Let's start our discussions about the benefits of markets with the flow of funds. How corporations access financing on markets. What markets do is allocate capital efficiently to where it is most productively employed by mobilizing savings into investments, thereby facilitating the interaction between surplus units who provide the savings, the investments, and deficit units, the corporations who need to borrow money to invest in their projects. We distinguish two types of financing, two types of flow of funds. Indirect finance entails a financial intermediary. Savings are deposited by investors with a financial institution. In exchange, the investors receive interest, the financial institutions then transform these deposits into loans that they provide to corporations. The corporations in turn, provide payments on those loans in the form of interest to the financial institution. So a crucial role for a financial intermediary. Compare that to the direct flow of funds, direct finance where corporations directly tap into investments, thereby bypassing the financial intermediaries. That could either be through issues of shares or issues of bonds. Where the shares and bonds are issued to the investors and the investors provide the cash for payment for the ownership or the loan. Let's take a closer look at how financial intermediation works. Indirect finance allows transformation of assets. There is a mismatch between what the investors want and what the corporations deliver. The financial intermediary makes that mismatch disappear. Short-term liquid small deposits of low risk flow into the financial intermediary, the investors savings. The financial intermediary, then turns or transforms, the sum total of these liquid small deposits into a high risk illiquid large loan to a corporation. And financial institutions can do that because they have the ability, to effectively, pool the risk. They also have an information, a symmetry advantage over the individual investors, they are closer to the corporations, they've got a better understanding of the financial position of those corporations and thereby able to better assess the risk involved in the loan provided. As I already mentioned, by gathering many of those small deposits and issuing many loans to a variety of corporations, they also have an ability to effectively pool the risks of those loans, something that individual investors cannot easily do. Contrast that with direct financing. Direct finance eliminates the need for an intermediary, and thereby, also the cost. Financial intermediation is not cheap, but in that process, direct financing, directly connecting borrowers, corporations with investors, the savers, the asset transformation gets lost. So, that means that we now need to find a asset match between the corporation and the investor. They need to have the same investment borrowing horizon, the same quantity requirements, liquidity requirements, much more complicated. So the transformation advantage is the crucial difference between indirect finance and direct finance. Markets, on the other hand, do provide a number of advantages. First, and probably ever-so important is a regulatory cost advantage. In intermediated, in indirect finance, it is a lot more complicated to regulate each of those transactions and there's a higher cost attached to financial intermediaries than there is to financial markets. The intermediating cost advantage, the most obvious one, we've eliminated the middleman, the financial intermediary is no longer necessary to connect investors to borrowers. There's a size, or scale, advantage as well in those markets. We've seen that the debt market is a wholesale market, able to deal with really substantial loans. Something not so easily achieved for banks or other financial intermediaries. And last, but certainly not least on this list of market advantages is the competitiveness advantage. It's well known that auctions lead to better price outcomes and lower costs for the borrowers and better returns for the investors. So just summarizing the sources of financing that we've now seen. Borrowing funds on the one hand, could go through indirect financing, through a financial intermediary, by accessing the banks. The banks provide short and long-term loans to corporations and are able to effectively pull the risk of those loans. They could go to direct financing, debt markets, borrowing from money markets or bond markets, money markets typically short-term loans. Low risk but they're only available to truly, highly rated corporations. So this is a market that excludes many corporations of lower ratings. We'll discuss more of that later on when we focus on rating agencies. And then, there are the bond markets which provide long-term loans to corporations. Higher risk than money markets but they are available to most corporations, not so restrictive as the money markets are. The alternative to borrowing would be selling ownership in the corporation. And selling ownership occurs, as we've seen, through the equity markets where corporations issue shares in the primary market that then get listed on the secondary market for further trade. Issuing shares would be truly for the long term, it would be therefore the highest risk, the longer the investments are rising the higher the risk. And it would be available to most investment ready corporations that meet those conditions that we discussed in the first module. So let's get started with equity. Raising financing by issuing shares. While equity and dept primary markets where the shares first get issued provide initial financing for corporations. After issuing shares for public trading for the first time, those shares typically get listed on the secondary market, the stock exchange and corporations then have the opportunity to tap into those markets again by seeking recurrent financing. So the graph you see here, gives you an indication of the number of United States initial public offerings for the last seven years or so. And you can see that it's not really a stable pattern. So, we see that in the late 1990s, the number of IPOs was about 50 to 60 per month, but then we see a dramatic decline in the early 2000s. And while numbers have gone up, somewhat over the last few years, we see that they are nowhere near the heavy days of the late 1990s. What the graph also shows is the total value raised in those initial public offerings in billions of dollars. Those are the blue lines that you see in the graph, they measured on a quarterly basis. And just to give you some indication, worldwide equity deals which includes IPOs, but also the recurrent financing by corporations known as season equity offerings equaled $680 billion in the first nine months of 2014, just outside of this graph, capitalizing on strong investor demand. Investment banks have got an important role to fulfill here. If they sense that the market is ready for more shares, they will alert their corporate clients and corporate clients will assess the need for additional funding and capitalize on strong investor demand. But equity funding is not the most important source of recurrent financing for corporations. Corporations tend to use step markets much more frequently than going back for more financing in equity markets. So in 2013, global corporate bonds outstanding equaled $18 trillion. At that stage, for comparison, US GDP was slightly less at $16.7 trillion and Gross World Product was $74 trillion. So, this is truly a substantial market for the flow of funds for financing. 