Financing as a Tool for the Development of Business Activities - Term Paper Example

Much of the semi-permanent finance of companies – in a minority of cases all of it – is provided by shareholders. Many companies have different es of shares. Most of companies also borrow money on a long-term basis.” – Equity and Debt as sources of long term financing 1. Introduction The increase of operational costs of businesses worldwide has led to the relevant increase of needs for financing. A series of financing schemes are available to firms that need to locate funds for supporting their activities. However, when having to decide on the mode of financing used for supporting the business operations, a series of criteria need to be taken into consideration: a) whether the chosen method of financing will be able to respond to the firm’s needs, b) whether the terms under which this financing scheme is offered are aligned with the firm’s (borrower) interests and c) whether the conditions in the external environment – referring especially to the economy of the country where each firm is based – are supportive for such initiative. If severe market turbulences characterize a market, then the decision on financing should be delayed. Current paper focuses on the examination of the characteristics and the role of long – term financing as a tool for the development of business activities. Emphasis is given on two specific types of long term financing: equity and debt. The examination of the relevant literature leads to the assumption that, in most cases, long-term financing is preferred by managers as it offers the following advantages: a) longer time of repayment and b) lower amount of each installment. However, in order for such mode of financing to be chosen it is necessary the borrower will be capable of meeting the relevant terms – otherwise a short-term financing scheme should be preferred (Pride et al., 2009, p.563). The benefits of long – term financing has helped to its expansion in markets worldwide. The reasons for which managers prefer two particular types of long term financing (the equity and the debt) are analyzed below. 2. Long term financing – description and characteristics The type of financing preferred by a firm needs to meet specific criteria: a) the mode of financing chosen need to be appropriate for the company in terms of its liquidity/ cash availability, meaning that the firm’s managers need to be sure that the repayment of the debt will be feasible even in case of unexpected market turbulences, b) the performance and the consequences of the type of financing chosen need to be carefully examined in advance. This means that before taking the final decision on the type of financing in which a firm will be engaged it needs to be examined carefully whether the specific mode of financing has perform positively for other firms – emphasis should be given on the performance of this mode of financing for firms with similar characteristics. It is possible that a mode of financing is preferred within a particular market but still it may be inappropriate for a particular firm because of its size or because of its performance (referring especially to the instability in regard to its level of profits), c) the framework in which the particular method of financing is offered should be also taken into consideration. For instance, it is possible that a specific mode of financing is offered with more attractive terms from a particular financial institution. Intensive research should be developed across the market in order to identify the financial institution that offers the most attractive schemes of financing – attractiveness is related here to the years of repayment, the level of its installment, the provision of insurance and so on (McLaney, 2009, p.4). The above issues refer to all modes of financing – including the long-term financing, which is under examination in this paper. In order to identify the role of long – term financing in business development it would be necessary to explain the context of the type of financing – as developed within modern firms. The research on the existing literature – as presented below – leads to the assumption that firms are likely to choose their modes of financing using different criteria. Of course, there are certain terms, which are likely to be used in all firms when having to choose their mode of financing. These terms have been described above. In any case, the engagement of a firm in a long-term financing scheme usually reflects ‘the need for financing long-lived assets such as land, or equipment or construction projects’ (Shim et al., 2008, p.275). Another issue highlighted by the above researcher is the fact that modern firms prefer certain types of long term financing – reference is made to equity and debt (Shim et al., 2008, p. 275). In certain terms, the decision on a long term financing project may not be fully justified; this is the case of those firms which decide to proceed to a long term financing scheme in order to fund their projects without actually considering which the risks may be. For instance, Exxon was engaged in a long-term financing scheme of $10 million in order ‘to drill an oil well without knowing for sure whether oil would be found for sure’ (Pride et al., 2009, p.565). In the same context, Pfizer developed a research and development project the cost of which was estimated to $ 8 billion – without the actual benefits of this project to be clear (Pride et al., 2009, p.565). On the other hand, long-term financing can be quite valuable for the development of a business – helping to the realization of its projects and to the increase of its competitors towards its rivals. Indeed, the long – term financing schemes are preferred by firms that have to develop crucial business plans – they are usually plans that are expected to last for a long period of time; the modes of long-term financing most used by modern firms are the following three: ‘a) long term loans, b) bonds and c) equity financing’ (Boone et al., 2010, ch. 18). In the following sections two particular modes of long term financing will be examined: a) equity financing and b) debt. 2.1 Equity as a source of long term financing The importance of equity financing can be understood by referring to the equity capital – on which this mode of financing is based. In accordance with Bossert (2008) one of the key characteristics of equity capital is that it provides to its owner increased security in regard to the amount invested. This fact is explained as follows: through the equity capital the owner (shareholder) is given certain rights on the company involved – usually the right to vote. In this way, the owner of the equity capital can control – even partially – the