Corporate Financing Fundamentals

• Topic 1 is about corporate financing fundamentals

Creating Value with Financing Decisions

• Investment decisions enhance shareholder value and wealth
• Financial markets consist of demand and supply sides
• The demand side has a financial deficit where cash needed is greater than internally generated funds
• The supply side is investors with financial surplus
• If the demand side is financed at a price lower than true value the supply side worsens
• Firms should assume financing can be raised on fair term, the value of securities = true value
• In an efficient capital market, true value means all securities are fairly priced given currently available investor information where NPV == 0

Patterns of Corporate Financing

• Firms may raise funds by reinvesting profits earned by a business instead of distributing them to shareholders as dividends
• Internally generated funds are funds that come from operations instead of external sources
• Internal funding sources are:
  • Earnings (Net income): Profits generated after all expenses and taxes
  • Depreciation and amortization: Non-cash expenses that are added back to cash flow
• External funds can come from debt or equity

Sources of Funds (FedEx)

• The amount generated internally has a difference with the cash companies need. This difference is the financial deficit

Corporate Financing Example

• Plasti-tech's earnings this year were $236,000
• The company decided to plow back $69,000 and recorded $29,000 of depreciation
• Plasti-tech's internally generated funds are $236,000 + $29,000 = $265,000

Debt Ratio (FedEx)

• Debt ratio is the ratio of long term debt to long term debt plus equity

Common Stock

• Issued Shares are shares that the company has issued
• Outstanding Shares are shares that have been issued by the company and held by investors
• Treasury Stock is stock that has been repurchased by the company and held in its treasury

Shareholder Equity Account in the Financial Statement

• The maximum number of shares that can be issued is known as the authorized share capital
  • For FedEx this is 800 million shares
• At the end of fiscal 2020, FedEx had outstanding 262 million shares of common stock
• While 262 million shares are currently held by investors, FedEx has issued in total 318 million shares
• The difference (treasury stock): 56 million shares that FedEx has bought back from investors
• The price at which each share is recorded is known as its par value
• The difference is entered into the company's accounts as addition al paid-in capital, or capital surplus

Common Stock - Book Value of FedEx

• Book Value (5/31/2020)
  • Common shares ($.10 par value per share) = $32
  • Additional paid-in capital = 3,356
  • Retained earnings = 25,216
  • Treasury shares at cost = (9,162)
  • Other = (1,147)
  • Net common equity = $18,295
• Note:
  • Authorized shares (millions) 800
  • Issued shares, of which, Outstanding shares = 262

Common Stock - Market Value of FedEx

• Market Value (5/31/2020)
• Total Shares outstanding = 262 million
  • Market price = $270/share -Market value = $70.74 billion

Retained Earnings

• Assume a firm with 5,900 shares outstanding earns $10 per share and has a 30% plowback ratio
  • Retained earnings will increase by $17,700

Common Stock: Voting Procedure

• Majority voting is a voting system in which each director is voted on separately.
• Cumulative voting is a voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors.
• Proxy contest is a takeover attempt in which outsiders compete with management for shareholders' votes.

Dual-Class Shares and Private Benefits

• Companies usually have one class of common stock, each share has one vote
• Some companies have two classes of stock with the same cash flow rights but different control rights
• Greater control rights grant private benefits

Preferred Stock

• Stock that's dividends take priority over common stock.
• Net worth is book value of common shareholder's equity plus preferred stock.
• Floating-rate preferred pays dividends that vary with short term interest rates
• The company can't deduct preferred dividends when they calculate taxable income
• If the company receives investment income in the form of dividend of common/preferred stock, 50% is taxed

Tax Advantage of Investment Income

• If a corporation receives $53,000 in preferred stock dividends, the corporate tax rate is 21%, then the tax is $5,565

Corporate Debt

• Debt has the unique feature that borrowers may forego their obligation in exchange for the company's assets
• Default Risk describes the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily
• Bond Ratings are issued on debt instruments to help investors assess the default risk of a firm

Types of Corporate Debt

• Prime rate is the benchmark interest rate charged by banks.
• Funded debt is debt with more than 1 year remaining to maturity.
• Sinking fund is a fund established to retire debt before maturity.
• Callable bond is a bond that may be repurchased by the firm before maturity at a specified call price.

Other Types of Corporate Debt

• Subordinate debt may be repaid in bankruptcy only after senior debt is repaid.
• Secured debt has a first claim on specified collateral in the event of default.
• Investment grade bonds are rated Baa or above by Moody's or BBB or above by S&P.
• Junk bonds have ratings below Baa or BBB.

More Types of Corporate Debt

• Eurodollars are dollars held on deposit in a bank outside the United States.
• Eurobond is a bond denominated in a currency not of the country in which it is issued.
• Private placement is the sale of securities to a limited number of investors without a public offering.
• Lease is a long-term rental agreement.

A Debt by Any Other Name

• Some debts are treated differently in accounts.
• Accounts payable are goods received, not yet paid for, and typically like short-term debt.
• Unfunded obligations are senior debt, for example, employee pensions.
• Special-purpose entities (SPEs) raise cash through equity and debt and do not show up on the balance sheet.

Convertible Securities

• Warrants are the right to buy shares from a company at a stipulated price before a set date.
• Convertible bonds have exchange for a specified amount of another security
• Convertibles are a combined security, consisting of both a bond and a call option.

Financial System Role

• Payment Mechanism allows individuals to make and receive payments quickly and safely over long distances.
• Borrowing and Lending channels savings toward those who can best use them.
• Pooling Risk allows individuals to share risk, that is, insurance companies.
• Information allows estimation of expected rates of return.

Financial Markets and Intermediaries

• Financial markets assets are where financial assets are issued and traded.
• Financial Intermediaries are organizations that raise money from investors
• Intermediaries provide financing for individuals, companies, and other organizations

Financial Markets and Intermediaries - Investment Funds

• Mutual funds raise money by selling shares to investors and each share represents a proportional interest in the fund's portfolio of securities
• Funds raised are invested in a diversified portfolio of assets
• Open-Ended Funds continuously issue and redeem shares based on investor demand
• Closed-Ended Funds:a fixed number of shares during an initial public offering (IPO). These shares are then traded on a stock exchange.
• Index Funds replicate the performance of a specified market index.