Long Term Financing
a. International Capital Markets
International capital markets have increased in importance during the last several
decades and continue to become larger, and more efficient and competitive. The
evolution and growth of these markets can be traced to several important economic trends
over the last two decades. First, and perhaps foremost, all major economies around the
world have adopted the basic principles of capitalism. Prior to 1991 this was not true.
Both the Soviet Union and the People’s Republic of China explicitly rejected capitalism’s
private ownership of productive property in favor of communism, which called for
government control of productive assets. The Soviet Union disbanded in 1991, and China
has moved along an increasingly capitalistic course for several decades. In the long run,
capitalism has proven to be a more efficient system.
Even outside the Soviet Union and China, economies generally evolved toward
capitalism. Central and Eastern European countries privatized many of their state
industries during the 1990s as they moved toward market-based economies. Across the
globe, countries sold off state-owned electric utilities, airlines, telephone systems,
railroads, banks, and insurance companies. Privatization has been particularly important
and successful in telecommunications where genuine competition has taken place. As
state-owned companies lost their monopolies due to both legislation and technological
change, prices for telecommunication services fell dramatically. Cheap and dependable
telecommunication has allowed other technologies to be deployed rapidly.
Another important evolution for international capital markets has been the
continuing development of international “free trade.” In 1994 the North American Free
Trade Agreement (NAFTA) was established among the United States, Canada, and
Mexico. While this trade agreement has facilitated trade among these three countries,
many, including President Trump, think that Canada and Mexico have gotten the better
part of the deal. Because it is cheaper to manufacture in Mexico with lower labor costs,
many manufacturing jobs have moved from the United States to Mexico. This has caused
a problem in the Rust Belt states that have lost jobs. President Trump has vowed to
renegotiate the deal, and time will tell if the United States ends up better off.
Other areas of the world have also seen trade barriers fall, and the European
Union (EU) has grown to include 28 countries in this free trade zone. Nineteen countries
have adopted the euro as their domestic currency, and the European Central Bank is in
charge of monetary policy for these countries. This has caused some problems because
not all countries are on the same economic level of development. For example, it is
difficult to compare the Lithuanian or Greek economy to the German economy. However,
because of the monetary union, the euro is the second most important international
currency after the dollar. Once the Chinese yuan becomes convertible into world
currencies, it most likely will take its place with the U.S. dollar, euro, and Japanese yen
as a major currency.
On an even more global scale, the World Trade Organization (WTO) strives to
further liberalize international trade. Russia, which was admitted to membership in 2012,
is 1 of 164 countries in the WTO. Algeria, Ethiopia, Iraq, Iran, and dozens of other
countries (mostly in northern Africa and central Asia) are seeking membership. Iran is
currently the world’s largest non-WTO economy, mostly because of its oil deposits.
All these events—the rise of capitalism, global privatizations, reduced
telecommunication costs, and increased international trade—have combined to create an
international demand and a need for capital worldwide. While the U.S. capital markets
are still the largest and most important, other capital markets are increasing in size
relative to the United States. In particular, European markets have changed markedly in
the last decade, and the Asian markets of China, India, Indonesia, Thailand, and others
have grown dramatically.
Taking advantage of free trade and improved global capital markets, companies
search the international markets for opportunities to raise debt and equity capital at the
lowest cost. Many corporations list their common stock worldwide to increase liquidity
for their stockholders and to provide opportunities for the sale of new stock in foreign
countries
This also gives us an idea of the size of the domestic economy and the size of the
companies listed in U.S. dollars. Notice that the two largest markets, the NASDAQ and
NYSE, are headquartered in the United States. However, both have significant
international operations, and some foreign companies are listed on the U.S. exchanges as
American Depository Receipts. What has changed since the last edition of this text three
years ago is that there are now three Chinese exchanges listed —the Shanghai, the
Shenzhen, and the Hong Kong exchanges. They have all grown, and combined they make
up the secondlargest market capitalization.
The well-developed equity markets in the United States have facilitated
investment in the U.S. economy by foreigners. This is not surprising since the United
States is one of the most politically stable countries in the world. Not only do well-
developed financial markets facilitate investment in the United States, but foreign
investors also choose to invest in the United States because they believe that the U.S.
economy will continue to prosper. Moreover, the U.S. government is not likely to
confiscate foreigners’ assets, an issue that is of considerable concern in some countries.
For example, in recent years Venezuela has confiscated assets from oil companies,
cement producers, steel mills, and food processors. Between 2000 and 2010, Venezuela
confiscated over 1,000 corporations from foreign and domestic owners. Unsurprisingly,
and in contrast to the United States, foreign investors currently have almost no interest in
investing in Venezuela.
b. Competition for Funds in the U.S. Capital Markets
Let’s return to markets in the United States. In order to put U.S. corporate
securities into perspective, it is necessary to look at other securities available in the
capital markets. The federal government, government agencies, state governments, and
local municipalities all compete with one another and corporations for a limited supply of
financial capital. The capital markets serve as a way of allocating the available capital to
the most efficient user. Therefore the ultimate investor must choose among many kinds of
securities, both corporate and noncorporate. Before investors part with their money they
desire to maximize their return for any given level of risk, and thus the expected return
from the universe of securities acts as an allocating mechanism in the markets.
In accordance with government fiscal policy, the U.S. Treasury manages the
federal government’s debt in order to balance the flow of funds into and out of the U.S.
Treasury. When deficits are incurred, the Treasury can sell short-term or long-term
securities to finance the shortfall and when surpluses occur, the government can retire
debt. When the U.S. government collects more in taxes than it is spending, it doesn’t
need to borrow and this frees up capital for the other sectors of the economy.
The federally sponsored credit agencies are governmental units that issue their
securities on a separate basis from those securities sold directly by the U.S. Treasury.
