L14 - Corporate Financing Flashcards
What do Corporation invest in?
Corporations invest in long-term assets (e.g., property, plant, equipment, machinery) and in net working capital (current assets minus current liabilities).
So how do companies finances their investments?
- Internal Funds –> Profits, Depreciations - (non-cash expenses)
- External Funds –> New equity, Borrowing
Firms tend to prefer to use their own money to finance their investments, after then they prefer to raise finances external using debt (their preferences change depending on the economics situation)
Why is internal funding more convenient than external?
Internal funding (retained earnings + depreciation) makes up more than 2/3 of corporate financing in Germany, Japan, UK.
internal funding is more convenient than external — Why?
- avoids the costs of issuing new securities or negotiating debt;
- shareholders happy if retained profits finance +NPV projects(they forego dividends but the stock has a greater market value).
When managers are too averse to external funding (and risk) they tend to rely too much on internal funds (losing risky but
+NPV projects).
How do you measure a firms reliance on Debt vs. New Equity?
measured using the debt ratio –> the proportion of debt relative to the firm value
Debt ratio = value of debt/ value of debt + value of shares
value of debt = current liabilities + long-term liabilities
The ratio varies from company to industry but you don’t want a debt ratio more than 1 –> it means you are financing a lot of investments by borrowing and thus owe lots of money to multiple creditors
Debt Ratio can be measured by either :
- Book value: tells us how much capital the firm has raised from shareholders in the past (accounting value)
- Market value: measures the value that shareholders place on those shares today.
How does the measurement of new equity and debt affect their value?
the market value of equity is often much larger than the book value of equity –> market has more current information and thus tends to price them higher than the book value does
the market debt ratio is often much lower than the book debt ratio
What is new equity in terms of common stock?
- A corporation is owned by its common stockholders.
- Corporations can raise new cash by issuing new stock.
- Stocks (or shares) held by investors are called issued and outstanding;
- Stocks/shares that are bought back from investors are called issued but not outstanding.
What is the difference between stocks and shares?
Shares refers to the ownership certificates of a particular company;
Stocks refers to the ownership certificates of any company, i.e. to the overall ownership in one or more companies.
Who holds the most of common stocks?
What are residual cash flow rights?
- Shareholders have residual cash flow rights
- the privileged rights go to lenders of the firm e.g. banks, bank holders - this is why a company prefers internal sources of finance so they don’t have to may all their profit to lenders first before their shareholders
- Shareholders have residual (but ultimate) control rights over the firm’s affairs (e.g.: investment decisions, recruitment policy, decided to merge, etc.)
- In widely held corporations, common stockholders control is limited or restricted to the individual entitlement to vote (owning few shares =} little impact on the outcome).
- Cash flow and control rights are limited (or extinguished) in case the firm goes into bankruptcy
What is the Voting procedure in a company?
- Stockholders exercise their control rights by voting.
- Many decisions require a simple majority vote to be approved.
- Some decisions require a supermajority, e.g. 75% of those eligible to vote. (e.g. mergers)
What are the different classes of shares?
- 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.
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.
Why do you have to pay a premium for stocks with superior voting power?
Greater control rights grant larger private benefits!
- Prevent challenge to his/her management position
- extra bargaining power in an acquisition secure a business advantage
- toss out bad management or force management to adopt policies that enhance shareholder value (these can also benefit all shareholders) –> help deal with the principal-agent problem
What is the preferred stock?
- The dividend rate on preferred stocks is fixed at the time of their issue –> like debt
- They give priority over common stock when receiving dividends. –> paid before common stockholders but still after debt
- Common stockholders do not receive dividends unless preferred stockholders receive theirs.
- They do not give ownership right… unless the company fails to pay the preferred dividend.
- In that case, preferred stockholders gain some voting rights.
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What is Debt Financing?
- When companies borrow money, they promise to make regular interest payments and to repay the principal.
- However, this liability is limited.
- Debt has the unique feature of allowing the borrowers (i.e., stockholders) to walk away from their obligation to pay (i.e., default) in exchange for the assets of the company.
- They are willing to do so if Value of Assets < Value of Debt
- this is not straightforward → bankruptcy process
What is Default risk?
Default risk: a term used to describe the likelihood that a firm will walk away from its obligation, voluntarily or involuntarily.
Bond ratings are issued on debt instruments to help investors assess the default risk of a firm.
What is a Debt Claim?
- The claim a lender has on a business
- Debt claim on cash flows is limited (to the interest and principal) =} no residual cash flow rights (contrary to equity).
- Debt offers no control rights (unless the firm defaults).
- As lenders are not owners → no voting power
How can debt be seen as a tax subsidy?
a subsidy helps you give some sort of competitive advantage e.g. makes the costs of your goods cheaper, makes exporting cheaper so you can compete in international markets, to help a subsidy an infant industry so they can thrive
- debt is a subsidy as it reduces the amount of taxable income as interest is paid out to lenders before tax
- interest is paid of pre-tax income
- dividends are paid on after-tax income
As with equity, financial institutions hold the vast majority of corporate debt (in the form of bonds)
How are corporations and investors linked?
Flow of savings to corporations’ investments
The savings may flow through financial markets or financial intermediaries
