Like small businesses, large companies must also manage their short-term financing, typically for continuing their operations, increasing their inventories, and covering their payrolls.

Many of the short-term financing strategies available to small businesses discussed, such as lines of credit and collateralized loans, are available to big businesses to finance short-term needs. In addition, other options are available to larger, more established companies, including the option to sell commercial paper. Commercial paper is unsecured, short-term debt that matures in 270 days (nine months) or less. Commercial paper does not need to be registered with the Securities and Exchange Commission. Because of government regulations, the proceeds generated from selling commercial paper can be used only to purchase current assets, such as inventory, and cannot be used on fixed assets, such as equipment, buildings, or real estate. Because the debt is unsecured, only companies with excellent credit reputations are able to sell commercial paper. Buyers of commercial paper are those who want to invest their cash for short periods of time.

Why do large companies need long-term financing solutions? Remember that to grow, companies need expansion projects, such as establishing new offices or manufacturing facilities, developing a new product or service, or buying another company. These projects generally cost millions of dollars and may take years to complete. Long-term financing is therefore needed because it provides funds for a period greater than one year. For example, Joseph Cortez needs a significant amount of financial resources over the next few years to meet the increase in the demand for his company’s solar-powered cars. These resources include financing real-estate and equipment purchases for a new production plant. Large capital projects such as these require a significant amount of long-term planning to ensure that the financing and other business components are ready when needed. In most cases, a company will use several sources of long-term financing, even for one project.

What are the different types of long-term financing? For large capital-intensive projects or general expansion, business owners can use securities—investment instruments such as bonds (debt) or stock (equity). Debt financing occurs when a company borrows money that it is legally obligated to repay, with interest, by a specified time. Contrary to debt financing, equity financing occurs when funds are generated by the owners of a company rather than being borrowed from outside lenders. These funds might come from an owner’s personal investments or from a partial sale of ownership in a company in the form of stock.

How do companies choose between debt and equity financing? Most companies use debt (loans or bonds) to finance large projects, such as the purchase of real estate, equipment, or building construction. Equity is often used to provide funds for ongoing expansion and growth. Debt and equity financing are very different forms of financing and can be complementary financing options. It is not unusual for a company to use both types of financing, aiming to achieve an optimal balance between both. Table 15.1 summarizes the factors that come into play when a firm is deciding to finance with debt or equity. In the next few pages, we’ll look into each type of financing in more detail.

Table 15.1

Debt or Equity Financing: What Does Each Mean for the Company?

Why finance with bonds? In our personal lives, when we want to buy something such as a house or car, that costs more than what we have saved, our best option is to borrow money. We take out a loan (such as a home mortgage or auto loan) specifically to pay for the item, and that item is used as collateral in case we cannot repay the loan. Similarly, when a company has a project or desired asset that it cannot finance with existing company assets, it can take out a business loan. Common lenders include banks, finance companies, credit card companies, and private corporations.

Eventually, a company’s financing needs may grow beyond what these common lenders can provide. In these situations, companies may use bonds to acquire the needed funds. Bonds are debt instruments issued by companies or governments with the purpose of raising capital to finance a large project. Simply put, bonds are like loans, but the lenders are investors, not banks. A bond consists of the principal (the amount borrowed) and interest (the fee charged by the lender for using the borrowed money). Investors loan money to a company by purchasing bonds and, in return, generally receive interest on the bonds they purchase. Although some bonds do not pay interest, all bonds require repayment of the principal.

What are the advantages of financing with bonds? Financing with bonds allows a company to use money from investors to create or obtain business assets. Using debt increases a company’s leverage. Leverage is the practice of borrowing to finance an investment with the expectation that the profits from the investment will be far greater than the interest you will have to pay on the loan. For example, most home owners use leverage to buy a house. Suppose you want to buy a $400,000 home but saved only $200,000. You could wait to accumulate enough cash to purchase the home, or you could use some of your money and borrow the rest with a mortgage. Although there is a cost to borrowing (interest), as long as that cost is less than what you can earn by investing, borrowing (leverage) makes sense. So, assume you put down $100,000 of your own money and borrow $300,000 with a 5 percent mortgage. You now have a $400,000 asset by using only $100,000 of your money. You can then invest the other $100,000 in the stock market, which historically has earned 8 to 10 percent. Had you used all your $200,000 to buy the house, you would have had less interest expense but would not have been able to invest in anything else. Therefore, by using leverage wisely, your investments will offset your financing costs, with hopefully a little more left over! Businesses use leverage in the same way.

Because it can be risky to take on too much debt, lenders consider how much debt a company has relative to the amount of equity (or assets) a company owns before they borrow. A common leverage ratio is for a company to have at least twice the amount of equity as it has debt. A company that borrows considerably more money than it has in assets is considered to be highly leveraged.

Another advantage to financing with bonds is that the ownership of a company is not diluted. For many business owners, giving up or diluting ownership or control of a business by issuing stock (which will be discussed next) is not a feasible or a desirable option. Unlike shareholders, bondholders have no voice or control in how a business is managed. Their only requirement is that the loans be paid back on time and with interest.