Some of the largest sponsored credit agencies are involved in mortgage lending to the
U.S. housing market. Historically, the U.S. government did not directly guarantee
securities issued by federally sponsored credit agencies. Instead, these guarantees were
implicit. However, in 2008, the two largest agencies, the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac), were placed into government conservatorship, and the implicit guarantee became
explicit. The U.S. government also promised to buy an unlimited amount of debt issued
by the Federal Home Loan Banks (FHLB), another sponsored agency, thereby
guaranteeing that the FHLB could also raise as much capital as it needed. These actions
were deemed necessary due to the collapse of residential real estate prices around the
country in 2007 and 2008. The bailouts were highly controversial. Many blamed Fannie
Mae and Freddie Mac, both of which are private stockholder-owned corporations, for
promoting policies that led to the housing “price bubble” whose ultimate collapse drove
these same companies to the brink of bankruptcy. Fortunately, as the economy recovered,
so did these agencies.
Farm Credit Banks, the Student Loan Marketing Association (Sallie Mae), and the
Federal Agricultural Mortgage Corporation (Farmer Mac) are other federally sponsored
credit agencies. Like Fannie Mae and Freddie Mac, Sallie Mae and Farmer Mac are
private companies whose stocks are traded on the New York Stock Exchange.
State and local issues are referred to as municipal securities or tax-exempt
offerings. Interest payments from securities issued by state and local governments are
exempt from federal income taxes and income taxes levied by the state of issue. (For
example, if the state of California issues a bond that is bought by someone living in the
state of California, the interest is not taxable by California. However if someone living in
the state of California buys a bond issued by the state of New York, the interest will be
taxable by California.) Because these securities are exempt from federal taxes, they tend
to be purchased by investors in high marginal tax brackets. Unlike the federal
government, most state governments are required by law to balance their budgets.
Therefore, bonds issued by municipal governments or state entities are often supported
by revenuegenerating projects such as sewers, college dormitories, and toll roads.
One misconception held by many investors is that the market for common stocks
dominates the corporate bond markets in size. This is far from the truth. Bonds are debt
instruments that have a fixed life and must be repaid at maturity. As bonds come due and
are paid off, the corporation normally replaces this debt with new bonds. For this reason,
corporate bond issuances have traditionally made up the majority of external financing
transactions by corporations.
In general, when interest rates are expected to rise, financial managers try to lock
in long-term financing at a low cost and balance the company’s debt structure with more
long-term debt and less short-term debt. This has been especially true in the 2012 to 2015
period that has seen historically low long-term rates. Rates began rising in 2017, and the
market expects at least two more rate increases by the Fed in 2018. This is more
motivation for companies to get in their last bit of low-cost debt. The amount of long-
term debt a corporation chooses to employ as a percentage of total capital is also a
function of several options. Management must decide about its willingness to accept risk
and examine the amount of financing available from other sources, such as internal cash
flow, common stock, and preferred stock.
Preferred stock is the least used of all long-term corporate securities. The major
reason for the small amount of financing with preferred stock is that the dividend is not
tax-deductible to the corporation, as is bond interest. Corporations that are at their
maximum debt limit issue much of the preferred stock that is sold. These companies may
also suffer from low common stock prices or want to issue preferred stock that may
someday be convertible into common stock.
Companies seeking new equity capital sell common stock. As explained in the
next on investment banking, common stock is either sold as a new issue in an initial
public offering (IPO) or as a secondary offering. A secondary offering means that shares
are already being publicly traded in the markets and the new offering will be at least the
second time the company has sold common stock to the public. When companies
purchase their own shares in the market because they have excess cash, these shares are
shown on the company’s balance sheet as treasury stock. Because common stock has no
maturity date like bonds, new common stock is never sold to replace old stock in the way
that new bonds are used to refund old bonds.
So far we have discussed how corporations raise funds externally through
longterm financing using bonds, common stock, and preferred stock. Another extremely
important source of funds to the corporation is internally generated funds as represented
by retained earnings and cash flow added back from depreciation. On average, during the
last 30 years corporations raised about 40 percent of their funds internally and 60 percent
of their funds externally through the sale of bonds, common and preferred stock.
What makes up the internal funds? The composition of internal funds is a function
of corporate profitability, the dividends paid and the resultant retained earnings, and the
depreciation tax shield firms get from making additions to plant and equipment. To arrive
at the internally generated funds of the firm, we usually begin with the firm’s earnings
and add back deducted depreciation expense. Depreciation is deducted from corporate
income, but depreciation does not result in lower cash flows. Although we frequently
refer to depreciation as “a source of cash flow,” in reality, we refer to depreciation in this
way because we have chosen to start the calculation of cash flows using corporate
earnings as calculated by the firm’s accountants. Those earnings include a noncash
depreciation deduction, and we must add the depreciation back to reflect the actual cash
generated. When companies invest heavily in new plant and equipment, depreciation can
rise substantially in the following years.
During the period covered in panel A, retained earnings provided less than a
quarter of the internal funds while depreciation provided the rest. In times of recession
when corporate profits fall, retained earnings decline as a percentage of internal funds
while the opposite is true during economic expansions. Panel B shows the breakdown of
corporate income, dividends paid, retained earnings, and depreciation. The graph gives a
good depiction of the relative size of each, with corporate earnings generating the
dividend payments and retained earnings. Notice that funds from depreciation are larger
than corporate earnings.
c. The Organization of the Security Markets
The structure of the security markets has changed drastically in the last decade,
and markets are expected to continue evolving toward a global electronic structure. The
most important change that markets have undergone may be the rise of electronic
communication networks (ECNs). ECNs are electronic trading systems that automatically
match buy and sell orders at specific prices via computers. They have lowered trading
costs and forced organized security exchanges to make significant changes in their
operations and structure. These changes include mergers and alliances between
traditional exchanges, their transformation from membership-owned organizations to
public companies, and the acquisition of leading ECNs by the traditional exchanges.
Traditional organized exchanges are either national or regional, but both are
structured in a similar fashion. Historically, exchanges have had a central trading location
where securities are bought and sold in an auction market by brokers acting as agents for
the buyers and sellers. If a stock is not traded electronically and instead is traded on the
floor of an exchange, it is traded at a physical location, a trading post, on the exchange’s
trading floor. Brokers are registered members of the exchanges, and their number is fixed
by each exchange. The largest of the traditional exchanges with a physical location is the
New York Stock Exchange (NYSE).
