Debt and Types of Debt

When companies borrow money, they promise to make regular interest payments and to repay the principal. However, this liability is limited. Stockholders have the right to default on the debt if they are willing to hand over the corporation’s assets to the lenders. Clearly, they will choose to do this only if the value

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Financial Markets and Intermediaries

The flow of savings to large public corporations is shown in Figure 14.7. Notice that the savings travel from investors worldwide through financial markets, financial intermediaries, or both. Suppose, for example, that Bank of America raises $300 million by a new issue of shares. An Italian investor buys 6,000 of the new shares for

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The Role of Financial Markets and Intermediaries

Financial markets and intermediaries provide financing for business. They channel savings to real investment. That much should be loud and clear. But other functions may not be quite so obvious. Financial intermediaries contribute in many ways to our individual well-being and the smooth functioning of the economy. Here are some examples. 1. The Payment

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Venture Capital

On April 1, 2031, George and Mildred Marvin met with Chip Norton in their research lab (which also doubled as a bicycle shed) to celebrate the incorporation of Marvin Enterprises. The three entrepreneurs had raised $100,000 from savings and personal bank loans and had purchased 1 million shares in the new company. At this

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The Initial Public Offering

There comes a stage in the life of many young companies when they decide to make an initial public offering of stock, or IPO. This may be a primary offering, in which new shares are sold to raise additional cash for the company. Or it may be a secondary offering, where the existing shareholders

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Alternative Issue Procedures for IPOs

Table 15.2 summarizes the main steps involved in making an initial public offering of stock in the United States. You can see that Marvin’s new issue was a typical IPO in almost every respect. In particular, most IPOs in the United States use the bookbuilding method in which the underwriter builds a book of

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Security Sales by Public Companies

A company’s first public issue of stock is seldom its last. As the firm grows, it is likely to make further issues of debt and equity. Public companies can issue securities either by offering them to investors at large or by making a rights issue that is limited to existing stockholders. We begin by

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Private Placements and Public Issues

Whenever a company makes a public offering, it is obliged to register the issue with the SEC. It could avoid this costly process by selling the securities privately. The rules on what consti­tutes a private placement are complicated. The securities can generally be sold to an unlimited number of financial institutions, but there are

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Facts about Payout

Corporations pay out cash by distributing dividends or by buying back some of their outstand­ing shares. Repurchases were rare in the early 1980s, but Figure 16.1 shows that the total value of repurchases in the United States is now similar to total dividends. Figure 16.1 shows that dividends are more stable than repurchases. Notice

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The Information Content of Dividends and Repurchases

A survey in 2004 asked senior executives about their companies’ dividend policies. Figure 16.3 paraphrases their responses. Three themes stand out: Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would issue shares or borrow to

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Dividends or Repurchases? The Payout Controversy

Announcements of dividends and repurchases can convey information about management’s confidence and so affect the stock price. But eventually, the stock price change would happen anyway as information seeps out through other channels. Does payout policy affect value in the long run? Suppose you are CFO of a successful, profitable public company. The company

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The Rightists

MM said that dividend policy is irrelevant because it does not affect shareholder value. MM did not say that payout should be random or erratic; for example, it may change over the life cycle of the firm. A young growth firm pays out little or nothing, retaining cash flow for investment. As the firm

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Taxes and the Radical Left

The left-wing dividend creed is simple: Whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash dividend they can get away with. Cash avail­able for payout should be used to repurchase shares. By shifting their distribution policies in this way, corporations can transmute dividends into capital gains. If this

Payout Policy and the Life Cycle of the Firm

MM said that payout policy does not affect shareholder value. Shareholder value is driven by the firm’s investment policy, including its future growth opportunities. Financing pol­icy, including the choice between debt and equity, can also affect value, as we will see in Chapter 18. In MM’s analysis, payout is a residual, a by-product of

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The Effect of Financial Leverage in a Competitive Tax-Free Economy

Financial managers try to find the combination of securities that has the greatest overall appeal to investors—the combination that maximizes the market value of the firm. Before tackling this problem, we should check whether a policy that maximizes the total value of the firm’s securities also maximizes the wealth of the shareholders. Let D

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Financial Risk and Expected Returns

Consider now the implications of MM’s proposition 1 for the expected returns on Macbeth stock: Leverage increases the expected stream of earnings per share but not the share price. The reason is that the change in the expected earnings stream is exactly offset by a change in the rate at which the earnings are

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No Magic in Financial Leverage

MM’s propositions boil down to the simple warning: There is no magic in financial lever­age. Financial managers who ignore this warning can be sucked into practical mistakes. For example, suppose that someone says, “Shareholders demand—and deserve—higher expected rates of return than bondholders. Therefore, debt is the cheaper source of capital. We can reduce the

A Final Word on the After-Tax Weighted- Average Cost of Capital

MM left us a simple message. When the firm changes its mix of debt and equity securities, the risk and expected returns of these securities change, but the company’s overall cost of capital does not change. Now if you think that message is too neat and simple, you’re right. The complications are spelled out

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Corporate Taxes

Debt financing has one important advantage under the corporate income tax system in the United States and many other countries. The interest that the company pays is a tax-deductible expense. Thus, the return to bondholders escapes taxation at the corporate level. There is one restriction on this tax benefit. Since 2018, the net amount

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Corporate and Personal Taxes

When personal taxes are introduced, the firm’s objective is no longer to minimize the corporate tax bill; the firm should try to minimize the present value of all taxes paid on corporate income. “All taxes” include personal taxes paid by bondholders and stockholders. Figure 18.1 illustrates how corporate and personal taxes are affected by

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