Raising Money to Grow a Business

Lesson 4 Issuing Stock vs. Bonds

Debt vs. Equity Financing

Aim: What are the pros and cons of equity

vs. debt financing?

Do Now: We have been discussing potential

debt vs. equity financing of Frizzle, Inc. What is the reason it needs financing in the first place?

Debt vs. Equity Financing Do Now answers:

1. It is a profitable company that has tremendous opportunity to expand geographically

2. To expand, it needs a significant amount of money!

Ice cream and restaurant. Opening new Frizzle’s around the world for the past five

years. One of the most popular ice cream restaurants in the

United States and Europe. 20% market share. 25,000 employees in multiple locations in the United States

and Europe. Headquartered in New York, NY. Looking to expand to China or Russia. Needs $500 million in order to expand. Financial statements indicate a healthy, profitable company.

Frizzle, Inc.

1. When we sell stock, which type of financing is this? Equity financing. Equity is another term for

ownership. Shares of stock represent ownership.

2. When we sell bonds, which type of financing is this? Debt financing. Bonds represent borrowed

money, which is owed back. It is debt!

Debt vs. Equity Financing

Review: What am I, a share of common stock or a bond?1. I come with one vote per unit

2. Those who own me are entitled to receive interest payments twice per year

3. At the end of my term I am turned in for what the investor paid for me

4. If the corporation goes out of business, my owners get in line first to receive cash from the liquidation of assets

5. If the corporation didn’t earn enough profit, it may not pay dividends to my owners

For the corporation…Upside Downside

Issuing stock

Raises money without a requirement to pay the investor anything!

May upset current shareholders by diluting them

Issuing bonds

Raises money for the corporation without diluting existing shareholders

Must pay interest and then the face value back at maturity

1. Can you tell which one is safer for a company to issue? For example, if it wants to raise $1 billion, is it safer to issue $1 billion in new shares of stock or in new bonds? Issuing stock (equity financing) is safer!

Let’s take a closer look at what we as corporate financial managers really owe shareholders once we get their money:

Debt vs. Equity Financing

After collecting the $1 billion from selling investors new shares of stock, when must it return this money?

Never! Stock exists in perpetuity. Its life never ends (unless it goes out of business). So, the company never needs to worry about paying this money back.

Financial Obligations of Company to its Shareholders

After collecting the $1 billion from selling investors new bonds, when must it return this money?

When the bond matures! Sure, the term of the borrowing can be as long as 10 or 20 years, but it can be as little as 5 or less years. The due date will eventually arrive!

Financial Obligations of Company to its Shareholders

What payments must the company make to shareholders each year they own the stock?

None! We said earlier that companies choose to pay dividends if they have extra profits they can afford to pay out. But if there are no extra profits (or profits at all), the dividend can be cut to $0!

Financial Obligations of Company to its Shareholders

What payments must the company make to bondholders each year they own the bonds?

Interest! Assuming the coupon rate on the $1 billion of bond was a reasonably low 5%, that percentage of $1 billion is $50 million. The company must come up with $50 million to pay out each year!

Financial Obligations of Company to its Shareholders

So it should be very clear. Companies that sell stock are under no obligation to pay their shareholders anything! This is the safest way to raise money!

Companies that borrow money must make annual payments of interest and eventually pay back all the money borrowed! This is the riskiest way of raising money!

Financial Obligations of Company to its Shareholders

Is it all or nothing? Does a company wanting to raise $1 billion have to choose debt financing or equity financing?• Absolutely not! This is where an investment

bank can be of assistance. The bank may advise a split right down the middle:

– Sell $500m of stock and $500m of bonds!

Debt vs. Equity Financing

If selling stock is so safe, why don’t companies avoid issuing debt altogether?• We will address this in a future activity. But

we’ll preview it here:

• Each time it raises money by selling new shares of stock, the company grows the number of owners. Existing shareholders don’t like this, because their claim on the company’s profits is watered down

Debt vs. Equity Financing

Securing the Debt Debenture – An ordinary bond, meaning it is not

“backed” by any collateral, just the promise to pay Collateralized or Secured Bonds – Are backed by

either a real asset (eg: a building) or financial asset (eg: the right to collect money). In the case of bankruptcy, the collateral is sold and the proceeds (ie: money) are used to pay back the holder of the these bonds.

If a corporation offers a debenture and a collateralized bond with the same maturity at the same time, which will have a higher coupon? Why? Answer: The debenture because it is more risky.

Lesson Summary1. What are the two types of financing a

company can use to raise money?

2. Which type of financing is safer and why?

3. If a company sold $100 million of bonds with a 6% coupon, what dollar amount of annual interest would it owe?

4. Do companies have to choose one or the other when they want to raise money?

4. What are the pros and cons of debt vs. equity financing?

Web Challenge #1Q: Are there companies that live on the edge by raising all their money through debt?

• A: Yes. They are known as “highly leveraged” companies.

• Challenge: Research highly leveraged companies that are having difficulties staying alive. What problems are they having in their business or industry that is causing them to have trouble making their interest payments?

Web Challenge #2 Challenge: There are trillions of dollars

invested in publicly held companies. One way to determine if a company has too much debt is to compare its debt to some other dollar figure in the company, such as its annual profit. This is called ratio analysis. Research “financial leverage ratios” and find three that are commonly used to assess indebtedness.

Web Challenge #3 Challenge: Interest is required to be paid to

bondholders. Therefore, it is a valid business expense that reduces overall company profits. Lower profits means lower income taxes. The same is not true for dividends, which are an optional payout of excess profits.

In a way, the gov’t tax policy actually gives a preference to borrowing, which is risky. Research this issue and identify proposals to change the policy so companies do not borrow excessively.