2.

Whats What in Corporate Finance

2.1. Equity Equity is that portion of a firm's total value to which the owners (shareholders) have claim. In a small, privately held firm, the equity is simply the value of the firm left to the owner at any point in time after he/she pays off all of the firm's debts and other liabilities. In a large, publicly held firm, the equity claim belongs to the shareholders, those investors who hold common stock in the firm. Common Stock Common stock is the claim which entitles the holder to that portion of the firm's value remaining after all liabilities have been satisfied. If a company has 1 million shares outstanding then each share entitles its owner to 1/1,000,000 of the total equity of the company. Common stock is a residual claim. If the firm defaults on its liabilities, the common stock holders are entitled to a payment only after all other claimants have been paid in full. While this appears to be a fairly weak position, the rights of shareholders as owners of the firm extend beyond their entitlement to payment. The shareholders decide who will manage the assets of the firm, and can impact the way in which those assets are managed, thus affecting the values of all claims to the firm's cashflows and assets. One will regularly hear two (or sometimes three) alternative "values" for a given company's common equity: (1) Book Value or (2) Market Value (or sometimes even (3) Replacement Value, which is fairly self explanatory). (1) Book Value: When a firm issues common shares, it must state a par value for those shares. The par value is a nominal amount whose importance and purpose varies depending upon the laws in effect in the country (or state) of incorporation. In general, the par value refers to an accounting value which may have no connection whatsoever with the actual value of the common shares being issued. (For example, most U.S. companies have a common share par value of $1 to $2, even though many of these shares may trade in the market at values in excess of $50 or $100.) The difference between the par value, and the price received when the shares are actually issued (sold to the marketplace) is called the capital surplus. The last component of the book value of common equity is the cumulated retained earnings, which is simply that amount of income retained each year (rather than being paid out as dividends) cumulated since the company's incorporation. These three accounting measures sum to the book value of common equity . Example: At incorporation in 1983, Marvelous Maple Syrup, Corp., of Montral authorized the issuance of 1 million shares1, and assigned a par value of Cdn $1 per share. It then chose to issue 800,000 of the authorized shares. Thus, the firm has a par value of common equity of (Cdn $1)(800,000) = Cdn $800,000. Upon issuance, these shares fetched a price of Cdn $10. As a result, Marvelous has a capital surplus of ($10 - $1)(800,000) = Cdn $7,200,000.
Upon incorporation, a firm's charter states the number of common shares the firm isauthorized to issue (to current or future shareholders). This number need not actually be issued, however, if the firm wishes to go beyond this number,a shareholder vote is required to change the company charter. Professor Kevin Kaiser | Turbo Lecture Notes | November 12, 1996 Page 10
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Finally, since incorporation the firm has cumulated retained earnings of Cdn $2,000,000. Thus, Marvelous Maple Syrup has a book common equity value of $800,000 + $7,200,000 + $2,000,000 = Cdn $10,000,000. (2) Market Value: Many firms' shares are traded on public markets. These include over-thecounter markets (where the shares are not listed on any particular exchange, but you can purchase them from anyone who owns some (in most cases, the bank which was involved in the original issue will "make a market" in the shares by being willing to buy or sell to meet market demand), or listed exchanges. Provided a firm's common shares are traded, we can easily observe the prices at which recent trades have taken place. This will tell us what the "market" thinks the shares are worth. Multiplying the number of outstanding (authorized and issued) shares by the most recent observed price will tell us the market value of the firm's common equity. Example: Marvelous Maple Syrup's shares are traded over-the-counter in Qubec and Ontario, and have been quoted most recently at Cdn $17.50 per share. With 800,000 shares outstanding, this implies a market value for Marvelous' common equity of (Cdn $17.50)(800,000) = Cdn $14,000,000. Voting Rights Common stock is normally sold with voting rights2 which enable the shareholder holding the shares to vote for members of the board of directors (who are responsible for choosing the management and authorizing various decisions related to the business). As there are several members sitting on the board of directors, the shareholders must use their votes to choose among the available candidates that number needed to fill the board. While the number of members on the board of directors varies from firm to firm, for the purpose of discussion, let us suppose that the firm we are considering has 8 members on the board. There are two main methods of voting permitted, (1) Straight Voting and (2) Cumulative Voting. If a company's charter permits straight voting only, it means that a shareholder who holds, say, 10 shares, will have 10 votes to cast for each member of the board to be elected. On the other hand, if a company's charter permits cumulative voting, then the same shareholder, who holds 10 shares, will be able to cumulate his/her votes among the number of members to be elected, and then use them in anyway across those to be elected that he/she chooses. Example: Marvelous Maple Syrup is holding its annual meeting tomorrow and will be electing 10 members to its board of directors. There are currently 800,000 shares outstanding and we will assume that all of the shareholders will be voting. It is worth asking: How many shares do I need to own to be certain that I can elect at least one director? Straight Voting If only straight voting is permitted, then there will be a total of 800,000 votes to be cast for each member of the board to be elected. In this case, I need to be able to cast at least 400,001 votes for the director I want. But to be able to cast 400,001 votes, I must hold

