Chapter 19-1. Chapter 19-2 Chapter 19 Managerial Accounting Accounting Principles, Ninth Edition.
Chapter 19
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Transcript of Chapter 19
Chapter 19Chapter 19
Business Borrowing: Corporate Business Borrowing: Corporate Bonds, Asset-Backed Bonds, Asset-Backed
Securities, Bank Loans, and Securities, Bank Loans, and Other Forms of Business DebtOther Forms of Business Debt
Learning Objectives Learning Objectives
To look at how business firms issue To look at how business firms issue debt securities and negotiate loans in debt securities and negotiate loans in order to raise funds in the money and order to raise funds in the money and capital markets.capital markets.
To learn about the key factors affecting To learn about the key factors affecting the volume of funds that businesses the volume of funds that businesses seek to raise in the financial system.seek to raise in the financial system.
To see the often powerful impact that To see the often powerful impact that business borrowing has upon market business borrowing has upon market interest rates and credit conditions.interest rates and credit conditions.
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IntroductionIntroduction
Business firms draw on a wide variety of Business firms draw on a wide variety of fund sources to finance their daily operations fund sources to finance their daily operations and to carry out long-term investment.and to carry out long-term investment.
In 2006, nonfinancial business firms in the In 2006, nonfinancial business firms in the U.S. raised nearly $1.9 trillion, of which U.S. raised nearly $1.9 trillion, of which approximately $516 billion was supplied from approximately $516 billion was supplied from the financial markets through issues of the financial markets through issues of bonds, stocks, notes, and other financial bonds, stocks, notes, and other financial instruments.instruments.
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Factors Affecting Business Activity in Factors Affecting Business Activity in the Money and Capital Marketsthe Money and Capital Markets
Many factors affect the extent to which Many factors affect the extent to which business firms draw on the money and business firms draw on the money and capital markets for external funds:capital markets for external funds: Total funding demands of business firmsTotal funding demands of business firms Level and expected growth of internally Level and expected growth of internally
generated fundsgenerated funds Condition of the economyCondition of the economy Credit availability and interest ratesCredit availability and interest rates
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
Maturity definitionMaturity definition A A notenote has an original maturity of five years or has an original maturity of five years or
lessless A A bondbond carries an original maturity of more than carries an original maturity of more than
five yearsfive years General characteristicsGeneral characteristics
An amount equal to the par value at maturityAn amount equal to the par value at maturity Interest payments at specified intervalsInterest payments at specified intervals Generally issued in units of $1,000Generally issued in units of $1,000 Accompanied by Accompanied by indenturesindentures
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
Corporate bonds tend to be issued with Corporate bonds tend to be issued with longer maturities when both interest longer maturities when both interest rates and inflation are lowrates and inflation are low
Some corporate bonds are backed by Some corporate bonds are backed by sinking fundssinking funds
A considerable proportion of corporate A considerable proportion of corporate bonds that are outstanding today carry bonds that are outstanding today carry call privilegescall privileges
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
During rapid economic expansionDuring rapid economic expansion The supply of credit is relatively scarceThe supply of credit is relatively scarce The cost of borrowing rises The cost of borrowing rises
Yield movementsYield movements Yields on the highest-grade bonds tend to move closely with Yields on the highest-grade bonds tend to move closely with
government bond yieldsgovernment bond yields Yields carried by lower-grade corporate bondsYields carried by lower-grade corporate bonds
More tied to conditions in the economyMore tied to conditions in the economy Also tied more to factors specifically affecting the risk Also tied more to factors specifically affecting the risk
position of the borrowerposition of the borrower
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
For a bond that matures in 10 years:For a bond that matures in 10 years:
Interest charges on debt are tax Interest charges on debt are tax deductible, so k’ = k (1 – t)deductible, so k’ = k (1 – t)
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
Signals Corporate Bond Issues May SendSignals Corporate Bond Issues May Send A bond issue that appears to be driven by A bond issue that appears to be driven by
an unanticipated cash-flow shortage an unanticipated cash-flow shortage Tends to lower bond prices of the issuerTends to lower bond prices of the issuer Tends to lower equity prices of the issuerTends to lower equity prices of the issuer
