2.9Summary and Conclusions

This chapter has provided an introduction to the variousOne of the goals of this text is to bring the reader fromsources of debt financing: bank loans, leases, commercialhaving merely an intuitive feel for the time value ofpaper, and debt securities. Alarge variety of debt financingmoney—as exemplified by the discussion in the appendixis available. In addition, there are many ways to categorizeat the end of this textbook—to being able to pick up a busi-debt instruments: by their covenants, options, cash flowness newspaper or examine a computer screen and usefullypattern, pricing, maturity, and rating.employ the data displayed to value financial and real

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Strategy, Second Edition

64Part IFinancial Markets and Financial Instruments

assets. Accomplishing this goal requires a substantialkets. These skills are useful to the corporate manager whoamount of knowledge about debt securities, some of whichneeds to determine whether to finance an investment withis found in this chapter.debt securities or equity securities.

In addition to learning how debt prices and yields areTo complete the institutional education of the financialquoted, a variety of skills are acquired in this chapter.manager, it is important to explore in similar detail theAmong them is knowing where to trade debt, where to is-main competitor to debt financing: equity financing. Forsue debt, and what role debt plays in global capital mar-this, we turn to Chapter 3.

Key Concepts

Result 2.1:	For straight-coupon, deferred-coupon, zero-	value) and (2) settle on a coupon date, have
	coupon, perpetuity, and annuity bonds, the	yields to maturity that equal their coupon
	bond price is a downward sloping convex	yields.
	function of the bond’s yield to maturity.	Result 2.3:Abond between coupon dates has a flat price
Result 2.2:	Straight-coupon bonds that (1) have flat	that is less than par with a yield to maturity
	prices of par (that is, $100 per $100 of face	that is the same as its coupon rate.

Key Terms

accrued interest60	currency swap54
annuity bond44	debenture39
amortization36	defaults30
asset-backed securities52	deferred-coupon bond44
asset covenant37	direct lease34
balloon payment43	discount bond47
bearer bond54	dividend covenant37
benchmark rate31	dual-coupon bond47
bill47	equipment trust certificate39
bond covenants (bond indentures)36	Eurobond54
bond equivalent yield58	Eurocurrency loan54
bond rating36	Eurodollar deposits55
bonding covenant37	exchangeability42
bonding mechanism39	ex-date60
bonds35	face value36
bullet bond44	fallen angels50
callability42	Fed funds rate32
cap33	financial lease (capital lease)34
cash flow pattern36	financing covenant37
collared floating-rate loan33	fixed-income investments30
collateral trust bond39	flat price60
commercial paper rate32	floating rate31
consol44	floor33
conversion premium43	full price60
conversion price43	high-yield bonds (junk bonds)49
convertibility42	increasing-rate notes (IRNs)53
convex curvature59	interest coverage ratio37
coupon36	investment-grade rating49
coupon rate36	interest rate swap60
coupon yield62	junior bonds36
credit spread30	junk bonds49

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Chapter 2

Debt Financing

65

lease34	premium bond47
lessee34	price36
lessor34	prime rate32
leveraged buyout43	principal30
leveraged lease34	pure discount bond44
leveraged recapitalization43	putability42
LIBID32	refundable bonds42
LIBOR32	repurchase agreements56
line of credit31	revolver31
loan commitment31	sale and leaseback34
loan covenants32	scallop effect63
lock-box37	secured bonds36
maturity36	senior bonds36
mortgage bond39	settlement date59
negative amortization45	short sales56
negotiable30	sinking fund provision39
net working capital37	straight-coupon bond44
nonnegotiable30	subordinated claims36
note47	syndicate desk56
nonrevolving loan commitment31	takedown31
oil-linked bonds52	Treasury bills32
on-the-run Treasuries32	Treasury bonds32
operating lease34	Treasury Inflation Protected Securities (TIPS)52
options36	Treasury notes32
original issue discount (OID)47	Treasury rate32
over the counter (OTC)56	Treasury strips58
par value43	unsecured creditors39
par bond47	yield to maturity58
perpetuity bond (consol)44	Zerfix bonds44
PIK (payment-in-kind) bonds44	zero-coupon bond44
poison put bond43

