treated differently in the accounts. Some of these obligations are easily identifiable. For
example, accounts payable are simply obligations to pay for goods that have already
been delivered and are therefore like a short-term debt.
Other arrangements are not so easy to spot. For example, instead of borrowing
money to buy equipment, many companies lease or rent it on a long-term basis. In this
case the firm promises to make a series of payments to the lessor (the owner of the
equipment). This is just like the obligation to make payments on an outstanding loan.
What if the firm canÔÇ™t make the payments? The lessor can then take back the equipment,
which is precisely what would happen if the firm had borrowed money from the lessor,
using the equipment as collateral for the loan.
The Terms of HeinzÔÇ™s Bond Issue
Now that you are familiar with some of the jargon, you might like to look at an exam-
ple of a bond issue. Table 5.9 is a summary of the terms of a bond issue by Heinz taken
from MoodyÔÇ™s Industrial Manual. We have added some explanatory notes.
INNOVATION IN THE DEBT MARKET
We have discussed domestic bonds and eurobonds, fixed-rate and floating-rate loans,
secured and unsecured loans, senior and junior loans, and much more. You might think
that this gives you all the choice you need. Yet almost every day companies and their
advisers dream up a new type of debt. Here are some examples of unusual bonds.
Indexed Bonds. We saw in earlier how the United States government has issued
bonds whose payments rise in line with inflation. Occasionally borrowers have linked
the payments on their bonds to the price of a particular commodity. For example, Mex-
An Overview of Corporate Financing 505
HeinzÔÇ™s bond issue
Comment Description of Bond
1. A debenture is an unsecured bond. H. J. Heinz Company 6.375% debentures, due 2028
2. Coupon is 6.375 percent. Thus each bond makes an
annual interest payment of .06375 ├— $1,000 = $63.75.
3. MoodyÔÇ™s bond rating is A, the third-highest quality RatingÔÇ”A
AUTH. $250,000,000: outstg. $250,000,000.
4. Heinz is authorized to issue (and has outstanding) $250
million of the bonds.
DATED July 10, 1998. DUE July 15, 2028.
5. The bond was issued in July 1998 and is to be repaid in
INTEREST J&J 15.
6. Interest is payable at 6-month intervals on January and
TRUSTEE First National Bank of Chicago.
7. A trustee is appointed to look after the bondholdersÔÇ™
DENOMINATION Fully registered. $1,000 and integral
8. The bonds are registered. The registrar keeps a record of
multiples thereof. Transferable and exchangable without
who owns the bonds.
9. The bond can be held in multiples of $1,000.
EARLY REDEMPTION The debentures are not
10. Unlike some bond issues, the Heinz issue does not give
redeemable prior to maturity.
the company an option to call (i.e., repurchase) the
bonds before maturity at specified prices. Also Heinz
does not set aside money each year in a sinking fund
that is then used to redeem the bonds.
SECURITY Not secured. Ranks equally with all other
11. The bonds are not secured, that is, no assets have been
unsecured and unsubordinated indebtedness of the
set aside to protect the bondholders in the event of
Company. Company or any affiliate will not create as
security for any indebtedness for borrowed money, any
12. However, if Heinz sets aside assets to protect any other
mortgage, pledge, security interest, or lien on any stock
bondholders, the debenture will also be secured on these
or any indebtedness of any affiliate . . . without
assets.This is termed a negative pledge clause.
effectively providing that the debentures shall be secured
equally and ratably with such indebtedness, unless such
secured debt would not exceed 10% of Consolidated Net
OFFERED $250,000,000 at 99.549 plus accrued interest
13. The bonds were sold at a price of 99.549 percent of face
(proceeds to Company 98.674) thru Goldman, Sachs &
value. After deducting the payment to the underwriters
Co., J. P. Morgan & Co., Warburg Dillon Read LLC.
the company received $986.74 per bond. The bonds
could be bought from the listed underwriters.
ico, which is a large oil producer, has issued billions of dollars worth of bonds that pro-
vide an extra payoff if oil prices rise. Mexico reasons that oil-linked bonds reduce its
risk. If the price of oil is high, it can afford the higher payments on the bond. If oil prices
are low, its interest payments will also be lower. The Swiss insurance company Win-
terthur has also issued an unusual bond with varying interest payments. The payments
on the bonds are reduced if there is a hailstorm in Switzerland which damages at least
6,000 cars that have been insured by Winterthur.5 The bondholders receive a higher in-
terest rate but take on some of the companyÔÇ™s risk.
