MN10500 Lecture 7: Corporate Financing & Capital Structure in a Perfect Market
Corporate Financing Patterns
● Internally generated funds:
○ Retained earnings/plowback profit
● External sources of finance:
○ Debt
○ Equity
● Firms may raise funds from external sources or plow back profits (internal funds).
External financing involves the choice between debt & equity.
● In practice, there are securities lying between the spectrum of 'pure' debt & equity
and they are sometimes called 'mezzanine' or 'hybrid' securities.
Capital Structure: FedEx
Historical Sources of Funds for FedEx 1995-2010
Financing Pattern: US Market
Sources of funds, US non-financial corporations
This shows that a major part of financing for firms in the USA is from internally generated
funds.
Financing Choice across Corporate Life Cycle
, 29/03
● The forms that debt and equity take will change as a firm moves through its lifecycle.
● Early in the process, equity will take the form of owner's wealth or savings and debt
will be bank debt.
● As the firm evolves, the equity choices will expand first to include venture capital and
private equity.
● When the firm goes public, its choices expand further.
Why Internal Funds?
● Cost of issuing securities
○ Direct Cost: due diligence, underwriting,...
○ Indirect Cost: time, effort in confirming to accounting standards,...
● New equity announcement implications
○ The announcement of a new equity issue is usually bad news for investors - it
can be perceived as an attempt by management to sell overpriced stock.
● Raising capital internally avoids the costs and bad omens associated with new
equity issues.
The Choices of External Financing: Debt VS Equity
Rather than categorizing financing based on what it is called or categorized as by
accountants, we should be thinking whether financing is debt or equity by looking at the
following questions:
● Are the payments on the securities contractual or residual?
○ If contractually set, it is closer to debt.
○ If residual, it is closer to equity.
● Are the payments tax-deductible?
○ If yes, it is closer to debt.
○ If no, it is closer to equity.
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