1.6Trends in Raising Capital

This chapter has so far provided a general overview of the process of how the modern

firm raises capital. Much of what you have learned—the sources of external financing,

the process of issuing securities, parts of the regulatory environment—has remained

the same for decades and, in some cases, as long as a century. In many respects, how-

ever, the capital markets throughout the world have changed dramatically over the past

20 to 30 years and should continue to change in the future. Barriers to trade and cap-

ital flows are being eliminated all the time in both the developed and the developing

world. Europe, a continent at war in much of the last millennium, is now home to a

monetary and trade union. Although no one can predict the future, we should note a

number of trends in the capital markets.

Globalization

Capital markets are now global. Large multinational firms routinely issue debt and

equity outside their home country. By taking advantage of the differences in taxes

and regulations across countries, corporations can sometimes lower their cost of

funds. As firms are better able to shop globally for capital, we can expect regulations

around the world to become similar and the taxes associated with raising capital to

decline. As a result, the costs of raising capital in different parts of the world are

likely to equalize.

Deregulation

Deregulation and globalization go hand in hand. Capital will tend to go to countries

where returns are large and restrictions on inflows and outflows are small. As coun-

tries have opened up their domestic markets to foreign issues and foreign buyers, firms

and investors have responded with massive capital movements. In turn, countries now

find it difficult to maintain highly regulated capital markets because capital flows to

other countries escape this regulation so easily.

Innovative Instruments

Globalization has also spurred financial innovation. Wall Street firms have cleverly

designed new instruments that (1) allow firms to avoid the constraints and costs

imposed by governments, (2) tailor securities to appeal to new sets of investors, and

(3) allow firms to diminish the effects of fluctuating interest and exchange rates. The

result is an astonishing range of financial instruments available in the global market-

place.

Technology

Technology allows many of these recent trends to take place. The ability to simulta-

neously issue billions of dollars of securities in a score of countries across the globe,

to trade trillions of dollars in the secondary markets, and to price new instruments

requires the latest information technology. Technology is likely to lead to continu-

ous, 24-hour trading around the world, thus producing a true world market in some

securities.

Grinblatt76Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw76Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

26Part IFinancial Markets and Financial Instruments

Securitization

Securitizationis the process of bundling—that is, combining financial instruments that

are not securities, registering the bundles as securities, and selling them directly to the

public. For example, securitization has produced a revolution in the mortgage market

through the creation of collateralized mortgage obligations (CMOs), which are debt

contracts based on the payoffs of bundles of publicly traded mortgages. It has also

launched a whole new market in asset-backed securities. Firms can now sell assets, like

their accounts receivable, that were previously costly or impossible to sell.

Result 1.5

Current trends are likely to have an important influence on how corporations raise capitalin the future. These include the globalization and deregulation of capital markets, an abun-dance of new financial instruments, more efficient trading technology, and securitization.

1.7	Summary and Conclusions

Because of the changes taking place in financial markets,developing the necessary skills is to become familiar withfinancial managers face vastly more complex choices nowwhat the new world looks like, who the players are, andthan they did 20 years ago. Because of this increase inwhat the choices are. In this vein, this chapter hascomplexity, corporate finance professionals are required toattempted to broadly describe the securities available forhave an advanced knowledge of how these financial mar-external financing, current trends in financing the firm,kets operate, how financial instruments are priced, andthe institutional and regulatory environment in whichhow they can be used to add value to their corporations.securities are issued, the process of issuing securities, and

This text is devoted to making its readers adept at deal-global differences and recent trends in raising capital. Aing with the new world of finance around them and themore detailed discussion of the debt and equity marketsnew challenges they face in this world. The first step inwill be provided in the following two chapters.

Key Concepts

Result 1.1:Debt is the most frequently used source ofResult 1.3:In the wake of the Great Depression, U.S.

outside capital. The important distinctionsfinancial markets became more regulated.

between debt and equity are these:These regulations forced commercial banks,

the most important provider of private

•Debt claims are senior to equity claims.

capital, out of the investment banking

•Interest payments on debt claims are

business. These regulatory constraints were

tax deductible, but dividends on equity

relaxed in the 1980s and 1990s, making the

claims are not.

banking industry more competitive and

providing corporations with greater varietyResult 1.2:U.S. corporations raise capital from both

in their sources of capital.

private and public sources. Some

advantages associated with private sourcesResult 1.4:Issuing public debt and equity can be a

are as follows:lengthy and expensive process. For large

corporations, the issuance of public debt is

•Terms of private bonds and stock can

relatively routine and the costs are

be customized for individual investors.

relatively low. However, equity is much

•No costly registration with the SEC.more costly to issue for large as well as

•No need to reveal confidentialsmall firms, and it is especially costly for

information.firms issuing equity for the first time.

