Achieving the goals of corporate finance requires appropriate financing of any corporate investment. The sources of financing are, generically, capital that is self-generated by the firm and capital from external funders, obtained by issuing new debt and equity.
Management must attempt to match the long-term or short-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Figure 1
Businesses need long-term financing for acquiring new equipment, R&D, cash flow enhancement and company expansion. Major methods for long-term financing are as follows:
This includes preferred stocks and common stocks and is less risky with respect to cash flow commitments. However, it does result in a dilution of share ownership, control and earnings. The cost of equity is also typically higher than the cost of debt - which is, additionally, a deductible expense - and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
A corporate bond is a bond issued by a corporation to raise money effectively so as to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity.
Capital notes are a form of convertible security exercisable into shares. They are equity vehicles. Capital notes are similar to warrants, except that they often do not have an expiration date or an exercise price (hence, the entire consideration the company expects to receive, for its future issue of shares, is paid when the capital note is issued). Many times, capital notes are issued in connection with a debt-for-equity swap restructuring: instead of issuing the shares (that replace debt) in the present, the company gives creditors convertible securities – capital notes – so the dilution will occur later.
Short-term financing can be used over a period of up to a year to help corporations increase inventory orders, payrolls and daily supplies. Short-term financing includes the following financial instruments:
This is an unsecured promissory note with a fixed maturity of 1 to 364 days in the global money market. It is issued by large corporations to get financing to meet short-term debt obligations. It is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price.
Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. ABCP is typically a short-term instrument that matures between 1 and 180 days from issuance and is typically issued by a bank or other financial institution.
This is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms.
This type of loan, often short term, is secured by a company's assets. Real estate, accounts receivable (A/R), inventory and equipment are typical assets used to back the loan. The loan may be backed by a single category of assets or a combination of assets (for instance, a combination of A/R and equipment).
These are short-term loans (normally for less than two weeks and frequently for just one day) arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
Letter of Credit
This is a document that a financial institution or similar party issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a third-party buyer. The issuer then seeks reimbursement from the buyer or from the buyer's bank. The document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter of credit, regardless of whether the buyer ultimately fails to pay.