The regional exchanges began their existence trading securities of local firms. As
the firms grew, they also were listed on the national exchanges but continued to be traded
on the regionals. Many cities, such as Chicago, Cincinnati, Philadelphia, and Boston,
have regional exchanges. Today most of the trading on these exchanges is done in
nationally known companies. Trading in the same companies is common between the
NYSE and such regionals as the Chicago Stock Exchange. More than 90 percent of the
companies traded on the Chicago Stock Exchange are also listed on the NYSE. This is
referred to as dual trading.
One of the major factors distinguishing an exchange is its listing requirements.
The only way a firm’s securities can be traded on an exchange is if the company meets
the listing requirements and has been approved by the board of governors of that
exchange. All exchanges have minimum requirements that must be met before trading
can occur in a company’s common stock. The NYSE was historically the largest
exchange and now generates the most dollar volume in large, well-known companies. Its
listing requirements also are the most restrictive. However, while the NASDAQ Stock
Market has less restrictive listing requirements than the NYSE, it lists many large
technology companies such as Microsoft, Google, Apple, and Cisco Systems that would
easily meet the NYSE standards.
A competing trading platform to the traditional organized exchanges is the
electronic communication networks (ECNs). As previously indicated, ECNs are
electronic trading systems that use computers to automatically match buy and sell orders.
ECNs are also known as alternative trading systems (ATSs) and have been given SEC
approval to be more fully integrated into the national market system by choosing to act
either as a broker-dealer or as an exchange. Unlike traditional organized exchanges,
ECNs do not have an exchange floor or physical trading posts. An ECN’s subscribers can
include retail and institutional investors, market makers, and broker-dealers. If a
subscriber wants to buy a stock through an ECN, but there are no sell orders to match the
buy order, the order cannot be executed. The ECN can wait for a matching sell order to
arrive, or if the order is received during normal trading hours, the order can be routed to
another market for execution. Some ECNs will let their subscribers see their entire order
books, and some will even make their order books available on the web.
Because they offered significant cost advantages, ECNs were a competitive threat
for even the most successful floor-based exchange, the New York Stock Exchange. In
response, and in keeping with the old adage, “If you can’t beat them, buy them,” both the
New York Stock Exchange and the NASDAQ acquired ECNs. But in the end the ECN
model prevailed and the NYSE was bought by the Intercontinental Exchange (ICE).
The BATS exchange, a relatively young exchange, started as an ECN and attained
exchange status in 2008. It now operates four stock exchanges in the United States. Its
original BZX and BYX exchanges were combined with the EDGA and EDGX exchanges
acquired with their 2014 merger with Direct Edge. According to its website, “The
combined BATS Global Markets enterprise is now the largest U.S. equities market
operation on any given day.” BATS does not list stocks like the NYSE or NASDAQ and
is strictly an electronic trading platform that matches orders and offers excellent
execution speed and is popular with hedge funds and other professional traders.
The New York Stock Exchange (NYSE) is located on Wall Street in New York
City. Traditionally, the NYSE had a fixed number of memberships that allowed members
to trade on the floor. At its height in 2005, one membership traded for $3.5 million. In
2006, the NYSE merged with Archipelago, a large ECN, and became a public company.
When the NYSE converted to a publicly traded company, NYSE members received stock
in the NYSE Group and were given a trading license with an annual fee attached. Now
owned by ICE, it operates as a subsidiary of the ECN.
Most trading on the floor of the NYSE occurs around a special group of traders
known as designated market makers (DMMs). Technically, DMMs succeeded the
“specialist” system, but for most purposes DMMs fill the same role as that previously
filled by specialists. Specialists were employed by NYSE member firms but were
assigned by the exchange to trade specific stocks. Specialists made a market in their
assigned stocks by standing ready to buy or sell shares at the current bid and ask prices.
In other words, the specialist was required to buy when no one else was buying, and sell
when no one else was selling. This obligation was not onerous when securities were
actively traded. On a normal trading day for IBM, Coca-Cola, and DuPont, millions of
shares are traded. However, smaller companies generally trade far less often. National
Presto, a relatively small company traded on the NYSE, had an average daily trading
volume of 35,000 shares as of January 2018.
Suppose you placed an order to sell 100 shares of National Presto at the market
price. If the broker who executed your order arrives at the National Presto trading post
and no buyer is present, the broker can’t wait around hoping that a buying broker will
appear soon. He has other orders to execute. Instead, the broker could sell the shares to
the designated market maker who was always available and obligated to buy. The
designated market maker would buy the shares for her own inventory. Later, when
another broker showed up at the trading post looking to buy shares in National Presto, the
designated market maker would sell the 100 shares that she purchased from the first
broker earlier in the day.
As you might imagine, standing ready to buy shares when no one else will do so
can be very risky. In a classic case, specialists stabilized the market by absorbing wave
after wave of sell orders when President Reagan was shot in 1981. The specialists
continued to buy even as stock prices continued to fall. So why were specialists willing to
do this? In exchange for helping to maintain orderly markets, the specialist was allowed
to “peek” at all the other unfilled orders, and this gave him a profit opportunity in normal
trading periods.
While the specialist system had endured since the 1800s, technological changes
made the specialist’s job less profitable and more risky. The DMM now fills the
specialist’s position, but the DMM has greater flexibility regarding when he must step in
to stabilize market prices. While the DMM no longer can “peek” at the order flow, he can
earn small profits on many trades because he enjoys some priority in having his trades
filled. The cost advantage enjoyed by ECNs and electronic exchanges has significantly
reduced the floor activity of specialists at the NYSE. As a public company, the NYSE has
not been willing to stand pat while trading systems and capital markets evolve around it.
In addition to acquiring the large ECN Archipelago, the NYSE also merged with the
largest European exchange, Euronext. In December 2012, NYSE Euronext itself agreed
to be acquired by Intercontinental Exchange (ICE), a large electronic commodity trading
exchange. The merger was completed in 2013, and Euronext was spun off to satisfy
regulators in the European Union.
The NASDAQ Stock Market used to be considered an over-the-counter market
even though it had listing requirements for the companies that traded on its market.
