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Chapter 12
Global Financial Markets and Long-Term Corporate Financing
Shapiro and Balbirer: Modern Corporate Finance:
A Multidisciplinary Approach to Value Creation
Graphics by Peeradej Supmonchai
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Learning Objectives Identify the functions and consequences of
well-functioning financial markets.
Describe how the financial markets are organized.
Define and explain the forces that underlie securitization and indicate how it has affected the financing policies of corporations.
Discuss the differences between financial systems and how they influence corporate governance.
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Learning Objectives (Cont.)
Explain the advantages and dis-advantages of various sources of corporate financing.
Describe the links between national and international financial markets.
Explain why firms choose to raise capital overseas.
Describe the Eurocurrency and Eurobond markets and explain why they exist.
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Flow of Funds in the Financial Markets
Financial Markets
BorrowersParties Whose
Spending Exceeds
Their Income
SaversParties Whose
Income Exceeds
Their Spending
Cash Cash
Financial Assets
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Functions of the Financial Markets
Mobilize savings and allocate these funds
to borrowers
Facilitate risk transfer
Provide a source of liquidity
Provide a mechanism for valuing financial
assets
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Flow of Funds Through Financial Intermediaries
Financial Intermediaries Banks Insurance Companies Mutual Funds Finance Companies
BorrowersParties Whose
Spending Exceeds
Their Income
SaversParties Whose
Income Exceeds
Their Spending
Cash Cash
Secondary
Claims
Primary
Claims
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Functions of Financial Intermediaries
Reduce the cost of bringing borrower and saver together
Bridge borrower’s and lender’s maturity preferences
Reduce investment risk through diversification
Some services of intermediaries provide a payments mechanism
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Money Market Instruments
Treasury Bills
Tax-Exempt Paper
Negotiable Certificates of Deposit (CDs)
Bankers Acceptances
Commercial Paper
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Capital Market Instruments
Treasury Notes and Bonds
Mortgages
Municipal Bonds
Corporate Notes and Bonds
Preferred Stock
Common Stock
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Primary versus Secondary Markets
Primary Market: The market for new
issues where funds flow to issuers from
creditors and investors
Secondary Market: The market where
already-issued financial assets are
bought and sold
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Dealer versus Brokered Markets
Dealer Markets: Where individuals or firms
facilitate trades by buying and selling
financial assets out of their own account
Brokered Markets: Markets where individuals
or firms simply serve as agents in bringing
buyers and sellers together
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Organized versus Over-the-Counter (OTC) Markets
Organized Exchanges: An actual physical
place for the exchange of securities
OTC Markets: The OTC market has no
physical place; instead, it is a set of
dealers tied together by a tele-
communications network.
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Spot versus Derivatives Markets
Spot or Cash Market
Derivatives Market Forward Contracts (OTC Markets)
Futures Contracts (CBOT)
Option Contracts (CBOE and OTC Markets)
Swaps (OTC Markets)
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External Financing Patterns
Demand is greatest after economic peaks
Most external financing is in the form of debt
Need for external financing is lowest after a
recession
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Securitization
There is a growing tendency towards
securitization - the process whereby
corporate borrowing takes the form of
issuing negotiable securities issued in the
public capital markets rather than through
nonmarketable loans through financial
intermediaries.
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Financial Systems and Corporate Governance
Anglo-Saxon (AS) Model: Market-oriented
financial system where the firm’s accepted
objective is to maximize shareholder value
Continental European - Japanese Model:
Bank-centered system in which banks not
only provide financing but also have an
ownership interest in their client firms
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The Japanese Keiretsu
Large industrial grouping - often with a major bank at the center.
Keiretsu ties involve a complex set of traditions, cross-shareholding, trading relationships, management and information swapping. The key mission of the keiretsu is to provide a safety net for its members.
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Universal Banking
A system practiced in Germany, where banks
perform not only “banking” activities but also take
major equity positions in their client firms. As both
stockholders and creditors, universal banks can
reduce the conflicts between the two classes of
investors. This leads to lower costs and a faster
speed of “workouts” of financial problems.
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Sources of Corporate Financing
Retained Earnings
Common Stock
Corporate Debt
Preferred Stock
Convertible Securities
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Advantages of Financing With Retained Earnings
Does not involve bringing in “outsiders”
Relative to dividends, the capital gains
associated with retentions has tax benefits
Avoids the cost of new security issues
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Disadvantages of Financing With Retained Earnings
May be a unreliable source of financing if
earnings are unstable
Retentions come at the expense of dividends
Many firms treat retained earnings as free
capital
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Advantage of Common Stock Financing
Requires no contractual payments; a firm
is not required to pay dividends.
With no maturity date, common stock is a
permanent source of funds.
Sales of common stock lowers the cost of
debt or preferred stock.
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Disadvantages of Common Stock Financing
Sale of common stock brings in new owners.
Dividends are paid out of after-tax earnings.
Flotation costs are higher than raising the
same amount of money using debt.
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Advantages of Debt Financing
Interest payments are tax deductible.
Debtholders receive a fixed return and do
not share in the value created by growth
opportunities.
Bondholders don’t have voting rights.
Issue costs on bonds are typically low.
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Disadvantages of Debt Financing
Greater use of debt increases financial risk.
Debt servicing payments are contractual; failure to meet them is an act of default.
Increasing leverage increases the cost of equity.
Bonds typically have restrictive covenants.
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Advantages of Preferred Stock Financing
Provides firm with financial leverage without increasing bankruptcy risk.
Lack of a set maturity date and ability to skip payments provides a firm with flexibility in managing its cash flows.
Under normal circumstances, preferred stockholders don’t have voting rights.
Corporate holders can exclude from taxes 70 percent of the dividends they receive.
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Disadvantages of Preferred Stock Financing
Preferred stock dividends are not tax-deductible.
The claims of preferred stockholders on earnings
and assets take priority over common stockholders.
Fixed dividend payment can lead to unfavorable
leverage if earnings decline.
Preferred stockholders may be granted voting
rights if dividend payments are not made.
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Advantages and Disadvantages of Convertible Securities Advantages
Convertible debt carries a lower interest rate than straight bonds
Since investors share in upside potential, convertible debt contains fewer covenants than straight debt
Allows for a deferred equity offering at a higher price
Disadvantages Gives the holder the right to participate in an
unexpected increase in share price
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International Financial Markets
Foreign Bond Market: That portion of the domestic bond market that represents issues by foreign firms or governments
Foreign Bank Market: That portion of domestic bank loans supplied to foreigners for use abroad
Foreign Equity Market: That portion of the equity markets represented by equity issued by foreign firms
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The Eurocurrency Market
A Eurocurrency is a dollar or any other freely-
convertible currency in a bank deposit
outside its country of origin. Eurocurrency
loans are made on a floating-rate basis.
Historically, these rates have been set in
relation to the London interbank offer rate
(LIBOR).
