corporate finance sources of capital Flashcards
raising capital
Raising capital is a fundamental business activity, and companies have multiple short-term and long-term financing choices. Short-term funds without explicit interest rates, such as accounts payable, are part of working capital management, which is the management of short-term assets and liabilities. Other debt and equity obligations used to finance the business longer term are considered part of the firm’s capital structure. The goal of effective working capital management is to ensure that a company has adequate, ready access to the funds necessary for day-to-day operations, while at the same time making sure that the company’s assets are invested in the most productive way. The goal of capital structure management is to balance the risks and costs of the firm’s long-term finances
funding
When a company issues stocks and bonds, it is using external sources for funding. Funding can also be generated internally by reinvesting cash flow from operations, delaying payment of liabilities such as accounts payable, or selling or borrowing against assets such as accounts receivable.
internal funding sources
- After tax Operating Cash Flows
- Accounts payable
- Accounts receivable
- Inventory
- Marketable securities
After tax operating cash flows
These are the company’s after-tax operating cash flows less interest and dividend payments (adjusted for taxes) that can be used to invest in assets and are equal to net income plus depreciation charges minus dividend payments. A company with higher, more predictable after-tax operating cash flows has greater ability to internally finance itself.
Accounts Payable
Accounts payable are amounts due suppliers of goods and services that have not been paid. They arise from trade credit, which is a spontaneous form of credit in which a purchaser of the goods or service is, effectively, financing its purchase by delaying the date on which payment is made. Trade credit might involve a delay of payment, with a discount for early payment. The terms of the latter form of credit are generally stated in the discount form: A discount from the purchase price is allowed if payment is received within a specified number of days; otherwise, the full amount is due by a specified date
Accounts Receivable
Accounts receivable can be thought of as being the opposite of accounts payable. Instead of representing amounts due to suppliers, accounts receivable are amounts owed by customers. In general, businesses prefer to delay paying what they owe, but prefer to receive what is owed to them as quickly as possible. One company’s accounts payable represent another company’s accounts receivable. The sooner a company can collect what it is owed, the lesser its need to finance its operations in some other way.
Inventory
Like accounts receivable, inventory is a current asset on the balance sheet. These are goods waiting to be sold. Investing in and holding inventory costs money. Companies would prefer not to put a lot of money into inventory when that money could be used for more productive means. The longer the inventory remains unsold, the longer that money is tied up and not usable for other purposes. As a result, an efficient company holds as little inventory as is necessary and sells or turns over the inventory as quickly as possible. Many companies use a just-in-time inventory system, which means the inventory arrives from suppliers when it is needed. That way, it does not sit in storage waiting to be used or sold. This approach makes the supply chain much more efficient, but it also increases the risk of a critical component or item being out of stock when needed. Once inventory is sold, the purchase amount moves into accounts receivable, and the money becomes available once the customer makes payment.
Marketable Securities
Like accounts receivable, inventory is a current asset on the balance sheet. These are goods waiting to be sold. Investing in and holding inventory costs money. Companies would prefer not to put a lot of money into inventory when that money could be used for more productive means. The longer the inventory remains unsold, the longer that money is tied up and not usable for other purposes. As a result, an efficient company holds as little inventory as is necessary and sells or turns over the inventory as quickly as possible. Many companies use a just-in-time inventory system, which means the inventory arrives from suppliers when it is needed. That way, it does not sit in storage waiting to be used or sold. This approach makes the supply chain much more efficient, but it also increases the risk of a critical component or item being out of stock when needed. Once inventory is sold, the purchase amount moves into accounts receivable, and the money becomes available once the customer makes payment.
External funding sources
financial intermediaries
capital markets
others
financial intermediaries
Uncommitted lines of credit Committed lines of credit Revolving credit Secured loans Factoring Web based lenders and non bank lenders
Uncommitted lines of credit
Uncommitted lines of credit are, as the name suggests, the least reliable form of bank borrowing. A bank can offer an uncommitted line of credit for an extended period of time but reserves the right to refuse to honor any request for use of the line. In other words, an uncommitted line is very unstable and is only as good as the bank’s desire to offer it. Therefore, companies should not rely very much on uncommitted lines. In fact, banks will not “officially” acknowledge that an uncommitted line is usable, which means that uncommitted lines cannot be shown as a financial reserve in a footnote to the company’s financial statements. The primary attraction of uncommitted lines is that they do not require any compensation other than interest.
Committed lines of credit
Committed (regular) lines of credit are the form of bank line of credit that most companies refer to as regular lines of credit. They are more reliable than uncommitted lines because of the bank’s formal commitment, which can be verified through an acknowledgment letter as part of the annual financial audit and can be footnoted in the company’s annual report. These lines of credit are in effect for 364 days, less than a full year. This term length benefits companies by minimizing amounts needed to meet bank capital requirements. For commitments of a year or longer, banks require more capital. This also effectively ensures that they are short-term liabilities, usually classified as notes payable or the equivalent, on the financial statements.
Regular lines are unsecured and are pre-payable without any penalties. The borrowing rate paid by the company is a negotiated item. The most common interest rates negotiated are borrowing at the bank’s prime rate or at a money market rate plus a spread. The most common money market rate is a benchmark reference rate plus a spread. The spread varies depending on the borrower’s creditworthiness, which is the perceived ability of the borrower to pay its debt obligations in a timely manner and represents the ability of a company to withstand adverse impacts on its cash flows
Revolving
Revolving credit agreements, also referred to as “revolvers,” are the most reliable form of short-term bank borrowing. They involve formal legal agreements that define the aspects of the agreement. These agreements are similar to those for regular lines with respect to borrowing rates, compensation, and being unsecured. Revolvers differ in that they are in effect for multiple years (e.g., three to five years) and can have optional medium-term loan features. In addition, they are often used for much larger amounts than a regular line, and these larger amounts are spread out among more than one bank. With revolvers, borrowers draw down and pay back amounts periodically.
Secured loans
Secured (“asset-based”) loans are loans in which the lender requires the company to provide collateral in the form of an asset, such as a fixed asset that the company owns or high-quality receivables and inventory. These assets are pledged against the loan, and the lender files a lien against them. This lien becomes part of the borrower’s financial record and is shown on its credit report. Companies that lack sufficient credit quality to qualify for unsecured loans might arrange for secured loans. For example, a company can use its accounts receivable to generate cash flow through the assignment of accounts receivable, which is the use of these receivables as collateral for a loan.
Factoring
A company can also sell its accounts receivable to a lender (called a factor), typically at a substantial discount. In an assignment arrangement, the company remains responsible for the collection of the accounts, whereas in a factoring arrangement, the company shifts the credit granting and collection process to the lender or factor. The cost of this credit (i.e., the amount of the discount) depends on the credit quality of the accounts and the costs of collection. Similarly, inventory can be used in different ways as collateral for a loan.
Web based lenders and non bank lenders
Web-based lenders and non-bank lenders are recent innovations not typically used by larger companies. Web-based lenders operate primarily on the internet, offering loans in relatively small amounts, typically to small businesses in need of cash. Non-bank lenders also lend to businesses, but unlike typical banks, which make loans and take deposits, these lenders only make loans.
Capital Markets
Commercial markets Public and Private Debt Long term debt Common equity Preferred Equity Other Hybrid securities
Commercial markets
Commercial paper is a short-term, unsecured instrument typically issued by large and well-rated companies. Commercial paper can be sold directly to investors or through dealers. To avoid registration costs with national regulatory agencies, maturities for commercial paper typically range from a few days up to 270 days. Although a significant amount of asset-backed commercial paper exists, most commercial paper is unsecured, with no specific collateral. It is a feasible source of funds for large, highly creditworthy companies. Issuers of commercial paper are often required to have a backup line of credit. The short-term nature of commercial paper, along with the creditworthiness of the borrower and the backup line of credit, generally make commercial paper a low-risk investment for investors.
Public and Private Debt
Public debt is negotiable and approved for sale on open markets. In this context, a negotiable instrument is a written document describing the promise to pay that is transferable and can be sold to another party. Private debt can also be negotiable; however, private debt does not trade on a market. As a result, private debt is more difficult for the holder to sell. While some private debt instruments are not negotiable, such as savings bonds and certificates of deposit, private debt issued by businesses can usually be sold by one party to another.
