Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

a predetermined formula. These basic financial instruments exist in most countries, and the rights and

responsibilities of the holders of these instruments are very similar. Companies around the world face

the same basic financing problem: how to fund projects and activities that will allow the firm to grow

and prosper. This section examines the firm’s financing alternatives, particularly the choice between

internal and external financing, and surveys key issues related to raising external financing either through

financial intermediaries or in capital markets. In Australia, these markets for raising equity and debt

capital are respectively referred to as the equity capital market (ECM) and the debt capital market (DCM).

Since the US capital market is one of the largest and most developed markets in the world, as well

as one of those that tends to display the most activity, it has had a significant influence on the process

of raising long-term finance around the globe. With this in mind, much of this chapter draws on the

experience of the US market.

12-1a THE NEED TO FUND A FINANCIAL DEFICIT

Corporations everywhere are net dis-savers, which is an economic way of saying they demand more

financial capital for investment than they supply in the form of retained earnings. Corporations must

close this financial deficit by borrowing or by issuing new equity securities. Every major firm confronts four

key financing decisions on an ongoing basis:

1 How much capital must the company raise each year?

2 How much should be raised externally rather than through retained earnings?

3 How much of the external funding should be raised through borrowing from a bank or another

financial intermediary, and how much should be raised externally by selling securities directly to

investors?

4 What proportion of the external funding should be structured as long-term debt, ordinary equity or

preferred equity?

The answer to the first question depends on the capital budgeting process followed by a company, which

would ideally raise enough capital to fund all its positive-NPV investment projects and to cover its

working capital needs.

12-1b THE CHOICE BETWEEN INTERNAL AND EXTERNAL

FINANCING

At first glance, the internal/external choice in Question 2 seems to be a decision that companies can

make mechanically. The difference between total financing needs and internally generated funding

equals the external financing requirement. Its internally generated funds are its cash flow from operations,

calculated as net income plus depreciation and other non-cash charges minus dividends. So the external

financing requirement would equal the firm’s capital expenditures plus change in net working capital

minus its internally generated funding.

External financing requirement = (Capital expenditures) + (Change in net working capital)

• (Internally generated funding)

seniority
The order in which repayments
must be made to investors,
in the event of loan defaults,
liquidations, bankruptcy or
similar negative events. In
general, bondholders (or debt
investors) must be repaid
before equity investors;
senior debt must be repaid
before subordinated debt
and preferred equity must be
repaid before ordinary equity.
This is why equity investment
is considered much riskier
than debt investment. It is
said to be junior to debt

equity capital market
(ECM)
The market for raising equity
capital. Financial institutions
providing ECM services in
Australia will often have
separate divisions or teams
focusing purely on these
services, rather than covering
both debt and equity markets.
Some broking firms get
involved in this market

debt capital market
(DCM)
This refers to the market for
raising debt capital. Financial
institutions providing DCM
services in Australia will
often have separate divisions
or teams focusing purely on
these services, rather than
covering both debt and equity
markets.

financial deficit
Occurs when a corporation
requires more financial capital
for investment than it supplies
in the form of retained
earnings

cash flow from operations
Cash inflows and outflows
directly related to the
production and sale of a
company’s products and
services. Calculated as net
income plus depreciation and
other non-cash charges