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31305_1975-1979

31305_1975-1979

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Published by: fedfraser on May 05, 2014
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Recent Developments in Corporate Finance
This article was prepared in the Capital Mar  kets Section of the Division of Research an
 
Statistics.
The concurrence of rapid inflation and declining
 
real economic activity placed unusual financing
 
pressures on nonfinancial business corporations
 
in 1974. Even though real business activity
 
weakened progressively throughout the year,
 
current-dollar requirements by industry for
 
working capital and investment outlays contin ued to rise because of the persistent advance of 
 
prices and costs. Consequently, corporations
 
tapped financial markets for a record volume of 
 
funds last year. In contrast, during the first half 
 
of 1975 total demands on credit markets abated
 
as corporations made sizable cutbacks in inven tories and fixed investment outlays. Never theless, the volume of bond financing has
 
reached historically high levels in recent months
 
as corporations have shifted from short- to
 
long-term debt.The record total of $77 billion raised by
 
nonfinancial corporations in external markets in
 
1974 was 15 per cent more than in the boom
 
year of 1973. Rather than sell new equity shares
 
at depressed 1974 market prices, firms turned
 
to debt markets for funds to meet their increased
 
financing requirements. Thus, while net stock
 
issues of nonfinancial corporations declined to
 
$4.1 billion, the lowest volume since 1969, net
 
issues of corporate debt soared to a record $73
 
billion. Short-term debt accounted for a signifi cant share of this increased corporate borrow ing, with bank loans to business expanding at
 
the same advanced pace in 1974 as in 1973.
 
Corporate issuance of open-market paper also
 
rose substantially in 1974; this was in contrast
 
to 1973, when corporations had substituted bank
 
loans for funds raised through sales of commer cial paper because of the much lower relative
 
cost of bank credit.Over the past decade, trends in corporate
 
finance have led to a considerable reduction in
 
the relative importance of equity in corporate
 
balance sheets. The sharp increase in debt fi nancing in 1974 accelerated this decline, and
 
corporate debt-to-equity ratios rose to unprece dented levels. In addition, the already unfavor able maturity structure of the debt shown on
 
many corporate balance sheets was worsened by
 
the continued heavy reliance on short-term fi nancing. Because of this deterioration, many
 
corporations found their credit ratings ques tioned and their ability to obtain external funds
 
impaired at a time when their internal funds
 
were declining. Market investors became in creasingly quality-conscious, requiring large
 
risk premiums for lower-rated corporate issues;
 
as a result, firms with less than prime credit
 
ratingsincluding many public utilities—were
 
virtually excluded from market participation for
 
many months of last year.Efforts to repair these widespread financial
 
imbalances began late in 1974 and dominated
 
corporate financial strategy through the first half 
 
of 1975. With the economy in the midst of the
 
deepest decline of the postwar period, busi nesses curtailed their capital outlays and reduced
 
their inventories sharply, thus lessening pres sures on total external financing. The funding
 
of short-term liabilities in order to restructure
 
balance sheets and to rebuild liquidity has been
 
reflected in the large volume of corporate bond
 
offerings and the pronounced decline in short term borrowings during the first 6 months.
 
Meanwhile, the recovery in stock prices has led
 
to an increase in the volume of new equity
 
issues, with public utilities accounting for a
 
large share of this growth.These efforts have improved the financial base
 
of many corporations, though considerable re structuring remains to be done. In particular,
 
a significant accumulation of financial assets
 
August 1975
 
464 Federal Reserve Bulletin August 1975
probably will not occur until corporate profits
 
rebound from their decline earlier this year.
 
Moreover, for many of the weaker firms, im proving their financial position is an arduous
 
process, which could conceivably be hindered
 
if the economic recovery should sharply in crease total demands on capital markets.CAPITAL EXPENDITURES
 