Most exchanges permit multiple classes of stock where the distinguishing feature between classes is the voting rights assigned to shares in that class. For example, it is not uncommon for a firm to issue two classes of stock, with one class , referred to as Class A, carrying one vote per share, and the second class, referred to as Class B, carrying 10 votes per share (or perhaps no votes per share). Professor Kevin Kaiser | Turbo Lecture Notes | November 12, 1996 Page 11

400,001 shares. Cumulative Voting With cumulative voting, there are 10 members to be elected. With 800,000 shares outstanding, this means there are (10)(800,000) = 8,000,000 votes to be voted. In order to be certain to elect a director to one of the 10 spots, you must be certain that you have enough votes so that your candidate receives more votes than the 11th place candidate. (i.e., the candidate with the most votes will receive a spot on the board, as will the candidate with the second most votes, etc. until the 10th spot is filled, and remaining candidates will not be elected to the board.) Let x be the number of shares you must hold, corresponding to 10x votes. Given 8,000,000 votes to go around, you need to ensure that the remaining votes are not sufficient to elect 10 directors without your votes. Thus, you require your number of votes, 10x, to be larger than the number remaining, (8,000,000 - 10x), if split among 10 candidates3: 10x > (8,000,000 - 10x)/10. Solving for x we see that you require x > 72,727.27, which tells us that holding 72,728 shares would enable you to be certain of electing at least one director. Note that cumulative voting makes it much easier for small shareholders (or groups of small shareholders) to have an impact on the election of the board of directors. In this example, under straight voting, any given shareholder (or group of shareholders voting as a block) require 400,001 shares to be sure of electing a member of the board, whereas under cumulative voting this shareholder (or group) would only require 72,728 shares to be sure of electing a member of the board. Preferred Stock is legally an equity security, but it resembles debt in many respects. Like debt, preferred stock comes with a promised stream of "dividends" to the holder. However, like equity, preferred stock does not have a fixed maturity, thought the issuer often retains the right to repay (call) the preferred stock at a pre-specified price after some initial period (as with callable debt, see below). Preferred stock is senior to common stock in the event of default, and often stipulates that no cash be distributed to common stock until the promised dividends to preferred stock holders have been paid in full. Dividends paid on preferred stock are treated as normal income to the investor (except for corporations who pay tax on only 30 percent of dividend income received), but is not an allowable deduction from corporate income as are interest payments on debt. Preferred stock does not have the voting power that common stock has, though it often has some voting power, making it more similar to common stock than debt in this regard.

2.2. Debt We all understand what debt is. Debt is an obligation to pay a specified stream of payments to

For a simpler example, suppose there are 1000 vote available, and you have 80 votes. Then the remaining votes are 920. s If these votes are split evenly among 10 candidates (not of your choosing), then each candidate would receive 92 votes, while the most you could offer to your candidate would be 80. Thus, your candidate would not be elected. Professor Kevin Kaiser | Turbo Lecture Notes | November 12, 1996 Page 12

