Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 14

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 C H A P T E R F O U R T E E N AN OVERVIEW OF C O R P O R A T E F I N A N C I N G 376 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 WE NOW BEGIN our analysis of long-term financing decisions—an undertaking we will not complete until Chapter 26. This chapter provides an introduction to corporate financing. It reviews with a broad brush several topics that will be explored more carefully later on. We start the chapter by looking at aggregate data on the sources of financing for U.S. corpora-tions. Much of the money for new investments comes from profits that companies retain and rein-vest. The remainder comes from selling new debt or equity securities. These financing patterns raise several interesting questions. Do companies rely too heavily on internal financing rather than on new issues of debt or equity? Are debt ratios of U.S. corporations dangerously high? How do patterns of financing differ across the major industrialized countries? Our second task in the chapter is to review some of the essential features of debt and equity. Lenders and stockholders have different cash flow rightsand also different control rights.The lenders have first claim on cash flow, because they are promised definite cash payments for interest and prin-cipal. The stockholder receives whatever cash is left over after the lenders are paid. Stockholders, on the other hand, have complete control of the firm, providing that they keep their promises to lenders. As owners of the business, stockholders have the ultimate control over what assets the company buys, how the assets are financed, and how they are used. Of course, in large public corporations the stockholders delegate these decisions to the board of directors, who in turn appoint senior man-agement. In these cases effective control often ends up with the company’s management. The simple division of sources of cash into debt and equity glosses over the many different types of debt that companies issue. Therefore, we close our discussion of debt and equity with a brief can-ter through the main categories of debt. We also pause to describe certain less common forms of eq-uity, particularly preferred stock. Financial institutions play an important role in supplying finance to companies. For example, banks provide short- and medium-term debt, help to arrange new public issues of securities, buy and sell foreign currencies, and so on. We introduce you to the major financial institutions and look at the roles that they play in corporate financing and in the economy at large. 14.1 PATTERNS OF CORPORATE FINANCING Companies invest in long-term assets (mainly property, plant, and equipment) and net working capital. Table 14.1 shows where they get the cash to pay for these in-vestments. You can see that by far the greater part of the money is generated inter- nally. In other words, it comes from cash that the company has set aside as depre-ciation and from retained earnings (earnings not paid out as dividends).1 Shareholders are happy for companies to plow back this money into the firm, so long as it goes to positive-NPV investments. Every positive-NPV investment gen-erates a higher price for their shares. In most years there is a gap between the cash that companies need and the cash that they generate internally. This gap is the financial deficit. To make up the deficit, companies must either sell new equity or borrow. So companies face two basic financing decisions: How much profit should be plowed back into the 1In Table 14.1, internally generated cash was calculated by adding depreciation to retained earnings. Depreciation is a noncash expense. Thus, retained earnings understate the cash flow available for reinvestment. 377 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 378 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER 14 An Overview of Corporate Financing 379 business rather than paid out as dividends? and What proportion of the deficit should be financed by borrowing rather than by an issue of equity? To answer the first question the firm requires a dividend policy (we discuss this in Chap-ter 16); and to answer the second it needs a debt policy (this is the topic of Chap-ters 17 and 18). Notice that net stock issues were negative in most years. That means that the amount of new money raised by companies issuing equity was more than offset by the amount of money returned to shareholders by repurchase of previously outstanding shares. (Companies can buy back their own shares, or they may re-purchase and retire other companies’ shares in the course of mergers and acqui-sitions.) We discuss share repurchases in Chapter 16 and mergers and acquisi-tions in Chapter 33. Net stock issues were positive in the early 1990s. Companies had entered the decade with uncomfortably high debt levels, so they paid down debt in 