•Easier to renegotiate.Result 1.5:Current trends are likely to have an

important influence on how corporations

Privately placed financial instruments also

raise capital in the future. These include

can have disadvantages:

the globalization and deregulation of

•Limited investor base.capital markets, an abundance of new

financial instruments, more efficient

•Less liquid.

trading technology, and securitization.

Grinblatt78Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw78Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 1

Raising Capital

27

Key Terms

ask10		offer for sale by tender24
Bank Holding Company Act of 195610		origination12
Banking Act of 1933 (Glass-Steagall Act)	9	overallotment option (Green-Shoe option)12
best-efforts offering15		pension fund4
bid10		primary issue15
bid-ask spread10		private placements7
“Big Bang”22		proprietary trading10
capital markets3		prospectus9
charitable foundation4		registration statement8
commercial bank4		rights offering17
Chinese wall9		risk bearing12
competitive offering16		Rule 144A7
dealer10		Rule 41516
debt5		Rules of Fair Practice12
direct issuance18		seasoned offering15
distribution12		secondary issue15
due diligence9		secondary markets7
equity5		securities6
Eurodollar bonds18		Securities Act of 19338
Euromarkets18		Securities Exchange Act of 19348
Euroyen bonds18		Securities and Exchange Commission (SEC)7
financial intermediaries3		securitization26
firm commitment offering15		senior5
Glass-Steagall Act9		shelf offering16
initial public offering (IPO)15		standby basis17
inside information7		subscription price17
insurance company4		tombstone ad12
internal capital3		underwriter9
investment bank4		underwriting agreement12
Investment Company Act of 194010		underwriting spread12
keiretsu22		underwriting syndicate9
market making10		universal banking10
mutual fund4		venture capital firm4
negotiated offering16

Exercises

1.1In many European countries such as the United1.4The Securities Exchange Act of 1934 made insider

Kingdom and Switzerland, rights issues are muchtrading illegal. What are the costs and benefits of

more common than the public, underwritten offersprohibiting insider trading?

that firms in the United States chiefly use. Can you1.5Smaller firms tend to raise most of their outside

think of some reasons for this?capital from private sources, mainly banks. As firms1.2In a rights offering with a fixed price for exercisingbecome larger, they obtain greater proportions of

the right, does it matter what the exercise price is?their outside capital needs from the public markets.

Do shareholders care? Explain.Explain why.

1.3Competitive underwritings appear to be cheaper than1.6Why do you think the largest banks in the world are

negotiated ones, but almost no firms use the former.in Japan and Germany, not the United States? Do

Can you give some reasons for this?you expect this to change in the future?

Grinblatt80Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw80Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

28Part IFinancial Markets and Financial Instruments

References and Additional Readings

Aggarwal, Reena.“Stabilization Activities by

Underwriters after Initial Public Offerings.” Journal

of Finance55 (2000), pp. 1075–1104.

Ang, James, and Terry Richardson. “The Underwriting

Experience of Commercial Bank Affiliates Prior to

the Glass-Steagall Act: ARe-examination of

Evidence for Passage of the Act.” Journal of Banking

and Finance18 (1994), pp. 351–95.

Barry, Christopher; Chris Muscarella; and Michael

Vetsuypens. “Underwriter Warrants, Underwriter

Compensation, and the Costs of Going Public.”

Journal of Financial Economics29 (1991),

pp. 113–35.

Bhagat, Sanjai. “The Effect of Pre-emptive Right

Amendments on Shareholder Wealth.” Journal of

Financial Economics12 (1983), pp. 289–310.

———. “The Effect of Management’s Choice between

Negotiated and Competitive Equity Offerings on

Shareholder Wealth.” Journal of Financial and

Quantitative Analysis 21 (1985),

pp. 181–96.

Bhagat, Sanjai, and Peter Frost. “Issuing Costs to Existing

Shareholders in Competitive and Negotiated

Underwritten Public Utility Equity Offerings.”

Journal of Financial Economics15 (1986), pp.

233–60.

Bhagat, Sanjai; M. Wayne Marr; and G. Rodney

Thompson. “The Rule 415 Experiment: Equity

Markets.” Journal of Finance40 (1985), pp.

1385–1401.

Booth, James R., and Richard L. Smith II. “Capital

Raising Underwriting and the Certification

Hypothesis.” Journal of Financial Economics15

(1/2) (1986), pp. 261–81.

