The limited liability corporation arose to become the overwhelmingly dominant economic institution of our times because it facilitated raising capital. Proprietors and partners in business find it relatively difficult to raise new capital because any participant in these forms of business is liable for all of the debts of the business. Because it is risky to enter such organization it is difficult to get out thus creating a further impediment to securing financing. Corporations, on the other hand, involve the limited risk of the initial investment and so can secure more investors. Corporations are financed by a great variety of means. The major categories are:

• Internal (retained earnings and depreciation credits),
• Equity (common stock, preferred stock),
• Long term debt (bonds, debentures),
• Short term debt (commercial paper, trade credit).

There are also other odd types of financing including warrants and convertible debt.

Common stock involves the right to share in the dividends and usually a right to vote. There are some cases of common stock that does not have a voting right. For example, when Henry Ford died the Ford family dealt with the tax problem by creating the Ford Foundation and donating non-voting shares in the Ford Motor Company to the Ford Foundation. The Ford family retained the voting common stock and thus control of the company.

Preferred stock is a peculiar case. Generally preferred stock is issued by regulated public utilities where the disadvantage of the non-deductibility of the dividend is not important. Preferred stock is purchased by corporations, for whom the dividend is 70 percent tax free.

In recent years U.S. corporation have met about 80 percent of their capital needs from internal sources of funds (retained earnings and depreciation allowances). The vast majority of the external funds coming from increases in debt. There has been a small amount created by increases in accounts payable but no new capital coming from new stock issues. In fact, corporation have been buying back their own stock with funds raised by issuing debt. Obviously the trend for corporation is higher debt ratios. Rather steadily the debt/asset ratio for all corporations has risen from about 35 percent in 1954 to about 60 percent in 1990. However the extent of debt financing in the U.S. is about the same now as that of most other industrial nations and significantly below that of Japan.

Corporations may issue new securities through a private placement or a public offering. A private placement avoids the costly process of registering the issue with the Securities and Exchange Commission. The private placements are traditionally for the small, risky, and unusual issue.

The first stage of the registration process is the distribution of a prospectus, sometimes called a red herring, because of the warning printed in red informing the reader that the company is trying to sell securities before the registration is effective.

A public offering may be either a general cash offer or a rights issue. The general cash offering make use of underwriters. The underwriters fees will typically be less than five percent for a large issue but could be as much as ten percent for a small offering. A tombstone advertisement is published for an underwritten issue listing all the underwriters involved.

A RIGHTS ISSUE OF STOCK

In a rights issue of new stock a lower offer price for the stock does not make the stockholders any better off than a higher price because what they gain in terms of the increase in the price of the new stock is offset by the decrease in the price of the stock they already own.

When a corporation is raising money by the sale of new stock they are doing it to fund a worthwhile investment project. The only real gain for the stockholders is from the positive net present value of the investment project. All the rest of the operation is "smoke and mirrors." To see what this mean consider the following example.

Suppose a corporation has a project that costs $1 million but will return $3 million. Its NPV is thus $2 million. The corporation can raise the $1 million by selling 20,000 shares at $50 each or 100,000 at $10 each. Or it can use any other combination of price and shares that amounts to $1 million.

Suppose the shares are selling at $60 before the project and that there are 500,000 shares outstanding. It thus has $30 million in equity capital. Consider the results after the sale of the new shares and the undertaking of the investment project.

Consider an owner of 25 shares. Before the project his/her holdings are worth 25(60)=$1500. Under the $50 per share offering he/she can buy one share and so owns 26 after the financing of the project. Each of the shares is worth $63.46 so the total value of his/her holdings is 26(63.46)=$1650. Since he/she paid out $50 for the new share the net gain is $1650-1500-50=$100. This $100 net gain is just the shareholders share of the NPV of the project. The $100 net gain came as a result of a capital gain of $63.46-50=$13.46 on the one new share and capital gains of $3.46 on each of the 25 old shares. This amounts to a total of 86.54 on the old shares and $13.46 on the new share for a total of $100.

Under the $10 per share offering the owner of 25 shares can buy 5 shares. After the financing each of the 30 shares is worth $55 so his/her holdings are worth $1650 the same as in the $50 per share offering and their the same net gain of $100. The $100 is the net gain of $55-$10=$45 per share on the 5 new shares and a capital loss of $5 per share on the old shares. The net is thus 5(45)-25(5)=225-125=$100.