are felt mainly by the common stockholders, it makes sense to give them control over how the firm’s assets are used. Because they have the ultimate right of control and simultaneously have the residual cash flow entitlement, shareholders have an incentive to ensure that management maximizes their wealth.
BEYOND THE PAGE
Empty voting
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Public corporations may be owned by tens of thousands of stockholders. The common stockholders in these corporations still have the residual rights over the cash flows and have the ultimate right of control over the company’s affairs. In practice, however, their control is limited to an entitlement to vote on appointments to the board of directors, and on other crucial matters such as the decision to merge. Many shareholders do not bother to vote. They reason that because they own so few shares, their vote will have little impact on the outcome. The problem is that, if all shareholders think in the same way, they cede effective control and management gets a free hand to look after its own interests.
This free-rider problem was highlighted in a book written in 1932 by Berle and Means.7 They warned of the emergence of a powerful class of managers that were insulated from outside pressure. Economists today are less convinced that managers enjoy the degree of liberty that Berle and Means envisaged. The majority of corporations have large shareholders who are prepared to challenge self-serving or incompetent managers. For example, Clifford Holderness found that 96% of a sample of U.S. public corporations have blockholders with at least 5% of the outstanding shares.8 In many other countries blockholders are even more important. Look, for example, at Figure 14.5, which is taken from a comprehensive study of share ownership in 85 countries. You can see that in the United States, the largest shareholder owns, on average, just over 21% of the outstanding shares. In many of these cases, investors may take comfort from the fact that there are large shareholders with an incentive to keep a watchful eye on management. But the presence of blockholders is not always good news. In countries where the rule of law is weak, they may be able to profit at the expense of small shareholders, and their existence may be more a concern than a comfort. We will return to this topic of ownership when we review different governance systems in Chapter 33.
Voting Procedures
For many U.S. companies, the entire board of directors comes up for reelection each year. However, about 1 in 10 large companies have classified (or staggered) boards, where only a third of the directors are reelected annually. Proponents of such staggered boards argue that they help to insulate management from short-term pressure and allow the company to innovate and take risks. Shareholder activists, on the other hand, complain that staggered elections serve to entrench management since dissident shareholders must wait two years before they can gain majority representation on the board. Consequently, in recent years activists have successfully pressured many companies into declassifying their boards.
FIGURE 14.5 Average percentage of equity owned by largest shareholders. (Shareholders from one family are grouped together).
Source: G. Aminadav and E. Papaioannou, “Corporate Control around the World,” National Bureau of Economic Research, Working Paper 23010, December 2016 http://www.nber.org/papers/w23010.
On many issues, a simple majority of shareholder votes cast is sufficient to carry the day, but the company charter may specify some decisions that require a supermajority of, say, 75% of those eligible to vote. For example, a supermajority vote is sometimes needed to approve a merger or a change to the charter. Such provisions have also attracted shareholder complaints that they help to entrench management and prevent worthwhile takeovers.
BEYOND THE PAGE
Voting procedures
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The issues on which stockholders are asked to vote are rarely contested, particularly in the case of large, publicly traded firms. Occasionally, there are proxy contests in which the firm’s existing management and directors compete with outsiders for effective control of the corporation. The odds in a proxy fight are stacked against the outsiders, for the insiders can get the firm to pay all the costs of presenting their case and obtaining votes.9 But there are a growing number of activist investors who campaign for changes in management policy. If they can gather sufficient shareholder support, the corporation may get the message without incurring a proxy battle. For example, when activist investor Dan Loeb acquired a $3.5 billion stake in Nestlé, the company moved to adopt most of his reforms.
Dual-Class Shares and Private Benefits
Usually, companies have one class of common stock and each share has one vote. Occasionally, however, a firm may have two classes of stock outstanding, which differ in their right to vote. For example, when Facebook made its first issue of common stock, the founders were reluctant to give up control of the company. Therefore, the company created two classes of shares. The A shares, which were sold to the public, had 1 vote each, while the B shares, which were owned by the founders, had 10 votes each. Both classes of shares had the same cash-flow rights, but they had different control rights.
BEYOND THE PAGE
Facebook’s proposed share issue
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When two classes of stock coexist, shareholders with the extra voting power may sometimes use it to toss out bad management or to force management to adopt policies that enhance shareholder value. But as long as both classes of shares have identical cash-flow rights, all shareholders benefit equally from such changes. So here is the question: If everyone gains equally from better management, why do shares with superior voting power typically sell at a premium? The only plausible reason is that there are private benefits captured by the owners of these shares. For example, the holder of a block of voting shares might prevent any challenge to his or her management position. The shares might have extra bargaining power in an acquisition. Or they might be held by another company, which could use its voting power and influence to secure a business advantage.
BEYOND THE PAGE
Alibaba and dual-class shares
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These private benefits of control seem to be much larger in some countries than others. For example, Tatiana Nenova has looked at a number of countries in which firms may have two classes of stock.10 In the United States, the premium that an investor needed to pay to gain voting control amounted to only 2% of firm value, but in Italy it was over 29% and in Mexico it was 36%. It appears that in these two countries, majority investors are able to secure large private benefits.
BEYOND THE PAGE
The value of voting rights
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Even when only one class of shares exists, minority stockholders may be at a disadvantage; the company’s cash flow and potential value may be diverted to management or to one or a few dominant stockholders holding large blocks of shares. In the United States, the law protects minority stockholders from exploitation, but minority stockholders in some countries may not fare so well.11
Financial economists sometimes refer to the exploitation of minority shareholders as tunneling; the majority shareholder tunnels into the firm and acquires control of the assets for himself. Let us look at tunneling Russian-style.
EXAMPLE 14.1 
Raiding the Minority Shareholders
To grasp how the scam works, you first need to understand reverse stock splits. These are often used by companies with a large number of low-priced shares. The company making the reverse split simply combines its existing shares into a smaller, more convenient number of new shares. For example, the shareholders might be given two new shares in place of the three shares that they currently own. As long as all shareholdings are reduced by the same proportion, nobody gains or loses by such a move.
However, the majority shareholder of one Russian company realized that the reverse stock split could be used to loot the company’s assets. He therefore proposed that existing shareholders receive 1 new share in place of every 136,000 shares they currently held.12
Why did the majority shareholder pick the number “136,000”? Answer: Because the two minority shareholders owned less than 136,000 shares and therefore did not have the right to any shares. Instead, they were simply paid off with the par value of their shares, and the majority shareholder was left owning the entire company. The majority shareholders of several other companies were so impressed with this device that they also proposed similar reverse stock splits to squeeze out their minority shareholders.
Such blatant exploitation would not be permitted in the United States or in many other countries.
Equity in Disguise
Common stocks are issued by corporations, but a few equity securities are issued not by corporations but by partnerships or trusts. We will give some brief examples.
