Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER FOURTEEN 376 AN OVERVIEW OF C O R P O R A T E F I N A N C I N G Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 WE NOW BEGIN our analysis of long-term financing decisions—an undertaking we will not complete until Chapter 26. This chapter provides an introduction to corporate financing. It reviews with a broad brush several topics that will be explored more carefully later on. We start the chapter by looking at aggregate data on the sources of financing for U.S. corpora- tions. Much of the money for new investments comes from profits that companies retain and rein- vest. The remainder comes from selling new debt or equity securities. These financing patterns raise several interesting questions. Do companies rely too heavily on internal financing rather than on new issues of debt or equity? Are debt ratios of U.S. corporations dangerously high? How do patterns of financing differ across the major industrialized countries? Our second task in the chapter is to review some of the essential features of debt and equity. Lenders and stockholders have different cash flow rights and also different control rights. The lenders have first claim on cash flow, because they are promised definite cash payments for interest and prin- cipal. The stockholder receives whatever cash is left over after the lenders are paid. Stockholders, on the other hand, have complete control of the firm, providing that they keep their promises to lenders. As owners of the business, stockholders have the ultimate control over what assets the company buys, how the assets are financed, and how they are used. Of course, in large public corporations the stockholders delegate these decisions to the board of directors, who in turn appoint senior man- agement. In these cases effective control often ends up with the company’s management. The simple division of sources of cash into debt and equity glosses over the many different types of debt that companies issue. Therefore, we close our discussion of debt and equity with a brief can- ter through the main categories of debt. We also pause to describe certain less common forms of eq- uity, particularly preferred stock. Financial institutions play an important role in supplying finance to companies. For example, banks provide short- and medium-term debt, help to arrange new public issues of securities, buy and sell foreign currencies, and so on. We introduce you to the major financial institutions and look at the roles that they play in corporate financing and in the economy at large. 377 14.1 PATTERNS OF CORPORATE FINANCING Companies invest in long-term assets (mainly property, plant, and equipment) and net working capital. Table 14.1 shows where they get the cash to pay for these in- vestments. You can see that by far the greater part of the money is generated inter- nally. In other words, it comes from cash that the company has set aside as depre- ciation and from retained earnings (earnings not paid out as dividends). 1 Shareholders are happy for companies to plow back this money into the firm, so long as it goes to positive-NPV investments. Every positive-NPV investment gen- erates a higher price for their shares. In most years there is a gap between the cash that companies need and the cash that they generate internally. This gap is the financial deficit. To make up the deficit, companies must either sell new equity or borrow. So companies face two basic financing decisions: How much profit should be plowed back into the 1 In Table 14.1, internally generated cash was calculated by adding depreciation to retained earnings. Depreciation is a noncash expense. Thus, retained earnings understate the cash flow available for reinvestment. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 378 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1. Capital expenditure 87.1% 104.5% 87.5% 87.3% 83.2% 77.6% 87.6% 81.0% 89.1% 80.4% 86.6% 2. Investment in net working capital and other uses 12.9% Ϫ4.5% 12.5% 12.7% 16.8% 22.4% 12.4% 19.0% 10.9% 19.6% 13.4% 3. Total investment 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Total investment, billions $ 498 $ 412 $ 517 $ 567 $ 754 $ 789 $ 755 $ 880 $ 872 $ 1,116 $ 1,162 4. Internally generated cash 86.8% 108.6% 90.0% 90.2% 87.7% 78.6% 89.5% 82.7% 85.7% 72.1% 76.7% 5. Financial deficit 13.2% Ϫ8.6% 10.0% 9.8% 12.3% 21.4% 10.5% 17.3% 14.3% 27.9% 23.3% Financial deficit covered by 6. Net stock issues Ϫ12.7% 4.4% 5.2% 3.8% Ϫ6.9% Ϫ7.4% Ϫ9.2% Ϫ13.0% Ϫ30.6% Ϫ12.9% Ϫ14.3% 7. Net increase in debt 25.9% Ϫ13.0% 4.8% 6.1% 19.3% 28.8% 19.7% 30.3% 45.0% 40.8% 37.6% TABLE 14.1 Sources and uses of funds in nonfinancial corporations expressed as percentages of each year’s total investment. Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F.102 for Nonfarm, Nonfinancial Corporate Business, at www.federalreserve.gov/releases/z1/current/data.htm . Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 business rather than paid out as dividends? and What proportion of the deficit should be financed by borrowing rather than by an issue of equity? To answer the first question the firm requires a dividend policy (we discuss this in Chap- ter 16); and to answer the second it needs a debt policy (this is the topic of Chap- ters 17 and 18). Notice that net stock issues were negative in most years. That means that the amount of new money raised by companies issuing equity was more than offset by the amount of money returned to shareholders by repurchase of previously outstanding shares. (Companies can buy back their own shares, or they may re- purchase and retire other companies’ shares in the course of mergers and acqui- sitions.) We discuss share repurchases in Chapter 16 and mergers and acquisi- tions in Chapter 33. Net stock issues were positive in the early 1990s. Companies had entered the decade with uncomfortably high debt levels, so they paid down debt in 1991 and replenished equity in 1991, 1992, and 1993. But net stock issues turned negative in 1994 and stayed negative for the rest of the decade. Aggregate debt issues in- creased to cover both the financial deficit and the net retirements of equity. Companies in the United States are not alone in their heavy reliance on internal funds. Internal funds make up more than two-thirds of corporate financing in Ger- many, Japan, and the United Kingdom. 2 Do Firms Rely Too Much on Internal Funds? We have seen that on average internal funds (retained earnings plus depreciation) cover most of the cash firms need for investment. It seems that internal financing is more convenient than external financing by stock and debt issues. But some ob- servers worry that managers have an irrational or self-serving aversion to external finance. A manager seeking comfortable employment could be tempted to forego a risky but positive-NPV project if it involved launching a new stock issue and fac- ing awkward questions from potential investors. Perhaps managers take the line of least resistance and dodge the “discipline of capital markets.” But there are also some good reasons for relying on internally generated funds. The cost of issuing new securities is avoided, for example. Moreover, the an- nouncement of a new equity issue is usually bad news for investors, who worry that the decision signals lower future profits or higher risk. 3 If issues of shares are costly and send a bad-news signal to investors, companies may be justified in look- ing more carefully at those projects that would require a new stock issue. Has Capital Structure Changed? We commented that in recent years firms have, in the aggregate, issued much more debt than equity. But is there a long-run trend to heavier reliance on debt finance? This is a hard question to answer in general, because financing policy varies so CHAPTER 14 An Overview of Corporate Financing 379 2 See, for example, J. Corbett and T. Jenkinson, “How Is Investment Financed? A Study of Germany, Japan, the United Kingdom and the United States,” The Manchester School 65 (Supplement 1997), pp. 69–93. 3 Managers do have insiders’ insights and naturally are tempted to issue stock when the price looks good to them, that is, when they are less optimistic than outside investors. The outside investors real- ize this and will buy a new issue only at a discount from the pre-announcement price. More on stock issues in Chapter 15. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 much from industry to industry and from firm to firm. But a few statistics will do no harm as long as you keep these difficulties in mind. Table 14.2 shows the aggregate balance sheet of all manufacturing corporations in the United States in 2001. If all manufacturing corporations were merged into one gigantic firm, Table 14.2 would be its balance sheet. Assets and liabilities in Table 14.2 are entered at book, that is, accounting values. These do not generally equal market values. The numbers are nevertheless in- structive. The table shows that manufacturing corporations had total book assets of $4,903 billion. On the right-hand side of the balance sheet, we find total long- term liabilities of $1,717 billion and stockholders’ equity of $1,951 billion. So what was the book debt ratio of manufacturing corporations in 2001? It de- pends on what you mean by debt. If all liabilities are counted as debt, the debt ra- tio is .60: This measure of debt includes both current liabilities and long-term obligations. Sometimes financial analysts focus on the proportions of debt and equity in long- term financing. The proportion of debt in long-term financing is The sum of long-term liabilities and stockholders’ equity is called total capitaliza- tion. Figure 14.1 plots these two ratios from 1954 to 2001. There is a clear upward trend. But before we conclude that industry is becoming weighed down