Subject: Corporate Finance
Course Code: MGT 307
Class: BBA 8th Semester
Introduction to Corporate Finance
➢ Creating value with financing decisions
➢ Pattern of corporate financing
Week 01 & 02
Chapter 14
➢ Common stock
Ownership of the corporation
Voting procedures
Classes of stock
➢ Preferred stock
➢ Corporate debt
➢ Convertible securities
Creating Value with Financing Decisions
The financial manager’s second main responsibility is to raise the money that the firm requires
for its investments and operations that could increase shareholders value.
Investment decisions are also called capital budgeting or capital expenditure (CAPEX)
decisions.
Just like all investment decision does not succeed, there are no free guarantees in finance. But
you can tilt the odds in your favor if you learn the tools of investment analysis and apply them
intelligently.
In some ways, financing decisions are less important than investment decisions.
Financial managers say that “value comes mainly from the investment side of the balance sheet.”
Also, the most successful corporations sometimes have the simplest financing strategies.
Where did this market value come from? It came from organizations products, from its brand
name and worldwide customer base, from its R&D, and from its ability to make profitable future
investments.
It did not come from sophisticated financing. Some organization financing strategy is very
simple: It finances almost all investment by retaining and reinvesting operating cash flow.
Financing decisions may not add much value compared to good investment decisions, but they
can destroy value if they are stupid or ambushed by bad news.
Patterns of Corporate Financing
Firms have three broad sources of cash:
They can plow back part of their profits, or they can raise money externally by an issue of either
shares or debt.
➢ The firm’s capital provided by the sale of shares.
➢ The issues of long- or short-term debt.
➢ The contribution from internally generated fund (defined as depreciation plus earnings
that are not paid out as dividends),
Mostly the largest sources of cash for companies came from plowing back of profits.
The gap between this internally generated cash and the cash that the company needs is called the
financial deficit.
To make up the deficit, the company must either sell new equity or borrow.
However, some companies use cash to buy back shares that had been issued earlier.
Some companies rely on debt while other almost entirely on internal funds and have no debt.
Common Stock
Common stock is one of the different sources of finance for organizations. In large companies,
hundreds of thousands of different investors, each of whom holds a number of shares of common
stock. These investors are known as shareholders, or stockholders.
Treasury stock: Stock that has been repurchased by the company and is held in its treasury.
Treasury shares are said to be issued but not outstanding.
Issued shares: Shares that have been issued by the company and held by investors are said to be
issued and outstanding shares.
Outstanding shares: Shares that have been issued by the company and are held by investors.
Authorized share capital: Maximum number of shares that the company is permitted to issue
without shareholder approval is known as authorized share capital. A company can not issue
more than it without the approval of the current shareholders.
Par Value: The price at which each share is recorded in company accounts is known as its par
value.
Additional paid-in capital: The price at which new shares are sold to investors almost always
exceeds par value and the difference between issue price and par value of stock. Also called
capital surplus.
Retained earnings: Earnings not paid out as dividends. Besides buying new stock, shareholders
also indirectly contribute new capital to the firm whenever profits that could be paid out as
dividends are instead plowed back into the company.
Net Common Equity: The sum of the par value, additional paid-in capital, and retained earnings,
less repurchased stock and some miscellaneous other adjustments, is known as the net common
equity of the firm. It equals the total amount contributed directly by shareholders when the firm
issued new stock and indirectly when it plowed back part of its earnings.
Ownership of the Corporation
A corporation is owned by its common stockholders.
Some of this common stock is held directly by individual investors, but the greater proportion
belongs to financial institutions such as mutual funds, pension funds, and insurance companies.
Shareholders have the following rights:
➢ They are entitled to profits.
➢ They have ultimate control over the company decisions.
➢ To vote on appointments to the board of directors.
The board of directors is supposed to represent the shareholders’ interests.
The board appoints and oversees management and must vote to approve important financial
decisions, including major capital investments, payment of dividends, share repurchase
programs, and new stock issues.
For public companies, the board usually includes the CEO, perhaps one or two other members of
top management, and outside directors, who are not employees.
A majority of the board consist of independent outside directors.
The CEO has traditionally also served as the chair of the board.
Voting Procedures
In most companies, stockholders elect directors by a system of majority voting.
Majority voting: Voting system in which each director is voted on separately and stockholders
can cast one vote for each share they own.
In some companies, directors are elected by cumulative voting.
Cumulative voting: Voting system in which all the votes a shareholder is allowed to cast can be
cast for one candidate for the board of directors.
Shareholders can either vote in person or appoint a proxy to vote.
Proxy contest: Takeover attempt in which outsiders compete with management for shareholders’
votes.
Classes of Stock
Companies have one class of common stock and each share has one vote.
However, a firm may have two classes of stock outstanding, which differ in their right to vote.
➢ The A shares, which were sold to the public, had 1 vote each, while the B shares, which
were owned by the founders, had 10 votes each.
➢ Both classes of shares had the same cash-flow rights, but they had different control rights.
Preferred Stock
Preferred stock: Stock that takes priority over common stock in regard to dividends.
The sum of a company’s common equity and preferred stock is known as its net worth.
➢ Preferred stock promises a series of fixed payments to the investor
➢ They have preference in payment of dividend than common stockholders.
➢ In case of liquidation, they get in the queue after the debtholders but before the common
stockholders.
➢ Preferred stockholders have no voting privileges.
➢ Like common stock dividends, preferred dividends are paid after-tax income.
➢ It is no surprise that most preferred shares are held by corporations.
Floating-rate preferred: Preferred stock for which the dividend rate is linked to current market
interest rates.
Corporate Debt
When Company borrow money, they promise to make regular interest payments and to repay the
principal (i.e., the original amount borrowed).
However, due limited liability, this promise is not always kept, they get the residual of the
company.
➢ They don’t normally have any voting power.
➢ Interest on debt is regarded as a cost and are therefore deducted from taxable income.
➢ This tax subsidy is given only on the use of debt, and are not provided on stock.
The major distinguishing characteristics.
Interest Rate The interest payment, or coupon, on most long-term loans is fixed at the time of
issue.
If a $1,000 bond is issued with a coupon of 10%, the firm continues to pay $100 a year
regardless of how interest rates change.
Zero-Coupon bonds: A zero-coupon bond is a bond that pays no interest and trades at a
discount to its face value.
Floating Interest Rate: A floating interest rate is an interest rate that moves up and down with
the market or an index. It can vary over the duration of the debt obligation. It is tied with prime
rate or LIBOR.
Prime rate is the interest rate that banks charge their preferred customers, or those with the
highest credit ratings.
LIBOR (London Interbank Offered Rate) is the benchmark interest rate at which major global
banks lend to one another.
Karachi Inter Bank Offer Rates (KIBOR) is the average interest rate at which banks want to lend
money to other banks.
Maturity: The maturity (termination or due) date is the date on which the principal amount of a
note, draft, acceptance bond or other debt instrument becomes due.
Funded (Long-term) debt is any debt repayable more than 1 year from the date of issue.
Unfunded (short-term) debt is debt due in less than a year and is carried on the balance sheet as a
current liability.
Perpetual bonds, also known as perps or consol bonds, are bonds with no maturity date.
Repayment Provisions: The repayment provision of a debt outlines exactly the payment plan
for the loan.
A sinking fund is an account containing money set aside to pay off a debt or bond. Sinking
funds may help pay off the debt at maturity or assist in buying back bonds on the open market.
A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before
it reaches the stated maturity date.
Country and Currency: Nowadays, companies can borrow in the national as well as in the
international capital market to finance their operations throughout the world. A company can
either borrow dollars from a bank in the host country or borrow dollars from a bank in foreign.
Alternatively, it can sell the bonds to investors in several countries.
Eurodollars refers to a time deposit account that is denominated in U.S. dollars and held in
foreign banks.
Similarly, yen held outside Japan were termed euro yen.
A Eurobond is a debt instrument that's denominated in a currency other than the home currency
of the country or market in which it is issued.
Public versus Private Placements:
Publicly (Initial Public Offering, IPO) issued bonds are sold to anyone who wishes to buy, and
once they have been issued, they can be freely traded in the securities markets.
Private placement offerings are securities released for sale only to small number of investors
such as investment banks, pensions, or mutual funds.
A Debt by Any Other Name:
Companies also arrange finances that look like debt but treated differently in accounts, for
example:
Accounts payable are simply obligations to pay for goods that have already been delivered and
are, therefore, like a short-term debt.
Instead of borrowing money to buy equipment, many companies lease or rent it on a long-term
basis. The firm promises to make a series of payments to the lessor (the owner of the equipment).
Postretirement health benefits and pension promises can also be huge liabilities for firms.
That is a debt the company will eventually need to pay.
Innovation in the Debt Market
Two examples of innovative bonds.
Asset-Backed Bonds: Instead of borrowing money directly, companies sometimes bundle a
group of loans and then sell the cash flows from these loans. This issue is known as an assetbacked bond.
For example, automobile loans, student loans, and credit card receivables have all been bundled
together and remarketed as asset-backed bonds. However, by far the most common application
has been in the field of mortgage lending.
Collateralized debt obligations (CDO) are debt instruments, like mortgages, bundled together
to create a new type of asset-backed security that can be traded or split. In other words, these are
groups of receivables that are insured with an asset.
Mortality Bonds: Managers of life insurance companies agonize about the possibility of a
pandemic or other disaster that results in a sharp increase in the death rate. In 2015, the French
insurance company Axa sought to protect itself against this danger by issuing €285 million of
mortality bonds. Axa’s unusual bonds offer a tempting yield, but if mortality rates in the United
States, France, and Japan exceed a predetermined threshold, the investors’ funds are used to help
pay Axa’s life insurance obligations. So, the investors are in a way betting that people will die on
schedule.
Convertible Securities
Convertible security is a bond/preferred stock that can be exchanged or converted into a
specific number of shares of the issuer's common stock.
Warrant: Right to buy shares from a company at a stipulated price before a set date.
A convertible bond gives its owner the option to exchange the bond for a predetermined number
of common shares.