Chapter X
Long-Term Corporate Financing
How companies raise capital: stocks, bonds, warrants, and preferred shares -- from issuance through trading.
Overview
This chapter covers long-term corporate financing mechanisms, specifically addressing how companies raise capital through equity and debt instruments. The two primary financing approaches are:
- Selling Ownership: Stocks and Warrants
- Borrowing: Bonds and Preferred Shares
Figure 9.1. The major categories of long-term corporate financing instruments and their claim priority.
The Life Cycle of Stock
Equity transitions through several stages from private ownership through public markets. The lifecycle traces from initial design through market trading:
- Design: The company determines the characteristics of its shares -- voting rights, par value, and other features that define the ownership claim.
- Initial Public Offering (IPO): Through investment banking, shares are offered to the public for the first time. The investment bank underwrites the offering, taking on the risk of distributing shares.
- Exchange Trading: Once public, shares trade on organized exchanges. On the NYSE, a specialist makes a market in the shares, matching bidders and askers (i.e. buyers and sellers). On NASDAQ, electronic matching systems connect dealers who compete to offer the best prices.
Key Concept: Primary vs. Secondary Markets
The IPO occurs in the primary market -- the company receives the proceeds. Subsequent trading among investors occurs in the secondary market -- the company receives nothing, but benefits from the liquidity that makes its shares attractive to initial investors.
The Bond Lifecycle
Bond issuance involves designing specific features that define the borrowing arrangement:
| Feature | Description |
|---|---|
| Borrowing amount | Total principal (face value) of the issue |
| Repayment schedule | Coupon rate, payment frequency, maturity date |
| Financing constraints | Covenants restricting additional borrowing or asset sales |
| Callability | Issuer's right to repay early at a specified price |
| Sinking fund | Scheduled partial repayments before maturity |
| Security | Debentures (unsecured) vs. secured bonds (backed by specific assets) |
Bonds are issued through syndicates -- groups of investment banks that collectively distribute the offering to investors -- and are subsequently traded in over-the-counter markets.
Preferred Shares
Preferred shares are a hybrid instrument combining features of both debt and equity:
- Non-voting: Unlike common stock, preferred shares typically do not confer voting rights
- Senior claims: Preferred shareholders have priority over common equity holders for cash distributions (dividends and liquidation)
- Fixed dividends: Like bonds, preferred shares pay a fixed periodic distribution
- Tax advantages: Commonly held by corporations, because corporate holders can exclude a large portion of preferred dividends from taxable income (the dividends-received deduction)
Warrants
A warrant is a right to purchase shares for a fixed price, over a fixed period of time. Key characteristics:
- Warrants are issued by the company itself (unlike exchange-traded options)
- When exercised, new shares are created, diluting existing shareholders
- Often attached to bond issues as a "sweetener" to make the debt more attractive
- Similar to call options but typically with longer maturities (years rather than months)
Key Concept: The Capital Structure Spectrum
Corporate financing instruments form a spectrum from safest (senior secured bonds) to riskiest (common equity). Each step up in risk priority demands a higher expected return. The firm chooses its capital structure -- the mix of debt and equity -- to minimize its overall cost of capital while maintaining financial flexibility.