2.2.1 Sources of Long-term Debt Financing
2.2.1.1 Debentures
A debenture is a document issued by a company containing an acknowledgement of indebtedness which is not secured by a mortgage or other properties (Samuels et al 1995). Debentures are backed only by the general creditworthiness and reputation of the issuer and documented by an agreement called indenture (Samuels et al 1995). By issuing debentures, company can leave specific assets burden free, and thereby leave them open for subsequent financing ().
- Bonds
A certificate of debt (usually interest-bearing or discounted) that is issued by a government or corporation in order to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal (Jones 1967). He also stated that bonds are rated based on the issuer's creditworthiness. When issuing bonds, companies can enjoy lower interest rates and longer term than a traditional commercial bank and flexibility in choosing a variable or fixed interest rate (http://www.state.nj.us/njbusiness/financing/general/bond.shtml).
2.2.1.3 Term Loan
According to () a term loan is a secured commercial loan made to business for a specific period, normally three to ten years with interest. The website also stated that term loans usually are granted for the purchase of longer-term fixed assets and also other purposes such as raising working capital, business expansion investments and company acquisitions. It stated that the repayment term of the loan vary accordingly to the useful life of the asset being financed.
2.2.1.3.1 Advantages and Disadvantages of Term Loan
Source of Reference:
2.2.1.4 Convertible Securities
According to () convertibles securities are usually bonds or preferred stocks which can be converted into a specified number of the issuing company's shares at the option of the convertible holder. The conversion option of convertible securities provides the potential for significant growth to company (Lynch 2008).
2.2.1.5 Warrants
According to (http://en.wikipedia.org/wiki/Warrant_(finance)) a usually attached to bonds or preferred stock entitling the to a specific amount of securities at a specific (usually higher than current market price at time of issue) at a specific period. The website also stated that they are utilized to attract potential buyers to enhance the yield of bond. Warrants are listed on options exchanges and trade independently of the security with which it was issued. (http://en.wikipedia.org/wiki/Warrant_(finance)).
2.2.1.6 Leasing
According to () leasing enables one party to use another’s property, plant, or equipment for a stated period of time in exchange for consideration. The website stated that a lease agreement involves at least two parties, a lessor (who owns the property) and a lessee (who uses the property). The lessor, essentially a creditor in the transaction is repaid from a combination of lease or rental payments, tax benefits, and proceeds from the sale or re-lease of the property at the end of the lease term ().
2.2.1.6.1 Advantages and Disadvantages of Leasing
Source of Reference:
2.2.1.7 Secured and Unsecured Loans
A secured loan is a in which the borrower hypothecates their asset as for the loan which then becomes a secured debt owed to the creditor who provides the loan (http://www.answers.com/secured+loan?cat=biz-fin). The website stated that the debt is thus secured against the collateral and in the event that the borrower fails to repay, the creditor takes possession of the asset and may sell it to satisfy the amount originally lent to the borrower. While unsecured loan is a loan granted on the creditworthiness of the borrower or reputation in the community, earnings potential, and other assets owned ().
3.0 Pros and Cons of Equity Financing
3.1 Pros of Equity Financing
The advantages of equity finance are:
Commitment of Funds: The funding is committed to the business and intended projects. Investors only realize their investment if the business is doing well (eg. through flotation or a sale to new investors).
Vested Interest: Investors have the same interest that is to keep the business going on well and generate maximum profits which leads to an increase in the value of the business.
Follow-up Funding: When business grows, investors are often prepared to provide follow-up funding.
(Source of reference:
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Wider Pool of Finance: When company is listed in stock exchanged, the company has the access to wider pool of finance.
Quality Products: The owners will pay proper attention for improving the quality of products. The reason is the appropriate of quality product goes to them.
No Interest Cost: No payment of interest for the funds provided by the shareholders. The cost of production remains low as there is no burden of interest.
Earning Remains with the Firm: When funds provided by shareholders for improvement in the business are making profits, the earnings are remained with the owners. Earnings are not shared by the creditors.
To Tide over Emergencies: Firm is in a better position to tide over recession period and other emergencies due to no burden of rate of interest.
Ability to borrow: Borrowing ability is improved if the equity capital is financed well.
(Source of Reference: http://www.blurtit.com/q303144.html)
Sources of Skills and Experiences: Good investors can bring resources for the business. They can help one to get skilled people, right contacts to build the business. They might also help out with their own experience in the formation of the strategy or with decision making.
No Obligation for Repayment: No obligation for the repayment of the finances in the initial phase of the business when the cash flow is quite slow. Whereas, in bank loans there are severe obligations and penalties in case a business fails to generate monthly interests and make the monthly payments to the bank.
(Sources of Reference:
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Pledge No Assets: Corporation does not have to pledge their assets as collateral to obtain equity investments.
Availability of Cash: Business will have more cash available due to no debt payments have to be made.