Partnerships Plains All American Pipeline LP is a master limited partnership that owns crude oil pipelines in the United States and Canada. You can buy “units” in this partnership on the New York Stock Exchange, thus becoming a limited partner in Plains All American. The most the limited partners can lose is their investment in the company.13 In this and most other respects, the partnership units are just like the shares in an ordinary corporation. They share in the profits of the business and receive cash distributions (like dividends) from time to time.
Partnerships avoid corporate income tax; any profits or losses are passed straight through to the partners’ tax returns. But various limitations offset this tax advantage. For example, the law regards a partnership merely as a voluntary association of individuals; like its partners, it is expected to have a limited life. A corporation, on the other hand, is an independent legal “person” that can, and often does, outlive all its original shareholders.
Trusts and REITs Would you like to own a part of the oil in the Prudhoe Bay field on the north slope of Alaska? Just call your broker and buy a few units of the BP Prudhoe Bay Royalty Trust. BP set up this trust and gave it a royalty interest in production from BP’s share of the Prudhoe Bay revenues. As the oil is produced, each trust unit gets its share of the revenues.
This trust is the passive owner of a single asset: the right to a share of the revenues from BP’s Prudhoe Bay production. Operating businesses, which cannot be passive, are rarely organized as trusts, though there are exceptions, notably real estate investment trusts, or REITs (pronounced “reets”).
REITs were created to facilitate public investment in commercial real estate; there are shopping center REITs, office building REITs, apartment REITs, and REITs that specialize in lending to real estate developers. REIT “shares” are traded just like common stocks. The REITs themselves are not taxed, so long as they distribute at least 95% of earnings to the REITs’ owners, who must pay whatever taxes are due on the dividends. However, REITs are tightly restricted to real estate investment. You cannot set up a widget factory and avoid corporate taxes by calling it a REIT.
Preferred Stock
Usually, when investors talk about “stock” or “equity,” they are referring to common stock. But some companies also issue preferred stock, and this too forms part of its equity. Despite its name, preferred stock provides only a small part of most companies’ cash needs, and it will occupy less time in later chapters. However, it can be a useful method of financing in mergers and certain other special situations.
Like debt, preferred stock offers a series of fixed payments to the investor. The company can choose not to pay a preferred dividend, but in that case it may not pay a dividend to its common stockholders. Most issues of preferred are known as cumulative preferred stock. This means that the firm must pay all past preferred dividends before common stockholders get a cent. If the company does miss a preferred dividend, the preferred stockholders generally gain some voting rights, so that the common stockholders are obliged to share control of the company with the preferred holders. Directors are also aware that failure to pay the preferred dividend earns the company a black mark with investors, so they do not take such a decision lightly.
14-3Debt
When companies borrow money, they promise to make regular interest payments and to repay the principal. However, this liability is limited. Stockholders have the right to default on the debt if they are willing to hand over the corporation’s assets to the lenders. Clearly, they will choose to do this only if the value of the assets is less than the amount of the debt.14
Debt has first claim on cash flows, but its claim is limited. Therefore, in contrast to equity, it does not have residual cash-flow rights and does not participate in the upsides of the business. Also, unlike equity, debt offers no control rights unless the firm defaults or violates debt covenants. Because lenders are not considered to be owners of the firm, they do not normally have any voting power.
The company’s payments of interest are regarded as a cost and are deducted from taxable income. Thus interest is paid from before-tax income, whereas dividends on common and preferred stock are paid from after-tax income. Therefore, the government provides a tax subsidy for debt that it does not provide for equity (and from time to time complains that companies borrow too much). We discuss debt and taxes in detail in Chapter 18.
We have seen that financial intermediaries own the majority of corporate equity. Figure 14.6 shows that this is also true of the company’s bonds. In this case, it is the insurance companies that own the largest stake.15
FIGURE 14.6 Holdings of bonds issued in the United States by U.S. and foreign corporations, December 2017
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Financial Accounts of the United States—Z1, Table L.213, at https://www.federalreserve.gov/releases/z1/current/default.htm.
Debt Comes in Many Forms
The financial manager is faced with an almost bewildering choice of debt securities. In Chapter 24, we look in some detail at the different types of corporate debt. For the moment, simply notice that the mixture of debt securities that each company issues reflects the financial manager’s response to a number of questions:
1. Should the company borrow short-term or long-term? If your company simply needs to finance a temporary increase in inventories ahead of the holiday season, then it may make sense to take out a short-term bank loan. But suppose that the cash is needed to pay for expansion of an oil refinery. Refinery facilities can operate more or less continuously for 15 or 20 years. In that case, it would be more appropriate to issue a long-term bond.16
Some loans are repaid in a steady, regular way; in other cases, the entire loan is repaid at maturity. Occasionally the borrower has the option to terminate the loan early.
2. Should the debt be fixed or floating rate? The interest payment, or coupon, on long-term bonds is commonly fixed at the time of issue. If a $1,000 bond is issued when long-term interest rates are 10%, the firm continues to pay $100 per year regardless of how interest rates fluctuate.
Most bank loans and some bonds offer a variable, or floating, rate. For example, the interest rate in each period may be set at 1% above LIBOR (London Interbank Offered Rate), which is the interest rate at which major international banks lend dollars to each other. When LIBOR changes, the interest rate on the loan also changes.
3. Should you borrow dollars or some other currency? Many firms in the United States borrow abroad. Often they may borrow dollars abroad (foreign investors have large holdings of dollars), but firms with overseas operations may decide to issue debt in a foreign currency. After all, if you need to spend foreign currency, it probably makes sense to borrow foreign currency.
International bonds have usually been marketed by the London branches of international banks, and have traditionally been known as eurobonds. A eurobond may be denominated in dollars, yen, or any other currency. Unfortunately, when the single European currency was established, it was called the euro. It is, therefore, easy to confuse a eurobond (a bond that is sold internationally) with a bond that is denominated in euros.
4. What promises should you make to the lender? Lenders want to make sure that their debt is as safe as possible. Therefore, they may demand that their debt is senior to other debt. If default occurs, senior debt is first in line to be repaid. The junior, or subordinated, debtholders are paid only after all senior debtholders are satisfied (though all debtholders rank ahead of the preferred and common stockholders).
The firm may also set aside some of its assets specifically for the protection of particular creditors. Such debt is said to be secured, and the assets that are set aside are known as collateral. Thus, a retailer might offer inventory or accounts receivable as collateral for a bank loan. If the retailer defaults on the loan, the bank can seize the collateral and use it to help pay off the debt.
Usually, the firm also provides assurances to the lender that it will not take unreasonable risks. For example, a firm that borrows in moderation is less likely to get into difficulties than one that is up to its gunwales in debt. So the borrower may agree to limit the amount of extra debt that it can issue. Lenders are also concerned that, if trouble occurs, others will push ahead of them in the queue. Therefore, the firm may agree not to create new debt that is senior to existing debtholders or to put aside assets for other lenders.
5. Should you issue straight or convertible bonds? Companies often issue securities that give the owner an option to convert them into other securities. These options may have a substantial effect on value. The most dramatic example is provided by a warrant, which is nothing but an option. The owner of a warrant can purchase a set number of the company’s shares at a set price before a set date. Warrants and bonds are often sold together as a package.
A convertible bond gives its owner the option to exchange the bond for a predetermined number of shares. The convertible bondholder hopes that the issuing company’s share price will zoom up so that the bond can be converted at a big profit. But if the shares zoom down, there is no obligation to convert; the bondholder remains a bondholder.
A Debt by Any Other Name
The word debt sounds straightforward, but companies make a number of promises that look suspiciously like debt but are treated differently in the accounts. Some of these disguised debts are easily spotted. For example, accounts payable are simply obligations to pay for goods that have already been delivered and are, therefore, like short-term debt.
Other arrangements are less obvious. For example, instead of borrowing to buy new equipment, the company may rent or lease it on a long-term basis. In this case, the firm promises to make a series of lease payments to the owner of the equipment. This is just like the obligation to make payments on an outstanding loan. If the firm gets into deep water, it can’t choose to miss out on its debt interest, and it can’t choose to skip those lease payments.
Here is another example of a disguised debt. When American Airlines filed for bankruptcy in 2011, it had promised its employees pensions valued at $18.5 billion. This obligation was, in effect, a senior debt because American was obligated to make payments to retired employees. Unfortunately, American had set aside only $8.3 billion to meet this obligation.
Pension obligations should be valued by discounting future payments at a debt interest rate. When interest rates change, the present value of pension obligations changes, too. For example, in May 2015, the German airline Lufthansa announced that the present value of its pension obligations increased from €7.2 billion to €10.2 billion in the first quarter of 2015, largely because of a decrease from 2.6% to 1.7% in the interest rate used for discounting.
There is nothing underhanded about lease or pension obligations. They are explained in the notes to a corporation’s financial statements when they do not appear explicitly on its balance sheet. Investors recognize the debt-equivalent obligations and the financial risks that they create.17
But now and then, a company works hard to ensure that investors do not know how much the company has borrowed. For example, Enron was able to borrow $658 million by setting up special-purpose entities (SPEs), which raised cash by a mixture of equity and debt and then used these debts to help fund the parent company. None of this debt showed up on Enron’s balance sheet, but the debt showed up with a vengeance in Enron’s death spiral toward bankruptcy in 2001.
Variety’s the Very Spice of Life
We have indicated several dimensions along which corporate securities can be classified. That gives the financial manager plenty of choice in designing securities. As long as you can convince investors of its attractions, you can issue a convertible, subordinated, floating-rate bond denominated in Swedish kronor. Rather than combining features of existing securities, you may create an entirely new one. We can imagine a coal mining company issuing convertible bonds on which the payment fluctuates with coal prices. We know of no such security, but it is perfectly legal to issue it—and who knows?—it might generate considerable interest among investors.
That completes our tour of corporate securities. You may feel like the tourist who has just seen 12 cathedrals in five days. But there will be plenty of time in later chapters for reflection and analysis. It is now time to move on and to look at the markets in which the firm’s securities are traded and at the financial intermediaries that hold them.
14-4Financial Markets and Intermediaries
The flow of savings to large public corporations is shown in Figure 14.7. Notice that the savings travel from investors worldwide through financial markets, financial intermediaries, or both. Suppose, for example, that Bank of America raises $300 million by a new issue of shares. An Italian investor buys 6,000 of the new shares for $10 per share. Now Bank of America takes that $60,000, along with money raised by the rest of the issue, and makes a $300 million loan to ExxonMobil. The Italian investor’s savings end up flowing through financial markets (the stock market), to a financial intermediary (Bank of America), and finally to Exxon.
Of course, our Italian friend’s $60,000 doesn’t literally arrive at Exxon in an envelope marked “From L. DaVinci.” Investments by the purchasers of the Bank of America’s stock issue are pooled, not segregated. Sr. DaVinci would own a share of all of Bank of America’s assets, not just one loan to Exxon. Nevertheless, investors’ savings are flowing through the financial markets and then the bank to finance Exxon’s capital investments.
Suppose that another investor decides to open a checking account with Bank of America. The bank can take the money in this checking account and also lend it on to ExxonMobil. In this case, the savings bypass the financial markets and flow directly to a financial intermediary and from there to Exxon.
We now need to flesh out Figure 14.7 by looking at the main financial markets and intermediaries.
FIGURE 14.7 Flow of savings to investment for a large, public corporation. Savings come from investors worldwide. The savings may flow through financial markets or financial intermediaries. The corporation also reinvests on shareholders’ behalf.
Financial Markets
A financial market is a market where financial assets are issued and traded. In our example, Bank of America used the financial markets to raise money from investors by a new issue of shares. Such issues are known as primary issues. But in addition to helping companies to raise cash, financial markets also allow investors to trade stocks or bonds among themselves. For example, Mr. Rosencrantz might decide to raise some cash by selling his Bank of America stock at the same time that Mr. Guildenstern invests his savings in the stock. So they make a trade. The result is simply a transfer of ownership from one person to another, which has no effect on the company’s cash, assets, or operations. Such purchases and sales are known as secondary transactions.
Some financial assets have less active secondary markets than others. For example, when a bank lends money to a company, it acquires a financial asset (the company’s promise to repay the loan with interest). Banks do sometimes sell packages of these loans to other banks, but generally they retain the loan until it is repaid by the borrower. Other financial assets are regularly traded. Some, such as shares of stock, are traded on organized exchanges like the New York, London, or Hong Kong stock exchanges. In other cases, there is no organized exchange, and the assets are traded by a network of dealers. Such markets are known as over-the-counter (OTC) markets. For example, in the United States, most government and corporate bonds are traded OTC.
Some financial markets are not used to raise cash but, instead, help firms to manage their risks. In these markets firms can buy or sell derivatives, whose payoffs depend on the prices of other securities or commodities. For example, if a chocolate producer is worried about rising cocoa prices, it can use the derivatives markets to fix the price at which it buys its future cocoa requirements.
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Stock exchanges: From clubs to commercial companies
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Financial Intermediaries
A financial intermediary is an organization that raises money from investors and provides financing for individuals, companies, and other organizations. Banks, insurance companies, and investment funds are all intermediaries. These intermediaries are important sources of financing for corporations. They are a stop on the road between savings and real investment.
Why is a financial intermediary different from a manufacturing corporation? First, it may raise money in different ways, for example, by taking deposits or selling insurance policies. Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to businesses or individuals. In contrast, a manufacturing company’s main investments are in plant, equipment, or other real assets.
