National University 2016-17

CLASS NUMBER: 23

Valmonte, Jeremy Allyza L.

ACT157

DEBT AND EQUITY

Loan = a debt = money you have to pay back.

Lender = the one who is supplying/lending the money, the bank for example, or your uncle, if
its not a gift and he wants you to pay him back after you get a good job.

Borrower = the one who is borrowing the money, and they must pay it back, Ford Motor in the
example below.

Investment Bank – They are financial intermediaries, they arrange debt and equity offerings by
underwriting (guaranteeing their issue with their own money). Investment banks match up the
investors that want to buy debt and equity offerings with the companies that need to do debt
and equity offerings.

a Debenture or Bond is a loan but the lenders are a group of different investors who buy 1 or
10 or 1,000 etc.. of the debentures. The borrower receives the money that the investors pay to
get the debenture. Investment Banks are the ones that arrange debenture issues, like
Goldman Sachs. So it’s another form of borrowing, just its borrowing from
Investors instead of from the bank.

LIBOR = London InterBank Offered Rate An interest rate, is one of many different
interest rates that banks or other lenders use. INTEREST RATES
DEPEND ON THE RISK OF THE BORROWER, IF YOU ARE A HIGH
RISK, YOU MIGHT PAY 35% or MORE, IF YOU ARE A VERY, VERY
LOW RISK COMPANY LIKE MICROSOFT YOU MIGHT PAY ONLY A
SLIGHTY HIGHER RATE THAN THE UNITED STATES GOVERNMENT,
SO ABOUT 3% OR 4%.

THE WORLD OF FINANCE IS DRIVEN BY RISK AND REWARD, THE HIGHER THE RISK THE HIGHER
THE POTENTIAL REWARD (lender can earn 35% lending to a high risk borrower but as the
lender you are taking the risk that the borrower cannot pay you back at all, and
You will possibly lose ALL OF THE MONEY YOU LENT TO THE BORROWER!

In the case of LIBOR, it is fixed on a daily basis by the British Bankers'

Association. The LIBOR is derived from a filtered average of the world's
most creditworthy banks' interbank deposit rates for larger loans with
maturities between overnight and one full year.

default – you have broken the terms of an agreement, the bank or other lender can take
measures to make you pay it back (per the loan agreement)
National University 2016-17

Share Capital = Equity – it is money or other assets that represent ownership in a company.
For example, if you are starting a business, and your rich uncle gives you $10,000 to start it,
buy your first products to sell, set up a store, ect… that $10,000 is the equity of your business.
And unless your uncle tells you that it is a loan, and you can pay him back later, OR THAT IT IS A
GIFT AND YOU CAN DO WHAT YOU WANT WITH IT, THEN HE IS THE 100% owner of the
business. Whoever owns the equity is the owner of the business.
IPO = Initial Public Offering – It is when a private company (not yet a public company)
with any shares to trade in the stock market issues shares to the public which can be traded on
an exchange like the New York Stock Exchange. Then the company has a symbol (three or four
letters, like IBM, or MSFT for Microsoft), and every day in the stock market those shares
(representing ownership in the company) are traded, sometimes as many as 100 million or 200
million shares in one day.

THE ADVANTAGE OF BECOMING A PUBLIC COMPAY IS THAT THE OWNERS CAN CASH
OUT OF THEIR INVESTMENT BY SELLING TO THE PEOPLE THAT WANT TO BUY THE NEW
SHARES, AND YOU GET EXPOSURE (like advertising, people become aware of the company and
its products). BY PEOPLE HEARING MORE ABOUT YOUR COMPANY YOU CAN BENEFIT IF THEY
BUY THE SHARES (making the price of the stock go up), your stock is rising and you are getting
richer. A company’s shares usually RISE IF THE COMPANY DOES WELL (INCREASES
NET INCOME).

THE GREATEST DISADVANTAGE TO BEING A PUBLIC COMPANY IS THAT AS A PUBLIC COMPANY

YOU HAVETO SUBMIT MANY DIFFERENT FILINGS TO THE GOVERNMENT AUTHORITIES
(SECURITIES AND EXCHANGE COMMISSION IN THE USA, KNOWN AS THE ¨SEC¨) AND ARE VERY
REGULATED, THIS IS COSTLY AND TAKES A LOT OF TIME.

THE FACEBOOK IPO RAISED $5 BILLION (CASHING OUT THE OWNERS). Company was valued
at more than $100 billion, so the original owners still had about 85% of the ownership, and the
public the rest.

Earnings per Share = EPS, is the amount of net profit the company earned for the period (each
quarter it is measured), so if the earned $100 and have 50 shares, the EPS would be $2 per
share. It is the single most important thing that determines a company´s stock price.

Publicly traded company (= a stock) – After the company has had its IPO, then it is a publicly
traded company from that day on.