However, as of August 1, 2006, the NASDAQ became officially recognized as a national
securities exchange by the SEC. This designation really doesn’t change the way securities
trade on the NASDAQ Stock Market, but it does allow the exchange to charge fees for
data and market information. All trades on the NASDAQ are done electronically but
there is no physical location, and there are no designated market makers as on the NYSE
floor. NASDAQ is the largest exchange in the United States by dollar trading volume,
and it often trades more shares on a daily basis than the NYSE. Like the NYSE, the
NASDAQ Stock Market has gone through a transformation from a not-for-profit
company to a for-profit company.
NASDAQ has always been an electronic stock exchange known for its trading
technology and its listing of many of the world’s largest technology companies such as
Google, Cisco, Microsoft, and Apple. NASDAQ created SuperMontage, an electronic
trading system that integrates the trading process with limit orders, time stamps for
receipt of orders, multiple quotes, and more. The speed with which an exchange can
process an order is extremely important to traders, and both the NYSE and NASDAQ
claim to have the fastest order processing.
NASDAQ stocks are divided between global market issues and small cap issues.
As the name implies, the global market issues represent larger NASDAQ companies that
must meet higher listing standards than the small cap market. The standards are not as
high as those on the NYSE but cover most of the same areas: net tangible assets, net
income, pretax income, public float (shares outstanding in the hands of the public),
operating history, market value of the float, a minimum share price, the number of
shareholders, and the number of market makers. Because the listing requirements are
lower than those on the NYSE, many small public companies choose to begin trading on
the NASDAQ Stock Market, but as they get larger, they often decide to stay there long
after they have exceeded the listing requirements of the NYSE. In particular, technology
companies have shown an inclination to remain listed on NASDAQ, which historically
has adopted technological innovations in trading more rapidly than the more traditional
NYSE.
NASDAQ prides itself on its corporate governance, efficiency, and surveillance
systems that avoid conflicts of interest and market manipulation. With the passage of the
Sarbanes–Oxley Act of 2002, corporate governance issues became more important to all
publicly traded companies, including NASDAQ. It is incumbent on NASDAQ to be a
corporate governance role model for its listed firms and it has set a high standard in that
area.
d. Enumeration of Functions
In most cases, the investment banker is a risk taker. The investment banker will
contract to buy securities from the corporation and resell them to other security dealers
and the public. By giving a “firm commitment” to purchase the securities from the
corporation, the investment banker is said to underwrite any risks that might be
associated with a new issue. While the risk may be fairly low in handling a bond offering
for ExxonMobil or General Electric in a stable market, such may not be the case in
selling the shares of a lesser-known firm in a volatile market environment.
Though most large, well-established investment bankers would not consider
managing a public offering without assuming the risk of distribution, smaller investment
houses may handle distributions for relatively unknown corporations on a “best-efforts,”
or commission, basis. Some issuing companies even choose to sell their own securities
directly. Both the “best-efforts” and “direct” methods account for a relatively small
portion of total offerings.
During distribution and for a limited time afterward, the investment banker may
make a market in a given security—that is, engage in the buying and selling of the
security to ensure a liquid market. The investment banker may also provide research on
the firm to encourage active investor interest.
The investment banker may advise clients on a continuing basis about the types of
securities to be sold, the number of shares or units for distribution, and the timing of the
sale. A company considering a stock issuance to the public may be persuaded, in counsel
with an investment banker, to borrow the funds from an insurance company or, if stock is
to be sold, to wait for two more quarters of earnings before going to the market. The
investment banker also provides important advisory services in the area of mergers and
acquisitions, leveraged buyouts, and corporate restructuring.
Rather than looking at the leadership of individual investment banks, presents a
quarter-by-quarter look at the industry as a whole. Bond offerings generate the most fees
followed by mergers and acquisitions, while equity offerings and syndicated loans are in
third and fourth places. However, when you look at the bottom line of the table that
shows average fee per deal, you can see that equity offerings have the highest fee because
they are also the riskiest. Mergers and acquisitions have the lowest fee per deal because
they have the least risk.
e. Pricing the Security
Because the syndicate members purchase the stock for redistribution in the
marketing channels, they must be careful about the pricing of the stock. When a stock is
sold to the public for the first time (i.e., the firm is going public), the managing
investment banker will do an in-depth analysis of the company to determine its value.
The study will include an analysis of the firm’s industry, financial characteristics, and
anticipated earnings and dividend-paying capability. Based on valuation techniques that
the underwriter deems to be appropriate, a price will be tentatively assigned and will be
compared to that enjoyed by similar firms in a given industry. If the industry’s average
price-earnings ratio is 20, the firm is likely to be priced near this norm. Anticipated
public demand will also be a major factor in pricing a new issue.
The great majority of the issues handled by investment bankers are, however,
additional issues of stocks or bonds for companies already trading publicly. When
additional shares are to be issued, the investment bankers will generally set the price at
slightly below the current market value. This process, known as underpricing, will help
ensure a receptive market for the securities.
At times, an investment banker also will underwrite the sale of large blocks of
stock for existing stockholders, rather than for the company. When holders of these
blocks wish to sell too many shares for normal channels to handle, the investment banker
will manage the sale and underprice the stock below current market prices. This process
is known as a secondary offering. Secondary offerings occur after an IPO, also known as
a primary offering, in which securities are sold to the public for the first time. Secondary
offerings often combine shareholder blocks with additional shares being issued directly
by the company.
A secondary offering can also occur without shareholder blocks being included.
Three of the largest equity offerings ever were secondary offerings that occurred in
December 2009. Several banking giants (Citigroup, Bank of America, and Wells Fargo)
raised over $52 billion in new capital to pay back the U.S. government for bailout
funding received the previous year. These banks wished to avoid restrictions on their
activities that the government had imposed until repayments were made.
Students are often surprised that debt offerings outnumber equity offerings in
number and dollar amounts. Perhaps it is because we are bombarded with daily Dow
Jones updates in the financial press that stock seems to take preference over bonds. In
2017, $6.998 trillion of debt was issued globally, while $872 billion of equity was issued.
There were 22,899 debt offerings and 6,442 equity offerings. It is no surprise that debt
was the more common offering. Interest rates had started to move up and companies were
trying to lock in low-cost debt before rates began their up cycle. Rates moved up in early
2018 and the Fed was expected to raise rates three or four times during the year.