1991 and replenished equity in 1991, 1992, and 1993. But net stock issues turned negative in 1994 and stayed negative for the rest of the decade. Aggregate debt issues in-creased to cover both the financial deficit and the net retirements of equity. Companies in the United States are not alone in their heavy reliance on internal funds. Internal funds make up more than two-thirds of corporate financing in Ger-many, Japan, and the United Kingdom.2 Do Firms Rely Too Much on Internal Funds? We have seen that on average internal funds (retained earnings plus depreciation) cover most of the cash firms need for investment. It seems that internal financing is more convenient than external financing by stock and debt issues. But some ob-servers worry that managers have an irrational or self-serving aversion to external finance. A manager seeking comfortable employment could be tempted to forego a risky but positive-NPV project if it involved launching a new stock issue and fac-ing awkward questions from potential investors. Perhaps managers take the line of least resistance and dodge the “discipline of capital markets.” But there are also some good reasons for relying on internally generated funds. The cost of issuing new securities is avoided, for example. Moreover, the an- nouncement of a new equity issue is usually bad news for investors, who worry that the decision signals lower future profits or higher risk.3 If issues of shares are costly and send a bad-news signal to investors, companies may be justified in look-ing more carefully at those projects that would require a new stock issue. Has Capital Structure Changed? We commented that in recent years firms have, in the aggregate, issued much more debt than equity. But is there a long-run trend to heavier reliance on debt finance? This is a hard question to answer in general, because financing policy varies so 2See, for example, J. Corbett and T. Jenkinson, “How Is Investment Financed? A Study of Germany, Japan, the United Kingdom and the United States,” The Manchester School 65 (Supplement 1997), pp. 69–93. 3Managers do have insiders’ insights and naturally are tempted to issue stock when the price looks good to them, that is, when they are less optimistic than outside investors. The outside investors real-ize this and will buy a new issue only at a discount from the pre-announcement price. More on stock issues in Chapter 15. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 380 PART IV Financing Decisions and Market Efficiency Current assets† Fixed assets Less depreciation Net fixed assets Other long-term assets Total assets§ $1,547 Current liabilities† $1,234 $2,361 Long-term debt $1,038 1,166 Other long-term liabilities‡ 679 1,195 Total long-term liabilities 1,717 Stockholders’ equity 1,951 2,160 $4,903 Total liabilities and stockholders’ equity§ $4,903 TABLE 14.2 Aggregate balance sheet for manufacturing corporations in the United States, 1st quarter, 2001 (figures in $ billions)*. *Excludes companies with less than $250,000 in assets. †See Table 30.1 for a breakdown of current assets and liabilities. ‡Includes deferred taxes and several miscellaneous categories. §Columns may not add up because of rounding. Source: U.S. Census Bureau, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, 1st Quarter, 2001 (www.census.gov/csd/qfr). much from industry to industry and from firm to firm. But a few statistics will do no harm as long as you keep these difficulties in mind. Table 14.2 shows the aggregate balance sheet of all manufacturing corporations in the United States in 2001. If all manufacturing corporations were merged into one gigantic firm, Table 14.2 would be its balance sheet. Assets and liabilities in Table 14.2 are entered at book, that is, accounting values. These do not generally equal market values. The numbers are nevertheless in-structive. The table shows that manufacturing corporations had total book assets of $4,903 billion. On the right-hand side of the balance sheet, we find total long-term liabilities of $1,717 billion and stockholders’ equity of $1,951 billion. So what was the book debt ratio of manufacturing corporations in 2001? It de-pends on what you mean by debt. If all liabilities are counted as debt, the debt ra-tio is .60: Debt 1,234 1,717 Total assets 4,903 This measure of debt includes both current liabilities and long-term obligations. Sometimes financial analysts focus on the proportions of debt and equity in long-term financing. The proportion of debt in long-term financing is Long-term liabilities 1,717 Long-term liabilities stockholders’ equity 1,717 1,951 The sum of long-term liabilities and stockholders’ equity is called total capitaliza-tion. Figure 14.1 plots these two ratios from 1954 to 2001. There is a clear upward trend. But before we conclude that industry is becoming weighed down by a crip-pling debt burden, we need to put these changes in perspective. ... - tailieumienphi.vn