Long-Term Sources of Finance - Essay Example

Long-Term Sources of Finance Contents Contents 2 Introduction 3 Long-term Finances 3 Sources of Long-term Finance 4 Conclusion 11 References 13 Bibliography 13 Introduction This essay is a detailed analysis of a variety of long-term sources of finance along with their advantages and disadvantages. It also includes the suitability of each source of financing to different firms based on the kind of business stage the firm is in. The long-term finances for a firm are mainly of two types- Equity and Debt. Mainly four sources of long-term finances are discussed i.e. preference equity, common equity, debt and leasing. Long-term Finances A business needs funds for capital investments such as fixed assets like plant, machinery, land, building, furniture etc. These assets must be financed with long-term financing sources. The chief financial officer (CFO) is usually responsible for making suggestions to the senior management and board of directors related to financing issues. These suggestions and recommendations carefully analyze the advantages and disadvantages of each long-term financing option. After the decision is made by the senior management and the board, the CFO is responsible for obtaining the long-term finances. The common forms of long-term finances are preferred stock, common stock, long-term debt and leasing. A firm faces need of different types of finances through its various stages of development. A firm in its start-up generally avail funds from the banks for personal loans, government agencies and personal savings. During the rapid growth phase a firm uses internally generated funds or direct financing. The direct financing includes loans from insurance company, commercial banks or pension funds and financing by venture capitalists. The maturity phase is financed by issuing equity or debt in primary markets. The firm in its final stage finances from internal sources while making debt repayments or buying back the common stock (Weaver & Weston, 2004, p.311-312). Figure 1: Financing Sources Source: (Weaver & Weston, 2004, p.312) Sources of Long-term Finance Sources of long-term finance differ with the type and size of the firm. There are mainly two categories of financing-Equity and Debt. The equity financing consists of two types of equity instruments, one is preference stock and the second is common stock. The debt financing can take two forms, first long-term debt from financial institutions and second in the form of leasing. Each financing option is discussed as follows: Preferred Stock Preference capital is a distinctive type of long-term financing which combines the features of both debt and equity. As a hybrid security it has a fixed rate of dividend and ranks higher than the common equity in terms of claims over the firm’s earnings. The preference shareholders do not have voting rights as the common shareholders have. Advantages: The preference dividends can be omitted in case of low or zero earnings. This provides the firm greater flexibility and chance of surviving a downturn. However skipping a dividend may reflect dim view of the firm in investors’ community and may affect the share price as investors lose confidence and sell. Preference share capital is an additional source of capital which does not provide voting rights to the preference shareholders and therefore do not dilute the influence of ordinary shareholders. Fixed and limited preference dividends mean that the firms can retain or distribute common dividends in case of extra-ordinary earnings in a fiscal year. In case of limits on raising debts under the debt covenants, the preference share capital is a good alternative if a firm wants to expand raising external finance. Disadvantages: The high risk associated with capital and annual returns leads the preference shareholders to demand higher return than debt holders. The preference dividends are regarded as distribution of profits. Therefore they are not tax deductible. In comparison to this the lenders are not owners and so their interests are regarded as the expense which reduces the taxable income of the firm (Arnold & Kumar, 2008, p.402-403). Common Stock The commons shareholders or ordinary shareholder of a firm have the right to exercise control over firm. They can vote in shareholders’ meeting and take crucial decisions of the firm such as senior management and compensation. A company which is in high growth phase and has good earnings track record successfully raise equity in the primary market by issuing the common equity shares. The earnings quality of the firm determines its ability to raise capital in equity market. The common equity capital has the following advantages and disadvantages. Advantages: There is no obligation over firms to pay dividends to the shareholders. Therefore even if the firm has not made earnings in any year or faced losses, the company does not face problems with dividend payments. Equity acts as a shock absorber for the firm. The firm does not need to pay back the equity capital. The ordinary shares do not have a redemption date. Major retailers such as Burton (now Arcadia) expanded rapidly in 1980s. But in late 1980s and early 1990s the company was hit badly by recession and had to pay a huge amount borrowed back to the lenders in a short span of time. This put a considerable strain on the company’s ability to generate positive cash flows and its survival was doubtful. If the company had chose to use equity instead of huge amounts of debt as capital it would not have faced such liquidity and solvency problems (Arnold & Kumar, 2008, p.400). This puts a greater emphasis on the ability of firms to maintain an optimal capital structure. Disadvantages: The cost of raising equity is higher than raising equal amounts of debt. The company which wants to raise equity capital has to do so through Initial Public Offer (IPO) and additional equity capital can be raise subsequently through Follow-on Public Offer (FPO). The costs in raising equity through this channel involves the costs of security registration, investment banker’s fees etc. The entrepreneur sometimes faces with the situation of choosing between slow or no growth without additional equity and dilution of control. The external owners of the firm may impose certain conditions such as veto rights and rights in appointment of directors and managers which reduces the entrepreneurs’ control of the firm. The dividends are not tax deductible expenses like the interest expense to the lenders. Long-term Debt Many medium and large corporations use long-term debt to finance their fixed assets. The debt may be a secured bond or unsecured debenture. The firms such as utilities rely heavily on the use of debt. Contrary to this the manufacturing firms rely on debt to varying degrees and usually go for unsecured debt than secured debt. The purpose of raising debt is usually to fund the capital expenditure. During the normal course of business when the firm is profitable, it tries to gradually retire its long-term debt as it matures. The retained earnings which form a part of equity increases over time and thus the debt-equity ratio of the firm decreases. In order to maintain a stable capital structure the firm has to raise long-term debt intermittently. The tax deductibility of interest and refunding of debt has led to 85-90% of external financing by debt in US (Moyer, McGuigan & Kretlow, 2008, p.235). Following are the major advantages and disadvantages. Advantages: The tax deductibility of interest is the major advantage to firms issuing long-term debt. When the firm issues long-term debt the existing owners i.e. shareholders of the firm do not lose their control over the firm because the bondholders do not have voting rights which is not the case with issuing additional equity shares. The increase in earnings per share is possible through the financial leverage. When a firm earns more form the raised funds through debt than the interest it pays to the bondholders the surplus increases the earnings of the firm. This is known as financial leverage. Disadvantages: When a firm’s operations are subject to volatile economy, a high level of debt increases the firm’s risk. This may lead to weak cash flows leading to firm’s inability to repay its debt at maturity and make periodic interest payments. This may lead to solvency issues for the firm. Such risks have been faced by airlines industry in the past due to heavy usage of debt. The Continental Airlines and United Airlines could not make payments on their various liabilities and long-term debt. Therefore they filed for bankruptcy protection. Later on, after restructuring their debt and making interest payments, both the firms managed to come out of bankruptcy situation (Needles, Powers & Crosson, 2010, p.564-565). The advantages from financial leverage can become disadvantage for the firm if it is unable to produce earnings from investments more than its interest payments. For example, recently many small internet companies have failed due to heavy reliance on debt financing before developing ample resources to ensure positive earnings (Needles, Powers & Crosson, 2010, p.565). Leasing Leasing is a different form of financing which gives a firm access to fixed assets such as building, aircraft, automobile etc without acquiring these assets. The lessee firm pays a fixed periodic fee to the lessor firm for usage of the asset. The payment covers the lessor firm’s costs of asset ownership, tax expenses and financing. It also provides the lessor firm with an economic return on the asset. Leasing is essentially of two types- operating lease and financing lease. In an operating lease the lessee firm uses the asset for a specified period which is less than the physical life of the asset and does not assume the risks of ownership and obsolescence. The finance lease, also known as capital lease is typically a source of long-term financing because the ownership of the asset is transferred to the lessee firm at the end of lease, directly or through nominal purchase option (Helfert, 2001, p.347). Advantages: When the firm has shortage of funds for capital investment, leasing rather than purchasing the asset is a viable option to the firm. This conserves working capital. Leasing an asset is less complex than acquiring it. The documentation in leasing is not as cumbersome as in external financing. The lease contract is negotiated between the lessee and lessor so it may not contain strict provisions as other forms of borrowing do. The risk of obsolescence is reduced. Under some of the leases, the debt and assets are not shown in the balance sheet of the lessee firm. Therefore there is not interest and depreciation expense in the income statement. Such lease is called synthetic lease (Robinson et al, 2008, pp.2-4). Disadvantages: The costs of owning the asset and leasing it depend on a number of factors. But for a firm with strong earnings and easy access to credit markets the leasing becomes a costly option. Moreover, the lessee firm loses the salvage value of the asset which for some assets is quite significant such as real estate. The lessor may be reluctant in allowing the lessee to alter the structure of asset due to substantial alterations. If a leased asset becomes obsolete or the project becomes uneconomical, the lessee firm may not cancel the lease without paying penalty. The four major forms of financing with their respective costs and suitability to the types of firms are given in figure 2. The leasing which is not provided in the figure is suitable for low to medium growth firm and not for established corporations as it restricts the flexibility of a large corporation in asset usage. Figure 2: Long-term Financing Option Source: (Pride, Hughes & Kapoor, 2011, p.589) Conclusion The four major types of sources of long-term financing have been discussed in this essay. The preference equity capital is a good option for firms that do not want to dilute the ownership and control of the firm and also has debt raising limits. The equity capital is the most common form of capital for an established firm. The long-term debt provides the benefit of financial leverage as long as the firm is generating higher rate or return than the interest it is paying on debt. Leasing, especially the finance lease, is a unique way of financing for the fixed capital requirements which cannot afford to buy the asset from internal funds as well as external financing. References Arnold, G & Kumar, M. (2008). Corporate Financial Management, 3/E. Pearson Education India. Helfert, E.A. (2001). Financial analysis: tools and techniques: a guide for managers. McGraw-Hill Professional. Moyer, R.C. McGuigan, J.R. & Kretlow, W.J. (2008). Contemporary Financial Management. Cengage Learning. Needles, B.E. Powers, M. & Crosson, S.V. (2010). Principles of Accounting 11th ed. Cengage Learning. Pride, W.M. Hughes, R.J. & Kapoor, J.R. (2011). Business 11th ed. Cengage Learning. Robinson, T.R. et al. (2008). International Financial Statement Analysis. John Wiley & Sons. Weaver, S.C. & Weston, J.F. (2004). Finance & Accounting for Non-Financial Managers. McGraw-Hill Professional. Bibliography Jones, M. (2007). Accounting For Non-Specialists. Wiley-India. Khan, M.Y. (2004). Financial Management: Text, Problems And Cases 2nd ed. Tata McGraw-Hill Education. Schmidgall, R.S. (2003). Superintendents Handbook of Financial Management 2nd ed. John Wiley and Sons. Read More