the holder over some period of time. Unfunded (short-term) debt is debt due within one year. Funded (long-term) debt is debt repayable over a period longer than one year. Callable debt is debt which the issuer has the right to repay at any time (usually after a pre-specified grace period) at a pre-specified price. Seniority. Firms often have many issues of debt outstanding at varying levels of seniority. The more senior debt must be paid before any junior lenders receive anything. Subordinated debt is junior debt. Some senior debt is secured, meaning that the debt holder has a claim on a specific piece of the borrower's property in the event of default. This security can be either fixed or floating, where a fixed security is normally land, buildings, equipment, or similar fixed assets, and a floating security might be accounts receivable, or other such non-fixed assets. Default Risk. All debt is subject to the possibility of default. Clearly, senior, secured debt is least at risk, but it is still not risk-free. There are various ratings agencies around the globe, but the most important ones (for companies and governments regardless of their domicile) are the large U.S. ratings agencies, Standard & Poors, and Moody's (with Duff & Phelps holding a distant third place). Debt is considered investment grade if it is rated BBB (by Standard & Poor's rating service) or Baa (by Moody's rating service) or higher. Bonds rated below these ratings are termed junk bonds. Debt Placement. Debt can be placed as either public, issued to anyone who wishes to buy, or private, issued to a small number of qualified investors (banks or similar lending institutions such as insurance companies or pension funds). Coupon Rates. Most public debt is issued with a fixed coupon rate, that percentage of the principal that will be paid as interest each year. However some public debt, and most private debt is issued with the payments being determined by a floating rate, which varies over time (usually depending upon the LIBOR, or the prime rate, that rate charged to only the most creditworthy customers). 2.3. Derivative Securities: Options, Futures & Forwards Many corporate securities are options themselves or contain options. An option is a contract which gives the holder the right (not the obligation) to purchase or sell a given security or asset at a specified price on or before or after (as specified in the contract) a specified date. Thus, the callable debt described above is normal debt with the added characteristic that the corporation issuing the debt has the option to repurchase the debt at an agreed upon price (set at time of issue) at any time after an initial period has past. As the issuing party holds the option in this case, would you expect this debt to be more or less valuable than otherwise identical debt where the firm did not have the option to call the debt in the future?

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Warrants are options to purchase a set number of common shares at a specified price on or before a specified date. Warrants are securities issued by the firm whose shares the holder has the right to purchase and are most often sold bundled with debt. Thus, the investor usually purchases warrants during a purchase of debt. In this case, the option is held by the purchaser of the debt; would you expect this debt to be more or less valuable than otherwise identical debt which does not come with warrants? Rights: Warrants are also sometimes issued to existing common share holders. These warrants are called rights. The firm uses these rights when it wishes to issue new stock to raise money but has decided to offer the new shares to existing shareholders exclusively (though the individual investors may sell these rights to others who are not existing shareholders if they choose). The idea is this: each shareholder receives one right per share. The firm then announces that it will sell one new share at some price, usually below the current prevailing market price, to each shareholder holding some specific number of rights. For example, the firm may say that 5 rights entitle a shareholder to purchase one new share for $10. In this case, if a shareholder owns 50 shares, that shareholder has 50 rights and can therefore purchase up to 10 new shares for $10 per share. This is an option since the shareholders receive these rights but need not exercise them if they do not benefit from doing so. In the above case, if the stock price is greater than $10, then shareholders may decide to use their rights and purchase new shares at $10 per share. If the current share price is below $10, then investors would certainly not profit by exercising their rights and they would therefore choose not to; the option is theirs. (In the example in Equity Financing below, it is shown that, provided all shareholders exercise their rights, rights offerings cannot have a dilutive effect on shareholder value.) Convertible bonds are bonds which the holder has the option to convert into common stock at a fixed (at time of issue) ratio. The conversion portion of the debt contract will specify that the holder can exchange the bond at any time for, say, 20 shares of common stock. The remainder of the debt contract is the same as any normal debt. Thus, if the holder converts, he/she becomes a common stock holder, but the investor need never convert if it is not in his/her interests. The holder has the option here, and they can exercise that option at their discretion. Would you expect convertible debt to be more or less valuable than otherwise identical straight (normal) debt? Options do not need to be issued by corporations. In fact, the vast majority of options are not issued by corporations, but are merely written on corporate stocks or other assets by some investors and purchased by other investors. For example, you might call your broker and ask to write an option on IBM stock and sell it to a willing buyer. Your broker would inform you that such options are traded at the Chicago Board Options Exchange, and you must specify the price at which you are willing to sell the IBM stock if the purchaser of your option decides to exercise the option, and the date on which your option expires. You respond that you are willing to sell 100 shares of IBM stock for $100 per share anytime between now and the third Friday in June, 1992. The broker will then relay your order to a trader on the floor of the CBOE who will sell your option for you. You pay your broker for his time and trouble and pocket the
Professor Kevin Kaiser | Turbo Lecture Notes | November 12, 1996 Page 14