5The Winterthur bond is an example of a catastrophe (or CAT) bond. Its payments are linked to the occur-
rence of a natural catastrophe. CAT bonds are discussed in M. S. Cantor, J. B. Cole, and R. L. Sandor, ÔÇťIn-
surance Derivatives: A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance
Industry,ÔÇŁ Journal of Applied Corporate Finance 10 (Fall 1997), pp. 69ÔÇ“83.
FINANCE IN ACTION
Marriott Plan Enrages Holders of Its Bonds
Bond investors and analysts worry that if the Marriott
Marriott Corp. has infuriated bond investors with a re-
structuring plan that may be a new way for companies spinoff goes through, other companies will soon follow
to pull the rug out from under bondholders. suit by separating debt-laden units from the rest of
Prices of MarriottÔÇ™s existing bonds have plunged as the company. ÔÇť Any company that fears it has underper-
much as 30% in the past two days in the wake of the forming divisions that are dragging down its stock price
hotel and food-services companyÔÇ™s announcement that is a possible candidateÔÇŁ for such a restructuring, says
it plans to separate into two companies, one burdened Dorothy K. Lee, an assistant vice president at MoodyÔÇ™s.
with virtually all of MarriottÔÇ™s debt. If the trend heats up, investors said, the Marriott re-
On Monday, Marriott said that it will divide its opera- structuring could be the worst news for corporate
tions into two separate businesses. One, Marriott Inter- bondholders since RJR Nabisco Inc.ÔÇ™s managers
national Inc., is a healthy company that will manage shocked investors in 1987 by announcing they were
taking the company private in a record $25 billion lever-
MarriottÔÇ™s vast hotel chain; it will get most of the old
aged buy-out. The move, which loaded RJR with debt
companyÔÇ™s revenue, a larger share of the cash flow and
and tanked the value of RJR bonds, triggered a deep
will be nearly debt-free.
slump in prices of many investment-grade corporate
The second business, called Host Marriott Corp., is
bonds as investors backed away from the market.
a debt-laden company that will own Marriott hotels
along with other real estate and retain essentially all of
Strong Covenants May Re-Emerge
the old MarriottÔÇ™s $3 billion of debt.
The announcement stunned and infuriated bond-
Some analysts say the move by Marriott may trigger the
holders, who watched nervously as the value of their
re-emergence of strong covenants, or written protec-
Marriott bonds tumbled and as MoodyÔÇ™s Investors Ser-
tions, in future corporate bond issues to protect bond-
vice Inc. downgraded the bond to the junk-bond cate-
holders against such restructurings as the one being
engineered by Marriott. In the wake of the RJR buy-out,
many investors demanded stronger covenants in new
corporate bond issues.
Some investors blame themselves for not demand-
ing stronger covenants. ÔÇť ItÔÇ™s our own fault,ÔÇŁ said Robert
In trading, MarriottÔÇ™s 10% bonds that mature in 2012,
Hickey, a bond fund manager at Van Kampen Merritt. In
which Marriott sold to investors just six months ago,
their rush to buy bonds in an effort to lock in yields,
were quoted yesterday at about 80 cents on the dollar,
many investors have allowed companies to sell bonds
down from 110 Friday. The price decline translates into
with covenants that have been ÔÇť slim to none,ÔÇŁ Mr.
a stunning loss of $300 for a bond with a $1,000 face
Marriott officials concede that the companyÔÇ™s spinoff
plan penalizes bondholders. However, the company Source: Reprinted by permission of The Wall Street Journal, ┬© 1992
notes that, like all public corporations, its fiduciary duty Dow Jones & Company, Inc. All Rights Reserved Worldwide.
is to stockholders, not bondholders. Indeed, MarriottÔÇ™s
stock jumped 12% Monday. (It fell a bit yesterday.)