by a crip- pling debt burden, we need to put these changes in perspective. Long-term liabilities Long-term liabilities ϩ stockholders’ equity ϭ 1,717 1,717 ϩ 1,951 ϭ .47 Debt Total assets ϭ 1,234 ϩ 1,717 4,903 ϭ .60 380 PART IV Financing Decisions and Market Efficiency Current assets † $1,547 Current liabilities † $1,234 Fixed assets $2,361 Long-term debt $1,038 Less depreciation 1,166 Other long-term liabilities ‡ 679 Net fixed assets 1,195 Total long-term liabilities 1,717 Other long-term Stockholders’ equity 1,951 assets 2,160 Total assets § $4,903 Total liabilities and stockholders’ equity § $4,903 TABLE 14.2 Aggregate balance sheet for manufacturing corporations in the United States, 1st quarter, 2001 (figures in $ billions)*. *Excludes companies with less than $250,000 in assets. † See Table 30.1 for a breakdown of current assets and liabilities. ‡ Includes deferred taxes and several miscellaneous categories. § Columns may not add up because of rounding. Source: U.S. Census Bureau, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, 1st Quarter, 2001 (www.census.gov/csd/qfr ). Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 1990 versus 1920 Debt ratios in the 1990s, though clearly higher than in the early postwar period, are no higher than in the 1920s and 1930s. You could argue that Figure 14.1 starts from an abnormally low point. 4 Inflation Some of the upward movement in Figure 14.1 may have reflected infla- tion, which was especially rapid—by U.S. standards—throughout the 1970s and early 1980s. Rapid inflation means that the book value of corporate assets falls behind the actual value of those assets. If corporations were borrowing against actual value, it would not be surprising to observe rising ratios of debt-to-book asset values. To illustrate, suppose that you bought a house 10 years ago for $60,000. You fi- nanced the purchase in part with a $30,000 mortgage, 50 percent of the purchase price. Today the house is worth $120,000. Suppose that you repay the remaining bal- ance of your original mortgage and take out a new mortgage of $60,000, which is again 50 percent of current market value. Your book debt ratio would be 100 percent. The reason is that the book value of the house is its original cost of $60,000 (we as- sume no depreciation). An analyst having only book values to work with would ob- serve that 10 years ago your book debt ratio was only 50 percent and might conclude CHAPTER 14 An Overview of Corporate Financing 381 1954 1958 10 Debt ratio, percent Year 20 30 40 50 60 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2001 Debt versus total assets Debt versus total long-term financing FIGURE 14.1 Average debt ratios for manufacturing corporations in the United States have increased in the postwar period. However, note that these ratios compare debt with the book value of total assets and total long-term financing. The actual value of corporate assets is higher as a result of inflation. Source: U.S. Census Bureau, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, various issues. 4 See Figure 1.3 on p. 25 in R. A. Taggart, Jr., “Secular Patterns in the Financing of U.S. Corporations,” in B. M. Friedman (ed.), Corporate Capital Structures in the United States, University of Chicago Press, 1985. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 that you had decided to “use more debt.” But you have no more debt relative to the actual value of your house. Despite such qualifications, it’s still the case that many U.S. corporations are car- rying a lot more debt than they used to. Should we be worried? It’s true that higher debt ratios mean that more companies will fall into financial distress if a serious re- cession hits the economy. But all companies live with this risk to some degree, and it does not follow that less risk is better. Finding the optimal debt ratio is like find- ing the optimal speed limit. We can agree that accidents at 30 miles per hour are generally less dangerous than accidents at 60 miles per hour, but we do not there- fore set the speed limit on all roads at 30. Speed has benefits as well as risks. So does debt, as we will see in Chapter 18. There is no God-given, correct debt ratio, and if there were, it would change. It may be that some of the new tools that allow firms to manage their risks have made higher debt ratios practicable. International Comparisons Corporations in the United States are generally viewed as having less debt than many of their foreign counterparts. That was surely true in the 1950s and 1960s. Now it is not so clear. Rajan and Zingales examined the balance sheets of a large sample of publicly traded firms in the seven largest industrialized countries. They calculated debt ra- tios using both book and market values of shareholders’ equity. (The book value of debt was assumed to approximate market value.) A taste of their results is given in Table 14.3. Notice that the