Carosso, Vincent. Investment Banking in America.

Boston: Harvard University Press, 1970.

Creating World Class Financial Management.New York:

Business International Corp., 1992.

Denis, David. “Shelf Registration and the Market for

Seasoned Equity Offerings.” Journal of Business64

(1991), pp. 189–212.

Dyl, Edward, and Michael Joehnk. “Competitive versus

Negotiated Underwriting of Public Utility Debt.”

Bell Journal of Economics7 (1976), pp. 680–89.

Eckbo, B. Espen, and Ronald Masulis. “Adverse

Selection and the Rights Offer Paradox.” Journal of

Financial Economics32 (1992), pp. 293–332.

Economist Intelligence Unit, Financing Foreign

Operations.London: Business International Group,

1992–1994.

Global Treasury Management.Bill Millar, ed. New York:

Harper Business, 1991.

Hansen, Robert. “The Demise of the Rights Issue.”

Review of Financial Studies 1 (1988), pp. 289–309.

Hansen, Robert, and John Pinkerton. “Direct Equity

Financing: AResolution of a Paradox.” Journal of

Finance37 (1982), pp. 651–65.

Hansen, Robert, and Paul Torregrosa. “Underwriter

Compensation and Corporate Monitoring.” Journal

of Finance47 (1992), pp. 1537–55.

Hodder, James, and Adrian Tschoegl. “Corporate Finance

in Japan.” InJapanese Capital Markets.Shinji

Takagi, ed. Cambridge, MA: Blackwell, 1993.

Holderness, Clifford, and Dennis Sheehan. “Monitoring

an Owner: The Case of Turner Broadcasting.”

Journal of Financial Economics30 (1991),

pp. 325–46.

Hoshi, Takeo; Anil Kashyap; and David Scharfstein.

“Bank Monitoring and Investment: Evidence from

the Changing Structure of Japanese Corporate

Banking Relationships.” In Asymmetric Information,

Corporate Finance, and Investment.R. Glenn

Hubbard, ed. Chicago: University of Chicago Press,

1990.

Kester, W. Carl, “Governance, Contracting, and

Investment Horizons: ALook at Japan and

Germany.” Journal of Applied Corporate Finance

(1992), pp. 83–98.

Kidwell, David; M. Wayne Marr; and G. Rodney

Thompson. “SEC Rule 415: The Ultimate

Competitive Bid.” Journal of Financial and

Quantitative Analysis19 (1984), pp. 183–95.

Kroszner, Randall, and Raghuram Rajan. “Is the Glass-

Steagall Act Justified? AStudy of the United States

Experience with Universal Banking before 1933.”

American Economic Review84 (1994), pp. 810–32.Lee, Inmoo; Scott Lochhead; Jay Ritter; and Quanshui

Zhao. “The Costs of Raising Capital.” Journal of

Financial Research19 (1996), pp. 59–74.

Logue, Dennis, and Robert Jarrow. “Negotiation vs.

Competitive Bidding in the Sale of Securities by

Public Utilities.” Financial Management7 (1978),

pp. 31–39.

Roe, Mark. Strong Managers, Weak Owners.Princeton,

NJ: Princeton University Press, 1994.

Sahlman, William. “The Structure and Governance of

Venture Capital Organizations.” Journal of Financial

Economics27 (1990), pp. 473–524.

Sherman, Ann. “The Pricing of Best Efforts New Issues.”

Journal of Finance47 (1992), pp. 781–90.

Smith, Clifford. “Alternative Methods of Raising Capital:

Rights versus Underwritten Offerings.” Journal of

Financial Economics5 (1977), pp. 273–307.

Grinblatt82Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw82Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

CHAPTER
2
	Debt	Financing

Learning Objectives

After reading this chapter you should be able to:

1.Describe the main sources of debt financing: bank loans, leases, commercial paper

and debt securities.

2.Describe the various characteristics of the debt securities that a firm can issue.

3.Understand the principle of amortization for some types of debt securities.

4.Describe the global environment in which firms issue debt securities.

5.Discuss the operation of secondary markets for debt securities.

6.Understand what a yield to maturity is and how it relates to a coupon yield.

7.Compute accrued interest for Treasury securities and corporate securities.

Harman International, a manufacturer of high-quality audio and video products, set

up its first revolving credit facility in 1994. Since then, it has extended the expiration

date of the facility twice and amended the agreement five times. The firm currently

maintains a $275 multi-currency revolving loan agreement with a group of 11 banks.

With this line of credit, the banks are committed to lending Harman the money

without requiring Harman to explain why the loan is needed.