What must financial managers consider before choosing to finance with bonds? Financial managers must consider several factors before choosing to finance with bonds. First and foremost, the cost of the loan—the interest rate the lender will demand—is an important consideration. If the interest rate is too high, it can force the cost of the project to rise to the point where it is not affordable or does not make economic sense. If this happens, the company will have to consider a different type of financing or postpone the project until the interest rate is more attractive. Before making a final decision to issue bonds, a financial manager must also consider how the additional debt will affect the overall financial health of a company. From a balance sheet perspective, too much debt may impair a company’s credit rating, thus making it difficult to obtain further financing. The firm’s statement of cash flows will help determine whether there will be enough cash to make the debt payments and keep the business operating. As you have learned, too little cash flow can quickly send a company into a disastrous financial tailspin.

How are bond interest rates determined? Bond interest rates are determined by a combination of several factors, including issuer risk and the length of the bond term. Issuer risk is a measure of a company’s ability to pay back the loan. Credit rating agencies, such as Standard & Poor’s and Moody’s, assess the creditworthiness of a company. As the risk increases, so does the interest rate. As you’ll learn in Chapter 16, firms that issue bonds often buy bond insurance to help lower the risk of the bonds and therefore the interest rates they have to pay on them. The amount of money saved by having a lower interest rate is greater than the cost of bond insurance. In addition to issuer risk, the length of the bond term (known also as the maturity) affects the rate. Longer-term bonds have a greater chance of the issuer not being able to pay the principal or interest when it is due. Therefore, bonds that have terms of 20 or 30 years carry additional risk and have higher interest rates than bonds with terms of 5 or 10 years.

How do companies pay back their bond debt? As noted already, bond investors receive two types of payments: principal and interest. Most bondholders periodically receive interest payments in amounts and at the times specified in their bond agreements. Most interest payments are made semiannually. The interest is calculated on the amount of principal outstanding and the periodic interest rate associated with the debt. So, if you have a $10,000 15-year bond with a 5 percent interest rate paid semiannually, you should receive $\left(\text{\$}10,000\times 0.05\right)/2,$ or $250, in interest payments twice a year for as long as you own the bond. At the end of the loan period, the company is responsible for paying you the entire initial amount you invested (the principal), which in this case is $10,000.

To ensure there’s enough money at the end of the loan period to pay back the principal to all the bondholders, companies set aside money annually in a sinking fund—a type of savings fund into which companies deposit money regularly. Figure 15.6 explains the payment cycle of a bond issue.

Figure 15.6

Payment Cycle of a Bond Issue

What kinds of equity financing are available? If a company is successful, finding long-term funding can be as simple as looking at its balance sheet for accumulated profits known as retained earnings. Using retained earnings is an ideal way to fund long-term projects because it saves companies from paying interest on loans or underwriting fees on bonds. Unfortunately, not all companies have enough retained earnings to fund large projects.

What kind of private equity financing is available? A company may look for long-term financing in the form of venture capital. Venture capital is an investment in the company by a group of outside investors, called venture capitalists, who take an active role in a company’s management decisions. Venture capitalists seek their return in the form of equity, or ownership, in a company. They anticipate a large return on their investments when a company is sold or goes issues stock for the first time. Venture capitalists are willing to wait longer than other investors, lenders, or shareholders for returns on their investments, but they expect higher-than-normal returns.

Why finance with stock? Instead of relying on venture capital or bonds, which are generally usually used to fund short-term projects rather than ongoing operations, a company might choose to issue stock (often referred to as equity). Stock is a unit of ownership in a company. A stock certificate is a document that represents ownership of stock and includes details such as the issuing company’s name, the number of shares the certificate represents, and the type of stock being issued. Paper stock certificates, however, are not routinely issued these days because companies are opting to record them electronically. When a company first sells stock to the public, the event is referred to as an initial public offering. Offering shares of ownership in a company to the general public—called “going public”—can be a great option. A company can choose to go public when it feels it has enough public support to attract new shareholders.

Are there disadvantages to financing with stock? The biggest disadvantage of financing with stock is the dilution of ownership of a business. Stockholders become owners of the company, and although they do not have direct control over the day-to-day management of a company, they do have a say in the composition of its board of directors. The board of directors is charged with hiring the senior management team. This means that although shareholders do not directly control how a company is managed, they do directly control who manages the company. As a result, shareholders can have a strong influence on management’s decisions.

What are the advantages to financing with stock? Unlike bonds and other forms of debt, equity financing does not need to be repaid, even if a company goes bankrupt, and no assets need to be pledged as collateral. In addition, financing with equity enables a company to retain its cash and profits rather than using the funds to make interest and principal payments. In many instances, financing with equity can make a company’s balance sheet look stronger because high levels of debt can make lenders and investors wary of a company’s financial viability.

How does a company choose between debt and equity? The choice between financing with debt or equity depends on many factors, including the maturity, the size, and financial worthiness of a company, the number of assets and liabilities a company already has, and the size and nature of the project being financed. Managers can reach the best decision by understanding the financing needs of the project itself and the impact the financing decision has on the company’s earnings, cash flow, and taxes. In addition, a company must consider how much debt it already has before issuing bonds or whether it wants to dilute ownership by issuing stock. Also, business owners must decide if they are willing to compromise the vision they have for their companies by allowing stockholders to have a say in the management of their companies.

Finally, a company must also consider external factors at the time of financing, such as the state of the bond or stock market, the economy, and the anticipated interest of the investors. It is important to note that debt and equity should not be considered as substitutes for one another. Instead, they should be viewed as complementary financing; most large companies will use both.