Types of Financing Methods

Every source of capital has different risks for the company and the investor. For example, debt is a safer investment than common stock because it has a higher priority in claims in case of financial distress. It is, however, riskier as it increases the probability of financial distress.

Short-term sources include financing from operating activities such as accounts payable, short-term loans, and short-term instruments sold or issued by the company in the capital markets. In contrast, long-term sources include bonds and leases, common shareholders’ equity, and, to lesser extents, hybrids such as preferred shares and convertible debt. https://todotvnews.com xanax apteka online

Internal Financing

Companies can generate internal financing and liquidity from shorter-term operating activities in several ways, including:

• generating larger after-tax operating cash flow;
• increasing working capital efficiency like shortening the asset conversion cycle; and
• converting liquid assets into cash.

Operating Cash Flow

These are the company’s after-tax operating cash flows (adjusted for taxes), minus interest and dividend payments, that can be utilized to invest in assets. A corporation that generates higher, more predictable after-tax operating cash flows can better fund itself internally.

Accounts Payable

Accounts payable are unpaid amounts owed to suppliers of products and services. They are derived from trade credit, a spontaneous kind of credit in which a buyer of goods or services effectively funds the transaction by deferring payment.

Account Receivable

These are amounts owed by customers. Companies prefer delaying making payments for what they owe but prefer receiving what is owed to them as quickly as possible. The faster a company can collect what it is owed, the lesser its need to finance its operations in some other way.

Inventory

Inventory is a current asset on the balance sheet. Investing in and holding inventory costs money. Companies would rather not invest a significant amount in inventory when that money may be better spent on more productive activities.

Marketable Securities

Marketable securities are financial instruments that can be swiftly sold and converted to cash, such as stocks and bonds. Companies frequently invest in marketable securities to obtain a higher rate of return than they would if they held cash..

Financing through Financial Intermediaries

These include both bank and non-bank lenders. Short-term bank financing includes committed bank lines of credit, uncommitted bank lines of credit, and revolving credit agreements or revolvers.

• Uncommitted lines of credit are the least reliable. A bank can provide an uncommitted line of credit for a lengthy period of time, but it retains the authority to refuse any request to use it.
• Committed (regular) lines of credit. These are reliable because of a bank’s formal commitment. They are in effect for less than a year, ensuring they are classified as short-term liabilities on financial statements. Additionally, they are unsecured.
• Revolving credit arrangements or revolvers. They are the most reliable form of short-term bank borrowing. They are in effect for multiple years. Borrowers can draw down and pay back amounts periodically.
• Secured loans require companies to provide collateral against the loan. These may be available to companies that have a credit quality to qualify for unsecured loans.
• Web-based lenders or non-bank lenders are recent innovations that offer loans in small amounts.  

Capital Markets Financing

Commercial Paper

This is a short-term unsecured loan instrument usually issued by a large company with a good credit rating. They typically range from a few days to 270 days. The good credit rating of the issuer and their short-term nature make them low-risk investments for investors.

Debt vs. Equity Financing

Businesses are typically financed over a longer period of time with a mix of debt and equity securities. The key differences between debt and equity are:

$$
\begin{array}{l|l|l}
& \textbf { Debt } & \textbf { Equity } \\
\hline \text { Legal Agreement } & \text { The company owes debtors a contractual duty. } & \begin{array}{l}
\text { Shareholders are the company’s residual } \\
\text { owners. }
\end{array} \\
\hline \text { Claim Priority } & \begin{array}{l}
\text { Interest and principal payments to debtors take } \\
\text { precedence. }
\end{array} & \begin{array}{l}
\text { Residual claimants to distributions and } \\
\text { corporate assets. }
\end{array} \\
\hline \text { Distributions } & \begin{array}{l}
\text { Interest payments are made on a regularly, } \\
\text { and the principal is repaid when the loan } \\
\text { matures. }
\end{array} & \begin{array}{l}
\text { The Board of Directors has discretion on } \\
\text { dividend distributions. }
\end{array} \\
\hline \text { Taxation } & \text { Interest payments are tax-deductible expenses. } & \begin{array}{l}
\text { Dividend payments and stock repurchases } \\
\text { aren’t tax deductible. }
\end{array} \\
\hline \text { Term } & \text { Stated term to maturity. } & \text { No finite term. } \\
\hline \text { Voting Rights } & \text { No voting rights. } & \text { Voting rights. } \\
\hline \text { Cost to Company } & \text { Lower cost to a company. } & \text { Higher cost to a company. } \\
\hline \text { Investor Risk } & \text { Low risk to investors. } & \text { Higher risk to investors. } \\
\end{array}
$$

Long-Term Debt

Long-term debt is a debt with a maturity of over one year. Remember that money market instruments have maturities of less than a year, notes have maturities of between one to ten years, and bonds have maturities of over ten years. Due to their long-term maturities, bonds are riskier than notes and money market instruments. For this reason, lenders and borrowers will agree to bond covenants that specify the lender’s rights and restrictions of the borrower.

