Long term financing

The capital market you may remember deals with bonds and stocks. Within the capital market there exists both a primary and a secondary market. A primary market is a “new issues” market. It is here that funds rose through the sale of new securities flow from the buyers of securities to the issuers of securities. In a secondary market, existing securities are bought and sold. Transactions in these already existing securities do not provide additional funds to finance capital investment.

A large company typically raises funds both publicly and privately. With a public issue, securities are sold to hundreds and often thousands of investors under a formal contract overseen by federal and state regulatory authorities. A private placement on the other hand, is made to a limited number of investors, sometimes only one, and with considerably less regulation. An example of a private placement might be a loan by a small group of insurance companies to a corporation. Thus, the two types of security issues differ primarily in the number of investors involved and in the regulations governing issuance.

When a company opted for expansion, it obviously must be financed. Often the seed money (i.e. the initial financing) comes from the founders and their families and friends. For some companies, this is sufficient to get things launched, and by retaining future earnings they need no more external equity financing. For others infusions of additional external equity are necessary.

Venture Capital: venture capital represents funds invested in a new enterprise. Wealthy investors and financial institutions are the major sources of venture capitals. Debt funds are sometimes provided, but it is mostly common stock that is involved. This stock is almost always initially placed privately.

Initial Public Offerings: If the enterprise is successful, the owners may want to “take the company public” with a sale of common stock to outsiders. Often this desire is prompted by venture capitalists, who want to realize a cash return on their investment. In another situation, the founders may simply want to establish a value, and liquidity, for their common stock. Initial Public Offerings are accomplished through underwriters.

Bonds: a bond is a long term debt instrument with a final maturity generally being 10 years or more. If the security has a final maturity shorter than 10 years, it is usually called a note. To fully understand bonds, we must be familiar with certain basic terms and common features. Par value for a bond represents the amount to be paid the lender at the bond’s maturity.

It is also called face value or principal. Coupon rate is the interest rate on a bond for example a 13% coupon rate indicates that the issuer will pay bondholders $ 130 per annum for every $1000 par value bond that they hold. Bonds almost always have a stated maturity. This is the time when the company is obligated to pay the bondholder the par value of the bond.

Preferred stocks: it is a hybrid form of financing, combining features of debt and common stock. In the event of liquidation a preferred stockholder’s claim on assets comes after that of creditors but before that of common stock holders. Usually, this claim is restricted to the par value of the stock, if the par value of a share of preferred stock is $100, the investors will be entitled to a maximum of $100 in settlement of the principal amount.

Term loans: commercial banks are a primary source of term financing. Two features of a bank term loan distinguish it from other types of business loans. First, a term loan has a final maturity of more than 1 year. Second it most often represents credit extended under a formal loan agreement. For the most part, these loans are repayable in periodic installments. Quarterly, semiannually, or annual – that covers both interest and principal.

Lease financing: a lease is a contract; by its terms the owner of an asset (the lessor) gives another party (the lessee) the exclusive right to use the asset, usually for a specific period of time, in return for the payment of rent. Most of us are familiar with leases of houses, apartments, officers or automobiles. Recent decades have seen an enormous growth in the leasing of business assets, such as cards and trucks, computers, machinery and even manufacturing plants.

An obvious advantage, the lessee incurs several obligations. First and foremost is the obligation to make periodic lease payments, usually monthly or quarterly. Almost, the lease contact specifies who is to maintain the asset.

The decision to borrow rests on the relative timing and magnitude of cash flows. Under the two financing alternatives, as well as on the discount rate employed. To evaluate whether or not a proposal for financing makes economic sense one should compare the proposal with financing the asset with debt.

References

Neil Seitz and Mitch Ellison (2004), Capital Budgeting and Long-Term Financing Decisions

Richard H. Bernhard, (2005), Capital Budgeting and Long-Term Financing Decisions, 2d ed

Robert G. Beaves (2005), Capital Budgeting and Long-Term Financing Decisions.