A new bond sold to expand the firm’s A new bond sold to expand the firm’s capitalization tends to send a positive capitalization tends to send a positive signal to the marketsignal to the market
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
Common types of corporate bondsCommon types of corporate bonds Debentures – Unsecured by a specific assetDebentures – Unsecured by a specific asset Subordinated debentures – junior securitiesSubordinated debentures – junior securities Mortgage bonds – closed end or open endMortgage bonds – closed end or open end Income bonds – interest is paid only when Income bonds – interest is paid only when
income is actually earnedincome is actually earned Equipment trust certificates – resemble leasesEquipment trust certificates – resemble leases Industrial development bonds (IDBs) – issued Industrial development bonds (IDBs) – issued
by a local government borrowing authorityby a local government borrowing authority
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Characteristics of Characteristics of Corporate Notes and BondsCorporate Notes and Bonds
Innovations in corporate debt include:Innovations in corporate debt include: Discount bonds – including zero coupon Discount bonds – including zero coupon
bondsbonds Floating-rate bondsFloating-rate bonds Commodity-backed bonds – face value is Commodity-backed bonds – face value is
tied to the market price of an internationally tied to the market price of an internationally traded commoditytraded commodity
Inflation-linked corporate notesInflation-linked corporate notes Medium-term notes (MTNs) – carry Medium-term notes (MTNs) – carry
maturities of one to ten yearsmaturities of one to ten years19-11
Asset-Backed Securities Asset-Backed Securities Issued by CorporationsIssued by Corporations
SecuritizationSecuritization The process that gives rise to the creation The process that gives rise to the creation
of of asset-backed securitiesasset-backed securities (ABS) (ABS) Example: Packaging group of home Example: Packaging group of home
mortgagesmortgages Usually with federal agency guaranteesUsually with federal agency guarantees Removed from the lenders’ balance sheetsRemoved from the lenders’ balance sheets Placing them in a separate trust accountPlacing them in a separate trust account Selling securities backed by mortgagesSelling securities backed by mortgages With the help of an investment bankWith the help of an investment bank
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Asset-Backed Securities Asset-Backed Securities Issued by CorporationsIssued by Corporations
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Asset-Backed Securities Asset-Backed Securities Issued by CorporationsIssued by Corporations
Securitization may:Securitization may: Reduce the cost of raising funds Reduce the cost of raising funds Grant companies greater control over their Grant companies greater control over their
balance sheetsbalance sheets Help a company avoid the issuance of Help a company avoid the issuance of
additional balance-sheet debt additional balance-sheet debt Improve the apparent financial strength of an Improve the apparent financial strength of an
issuing firmissuing firm Permit greater asset diversificationPermit greater asset diversification Provide a new source of company earningsProvide a new source of company earnings
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Asset-Backed Securities Asset-Backed Securities Issued by CorporationsIssued by Corporations
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Investors in Corporate DebtInvestors in Corporate Debt
The market is institution dominatedThe market is institution dominated Pension funds prefer public corporate debtPension funds prefer public corporate debt Insurance companies frequently prefer Insurance companies frequently prefer
private placementprivate placementForeign institutions are a very dynamic Foreign institutions are a very dynamic
sector of the marketsector of the market Many dealers are internationalMany dealers are international Many of the debt instruments are for foreign Many of the debt instruments are for foreign
takeovers of U.S. companiestakeovers of U.S. companies Many more are ways to access dollarsMany more are ways to access dollars
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Investors in Corporate DebtInvestors in Corporate Debt
Rapid growth in debt instruments in the U.S.Rapid growth in debt instruments in the U.S. Not matched by rise of U.S. resident bond holdingsNot matched by rise of U.S. resident bond holdings Differential filled by foreign investorsDifferential filled by foreign investors Bonds by U.S. companies between 1995 and 2006Bonds by U.S. companies between 1995 and 2006
Tripled from $2.5 trillion to $8.2 trillionTripled from $2.5 trillion to $8.2 trillion Foreign investment went from $461 billion to $2.7 Foreign investment went from $461 billion to $2.7
trilliontrillion
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Investors in Corporate DebtInvestors in Corporate DebtPrincipal Investors in Corporate and Foreign Bonds, 2006
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts: Financial Assets and Liabilities, Fourth Quarter 2006.
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The Secondary Market for The Secondary Market for Corporate DebtCorporate Debt
The secondary market for corporate debt The secondary market for corporate debt Relatively limited compared to the markets for Relatively limited compared to the markets for
other long-term securities other long-term securities The number of active individual investors is The number of active individual investors is
smallsmall Institutional investors tend to follow a Institutional investors tend to follow a buy and buy and
holdhold strategy strategy Some changes in strategies more recentlySome changes in strategies more recently
Many institutions are looking at total performance
Have become more aggressive19-19
The Marketing of Corporate DebtThe Marketing of Corporate Debt
Corporate bonds may be offered publicly Corporate bonds may be offered publicly Through a Through a public salepublic sale Sold privately to a limited number of investors Sold privately to a limited number of investors
via a via a privateprivate or or direct placementdirect placement The majority of offerings are public salesThe majority of offerings are public sales
Popular with firms having unique financing Popular with firms having unique financing requirementsrequirements
Private placements are common among Private placements are common among smaller companiessmaller companies
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The Marketing of Corporate DebtThe Marketing of Corporate Debt
The decision of small firms is often a The decision of small firms is often a function of the nature of the marketfunction of the nature of the market Economies of scale in public issuance of debtEconomies of scale in public issuance of debt
So relatively cheaper for firms with large debt So relatively cheaper for firms with large debt issuancesissuances
For smaller firms with less debt the public For smaller firms with less debt the public market is relatively more expensivemarket is relatively more expensive
The flexibility of private issuesThe flexibility of private issues More easily address potential agency costsMore easily address potential agency costs Allow smaller debt issuesAllow smaller debt issues
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The Marketing of Corporate DebtThe Marketing of Corporate Debt
A public sale uses an underwriterA public sale uses an underwriter An investment banking firm or a An investment banking firm or a syndicatesyndicate
of underwriters may do one of two thingsof underwriters may do one of two things Purchase the securities directly from the Purchase the securities directly from the
issuing company through a bidding issuing company through a bidding processprocess
Guarantee the issuer a specific priceGuarantee the issuer a specific price The underwriter carries the risk of The underwriter carries the risk of
losses (or gains) when the securities losses (or gains) when the securities are marked for sale in the open marketare marked for sale in the open market
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The Marketing of Corporate DebtThe Marketing of Corporate Debt
Private placements have accounted for Private placements have accounted for about 10% of market sales of corporate about 10% of market sales of corporate bondsbonds
Interest rates influence the private versus Interest rates influence the private versus public decisionpublic decision Rising interest rates bring more borrowing Rising interest rates bring more borrowing
companies into the public marketcompanies into the public market Falling interest rates often bring about a rise Falling interest rates often bring about a rise
in private placementsin private placements
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The Volume of The Volume of Borrowing by CorporationsBorrowing by Corporations
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The Volume of The Volume of Borrowing by CorporationsBorrowing by Corporations
Growth in corporate borrowing is due to: Growth in corporate borrowing is due to: InflationInflation The increased use of financial leverage to boost The increased use of financial leverage to boost
returns to corporate stockholdersreturns to corporate stockholders The development of international capital marketsThe development of international capital markets Recent relatively-low interest ratesRecent relatively-low interest rates The rash of corporate takeovers (leveraged The rash of corporate takeovers (leveraged
buyouts) and mergersbuyouts) and mergers
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The Volume of The Volume of Borrowing by CorporationsBorrowing by Corporations
Also more borrowing due to corporate Also more borrowing due to corporate stock retirementsstock retirements A significant growth in popularityA significant growth in popularity Among larger corporationsAmong larger corporations
Stock retirements exceeded $400 billion for Stock retirements exceeded $400 billion for the year ending in June 2006the year ending in June 2006
Was only $130 billion in 2001Was only $130 billion in 2001 Various factors for the expansionVarious factors for the expansion
More M&A activityMore M&A activity More companies tapping the debt marketMore companies tapping the debt market
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Bank Loans to Business FirmsBank Loans to Business Firms
Commercial banks are direct Commercial banks are direct competitors with the corporate debt competitors with the corporate debt markets markets Making both short-term and long-term Making both short-term and long-term
loans to businessesloans to businesses Growing numbers of corporations have Growing numbers of corporations have
turned to selling securities in the open turned to selling securities in the open marketmarket
The volume of bank credit for business The volume of bank credit for business firms remains enormousfirms remains enormous
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Bank Loans to Business FirmsBank Loans to Business Firms
The Fed has been carrying out The Fed has been carrying out surveyssurveys Examine business lending practicesExamine business lending practices Look at banks across the U.S.Look at banks across the U.S.
