When companies need money, they have many choices of sources of finance. And, the choice they make about how to get it can tell you a great deal about the company.
It is not an easy choice, as the company must weigh the advantages and disadvantages of each option against its needs and financial situation. Each of the choices can have significant consequences in the future.
As you read and discuss this introduction to the capital markets, think about the strengths and weakness of each alternative. Pay attention because when you are finished you will become an instant expert, a financial advisor, called in to give advice to an indecisive corporation.
Here are the alternatives.
1. Retained Earnings
Retained earnings is the amount of profit (Net Profit after Interest and TAX after dividends are paid out) a company keeps to buy new equipment, buildings, and other resources that the company uses to expand and modernize.
(+) Using the corporation’s Net Profit after Interest and TAX, putting it back into the company can be done quickly and without finance charges because this option is internal. It does not require going outside the business to ask for money.
(+) No debt. This is not a loan.
(+) Does not increase control by others over the firm, since no new stockholders are brought on board as owners.
(-) Not all companies have retained earnings available, especially companies that are experiencing growth and expansion. Also, new companies may not have retained earnings in the first few years of operation. That is why many companies cannot use this option.
2. Debt: Take a Loan
Short-term loans from financial institutions such as a commercial bank, savings and loan, credit union, insurance company. Banks are usually unwilling to lend long-term, and if they do, they will want large collateral.
Long-term borrowings by issuing corporate bonds (debentures). The corporation borrows from the public and issues I Owe You (IOU) through corporate bonds. Owners of these IOUs receive fixed interest payments from the borrowing corporation until the IOU is repaid at a given date in the future.
(+) Because they are not shareholders, bondholders cannot vote and exercise control. The relationship ends when the debt is paid.
(+) Interest on the debt is TAX deductible. This reduces the burden of making the interest payments because it reduces the corporation’s TAX liability.
(-) Increase in the firm’s debt (liabilities). Loans could make the company look bad.
(-) The bond represents a fixed obligation. The money will have to be paid back – both interest payments and principal – at maturity. This obligation could cause a cash-flow problem. Since interest must be paid whether there are profits or not, taking on debt is always a risk.
3. Equity: Selling ownership, shares of stock in the corporation
There are two major types of shares of stock in a public limited company – preferred shares and common shares.
Preferred stockholders receive special treatment because company dividends, usually fixed, are distributed to them before being paid to holders of common stock. The equity alternative involving preferred stock is similar to getting a loan, since preferred stockholders usually cannot vote.
Owners of common stock receive a share of company’s profits – or bear a share of its losses up to the amount invested in the stock. They vote for the Board of Directors (BOD) who appoint the management of the company. The corporation decides, if the stockholders receive a dividend, but they can vote and exercise control.
(+) No debt. Money received from sale of stock does not have to be repaid, since stockholders are owners, too. Not as risky as bonds. Company looks stronger financially.
(+) Firm does not have to pay dividends, so future total Net Profit after Interest and TAX (or retained earnings) can be put back into the company.
(-) Give up some control, since stockholders can vote. They could limit or interfere with the major owner/manager of the firm and the firm’s current direction.
(-) Dividends are paid out of Net Profit after Interest and TAX, and are not TAX deductible like interest.
Once the choices of sources of finance are made
RETAINED EARNINGS: When a corporation uses retained earnings, the decision is made internally and implemented by means of an accounting procedure. No outside approvals are required. For these reasons, use of retained earnings is a preferred way of obtaining financing.
Corporations that decide to sell debt (bonds) or sell ownership in their company (stocks) ‘go’ to the capital markets.
DEBT: Loans from financial institutions require agreements between the corporation and the lending institution regarding the amount of money loaned, the interest to be paid, the length of the loan, and the amount of the payments.
EQUITY: Businesses usually turn to an investment banker who gives them advice on what securities to issue and what steps need to be taken to sell these securities. The investment banking system acts as an intermediary between the demand for and supply of money in the capital market. These markets allow buyers and sellers to find each other, and reduce the costs of trade. These stocks, initial offerings, and bonds are sold in the primary market, and then traded in the secondary markets.
Obviously, these capital markets, essential sources of corporate financing, allow businesses to start up and expand. And, the effect of this is to foster economic growth by creating jobs and income for workers and by providing goods and services for consumers and other businesses.
