Money and Capital Markets21 C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuBusiness Borrowing 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 2 Learning Objectives w To look at how business firms issue debt securities and negotiate loans in order to raise funds in the money and capital markets. w To learn about the key factors affecting the volume of funds that businesses seek to raise in the financial system. w To see the often powerful impact that business borrowing has upon market interest rates and credit conditions. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 3 Introductionw Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment. w In 2000, nonfinancial business firms in the U.S. raised about $1,250 billion, of which approximately $860 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 4 Factors Affecting Business Activity in the Money and Capital Marketsw Many factors affect the extent to which business firms draw on the money and capital markets for external funds:Total funding demands of business firmsLevel and expected growth of internally generated fundsCondition of the economyCredit availability and interest rates 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 5 Characteristics of Corporate Notes and Bondsw A note has an original maturity of five years or less, while a bond carries an original maturity of more than five years. w Both securities promise the investor an amount equal to the securitys par value at maturity plus interest payments at specified intervals. w They are generally issued in units of $1,000, and accompanied by indentures. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 6 Characteristics of Corporate Notes and Bondsw Corporate bonds tend to be issued with longer maturities when both interest rates and inflation are low. w Some corporate bonds are backed by sinking funds. w A considerable proportion of corporate bonds that are outstanding today carry call privileges. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 7 Characteristics of Corporate Notes and Bondsw During periods of rapid economic expansion, when the supply of credit is relatively scarce, the cost of borrowing rises. w Yields on the highest-grade bonds tend to move closely with government bond yields. w Yields carried by lower-grade corporate bonds are more closely tied to conditions in the economy and to factors specifically affecting the risk position of each borrowing firm. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 8 Characteristics of Corporate Notes and BondsThe Signals that Corporate Bond Issues Sendw A bond issue that appears to be driven by an unanticipated cash-flow shortage tends to lower the bond and equity prices of the issuer.w On the other hand, a new bond sold to expand the firms capitalization tends to send a positive signal to the market. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 9 Characteristics of Corporate Notes and Bondsw Common types of corporate bonds include:Debentures bonds that are not secured by any specific assetSubordinated debentures junior securitiesMortgage bonds may be closed end or open endIncome bonds interest is paid only when income is actually earnedEquipment trust certificates resemble leasesIndustrial development bonds (IDBs) issued by a local government borrowing authority 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 10 Characteristics of Corporate Notes and Bondsw New types of corporate notes and bonds include:Discount bonds include zero coupon bondsFloating-rate bondsCommodity-backed bonds the face value is tied to the market price of an internationally traded commodityMedium-term notes (MTNs) carry maturities of one to ten yearsInvestors in Corporate BondsData Source: Board of Governors of the Federal Reserve System21 - 11 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin21 - 12 The Secondary Market for Corporate Bondsw The secondary market for corporate bonds is relatively limited compared to the markets for other long-term securities like common stock and municipal bonds. w The number of active individual investors is small and institutional investors tend to follow a buy and hold strategy. w Recently however, many institutions are looking at total performance and have become more aggressive. 2003 by The McGraw-Hill Compa