Sources of Capital

Corporations฀can฀raise฀outside฀capital฀for฀major฀projects฀from฀three฀general฀sources:฀(1)฀borrowing฀from฀ banks฀or฀other฀lenders,฀usually฀in฀the฀form฀of฀long-term฀bonds;฀(2)฀issuing฀preferred฀stock;฀and฀(3)฀issuing฀ common฀stock.฀The฀current฀amounts฀from฀these฀sources฀appear฀on฀a฀firm’s฀balance฀sheet฀as฀long-term฀ debt,฀preferred฀stock,฀and฀common฀stock,฀respectively.

The฀obligation฀to฀repay฀is฀different฀for฀each฀source.฀Debt฀is฀a฀contractual฀obligation฀to฀repay฀a฀loan.฀ Amounts฀borrowed฀must฀be฀repaid฀to฀creditors฀at฀the฀rates฀specified฀by฀the฀loan฀agreements฀or฀the฀coupon฀ rate฀of฀any฀bonds฀issued.

Debt฀is฀more฀risky฀than฀equity฀from฀a฀corporation’s฀standpoint,฀but฀is฀less฀risky฀for฀a฀lender฀or฀inves- tor.฀Interest฀on฀debt฀must฀be฀paid฀out฀before฀dividends,฀and฀if฀a฀company฀goes฀into฀liquidation,฀lenders฀ are฀first฀in฀line฀to฀be฀repaid฀before฀shareholders.฀From฀a฀company’s฀standpoint,฀debt฀is฀less฀expensive฀ and฀interest฀on฀debt฀is฀a฀tax-deductible฀expense.฀On฀the฀other฀hand,฀a฀company฀is฀not฀liable฀for฀repaying฀ shareholders for their purchases of stock.

1 This is known as the MM Proposition 1 of F. Modigliani and E. Miller, which appeared in their article “The Cost of Capital, Corporation

294 ❧ Corporate Financial Analysis with Microsoft Excel ®

Equity฀is฀a฀combination฀of฀preferred฀and฀common฀stock.฀Shareholders฀are฀stakeholders฀in฀a฀company฀and฀are฀said฀to฀have฀an฀equity฀position฀in฀a฀corporation.฀They฀have฀noncontractual฀claims฀on฀a฀firm’s฀ residual฀cash฀flow—that฀is,฀on฀the฀difference฀between฀cash฀inflow฀minus฀debt฀payments.฀Dividends฀must฀ be฀paid฀at฀a฀specified฀rate฀to฀holders฀of฀preferred฀stock฀before฀holders฀of฀common฀stock฀receive฀any฀dividends.฀Holders฀of฀common฀stock฀are฀paid฀dividends฀after฀the฀obligations฀to฀debt฀payments฀and฀dividends฀ to preferred stockholders are satisfied. The rate depends on what is left from company profits after paying for฀long-term฀borrowing฀and฀preferred฀stock.฀It฀may฀be฀higher฀or฀lower฀than฀the฀other฀two.฀Historically,฀ as฀described฀in฀Chapter฀8,฀the฀annual฀return฀from฀investing฀in฀a฀market฀portfolio฀of฀common฀stocks฀has฀ averaged 12.2 percent for the past half century.

For฀a฀profitable฀company฀in฀normal฀times,฀debt฀is฀usually฀the฀cheapest฀source฀of฀outside฀capital฀ because฀selling฀bonds฀is฀less฀expensive฀than฀issuing฀preferred฀or฀common฀stock.฀However,฀going฀into฀debt฀ is฀risky;฀it฀leads฀to฀bankruptcy฀if฀debts฀cannot฀be฀satisfied.฀On฀the฀other฀hand,฀issuing฀stock฀dilutes฀the฀ equity฀of฀stockholders.

Bonds and preferred stock sometimes have an option for conversion into common stock or for purchasing฀common฀stock฀at฀favorable฀prices.฀This฀option฀makes฀it฀easier฀for฀companies฀to฀sell฀bonds฀or฀ preferred฀stock฀or฀to฀float฀new฀issues฀at฀more฀favorable฀terms.฀When฀bonds฀are฀converted฀to฀stock,฀the฀ long-term฀debt฀on฀a฀company’s฀balance฀sheet฀is฀reduced.฀Exercising฀a฀stock฀warrant,฀on฀the฀other฀hand,฀ increases฀cash฀flow฀but฀does฀not฀change฀the฀values฀of฀the฀existing฀debt฀and฀preferred฀stock.