(Source of reference:
http://forums.forbes.com/forbes/board/message?board.id=entreforum&message.id=399)
3.2 Cons of Equity Financing
The disadvantages of equity finance are:
Costly and Time Consuming: Raising equity finance is costly and time-consuming. Business may suffer as times are devoted to the deal. Potential investors will seek background information on owner and his business and they will closely scrutinize past results and forecasts and will delve the management team.
Interference in Management: The equity investors can interfere in the management of the company and in addition they also have the voting rights which could influent the making of major decisions.
Extra Effort to Provide Information: Founder will have to invest management time to provide regular information for the investor to monitor the situation of the business.
Share Dilution: Founder’s share in the business will be diluted which means lessen in strength. Besides that, business’s profits will be shared by other equity investors.
Legal and Regulatory Compliance: There can be legal and regulatory issues to comply with when raising finance (eg. when promoting investments).
(Source of Reference;
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Limitation of Control: Founders must give up some control of the business. If investors have different perceptions and ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur.
(Source of Reference: )
No Tax Deduction: Dividend payments are not tax deductible.
(Source of Reference:
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4.0 Pros and Cons for Debt Financing
4.1 Pros of Debt Financing
Maintain ownership: The debt holder cannot interfere in the management of the company and they do not have the voting rights. Therefore, business can be run without outside interference
Tax deductions: Principal and interest payments on a business loan are classified as business expenses and thus tax deductible. It also lowers the actual cost of the loan to the company.
Lower interest rate: There is a lower interest rate of debt financing when interest rate is lower than tax rate (where the business can take a loan and have a deduction on tax rather than high interest rate).
(Source of Reference: )
No Complex Procedures Required: Debt financing is easier to obtain than equity financing. Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
No Profits Sharing: Profits of company are not shared with the lenders who require capital appreciation and dividends on their investments.
Forecasting: Interest and principal payments are typically a know amount that can be forecast.
(Source of Reference: )
No Extra Rewards: Debt holders are entitled only to repayment of the agreed-upon principal of the loan plus interest and have no direct claim on future profits of the business if the company has made extra profits.
Saving Management Time: Company does not have to send periodic mailings to large numbers of investors, hold periodic meetings with shareholders and seek the vote of shareholders before taking certain actions.
(Source of Reference: ) David H. Schwartz
4.2 Cons of Debt Financing
Repayment: Sole obligation to the lender is to make payments on time. If the business fails, the company still has to make payments. If business goes into bankruptcy, lenders will have claim to repayment before any equity investors.
Impacts Credit Rating: It seems to be attractive to keep bringing on debt when company needs money, a practice known as levering up, but each loan will be noted on your credit rating. The more borrowings, the higher the risk to the lender and the higher interest rate the company will have to pay.
Cash and Collateral: The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.
(Source of Reference: )
Difficulty in Business Growth: Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that have large amounts of debt as compared to equity often find it difficult to grow because of the high cost of servicing the debt.
Restrictions on Activities: Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options and non-core business opportunities which results in losing of other investment opportunities.
(Source of Reference:
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5.0 Consideration factors for Sources of Finance
Equity financing and debt financing is the option for a company that needs financing. Each company is unique and they have their own financing requirements and therefore, it is inappropriate to determine any one of the financing methods is the best option for companies. There are certain factors that a company needs to consider before choosing the right financing method:
The size of the company: Larger companies may obtain financing by equity financing due to the needs of wider pool of finance for company growth (Joseph 2008). However for smaller companies, debt financing is much easier to obtain because it’s not easy to reach the status of public limited company and the issuance cost of equity finance is unaffordable by smaller companies (Joseph 2008).
The ability to generate cash flow: This relies upon the operations of the company (Joseph 2008). If the company is able to generate enough cash flow, the company may seek debt financing because debt financing requires cash make frequent repayment of interest and principal (Joseph 2008).
Any Restrictive Covenants: If the company is restricted by the lender from subsequent borrowings, equity financing is more appropriate due to the bindings against the company.
The Cost of Financing: The cost of financing for debt financing is cheaper than equity financing due to the debt financer is exposed to lesser risk and he is entitled for prior claim in the company’s profits and interest payable are tax deductible (which means actual cost of debt is lesser) (Joseph 2008).
The Duration of Borrowing: The longer the duration, the interest rate charged on the borrower will be higher (Joseph 2008).
The Current Gearing Level: If a company has a high gearing level, it is the best to go for equity financing whilst if a company has a low gearing level, they can go for debt financing (Joseph 2008).
6.0 Conclusion
Investments into companies usually require both debt and equity financing as every single plan or investment will need different features from both of the financing strategies. Debt and equity financing are very different in nature and complement to each other. The needs that a company has to finance can be either found in debt financing or equity financing. For example, when your company is short of cash, equity financing is the appropriate way where the company does not have to repay the funds obtained. Debts need to be repaid in cash while equity needs to be rewarded with long-term profits. Depending on the company circumstances and opportunities, a company can make a successful investment if the right mixture of debt financing and equity financing is found.
7.0 List of References
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