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depreciation plus earnings
not paid out as dividends.
DO FIRMS RELY TOO HEAVILY
ON INTERNAL FUNDS?
Gordon Donaldson, in a survey of corporate debt policies, encountered several firms
which acknowledged “that it was their long-term object to hold to a rate of growth
which was consistent with their capacity to generate funds internally.” A number of
other firms appeared to think less hard about expenditure proposals that could be fi-
nanced internally.7
At first glance, this behavior doesn™t make sense. As we have already noted, retained
profits are additional capital invested by shareholders and represent, in effect, a com-
pulsory issue of shares. A firm that retains $1 million could have paid out the cash as
dividends and then sold new common shares to raise the same amount of additional
capital. The opportunity cost of capital ought not to depend on whether the project is fi-
nanced by retained profits or a new stock issue.



6 Remember that depreciation is a noncash expense.
7 See G. Donaldson, Corporate Debt Capacity, Division of Research, Graduate School of Business Adminis-
tration, Harvard University, Boston, 1961, Chapter 3, especially pp. 51“56.
An Overview of Corporate Financing 509


FIGURE 5.4
Sources of funds, 800
nonfinancial corporate Internal funds
700
sector. Net equity issues
Debt instruments
600




Source of funds (billions of dollars)
500

400

300

200

100

0

100

200

300
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Year


Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System,
1999. Values for 1999 are for first two quarters, expressed at annual rates.


Why then do managers have an apparent preference for financing by retained earn-
ings? Perhaps managers are simply taking the line of least resistance, dodging the dis-
cipline of the securities markets.
Think back, where we pointed out that a firm is a team, consisting of managers,
shareholders, debtholders, and so on. The shareholders and debtholders would like to
monitor management to make sure that it is pulling its weight and truly maximizing
market value. It is costly for individual investors to keep checks on management. How-
ever, large financial institutions are specialists in monitoring, so when the firm goes to
the bank for a large loan or makes a public issue of stocks or bonds, managers know
that they had better have all the answers. If they want a quiet life, they will avoid going
to the capital market to raise money and they will retain sufficient earnings to be able
to meet unanticipated demands for cash.
We do not mean to paint managers as loafers. There are also rational reasons for re-
lying on internally generated funds. The costs of new securities are avoided, for exam-
ple. Moreover, the announcement of a new equity issue is usually bad news for in-
vestors, who worry that the decision signals lower profits.8 Raising equity capital from
internal sources avoids the costs and the bad omens associated with equity issues.


“Since internal funds provide the bulk of industry™s needs for capital, the securities mar-
Self-Test 7
kets serve little function.” Does the speaker have a point?

8 Managers do have insiders™ insights and naturally are tempted to issue stock when the stock price looks good
to them, that is, when they are less optimistic than outside investors. The outside investors realize all this and
will buy a new issue only at a discount from the preannouncement price.
510 SECTION FIVE


EXTERNAL SOURCES OF CAPITAL
Of course firms don™t rely exclusively on internal funds. They also issue securities and
retire them, sometimes in big volume. For example, in the early 1990s Heinz dramati-
cally increased its reliance on new debt by issuing considerable amounts of bonds. Be-
tween 1991 and 1993, its outstanding long-term debt more than doubled. After 1994,
however, Heinz reduced its reliance on new debt financing, and its level of outstanding
long-term debt stabilized. Despite this, the ratio of debt to the book value of equity con-
tinued to rise. The ratio continued to rise because Heinz was buying back shares from
the public. So over this period, Heinz had negative net stock issues.
Figure 5.5 shows the ratio of the book value of Heinz™s long-term debt to both the
book value and market value of its equity. The ratio based on book values rose through-
out the 1990s. However, the ratio of debt to the market value of equity was far more sta-
ble. This reflects the great rise in stock market values in the 1990s, which allowed the
market value of Heinz™s equity to keep up with its issues of long-term debt.
If you look back at Figure 5.4, you will see that Heinz was not alone in its use of
share repurchases in the latter part of the 1990s. The figure shows that for most of this
period corporate America was making large issues of debt and using part of the money
to buy back common stock. Despite this policy, debt-to-equity ratios did not rise. The
high profit levels during this period resulted in record-setting levels of internally gen-
erated funds. As a result, despite the share repurchases, common equity rose in line with
long-term debt.
The net effect of these financing policies is shown in Figure 5.6, which confirms that
debt-to-equity ratios for United States firms in the 1990s were relatively stable in book-
value terms but declined considerably in market-value terms. Again, this reflects the
run-up of stock prices during this period.
United States corporations are carrying more debt than they did 30 years ago.
Should we be worried? It is true that higher debt ratios mean that more companies are
likely to fall into financial distress when a serious recession hits the economy. But all
companies live with this risk to some degree, and it does not follow that less risk is
better. Finding the optimal debt ratio is like finding the optimal speed limit: we can
agree that accidents at 30 miles per hour are less dangerous, other things being equal,


