Equity and Debt Five Grain Inc., a fictional bread-baking company, needs an expensive state-of-the-art oven system. It decides to raise money for equipment by selling part of itself. In other words, it issues common stock, which in effect, sells a fraction of the company to others. Five Grain Inc. can also sell bonds or other short-term debt to raise money.

Equity vs debt The way a firm pays for its productive assets is via a combination of equity and debt. For example, if you want to buy a $1 000 000 piece of equipment, you use equity (pay for it with money raised via sale of ownership), debt (borrowed money), or some combination of both.

When a firm issues stock in the primary market, it is raising equity. Firms can then take this money and use it for their business needs. The other option open is to borrow money. Firms can borrow via a bank loan or they may opt to sell bonds or other short-term debt, such as commercial paper.

Common Stock Each share of common stock represents fractional ownership in the company. If a firm has only 100 shares of common stock issued and outstanding, then each share represents 1% ownership of the company. An investor with 10 shares would own 10% of the company and would be entitled to 10% of any cash or stock distribution the company makes. Most publicly traded companies have millions of shares of common stock outstanding, each share represents a very small fractional ownership of the firm.

A firm issues stock by approaching and investment banker. The banker evaluates the financial condition and business model of the company that wishes to issue equity, and makes some assessment of value. At that point, the investment banking firm may opt to underwrite the issue, which is basically a direct purchase of the stock. The investment banking firms gets the stock issue registered with SEC, and gets the issue listed on either an organized exchange or the OTC market. At that point, the underwriter begins selling or placing the issue. This transaction is called the initial public offering.

Common Stock Negotiation At this point, the issuing firm has its money and is no longer involved in the process. The underwriter has some placement options and may sell the stock through a syndicate or group of other underwriters. The underwriters make their money on the difference between what they paid the firm for the stock and what they sell it for.

Sometimes, firms that want to raise capital allow underwriters to bid on equity using a competitive process. At other times, the price may simply be negotiated with one investment banking firm. This choice is dictated by the firm's prospects and visibility. Firms with high visibility (high-profile) owners can typically negotiate better deals than firms without name recognition.

At times, the investment banking firm may opt to put the issue together for a fee and then sell the stock on a commission basis. In this case, the issue is not underwritten or purchased outright. The investment banking firm may be successful in selling all or part of the stock, but only guarantees to give their best effort to place the issue.

Corporate Bond Features A bond will have a fixed maturity date, and a coupon rate. A fixed maturity date is the date at which the bod is scheduled to be repaid in full, which is established at issuance. The coupon rate is the suggested rate of interest paid on the bond.

Debenture Bond The typical corporate bond is insecure and is known as a debenture bond. A debenture bond is an unsecured bond or a bond that is not backed by any assets. If the company opts to pledge assets as collateral against the debt, it is dubbed a mortgage bond. In the case of a mortgage bond, the creditors have some assets to sell if the company defaults on the debt. Mortgage bonds are therefore, not as sky as debentures, and allow the firm to pay a lower coupon rate.

Sweeteners Because most corporate bonds are debentures, there are other features firms can use as sweeteners that allow them to pay lower coupon rates. Some bonds are convertible to a fixed number of shares of common stock after a certain period time. This feature allows bondholders to receive a constant return in the form of coupon payments, but it also gives them the option to convert to equity at some point.

These conversion can only occur if the company's stock price increases beyond the conversion price. At other times, companies may attach warrants that allow the investor to use some fixed number of warrants to buy shares of stock at some point. Both these options give bondholders the potential to participate in ownership, and allow the firm to pay lower interest rates.

	Created by britneysoll about 11 years ago

Grade 11 Introduction to Finance Note on Financial Markets, Instruments, and Interest Rates, created by britneysoll on 14/09/2015.

Financial Markets, Instruments, and Interest Rates