366 Part Four Financing Decisions and Market Efficiency
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Here is another example of a disguised debt. When American Airlines filed for bankruptcy
in 2011, it had promised its employees pensions valued at $18.5 billion. This obligation was,
in effect, a senior debt because American was obligated to make payments to retired employ-
ees. Unfortunately, American had set aside only $8.3 billion to meet this obligation.
Pension obligations should be valued by discounting future payments at a debt interest
rate. When interest rates change, the present value of pension obligations changes, too. For
example, in May 2015, the German airline Lufthansa announced that the present value of its
pension obligations increased from €7.2 billion to €10.2 billion in the first quarter of 2015,
largely because of a decrease from 2.6% to 1.7% in the interest rate used for discounting.
There is nothing underhanded about lease or pension obligations. They are explained in
the notes to a corporation’s financial statements when they do not appear explicitly on its
balance sheet. Investors recognize the debt-equivalent obligations and the financial risks that
they create.^18
But now and then a company works hard to ensure that investors do not know how much
the company has borrowed. For example, Enron was able to borrow $658 million by set-
ting up special-purpose entities (SPEs), which raised cash by a mixture of equity and debt
and then used these debts to help fund the parent company. None of this debt showed up
on Enron’s balance sheet, but the debt showed up with a vengeance in Enron’s death spiral
towards bankruptcy in 2001.Variety’s the Very Spice of Life
We have indicated several dimensions along which corporate securities can be classified. That
gives the financial manager plenty of choice in designing securities. As long as you can con-
vince investors of its attractions, you can issue a convertible, subordinated, floating-rate bond
denominated in Swedish kronor. Rather than combining features of existing securities, you
may create an entirely new one. We can imagine a coal mining company issuing convertible
bonds on which the payment fluctuates with coal prices. We know of no such security, but it
is perfectly legal to issue it—and who knows?—it might generate considerable interest among
investors.
It does help to remember that equity is a residual claim that participates in the upsides
and downsides of the business after debt claims are satisfied. Equity has residual cash-flow
rights and residual control rights. Debt has first claim on cash flows, but its claim is limited. It
does not participate in the upsides of the business. Debt has no control rights unless the firm
defaults or violates debt covenants.
That completes our tour of corporate securities. You may feel like the tourist who has just
seen 12 cathedrals in five days. But there will be plenty of time in later chapters for reflection
and analysis. It is now time to move on and to look at the markets in which the firm’s securi-
ties are traded and at the financial intermediaries that hold them.14-4 Financial Markets and Intermediaries
The flow of savings to large public corporations is shown in Figure 14.5. Notice that the
savings flow from investors worldwide through financial markets, financial intermediaries,
or both. Suppose, for example, that Bank of America raises $300 million by a new issue
of shares. An Italian investor buys 6,000 of the new shares for $10 per share. Now Bank of
America takes that $60,000, along with money raised by the rest of the issue, and makes a(^18) For example, see Z. Bodie, L. Jin, and R. C. Merton, “Do a Firm’s Equity Returns Reflect the Risk of its Pension Plan?” Journal of
Financial Economics 81 (2006), pp. 1–26.