Debt is typically indirect loans from other

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equity. Debt is typically indirect (loans from other intermediaries) rather than direct (issue of debt securities) The Importance of External Financing- o Mostly internal because external is fraught with difficulty and is expensive o Preference for internal finance is one reason bond issues exceed stock issues by such a large margin o Internal funds are a source of equity- makes them a but for the issue of stock o External finance is the marginal source of funds for investments- and marginal is crucial o External finance is important for industries that are expanding or heavily investing in new technology The Difficulties of External Financing Financing in financial markets heightens the issue of someone not keeping a promise: because it’s typically for a longer period the opportunity to misbehave is longer. Two forms of financing- debt and equity Debt vs. Equity from the POV of the Providers of Financing- o Borrower can default on promise- not just company. If this happens lender can force borrower into bankruptcy or can require borrower to pay more back than what was lent to him. Latter is only a good option if it seems promising that the borrower will recover o Safe debt has benchmark rate- serves as reference point for pricing other debt o Risky debt has no upside: at best lender receives what is due to him, at worst he loses everything Could require equity component to compensate for downside if all things go well o Equity finance avoids some of the problems of risky debt but it brings other instead Debt vs. Equity from the POV of the Recipients of financing- o Safe debt- cheap source of financing for recipient- excellent credit makes you a safe debt o Risky debt and equity- are more expensive for recipient, average yield must be higher to compensate provider
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Disadvantage- providers have some control over enterprise The Primary Market and the underwriting of new issues Ways to sell new issues of securities to investors- 1. issuer can sell directly 2. can pay broker a commission to distribute new issue 3. may sell the whole issue to an underwriter (who resells it to the public) Today in US most new issues are sold through underwriter which then distribute to brokers Due diligence of underwriter is good for legal reason but also for reputation Underwriter buys issue with the intention of selling is at a higher price to the public - Advantage for issuer: removes uncertainty about the amount of fund the issue will raise and it relieves the issues of the considerable transactions costs of marketing the issue Underwriters are mostly security firms- however banks are reentering LIST OF CORPORATE SECURITIES ON PAGE 316 Risks and rewards of underwriting- If misprices and issue they will lose Underwriter can stabilize the price of the issue in the second market however this can leave large amounts of unsold shares Face risk of interest rates increasing As compensation, they often earn a spread and explicit fees
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