Chapter 14

Financing

Financing
Learning Objectives:
Identify the common methods of debt financing for firms. Identify the common methods of equity financing for firms. Explain how firms issue securities to obtain funds. Describe how firms determine their composition of financing.
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Financing
Two major types of financing: Debt financing
Act of borrowing funds.

Equity financing
Act of receiving investment from owners (by issuing stock or retaining earnings).

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Methods of Debt Financing

Firms can engage in debt financing by: Borrowing from financial institutions Revising capital structure Issuing bonds Issuing commercial papers

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Methods of Debt Financing

Borrowing from financial institutions: Commercial banks Savings institutions Finance companies

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Methods of Debt Financing

Revising the capital structure: Increase debt during periods of low interest rates Decrease debt during periods of high interest rates

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Interest Rates Charged on Loans under Three Different Scenarios

I2 (Floating rate while interest rates are rising) I1 (Fixed rate) I3 (Floating rate while interest rates are declining)

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Interest Rate

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Methods of Debt Financing

Bonds: long-term debt securities (IOUs) purchased by investors. Bond terms: Par value
Amount that the bondholders receive at maturity.

Indenture
Legal document explaining obligations to bondholders
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Methods of Debt Financing

Bond terms (cont.): Secured bonds
Bonds backed by collateral.

Unsecured bonds
Bonds not backed by collateral.

Call feature
Provides right for issuing firm to repurchase bonds before maturity.
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Methods of Debt Financing

Issuing commercial paper: Commercial paper: short-term debt security normally issued by firms in good financial condition.

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Methods of Equity Financing

Firms can engage in equity financing by: Retaining earnings Issuing stock

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Methods of Equity Financing: Stocks

Types of stock: Common stock
Represents partial ownership of a firm Holders allowed to vote

Preferred stock
Offers priorities over common stockholders Stockholders get dividends first No voting rights
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Methods of Equity Financing: Stocks

Initial public offering (IPO): privately held business issues stock to the public. Why IPOs are done: Small business wants to expand Obtain additional funds

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Methods of Equity Financing: Stocks

Advantages of IPOs: Gain access to more funds Can use funds to reduce debt Disadvantages of IPOs: Must disclose financial information Difficulty in encouraging stock purchase Ownership structure is diluted Investment banks charge high fees
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How Firms Issue Securities

Process: Origination
Investment bank advises firm on amount of stock and bonds to issue.

Underwriting
Investment bank guarantees a price to the issuing firm.

Distribution
Prospectus is distributed to investors.
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How Firms Issue Securities

Other methods of financing: Financing from suppliers
Firm buys supplies from suppliers and pays at a later date.

Leasing
Renting the assets for a specified period of time.

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Deciding the Capital Structure

Capital structure: the composition of debt versus equity financing.
High debt vs. high equity: High debt financing Achieves higher return on equity Increases risk of interest payments High equity financing No interest expenses incurred
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Dividend Policy
Dividend policy: a companys decision regarding how much of the firms earnings should be retained versus distributed as dividends to owners. What affects policy: Shareholder expectations Firms financing needs

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