strategic business decisions. On the other hand, the equity capital is the capital on which the firm is mainly based; this means decreased risks for losses. For this reason, the equity capital is less risky for owners/ investors as it can guarantee limited risks for their funds – which have been incorporated in the equity capital. Equity financing can have different forms. In accordance with Pride et al. (2009, p.58) retained earnings can be considered as a form of equity financing. Retained earnings are the earnings related to the shares of shareholders – as estimated annually or in a different time period in accordance with the organizational profits – which are not distributed to shareholders but they are held by the firm in order to be re-invested on the organization. For this reason, retained earnings can be considered as a form of equity financing. However, the most common form of equity financing remains the selling of stock; an organization can sell stock – in form of shares – to the public in order to gather the money required for the firm’s financial obligations – including the development of various organizational projects (Pride et al., 2009, p.573). The particular method of equity financing does not involve in risks for the organizations neither it has specific requirements; the only requirement that needs to be met is that the selling of stock has to follow the formal requirements – process – which the law defines (Pride et al., 2009, p.573). 2.2 Debt in long term financing The engagement of a firm in a debt financing scheme has to be based on the following criterion: the level of each firm’s debt towards its equity needs to be kept low; the specific issue is highlighted in the study of Needles et al. (2007) where it is noted that ‘in most firms, the long term debt it is less than 1.0 times the firms’ equity’ (Needles et al., 2007, p.521); the increase of a firm’s long term debt above this limit has to be decided only in the context of emergent needs and since there is no other method of financing available – even in this case, the long term equity ‘cannot be increased more than 1.1 to 2.4 times over the firm’s equity’ (Needles et al., 2007, p.521). In accordance with Needles et al. (2007) an indicative example of excessive use of debt financing can be identified in the case of McDonald’s; the above firm has used the specific type of financing for its 15,000 stores worldwide (Needles et al., 2007, p.521). The most common form of debt financing is the mortgage. The specific type of debt financing offers an increased security to the lender – since the funds have been invested on assets, which can be sold in order to guarantee the repayment of the loan (Renneboog, 2006, p.371). 2.3 Comparison of equity and debt as long term sources of financing – advantages and disadvantages As explained above, the choice of a financing scheme by firms is based on certain criteria. Regarding specifically the equity financing and the debt financing the following issue has to be noted: not all firms meet the requirements for both the above methods of long-term financing. Moreover, these two methods of financing are not expected to benefit equally all firms, which are engaged in such projects. For instance, firms, which are heavily based on intangible assets, instead of tangible assets, should prefer the equity financing instead of debt financing (Stickney et al., 2009, p.124). Furthermore, firms, which are interested, in order to finance a long-term construction project or buy land would rather prefer the debt financing – setting a mortgage on the building/ land in which the particular financing scheme is involved. Equity financing has the following advantages compared to the debt financing: a) the lender already has interests on the firm – being a shareholder; this means that he is not expected to press the firm for the repayment of the fund borrowed – actually, the funds borrowed are part of the firm’s equity capital and they are too difficult to be lost, b) there is no dependency from a financial institution – to approve the funding; the firm addresses the public and can gather the money without waiting for the approval of the financial institution. On the other hand, equity financing is not appropriate for all firms – in the context described above. Because of their different characteristics the above two forms of long term financing are related to specific organizational needs (Melicher et al., 2010, p.458): debt financing for investments on land/ property projects and equity financing for the completion of other business projects, such as mergers/ acquisitions, entrance in a foreign market and so on. 3. Conclusion The development of a long – term financing project has many different aspects. In practice, firms extensively use long term financing since it offers certain advantages compared to the debt financing – as explained above. On the other hand, there are certain cases in which equity financing should not be chosen – for instance in firms which are based on intangible assets or when the project in which the financing involves is related to the development of property projects. Moreover, there are certain cases, where no long – term financing scheme can be used. Two of these cases are the following ones: a) when the market instability is extremely high and b) when there are no long – term savings – or when the existing long – terms savings are not adequate in order to support a long term financing scheme (Glen et al., 1994, p.38). As noted by Melicher et al. (2010, p.458) the managers of each firm will decide on the financing scheme appropriate for their organization in accordance with the characteristics of the project involved, the firm’s financial status, the market’s conditions and the terms under which each financing scheme is provided. References Boone, L., Kurtz, D. (2010). Contemporary Business. John Wiley and Sons Bossert, T. (2008). Methods of Equity Financing. GRIN Verlag Glen, J., Pinto, B. (1994) Debt or equity?: how firms in developing countries choose. World Bank Publications McLaney, E. (2009). Business finance: theory and practice. Pearson Education, 2009 Melicher, R., Norton, E. (2010). Introduction to Finance: Markets, Investments, and Financial Management. John Wiley and Sons Needles, B., Powers, M., Crosson, S. (2007) Financial and Managerial Accounting. Cengage Learning Pride, W., Hughes, R., Kapoor, J. (2009). Business. Cengage Learning Renneboog, L. (2006). Advances in corporate finance and asset pricing. Emerald Group Publishing, 2006 Shim, J., Siegel, J. (2008). Financial Management. Barrons Educational Series Stickney, C., Weil, R., Schipper, K. (2009). Financial Accounting: An Introduction to Concepts, Methods and Uses. Cengage Learning Read More