1.1 Financing the Firm

Households, firms, financial intermediaries, and government all play a role in the finan-

cial system of every developed economy. Financial intermediariesare institutions

such as banks that collect the savings of individuals and corporations and funnel them

to firms that use the money to finance their investments in plant, equipment, research

and development, and so forth. Some of the most important financial intermediaries are

described in Exhibit 1.1.

In addition to financing firms indirectly through financial intermediaries, house-

holds finance firms directly by individually buying and holding stocks and bonds. The

government also plays a key role in this process by regulating the capital markets and

taxing various financing alternatives.

Decisions Facing the Firm

Firms can raise investment capital from many sources with a variety of financial instru-

ments. The firm’s financial policy describes the mix of financial instruments used to

finance the firm.

Internal Capital.Firms raise capital internally by retaining the earnings they gen-

erate and by obtaining external funds from the capital markets. Exhibit 1.2 shows

that, in the aggregate, the percentage of total investment funds that U.S. firms generate

Grinblatt35Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw35Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

4Part IFinancial Markets and Financial Instruments

EXHIBIT1.1Description of Financial Intermediaries

Financial
Intermediary	Description

Commercial bank	Takes deposits from individuals and corporations and lends
	these funds to borrowers.

Investment bank

Raises money for corporations by issuing securities.

Insurance company	Invests money set aside to pay future claims in securities,
	real estate, and other assets.

Pension fund

Invests money set aside to pay future pensions in securities, real estate, and other assets.

Charitable foundationInvests the endowment of a nonprofit organization such as a

university.

Mutual fund

Pools savings from individual investors to purchase securities.

Venture capital firm

Pools money from individual investors and other financial intermediaries to fund relatively small, new businesses, generally with private equity financing.

EXHIBIT1.2Aggregate Percent of Investment Funds Raised Internally

100

80

Percent60

40

20

0
1970	1975	1980	1985	1990	1995	2000
			Year

Source: Federal Reserve Flow of Funds.

internally—essentially retained earnings plus depreciation—is generally in the 40–80

percent range. Thus, internal cash flows are typically insufficient to meet the total cap-

ital needs of most firms.

External Capital: Debt vs. Equity.When a firm determines that it needs external

funds, as Amazon did (as described in the opening vignette), it must gain access to cap-

ital markets and make a decision about the type of funds to raise. Exhibit 1.3 illustrates

the two basic sources of outside financing: debt and equity, as well as the major forms

Grinblatt37Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw37Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

	Chapter 1Raising Capital	5
EXHIBIT1.3	Sources of Capital

	Capital markets
Debt		Equity

Bank		Commercial
	Bonds		Leases	Common	Preferred	Warrants
loans		paper

of debt and equity financing.¹Although Amazon’s financing is clearly debt, its con-

vertibility feature implies that it might someday be converted into equity, at the option

of the debt holder.

The main difference between debtand equityis that the debt holders have a con-

tract specifying that their claims must be paid in full before the firm can make pay-

ments to its equity holders. In other words, debt claims are senior, or have priority,

over equity claims. Asecond important distinction between debt and equity is that pay-

ments to debt holders are generally viewed as a tax-deductible expense of the firm. In

contrast, the dividends on an equity instrument are viewed as a payout of profits and

therefore are not a tax-deductible expense.

Major corporations frequently raise outside capital by accessing the debt markets.

Equity, however, is an extremely important but much less frequently used source of

outside capital.

Result 1.1 summarizes the discussion in this subsection.

Result 1.1

Debt is the most frequently used source of outside capital. The important distinctionsbetween debt and equity are:

•	Debt claims are senior to equity claims.
•	Interest payments on debt claims are tax deductible, but dividends on equity claimsare not.

How Big Is the U.S. Capital Market?

Exhibit 1.4 shows the value of the outstanding debt and equity capital of U.S. firms

since 1970.²The relative proportions of debt and equity have not changed dramatically

over time. Since 1970, firms have been financed with about 60 percent equity and 40

percent debt, with the percentage of equity financing increasing somewhat in the 1990s.

¹The different sources of debt financing will be explored in detail in Chapter 2; the various sources

of equity capital are examined in Chapter 3.

²Unfortunately, the data are not strictly comparable because the equity is expressed in market value

terms, the price at which the security can be obtained in the market, and the debt is expressed in book

value terms, which is generally close to the price at which the debt originally sold.

Grinblatt38Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw38Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

6	Part IFinancial Markets and Financial Instruments
EXHIBIT1.4	Value of Debt and Equity Outstanding in the U.S., Billions of Dollars

$15,000

$12,500

Billions of dollars
	$10,000	Equity value

$7,500

$5,000

$2,500
	Debt value

$0
1970	1975	1980	1985	1990	1995	2000

Year

Source: Federal Reserve Flow of Funds.

In the 1980s, the aggregate amount of debt financing relative to equity financing,

with debt and equity measured in book value terms, increased substantially. Countless

writers in the business press, as well as countless politicians, have interpreted this to

mean that firms were replacing equity financing with debt financing in the 1980s. This

interpretation is somewhat misleading. Firms retired a substantial number of shares in

the 1980s, through either repurchases of their own shares or the purchases of other

firms’shares in takeovers. Far more shares were retired than were issued. However,

offsetting these share repurchases was an unprecedented boom in the stock market that

substantially increased the market value of existing shares. As a result, firms were able

to retire shares and issue debt without increasing their debt/equity ratios, expressed in

market value, above their pre-1980 levels. As Exhibit 1.4 illustrates, using market val-

ues, the ratio of debt to equity remained relatively constant in the 1980s. During the

1990s, the meteoric rise of the U.S. stock market caused debt/equity ratios, expressed

in market value terms, to fall, even though corporations continued to issue large

amounts of debt.