FIGURE 5.5
Debt-to-equity ratios for H. J. 1.40
Heinz Company.
1.20
D/E book
D/E market
Debt-to-equity ratio




1.00

0.80

0.60

0.40

0.20

0.00
1980 1985 1990 1995 2000
Year
An Overview of Corporate Financing 511


FIGURE 5.6
Debt-to-equity ratio, 1
nonfinancial corporate 0.9
sector.
0.8




Debt-to-equity ratio
0.7
0.6
0.5
0.4
0.3
D/E book
0.2 D/E market
0.1
0.0
1988 1990 1992 1994 1996 1998
Year




than accidents at 60 miles per hour, but we do not therefore set the national speed limit
at 30. Speed has benefits as well as risks. So does debt.



Summary
What are the major classes of securities issued by firms to raise capital?
Companies may raise money from shareholders by issuing more shares. They also raise
money indirectly by plowing back cash that could otherwise have been paid out as
dividends.
Preferred stock offers a fixed dividend but the company has the discretion not to pay it.
It can™t, however, then pay a dividend on the common stock. Despite its name, preferred
stock is not a popular source of finance, but it is useful in special situations.
When companies issue debt, they promise to make a series of interest payments and to
repay the principal. However, this liability is limited. Stockholders have the right to default
on their obligation and to hand over the assets to the debtholders. Unlike dividends on
common stock and preferred stock, the interest payments on debt are regarded as a cost and
therefore they are paid out of before-tax income. Here are some forms of debt:

• Fixed-rate and floating-rate debt
• Funded (long-term) and unfunded (short-term) debt
• Callable and sinking-fund debt
• Senior and subordinated debt
• Secured and unsecured debt
• Investment grade and junk debt
• Domestic and international debt
• Publicly traded debt and private placements

The fourth source of finance consists of options and optionlike securities. The simplest
option is a warrant, which gives its holder the right to buy a share from the firm at a set
price by a set date. Warrants are often sold in combination with other securities.
512 SECTION FIVE


Convertible bonds give their holder the right to convert the bond to shares. They therefore
resemble a package of straight debt and a warrant.

What are recent trends in firms™ use of different sources of finance?
Internally generated cash is the principal source of company funds. Some people worry
about that; they think that if management does not go to the trouble of raising money, it may
be profligate in spending it.
In the late 1990s, net equity issues were negative; that is, companies repurchased more
equity than they issued. At the same time companies issued large quantities of debt.
However, large levels of internally generated funds in this period allowed book equity to
increase despite the share repurchases, with the result that the ratio of long-term debt to
book value of equity was fairly stable. Moreover, the stock market boom of the 1990s meant
that the ratio of debt to the market value of equity actually fell considerably during this
period.



www.AshtonAnalytics.com/ Information about the debt markets
Related Web www.finpipe.com/ See “Types of Debt” for descriptions of many debt instruments
Links www.fcnbd.com/corporate/capital/mezzanine/index.html A menu of choices for corporations
issuing different kinds of debt
www.corpfinet.com/ The corporate finance network
www.hoovers.com/ Information about corporations and corporate financing


Key Terms secured debt
treasury stock proxy contest
eurodollars
issued shares preferred stock
eurobond
outstanding shares net worth
private placement
authorized share capital floating-rate preferred
protective covenant
par value prime rate
lease
additional paid-in capital funded debt
warrant
retained earnings sinking fund
convertible bond
majority voting callable bond
internally generated funds

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