Asset-Backed Bonds. The rock star David Bowie earns royalties from a number of
successful albums such as The Rise and Fall of Ziggy Stardust and Diamond Dogs. But
instead of waiting to receive these royalties, Bowie decided that he would prefer the
money upfront. The solution was to issue $55 million of 10-year bonds and to set aside
the future royalty payments from the singerÔÇ™s albums to make the payments on these
bonds. Such bonds are known as asset-backed securities; the borrower sets aside a
group of assets and the income from these assets is then used to service the debt. The
Bowie bonds are an unusual example of an asset-backed security, but billions of dollars
An Overview of Corporate Financing 507
of house mortgages and credit card loans are packaged each year and resold as asset-
Reverse floaters. Floating-rate bonds that pay a higher rate of interest when other in-
terest rates fall and a lower rate when other rates rise are called reverse floaters. They
are riskier than normal bonds. When interest rates rise, the prices of all bonds fall, but
the prices of reverse floaters suffer a double whammy because the coupon payments on
the bonds fall as the discount rate rises. In 1994 Orange County, California, learned this
the hard way, when it invested heavily in reverse floaters. Robert Citron, the treasurer,
was betting that interest rates would fall. He was wrong; interest rates rose sharply and
partly as a result of its investment in reverse floaters, the county lost $1.7 billion.
These three examples illustrate the great variety of potential security designs. As
long as you can convince investors of its attractions, you can issue a callable, subordi-
nated, floating-rate bond denominated in euros. Rather than combining features of ex-
isting securities, you may be able to create an entirely new one. We can imagine a cop-
per mining company issuing preferred shares on which the dividend fluctuates with the
world copper price. We know of no such security, but it is perfectly legal to issue it
andÔÇ”who knows?ÔÇ”it might generate considerable interest among investors.
Variety is intrinsically good. People have different tastes, levels of wealth, rates of
tax, and so on. Why not offer them a choice? Of course the problem is the expense of
designing and marketing new securities. But if you can think of a new security that will
appeal to investors, you may be able to issue it on especially favorable terms and thus
increase the value of your company.
Right to buy We have seen that companies sometimes have the option to repay an issue of bonds be-
shares from a company at a fore maturity. There are also cases in which investors have an option. The most dramatic
stipulated price before a set case is provided by a warrant, which is nothing but an option. Companies often issue
date. warrants and bonds in a package.
Macaw Bill wishes to make a bond issue, which could include some warrants as a
ÔÇťsweetener.ÔÇŁ Each warrant might allow you to purchase one share of Macaw stock at a
price of $50 any time during the next 5 years. If MacawÔÇ™s stock performs well, that op-
tion could turn out to be very valuable. For instance, if the stock price at the end of the
5 years is $80, then you pay the company $50 and receive in exchange a share worth
$80. Of course, an investment in warrants also has its perils. If the price of Macaw stock
fails to rise above $50, then the warrants expire worthless.
A convertible bond gives its owner the option to exchange the bond for a predeter-
Bond that the holder may mined number of common shares. The convertible bondholder hopes that the companyÔÇ™s
exchange for a specified share price will zoom up so that the bond can be converted at a big profit. But if the
amount of another security. shares zoom down, there is no obligation to convert; the bondholder remains just that.
Not surprisingly, investors value this option to keep the bond or exchange it for shares,
508 SECTION FIVE
and therefore a convertible bond sells at a higher price than a comparable bond that is
The convertible is rather like a package of a bond and a warrant. But there is an im-
portant difference: when the owners of a convertible wish to exercise their options to
buy shares, they do not pay cashÔÇ”they just exchange the bond for shares of the stock.
Companies may also issue convertible preferred stock. In this case the investor re-
ceives preferred stock with fixed dividend payments but has the option to exchange this
preferred stock for the companyÔÇ™s common stock. The preferred stock issued by Heinz
is convertible into common stock.
These examples do not exhaust the options encountered by the financial manager.
Patterns of Corporate Financing
We have now completed our tour of corporate securities. You may feel like the tourist
who has just gone through 12 cathedrals in 5 days. But there will be plenty of time in
later material for reflection and analysis. For now, letÔÇ™s look at how firms use these
sources of finance.
Firms have two broad sources of cash. They can raise money from external
sources by an issue of debt or equity. Or they can plow back part of their
profits. When the firm retains cash rather than paying the money out as
dividends, it is increasing shareholdersÔÇ™ investment in the firm.
Figure 5.4 summarizes the sources of capital for United States corporations. The
most striking aspect of this figure is the dominance of internally generated funds, de-
fined as depreciation plus earnings that are not paid out as dividends.6 During the 1980s
internally generated cash covered approximately three-quarters of firmsÔÇ™ capital re-
Cash reinvested in the firm: