Introduction to Finance

fi nancial assets
 
as claims against the income or assets of 
individuals, businesses, and governments. Businesses obtain long-term external fi nancial 
capital either by borrowing or by obtaining equity funds. Long-term borrowing can be privately 
negotiated or can be obtained by issuing debt obligations called bonds. Equity capital may be 
obtained by fi nding new partners with fi nancial capital to invest or through the public mar-
kets by issuing shares. This chapter describes the characteristics of bonds and applies the 
time-value-of-money techniques from Chapter 9 to see how to value bonds. In the following 
chapter, we’ll discuss the characteristics of stocks and tools used to value them.
10.1
Long-Term External Financing 
Sources for Businesses
Businesses obtain long-term fi nancing from internal funds, which are generated from profi ts, 
and from external funds, which are obtained from capital markets. Some fi rms will have little 
need for external funds. They may be able to generate suffi
cient internal funds to satisfy their 
need for capital, or they may require little investment in fi xed assets (for example, fi rms oper-
ating in service industries). Other businesses, such as high-tech fi rms that experience rapid 
growth, cannot generate enough internal funds for their capital needs and may be forced to 
seek fi nancing, often from the capital markets.
fi nancial assets 
claims against the 
income or assets of individuals, 
businesses, and governments
1
Mark Twain. 
Pudd’nhead Wilson, 
(Hartford, Conn: American Publishing Company, 1897). Print.

---

254
C H A PT E R 1 0 Bonds and Stocks: Characteristics and Valuations
The proportion of internal to external fi nancing varies over the business cycle. During 
periods of economic expansion, fi rms usually rely more on external funds because the funds 
needed for investment opportunities outstrip the fi rms’ ability to fi nance them internally. Dur-
ing periods of economic contraction, the reverse is true. As profi table investment opportun-
ities become fewer, the rate of investment is reduced and reliance on external capital markets 
decreases.
Long-term funds are obtained by issuing corporate bonds and stocks. In recent years, 
the total of new corporate security issues amounted to more than $2,600 billion in 2006 but 
declined to about $1,000 billion in in each year from 2008 to 2011 due to a steep recession and 
fi nancial market anxiety. By 2015 new corporate security issues were about $1,800 billion.
Most of the funds raised annually from security issues come from corporate bond sales. 
In fact, corporate bonds accounted for approximately 90 percent of total new security issues 
from 1995 to 2015. Firms issue more bonds than equities for two basic reasons. First, as we 
will see in Chapter 18, borrowing is cheaper than raising equity fi nancing. Second, bonds and 
other loans have a maturity date, when they expire or come due; at times, new bonds are sold 
to repay maturing ones. On the other hand, equity never matures. Firms can repurchase their 
outstanding stock, or the shares of one fi rm may be merged or acquired by another fi rm. For 
this reason, in