In addition to publicly traded equity, private equity is an important corporate financing alternative in many countries. Private equity is equity that is not registered with the national security regulatory agency and cannot be traded in the public equity markets. Much private equity consists of family and personal investments in small private businesses. Also, large organizations that are not publicly traded are called private equity firms and provide private equity financing to companies. Some of these private equity firms invest in venture capital firms, and others own a portfolio of publicly and non-publicly traded companies.
Long term debt
Long-term debt has a maturity of at least one year. Conventionally, money market instruments have a maturity of less than a year, notes have maturities from one to ten years, and bonds have maturities of at least ten years. Because of their long maturities, bonds are riskier from both an interest rate and credit risk perspective than notes or money market instruments. Hence, bond lenders (investors) and borrowers (companies) agree to bond covenants that are detailed contracts specifying the rights of the lender and restrictions on the borrower (company). These covenants regulate the company’s use and disposition of assets, restrict its ability to pay dividends, and restrict its ability to issue additional debt that might dilute the value of a bond.
Common equity
Common equity, or common shares, represents ownership in a company and is considered a more permanent source of capital. Shareholders have claims on the company’s profits after its obligations under other contractual claims are satisfied. Shareholders receive dividends distributed by the company and are entitled to the residual value of the assets if the company goes out of business. Shareholders elect the company’s board of directors and thereby, conceptually, at least, have control over how the company is managed and operated.
Preferred Equity
Preferred shares, or preferred equity, are hybrid securities that are issued by companies and have characteristics of both bonds and common equity. Like interest obligations on debt, dividends on preferred shares are often fixed but can be variable. For example, “participating” preferred shares pay dividends based on a company’s profitability. However, preferred dividends paid are not a tax-deductible expense for the company, and unlike with debt instruments, a company can choose to defer or decline to pay dividends on preferred equity. In some cases, preferred dividends are cumulative, meaning the company must pay any skipped preferred dividend payments before it can make any dividend payments on common equity. In case of business failure, bondholders have seniority (have a prior claim) over preferred shareholders on assets or cash flows, and preferred shareholders have similar seniority over common shareholders. Historically, the number of common stock issues by companies and their related proceeds has been substantially greater than financing from preferred issues.
Other hybrid securities
Convertible debt and convertible preferreds are hybrid securities issued by companies and are convertible into a fixed number of the companies’ common shares. These securities are considered hybrids because they are neither pure equity nor pure debt in nature. They are similar to regular preferred equity or debt but provide the owner with an option to convert to common stock. If the company’s share price remains low, there may be no financial benefit to converting, and convertible owners will retain ownership of their convertible security while continuing to receive its dividend or interest payments. If the share price rises sufficiently, however, convertible owners may choose to convert their security to common stock in the company, given the appreciation in value of their investment. The option to convert is a valuable right. As a result, companies can offer smaller dividends or interest payments on convertible securities.
Other funding sources
leasing
Leasing
Some companies might also be able to finance by leasing. In a leasing arrangement, the purchase of an asset and its financing are bundled instead of being separate transactions. In some cases, the leasing of real property or equipment might offer lower joint costs for the company and for suppliers of capital than buying and financing separately. The lease is a debt instrument where the asset owner (the lessor) gives another party (the lessee) the right to use the asset. The lessee agrees to make a set of contractually fixed payments. The leasing contract specifies the length of time the lessee can use the asset, whether the lessee is responsible for maintenance of the asset, and whether the lessee can buy the asset at the end of the leasing period and if so, at what price.
Considerations Affecting Financing Choices:-
Firm specific financing conditions
Company size Riskiness of assets Assets for collateral Public versus private equity Asset liability management Debt maturity structure Currency risks Agency costs Bankruptcy costs Flotation costs
Company Size
The size of a company affects its financing options. Small companies generally do not have access to funding sources such as commercial paper and publicly issued debt and equity. Smaller companies might not have the positive and predictable cash flows needed to meet fixed, periodic debt payments. Large companies with strong operating cash flows can rely more heavily on internal financing, while smaller companies, especially those that are younger and faster growing, or without cash flow, cannot satisfy their capital needs internally and must rely more on external financing—in particular, private equity. Because smaller companies typically lack the positive, predictable cash flows often required by lenders, and because debt financing may not be available or is too expensive, equity financing is usually the predominant source of financing.
