The goal of business finance is to raise sufficient capital at the least cost for the level of risk that management is willing to live with. The risk is that a business will not be able to service the debt and be forced into bankruptcy.
Broadly speaking there are 5 main ways of funding a company’s needs:
? Receive credit from suppliers
? Obtain lease financing
? Obtain bank loans
? Issue bonds
? Issue stock
This is the easiest way that companies obtain funding. Companies buy goods and services and have anywhere from seven days till 6 months to pay for them; when companies need more credit from suppliers the financial controllers will negotiate longer credit terms or larger credit lines. The payment terms can also be stretched and this can work well because the creditors do not want the customer to go into bankruptcy taking their money with them.
Instead of buying equipment, many companies choose to lease equipment – this is a form of franchising.Cars,computers and heavy equipment can be financed for short periods or indeed longer periods.
If it is a short period it is referred to as an operating lease and at the end of the lease the property is still useful and is returned to the finance company.
Long term leases are, in substance, ways are ways of funding a purchase rather than buying the temporary services of a piece of equipment. These are often referred to as capital leases.
For capital leases the leased assets and the financing liability are recorded on the leasing company’s books as though the company had bought the equipment outright.
The next level of financing involves banks. If a company has a credit line or revolver with a bank it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by assets of the firm however if a business runs into trouble it may not be able to pay the bank and go into bankruptcy
Bonds have fixed interest rate contractual payments and a principal maturity. The risk comes to the firm’s owners if they cannot be serviced. The principle bond owners can then exchange them for ownership of the company and oust the owners.
The After-Tax cost of Borrowing
Interest payments for borrowing from vendors, bankers or bondholders are tax-deductible, while dividends to shareholders are not. The after-tax cost of borrowing is the interest cost less the tax benefit.
Stock issues have non-contractual, non tax deductible dividend payments. Stock represents an ownership in the business and in all of its assets. If additional shares of stock are issued to raise cash, this is done at the at the expense of the current shareholders’ ownership interest. New shareholders share their ownership interest equally on a per-share basis with the current shareholders – this is why analysts say that the new shareholders dilute the interest of existing shareholders.
In summarising, the higher the percentage of debt to total capital, the higher a company’s value, to a point. At the point where the risk of bankruptcy becomes significant, values fall. The cost of financing decreases as a company adds lower-cost shielded debt to displace the higher returns required by equity investors.