Download Chapter 16 REAL FIRMS AND THEIR FINANCING: STOCKS AND

14
Real Firms and Their
Financing: Stocks and
Bonds
A bargain that is going to become a greater bargain is
no bargain.
MARTIN SHUBIK, YALE UNIVERSITY
Contents
● Corporations and Their Financing
● Financing Corporate Activity: Stocks
and Bonds
● Buying Stocks and Bonds
● Stock Exchanges and Their Functions
● Speculation
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Corporations and Their
Financing
● U.S. firms are of three types:
♦ Proprietorships (largest number of firms)
♦ Partnerships
♦ Corporations (have largest amount of business)
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Corporations and Their
Financing
● The largest U.S. firms are corporations,
which are treated by law as entities separate
from their owners.
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Corporations and Their
Financing
● Advantages:
♦ Limited liability
♦ Access to large amounts of capital
♦ Ease of operation with help of hired
management
♦ Remain permanent even when the owners
change
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Corporations and Their
Financing
● Disadvantages:
♦ Double taxation
♦ Hired managers may act against the interest of
the owners
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Corporations and Their
Financing
● The Effect of Double Taxation of Corporate
Earnings
♦ Reduces the extent of corporate activities
♦ Does not reduce the net returns to individual
investors
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Financing Corporate
Activity: Stocks and Bonds
● Why do corporations need additional funds?
♦ To add to plant or equipment
♦ To finance other types of real investment
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Financing Corporate
Activity: Stocks and Bonds
● How does a corporation get additional
funds?
♦ Take out a loan
♦ Print and sell new stock certificates or new
bonds
♦ Reinvest its own earnings (rather than paying
them out as dividends to stockholders)
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Financing Corporate
Activity: Stocks and Bonds
● Loans
♦ A company can obtain money by borrowing
from banks, insurance companies, other private
firms, or a U.S. government agency.
● Sell Stocks
♦ Common stock conveys an ownership claim
and entitles the stockholder to a proportionate
share of the dividends, if any.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Financing Corporate
Activity: Stocks and Bonds
● Sell bonds
♦ A bond purchase is like a loan.
♦ It conveys no ownership stake, and entitles the
bondholder to be repaid a certain fixed amount
if the bond is held to maturity.
♦ Bondholders have a prior claim to stockholders.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Financing Corporate
Activity: Stocks and Bonds
● Stock “ownership” may be an illusion since
large blocks are needed to exert influence
● Bonds can be a very risky investment due to
fluctuations in market price and inflation.
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Financing Corporate
Activity: Stocks and Bonds
● From the point of view of the corporation,
bonds are typically (not always) cheaper
than stocks, in terms of expected interest
payments versus return to the stockholders;
they are, however, riskier because they
establish a fixed obligation.
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Financing Corporate
Activity: Stocks and Bonds
● Stockholders usually demand a higher
return than bondholders do because, to
them, stocks are riskier.
● In other words, bonds are a way of
transferring some (not all) of the risk from
the investor to the company.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Financing Corporate
Activity: Stocks and Bonds
● Plowback or Retained Earnings
♦ As well as issuing stocks and bonds, firms can
finance their investments through plowback or
retained earnings.
♦ Firms often find this preferable and, in fact, in
1996, plowback constituted about 62 percent of
total U.S. corporate financing.
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Financing Corporate
Activity: Stocks and Bonds
● What Determines Stock Prices? The Role of
Expected Company Earnings
♦ Since most bonds carry a fixed nominal return,
their current market value fluctuates inversely
with interest rates.
♦ The market price of bond is equal to the
coupon divided by the current market interest
rate.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
14-2 Sources of New
Funds for U.S. Corporations
FIGURE
80
72.8
70
60
50
Percent
40
30
21.2
20
10
0
–10
–20
18.9
New
stocks
Plowback
New bonds
and
other debt
Other external
sources
–12.9
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Buying Stocks and Bonds
● Selecting a Portfolio: Diversification
♦ Investors reduce their risk by acquiring a
variety of assets.
♦ An easy way for an individual investor to
diversify is to invest money in an index fund.
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Buying Stocks and Bonds
● Selecting a Portfolio: Diversification
♦ Index funds
■Buy the securities used in one of the standard stock
price indexes
■Return reflects the performance of the whole
market
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Stock Exchanges and Their
Functions
● Stocks are bought and sold on stock
exchanges, the largest and most important
of which is the New York Stock Exchange.
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Stock Exchanges and Their
Functions
● Regulation of the Stock Market
♦ Stock exchanges are regulated internally and
by the Securities and Exchange Commission.
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Stock Exchanges and Their
Functions
● Stock Exchanges and Corporate Capital
Needs
♦ A special type of bank called an investment
bank usually handles new stock issues.
♦ Stock exchanges deal in previously issued
stock; they do not provide capital to firms
directly.
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Stock Exchanges and Their
Functions
● Stock Exchanges and Corporate Capital
Needs
♦ Stock exchanges have two critically important
functions for corporate financing:
■By providing a second-hand market for stocks, they
make individual investment in a company much
less risky.
■The stock market determines the current price of
the company’s stock.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Stock Exchanges and Their
Functions
● Stock Exchanges and Corporate Capital
Needs
♦ A high price of its stock on the exchange is
important to a firm because it allows the
issuance of new stock at a good price.
♦ If a firm has a promising future, its stock will
tend to command a high price on the stock
exchanges.
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Stock Exchanges and Their
Functions
● Stock Exchanges and Corporate Capital
Needs
♦ The stock market helps to allocate the
economy’s resources to firms that can best use
those resources.
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The Surge in Takeovers
● Takeover = group of outside financiers
buys a sufficient amount of company
stock to gain control of the firm.
♦ There has been an increase in takeovers,
including “hostile takeovers,” through the
buying of stock.
♦ Opinion is divided as to whether this is
good or bad for the economy.
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Speculation
● Speculators get bad press, but they usually
perform important, socially useful tasks.
● They protect other people against risk and
they help to smooth out price fluctuations.
● In some circumstances, they may even
prevent famine.
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?
Unpredictable Stock Prices
as “Random Walks”
● Even skilled analysts cannot accurately
predict individual stock prices.
● Rather, they move in a random fashion,
around a long-run market trend for stocks in
general.
● The reason for this may be the great skill
and foresight of investors or, alternately,
their irrational behavior.
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