14 Real Firms and Their Financing: Stocks and Bonds A bargain that is going to become a greater...

14Real Firms and Their Financing: Stocks and

BondsA bargain that is going to become a greater bargain is

no bargain.MARTIN SHUBIK, YALE UNIVERSITY

● Corporations and Their Financing

● Financing Corporate Activity: Stocks and Bonds

● Buying Stocks and Bonds

● Stock Exchanges and Their Functions

● Speculation

● Corporations and Their Financing

● Financing Corporate Activity: Stocks and Bonds

● Buying Stocks and Bonds

● Stock Exchanges and Their Functions

● Speculation

ContentsContents

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.


● U.S. firms are of three types: ♦ Proprietorships (largest number of firms)

♦ Partnerships

♦ Corporations (have largest amount of business)

● U.S. firms are of three types: ♦ Proprietorships (largest number of firms)

♦ Partnerships

♦ Corporations (have largest amount of business)

Corporations and Their FinancingCorporations and Their Financing


● The largest U.S. firms are corporations, which are treated by law as entities separate from their owners.

● The largest U.S. firms are corporations, which are treated by law as entities separate from their owners.




● Advantages:♦ Limited liability

♦ Access to large amounts of capital

♦ Ease of operation with help of hired management

♦ Remain permanent even when the owners change

● Advantages:♦ Limited liability

♦ Access to large amounts of capital

♦ Ease of operation with help of hired management

♦ Remain permanent even when the owners change



● Disadvantages:♦ Double taxation

♦ Hired managers may act against the interest of the owners

● Disadvantages:♦ Double taxation

♦ Hired managers may act against the interest of the owners


● The Effect of Double Taxation of Corporate Earnings♦ Reduces the extent of corporate activities

♦ Does not reduce the net returns to individual investors

● The Effect of Double Taxation of Corporate Earnings♦ Reduces the extent of corporate activities

♦ Does not reduce the net returns to individual investors



● Why do corporations need additional funds?♦ To add to plant or equipment

♦ To finance other types of real investment

● Why do corporations need additional funds?♦ To add to plant or equipment

♦ To finance other types of real investment

Financing Corporate Activity: Stocks and BondsFinancing Corporate Activity: Stocks and Bonds


● How does a corporation get additional funds?♦ Take out a loan

♦ Print and sell new stock certificates or new bonds

♦ Reinvest its own earnings (rather than paying them out as dividends to stockholders)

● How does a corporation get additional funds?♦ Take out a loan

♦ Print and sell new stock certificates or new bonds

♦ Reinvest its own earnings (rather than paying them out as dividends to stockholders)



● Loans♦ A company can obtain money by borrowing

from banks, insurance companies, other private firms, or a U.S. government agency.

● Sell Stocks ♦ Common stock conveys an ownership claim

and entitles the stockholder to a proportionate share of the dividends, if any.

● Loans♦ A company can obtain money by borrowing

from banks, insurance companies, other private firms, or a U.S. government agency.

● Sell Stocks ♦ Common stock conveys an ownership claim

and entitles the stockholder to a proportionate share of the dividends, if any.



● Sell bonds♦ A bond purchase is like a loan.

♦ It conveys no ownership stake, and entitles the bondholder to be repaid a certain fixed amount if the bond is held to maturity.

♦ Bondholders have a prior claim to stock-holders.

● Sell bonds♦ A bond purchase is like a loan.

♦ It conveys no ownership stake, and entitles the bondholder to be repaid a certain fixed amount if the bond is held to maturity.

♦ Bondholders have a prior claim to stock-holders.



● Stock “ownership” may be an illusion since large blocks are needed to exert influence

● Bonds can be a very risky investment due to fluctuations in market price and inflation.

● Stock “ownership” may be an illusion since large blocks are needed to exert influence

● Bonds can be a very risky investment due to fluctuations in market price and inflation.



● From the point of view of the corporation, bonds are typically (not always) cheaper than stocks, in terms of expected interest payments versus return to the stockholders; they are, however, riskier because they establish a fixed obligation.

● From the point of view of the corporation, bonds are typically (not always) cheaper than stocks, in terms of expected interest payments versus return to the stockholders; they are, however, riskier because they establish a fixed obligation.



● Stockholders usually demand a higher return than bondholders do because, to them, stocks are riskier.

● In other words, bonds are a way of transferring some (not all) of the risk from the investor to the company.

● Stockholders usually demand a higher return than bondholders do because, to them, stocks are riskier.

● In other words, bonds are a way of transferring some (not all) of the risk from the investor to the company.



● Plowback or Retained Earnings♦ As well as issuing stocks and bonds, firms can

finance their investments through plowback or retained earnings.

♦ Firms often find this preferable and, in fact, in 1996, plowback constituted about 62 percent of total U.S. corporate financing.

● Plowback or Retained Earnings♦ As well as issuing stocks and bonds, firms can

finance their investments through plowback or retained earnings.

♦ Firms often find this preferable and, in fact, in 1996, plowback constituted about 62 percent of total U.S. corporate financing.



● What Determines Stock Prices? The Role of Expected Company Earnings♦ Since most bonds carry a fixed nominal return,

their current market value fluctuates inversely with interest rates.