Look at Table 14.2, which shows the financial assets of the different types of intermediaries in the United States. It gives you an idea of the relative importance of different intermediaries. Of course, these assets are not all invested in nonfinancial businesses. For example, banks make loans to individuals as well as to businesses.18
|
$ Billions |
|
|
Mutual funds |
$15,899 |
|
Money market funds |
2,847 |
|
Closed-end funds |
275.2 |
|
ETFs |
3,401 |
|
Hedge fundsa |
3,541 |
|
Pension funds |
19,845 |
|
Banks and savings institutions |
18,925 |
|
Insurance companies |
9,340 |
TABLE 14.2 Financial assets of intermediaries in the United States, December 2017
a estimated
Sources: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Financial Accounts of the United States—Z1,www.federalreserve.gov; and Preqin, https://www.preqin.com/.
Investment Funds
We look first at investment funds, such as mutual funds, hedge funds, and pension funds. Mutual funds raise money by selling shares to investors. This money is then pooled and invested in a portfolio of securities.19 Investors in a mutual fund can increase their stake in the fund’s portfolio by buying additional shares, or they can sell their shares back to the fund if they wish to cash out. The purchase and sale prices depend on the fund’s net asset value (NAV) on the day of purchase or redemption. If there is a net flow of cash into the fund, the manager will use it to buy more stocks or bonds; if there is a net outflow, the fund manager will need to raise the money by selling some of the fund’s investments.
There are just over 8,000 equity and bond mutual funds in the United States. In fact, there are more mutual funds than public companies! The funds pursue a wide variety of investment strategies. Some funds specialize in safe stocks with generous dividend payouts. Some specialize in high-tech growth stocks. Some “balanced” funds offer mixtures of stocks and bonds. Some specialize in particular countries or regions. For example, the Fidelity Investments mutual fund group sponsors funds for Canada, Japan, China, Europe, and Latin America.
Mutual funds offer investors low-cost diversification and professional management. For most investors, it’s more efficient to buy a mutual fund than to assemble a diversified portfolio of stocks and bonds. Most mutual fund managers also try their best to “beat the market”—that is, to generate superior performance by finding the stocks with better-than-average returns. Whether they can pick winners consistently is another question, which we addressed in Chapter 13. In exchange for their services, the fund’s managers take out a management fee. There are also the expenses of running the fund. For mutual funds that invest in stocks, fees and expenses typically add up to nearly 1% per year.
Most mutual funds invest in shares or in a mixture of shares and bonds. However, one particular type of mutual fund, called a money market fund, invests only in short-term safe securities, such as Treasury bills or bank certificates of deposit. Money market funds offer individuals and small- and medium-sized businesses a convenient home in which to park their spare cash. There are nearly 400 money market funds in the United States. Some of these funds are huge. For example, the JPMorgan U.S. Government Money Market Fund had $140 billion in assets in 2017.
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Mutual fund assets
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Mutual funds are open-end funds—they stand ready to issue new shares and to buy back existing shares. In contrast, a closed-end fund has a fixed number of shares that are traded on an exchange. If you want to invest in a closed-end fund, you cannot buy new shares from the fund; you must buy existing shares from another stockholder in the fund.
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Exchange traded funds
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If you simply want low-cost diversification, one option is to buy a mutual fund that invests in all the stocks in a stock market index. For example, the Vanguard Index Fund holds all the stocks in the Standard & Poor’s Composite Index. An alternative is to invest in an exchange traded fund, or ETF, which is a portfolio of stocks that can be bought or sold in a single trade. These include Standard & Poor’s Depository Receipts (SPDRs, or “spiders”), which are portfolios matching Standard & Poor’s stock market indexes. You can also buy DIAMONDS, which track the Dow Jones Industrial Average; QUBES or QQQs, which track the Nasdaq 100 index; and Vanguard ETFs that track the U.S. Total Stock Market index, which is a basket of almost all of the stocks traded in the United States. You can also buy ETFs that track foreign stock markets, bonds, or commodities.
ETFs are, in some ways, more efficient than mutual funds. To buy or sell an ETF, you simply make a trade, just as if you bought or sold shares of stock. In this respect, ETFs are like closed-end investment funds. But, with rare exceptions, ETFs do not have managers with the discretion to try to “pick winners.” ETF portfolios are tied down to indexes or fixed baskets of securities. ETF issuers make sure that the ETF price tracks the price of the underlying index or basket.
Like mutual funds, hedge funds also pool the savings of different investors and invest on their behalf. But they differ from mutual funds in at least three ways. First, because hedge funds usually follow complex investment strategies, access is restricted to knowledgeable investors such as pension funds, endowment funds, and wealthy individuals. Don’t try to send a check for $3,000 or $5,000 to a hedge fund; most hedge funds are not in the “retail” investment business. Second, hedge funds are generally established as limited partnerships. The investment manager is the general partner and the investors are the limited partners. Third, hedge funds try to attract the most talented managers by compensating them with potentially lucrative, performance-related fees.20 In contrast, mutual funds usually charge a fixed percentage of assets under management.
Hedge funds follow many different investment strategies. Some try to make a profit by identifying overvalued stocks or markets that they then sell short. Some hedge funds take bets on firms involved in merger negotiations, others look for mispricing of convertible bonds, and some take positions in currencies and interest rates. “Vulture funds” specialize in the securities of distressed corporations. Hedge funds manage less money than mutual funds, but they sometimes take very big positions and have a large impact on the market.
There are other ways to pool and invest savings. Consider a pension plan set up by a corporation or other organization on behalf of its employees. The most common type of plan is the defined-contribution plan. In this case, a percentage of the employee’s monthly paycheck is contributed to a pension fund. (The employer and employee may each contribute 5%, for example.) Contributions from all participating employees are pooled and invested in securities or mutual funds. (Usually, the employees can choose from a menu of funds with different investment strategies.) Each employee’s balance in the plan grows over the years as contributions continue and investment income accumulates. The balance in the plan can be used to finance living expenses after retirement. The amount available for retirement depends on the accumulated contributions and on the rate of return earned on the investments.21
Pension funds are designed for long-run investment. They provide professional management and diversification. They also have an important tax advantage: Contributions are tax-deductible, and investment returns inside the plan are not taxed until cash is finally withdrawn.22
All these investment funds provide a stop on the road from savings to corporate investment. For example, suppose your mutual fund purchases part of that new issue of shares by Bank of America. The orange arrows show the flow of savings to investment:
Financial Institutions
Banks and insurance companies are financial institutions.23 A financial institution is an intermediary that does more than just pool and invest savings. Institutions raise financing in special ways, for example, by accepting deposits or selling insurance policies, and they provide additional financial services. Unlike most investment funds, they not only invest in securities but also lend money directly to individuals, businesses, or other organizations.
Commercial Banks There are just under 5,000 commercial banks in the United States. They vary from giants such as JPMorgan Chase with $2.6 trillion of assets to dwarves like the Emigrant Mercantile Bank with under $4 million.