remainder of the proceeds of your sale. You need not hold any IBM shares at the time you write your option. However, at anytime between now and the expiration of your option (third Friday in June, 1992) your broker may call you to inform you that the purchaser of your option has chosen to exercise his/her right to buy the 100 IBM shares from you at $100 per share. In this case, you must have your broker purchase the requisite shares on your account (at whatever the prevailing market price may be) and sell them to the buyer of your option at the agreed upon price. On the other hand, the buyer may not find it worthwhile to exercise the option, and you will simply hold the proceeds of your sale. Note that, as a seller of an option, your payoff is now determined by the action of the purchaser of the option, i.e., the purchaser has the right to determine whether the option is exercised or not, and thus determines the payoffs. Note also that the payoffs are zero-sum. This means that whatever one party profits the other loses. A futures contract is a contract which defines the terms of a sale or purchase of an asset or commodity for a transaction to take place in the future. Thus, using a futures contract, an investor can arrange to purchase $100,000 dollars worth of French Francs three months hence at an agreed upon price (number of French Francs for the $100,000). At the time the futures contract is arranged, the investor pays an agreed upon price for the contract, but does not pay the $100,000 until the French Francs and U.S. dollars actually change hands three months into the future. A forward contract is just a futures contract where the terms are specified according to the desires of the two parties in the contracting. (Futures contracts are standardized so that they can be widely traded. Forward contracts are arranged individually by the contracting parties.) One of the most common type of forward contracts involves corporations making forward loan arrangements with a bank. The firm and its bank agree that the firm will borrow some amount of money in the future at an interest rate that is fixed today. Forwards, futures and options are discussed at length in the next chapter introducing derivative securities. 2.4. Sources of Long-term Financing Among these securities, equity and long-term debt are the most typical external sources of longterm financing (though leases are also a very common form of long-term finance as can be other securities such as warrants). The alternative to these sources of financing is internally generated cash. The sources of long-term financing used by corporations vary markedly over time and across borders. The sharpest example of differing sources of long-term financing over time comes from the U.S. during the 1980's. Figure 2.1 illustrates U.S. corporate use of debt, equity, and internal financing over the longer period from 1946 through 1987. Figure 2.2 gives a better picture of what was occurring in the 1980s as equity represented a negative contribution to sources of long-term financing.

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U.S. Internal and External Financing, 1946-1987

100

(% of total sources)

Historical U.S. Financing Patterns

(% of total sources)

80

Retained earnings

Internally generated cash flow

60

New debt
Percent
40

Private debt Corporate bonds

20

Percent

New equity
0

New equity
-20 1946 1954 1962 1970 1978 1986

Year

Year

Figure 2.1. Long-term U.S. Financing, 1946-1987 (Source: "Do Firms Care Who Provides Their Financing?," Jeffrey MacKie-Mason, 1990.)

Figure 2.2. Recent Financing Sources, U.S. (Source: Ross, Westerfield and Jaffe, Corporate Finance, 3rd Edition, 1993, pp. 406-407.)

The salient features of Figures 2.1 and 2.2 include: (1) Over the entire period, 1946 through 1991, internally generated cash flow has been the preferred source of long-term financing for corporate America. (2) Debt has, on average, been the preferred source of external financing, compared against equity, over the period 1946-1991, though there were short periods, when equity was preferred. (3) Equity appears to be almost insignificant as a financing alternative. (4) The large equity buybacks of the 1980s resulted in equity being a use, rather than a source of financing, and this shift was financed mainly by additional debt. The differences in financing (short and long-term) across borders are highlighted in Table 2.1. As seen in Figure 2.1 above, this was an unusual time for equity issues in the U.S. Nonetheless, equity appears to be considerably more important as a source of financing in other countries than it is in the U.S. (or Germany). Also, internally generated cash appears to be relatively more important in the U.S. than in other countries (again, with the exception of Germany). Table 2.1. International Financing Patterns: 1985-1989 (sources of funds as a percent of total sources)
United States 72.5 7.8 -10.5 30.2 Japan 35.0 35.1 6.5 23.5 United Kingdom 48.9 27.0 13.0 11.1 Germany 77.2 11.4 11.4 Canada 56.6 11.7 11.6 20.1 France 49.2 27.5 14.8 8.5

Internally generated cash Increase in short-term debt Stock issued Increase in long-term debt

Source: Ross, Westerfield and Jaffe, Corporate Finance, 3rd Edition, 1993, p. 409.

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