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AN OVERVIEW OF CORPORATE FINANCING

This material begins our analysis of long-term financing decisions. In later material this will involve a careful look at some classic finance problems, such as how much firms should borrow and what dividends they should pay their shareholders. But before getting down to specifics, we will provide a brief overview of types of long-term finance.

It is customary to classify sources of finance as debt or equity. When the firm borrows, it promises to repay the debt with interest. If it doesn`t keep its promise, the debtholders may force the firm into bankruptcy. However, no such commitments are made to the equityholders. They are entitled to whatever is left over after the debtholders have been paid off. For this reason, equity is called a residual claim on the firm.

However, a simple division of sources of finance into debt and equity would miss the enormous variety of financing instruments that companies use today. For example, Table 5.7 shows the many long-term securities issued by H. J. Heinz. Yet H. J. Heinz has not come close to exhausting the menu of possible securities.

This material introduces you to the principal families of securities and explains how they are used by corporations. We also draw attention to some of the interesting aspects of firms issuing these securities.

After studying this material you should be able to

_ Describe the major classes of securities issued by firms to raise capital.

_ Summarize recent trends in the use made by firms of different sources of finance.

Common Stock

Most major corporations are far too large to be owned by one investor. For example, you would need to lay your hands on over $17 billion if you wanted to own the whole

H. J. Heinz Company.

Heinz is owned by about 61,000 different investors, each of whom holds a number of shares of common stock. These investors are therefore known as shareholders or stockholders. Altogether Heinz has outstanding 358 million shares of common stock.

Thus if you were to buy one Heinz share, you would own 1/358,000,000, or about .00000028 percent of the company. Of course, a large pension fund might hold many thousands of Heinz shares.

The 358 million shares held by investors are not the only shares that have been issued by Heinz. The company has also issued a further 72 million shares, which it later bought back from investors. These shares are held in the company`s treasury and are known as treasury stock. The shares held by investors are said to be issued and outstanding shares. By contrast, the 72 million treasury shares are said to be issued but not outstanding.

If Heinz wishes to raise more money, it can sell more shares. However, there is a limit to the number that it can issue without getting the approval of the current share holders. The maximum number of shares that can be issued is known as the authorized share capitalБІАААдfor Heinz, this is 600 million shares.

Since Heinz has already issued 431 million shares, it can issue 169 million more without shareholders` approval. Table 5.8 shows how the investment by Heinz`s common stockholders is recorded in the company`s books. The price at which each share is recorded is known as its par value. In Heinz`s case each share has a par value of $.25. Thus the total par value of the issued shares is 431 million shares АГАз $.25 per share = $108 million. Par value has little economic significance.1

The price at which new shares are sold to investors almost always exceeds par value. The difference is entered into the company`s accounts as additional paid-in capital, or capital surplus. For example, if Heinz sold an additional 100,000 shares at $50 a share, the par value of the common stock would increase by 100,000 АГАз $.25 = $25,000 and additional paid-in capital would increase by 100,000 АГАз ($50 $.25) = $4,975,000. You can see from this example that the funds raised from the stock issue are divided between par value and additional paid-in capital. Since the choice of par value in the first place was immaterial, so is the allocation between par value and additional paid-in capital.

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. Table 5.8 shows that the cumulative amount of such retained earnings is $3,853.

Heinz`s books also show the amount that the company has spent in the past on repurchasing its own stock. The repurchase of the 72 million shares cost Heinz $2,435 million. This is money that has in effect been returned to shareholders.

The sum of the par value, additional paid-in capital, and retained earnings, less repurchased stock, 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.

RETAINED EARNINGS Earnings not paid out as dividends.

AUTHORIZED SHARE CAPITAL Maximum number of shares that the company is permitted to issue, as specified in the firm`s articles of incorporation.

PAR VALUE Value of security shown on certificate.

ADDITIONAL PAID-IN CAPITAL Difference between issue price and par value of stock. Also called capital surplus.

TREASURY STOCK Stock that has been repurchased by the company and held in its treasury.

ISSUED SHARES Shares that have been issued by the company.

OUTSTANDING SHARES Shares that have been issued by the company and are held by investors.