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World bank rankings
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Commercial banks are major sources of loans for corporations. (In the United States, they are generally not allowed to make equity investments in corporations, although banks in most other countries can do so.) Suppose that a local forest products company negotiates a nine-month bank loan for $2.5 million. The flow of savings is
The bank provides debt financing for the company and, at the same time, provides a place for depositors to park their money safely and withdraw it as needed.
We will have plenty more to say about bank loans in Chapter 24.
Investment Banks We have discussed commercial banks, which raise money from depositors and other investors and then make loans to businesses and individuals. Investment banks are different.24 Investment banks do not take deposits, and they do not usually make loans to companies. Instead, they advise and assist companies in raising financing. For example, investment banks underwrite stock offerings by purchasing the new shares from the issuing company at a negotiated price and reselling the shares to investors. Thus, the issuing company gets a fixed price for the new shares, and the investment bank takes responsibility for distributing the shares to thousands of investors. We discuss share issues in more detail in Chapter 15.
Investment banks also advise on takeovers, mergers, and acquisitions. They offer investment advice and manage investment portfolios for individual and institutional investors. They run trading desks for foreign exchange, commodities, bonds, options, and derivatives.
Investment banks can invest their own money in start-ups and other ventures. For example, the Australian Macquarie Bank has invested in airports, toll highways, electric transmission and generation, and other infrastructure projects around the world.
The largest investment banks are financial powerhouses. They include Goldman Sachs, Morgan Stanley, Lazard, Nomura (Japan), and Macquarie Bank.25 In addition, the major commercial banks, including Bank of America and Citigroup, all have investment banking operations.26
Insurance Companies Insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations.
Suppose a company needs a loan of $2.5 million for nine years, not nine months. It could issue a bond directly to investors, or it could negotiate a nine-year loan with an insurance company:
The money to make the loan comes mainly from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company and get a financial asset (the policy) in exchange. You receive no interest payments on this financial asset, but if a fire does strike, the company is obliged to cover the damages up to the policy limit. This is the return on your investment. (Of course, a fire is a sad and dangerous event that you hope to avoid. But if a fire does occur, you are better off getting a return on your investment in insurance than not having insurance at all.)
The company will issue not just one policy but thousands. Normally the incidence of fires “averages out,” leaving the company with a predictable obligation to its policyholders as a group. Of course the insurance company must charge enough for its policies to cover selling and administrative costs, pay policyholders’ claims, and generate a profit for its stockholders.
14-5The Role of Financial Markets and Intermediaries
Financial markets and intermediaries provide financing for business. They channel savings to real investment. That much should be loud and clear. But other functions may not be quite so obvious. Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy. Here are some examples.
The Payment Mechanism
Think how inconvenient life would be if all payments had to be made in cash. Fortunately, checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payments services, but they are not alone. For example, if you buy shares in a money market mutual fund, your money is pooled with that of other investors and is used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit.
Borrowing and Lending
Financial institutions do not lend only to companies. They also channel savings toward those who can best use them. Thus, if Ms. Jones has more money than she needs now and wishes to save for a rainy day, she can put the money in a bank savings deposit. If Mr. Smith wants to buy a car now and pay for it later, he can borrow money from the bank. In other words, banks provide Jones and Smith with a time machine that allows them to transport their wealth backward and forward over time. Both are happier than if they were forced to spend cash as it arrived.
As we saw in Chapter 1, when individuals have access to borrowing and lending, companies do not have to worry that shareholders may have different time preferences. Companies can simply focus on maximizing firm value and investors can choose separately when they want to spend their wealth.
Notice that banks promise their checking account customers instant access to their money and at the same time make long-term loans to companies and individuals. This mismatch between the liquidity of the bank’s liabilities (the deposits) and most of its assets (the loans) is possible only because the number of depositors is sufficiently large that the bank can be fairly sure that they will not all want to withdraw their money simultaneously.
In principle, you don’t need financial institutions to provide borrowing and lending. Individuals with cash surpluses, for example, could take out newspaper advertisements to find those with cash shortages. But it can be cheaper and more convenient to use a financial intermediary, such as a bank, to link up the borrower and lender. For example, banks are equipped to check out the would-be borrower’s creditworthiness and to monitor the use of cash lent out.27
Pooling Risk
Financial markets and institutions allow firms and individuals to pool their risks. For instance, insurance companies make it possible to share the risk of an automobile accident or a household fire. Here is another example. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you would be wiped out if that company went belly-up. It is generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole will fall.
Information Provided by Financial Markets
In well-functioning financial markets, you can see what securities and commodities are worth, and you can see—or at least estimate—the rates of return that investors can expect on their savings. The information financial markets provide is often essential to a financial manager’s job. Consider these scenarios.
In December, Catalytic Concepts, a manufacturer of catalytic converters, is planning production for the next April. The converters include platinum, which is traded on the New York Mercantile Exchange. How much per ounce should the company budget for purchases of platinum in April? Easy: The company’s CFO looks up the market price of platinum on the New York Mercantile Exchange—$1,023 per ounce for delivery in April (this was the price for platinum in August 2017, for delivery the following April). The CFO can lock in that price if she wishes. We explain how in Chapter 26.
Now suppose the CFO of Catalytic Concepts needs to raise $400 million in new financing. She considers an issue of 30-year bonds. If the company’s bonds are rated Baa, what interest rate will it have to pay on the new issue? The CFO sees that existing Baa bonds yield 4.40%. The company should be able to sell its new bonds at a similar rate.
Finally, stock prices and company values summarize investors’ collective assessment of how well a company is doing, both its current performance and its future prospects. Thus an increase in stock price sends a positive signal from investors to managers.28 That is why top management’s compensation is linked to stock prices. A manager who owns shares in his or her company will be motivated to increase the company’s market value. This reduces agency costs by aligning the interests of managers and stockholders. This is one important advantage of going public. A private company can’t use its stock price as a measure of performance. It can still compensate managers with shares, but the shares will not be valued in a financial market.
The basic functions of financial markets are the same the world over. So it is not surprising that similar institutions have emerged to perform these functions. In almost every country you will find banks accepting deposits, making loans, and looking after the payments system. You will also encounter insurance companies offering life insurance and protection against accident. If the country is relatively prosperous, other institutions, such as pension funds and mutual funds, will also have been established to help manage people’s savings. Of course there are differences in institutional structure. Take banks, for example. In many countries where securities markets are relatively undeveloped, banks play a much more dominant role in financing industry. Often the banks undertake a wider range of activities than they do in the United States. For example, they may take large equity stakes in industrial companies; this would not generally be allowed in the United States.
The Financial Crisis of 2007–2009
The financial crisis of 2007–2009 raised many questions, but it settled one question conclusively: Financial markets and institutions are important. When financial markets and institutions ceased to operate properly, the world was pushed deeper into a global recession.
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Time line of the financial crisis
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The financial crisis had its roots in the easy-money policies that were pursued by the U.S. Federal Reserve and other central banks following the collapse of the Internet and telecom stock bubble in 2000. At the same time, large balance-of-payments surpluses in Asian economies were invested back into U.S. debt securities. This also helped to push down interest rates and contribute to the lax credit.