debt ratios for the United States sample fall in the mid- dle of the pack. International comparisons of this sort are always muddied by differences in ac- counting methods. For example, German companies show pension liabilities as a debtlike obligation on their balance sheets, with no offsetting entry for pension as- sets. 5 They also report “reserves” separately from equity. These reserves do not cover any specific obligations but serve as equity for a rainy day. Reserves might be drawn down to offset a future drop in operating earnings, for example. (This would be un- acceptably creative accounting in the United States.) When Rajan and Zingales crossed out the pension liabilities and added back reserves to equity, the adjusted debt ratios for German companies dropped to the low levels reported in Table 14.3. 382 PART IV Financing Decisions and Market Efficiency Debt to Total Capital Book, Market, Book Adjusted Market Adjusted Canada 39% 37% 35% 32% France 48 34 41 28 Germany 38 18 23 15 Italy 47 39 46 36 Japan 53 37 29 17 United Kingdom 28 16 19 11 United States 37 33 28 23 TABLE 14.3 Median debt-to-total-capital ratios in 1991 for samples of traded companies in the major countries. Debt includes short- and long-term debt. Total capital is defined as the sum of all debt and equity. The adjusted figures correct for some international differences in accounting. Source: R. G. Rajan and L. Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data,” Journal of Finance 50 (December 1995), pp. 1421–1460. 5 United States companies show a net liability only if the pension plan is underfunded. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 Corporations raise cash in two principal ways—by issuing equity or by issuing debt. The equity consists largely of common stock, but companies may also is- sue preferred stock. As we shall see, there is a much greater diversity of debt securities. We start our brief tour of corporate securities by taking a closer look at common stock. Table 14.4 shows the common equity of H.J. Heinz Company. The maximum number of shares that can be issued is known as the authorized share capital; for Heinz it was 600 million shares. If management wishes to increase the number of authorized shares, it needs the agreement of shareholders to do so. By May 2000 Heinz had already issued 431 million shares, and so it could issue 169 million more without further shareholder approval. Most of the issued shares were held by investors. These shares are said to be is- sued and outstanding. But Heinz has also bought back 84 million shares from in- vestors. Repurchased shares are held in the company’s treasury until they are ei- ther canceled or resold. Treasury shares are said to be issued but not outstanding. The issued shares are entered into the company’s books at their par value. Each Heinz share had a par value of $.25. Thus the total book value of the issued shares was 431 ϫ $.25 ϭ $108 million. Par value has little economic significance. 6 Some companies issue shares with no par value. In this case, the stock is listed in the ac- counts at an arbitrarily determined figure. The price of new shares sold to the public almost always exceeds par value. The difference is entered in the company’s accounts as additional paid-in capi- tal or capital surplus. Thus, if Heinz had sold an additional 100,000 shares at $40 a share, the common stock account would have increased by 100,000 ϫ $.25 ϭ $25,000, and the capital surplus account would have increased by 100,000 ϫ $39.75 ϭ $3,975,000. Heinz distributed about 50 percent of its earnings as dividends. The remainder was retained in the business and used to finance new investments. The cumulative amount of retained earnings was $4,757 million. CHAPTER 14 An Overview of Corporate Financing 383 14.2 COMMON STOCK Common shares ($.25 par value per share) $ 108 Additional paid-in capital 304 Retained earnings 4,757 Treasury shares (2,920) Other adjustments (652) Net common equity $1,596 Note: Authorized shares 600 Issued shares, of which: 431 Outstanding shares 347 Treasury shares 84 TABLE 14.4 Book value of common stockholders’ equity of H.J. Heinz Company, May 3, 2000 (figures in millions). Sources: H.J. Heinz Company, Annual Reports. 6 Because some states do not allow companies to sell shares below par value, par value is generally set at a low figure. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 The next entry in the common stock account shows the amount that the com- pany has spent on repurchasing its common stock. The repurchases have reduced the stockholders’ equity by $2,920 million. Finally, there is an entry for other ad- justments, principally currency losses stemming from Heinz’s foreign operations. We would rather not get into these accounting adjustments here. Heinz’s net common equity had a book value in May 2000 of $1,596 million. That works out at 1,596/347 ϭ $4.60 per share. But in May 2000, Heinz’s shares were priced at about $35 each. So the market value of the common stock was 347 mil- lion ϫ $35 ϭ $12.1 billion, over $10 billion higher than book. Ownership of the Corporation A corporation is owned by its common stockholders. Some of this common stock is held directly by individual investors, but the greater proportion belongs to fi- nancial institutions such as banks, pension funds, and insurance companies. For example, look at Figure 14.2. You can see that in the United States just over 60 per- cent of common stock is held by financial institutions, with pension funds and mu- tual funds each holding about 20 percent. What do we mean when we say that these stockholders own the corporation? The answer is obvious if the company has issued no other securities. Consider the simplest possible case of a corporation financed solely by common stock, all of which is owned by the firm’s chief executive officer (CEO). This lucky owner–manager receives all the cash flows and makes all investment and oper- ating decisions. She has complete cash-flow rights and also complete control rights. These rights are split up and reallocated as soon as the company borrows money. If it takes out a bank loan, it enters into a contract with the bank promising to pay interest and eventually repay the principal. The bank gets a privileged, but limited, right to cash flows; the residual cash-flow rights are left to the stockholder. The bank will typically protect its claim by imposing restrictions on what the firm can or cannot do. For example, it may require the firm to limit future borrow- ing, and it may forbid the firm to sell off assets or to pay excessive dividends. The stockholders’ control rights are thereby limited. However, the contract with the 384 PART IV Financing Decisions and Market Efficiency Other Households Rest of world Mutual funds, etc. Insurance companies Pension funds FIGURE 14.2 Holdings of corporate equities, 2000. Source: Board of Governors of the Federal Reserve System, Division of Research and Statis- tics, Flow of Funds Accounts Table L.213 at www.federal reserve.gov/releases/z1/ current/data.htm. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 bank can never restrict or determine all the operating and investment decisions necessary to run the firm efficiently. (No team of lawyers, no matter how long they scribbled, could ever write a contract covering all possible contingencies. 7 ) The owner of the common stock retains the rights of control over these decisions. For example, she may choose to increase the selling price of the firm’s products, to hire temporary rather than permanent employees, or to construct a new plant in Miami Beach rather than Hollywood. 8 Ownership of the firm can of course change. If the firm fails to make the prom- ised payments to the bank, it may be forced into bankruptcy. Once the firm is un- der the “protection” of a bankruptcy court, shareholders’ cash-flow and control rights are tightly restricted and may be extinguished altogether. Unless some res- cue or reorganization plan can be implemented, the bank will become the new owner of the firm and will acquire the cash-flow and control rights of ownership. (We discuss bankruptcy in Chapter 25.) There is no law of nature that says residual cash-flow rights and residual con- trol rights have to go together. For example, one could imagine a situation where the debtholder gets to make all the decisions. But this would be inefficient. Since the benefits of good decisions are felt mainly by the common stockholders, it makes sense to give them control over how the firm’s assets are used. We have focused so far on a firm that is owned by a single stockholder. In many countries, such as Italy, Hong Kong, or Mexico, there is generally a dominant stock- holder who controls 20 percent or more of the votes of even the largest corpora- tions. 9 There are also a few major businesses in the United States that are controlled by one or two large stockholders. For example, at the beginning of 2001 Bill Gates owned 21 percent of the common stock of Microsoft as well as being chairman and chief executive. However, such concentration of control is the exception. Owner- ship of most major corporations in the United States is widely dispersed. The common stockholders in widely held corporations still have the residual rights over the cash flows and have the ultimate right of control over the company’s affairs. In practice, however, their control is limited to an entitlement to vote, either in person or by proxy, on appointments to the board of directors, and on other crucial matters such as the decision to merge. Many shareholders do not bother to vote. They reason that, since they own so few shares, their vote will have little impact on the outcome. The problem is that, if all shareholders think in the same way, they cede effective control and management gets a free hand