Market Capitalization – How much the company is worth in total (multiply the number
of shares by the stock price to get the total market cap. Apple is number one in the world
today with almost $700 billion market cap.

A stock exchange – Where all the public companies are traded, each country has its own stock
exchange, and sometimes more than one. In the USA, there is the NYSE, which is the biggest in
the world, with 3,800 stocks, and the NASDAQ with 2,700 stocks. In the Philippines there is the
Philippine Stock Exchange. There are approximately 300 companies on the Philippine Stock
exchange. Website: http://www.pse.com.ph/stockMarket/home.html

Stock Chart – a chart that shows the historical movement of a stock price over time. Stock
charts can be for just one day, or for a month or a year, or 10 years, or the entire history of the
National University 2016-17

stock. Websites and software programs today let you make many different types of charts to
study stock price trends.

Wall Street – Wall Street is an actual street in downtown NYC. It is the street that the NYSE is
on. But when people refer to ¨Wall Street¨ they are referring to the community of investment
banks and big investors that are involved in the financing of US companies, and many foreign
companies as well. So Wall Street is all the Analysts, Portfolio Managers, investors and traders
working in that industry, issuing share capital, debentures, and then trading those issues too in
the markets (stock and debt markets).

Research Analysts – Each of the investment banks has Research Analysts that publish reports
on public companies with an extensive analysis of the stock, but very detailed and lengthy,
with financial projections also. The analyst will put an opinion on the report, like BUY (he/she is
recommending to buy the stock), or HOLD (he/she) is saying don’t buy it now, but if you have
already bought it, don’t sell it, keep it. Their role is important because all the people that
invest in stocks do not have time to analyze the companies themselves and rely on these
reports. And the companies that want to do an IPO will choose the investment bank that has a
good Analyst that will follow their company after the IPO.

Debt vs. Equity (from a company’s standpoint)

Debt is when you borrow from, and so owe money to another person or entity. Most typically
we think of debt borrowed from the bank directly. But there is actually more debt that is
borrowed from investors (via debentures or bonds).

As the borrower, you receive money from the lender (the bank, or the investor), and then you
sign a promissory Note (an IOU, or a promise to pay it back, with interest, on or before a
certain date).

So, for example, Ford Motor Company borrows $3 million from Citibank at LIBOR + 2%, due on
April 15, 2016. It’s a four year loan that Ford must pay interest on (usually a interest
paymenteach month), and then pay back the entire $3 million on or before April 15, 2016. If
they don’t they will be in default.

Borrowing like this (incurring debt) to get funds to grow your business dilutes your earnings
only slightly, because the only additional expense you now have is the interest expense, so
your net earnings will be lower than if you had not borrowed the $3 million.

Issuing share capital/equity is getting money to start or grow your business (or cash out your
earlier invested money, like the owners of Facebook are doing). In return for the money
received the person giving the money GETS OWNERSHIP in the company. Each share
represents a certain percentage of ownership, depending on how many shares there are.

So if I buy one share of MSFT (Microsoft), since there are 8.4 billon shares total, my one share
would represent 0.000000000119% ownership of the total Company.
So which is cheaper for a company if they need funds, to issue debt or equity?

This is a complex question that you will study in upper level finance courses. The short answer
is that normally we think of debt as being cheaper BECAUSE YOU ARE NOT DILUTING YOUR
National University 2016-17

SHARES. Wall Street looks at EPS more than anything when buying and selling stocks, and if
you issue more shares you are diluting your EPS. BUT AN EXCEPTION WOULD BE IF YOUR
STOCK PRICE IS OVERVALUED, THEN THE AMOUNT OF MONEY YOU GET FROM ISSUING STOCK
WILL MAKE UP FOR THE DILUTION.

Simple income statements with EPS follow on the next page:

Company has 100 shares, interest rate is 10%, tax rate I 30%, and stock price is $1 per share

Before debt or equity issuance

Sales 200
Costs (100)
Profit before interest and taxes 100

Tax 30
Net profit 70

EPS calculation 70/100 = 70 cents a share

Issues $100 of debt

Sales 200
Costs (100)
Profit before interest and taxes 100

Interest 10
Profit before taxes 90

Tax 27
Net profit 63

EPS calculation 63/100 = 63 cents a share

Issues $100 of equity

Sales 200
Costs (100)
Profit before interest and taxes 100

Interest 0
Profit before taxes 100

Tax 30
Net profit 70

EPS calculation 70/200 = 35 cents a share

Issues only $10 of equity to get the same $100,

because its share price is $10 a share, instead of
$1 per share

Sales 200
Costs (100)
Profit before interest and taxes 100
National University 2016-17

Interest 0
Profit before taxes 100

Tax 30
Net profit 70

EPS calculation 70/110 = 64 cents a share