Banks took advantage of this cheap money to expand the supply of subprime mortgages to low-income borrowers. Many banks tempted would-be homeowners with low initial payments, offset by significantly higher payments later.29 (Some home buyers were betting on escalating housing prices so that they could resell or refinance before the higher payments kicked in.) One lender is even said to have advertised what it dubbed its “NINJA” loan—NINJA standing for “No Income, No Job, and No Assets.”
Most subprime mortgages were then packaged together into mortgage-backed securities that could be resold. But, instead of selling these securities to investors who could best bear the risk, many banks kept large quantities of the loans on their own books or sold them to other banks.
The widespread availability of mortgage finance fueled a dramatic increase in house prices, which doubled in the five years ending June 2006. At that point, prices started to slide and homeowners began to default on their mortgages. A year later, Bear Stearns, a large investment bank, announced huge losses on the mortgage investments that were held in two of its hedge funds. By the spring of 2008, Bear Stearns was on the verge of bankruptcy, and the U.S. Federal Reserve arranged for it to be acquired by JPMorgan Chase.
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U.S. house prices
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The crisis peaked in September 2008, when the U.S. government was obliged to take over the giant federal mortgage agencies Fannie Mae and Freddie Mac, both of which had invested several hundred billion dollars in subprime mortgage-backed securities. Over the next few days, the financial system started to melt down. Both Merrill Lynch and Lehman Brothers were in danger of failing. On September 14, the government arranged for Bank of America to take over Merrill in return for financial guarantees. However, it did nothing to rescue Lehman Brothers, which filed for bankruptcy protection the next day. Two days later, the government reluctantly lent $85 billion to the giant insurance company AIG, which had insured huge volumes of mortgage-backed securities and other bonds against default. The following day, the Treasury unveiled its first proposal to spend $700 billion to purchase “toxic” mortgage-backed securities.
As the crisis unfolded throughout 2007 and 2008, uncertainty about which domino would be next to fall made banks reluctant to lend to one another, and the interest rate that they charged for such loans rose to 4.6% above the rate on U.S. Treasury debt. (Normally, this spread above Treasuries is less than .5%.) The bond market and the market for short-term company borrowing effectively dried up. This had an immediate knock-on effect on the supply of credit to industry, and the economy suffered one of its worst setbacks since the Great Depression.
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The rise and fall of Lehman Brothers
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Few developed economies escaped the crisis. As well as suffering from a collapse in their own housing markets, many foreign banks had made large investments in U.S. subprime mortgages. A roll call of all the banks that had to be bailed out by their governments would fill several pages, but here are just a few members of that unhappy band: the Royal Bank of Scotland in the United Kingdom, UBS in Switzerland, Allied Irish Bank in Ireland, Fortis in Belgium, ING in Holland, Hypo Group in Austria, and WestLb in Germany.
Who was responsible for the financial crisis? In part, the U.S. Federal Reserve for its policy of easy money. The U.S. government also must take some of the blame for encouraging banks to expand credit for low-income housing.30 The rating agencies were at fault for providing triple-A ratings for many mortgage bonds that shortly afterward went into default. Last but not least, the bankers themselves were guilty of promoting and reselling the subprime mortgages.
The banking crisis and subsequent recession left many governments with huge mountains of debt. By 2010, investors were becoming increasingly concerned about the position of Greece, where for many years government spending had been running well ahead of revenues. Greece’s position was complicated by its membership in the single-currency euro club. Although much of the country’s borrowing was in euros, the government had no control over its currency and could not simply print more euros to service its debt. Investors began to contemplate the likelihood of a Greek government default and the country’s possible exit from the eurozone. The failure of eurozone governments to deal decisively with the Greek problem prompted investors to worry about the prospects for other heavily indebted eurozone countries, such as Ireland, Portugal, Italy, and Spain. After several rescue attempts, Greece finally defaulted in 2011. But it was not the end of the story, and four years later, after failing to get further assistance, Greece defaulted on a loan from the IMF.
At least with hindsight, we can see that the run-up to the financial crisis saw plenty of examples of foolishness and greed. Nearly a decade after the crisis, bankers remain at the bottom of everyone’s popularity list. That position has been reinforced by the revelations that several major banks had been rigging the interest rate and foreign exchange markets. But the lesson of the financial crisis and the subsequent scandals is not that we don’t need a financial system; it is that we need it to work honestly and well.
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The Dodd-Frank Act
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Financial markets in the United States and most developed countries work well most of the time, but just like the little girl in the poem, “when they are good, they are very good indeed, but when they are bad, they are horrid.” During the financial crisis, markets were very horrid indeed. Think of some of the problems that you would have faced as a financial manager:
· Many of the world’s largest banks teetered on the edge or had to be rescued so that there were few, or no, safe havens for cash.
· Stock and bond prices bounced around like Tigger on stimulants.
· Periodically, markets for some types of security dried up altogether, making it tough to raise cash.
· In the eurozone, investors could not even be confident that governments would be able to service their bonds or retain the euro as their currency.
· From the peak in 2006, manufacturing profits fell away sharply and the number of business bankruptcies tripled.
It must have seemed to financial managers as if they were being assailed from all sides.
We hope that these years were just a very unfortunate blip and that the world has not become permanently more complex and risky.
SUMMARY
Financial managers are faced with two broad financing decisions:
1. How much internally generated cash flow should be plowed back into the business? How much should be paid out to shareholders by cash dividends or share repurchases?
2. To what extent should the firm use debt rather than equity financing?
The answers to these questions depend on the firm’s payout policy and debt policy.
Figure 14.1 summarizes how U.S. corporations raise and spend money. Have another look at it and try to get a feel for the numbers. Notice that internally generated cash is the major source of financing for investment. Borrowing is also significant. Net equity issues have been negative, however—that is, share repurchases have been larger than share issues.
Common stock is the simplest form of finance. The common stockholders own the corporation. They get all of the cash flow and assets that are left over after the firm’s debts have been paid. Common stock is, therefore, a residual claim that participates in the upsides and downsides of the business. Debt has first claim on cash flows, but its claim is limited. Debt has no control rights unless the firm defaults or violates debt covenants.
Preferred stock is another form of equity financing. Preferreds promise a fixed dividend, but if the board of directors decides to skip the dividend, holders of the preferred have no recourse. The firm must pay the preferred dividends before it pays any dividends on common stock, however.
Debt is the most important source of external financing. Holders of bonds and other corporate debt are promised interest payments and return of principal. If the company cannot make these payments, the debt investors can sue for payment or force bankruptcy. Bankruptcy usually means that the debtholders take over and either sell the company’s assets or continue to operate them under new management.
Note that the tax authorities treat interest payments as a cost, and therefore, the company can deduct interest when calculating its taxable income. Interest is paid from pretax income, whereas dividends and retained earnings come from after-tax income. That is one reason preferred stock is a less important source of financing than debt. Preferred dividends are not tax deductible.