to look after its own interests. Voting Procedures and the Value of Votes If the company’s articles of incorporation specify a majority voting system, each di- rector is voted upon separately and stockholders can cast one vote for each share that they own. If a company’s articles permit cumulative voting, the directors are voted upon jointly and stockholders can, if they wish, allot all their votes to just CHAPTER 14 An Overview of Corporate Financing 385 7 Theoretical economists therefore stress the importance of incomplete contracts. Their point is that contracts pertaining to the management of the firm must be incomplete and that someone must exercise residual rights of control. See O. Hart, Firms, Contracts, and Financial Structure, Clarendon Press, Oxford, 1995. 8 Of course, the bank manager may suggest that a particular decision is unwise, or even threaten to cut off future lending, but the bank does not have any right to make these decisions. 9 See R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate Ownership around the World,” Jour- nal of Finance 54 (1999), pp. 471–517. [...]... price? Explain Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER 14 An Overview of Corporate Financing 399 8 In 2001 Beta Corporation earned gross profits of $760,000 a Suppose that it is financed by a combination of common stock and $1 million of debt The interest... corporation’s shield of limited liability between the partnership and the human beings who ultimately own the general partner Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER 14 An Overview of Corporate Financing Trusts and REITs Would you like to own a part of the oil... Management, 24: 23–41 (Summer 1995) Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency © The McGraw−Hill Companies, 2003 14 An Overview of Corporate Financing CHAPTER 14 An Overview of Corporate Financing 1 The figures in the following table are in the wrong order Can you place them in their correct order? 397 QUIZ Percent of Total Sources, 2000 Internally... convertible preferred stock The Heinz preferred stock that we mentioned earlier is convertible Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER 14 An Overview of Corporate Financing at the markets in which the firm’s securities are traded and at the financial... bought and sold, most of the loans that banks make are illiquid This mismatch between the liquidity of the bank’s liabilities (the deposits) and most of its assets (the loans) is possible only because the number of depositors is sufficiently large so Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing ©... Corporate Finance, Seventh Edition 390 IV Financial Decisions and Market Efficiency © The McGraw−Hill Companies, 2003 14 An Overview of Corporate Financing PART IV Financing Decisions and Market Efficiency FIGURE 14. 3 Rest of world Holdings of corporate and foreign bonds, end 2000 Other Households Banks & savings institutions Source: Board of Governors of the Federal Reserve System, Division of Research... to cover the damages up to the policy limit This is the return on your investment Of course, the company will issue not just one policy but thousands Normally the incidence of fires 393 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 394 IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 PART IV Financing Decisions and... Almost all short-term debt issued by corporations is held by financial institutions Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER 14 An Overview of Corporate Financing US Dollar Debt Bank loans Commercial paper Senior unsecured notes and debentures Eurodollar... the risk that security prices as a whole will fall Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 396 IV Financial Decisions and Market Efficiency 14 An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 PART IV Financing Decisions and Market Efficiency Visit us at www.mhhe.com/bm7e Common stock is the simplest form of finance The common stockholders own the corporation... International Data,” Journal of Finance, 50 :142 1 146 0 (December 1995) For a discussion of the allocation of control rights and cash-flow rights between stockholders and debtholders, see: O Hart: Firms, Contracts, and Financial Structure, Clarendon Press, Oxford, 1995 Robert Merton gives an excellent overview of the functions of financial institutions in: R Merton: “A Functional Perspective of Financial Intermediation,” . value of the assets is less than the amount of the debt. 17 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate. investment. Of course, the com- pany will issue not just one policy but thousands. Normally the incidence of fires CHAPTER 14 An Overview of Corporate Financing 393 Brealey−Meyers: Principles of Corporate. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IV. Financial Decisions and Market Efficiency 14. An Overview of Corporate Financing © The McGraw−Hill Companies, 2003 CHAPTER