Part II. Sources of Long-Term Funds

Just as firms need short-term funding to cover their short-term expenditures, so they need long-term funding to finance their long-term expenditures on fixed assets. Firms need funds for the buildings and equipment necessary for conducting their business. Companies may seek long-term funds from outside the firm (debt financing), or they may draw on internal financial sources (equity financing).

Debt Financing

Long-term borrowing from outside the company - debt financing - is a major component of most firms' long-term financial planning. The two primary sources of such funding are long-term loans and the sale of corporate bonds.

Long-Term Loans.

In many respects, a long-term loan is very much like a short-term loan. The major difference is that a long-term loan extends for three to ten years, while short-term loans generally must be paid off in a few years or less. Most corporations get their long-term loans from a commercial bank, usually one with which the firm has developed a long-standing relationship. But credit companies, insurance companies, and pension funds also grant long-term business loans.

Long-term loans are attractive to the borrowing companies for several reasons. First, because the number of parties involved is limited, long-term loans can often be arranged very quickly. Second, the firm need not make a public disclosure of its business plans or the purpose for which it is acquiring the loan. Third, the duration of a long-term loan can easily be matched to the borrower's needs. Finally, if the firm's needs change, long-term loans usually contain clauses making it possible to change the loan's terms.

Long-term loans also have some disadvantages. Borrowers of large sums may have trouble finding lenders to supply the needed funds. Long-term borrowers also may have restrictions placed on them as conditions of the loan. They may have to pledge long-term assets as collateral. And they may have to agree not to take on any more debt until the borrowed funds are repaid.

The interest rate on long-term loans is negotiated between the borrower and the lender. Loans from banks usually have a floating rate that is tied to the prime rate. The prime rate is the interest rate the bank charges its most creditworthy customers. A company that obtains a loan at «one percent above prime» pays an interest rate that is one percentage point higher than the prime rate. This rate may fluctuate because the prime rate itself goes up and down as market conditions change.

Corporate Bonds.

Like commercial paper, a corporate bond is a contract - a promise by the issuing company or organization to pay the holder a certain amount of money on a specified date. Unlike commercial paper, however, bond issuers do not pay off quickly. In many cases, bonds may not be redeemed for 30 years from the time of issue. In addition, unlike commercial paper, most bonds pay the bondholder a stipulated sum of interest semiannually or annually. If the company fails to make a bond payment, it is said to be in default.

The terms of a bond, including the amount to be paid, the interest rate, and the maturity date (when the principal is to be paid off), differ from company to company and from issue to issue. They are spelled out in the bond contract, or bond indenture. The indenture also identifies which of the firm's assets, if any, are pledged as collateral for the bonds.

In addition to planning the types of bonds to sell, financial managers must plan for the retirement of these bonds - that is, how the borrowed funds will be repaid.

Corporate bonds are the major source of long-term debt financing for most corporations. These bonds are attractive when companies need large amounts of funds for long periods of time. The issuing company gets access to large numbers of lenders through nationwide bond markets and stock exchanges.

But bonds involve expensive administrative and selling costs. They also may require very high interest payments if the issuing company has a poor credit rating.

Equity Financing

Although debt financing has strong appeal in some cases, turning inside the company for long-term funding preferable under other circumstances. In small companies, the founders may increase their personal investment in the firm. In most cases, however, equity financing takes the form of issuing common stock or of retaining the firm's earnings. As you will see, both options involve putting the owners' capital to work.

Public Sales of Stock

The sale of stock, both preferred and common, to the general investor public represents a major source of equity funds for corporations. Such sales provide cash inflows for the firm and a share in ownership for the stock purchasers. Stocks are shares of ownership in the corporation, and stockholders are considered the real owners of the firm. However, they are not guaranteed dividend payments. Stockholders receive dividends only after a firm's bondholders are paid; and even then, dividend payments must be decided by the firms' board of directors. Since the stock of many corporations is traded on organized security exchanges, stockholders can easily sell their shares.

Common stock.

People who purchase common stock seek profit in the forms of both dividends and appreciation. Overall, shareholders hope for an increase in the market value of their stock because the firm has profited and grown. By selling shares of stock, the company gets the funds it needs for buying land, buildings, and equipment.

It should be noted that the use of equity financing via common stock can be expensive because paying dividends is more expensive than paying bond interest. Why? Because interest paid to bondholders is a business expense and, hence, a tax deduction for the firm. Stock dividends are not tax-deductible.

Retained Earnings.

Another approach to equity financing is the use of retained earnings. Retained earnings are profits not paid out in dividends. The use of retained earnings means that the firm will not have to borrow money and pay interest on loans or bonds.

A firm that has a history of eventually reaping much higher profits by successfully reinvesting retained earnings may be very attractive to some investors. However, more retained earnings means smaller dividends paid to shareholders, which may decrease the demand for - and thus the price of - the company's stock.

Financial Burden on the Firm.

If equity funding can be so expensive, why don't firms rely entirely on debt financing? Because long-term loans and bonds carry fixed interest rates and represent a fixed promise to pay, regardless of changes in economic conditions. If the firm defaults on its obligations, it may lose its assets and even go into bankruptcy.

When borrowers increase their indebtedness to make other investments, they are said to be more highly leveraged, and they have a higher risk of default.

Because of the risk of default, debt financing appeals most strongly to companies in industries that have predictable profits and cash flow patterns. The additional source of equity financing is venture capital. Venture capital refers to funds invested by outside investors in new, small, or struggling businesses with potential for rapid growth in exchange for an ownership share in the business.

Hybrid Financing: Preferred Stock

A middle ground between debt financing and equity financing is the use of preferred stock. Preferred stock is a hybrid because it has some of the features of corporate bonds and some of the features of common stocks. As with bonds, payments on preferred stock are for fixed amounts - for example, $ 6 per share per year. Unlike bonds, however, preferred stock never matures but can be held indefinitely, like common stock. In addition, preferred stocks have first rights (over common stock) to dividends.

A major advantage of preferred stock to the issuing corporation is its flexibility. Because preferred stockholders have no voting rights, preferred stock secures funds for the firm without relinquishing control. Furthermore, preferred stock does not require repayment of principal or the payment of dividends in lean times.