Basic corporate investment devices: economic attributes and formal characteristics

• Pages: 240-319
• Author: William A. Klein,John C. Coffee Jr.,Frank Partnoy

240

Chapter 4

BASIC CORPORATE INVESTMENT DEVICES:

ECONOMIC ATTRIBUTES AND FORMAL

CHARACTERISTICS

I. INTRODUCTION

In this chapter we will examine terms or concepts that define the

basic elements of what is called the financial structure of a corporation.

The principal focus is on the two classic and most common investment

devices, common stock (equity) and bonds or debentures (debt). (Com-

pare Chapter 1, Sec. II(E), discussing debt and equity.) A certificate of

common stock is a piece of paper that is tangible evidence of a set of

rights, interests, or claims in an incorporated business. It can be

thought of as a short-hand expression or symbol for all the rules

determining the common shareholder’s position in relation to the basic

elements that are the bedrock of business organization: risk of loss,

return, control, and duration. The same can be said of the piece of

paper that we call a bond or debenture. In this chapter we are

concerned with the content of financial instruments (common stock and

bonds, and certain other instruments such as preferred stock, options,

and warrants) and the language and concepts that people use to describe

that content. In the next chapter we will begin with an examination of

basic principles used in valuation of financial instruments or other

assets. Some readers may find it helpful to read that material (in Sec. I

of Chapter 5), at least quickly, before starting Sec. III of this chapter. In

Chapter 5, following the material on valuation, we will examine the

determinants of the relative amounts of debt (bonds and related instru-

ments) and equity (common stock and related instruments) that will be

used in financing the business.

Before proceeding, a word of warning and reminder is appropriate.

We have already seen (see, especially Chapter 1, Sec. II(G) and Sec.

XIII(B)) that simple debt and simple equity are polar cases and that

virtually infinite variations are possible as we alter the classic provisions

of each type of claim. In this chapter we focus on the classic terms of

bonds and common stock, but we must remember that those terms can

be varied to suit the needs, tastes, or whims of investors. In fact, a

significant number of intelligent, experienced, creative, and highly com-

pensated people spend much of their time in activity that some might

think of as fashioning and marketing new financial products. One can

also think of their role as finding new ways to define the rights,

interests, or claims of the various participants in an economic enter-

prise—a role much like that of a lawyer who reworks and refines a

241SOME DEFINITIONSCh. 4

partnership agreement, a buy-out agreement, or any of the many other

agreements defining business relationships.

One final point deserves emphasis. When we examine common

stock, bonds, and other securities, particularly in this chapter, we work

with abstractions. What is ultimately important, however, is how eco-

nomic forces and legal rules affect individual human beings. Equity

interests in public corporations are held directly by individuals or for

their benefit by mutual funds, pension funds, insurance companies, or

other intermediaries. Similarly, it is people, not abstractions, who are

the source of funds that are lent to corporations. An individual who

buys a corporate bond lends directly to the corporation (that is, acquires

a debt claim in the corporation, while other individuals, directly or

indirectly, acquire equity claims). The individual might lend indirectly to

the corporation by investing in a mutual fund, pension fund, or insur-

ance policy. Or the individual can lend money to a bank (that is, make a

deposit in or buy a certificate of deposit of the bank), which in turn will

lend to the corporation. Especially in thinking about rules that may be

thought to protect individuals, and about the emergence of new forms of

securities (such as ‘‘junk bonds’’), it is important to bear in mind the

wide variety of institutional intermediaries and mechanisms by which

people can and do invest in enterprises. For some purposes, for example,

it may be unobjectionable to think simply of a bank lending money to a

corporation. For other purposes, however, it may be essential to recog-

nize that the bank is an intermediary through which individuals (deposi-

tors and shareholders of the bank) make their funds available to the

corporation. Individuals can deposit their money in a bank and earn a

modest but secure rate of return, while the bank takes that money, plus

the money invested by its shareholders, and lends at a higher rate of

return, and with a higher risk, to the corporation. Or the individual can

invest in the corporate debt more directly by buying shares in a mutual

fund that holds a portfolio of corporate bonds; or invest even more

directly by buying the bonds for her or his own personal account. Thus,

the terms of investments by individuals are determined not just by the

nature of the securities issued by firms seeking funds but also by the

relationships between individuals and financial intermediaries. But to

avoid delusion, we must keep our eyes on the individuals.

II. SOME DEFINITIONS

We have previously examined (especially in Chapter 1) concepts of

risk, return, control, and duration, and the relationships among them.

Compared with the earlier material, the ideas that will be developed here

and in subsequent chapters rely less on intuition, experience, and

judgment and more on logic and rigorous analysis. That being so, we

will require more precise definitions.

242 BASIC CORPORATE INVESTMENT DEVICES Ch. 4

A. EXPECTED RETURN

Expected return is a measure of return that uses rudimentary

concepts of probability to take account of risk or uncertainty as to

outcome. Technically, expected return is the weighted average (or, if

you prefer, arithmetic mean) of all possible outcomes. (The symbol

commonly used to denote expected return is X.)

To illustrate, suppose that you bet $1 on the flip of a coin. If you

win, you will have $2, and if you lose, nothing. The expected monetary

value of that ‘‘investment’’ is $1, computed as follows:

Probability Return Value

.5 $2 $1

.5 0 0

1.0 $1

Note that here the expected return ignores the amount of the initial

investment and thus tells us nothing about profitability. When we are

concerned with profit we can use the concept of expected rate of return,

which is likely to be expressed on an annual basis. Sometimes the term

‘‘expected return’’ is used to refer to rate of return. The meaning should

be evident from the context.

Suppose that you buy 100 shares of stock of a corporation that does

not pay dividends currently; that you pay $10 per share or $1,000 total;

and that you expect to sell at the end of one year. Assume further that

your estimate of the prospective sale prices and their probabilities is

revealed in the first two columns below, with the corresponding expected

return revealed by the third column:

Sale

Price

Sale

Price

Probability (return) Value

.20 $ 900 $ 180

.50 1,000 500

.30 1,500 450

1.00 $1,130

The expected return calculation shows that in a statistical or probabilis-

tic sense your investment is expected to yield $1,130, which is the

expected return. The expected rate of return is 13 percent ($130 expect-

ed end-of-year gain on an investment of $1,000).

Where do these figures come from and how solid are they? The

answer to that depends on facts that have not been developed. It is

sufficient for our purposes to observe that people do, consciously or

unconsciously, make calculations of this sort. Their information may be