The variety of debt instruments is almost endless. The instruments differ by maturity, interest rate (fixed or floating), currency, seniority, security, and whether the debt can be converted into equity.
The majority of the firm’s debt and equity is owned by financial intermediaries—notably banks, insurance companies, pension funds, and mutual funds. They finance much of corporate investment, as well as investment in real estate and other assets. They run the payments mechanism, help individuals diversify and manage their portfolios, and help companies manage risk. The crisis of 2007–2009 and its aftermath dramatized the crucial role that these intermediaries play.
FURTHER READING
A useful article for comparing financial structure in the United States and other major industrial countries is:
R. G. Rajan and L. Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data,” Journal of Finance 50 (December 1995), pp. 1421–1460.
For a discussion of the allocation of control rights and cash-flow rights between stockholders and debtholders, see:
O. Hart, Firms, Contracts, and Financial Structure (Oxford: Oxford University Press, 1995).
Robert Merton gives an excellent overview of the functions of financial institutions in:
R. Merton, “A Functional Perspective of Financial Intermediation,” Financial Management 24 ( Summer 1995), pp. 23–41.
The Winter 2009 issue of the Journal of Financial Perspectives contains several articles on the crisis of 2007–2009. See also:
V. V. Acharya and M. W. Richardson, eds., Restoring Financial Stability (Hoboken, NJ: John Wiley & Sons, 2009).
F. Allen and E. Carletti, “An Overview of the Crisis: Causes, Consequences and Solutions,” International Review of Finance 10 (March 2010), pp. 1–26.
The following works cover financial crises more generally:
F. Allen and D. Gale, Understanding Financial Crises (Oxford: Oxford University Press, 2007).
C. M. Reinhart and K. Rogoff, “The Aftermath of Financial Crises,” American Economic Review 99 (May 2009), pp. 466–472.
C. M. Reinhart and K. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009).
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Terminology* Fill in the blanks, using the following terms: floating rate, common stock, convertible, subordinated, preferred stock, senior, warrant.
a. If a lender ranks behind the firm’s general creditors in the event of default, his or her loan is said to be ______.
b. Interest on many bank loans is based on a ______ of interest.
c. A(n) ______ bond can be exchanged for shares of the issuing corporation.
d. A(n) ______ gives its owner the right to buy shares in the issuing company at a predetermined price.
e. Dividends on ______ cannot be paid unless the firm has also paid any dividends on its ______.
2. Company financing True or false?
a. In the United States, most common shares are owned by individual investors.
b. An insurance company is a financial intermediary.
c. Investments in partnerships cannot be publicly traded.
3. Sources of funds True or false?
a. Net stock issues by U.S. nonfinancial corporations in most years are small but positive.
b. Most capital investment by U.S. companies is funded by retained earnings and reinvested depreciation.
c. Debt ratios in the United States are lower than in most other developed economies.
4. Security holdings* True or false?
a. Banks are huge investors in corporate equity.
b. Insurance companies are huge investors in corporate debt.
c. Rather than investing directly in corporate equities, most households prefer to pool their risk in a hedge fund.
d. Many individuals have a current account with an investment bank that then uses the cash to lend to industry.
5. Company ownership What do we mean when we say that stockholders have control rights and residual cash flow rights? How in practice do they exercise their control rights?
6. Classified boards Saga City has a declassified board with nine directors.
a. How many directors come up for election each year?
b. Would Saga be more or less vulnerable to a hostile takeover if it had a classified board?
7. Voting rights Suppose that East Corporation has issued voting and nonvoting stock. Investors hope that holders of the voting stock will use their power to vote out the company’s incompetent management. Would you expect the voting stock to sell for a higher price? Explain.
8. Preferred stock* In 2018, Beta Corporation earned gross profits of $760,000.
a. Suppose that Beta was financed by a combination of common stock and $1 million of debt. The interest rate on the debt was 10%, and the corporate tax rate in 2018 was 21%. How much profit was available for common stockholders after payment of interest and corporate taxes?
b. Now suppose that instead of issuing debt, Beta was financed by a combination of common stock and $1 million of preferred stock. The dividend yield on the preferred was 8%, and the corporate tax rate was still 21%. Recalculate the profit available for common stockholders after payment of preferred dividends and corporate taxes.
9. Corporate debt* Which of the following features would increase the value of a corporate bond? Which would reduce its value?
a. The bond is convertible into shares.
b. The bond is secured by a mortgage on real estate.
c. The bond is subordinated.
10. Financial markets and intermediaries. True or false?
a. Financing for public corporations must flow through financial markets.
b. Financing for private corporations must flow through financial intermediaries.
c. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London.
d. Derivative markets are a major source of finance for many corporations.
11. Financial markets and intermediaries. Which of the following are financial markets?
a. NASDAQ.
b. Vanguard Explorer Fund.
c. JPMorgan Chase.
d. Chicago Mercantile Exchange.
12. Financial markets and intermediaries* True or false?
a. Exchange traded funds are hedge funds that can be bought and sold on the stock exchange.
b. Hedge funds provide small investors with low-cost diversification.
c. The sale of insurance policies is a source of financing for insurance companies.
d. In defined-contribution pension plans, the pension pot depends on the rate of return earned on the contributions by the employer and employee.
13. Financial markets and intermediaries Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes:
a. Investor to financial intermediary, to financial markets, and to the corporation.
b. Investor to financial markets, to a financial intermediary, and to the corporation.
c. Investor to financial markets, to a financial intermediary, back to financial markets, and to the corporation.
14. Financial markets and intermediaries Explain briefly how each of the following allow individuals or companies to spread their risk:
a. An exchange traded fund.
b. Commodity markets.
c. A life insurance company.
15. Financial markets and intermediaries Some individuals are eager to spend income before it arrives; others want to postpone consumption. Give some examples of intermediaries that provide services to these individuals.
16. The financial crisis Construct a timeline of the important events in the financial crisis that started in the summer of 2007. When do you think the crisis ended? You will probably want to review some of the entries under Further Reading before you answer.
17. The financial crisis We mention several causes of the financial crisis. What other causes can you identify? You will probably want to review some of the entries under Further Reading before you answer.
FINANCE ON THE WEB
1. Use data from finance.yahoo.com to work out the financing proportions given in Figure 14.1 for a particular industrial company for some recent year.
2. The website www.federalreserve.gov/releases/z1/current/default.htm provides data on sources of funds and an aggregate balance sheet for nonfarm nonfinancial corporations. Look at Table F.102 for the latest year. What proportion of the cash that companies needed was generated internally, and how much had to be raised on the financial markets? Is this the usual pattern? Now look at “new equity issues.” Were companies, on average, issuing new equity or buying their shares back?
