>Finance

Created 7/1/1996
Go to
Brad De Long's Home Page


Business Administration 130:

How Corporations Raise Money

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty15.html


Basics:

 


 

Enormous variety of financing instruments

International Paper's debt securities (and equity) at the end of 1993:

 Asset

Amount (millions)

9.4% to 9.7% notes due 1995-2002

$400

7 5/8% notes due 2004, 2023

$398

6 1/8% notes due 2003

$199

6 7/8% notes due 2023

$197

Assorted medium-term notes due 1994-2006

$549

9 1/8% French franc notes due 1994

$95

5 1/8% debentures due 2012

$78

5 1/4% euro-convertible subordinated debentures due 2002

$199

Environmental and industrial development bonds

 $747

 Commercial paper

$516

 Other franc borrowoing

$95

 German mark borrowing

$214

 Equity Book Value

 Issued common shares (at par)

$127

 Additional capital

$1704

 Retained earnings

$4553

 Treasury shares (at cost)

-$159

 Net common equity

 $6225


 


Why so much innovation? Taxes and financial regulations are very important causes; a belief that wide investor choice is good for its own sake. But in a pure CAPM world there would be much, much, much less variety of securities.


Patterns of corporate financing.

Heavy reliance on internal financing. Does this mean that securities markets are overrated? Almost surely not...

Debt-to-market ratios vary between 11% and 36% across industrial economies.


Corporate governance

Dispersal of ownership; free-rider problem; managerial displacement via voting-with-the-feet and takeover threat; managerial displacement via directors' coup;

agency problems created by separation of ownership and control offset by (i) rights issues provided to top managers (less than perfect); (ii) fear of lawsuits; (iii) threat of takeover.

alternative systems--bank representatives on boards of directors; large voting blocks; universal banking; "keiretsu"

General Motors --> 100% of shares widely held

Daimler-Benz --> 32% "widely held"; 28% Deutsche Bank (U.S. banks forbidden to hold equity in non-financial corporations) (Deutsche Bank votes 42% "deposit rights");14% Kuwait; 25% Mercedes Auto Holdings.

You can't mount a takeover of Daimler-Benz; then again, you don't have to wait for a takeover artist in order to realize value...

 

sharks vs. watchers; sharks are good if skills are scarce, and you want those with managerial assessment skills prowling around; watchers are good if ultimate investors are pretty good at judging watchers

Connections with eastern european reform


Japan with its keiretsu follows the German form...


Summary:

Finance is mostly a "marketing" problem; company tries to split cash flows into different streams that will appeal to different investors with different tastes, wealth levels, and tax rates.

Another look: internal funds as most important; mix of outside financing chagnes from year to year; net equity issues in the 1980s stronglynegtaive: people leveraged up.


Inbox Software EquityAccount:

 Initial

After two years

After three years

 Stock at par

 $50,000

 $50,000

 $150,000

 Other contributions

 $1,950,000

 $1,950,000

 $6,850,000

 Retained earnings

 $120,000

$370,000

 $2,000,000

$2,120,000

 $7,370,000


Issuing Securities

First Meriam venture partners invests one million in round one venture capital... Marvin Enterprises:

Started with $100,000; which was spent; then went looking for VC and sold a 50% stake for $1,000,000

 

 Assets

Liabilities + Net Worth

 Cash

$1

 $1

 1m shares Venture Capital Equity

 "Intangible"

 $1

 $1

 1 m shares Founders' Equity

 $2

 $2

 

Round 2 of venture capital; sell a 4/14 = 28.5% stake in the company for $4,000,000

 Assets

Liabilities + Net Worth

 Cash from new equity

$4

 $4

 0.8 m shares 2nd Stage Equity @ $5/share

 Fixed assets

 $1

 $5

 1 m shares 1st Stage Equity

 "Intangible"

 $9

 $5

 1 m shares Founders' Equity

 $14

 $14

Venture capital--a low probability of success, but the prospect of a big win...

 

Initial Public Offering

Register with the SEC; SEC approval; prospectus "Red herring"; registrar; transfer agent; underwriters; substantial administrative costs; underpricing IPO's.

Marvin sells 500,000 primary shares (for the company) and 400,000 secondary shares (from VCs and from founders)

 Assets

Liabilities + Net Worth

 $72

 0.9 m shares IPO

Cashfrom new equity

$37.5

 $48

 0.6 2nd Stage Equity

 Fixed assets

 $5

 $80

 1.0 1st Stage Equity

 "Intangible"

 $221.5

 $64

 0.8 Founders' Equity

 $264

 $264

"Contentment at selling an article for one-third of its subsequent value is a rarity"


General Cash Offers by existing companies; SEC registration; "shelf" registration; market reaction to new stock issues-- 1/3 of value soaked up in stock price decline


Should you worry about dilution?

Quangle's profitability:

 Book net worth

$100,000

Number of shares

1000

Book value per share

$100

Net earnings

$8000

EPS

$8

PE

10

Price

$80 per share

Total market value

$80,000

By selling shares at less than market value, does the firm "dilute" its shareholders equity? You should see by now that this is the wrong question to ask. Suppose that Quangle has a 10% earnings-per-dollar invested opportunity open to it. Sells 100 shares at a price of $80 a share and puts the money to work at 10%--and is fine. Suppose that Quangle has a 20%-plus-one-dollar investment opportunity--and sells 200 shares at a price of $100 -less-half-a-penny a share

 Book net worth

$100,000

 $108,000

 $119,999

Number of shares

1000

 1100

 1200

Book value per share

$100

 $98.18

 $99.999

Net earnings

$8000

$8,800

 $12,000

EPS

$8

$8

 $10

PE

10

 10

 10

Price

$80 per share

 $80 per share

 $100 per share

Total market value

$80,000

 $88,000

 $120,000

It's silly to tie what you do to book value.


Summary:

Larger is cheaper--bunch security issues, for transaction costs are considerable

There are no issue costs for retained earnings

Private placements are well suited for the small, risky, unusual, and complex

Watch out for underpricing--the lion's share of costs come from underpricing

New issues may depress price (and so should be coreographed to be information-free)

shelf registration for large firms that don't need to be warranteed by IBs


Adam Smith
Send e-mail to Brad De Long

Return to Brad DeLong's Home Page

Return to Business Administration 130 Home Page