Corporate financing

The financing decision is one of the main decisions facing a financial manager. This page looks at the main options and considerations involved.

Main options

The basic choice for a business wanting to raise new finance is between equity finance and debt finance.

Equity finance

This is finance raised by the issue of shares to investors.

Equity holders (shareholders) receive their returns as dividends, which are paid at the discretion of the directors. This makes the returns potentially quite volatile and uncertain, so shareholders generally demand high rates of return to compensate them for this high risk.

From the business's point of view therefore, equity is the most expensive source of finance, but it is more flexible than debt given that dividends are discretionary (subject to the issues discussed on the page on dividend policy).

Equity finance can be explored in more detail here.

Debt finance

Short term debt finance

In the short term, businesses can raise finance through overdrafts or short term loans.

Overdrafts are very flexible, can be arranged quickly, and can be repaid quickly and informally if the company can afford to do so. However, if the bank chooses to, it can withdraw an overdraft facility at any time, which could leave a company in financial trouble.

A short term loan is a more formal arrangement, which will be governed by an agreement which specifies exactly what amounts should be paid and when, and what the interest rate will be.

Long term debt finance

Long term debt finance tends to be more expensive than short term finance, unless the debt is secured, when the reduction in risk brings down the cost. Long term debt tends to be used as an alternative to equity for funding long term investments. It is cheaper than equity finance, since the lender faces less risk than a shareholder would, and also because the debt interest is tax deductible. However, the interest is an obligation which cannot be avoided, so debt is a less flexible form of finance than equity.

Debt finance can be explored in more detail here.

Another alternative would be to use preference shares.

Practical considerations

Ongoing servicing costs

Debt is usually cheaper than equity due to lower risk faced by the providers of finance and the tax relief possible on interest payments. However, some debt, such as an unsecured overdraft, may be more expensive than equity. A detailed discussion of the topic of cost of capital can be found here.

Issue costs

The costs of raising debt are usually lower than those for issuing new shares (e.g. prospectus costs, stock exchange fees, stamp duty).

Gearing

Debt and preference shares give rise to fixed payments that must be made before ordinary shareholder dividends can be paid. These methods of finance thus increase shareholder risk.

Firms thus have to make a trade-off between the benefits of cheap debt finance on the one hand and the costs associated with high levels of gearing (such as the risk of bankruptcy) on the other. If the correct balance can be achieved, the cost of finance will fall to a minimum point, maximising NPVs and hence the value of the firm.

Theories of gearing are discussed in more detail here.

Availability of sources of finance

Not all firms have the luxury of selecting a capital structure to maximise firm value. More basic concerns, such as persuading the bank to release further funds, or the current shareholders to make a further investment, may override thoughts about capital structure.

Small and medium enterprises (SMEs) in particular face financing problems.

Tax position

The tax benefits of debt only remain available whilst the firm is in a tax paying position.

Flexibility

Some firms operating in high risk industries use mainly equity finance to gain the flexibility not to have to pay dividends should returns fall.

Cash flow profile

Cash flow forecasts are central to financing decisions - e.g.ensuring that two sources of finance do not mature at the same time.

Risk profile

Business failure can have a far greater impact on directors than on a well-diversified investor. It may be argued that directors have a natural tendency to be cautious about borrowing.

Covenants

There may be restrictions imposed on the level of gearing, either by the company's Articles of Association (the internal regulations that govern the way the company must be run), or by previous loan agreements.

Religious and ideological considerations

Some faith systems, such as Islam, see the charging of interest as wrong and hence have developed alternative financing arrangements such as Islamic finance.

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