Exercises

2.1.Critics of rating agencies argue that because the2.3.An article in The Economist(Sept. 25, 1993, p. 93)

firm pays rating agencies to rate the firm’s debt, thesaid, in part:

rating agencies have the wrong incentives. What do

Neither fish nor fowl, convertible bonds, which

you think of this argument? Can you think of ways

give investors an option to convert into equities,

to assess its validity?

have been gaining popularity in America. There2.2.On October 31, 1994, TheWall Street Journalwrote:

were $103 billion of them outstanding at the end

Once one of the raciest and most profitable areasof August, up from $52 billion in 1990. Why the

of investment banking, the Eurobond market hasenthusiasm? For an issuing company, convertibles

become boring and, even worse, not veryhave several good features. Afirm can borrow at

profitable. Though the volume of new issues thisabout three percentage points below the cost of

year in the market which comprises bondsstraight debt. It does not give up as much equity

underwritten outside a borrower’s home countryas with an ordinary share issue. That is why

is likely to exceed $900 billion, up from $337convertibles are particularly popular with small

billion in 1980, profit margins have plummeted.companies that hope to grow rapidly.

What do you think was happening in the Eurobond	Do you think that convertible debt represents a
market?	cheap way to finance the firm? Can you think of
	any reasons why small, growing firms might favor
	convertibles?

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

66Part IFinancial Markets and Financial Instruments

2.4.The diagram below shows default rates of ratedd.Actual/360 if the coupon payment date is

bonds.August 15, 1998.

2.6.Refer to the bond in exercise 2.5. What is the

Success and failureaccrued interest for settlement of a trade on

August 1, 1998, with each of the four day-count

Corporate bonds

methods? For parts aand b,assume that the coupon

payment date is August 15, 1998.

Cumulative default rates, 1970-94

% of issuers defaulting2.7.XYZ Corporation takes out a $1 million loan that

B40semiannually pays six-month LIBOR 50 bp on

March 4, 1999. Assume that LIBOR is at 9 percent

on March 4, 1999, 8.75 percent on September 4,

30

1999, and 9.125 percent on March 4, 2000. What

Ba

are the first three interest payments on the loan?

20When are they paid?

2.8.A5 percent corporate bond maturing November 14,

Baa

2020 (originally a 25-year bond at issue), has a

10

Ayield to maturity of 6 percent (a 3 percent discount

Aa

rate per 6-month period for each of its semiannual

Aaa0

payments) for the settlement date, June 9, 2001.

What is the flat price, full price, and accrued

1 5 10 15 20

interest of the bond on June 9, 2001?

Years

2.9.Abank loan to the Knowledge Company has a 50

basis point spread to LIBOR. If LIBORis at 6

percent, what is the rate of interest on the bank

loan?

What conclusions can you draw from the diagram?

2.10.Identify the conversion price in Euros and U.S.2.5.Consider a straight-coupon bond (or bank loan)dollars of Amazon’s convertible bond, as described

with semiannual interest payments at an 8 percentin Chapter 1’s opening vignette. Based on

annualized rate. Per $100 of face value, what is theAmazon’s closing price of $80 a share in early,

semiannual interest payment if the day count is2001, what was the bond’s conversion premium on

based on the following methods?that date? (Assume no change in the exchange rate

a.Actual/actualfrom that given in the vignette.)

b.30/360

c.Actual/365 if the coupon payment date is

August 15, 1998

References and Additional Readings

Altman, Edward. “The Anatomy of the High-Yield BondBencivenga, Joseph. “The High-Yield Corporate Bond

Market.” Financial Analysts Journal43 (1987), Market.” In The Handbook of Fixed Income

pp. 12–25.Securities.Frank Fabozzi, ed. Burr Ridge, IL: Irwin———. “Measuring Corporate Bond Mortality andProfessional Publishing, 1995.

