Corporate Financing and the Issuance of Securities Flashcards
What patterns of corporate financing the companies rely on: internal vs external financing
- firms may raise funds from external sources or plow back profits rather than distribute them to shareholders
- shareholders accept plow-back decisions, for cash to be invested into positive NPV projects
- if internal CF is not sufficient, the company faces a financial deficit. Companies must then cut back on dividends to increase retained earnings or raise new capital
- on average, internal funds cover most of the cash needed for investments
- managers can be tempted to forgo risky but positive NPV project if it involves new stock issue, the announcement of new equity issues are generally associated with negative stock returns
- a mix of debt and equity financing varies widely from industry to industry
- debt ratios also vary over time for firms
Basics: equity securities - common stock
common stocks represent an ownership share in a publicly held corporation.
each share of common stock entitles its owner to cash flow rights plus voting rights on any matters of corporate governance
corporation sometimes issues two classes of common stock, with and without voting rights
common stock has a residual claim - stockholders are last in a line of all investors who have a claim on a firm’s assets
shareholders have limited liability
stocks can be exchanged on the stock exchanges
Basics: equity securities - preferred stock
similar features to equity and debt but they receive a fixed amount of income every year, like a bond
preferred stocks rank after bonds in terms of priority in the event of bankruptcy
stock payments are not tax-deductible expenses for the firm
voting procedures
US companies: entire BoD is up for reelection each year, some have classified or staggered boards, where only a third is reelected
- a simple majority of shareholder votes is sufficient, but the company may specify the supermajority needed
- proxy contests involve the firm’s existing management and directors competing with outsiders for effective control of the corporation
The seniority of debt and debtholder’s rights
debt has the first claim on CF, but is limited to interest payments and the repayment of a face value
claim structure: if a default occurs, senior debt is first in line to be repaid. Junior or subordinated debtholders are paid after seniors are satisfied.
The firm provides insurance to the lender that it will not take unreasonable risks and the firm may set aside some assets in terms of collateral, the debt is then secured.
Convertible debt
Firms issue securities that give owners an option to convert them into securities.
The warrant gives the right to purchase a set number of the company’s shares at a set price, before the set date
A convertible bond gives the owner the option to exchange the bond for a predetermined number of equity shares
Debt by another name
accounts payable (good received, not yet paid for)
rents and leases (firms may lease the machinery, similar payments as loan)
unfunded obligations (similar to senior debt e.g. employee pension obligations)
special purpose entities (SPEs: raise cash through equity and debt issues of SPE, don’t show up on balance sheet)
The difference between lenders’ and stockholders’ rights
In contrast to equity, debt does not have residual CF rights and doesn’t participate in the upside of the business.
Lenders aren’t considered owners of the firm, so they don’t have voting power.
Debt offers no control rights unless the firm defaults or violates debt covenants
financial markets and intermediaries
financial markets: where financial assets are issued and traded
financial intermediaries (banks): organizations that raise money from investors, provide financing for individuals, and important sources of financing corporations
investment funds: mutual funds and hedge funds pool savings of different investors - main difference regulations. Pension funds are plans to secure retirement payments
Financial institutions
they are intermediaries, doing more than just pool and invest savings. They raise financing in special ways and provide additional financial services.
They do not only invest in securities but also lend money directly to individuals, businesses, or other organizations
the role of financial markets and intermediaries
- payment mechanism (allows individuals to make and receive payments quickly and safely over long distances)
- borrowing and lending (channels savings toward those who can best use them)
- pooling risk (allows individuals to share risk)
- information gathering (markets show what assets are worth, allows estimation of expected rates of return)
Venture capital
- a type of funding for young, growing private companies
- investors are institutions or wealthy individuals who finance firms before they can obtain debt or go public
- they pool funds from a variety of investors to build high-risk financial portfolios
- they provide funding and often also managerial services in exchange for equity
- they rarely give a young company upfront all the money it will need, they define stages and milestones
The role of venture capital organizations and how companies raise venture capital
VC funds are organized as limited private partnerships with a fixed life of about 10 years. Limited partners are the investors.
The management company is responsible for making and overseeing the investment and receives a fixed fee and a share of the profits (carried interest).
A typical arrangement: fee of 2% plus 20% of profit.
VC firms specialize in young firms that are difficult to evaluate but present the chance of becoming a big public company.
VC firms monitor these firms closely, provide ongoing advice and often play a major role in recruiting the senior management team.
VC may cash out in 2 ways: sell out or IPO
the performance of venture capital
The average annual IRR was 17% compared to the S&P return of 9.6% (best returns before 2000)
performance: assessment thereof is difficult because of risk. There is only one observation per fund and the portfolio firms are not listed, the beta of a VC fund cannot be derived from the weighted average beta of the portfolio firms’ betas (alternative: estimate the beta of peers and take their weighted average beta)
the IPO process: what is the role of the underwriters?
underwriter: an investment bank that buys an issue of securities from a company and resells it to the public
- they have firm and best-effort commitment and there are also flotation costs when issuing new securities to the public
