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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, let`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 shareholders` 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, defined as depreciation plus earnings that are not paid out as dividends.6 During the 1980s internally generated cash covered approximately three-quarters of firms` capital requirements.

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 financed 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 compulsory 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 financed by retained profits or a new stock issue.

Why then do managers have an apparent preference for financing by retained earnings? Perhaps managers are simply taking the line of least resistance, dodging the discipline 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. However, 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 relying on internally generated funds. The costs of new securities are avoided, for example. Moreover, the announcement of a new equity issue is usually bad news for investors, 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.

INTERNALLY GENERATED FUNDS Cash reinvested in the firm: depreciation plus earnings not paid out as dividends