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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 dramatically increased its reliance on new debt by issuing considerable amounts of bonds. Between 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 continued 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 throughout the 1990s. However, the ratio of debt to the market value of equity was far more stable.

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 generated 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, 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 asdividends.

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 option like 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.

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.