BUSFIN 4211: 3.4 Debt and Equity

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• Firms typically do not generate enough internal cash flow to finance growth

opportunities (that is, positive NPV investments)

• Firms that lack the cash to undertake investment have to

tap the external

financing markets, by issuing either debt or equity

Assets

• Where the money goes.

• Firm invests in _.

• These _ generate cash flows.

Liabilities and Shareholders’ Equity

Where the money comes from.

Equity

• a given number of shares

• The firm issues _ (sells shares to _

holders)

• holders receive dividends (payments)

Debt

• a given number of bonds, bank loans, and

trade credit

- The firm issues _ (sells bonds to bondholders,

borrows from banks, records accounts payable)

- Bondholders receive coupons and money back (at

maturity), banks are repaid, accounts payable are

written off

Debt is the

• most important source of external financing for firms

• Non-business entities, such as the U.S. government, state and local governments,

  foreign sovereigns, and individual people also rely heavily on debt financing

Types of Corporate Debt/Debt Financing Used by Non Financial Firms

Bonds and bank loans

Bonds

• are securities issued to investors at large

• Issuance process is similar to an equity offering, with underwriters and prospectus filings

Bonds PT 2

• After issuance, bonds trade in the secondary market so investors can buy or sell

• Only large firms (> $500 MM assets) have access to the bond market, due to need for

liquidity, fixed costs of issuance and costs of resolving information asymmetry

Loans

• Loans are private debt contracts issued to banks or other institutions

• Two main types of loan are revolving lines of credit and term loans

Loans PT 2

• Loans are not securities, so they are less liquid, but disclosure requirements are less onerous (difficult)

• Any firm can borrow from a bank. Startups, private firms, public firms all use bank financing

Securities

common investment contracts that are sold to investors by corporations and governments to raise capital. INVESTOPEDIA

Prospectus

a legal document issued by companies to provide essential details to potential investors about securities offerings, including financial information and associated risks. INVESTOPEDIA

Liquidity

a term used in finance to refer to how easy it is to convert an asset to cash without affecting its market price. INVESTOPEDIA

Bonds are a common source of financing for

large corporations

• Governments can also issue bonds. The U.S. government issues Treasury bonds to finance budget deficits. State and local governments in the U.S. issue in the municipal bond market. The terms of these types of bonds are similar to corporate bonds in many ways

Every corporate bond has the following security-specific features:

• Principal

• Coupon Rate

• Maturity

Principal:

The amount borrowed by the firm, to be repaid at maturity (aka, par value)

Coupon rate:

The interest rate, to be paid semi-annually

Maturity:

When the firm must make the last coupon payment and repay the principal

Bond issuance involves the firm

hiring an underwriter and filing a registration statement and

prospectus with the SEC

In contrast to equity issuance, where new shares are perfectly fungible with existing shares, many firms have

multiple bonds outstanding at a given time

Bond financing is only available to

large firms, due to the high fixed costs of issuance and inability of investors to assess the creditworthiness of small firms

• any firm can issue private debt to a bank or other institution

• Private debt has the advantage of

avoiding the cost of registration with the SEC, but the disadvantage of being illiquid or difficult for the lender to sell to another investor

Bank loans are the most common form of private debt

• The first external financing for most young firms is a bank loan

• At the same time, many bond issuers also borrow from banks

Term loans are

borrowings of a fixed amount and maturity (similar to bonds)

Revolving lines of credit are

credit commitments that the company can use as needed

Borrowing from a bank involves a different process than issuing a bond

• There is less regulatory oversight of private debt agreements. No need to file a prospectus

• Public firms must disclose the terms of the loan after an agreement is reached

Most corporate loans are provided by a syndicate of banks

• The lead arranger screens the borrower’s creditworthiness and negotiates terms

• Participant lenders provide debt capital but do not interact with the borrower

• Example: Scotts Miracle-Gro took out a $300 million term loan in 2015, led by Bank of America, JPMorgan Chase, and Wells Fargo. Each lead arranger took a 9% stake ($27 million), while the 16 other participants in the loan took stakes ranging from 1% to 7%

Loans are often issued

in packages, including multiple loan facilities

• Example: The Scotts Miracle-Gro loan mentioned above was part of a package that also included a $1.6 billion revolving credit facility with the same maturity as the term loan

In bankruptcy, senior claims are satisfied before junior claims get any recovery

• Debt is senior relative to equity

• Relative priority of loans and bonds: Loans tend to be senior to bonds

Borrowing from banks tends to be

• more expensive (Schwert 2020)

  • This is because all firms can access bank credit but very few can

  borrow from public markets

  • Seniority also affects the price

Borrowing from FinTech banks is even

more expensive

• Used by firms who don’t have access to bank loans

In bankruptcy, senior claims should be

fully satisfied before junior claims receive

any value. Debt is senior relative to equity;

Ownership rights

• The firm belongs to shareholders (unless it is bankrupt)

• Shareholders approve the firm’s important decisions

• Shareholders hire and fire managers

Residual cash-flow rights

• The firm pays suppliers, employees, tax authorities first

• . . . then creditors (banks, bondholders)

• . . . whatever is left can be distributed as dividends to shareholders

Shareholders have limited liability

• They can only lose the value of their shares; their private assets are not at risk!

• The equity of the firm can be thought of as an option on the firm’s assets

• If the firm’s assets are worth 𝐴 and the firm has principal amount 𝐷 of debt maturing at

time 𝑇, then the future payoff on the firm’s equity is:

• If the value of the firm’s assets is below the principal amount of the debt, then the firm

will be unable to repay the debt at maturity and will file for bankruptcy

• Otherwise, the firm will repay the debt and equity receives the residual payoff

Option

a type of financial instrument that's tied to an underlying security. Options give their buyers the right, but not the obligation, to purchase or sell the asset at a specified price. INVESTOPEDIA

Unlevered Equity

refers to a company or investment analyzed under the assumption that it has zero debt in its capital structure. AI

Levered Equity

represents an ownership stake in a company or asset that carries debt obligations, meaning a portion of the investment is financed with borrowed money. AI

Debt and equity involve very different payoffs and contractual rights

• Debt is a fixed obligation of the issuer

• Equity is a residual claim that gets paid only when debt is satisfied

• Debt gets paid first, then

equity receives all the remaining value

• Payoffs to debt and equity as

a function of asset value: