Summary-C6

1.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.

Convertible bonds give their holder the right to convert the bond to shares. They therefore

resemble a package of straight debt and a warrant.

2.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.