The interest rate for borrowing under the more than 100-page loan agreement

consists of the floating rate known as LIBOR plus an additional amount based on

the financial performance of Harman. Currently the rate is LIBOR 20 basis points

(0.20 percent) per year. To enter into the arrangement, Harman paid an up-front fee

of .65 percent of the credit line to the other participating banks, along with an

annual fee of .10 percent. Harman management was extremely pleased with the low

rates they were able to lock in by arranging the facility when they did. At the time of

this writing, the assistant treasurer of Harman estimated that similar credits were

paying 95–115 basis points above LIBOR.

29

Grinblatt84Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw84Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

30Part IFinancial Markets and Financial Instruments

hapter 1 noted that the most frequently used source of external financing is debt.¹

CCorporate managers, whose firms finance their operations by issuing debt, and the

investors who buy corporate debt need to have a thorough understanding of debt instru-

ments and the institutional features of debt markets.

Debt instruments, also called fixed-income investments, are contracts containing

a promise to pay a future stream of cash to the investors who hold the contracts. The

debt contract can be negotiable, a feature specified in the contract that permits its sale

to another investor, or nonnegotiable, which prohibits sale to another party. Generally,

the promised cash flows of a debt instrument are periodic payments, but the parties

involved can negotiate almost any sort of cash flow arrangement. Thus, a debt contract

may specify the size and timing of interest payments and a schedule for repayment of

principal, the amount owed on the loan. In addition to promises of future cash, a debt

contract also establishes:

•	The financial requirements and restrictions that the borrower must meet.
•	The rights of the holder of the debt instrument if the borrower defaults, thatis, violates any of the key terms of the contract, particularly the promise to pay.

The sheer variety of debt contracts generates a huge nomenclature and classifica-

tion system for debt. Athorough education in this nomenclature and classification sys-

tem is needed to implement many of the theoretical concepts developed in this text.

For example, the simplest calculation of the returns of a financial instrument requires

knowledge of the precise timing and magnitude of cash flows. Debt is full of conven-

tions and shorthand language that reveal this cash flow information to knowledgeable

participants in the debt market. To participate in the debt markets, either as a corpo-

rate issuer or as an investor, it is important to be grounded in the culture of the debt

markets.

Punctuating this message is the Harman credit facility. The description of this bank

loan in the opening vignette may seem like an incomprehensible sentence to the novice.

To knowledgeable debt-market players, however, like the assistant treasurer of Harman,

the conventions that determine the cash flows for LIBOR and the credit spread, which

is a markup, that is, an amount added to LIBOR, are quite familiar. This person would

have access to information about the credit risk of his or her firm and how to interpret

the nomenclature and shortcut symbols in the credit risk arena. In short, the sophisti-

cated investor can construct the exact cash flows of a debt instrument from what ini-

tially seems like a limited set of information, make comparisons, and quickly know

whether he is getting a good deal or a bad deal.

This chapter can be thought of as a reference manual for the novice who wants to

participate in the debt markets, but on a more level playing field. We begin this chap-

ter by focusing on the four most common forms of debt contracts that corporations

employ to finance their operations: bank loans, leases, commercial paper, and bonds

(sometimes called notes). We then analyze the relationship between the price of a debt

instrument and a commonly used measure of its promised return, the yield(defined

later; see yield-to-maturity). This relationship between price and yield requires an

understanding of a number of concepts that are peculiar to debt: accrued interest, set-

tlement conventions, yield quotation conventions, and coupon payment conventions.

¹It is a huge market. The Federal Reserve estimates that there was more than $18 trillion of debt out-

standing in the United States alone as of 2000. This figures excludes the debt of financial institutions,

like banks.

Grinblatt86Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw86Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

31

EXHIBIT2.1Types of Bank Loans

Line of credit

An arrangement between a bank and a firm, typically for a short- term loan, whereby the bank authorizes the maximum loan amount, but not the interest rate, when setting up the line of credit.

Loan commitment

An arrangement that requires a bank to lend up to a maximum prespecified loan amount at a prespecified interest rate at the firm’s request as long as the firm meets the requirements established when the commitment was drawn up. There are two types of loan commitments:

•	Arevolver, in which funds flow back and forth between thebank and the firm without any predetermined schedule. Funds are drawn from the revolver whenever the firm wantsthem, up to the maximum amount specified. They may besubject to an annual cleanup in which the firm must retireall borrowings.
•	Anonrevolving loan commitmentin which the firm maynot pay down the loan (known as a takedown) and then subsequently increase the amount of borrowing.