9.5 trillion of this 18 trillion was issued in US Dollars, in US Dollar loans. Not just by US corporations, overseas corporations also have the opportunity to issue bonds in US Dollars. They can do so in the US but they can also tap into the debt markets of Europe, of China, of Australia, and issue debt in those markets as well denominated in US Dollars. Tripling $350 billion was issued by US corporations in non-US Dollar currencies. So, it's clear that US corporations, by far, prefer to issue their debt in their domestic currency. That is not necessarily the case for European firms or Australian firms. $8.1 trillion was issued in effect by non-US corporations, overseas corporation in non-US Dollar currencies. Some currencies are becoming ever more important, whereas the Euro used to be the second most important currency for issue of bonds, the Chinese Yuan is now becoming ever more important. Of the corporations tapping into overseas capital markets, financial institutions are by far the most active corporate issuers. Which suggests that they're tapping into these markets to provide a substantial expansion over the deposits they get from investors to provide their indirect financing role. So, it's clear from those figures that corporations are not really restricted to just domestic markets, domestic investors or local currencies, corporations source financing worldwide. From investors that are located over the world, in a variety of currencies that can then be risk managed through those derivatives markets that we discussed in the first model. So, international corporate bonds are issued by non-US corporations in currencies other than the US Dollar. Foreign bonds on the other hand, are issued by non-US corporations in US Dollars. In New York, they would be called Yankee bonds. Eurodollar bonds on the other hand, would be foreign bonds that are issued by non-US corporations, in, say Hong Kong in the non-US market. Similar opportunities for issuing securities overseas exist in the equity market. So, international equity is issued in foreign markets as well. Many of the world's leading corporations nowadays have got listings on stock exchanges outside their home country, we would call those cross listings. Overseas corporations issuing shares in the US would do that typically under what is known as American Depositary Receipts. The New York Stock Exchange has 349 overseas companies listed. A substantial proportion of the total number of companies listed on the exchange, markets are truly global. So now let's take a look at our corporation, Kellogg's. What are Kellogg's financing needs? We go back to the financial statements that we've seen in the first course. And we'll take a closer look at what Kellogg's involvement in the markets is. So let's start with the equity needs of Kellogg's. The equity book value is actually quite small. Equity book value for Kellogg's, as it was recorded in 2014, is 105 million dollars. That 105 million dollars was established at historical issue prices of 25 cents per share. Kellogg's issued 420 million shares for public trading at 25 cents equaling 105 million dollars. Currently outstanding though, are only 356 million shares. And they would have been listed at the time of recording at about $63 per share. In the enormous gap between market value of the shares and the book value of just 25 cents per share. We can also see that what was issued, 420 million shares, is much larger than what is currently available for public trading on the New York Stock Exchange, 356 million shares. The difference is held as treasury stock by the corporation and it includes things as what Kellogg's did in 2014. Kellogg's bought shares on behalf of its employees as part of their compensation package. Four million shares at a cost to Kellogg's of $250 million. Kellogg's also engages in the buy-back of its shares. I've alluded to earlier if Kellogg's cannot identify net positive present value projects to invest in, it might decide to use the excess cash to buy back some of the ownership in Kellogg's. And it did so in 2014, it bought back 11 million shares at a cost to the company of $690 million so those items would be listed or held under treasury stock. Now, let's take a look at Kellogg's debt financing needs. Kellogg’s has got both short-term loans in its financial statements as it has a much larger position of long-term loans. Bonds markets versus market instruments on the money market, short-term loans include bank borrowings, intermediated or indirect finance. And direct financing through US commercial paper issued over much larger proportions, $681 million. But there is also issued commercial paper overseas, in Europe with about $100 million. In terms of the bond market, you can see that most of the bond's issues are in US Dollars. By far, the majority of the long-term bond issues are in US Dollars, but again, Kellogg's has also decided to issue Euro notes and Canadian dollar notes. On top of that, you can also see an item listed there which reads US Dollar floating rate notes, whereas most of the other long-term bond issues are at a fixed coupon rate. A fixed interest percentage to be paid annually by Kellogg's it also held a loan on which the interest rates varies over time. Just for completeness, you notice that the bottom of this list that there is subtraction out of the total long term debt where we distinguish between current and non-current liabilities. Where the current maturities of long-term debt, what Kellogg's needs to repay within the next year, amounts to $607 million. All of those debt issues of Kellogg's outstanding debt adds up to $5.9 billion. So, the graph that you see on the right-hand side gives you a picture of when the face value of those loans, of those bonds, is due. You can see that most of them are due, most of the amounts are due fairly soon in the next few years. Although, there is one large issue which was made in 2001 for Kellogg's to acquire Keebler Foods Company. And, you can see that at the time of issue, that was a 30 year bonds issue at 7.45%, a very high interest rate in compared to the very low interest rates at present. So you can see that for example in the more recent acquisition of Kellogg's of Pringles, that it was able to finance that acquisition by issuing US Dollar notes that mature in 2022 and US Dollar notes that mature much sooner in 2015, with just three years to maturity at the time of issue. And, you can see that the interest rates, the coupon rates on those two issues are much lower than what Kellogg's still needs to repay on the US Dollar debenture to acquire Keebler Foods Company.
