Foundations of Financial Management: An Analysis (part 53)

“I’d like to live as a poor man with lots of money.” 

– Pablo Picasso

Capital Markets

by

Charles Lamson

Security markets comprise a myriad of securities from government bonds to corporate common stock. These markets are influenced by variables such as interest rates, investors’ confidence, economic growth, global crises, and more. 

Domestic and world events all impact the world’s securities markets. Corporations come to these international markets for short-term sources of funds or long-term capital. When the markets are good, money is cheap and easy to find, and when the markets are bad, money is hard to find and relatively expensive. The world economic markets often move back and forth between the two extremes.

Security markets are generally separated into short-term and long-term markets. The short-term markets comprise securities with maturities of one year or less and are referred to as money markets. The securities most commonly traded in these markets are Treasury bills, commercial paper, and negotiable certificates of deposit.

The long-term markets are called capital markets and consist of securities having maturities greater than one year. The most common corporate securities in this category are bonds, common stock, preferred stock, and convertible securities. These securities are found on the firm's balance sheet under the designation long-term liabilities and equities. Taken together, these long-term securities comprise the firm's capital structure.

In the next several posts, we will be looking at how the capital markets are organized and integrated into the corporate and economic system of the United States. Capital markets are becoming increasingly international as suppliers of financial capital seek out the best risk-return opportunities from among the major industrialized countries in the global economy.

The globalization of capital markets is particularly important for large U.S. multinational corporations that use these markets to raise capital for both domestic and international operations.

Competition for Funds in the U.S. Capital Markets

In order to put U.S. corporate securities into perspective, it is necessary to look at other securities available in the capital markets. The federal government, government agencies, state governments, and local municipalities all compete with one another and corporations for a limited supply of financial capital. The capital markets serve as a way of allocating the available capital to the most efficient user. Therefore the ultimate investor must choose among many kinds of sufficient securities, both corporate and non-corporate. Before investors part with their money, they desire to maximize their return for any given level of risk, and thus the expected return from the universe of securities acts as an allocating mechanism in the markets.

Government Securities

U.S. Government Securities In accordance with government fiscal policy, the U.S. Treasury manages the federal government's debt in order to balance the flow of funds into and out of the U.S. Treasury. When deficits are incurred, the treasury can sell short-term or long-term securities to finance the shortfall and when surpluses occur, the government can retire debt. When the US government collects more in taxes than it is spending, it doesn't need to borrow and this frees up capital for the other sectors of the economy.

Federally Sponsored Credit Agencies The federally sponsored credit agencies are governmental units that issue their securities on a separate basis from those securities sold directly by the U.S. Treasury. Although the U.S. Treasury does not directly back these securities, none of these issues has ever failed. The Federal Home Loan Banks (FHLB) and the Federal National Mortgage Association (Fannie Mae) are both involved in lending to the housing market. Fannie Mae is included as a government-sponsored agency even though it is currently a privately-run corporation. It still maintains a quasi-agency relationship with the United States government, based on its original government charter. Two other large federal agencies are the Farm Credit Banks and the Student Loan Marketing Association.

State and Local Securities State and local issues are referred to as municipal securities or tax-exempt offerings. Interest payments from securities issued by state and local governments are exempt from federal income taxes and income taxes levied by the state of issue. (For example, if the state of California issues a bond that is bought by someone living in the state of California, the interest is not taxable by California. However if someone living in the state of California buys a bond issued by the state of New York, the interest will be taxable.) Because the securities are exempt from federal taxes, they tend to be purchased by investors in high marginal tax brackets. Unlike the federal government, most state governments are required by law to balance their budgets and so bonds issued by municipal government or state entities are usually supported by revenue-generating projects such as sewers, college dormitories, and toll roads.

Corporate Securities

Corporate Bonds One misconception held by many investors is that the market for common stocks dominates the corporate bond market in size. This is far from the truth. Bonds are debt instruments that have a fixed life and must be repaid at maturity. As bonds come due and are paid off, the corporation normally replaces this debt with new bonds. For this reason, corporate bonds have traditionally made up the majority of external financing by corporations.

In general, when interest rates are expected to rise, financial managers try to lock in long-term financing at a low cost and balance the company's debt structure with more long-term debt and less short-term debt. The amount of long-term debt a corporation chooses to employ as a percentage of total capital is also a function of several options. Management must decide about its willingness to accept risk and examine the amount of financing available from other sources, such as internal cash flow, common stock, and preferred stock.

Preferred Stock Preferred stock is the least used of all long-term corporate securities. The major reason for the small amount of financing with preferred stock is that the dividend is not tax-deductible to the corporation, as is bond interest. Corporations who are at their maximum debt limit issue much of the preferred stock that is sold. These companies may also suffer from low common stock prices or want to issue preferred stock that may some day be convertible into common stock.

Common Stock Companies seeking new equity capital sell common stock. As explained in upcoming posts on investment banking, common stock is either sold as a new issue in an initial public offering (IPO) or as a secondary offering. A secondary offering means that shares are already being publicly traded in the market and the new offering will be at least the second time the company has sold common stock to the public. Also, when companies purchase their own shares in the market because they have excess cash, the shares are shown on the company's balance sheet as treasury stock. Because common stock has no maturity date like bonds, new common stock is never sold to replace old stock in the way that new bonds are used to refund old bonds.

Internal vs. External Sources of Funds

So far we have discussed how corporations raise funds externally through long-term financing using bonds, common stock, and preferred stock. Another extremely important source of funds to the corporation is internally generated funds as represented by retained earnings and cash flow added back from depreciation.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 416-421*

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