A problem a company faces when issuing additional securities is the actual or
perceived dilution of earnings effect on shares currently outstanding. In the case of the
Maxwell Corporation, the 250,000 new shares may represent a 10 percent increment to
shares currently in existence. Perhaps the firm had earnings of $5 million on 2,500,000
shares before the offering, indicating earnings per share of $2. With 250,000 new shares
to be issued, earnings per share will temporarily slip to $1.82 ($5,000,000 ÷ 2,750,000).
Another problem may set in when the actual public distribution begins—namely,
unanticipated weakness in the stock or bond market. Since the sales group normally has
made a firm commitment to purchase stock at a given price for redistribution, it is
essential that the price of the stock remain relatively strong. Syndicate members,
committed to purchasing the stock at $20 or better, could be in trouble if the sale price
falls to $19 or $18. The managing investment banker is generally responsible for
stabilizing the offering during the distribution period and may accomplish this by
repurchasing securities as the market price moves below the initial public offering price.
The period of market stabilization usually lasts two or three days after the initial
offering, but it may extend up to 30 days for difficult-to-distribute securities. In a very
poor market environment, stabilization may be virtually impossible to achieve. Consider
Facebook’s initial public offering on Friday, May 18, 2012. The initial IPO price was set
at $38 by the lead underwriter, Morgan Stanley. The offering was a big news event, and
many small investors rushed into the stock in the first minutes of trading. The stock was
extremely volatile on the first day of trading, but the stock price never fell below the
offering price because Morgan Stanley was actively buying shares when the price hit $38.
Facebook’s price quotes near the end of the first trading day show the magnitude
of the price support. These are most likely bids by Morgan Stanley attempting to support
the price at that level. To put the size of this support into perspective, it was not unusual
for the bid size to be less than 5,000 shares in later transactions.
On Monday, May 21, the price support was removed and the price fell to $34. By
September, the price had collapsed to a low of $17.55. Investors who understood that the
underwriter was only temporarily supporting the price were probably able to avoid these
early losses. Those investors who held their stock for the long term would have been
amply rewarded as the stock traded at $190 per share in early 2018. Manipulation of
prices in security markets is normally illegal. Market stabilization or underwriter price
support is a rare exception to the general market manipulation prohibition. Temporary
market stabilization is accepted by the Securities and Exchange Commission as necessary
for smoothly functioning new-issue markets.
The investment banker is also interested in how well the underwritten security
behaves after the distribution period because the banker’s ultimate reputation rests on
bringing strong securities to the market. This is particularly true of initial public
offerings. Exhaustive research shows that initial public offerings tend to perform well in
the immediate aftermarket. According to Professor Jay Ritter at the University of Florida,
between 1980 and 2017 there were more than 8,360 initial public offerings in the United
States. The average first-day return for these stocks was 18 percent. In many countries,
the initial aftermarket returns are even higher. In fact, IPOs are underpriced in every
country where stocks are publicly traded.
The Glass–Steagall Act, passed after the great crash of 1929 and bank runs of the
early 1930s, required U.S. banks to separate their commercial banking operations and
investment banking operations into two different entities. Banks like J.P. Morgan were
forced to sell off Morgan Stanley. Congress took this position because they thought the
risk of the securities business impaired bank capital and put the banking system at risk of
default. As global financial markets grew, it became clear that U.S. commercial and
investment banks were at a competitive disadvantage against large European and
Japanese banks, who were not hobbled by these restrictions. Foreign banks were
universal banks and could offer traditional banking services as well as insurance,
securities brokerage, and investment banking.
f. Public Offerings
A classic example of an IPO is that of Rosetta Stone Inc., which went public on
April 16, 2009. The company offers self-study language software for over 30 languages.
Prior to the offering, the company filed a registration statement with the SEC that
included a prospectus that was distributed to potential investors. Every public offering
must be preceded by a prospectus that offers details about the company and the offering.
Morgan Stanley was the lead underwriter with William Blair & Company listed as
a co-lead. The other members of the syndicate are listed below these underwriters. On the
whole, the features are all very standard for primary offerings. The day of the offering,
Rosetta Stone’s shares began trading on the NYSE at $23 and closed at $25.12, for a
first-day gain of more than 39 percent ($25 − $18)/$18. This is a good example of the
first-day underpricing that frequently accompanies IPOs. Over the next several months,
the price of Rosetta Stone continued to climb, and the stock traded for almost $31 per
share on August 10, 2009. After the stock market closed on that day, Rosetta Stone
announced that it had filed another registration statement with the SEC for a secondary
offering of its common stock. Most of the stock to be sold in the secondary offering
would come from two shareholders who owned large stakes prior to the IPO, not from
new stock issued by the company. Because very little of the stock would be newly issued,
dilution would not be a problem. Nevertheless, the financial markets interpreted this news
negatively. If two large insiders believed the stock should be sold at this price, then
perhaps the market price was too high.
This narrative offers several general observations about IPOs and secondary
offerings. IPOs are typically underpriced and have high first-day returns. Consistent with
Rosetta Stone’s original plan, secondary offerings frequently occur after a stock has risen
significantly in value. Often the stockholders sell because they want to diversify their
portfolio, but the market generally interprets secondary offerings as a sign that company
managers or insiders view the stock as overvalued, and the share price declines when the
offering is announced. However, Rosetta Stone’s decline was larger than most.
g. The Debt Contract
This is the initial value of the bond. The par value is sometimes referred to as the
principal or face value. Most corporate bonds are initially traded in $1,000 units. This is
the actual interest rate on the bond, usually payable in semiannual installments. To the
extent that interest rates in the market go above or below the coupon rate after the bond
has been issued, the market price of the bond will change from the par value.
The bond agreement is supplemented by a much longer document termed a bond
indenture. The indenture, often containing over 100 pages of complicated legal wording,
covers every detail surrounding the bond issue—including collateral pledged, methods of
repayment, restrictions on the corporation, and procedures for initiating claims against
the corporation. The corporation appoints a financially independent trustee to administer
the provisions of the bond indenture under the guidelines of the Trust Indenture Act of
1939. Let’s examine two items of interest in any bond agreement: the security provisions
of the bond and the methods of repayment.
