Page 479 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 453

quarterly, receive some of the firm’s earnings in the form of a dividend. A simple
reason for this shareholder behavior is that shareholders want to consume some
of their earnings over time, as opposed to receiving all of their earnings years in
the future and consuming their income later. Even if the firm has profitable proj-
ects available to it, shareholders likely will want the firm to pay out some pro-
portion of its earnings as dividends. Some firms pay out a fixed dividend each
quarter, while others pay out a fixed proportion of their retained earnings to
shareholders. For example, if a firm had $1 million in net income after taxes and
a 30 percent dividend payout policy, it would pay $300,000 in dividends and have
$700,000 in retained earnings.
More than 50 percent of a firm’s assets are typically financed with retained earn-
ings. In this way, firms grow from within using internal earnings, as opposed to
using external sources of funds like debt and equity to expand their asset size. We
can infer that large firms were highly profitable in the past, which allowed them to
invest retained earnings in land, buildings, equipment, and other real assets. Obvi-
ously, firms that have higher retained earnings are able to grow faster than other
firms.
Many times, successful firms are growing so fast that retained earnings are not
sufficient to keep up with the costs of filling rising orders for their goods and serv-
ices. In this case, firms must turn to external financing to raise more funds to pay
for production costs. The major forms of external financing are debt and equity.

Debt. The largest source of external finance for most firms is debt. In a debt con-
tract, borrowers promise to pay back to lenders the loan (or principal) at a later time
known as the maturity date. Also, debtors must pay interest to lenders. Debt funds
can be obtained from bank loans and debt issues in the financial marketplace. Bank
loans are the most important type of debt financing, especially for small- and
medium-sized businesses and for short-term loans of less than one year. Debt
issues can be used to acquire short-term and long-term funds. Commercial commercial paper Short-term,
paper is the most common type of short-term debt issue. Larger, well-known firms unsecured debt securities normally
issued by large, financially sound firms
have greater access to commercial paper financing than smaller firms. Bonds
to raise funds
are used as a long-term source of funds; 5, 10, 20, and 30 years are typical maturi-
bonds Long-term debt securities issued
ties. Like commercial paper, bonds are sold in the financial marketplace. Today, by firms to raise funds to finance long-
firms can issue commercial paper and bonds on a global scale. Bonds issued term capital budgeting projects, such as
outside a firm’s home country are known as Eurobonds; bonds issued by a U.S. firm land, buildings, and equipment
in Japan are Eurobonds. The global bond market has grown rapidly in the last 10 Eurobonds Bonds that are issued
outside a firm’s home country
to 20 years, allowing firms to finance their international expansion into other
countries.
Which form of debt should a firm use? This financing decision is governed by
the length of the investment project. A one-year project should be financed with a
one-year debt. Since it is short-term in nature, bank loans and commercial paper
are recommended. Small- and medium-sized firms primarily rely on bank loans to
meet short-term financing needs. Larger firms can more readily use commercial
paper financing. A five-year project, such as the capital budgeting example of a five-
year machine (shown in the “Capital Budgeting for Multiple-Year Investments”
box), should be financed with five-year bonds. The bonds can be sold publicly to
anyone who wants to purchase them or privately to large financial institutions.
Debt financing is cheaper than equity financing due to the tax deductibility of
interest payments on debt. By contrast, dividends paid on equity are not tax
deductible. Let’s see how tax deductibility lowers debt costs. The following data
show how interest tax deductions lower the firm’s income taxes:

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