Corporate Financing and Equity/Debt Instruments: Financial Accounting Study Notes

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Creating Value with Financing Decisions

Overview of Financing Decisions

Financing decisions are central to corporate financial management, determining how a firm raises capital to fund its operations and growth. These decisions impact the firm's value and risk profile.

Financing Sources: Firms can use internal funds (retained earnings) or external funds (debt and equity).
Value Creation: The optimal mix of debt and equity can minimize the cost of capital and maximize shareholder value.
Risk Considerations: The choice between debt and equity affects financial risk and control over the company.

Patterns of Corporate Financing

Internal vs. External Financing

Corporations may finance their activities using profits retained within the business or by raising funds externally. The choice depends on the firm's profitability, growth prospects, and market conditions.

Internal Funds: Profits that are reinvested rather than distributed as dividends.
External Financing: Raising funds through debt (loans, bonds) or equity (issuing shares).
Decision Factors: Cost of capital, control implications, and market conditions influence the choice.

Trends in Corporate Financing

Historical data shows how firms balance internal and external sources over time. The following table summarizes typical patterns:

Year	Internal Funds	Net Equity Issues	Debt Issues
1991	High	Low	Moderate
2000	High	Moderate	High
2010	High	Negative	High
2017	High	Negative	Moderate
Additional info:	Internal funds are generally the largest source, with debt and equity fluctuating based on market cycles.

Debt Ratio Analysis

The debt ratio measures the proportion of a firm's assets financed by debt. It can be calculated using book values or market values:

Book Debt Ratio: Uses balance sheet values.
Market Debt Ratio: Uses market values of equity and debt.

Formula:

Trends in debt ratios reflect changes in corporate leverage and risk appetite over time.

Types of Securities

Classification of Securities

Corporations can issue various types of securities to raise capital. These include equity and debt instruments, each with distinct features and investor rights.

Type	Description
Common Stock	Represents ownership and voting rights in the company.
Preferred Stock	Has priority over common stock for dividends and liquidation.
Commercial Paper	Short-term unsecured debt instrument.
Debentures	Long-term unsecured debt.
Guaranteed Notes	Debt backed by a guarantee.
Marketable Debt	Debt that can be traded in financial markets.
Bonds	Long-term debt instruments.
Floating Notes	Debt with variable interest rates.
Foreign Currency Notes	Debt issued in currencies other than the issuer's home currency.
Bank Loans	Funds borrowed from financial institutions.
Additional info:	Other forms include convertible securities and private placements.

Common Stock

Key Terms and Features

Common stock is the primary equity security issued by corporations, conferring ownership and voting rights to shareholders.

Issued Shares: Total shares created and sold by the company.
Outstanding Shares: Shares held by investors, excluding treasury stock.
Treasury Stock: Shares repurchased and held by the company.

Components of Shareholders' Equity

Shareholders' equity consists of several components, each reflecting different sources of capital:

Component	Description
Authorized Share Capital	Maximum shares permitted by the articles of incorporation.
Par Value	Nominal value per share as stated on the certificate.
Retained Earnings	Profits not distributed as dividends.
Additional Paid Up Capital	Excess of issue price over par value.

Book Value vs. Market Value

Book value and market value are two important measures of a company's equity:

Book Value: Historical measure based on capital raised from shareholders.
Market Value: Forward-looking measure based on expected future dividends and market price.

Example: If a company has 262 million shares outstanding and the market price is $270 per share, the market value of equity is:

Voting Systems

Shareholders exercise control through voting systems:

Majority Voting: Each director is voted on separately.
Cumulative Voting: Shareholders can allocate all their votes to one candidate.
Proxy Contest: Outsiders compete for shareholders' votes to gain control.

Preferred Stock

Features of Preferred Stock

Preferred stock is a hybrid security with characteristics of both equity and debt. It has priority over common stock for dividends and liquidation.

Dividend Priority: Preferred dividends must be paid before common dividends.
Book Value: Includes both common and preferred equity.
Floating-Rate Preferred: Dividends vary with short-term interest rates.

Corporate Debt

Types and Features of Corporate Debt

Corporate debt includes various instruments used to borrow funds. Each type has unique features and risk profiles.

Default Risk: The likelihood that a firm will fail to meet its obligations.
Bond Ratings: Issued by agencies to assess default risk (e.g., Moody's, S&P).
Benchmark Rate: Standard interest rate charged by banks.
Funded Debt: Debt with more than one year to maturity.
Sinking Fund: Reserve to retire debt before maturity.
Callable Bond: Can be repurchased by the issuer before maturity at a specified price.

Debt Classifications

Type	Description
Subordinate Debt	Repaid after senior debt in bankruptcy.
Secured Debt	Has first claim on collateral.
Investment Grade	Bonds rated Baa/BBB or above.
Junk Bond	Below investment grade.

International Debt Instruments

Eurodollars: U.S. dollars held in banks outside the U.S.
Eurobond: Bond marketed internationally.
Private Placement: Sale of securities to a limited number of investors.
Long-Term Rental Agreement: Lease arrangements for assets.

Convertible Securities

Features and Types

Convertible securities combine features of debt and equity, allowing holders to convert into shares under specified conditions.

Warrant: Right to buy shares at a stipulated price before expiration.
Convertible Bond: Debt that can be exchanged for a specified amount of another security, usually common stock.
Combined Security: Convertible securities consist of both a bond and a call option.

Example: A convertible bond may allow the holder to exchange the bond for a fixed number of shares, providing upside potential if the stock price rises.

Summary Table: Key Features of Corporate Securities

Security Type	Ownership	Priority for Dividends	Voting Rights	Convertibility
Common Stock	Yes	Last	Yes	No
Preferred Stock	Yes	Before Common	Usually No	Sometimes
Corporate Debt	No	Interest Paid	No	Sometimes (Convertible)
Convertible Securities	No (until converted)	Interest Paid	No	Yes

Additional info: These notes expand on the original slides by providing definitions, formulas, and examples for key financial accounting concepts related to corporate financing and securities.