Finance Chapter: Debt and Equity Financing

Debt-Financing

• Raising funds through borrowing money from lenders, including bonds, with a fixed schedule of payment.

Equity-Financing

• Raising capital by selling company ownership (shares) to investors in exchange for ownership interests in the company.
• Can be done internally (retaining earnings) or externally (selling shares).

Short-Term Funds

• Used to finance immediate but temporary capital needs.
• Gives businesses an extra boost to enhance and expand operations using quick cash.
• Typically needs to be paid off within 6 months to 1 year, sometimes up to 18 months.
• Requirements are generally easier to meet, with smaller loan amounts.
• Some short-term loans don't specify a payment schedule or due date.

Lines of Credit

• Suppliers' Credit: extension of payment due date by suppliers.
• Credit Cards: borrowing funds from a pre-approved limit to pay for purchases, with a limit decided by the institution based on credit score and history.

Advances from Owners

• Personal funds advanced by a stockholder to a company, usually requiring interest.
• Little to no interest is required, especially if the owner is advancing funds to assist the company in a sudden liquidity crisis.
• Dependent on the availability of funds of an individual.

Short-Term Loans

• Involves lower borrowed amounts.
• Relatively easier to obtain.
• May require collateral.
• Can be paid in a lump-sum plus interest.

Sources of Short-Term Loans

• Credit Cooperatives: provide lending services to members, with members paying contributions.
• Banks: offer several loan products catering to different needs.
• Lending Companies: dedicated to lending, with higher interest rates than banks, but more lenient credit requirements.
• Pawnshops: provide funds in exchange for collateral, usually jewelry or items of value.
• Informal Lending Sources: charge excessive interest, often 20% per month, with no formal requirements.

Characteristics of Short-Term Funds

• Cost (Interest): informal lending sources like 5/6 may be the most expensive.
• Availability: informal lending sources like 5/6 are most available.
• Risk: lenders may foreclose some of the company's properties or the entire business if the company defaults.
• Flexibility: influenced by the nature of the company's business, leverage ratio, and stability of operating cash flows.
• Restrictions (Debt Covenants): some lenders may require a minimum deposit balance or approval before cash dividends can be declared.

Long-Term Funds

• Used to finance planned and large-scale business operations.
• Examples: adding a production line, constructing a new branch, funding intense research and development activities.

Equity Shares

• Represents ownership capital of a business.
• Can be raised from public by issuing ordinary or preference shares to investors.

Types of Equity Shares

• Common Shares: represents ownership capital, with owners receiving dividends and return of capital after preference shareholders.
• Preference Shares: carries rights to receive a fixed-rate dividend and return of capital in case of corporate dissolution.
  • Cumulative Preference Shares: receive dividends from previous years if not paid due to insufficient profits.
  • Non-Cumulative Preference Shares: receive dividends only from available profits in that year.
  • Participating Preference Shares: enjoy the right to participate in surplus profits after all shareholders are paid.
  • Non-Participating Preference Shares: carry no right to participate in surplus profits.
  • Convertible Preference Shares: can be converted into common shares after a specified period.
  • Non-Convertible Preference Shares: cannot be converted into common shares.
  • Redeemable Preference Shares: can be redeemed before corporate liquidation.

Retained Earnings

• Not all profits are distributed to stockholders.
• Some businesses retain a part of their undistributed profits to finance further business expansion, fund on-going research and development projects, etc.

Loans from Financial Institutions

• Banks and credit cooperatives provide long-term loans, depending on the nature of the need and credit rating of the borrower.
• Requires collateral roughly equal to the loan amount.

Bonds

• Debt investments where an investor loans money to an entity, which borrows the funds.
• Bond/Debenture holders are creditors of the business.
• Interest is payable even when there are no profits made.
• Can be secured (mortgaged) or unsecured (debentures).

Types of Bonds

• Bearer Bonds: transferable bonds, with holders receiving interest when due.
• Registered Bonds: names, addresses, and other information about holders are recorded in a register maintained by the company.
• Secured or Mortgaged Bonds: bonds secured with company assets.
• Redeemable Bonds: bonds issued for a specified period of time.
• Irredeemable Bonds: bonds only repayable when the company goes into liquidation.
• Convertible Bonds: holders can convert their bonds into common or preference shares at stated rates of exchange, after a certain period.
• Non-Convertible Bonds: bonds which are not convertible to any equity share.

Characteristics of Borrowers

• Character: refers to a borrower's credit history, which is their reputation or track record for repaying debts.
• Capacity: measures the borrower's ability to repay a loan by comparing income against recurring debts and assessing the debt-to-income ratio.
• Collateral: security pledged for payment of the loan.
• Capital: a customer's financial resources.
• Condition: lenders look at the length of time an applicant has been employed at their current job and future job stability.