A secured debt is one in which specific assets are pledged to bondholders in the
event of default. Only infrequently are pledged assets actually sold and the proceeds
distributed to bondholders. Typically the defaulting corporation is reorganized and
existing claims are partially satisfied by issuing new securities to the participating parties.
The stronger and better secured the initial claim, the higher the quality of the new
security to be received in exchange. When a defaulting corporation is reorganized for
failure to meet obligations, existing management may be terminated and, in extreme
cases, held legally responsible for any imprudent actions.
A number of terms are used to denote collateralized or secured debt. Under a
mortgage agreement, real property (plant and equipment) is pledged as security for the
loan. A mortgage may be senior or junior in nature, with senior requiring satisfaction of
claims before payment is given to junior debt. Bondholders may also attach an after-
acquired property clause, requiring that any new property be placed under the original
mortgage. You should realize not all secured debt will carry every protective feature, but
rather represents a carefully negotiated position including some safeguards and rejecting
others. Generally, the greater the protection offered a given class of bondholders, the
lower is the interest rate on the bond. Bondholders are willing to assume some degree of
risk to receive a higher yield.
A number of corporations issue debt that is not secured by a specific claim to
assets. In Wall Street jargon, the name debenture refers to a long-term, unsecured
corporate bond. Among the major participants in debenture offerings are such prestigious
firms as ExxonMobil, IBM, Dow Chemical, and Intel. Because of the legal problems
associated with “specific” asset claims in a secured bond offering, the trend is to issue
unsecured debt—allowing the bondholder a general claim against the corporation—rather
than a specific lien against an asset.
Even unsecured debt may be divided between high-ranking and subordinated
debt. A subordinated debenture is an unsecured bond in which payment to the holder will
occur only after designated senior debenture holders are satisfied. The hierarchy of
creditor obligations for secured as well as unsecured debt, along with consideration of the
position of stockholders. A classic case of the ranking of bondholders (debtholders) and
stockholders took place on June 1, 2009, when General Motors went into bankruptcy.
The government provided over $50 billion in funds to GM to help it survive and
ultimately come out of bankruptcy as a stronger company. The U.S. government owned
60 percent of the common stock of General Motors in early 2010 and was able to sell a
$13.6 billion stake when GM came to the market with an IPO in November 2010. By
December 2013, the U.S government had sold all of its shares in GM.
The method of repayment for bond issues may not always call for one lump-sum
disbursement at the maturity date. Some Canadian and British government bonds are
perpetual in nature. In 1951, West Shore Railroad Company issued bonds that were
scheduled to mature in 2361 (410 years later). More recently, the Coca-Cola Company
and the Walt Disney Company have issued “century” bonds that mature in 100 years.
Nevertheless most bonds have some orderly or preplanned system of repayment. In
addition to the simplest arrangement—a single-sum payment at maturity—bonds may be
retired by serial payments, through sinking-fund provisions, through conversion, or by a
call feature.
Bonds with serial payment provisions are paid off in installments over the life of
the issue. Each bond has its own predetermined date of maturity and receives interest
only to that point. Although the total issue may span over 20 years, 15 or 20 different
maturity dates may be assigned specific dollar amounts. A less structured but more
popular method of debt retirement is through the use of a sinking fund. Under this
arrangement semiannual or annual contributions are made by the corporation into a fund
administered by a trustee for purposes of debt retirement. The trustee takes the proceeds
and purchases bonds from willing sellers. If no willing sellers are available, a lottery
system may be used among outstanding bondholders.
A call provision allows the corporation to retire or force in the debt issue before
maturity. The corporation will pay a premium over par value of 5 to 10 percent—a
bargain value to the corporation if bond prices are up. Modern call provisions usually do
not take effect until the bond has been outstanding at least 5 to 10 years. Often the call
provision declines over time, usually by 0.5 to 1 percent per year after the call period
begins. A corporation may decide to call in outstanding debt issues when interest rates on
new securities are considerably lower than those on previously issued debt (let’s get the
high-cost, old debt off the books).
h. Bond Prices, Yields, and Ratings
The financial manager must be sensitive to interest rate changes and price
movements in the bond market. For example, the treasurer’s interpretation of market
conditions will influence the timing of new issues, the coupon rate offered, and the
maturity date. In case you may think bonds maintain stable long-term price patterns, you
need merely consider bond pricing during the five-year period 1967–72. When the
market interest rate on outstanding 30-year, Aaa corporate bonds went from 5.10 percent
to 8.10 percent, the average price of existing bonds dropped 36 percent. A conservative
investor would be quite disillusioned to see a $1,000, 5.10 percent bond now quoted at
$640.1 Though most bonds are virtually certain to be redeemed at their face value at
maturity ($1,000 in this case), this is small consolation to the bondholder who has many
decades to wait. At times, bonds also greatly increase in value, such as they did in 1984–
85, 1990–92, 1994–95, 2007–08, and 2011–12 when interest rates declined. As indicated
in the paragraph above, the price of a bond is directly tied to current interest rates. One
exception to this rule was discussed at the beginning ; that is, when bankruptcy becomes
a key factor in pricing and valuation. We will look at the more normal case where interest
rates are the key factor in determining price.
A bond paying 5.10 percent ($51 a year) will fare quite poorly when the going
market rate is 8.10 percent ($81 a year). To maintain a market in the older issue, the price
is adjusted downward to reflect current market demands. The longer the life of the issue,
the greater the influence of interest rate changes on the price of the bond. The same
process will work in reverse if interest rates go down. A 30-year, $1,000 bond initially
issued to yield 8.10 percent would go up to almost $1,500 if interest rates declined to
5.10 percent (assuming the bond is not callable). A further illustration of interest rate
effects on bond prices is presented for a bond paying 12 percent interest. Observe that not
only interest rates in the market but also years to maturity have a strong influence on
bond prices.
From 1945 through the early 1980s, the pattern had been for long-term interest
rates to move upward. However, long-term interest rates have generally been declining
since 1982. The figure shows both Moody’s Aaa bond yields for the highest quality
corporate bonds and Moody’s Baa bonds, which are three notches lower than the highest
investment-grade bonds. The graph does illustrate the pattern of rates over time but also
that the highest-quality bonds always have a lower interest rate than lower quality bonds.