Performance.” Journal of Finance44 (1989), Blume, Marshall; Donald Keim; and Sandeep Patel.

pp. 909–22.“Returns and Volatility of Low-Grade Bonds,Altman, Edward, and Scott Nammacher. “The Default1977–1989.” Journal of Finance46 (1991),

Rate Experience on High-Yield Corporate Debt.”pp. 49–74.

Financial Analysts Journal41 (1985), pp. 25–41.Cornell, Bradford, and Kevin Green. “The Investment

Asquith, Paul; David Mullins; and Eric Wolff. “OriginalPerformance of Low-Grade Bond Funds.” Journal of

Issue High-Yield Bonds: Aging Analyses of Defaults,Finance46 (1991), pp. 29–48.

Exchanges, and Calls.” Journal of Finance44Duffie, Darrell. “Special Repo Rates.”Journal of Finance

(1989), pp. 923–52.51 (1996), pp. 493–526.

Grinblatt158Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw158Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

67

Ederington, Louis, and Jess Yawitz. “The Bond Rating

Process.” In Handbook of Financial Markets and

Institutions.Edward Altman, ed. New York: John

Wiley, 1986.

Ederington, Louis; Jess Yawitz; and Brian Roberts. “The

Informational Content of Bond Ratings.” Journal of

Financial Research10 (1987), pp. 211–26.

Fabozzi, Frank. Bond Markets, Analysis, and Strategies.

3rd ed. Upper Saddle River, NJ: Prentice Hall, 1996.Fabozzi, Frank, and Dessa Fabozzi. The Handbook of

Fixed Income Securities.4th ed. Burr Ridge, IL:

Irwin Professional Publishing, 1995.

Franks, Julian, and Walt Torous. “An Empirical

Investigation of U.S. Firms in Chapter 11

Reorganization.” Journal of Finance44 (1989),

pp. 747–67.

Goh, Jeremy, and Louis Ederington. “Is a Bond Rating

Downgrade Bad News, Good News, or No News for

Stockholders?” Journal of Finance48 (1993),

pp. 2001–8.

Grinblatt, Mark, with Bing Han. “An Analytic Solution

for Interest Rate Swap Spreads.” Review of

International Finance,forthcoming, 2002.

Hand, John; Robert Holthausen; and Richard Leftwich.

“The Effect of Bond Rating Agency Announcements

on Bond and Stock Prices.” Journal of Finance47

(1992), pp. 29–39.

Holthausen, Robert, and Richard Leftwich. “The Effect of

Bond Rating Changes on Common Stock Prices.”

Journal of Financial Economics17 (1986),

pp. 57–89.

Jefferis, Richard. “The High-Yield Debt Market,

1980–1990.” Federal Reserve Bank of Cleveland,

Economic Commentary26 (1990), pp. 1–6.

Jones, Christopher. “Evidence on the Importance of

Market Making: Drexel’s Failure and the Junk Bond

Market.” Working paper, Stanford University,

Stanford, CA.

Kalay, Avner. “Stockholder-Bondholder Conflict and

Dividend Constraints.” Journal of Financial

Economics10 (1982), pp. 211–33.

Kester, W. C., and W. B. Allen. “R.J. Reynolds

International Financing.” Harvard Case 9-287-057,

November 1991.

Lehn, Kenneth, and Annette Poulsen. “Contractual

Resolution of Bondholder-Stockholder Conflicts.”

Journal of Law and Economics34, 2, part 2 (October

1991), pp. 645–73.

McDaniel, Morey. “Bondholders and Corporate

Governance.” Business Lawyer41 (1986),

pp. 413–60.

Moody’s Investors Service. Corporate Bond Defaults and

Default Rates 1970–93.Global Credit Research

Division, 1994.

