fininnov - Financing Innovations and Capital Structure...

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Financing Innovations and Capital Structure Choices Aswath Damodaran Stern School of Business New York University [email protected]
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2 Abstract The last two decades have seen a stream of innovation in financial markets, especially in the corporate bond arena. Some of these innovations were designed to give firms more flexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing more closely to cash flows on assets, thus increasing their debt capacity. These changes have been for the most part good news for corporate treasurers, but the relentless torrent of innovation has also resulted in some firms issuing these new and more complex securities for the wrong reasons. Some have done so to keep up with other firms in their peer group, and other to take advantage of loopholes in the way ratings agencies and regulatory agencies define debt and equity. In this context, it is worth noting that as corporate bonds have become more complex, investment bankers once more become indispensable to the process, proving both pricing and selling support. It is important that firms recognize when complexity serves their interests, and when it can end up hurting them.
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3 Firms, until the mid-seventies, had fairly simple choices when it came to financing. They could raise equity by issuing common stock or debt by borrowing from a bank or by issuing bonds. When borrowing, firms could choose between different maturities and degrees to which the debt was secured by the assets of the firm (secured, unsecured and subordinated debt). A few firms were daring enough to issue convertible bonds. The surge in inflation in the late seventies and the concurrent increase in the volatility of interest rates created the first wave of innovation in debt securities, with floating rate debt becoming a viable choice for most borrowers. Through the eighties, the innovation continued. Some of the innovations, such as the introduction of ratings sensitive bonds (where coupon rates vary with the company's bond rating), and equity- linked bond issues (such as LYONs and TIGRs) were driven by the need to reassure bond investors that they would be protected in the event the borrower attempted to expropriate wealth from them. Others, such as mortgage-backed securities, were created to allow firms to securitize assets which had hitherto been idle. Much of this innovation was facilitated by a greater understanding of how to incorporate multiple options into borrowing instruments, and how to price these complex securities. In the course of these innovations, investment banks also discovered the allure of coming up with new and more complex securities - they were much more profitable than ta raditional straight bond with a fixed maturity and coupon. Thus, corporate finance departments have continued through the nineties to offer their clients new and different ways of raising financing. While there are a number of different motivations for these innovations, some of these new securities share a common feature. Without being
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fininnov - Financing Innovations and Capital Structure...

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