♦ The market price of bond is equal to the coupon divided by the current market interest rate.

● What Determines Stock Prices? The Role of Expected Company Earnings♦ Since most bonds carry a fixed nominal return,

their current market value fluctuates inversely with interest rates.

♦ The market price of bond is equal to the coupon divided by the current market interest rate.


FIGURE 14-2 Sources of New Funds for U.S. Corporations

FIGURE 14-2 Sources of New Funds for U.S. Corporations


18.9

–12.9

21.2 Per

cen

t

New stocks

Other external sources

New bonds and

other debt

Plowback

–20

–10

0

10

20

30

40

50

60

72.8 70

80


● Selecting a Portfolio: Diversification♦ Investors reduce their risk by acquiring a

variety of assets.

♦ An easy way for an individual investor to diversify is to invest money in an index fund.

● Selecting a Portfolio: Diversification♦ Investors reduce their risk by acquiring a

variety of assets.

♦ An easy way for an individual investor to diversify is to invest money in an index fund.

Buying Stocks and BondsBuying Stocks and Bonds


● Selecting a Portfolio: Diversification♦ Index funds

■Buy the securities used in one of the standard stock price indexes

■Return reflects the performance of the whole market

● Selecting a Portfolio: Diversification♦ Index funds

■Buy the securities used in one of the standard stock price indexes

■Return reflects the performance of the whole market

Buying Stocks and BondsBuying Stocks and Bonds


● Stocks are bought and sold on stock exchanges, the largest and most important of which is the New York Stock Exchange.

● Stocks are bought and sold on stock exchanges, the largest and most important of which is the New York Stock Exchange.

Stock Exchanges and Their FunctionsStock Exchanges and Their Functions


● Regulation of the Stock Market♦ Stock exchanges are regulated internally and

by the Securities and Exchange Commission.

● Regulation of the Stock Market♦ Stock exchanges are regulated internally and

by the Securities and Exchange Commission.



● Stock Exchanges and Corporate Capital Needs♦ A special type of bank called an investment

bank usually handles new stock issues.

♦ Stock exchanges deal in previously issued stock; they do not provide capital to firms directly.

● Stock Exchanges and Corporate Capital Needs♦ A special type of bank called an investment

bank usually handles new stock issues.

♦ Stock exchanges deal in previously issued stock; they do not provide capital to firms directly.



Stock Exchanges and Their Functions Stock Exchanges and Their Functions

● Stock Exchanges and Corporate Capital Needs♦ Stock exchanges have two critically important

functions for corporate financing:■By providing a second-hand market for stocks, they

make individual investment in a company much less risky.

■The stock market determines the current price of the company’s stock.

● Stock Exchanges and Corporate Capital Needs♦ Stock exchanges have two critically important

functions for corporate financing:■By providing a second-hand market for stocks, they

make individual investment in a company much less risky.

■The stock market determines the current price of the company’s stock.


● Stock Exchanges and Corporate Capital Needs♦ A high price of its stock on the exchange is

important to a firm because it allows the issuance of new stock at a good price.

♦ If a firm has a promising future, its stock will tend to command a high price on the stock exchanges.

● Stock Exchanges and Corporate Capital Needs♦ A high price of its stock on the exchange is

important to a firm because it allows the issuance of new stock at a good price.

♦ If a firm has a promising future, its stock will tend to command a high price on the stock exchanges.




● Stock Exchanges and Corporate Capital Needs♦ The stock market helps to allocate the

economy’s resources to firms that can best use those resources.

● Stock Exchanges and Corporate Capital Needs♦ The stock market helps to allocate the

economy’s resources to firms that can best use those resources.

● Takeover = group of outside financiers buys a sufficient amount of company stock to gain control of the firm.♦ There has been an increase in takeovers,

including “hostile takeovers,” through the buying of stock.

♦ Opinion is divided as to whether this is good or bad for the economy.

● Takeover = group of outside financiers buys a sufficient amount of company stock to gain control of the firm.♦ There has been an increase in takeovers,

including “hostile takeovers,” through the buying of stock.

♦ Opinion is divided as to whether this is good or bad for the economy.

The Surge in TakeoversThe Surge in Takeovers



● Speculators get bad press, but they usually perform important, socially useful tasks.

● They protect other people against risk and they help to smooth out price fluctuations.

● In some circumstances, they may even prevent famine.

● Speculators get bad press, but they usually perform important, socially useful tasks.

● They protect other people against risk and they help to smooth out price fluctuations.

● In some circumstances, they may even prevent famine.

Speculation Speculation


● Even skilled analysts cannot accurately predict individual stock prices.

● Rather, they move in a random fashion, around a long-run market trend for stocks in general.

● The reason for this may be the great skill and foresight of investors or, alternately, their irrational behavior.

● Even skilled analysts cannot accurately predict individual stock prices.

● Rather, they move in a random fashion, around a long-run market trend for stocks in general.

● The reason for this may be the great skill and foresight of investors or, alternately, their irrational behavior.

Unpredictable Stock Prices as “Random Walks”Unpredictable Stock Prices as “Random Walks”??

14 Real Firms and Their Financing: Stocks and Bonds A bargain that is going to become a greater...

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