Rosengren, Eric. “The Case for Junk Bonds.” New

England Economic Review(May/June), Federal

Reserve Bank of Boston, 40–49.

Ruback, Richard. “RJR Nabisco.” Harvard Case

9-289-056, 1989.

Salomon Brothers Bond Portfolio Analysis Group. “Odd

Coupon Treasury Bonds: Price-Yield Calculations.”

July 1985.

Schallheim, James. Lease or Buy.Boston: Harvard

University Press, 1995.

Smith, Clifford, and Lee Wakeman. “Determinants of

Corporate Leasing Policy.” Journal of Finance540

(1985), pp. 896–908.

Smith, Clifford, and Jerry Warner. “On Financial

Contracting: An Analysis of Bond Covenants.”

Journal of Financial Economics7 (1979),

pp. 117–61.

Stigum, Marcia. The Money Market.Burr Ridge, IL:

Irwin Professional Publishing, 1990.

Tufano, Peter. “Financial Innovation and First Mover

Advantages.” Journal of Applied Corporate Finance

5 (1992), pp. 83–87.

Weinstein, Mark. “ACurmudgeon’s View of Junk

Bonds.” Journal of Portfolio Management13, no. 3

(1986–1987), pp. 76–80.

Wilson, Richard, and Frank Fabozzi. The New Corporate

Bond Market.Chicago: Probus Publishing, 1990.

Grinblatt160Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw160Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

CHAPTER
3
	Equity	Financing

Learning Objectives

After reading this chapter you should be able to:

1.Describe the types of equity securities a firm can issue.

2.Provide an overview of the operation of secondary markets for equity.

3.Describe the role of institutions in secondary equity markets and in corporate

governance.

4.Understand the process of going public.

5.Discuss the concept of informational efficiency.

Southern Company is one of the largest producers of electricity in the United States.

Before 2000, the company was a major player in both the regulated and unregulated

electricity markets. On September 27, 2000, Southern Energy, Inc. (since renamed

Mirant Corporation), the unregulated division of Southern Company, became an

independent company with an initial public offering. In the offering, Southern Energy

issued 66.7 million shares at $22 each, representing 19.7% of the newly formed

corporation’s shares. When the company originally filed its prospectus, it estimated

that the issue would be priced in the $15–$17 per share range. However, interest in

the issue was significantly greater than expected, and the range was increased to

$18–$20 per share on September 24. On September 26, the decision was made to

offer the shares at $22 per share. The first trade of Southern Energy was at $28.25,

and the stock closed the first day at $29.00 per share. The company raised about

$1.4 billion from the stock offering and another $345 million in a simultaneous

offering of convertible preferred stock. The funds are primarily being used to pay

down short-term debt and for the acquisition and construction of generation assets.

Southern Company plans to sell the remaining 80.3% of the shares in the near

future, making Southern Energy a completely independent company.

Chapter 2 discussed debt financing, a major source of external capital for firms. We

turn now to equity, the second major source of external capital. Although debt and

equity are alike in that both provide resources for investment in capital equipment,

research and development, and training that allow firms to prosper, they differ in sev-

eral important respects.

68

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 3

Equity Financing

69

•	Debt holder claims must be paid in full before the claims of equity holders canbe paid.
•	Equity holders elect the board of directors of the corporation and thusultimately control the firm.1
•	Equity holders receive cash in the form of dividends, which are not taxdeductible to the corporation, while the interest payments of debt instrumentsare a tax-deductible expense.2

This chapter describes various equity instruments, how they are traded, and the

individuals and institutions that own them. It also briefly discusses the efficient

markets hypothesis which provides some insights into how equity is priced in the

capital markets. In addition, it examines the distinction between firms that are

privately owned and hence have no publicly traded stock, and firms that are publicly

owned with publicly traded stock. Finally, the chapter covers why a firm might want

to have its stock publicly traded and the process by which a firm goes public.