Debentures฀are฀a฀special฀class฀of฀indebtedness฀that฀includes฀both฀debenture฀stocks฀and฀bonds.฀Some฀ are฀secured฀by฀trust฀deeds.฀These฀give฀certain฀rights฀to฀lenders฀to฀protect฀their฀interests,฀such฀as฀the฀right฀ to฀enforce฀contract฀and฀carry฀on฀the฀business฀in฀the฀event฀of฀default.฀Unsecured฀debentures฀are฀often฀ called “loan stock.”

Bonds,฀ debentures,฀ and฀ most฀ loans฀ contain฀ covenants฀ to฀ protect฀ lenders.฀ The฀ covenants฀ gen- erally฀ restrict฀ actions฀ on฀ the฀ part฀ of฀ the฀ borrower฀ until฀ the฀ loans฀ are฀ fully฀ repaid.฀ Such฀ restrictions฀ include:

•฀ Incurring฀further฀debt •฀ Disposition฀of฀assets • Paying dividends, redeeming shares of stock, and issuing stock or options •฀ Maintaining฀specified฀levels฀of฀working฀capital,฀loan฀collateral฀value฀(i.e.,฀the฀ratio฀of฀expected฀

future฀cash฀flows฀to฀total฀debt),฀and฀debt฀service฀ratio฀(i.e.,฀the฀ratio฀of฀annual฀cash฀flow฀to฀ annual฀interest฀and฀repayment฀charges)

Venture capitalists are another outside source of funds, particularly for high-technology start-ups and other new companies with innovative ideas. Venture capitalists advance funds for completing the research and฀development฀needed฀to฀bring฀new฀products฀to฀the฀market.฀In฀return,฀they฀take฀a฀position฀on฀the฀company’s฀board฀of฀directors฀and฀receive฀a฀percentage฀share฀of฀the฀company’s฀stock,฀which฀is฀typically฀on฀the฀ order of 38 to 40 percent. Large corporations such as Microsoft, Intel, and Cisco Systems are currently

Cost of Capital ❧ 295 providing฀billions฀of฀dollars฀of฀venture฀capital฀to฀finance฀start-up฀companies฀in฀the฀semiconductor,฀com-

puter, software, and telecommunications industries. Customers are another source of outside capital in certain industries, such as the aircraft industry. The฀production฀of฀new฀aircraft฀takes฀many฀years฀of฀design฀and฀development฀and฀often฀requires฀new฀man- ufacturing฀facilities฀and฀equipment.฀Aircraft฀manufacturers,฀such฀as฀Boeing,฀receive฀“up-front”฀payments฀ from฀airlines฀for฀aircraft฀that฀will฀not฀be฀delivered฀for฀several฀years.฀The฀up-front฀payments฀from฀customers฀ are฀part฀of฀the฀investment฀that฀must฀be฀repaid฀before฀the฀investment฀becomes฀profitable.

In addition to the sources of outside capital identified in the preceding paragraphs, corporations can also fund new projects from retained earnings. Figure฀ 9-2฀ shows฀ the฀ cash฀ flows฀ between฀ a฀ firm,฀ financial฀ markets,฀ and฀ the฀ government.฀ Money฀ received฀from฀the฀sale฀of฀stock฀and฀borrowing฀is฀invested฀by฀the฀firm฀in฀current฀and฀fixed฀assets.฀These฀are฀ used฀to฀generate฀the฀firm’s฀cash฀outflow,฀which฀is฀divided฀into฀three฀streams:฀(1)฀dividends฀to฀stockholders฀ and฀payments฀to฀lenders,฀(2)฀taxes฀to฀the฀government,฀and฀(3)฀retained฀earnings฀that฀are฀fed฀back฀into฀the฀ firm for new investments in assets. Value is created if the cash paid to investors in the form of dividends and฀debt฀payments฀exceeds฀the฀money฀provided฀by฀the฀financial฀markets.

Figure฀9-2

Cash Flows between a Firm, the Government, and Financial Markets

Financial Markets

Shares of stock

Dividends and

Short-term debt

Debt Payments

Long-term debt

Financial markets provide funds through issuing stock and making loans.

Firm invests cash inflows in assets Cash Outflow from Firm

Current assets Fixed assets

Taxes

Retained Earnings

Government

Value is created if the dividends and debt payments exceed the funds provided by the financial markets by selling stock and making loans.

296 ❧ Corporate Financial Analysis with Microsoft Excel ®

Sources of Capital