Common Equity

Common equity represents ownership in a company and is considered a long-term source of funds. Shareholders receive dividends and are entitled to the residual value of the company’s assets if the company goes out of business. They also elect the directors and therefore have control over how the company is managed.

Preferred Equity

These are hybrid securities that have characteristics of both equities and bonds. They receive fixed dividends, just like interest payments on debt. However, companies may defer these payments. In case of business failure, they have a senior claim to their assets over common equity.

Other Hybrid Securities

These include convertible debt and convertible preferred securities. They are convertible into a fixed number of the company’s common shares. If a company’s share price rises significantly, owners of these securities may choose to convert them to common equity.

Other Financing

Leasing Obligations

Companies may also finance through leasing. In a leasing arrangement, the purchase of an asset and its financing are bundle. The lease is a debt instrument where the asset owner (the lessor) gives another party (the lessee) the right to use the asset for a set of fixed payments. At the end of the lease agreement the lessee may be able to buy the asset.

Considerations Affecting Financing Choices

Firm-Specific Financing Considerations

• Company size: A small company may not have access to commercial paper or publicly traded debt or equity. They may also not have sufficient cash flow to rely on internal financing than large companies that generate strong operating cash flows. Small companies may therefore be forced to rely on external financing like private equity.
• The riskiness of assets: Companies with volatile operating cash flows that would make debt servicing difficult rely heavily on equity financing with little debt financing.  Companies having a high degree of business risk will seek to minimize financial risks and leverage.
• Assets for collateral: Real property is good collateral for mortgages and asset-backed bonds. A unique asset that is highly specialized and intangible might not be valuable as collateral. Good collateral improves a company’s access to debt financing as well as reduces its costs.
• Public vs. private equity: Many private companies are too small to sell their debt and equity securities publicly. An advantage private equity firms have is that they can reduce the agency costs associated with manager and shareholder conflicts of interest.
• Asset liability management: Businesses tend to match the maturity structures of their assets and liabilities. A mismatch of asset and liability maturity structures, e.g., using short-term debt to finance long-term projects, can be problematic.
• Debt maturity structure: If interest rates on short-term debt are lower than those on long-term debt, a firm can use short-term debt and continually refinance with new short-term debt whenever current debt matures. The risk that interest rates will change is called rollover risk.
• Currency risk: For a company that issues debt in a foreign currency it faces currency risk. Currency risk is the risk that the exchange rate will change significantly during the term of the debt, increasing its cost of debt.
• Agency costs: Debtholders can suffer losses if the borrowing company increases its riskiness beyond its original expectations. This can be due to a reduction in its creditworthiness, increase in its financial distress. Debtholders will attempt to protect themselves by having debt covenants that put certain limitations on the activities of the company.
• Bankruptcy costs: Bankruptcy introduces additional costs, with company resources being used by third parties, the legal system, and other administrative costs of bankruptcy, which is a net loss to the company’s suppliers of capital.
• Floatation costs: These costs can include company-specific expenses, such as underwriting fees, legal fees, registration fees, and audit fees. Flotation costs as a percentage of the capital raised are generally lower for debt offerings than for equity offerings.

General Economic Considerations

• Taxation: The cost of debt financing is typically lower than the cost of equity financing as interest payments on debt financing are tax-deductible. This encourages companies to use more debt. However, greater use of debt increases the risk of financial distress.
• Inflation:  Uncertainty over inflation rates can make longer-term, fixed-rate contracts unattractive to the company and lender. If inflation is expected to rise, companies may prefer a fixed-rate debt.
• Government policy: Governmental fiscal policies can be used to stimulate the econ­omy or to subsidize specific industries, e.g., making loans at a lower rate than capital market rates. Governments can also provide guarantees lowering the cost of debt.
• Monetary policy: The central bank may lower interest rates with the intent of stimulating economic growth. Companies may take on huge amounts of debt during these periods.

Question

Which of the following is least likely an advantage of using debt financing?

1. Dividend distribution.
2. Lower risk to investors.
3. Lower cost to the company.

Solution

The correct answer is A.

Debt holders do not receive dividends. This is a return on common equity holders. However, it is at the discretion of a company’s board of directors.

B is incorrect. Debt financing provides a lower risk to investors. The company does not have to give up a portion of the company to receive the financing. It is also for a limited amount of time compared to equity that is considered a permanent source of capital.

C is incorrect. Debt financing is a lower cost of financing for a company compared to equity financing especially during periods of low interest rates. Interest payments are also tax-deductible reducing a company’s tax expense.