Surveys indicate bank lending tends Surveys indicate bank lending tends to be short-termto be short-term Average maturity of commercial and Average maturity of commercial and
industrial loans (value-weighted) was 524 industrial loans (value-weighted) was 524 days in February 2007days in February 2007
Longer term loans averaged 54 monthsLonger term loans averaged 54 months19-28
Bank Loans to Business FirmsBank Loans to Business Firms
The The prime bank rateprime bank rate, or , or base ratebase rate The annual percentage rate that banks The annual percentage rate that banks
quote to their most creditworthy customersquote to their most creditworthy customers Tend to be unsecuredTend to be unsecured Often require compensating balancesOften require compensating balances These tend to be short-term loansThese tend to be short-term loans Traditionally, the prime rate was set by one Traditionally, the prime rate was set by one
or more of the nation’s leading banksor more of the nation’s leading banks Now, prime rates are often pegged to the Now, prime rates are often pegged to the
prevailing yields on Treasury billsprevailing yields on Treasury bills
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Commercial MortgagesCommercial Mortgages
Commercial mortgageCommercial mortgage The construction of commercial structureThe construction of commercial structure
Office buildingsOffice buildings Shopping centersShopping centers Other commercial structures Other commercial structures
Faced with inflation and a volatile economy, Faced with inflation and a volatile economy, new forms have been developed:new forms have been developed:
equity kickerequity kicker indexingindexing asset-backed securitizationasset-backed securitization
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Markets on the NetMarkets on the Net
American Capital Advance at American Capital Advance at americancapitaladvance.comamericancapitaladvance.com
Amerimerchant at Amerimerchant at amerimerchant.comamerimerchant.com Asset Securitization Report at Asset Securitization Report at
asreport.comasreport.com Bankrate.com at Bankrate.com at bankrate.combankrate.com Bond Market Association at Bond Market Association at
www.investinginbonds.comwww.investinginbonds.com// Bond Market Association – European Bond Market Association – European
Issues at Issues at www.bondmarkets.com/www.bondmarkets.com/
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Markets on the NetMarkets on the Net
British Bankers’ Association at British Bankers’ Association at www.bba.org.ukwww.bba.org.uk
Business.com at Business.com at www.business.comwww.business.comCBS Marketwatch at CBS Marketwatch at
www.cbs.marketwatch.comwww.cbs.marketwatch.com//CNN/Financial at CNN/Financial at www.cnnfn.comwww.cnnfn.com Financial Pipeline at Financial Pipeline at www.finpipe.comwww.finpipe.com Mortgage 101 at Mortgage 101 at www.mortgage101.comwww.mortgage101.com
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Markets on the NetMarkets on the Net
National Association of Small Business National Association of Small Business Investment Companies at Investment Companies at nasbic.orgnasbic.org
REBUZ – Commercial Mortgages at REBUZ – Commercial Mortgages at www.rebuz.comwww.rebuz.com
Small Business Notes at Small Business Notes at smallbusinessnotes.comsmallbusinessnotes.com
St. Louis Federal Reserve Bank research St. Louis Federal Reserve Bank research at at research.stlouisfed.org/fred2research.stlouisfed.org/fred2
Wikipedia at Wikipedia at en.wikipedia.orgen.wikipedia.org
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Chapter ReviewChapter Review
Introduction to business borrowingIntroduction to business borrowing Factors affecting business activity in Factors affecting business activity in
the money and capital marketsthe money and capital markets
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Chapter ReviewChapter Review
Characteristics of corporate notes and Characteristics of corporate notes and bondsbonds Principal featuresPrincipal features Recent trends in original maturitiesRecent trends in original maturities Call privilegesCall privileges Sinking fund provisionsSinking fund provisions Yields and costsYields and costs Signals corporate bond Issues may sendSignals corporate bond Issues may send The most common types of corporate The most common types of corporate
bondsbonds Innovations in corporate debtInnovations in corporate debt
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Chapter ReviewChapter Review
Asset-backed securities Issued by Asset-backed securities Issued by corporationscorporations
Investors in corporate debtInvestors in corporate debt The secondary market for corporate debtThe secondary market for corporate debt The marketing of corporate debtThe marketing of corporate debt
Public salesPublic sales Private placementsPrivate placements
The volume of borrowing by corporationsThe volume of borrowing by corporations
19-36
Chapter ReviewChapter Review
Bank loans to business firmsBank loans to business firms The volume of bank credit supplied to The volume of bank credit supplied to
businessesbusinesses The prime, or base, Interest rate on The prime, or base, Interest rate on
business loansbusiness loans Other examples of base rates for business Other examples of base rates for business
loansloans Commercial mortgagesCommercial mortgages
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