See the bond rating section for more details on bond quality.
The yield to maturity is the interest rate that will equate future interest payments
and the payment at maturity (principal payment) to the current market price. This
represents the concept of the internal rate of return. In the present case, an interest rate of
11.75 percent will equate interest payments of $100 for 10 years and a final payment of
$1,000 to the current price of $900.
Both the issuing corporation and the investor are concerned about the rating their
bond is assigned by the two major bond rating agencies—Moody’s Investor Service and
Standard & Poor’s Corporation. The higher the rating assigned a given issue, the lower
the required interest payments are to satisfy potential investors. This is because highly
rated bonds carry lower risk. A major industrial corporation may be able to issue a 30-
year bond at 5.5 to 6 percent yield to maturity because it is rated Aaa, whereas a smaller,
regional firm may only qualify for a B rating and be forced to pay 9 or 10 percent.
The first two categories of bond ratings represent the highest quality (for example,
IBM and Procter & Gamble); the next two, medium to high quality; and so on. The first
four categories are considered investment grade, while bonds below that are labeled
“junk bonds.” Moody’s also applies numerical modifiers to categories Aa through B: 1 is
the highest in a category, 2 is the midrange, and 3 is the lowest. Thus, a rating of Aa2
means the bond is in the midrange of Aa. Standard & Poor’s has a similar letter system
with + and − modifiers. Bonds receive ratings based on the corporation’s ability to make
interest payments, its consistency of performance, its size, its debt-equity ratio, its
working capital position, and a number of other factors. The yield spread between higher-
and lower-rated corporate bonds changes with the economy. If investors are pessimistic
about economic events, they will accept as much as 3 percent less return to go into
securities of very high quality, whereas in more normal times the spread may be only 1.5
percent.
Three actual bond issues are presented to illustrate the various terms we have
used. The data in this table reflect market conditions in February 2018. Recall that the
true return on a bond is measured by yield to maturity, which is shown in the last column
of the table. Microsoft Corp. bonds have the lowest expected return for the three bonds
shown. This is primarily due to the fact that Microsoft has the highest credit of AAA,
which denotes an extremely strong financial condition.
The Microsoft bond has a maturity date in 2035 and a coupon rate of 3.5 percent.
The bond was issued in 2015 (not shown) and the coupon rate can be assumed to reflect
the prevailing interest rate environment at that time. However, a 3.5 percent yield does
not meet yield requirements for February 2018. Thus, the bond is valued at less than its
$1,000 par ($994.79). The bond’s yield to maturity is slightly higher than the coupon rate,
because the current bond price is slightly lower than the par value. Apple’s bond has an
S&P rating of AA+, which is still a very high investment-grade rating. The Apple bond’s
slightly higher yield to maturity reflects the slightly lower credit rating, and it probably
also reflects the nine-years-later maturity date of the bond.
i. The Refunding Decision
The refunding decision involves outflows in the form of financing costs related to
redeeming and reissuing securities, and inflows represented by savings in annual interest
costs and tax savings. In the present case, we shall assume the corporation issued $10
million worth of 11.75 percent debt with a 25-year maturity and the debt has been on the
books for 5 years. The corporation now has the opportunity to buy back the old debt at 10
percent above par (the call premium) and to issue new debt at 9.5 percent interest with a
20-year life. The underwriting cost for the old issue was $125,000, and the underwriting
cost for the new issue is $200,000. We shall also assume the corporation is in the 35
percent tax bracket and uses a 6 percent discount rate for refunding decisions. Since the
savings from a refunding decision are certain—unlike the savings from most other capital
budgeting decisions —we use the aftertax cost of new debt as the discount rate, rather
than the more generalized cost of capital.3 Actually, in this case, the aftertax cost of new
debt is 9.5 percent (1 − Tax rate), or 9.5% × 0.65 = 6.18%. We round to 6 percent.
Note, however, that this is not a total gain. We would have gotten the $100,000
additional write-off eventually if we had not called in the old bonds. By calling them in
now, we simply take the write-off sooner. If we extended the write-off over the remaining
life of the bonds, we would have taken $5,000 a year for 20 years. Discounting the 20-
year annuity at 6 percent, we get an approximate present value of $57,350, as shown in
the margin.
Thus, we are getting a write-off of $100,000 now, rather than a present value of
future write-offs of $57,350. The gain in immediate tax write-offs is $42,650. The tax
savings from a noncash tax write-off equal the amount times the tax rate. Since we are in
the 35 percent tax bracket, our savings from this write-off are $14,928. The following
calculations, which were discussed earlier, are necessary to arrive at $14,928.
The refunding decision has a positive net present value, suggesting that interest
rates have dropped to a sufficiently low level to indicate refunding is in order. The only
question is: Will interest rates go lower—indicating an even better time for refunding?
There is no easy answer. Conditions in the financial markets must be carefully
considered. A number of other factors could be plugged into the problem. For example,
there could be overlapping time periods in the refunding procedure when both issues are
outstanding and the firm is paying double interest (hopefully for less than a month). The
dollar amount in these cases, however, tends to be small and is not included in the
analysis.
j. Other Forms of Bond Financing
As interest rates continued to show increasing volatility in the 1980s and early
1990s, two innovative forms of bond financing became very popular and remain so
today. We shall examine the zero-coupon rate bond and the floating rate bond. The zero-
coupon rate bond, or zero-coupon bond, as the name implies, does not pay interest. It is,
however, sold at a deep discount from face value. The return to the investor is the
difference between the investor’s cost and the face value received at the end of the life of
the bond. From an investor’s point of view, an advantage of the zero coupon bond is that
there are no coupons to reinvest and the yield to maturity on the bond is locked in for the
life of the bond. A dramatic case of a zero-coupon bond was an issue offered by PepsiCo
Inc. in 1982, in which the maturities ranged from 6 to 30 years. The 30-year $1,000 par
value issue could be purchased for $26.43, providing a yield of approximately 12.75
percent. The purchase price per bond of $26.43 represented only 2.643 percent of the par
value. A million dollars worth of these 30-year bonds could be initially purchased for a
mere $26,430.