3. An aggregate balance sheet for U.S. manufacturing corporations can be found on www.census.gov/econ/qfr. Find the balance sheet for the latest year. What was the ratio of long-term debt to long-term debt plus equity? What about the ratio of all long-term liabilities to long-term liabilities plus equity?
1In Figure 14.1, internally generated cash was calculated by adding depreciation to retained earnings. Depreciation is a noncash expense. Thus, retained earnings understate the cash flow available for reinvestment.
2Managers do have insiders’ insights and naturally are tempted to issue stock when the price looks good to them, that is, when they are less optimistic than outside investors. The outside investors realize this and will buy a new issue only at a discount from the preannouncement price. More on stock issues in Chapter 15.
3This debt ratio may be understated, because “Other long-term liabilities” probably include some debt-equivalent claims. We will not pause to sort through these other liabilities, however.
4Figure 14.4 does not show U.S. holdings of overseas shares. These amount to 20% of the total equity holdings of U.S. investors.
5Theoretical economists therefore stress the importance of incomplete contracts. Their point is that contracts pertaining to the management of the firm are inevitably incomplete and that someone must exercise residual rights of control. See, for example, O. Hart, Firms, Contracts, and Financial Structure (Oxford: Oxford University Press, 1995).
6Of course, the bank manager may suggest that a particular decision is unwise, or even threaten to cut off future lending, but the bank does not have any right to make these decisions.
7A. A. Berle and G. C. Means, The Modern Corporation and Private Property (New York, The Macmillan Company, 1932).
8See C. Holderness, “The Myth of Diffuse Ownership in the United States,” Review of Financial Studies 22 (April 2009), pp. 1377–1408; and R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate Ownership around the World,” Journal of Finance 54 (1999), pp. 471–517. For a review of the extent and influence of blockholders, see A. Edmans and C. G. Holderness, “Blockholders: A Survey of Theory and Evidence,” The Handbook of the Economics of Corporate Governance,1 (2017), pp. 541–636.
9In 2010 the SEC proposed Rule14a-11 that would allow shareholders to add their nominations to the company’s proxy material. This was successfully challenged in the courts. However, an SEC rule that allows shareholders to add proposals to change the bylaws was not overturned.
10T. Nenova, “The Value of Corporate Voting Rights and Control: A Cross-Country Analysis,” Journal of Financial Economics 68 (June 2003) pp. 325–351.
11International differences in the opportunities for dominant shareholders to exploit their position are discussed in S. Johnson et al., “Tunnelling,” American Economic Review 90 (May 2000), pp. 22–27.
12Since a reverse stock split required only the approval of a simple majority of the shareholders, the proposal was voted through.
13A partnership can offer limited liability only to its limited partners. The partnership must also have one or more general partners, who have unlimited liability. However, general partners can be corporations. This puts the corporation’s shield of limited liability between the partnership and the human beings who ultimately own the general partner.
14In practice, this handover of assets is far from straightforward. Sometimes thousands of lenders have different claims on the firm. Administration of the handover is usually left to the bankruptcy court (see Chapter 32).
15Figure 14.6 does not include shorter-term debt such as bank loans. Almost all short-term debt issued by corporations is held by financial intermediaries.
16A company might choose to finance a long-term project with short-term debt if it wished to signal its confidence in the future. Investors would deduce that, if the company anticipated declining profits, it would not take the risk of being unable to take out a fresh loan when the first one matured. See D. Diamond, “Debt Maturity Structure and Liquidity Risk,” Quarterly Journal of Economics 106 (1991), pp. 709–737.
17For example, see L. Jin, R.C. Merton, and Z. Brodie, “Do a Firm’s Equity Returns Reflect the Risk of its Pension Plan?” Journal of Financial Economics 81 (2006), pp. 1–26.
18Intermediaries often invest in each other also. For instance, an investor might buy shares in a mutual fund that then invests in Bank of America’s new share issue. If the money then finds its way from Bank of America to Exxon, it would show up as a financial asset of both Bank of America (its loan to Exxon) and the mutual fund (its shareholding in Bank of America).
19Mutual funds are not corporations but investment companies. They pay no tax, providing that all income from dividends and price appreciation is passed on to the funds’ shareholders. The shareholders pay personal tax on this income.
20Sometimes these fees can be very large indeed. For example, Forbes estimated that hedge fund manager James Simons earned $1.6 billion in 2016.
21In a defined-benefit plan, the employer promises a certain level of retirement benefits (set by a formula), and the employer invests in the pension plan. The plan’s accumulated investment value has to be large enough to cover the promised benefits. If not, the employer must put in more money. Defined-benefit plans are gradually giving way to defined-contribution plans.
22Defined-benefit pension plans share these same advantages, except that the employer invests rather than the employees. In a defined-benefit plan, the advantage of tax deferral on investment income accrues to the employer. This deferral reduces the cost of funding the plan.
23We may be drawing too fine a distinction between financial intermediaries and institutions. A mutual fund could be considered a financial institution. But “financial institution” usually suggests a more complicated intermediary, such as a bank.
24Banks that accept deposits and provide financing to businesses are called commercial banks. Savings banks accept deposits and savings accounts and loan the money out mostly to individuals, for example, as mortgage loans to home buyers. Investment banks do not take deposits and do not loan money to businesses or individuals, except as bridge loans made as temporary financing for takeovers or other transactions.
25Strictly speaking, Goldman Sachs and Morgan Stanley are not investment banks. In 2008, they handed in their investment banking charter in exchange for a banking charter that allows them to accept deposits. However, their principal focus is on investment banking activities.
26Bank of America owns Merrill Lynch, one of the largest investment banks. Merrill was rescued by Bank of America in 2008 after making huge losses from mortgage-related investments.
27However, in the past decade a number of peer-to-peer lending firms (P2PLs), such as Prosper and Lending Club, have been established. These firms receive applications for loans from individuals or small businesses and then advertise on the Web for interested lenders. Lenders do not know the identity of the borrower, but the peer-to-peer intermediary does provide a credit score and its own credit assessment of the borrower, which is reflected in the interest rate being offered. The P2PL provides a market place that links borrowers and lenders. In addition, it offers credit information, and collects payments from borrowers and forwards them to the lenders. By contrast a bank owns its portfolio of loans and offers its depositors instant access to their money.
28We can’t claim that investors’ assessments of value are always correct. Finance can be a risky and dangerous business—dangerous for your wealth, that is. With hindsight we see horrible mistakes by investors—for example, the gross overvaluation of Internet and telecom companies in 2000. On average, however, it appears that financial markets collect and assess information quickly and accurately.
29With a so-called option ARM loan, the minimum mortgage payment was often not even sufficient to cover that month’s interest on the loan. The unpaid interest was then added to the amount of the mortgage, so the homeowner was burdened by an ever-increasing mortgage that one day would need to be paid off.
30A rapid expansion of low-income home ownership is generally popular in government circles, and it chimed well with the aspirations set out in President Bush’s goals of an “Ownership Society.”