AND INTERNAL FUNDSThe gap between corporate internal funds and
 
capital expenditures widened substantially in
 
1974 for the fourth consecutive year. As a
 
result, firms had to turn to external sources of 
 
funds to finance more than $44 billion in total
 
capital outlays (including inventory investment)
 
during the year, $7 billion more than in 1973
 
and $21 billion more than in 1972.Capital outlays and internal funds
Billons of dollars
Internal funds are undistributed profits (including foreign branch
 
profits) plus capital consumption allowances.Flow of funds quarterly data for nonfinancial corporations at season ally adjusted annual rates. Data for 1975-11 are preliminary.
The increasing gap between internal funds
 
and capital outlays reflected in large part the
 
impact of inflation on business investment ac tivity. Although corporate plant and equipment
 
expenditures in real terms weakened in the first
 
half of 1974 and actually declined in the final
 
months, these outlays in current dollars were
 
more than 8 per cent higher for the year as a
 
whole than in 1973. The largest increases oc curred among manufacturers of nondurable
 
goods—particularly petroleum, chemicals, and
 
paper—but there were also strong advances for
 
durable goods manufacturers. In the nonmanu facturing sector, public utility outlays expanded
 
at a rate close to 10 per cent, even though the
 
utilities were scaling back their planned ex penditures throughout the year in response to
 
sharply rising operating costs, reductions in
 
consumer demand, and unfavorable terms of 
 
financing.Inventory investment in 1974 was below the
 
record pace of 1973, but it still remained high
 
by historical standards. A large part of the
 
inventory building in the first half of the year
 
was the result of producers’ desires to stockpile
 
materials that had been, or might be, in short
 
supply—especially steel and coal. But as the
 
year progressed, inflation and rising unemploy ment adversely affected consumer expenditures,
 
and sales fell off rapidly. The decline in demand
 
resulted in a sizable increase in inventories of 
 
finished goods, despite vigorous efforts by re tailers to reduce excessive stocks. Unintentional
 
inventory accumulation was most apparent in
 
the fourth quarter in the durable goods indus tries, especially in new cars.Whereas outlays for fixed investment and
 
inventories were rising during most of 1974,
 
corporate cash flow—retained earnings plus
 
capital consumption allowances—declined on
 
balance for the year. The reduction in cash flow
 
occurred despite a large increase in before-tax
 
profits, all of which was attributable to an enor mous expansion in inventory profits—that is,
 
profits generated by an increase in the value of 
 
inventories as a result of inflation. Although
 
inventory profits are taxed the same as all other
 
earnings, they are offset by increased costs of 
 
inventories needed for replacement and hence
 
August 1975
 
 Recent Developments in Corporate Finance
 465
Composition of capital outlays
Billions of dollarsBillions of dollars 10
Other fixed investment includes expenditures for multiunit and 1-
 
to 4-family residential construction.
do not provide corporations with internal funds
 
for any other purpose.With the sharp rise in prices—especially o
 
fuel—in 1974, inventory profits became ex tremely large and tended to obscure the picture
 
of firms’ liquidity. If inventory gains are ex cluded from reported profits, the resulting fig ureprofits from current production—shows a
 
sizable decline in corporate after-tax profits from
 
late 1973 to the fourth quarter of 1974, the first
 
sustained decline in such profits since 1969.
 
Retained earnings (adjusted to exclude inven tory profits) fell even more sharply as corpora tions increased their dividend payouts.Gains from inventory profits dropped sharply
 
in early 1975, in part because firms liquidated
 
stocks and also because many of them changed
 
their accounting methods from first-in, first-out
 
(FIFO) to last-in, first-out (LIFO) to minimize
 
the effects of inflation on reported inventory
 
values. The decline in inventory profits contrib uted to a sharp reversal in total before-tax profits
 
of nonfinancial corporations in the first two
 
quarters of this year. Nevertheless, after-tax
 
profits actually improved, as corporate tax lia bilities fell significantly because of the sharp
 
drop in inventory profits and the relief obtained
 
through the Tax Reduction Act of 1975.The gap between internal funds and capital
 
expenditures narrowed markedly in the first
Flow of funds quarterly data for nonfinancial corporations at season ally adjusted annual rates. Data for 1975-11 are preliminary.
quarter of 1975—in part because of the improve ment in cash flow, but primarily because of 
 
sharp reductions in capital outlays. Responding
 
to the accelerating decline in economic activity,
 
industrial firms—like the utilities earlier—began
 
to scale down or stretch out their expenditures.
 
As a result, the annual rate of outlays for plantCorporate profits
Flow of funds quarterly data for nonfinancial corporations at season ally adjusted annual rates. Data for 1975-11 are preliminary.
Billions of dollarsProfits before taxInventory profits-Before taxExcluding inventory profitsAfter taxExcluding inventory profits
 
August 1975

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