The advantage to the corporation is that there is immediate cash inflow to the
firm, without any outflow until the bonds mature. Furthermore, the difference between
the initial bond price and the maturity value may be amortized for tax purposes by the
corporation over the life of the bond. This means the corporation will be taking annual
deductions without current cash outflow. From the investor’s viewpoint, the zero-coupon
bonds allow him or her to lock in a multiplier of the initial investment. For example,
investors may know they will get three times their investment after a specified number of
years. The major drawback is that the annual increase in the value of bonds is taxable as
ordinary income as it accrues, even though the bondholder does not get any cash flow
until maturity. For this reason most investors in zero-coupon rate bonds have tax-exempt
or tax-deferred status (pension funds, foundations, charitable organizations, individual
retirement accounts, and the like).
The prices of the bonds tend to be highly volatile because of changes in interest
rates. Even though the bonds provide no annual interest payment, there is still an initial
yield to maturity that may prove to be too high or too low with changes in the
marketplace. The bonds listed are examples of zero-coupon bonds. The bonds sell at a
considerable discount from par value of $1,000 since they all have some time remaining
until maturity.
Another interesting type of bond issue is the floating rate bond (long popular in
European capital markets). In this case, instead of a change in the price of the bond, the
interest rate paid on the bond changes with market conditions (usually monthly or
quarterly). Thus, a bond that was initially issued to pay 9 percent may lower the interest
payments to 6 percent during some years and raise them to 12 percent in others. The
interest rate is usually tied to some overall market rate, such as the yield on Treasury
bonds (perhaps 120 percent of the going yield on long-term Treasury bonds).
The price of a floating rate bond stays close to the $1,000 par value since the
coupon adjusts with changes in market rates. The advantage to investors in floating rate
bonds is that they have a constant (or almost constant) market value for the security, even
though interest rates vary. An exception is that floating rate bonds often have broad limits
that interest payments cannot exceed. For example, the interest rate on a 6 percent initial
offering may not be allowed to go over 10 percent or below 3 percent. If long-term
interest rates dictated an interest payment of 12 percent, the payment would still remain
at 10 percent. This could cause some short-term loss in market value. To date, floating
rate bonds have been relatively free of this problem. From an investor’s point of view, the
best time to own floating rate bonds is when interest rates are expected to rise. Zero-
coupon rate bonds and floating rate bonds represent a relatively small percentage of the
total market of new debt offerings. Nevertheless, they should be part of a basic
understanding of long-term debt instruments.
k. Leasing as a Form of Debt
When a corporation contracts to lease an oil tanker or a computer and signs a non-
cancelable, long-term agreement, the transaction has similar characteristics to the
purchase of an asset on credit. In other words, entering into a lease creates both an asset
and a liability that should be recognized on a company’s balance sheet. There are two
parties to a lease, the lessee and the lessor. The lessee is the party that uses the asset, and
the lessor is the party that provides the asset to the lessee. In this section, we will consider
leases from the perspective of the lessee, the user of the property.
For the lessee, the lease agreement creates an asset and a liability on the balance
sheet. The commitment to making lease payments is recorded on the books as a liability,
and the oil tanker or computer is presented on the balance sheet as an asset. Long-term
leasing has not always been recognized as a debt obligation on the balance sheet, but
since the mid-1960s there has been a strong movement by the accounting profession to
force companies to fully divulge all information about leasing obligations and to indicate
the equivalent debt characteristics. This view has been bolstered by the release of
Accounting Standards Update 2016-02, which requires that all leases, with the exception
of short-term leases (less than 12 months), be included as an asset and a liability on the
balance sheet.
Before ASU 2016-02, certain types of leases were not required to be presented on
the balance sheet, giving the lessee an opportunity to engage in a practice known as “off-
balance-sheet financing.” In effect, operating leases allowed companies to conceal
liabilities that arose from these leases, and some leases were structured in a way that
ensured that the lessee would not need to record a liability.
We see that a right-of-use asset and a corresponding lease liability have been
recognized on the balance sheet. A right-of-use asset and lease liability will be
recognized for all leases of more than 12 months. Short-term leases of less than 12
months can be written off as a lease expense without impacting the balance sheet.
Comparing the balance sheet before the lease to the balance sheet after the signing of the
lease shows the effect that leasing has on certain financial ratios. Note that the addition of
the right-of-use asset and corresponding lease liability has caused the total-debt-to-assets
ratio to increase from 50 percent to 66.7 percent. It is important to realize how
recognizing leases on the balance sheet impacts key financial ratios of a corporation.
Both operating and finance leases call for presenting a right-of-use asset on the
balance sheet. The asset’s initial value is equal to the present value of the lease payments.
A lease liability equal to the right-of-use asset value is also initially recorded. However,
the two lease types differ in their income statement treatments. Operating leases require
the lessee to record a series of identical lease expense deductions during each year of the
lease. For example, if a lease calls for $100,000 in total over five years, the lease expense
is $20,000 per year. This is true even when the actual lease payments vary from year to
year.
In summary, a finance lease involves two expense classifications, interest and
amortization, while an operating lease recognizes a single lease expense. Before closing
this section, we should note that tax rules for recording leases are different from those
established for financial reporting under ASU 2016-02. For tax purposes, lease payments
for most operating leases will be expensed in the year they are paid.
There are also some tax factors to be considered. Where one party to a lease is in
a higher tax bracket than the other party, certain tax advantages, such as depreciation
write-off or research-related tax credits, may be better utilized. For example, a wealthy
party may purchase an asset for tax purposes, then lease the asset to another party in a
lower tax bracket for actual use. Leasing land also has tax advantages. Lease payments on
the use of land are tax-deductible, whereas land ownership does not allow a similar
deduction for depreciation.
Finally, firms occasionally engage in a sale-leaseback arrangement, in which
assets owned by the lessee are sold to the lessor and then immediately leased back. This
process provides the lessee with an infusion of capital, while allowing the lessee to
continue to use the asset. Even though the dollar costs of a leasing arrangement are often
higher than the dollar costs of owning an asset, the advantages cited in this section may
outweigh the direct cost factors.
