🛒principles of microeconomics review
17.1 How Businesses Raise Financial Capital
Last Updated on June 25, 2024
Companies need money to grow, and they've got options. Debt financing means borrowing cash, while equity financing involves selling ownership stakes. Each has its perks and drawbacks, impacting control, risk, and flexibility.
The way firms raise money sends signals to investors. Debt might show confidence, while equity could hint at overvaluation. Clear financial info helps bridge the knowledge gap between insiders and outsiders, making it easier for companies to access funds.
Raising Financial Capital
Debt Financing
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- Borrowing money from lenders (banks, bondholders)
- Requires regular interest payments and repayment of principal amount borrowed
- Does not dilute ownership or control of the firm, owners retain decision-making power
- Interest payments are tax-deductible, lowering the effective cost of borrowing
- Creates an obligation to make regular payments, increasing financial risk and potential for bankruptcy if unable to meet debt obligations
- May limit future borrowing capacity and flexibility as lenders assess debt-to-equity ratio
Equity Financing
- Issuing shares of stock to investors in exchange for capital
- Investors become partial owners of the firm, entitled to a share of profits and potential dividends
- Dilutes ownership and control of the firm among a larger group of shareholders
- No fixed obligations for dividend payments or repayment of capital, providing flexibility
- Increases the firm's equity base, improving its debt-to-equity ratio and potentially enabling more borrowing
- May involve higher costs and regulatory requirements (investment banking fees, SEC filings)
Retained Earnings
- Reinvesting profits back into the firm instead of distributing them to shareholders
- Internal source of financing, avoiding external costs and obligations associated with debt or equity
- Allows the firm to fund growth and investments without diluting ownership or increasing debt
- May be limited by the amount of profits generated and the need to balance shareholder expectations for returns
Advantages and Trade-offs
Advantages of Debt Financing
- Maintains ownership and control of the firm with owners
- Interest payments are tax-deductible, lowering the effective cost of borrowing
- Predictable cash outflows for budgeting and planning purposes
Trade-offs of Debt Financing
- Obligation to make regular interest payments and repay principal amount borrowed
- Increases financial risk and potential for bankruptcy if unable to meet debt obligations
- May limit future borrowing capacity and flexibility as lenders assess debt levels
Advantages of Equity Financing
- No fixed obligations for dividend payments or repayment of capital, providing flexibility
- Increases the firm's equity base, improving its debt-to-equity ratio
- Potential for higher long-term returns to attract investors seeking growth opportunities
Trade-offs of Equity Financing
- Dilutes ownership and control of the firm among a larger group of shareholders
- Requires sharing profits with investors through potential dividend payments
- May involve higher costs and regulatory requirements (investment banking fees, SEC filings)
Information Impact
Asymmetric Information
- Managers have more information about the firm's prospects than outside investors
- Can lead to adverse selection, where investors struggle to distinguish between high and low-quality firms
- Can lead to moral hazard, where firms take excessive risks knowing that investors bear the consequences
Signaling Theory
- Firms can signal their quality and prospects to investors through financial decisions
- Issuing debt may signal confidence in the firm's ability to repay and generate stable cash flows
- Issuing equity may signal overvaluation or lack of profitable investment opportunities
Financial Disclosure and Transparency
- Providing accurate and timely financial information to investors (financial statements, SEC filings)
- Reduces information asymmetry between managers and investors, improving investor confidence
- Helps firms access capital markets on more favorable terms by demonstrating transparency and credibility
Key Terms to Review (19)
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a crucial concept in the context of financial markets and capital allocation decisions made by both businesses and households.
Venture Capital: Venture capital is a type of private equity financing provided by investors to startups and small businesses with high growth potential. These investors, known as venture capitalists, offer funding, strategic guidance, and industry expertise to help innovative companies succeed and scale their operations.
Cost of Capital: The cost of capital refers to the required rate of return that a business must earn on its investments in order to maintain the value of its stock and attract capital from investors. It represents the opportunity cost of using funds for a particular investment or project.
Financial Capital: Financial capital refers to the monetary resources available to a business or individual that can be used to fund operations, invest, or generate economic value. It encompasses the various forms of capital, such as cash, credit, and other financial assets, that enable businesses to finance their activities and pursue growth opportunities.
Retained Earnings: Retained earnings refer to the portion of a company's net income that is kept within the business rather than being distributed to shareholders as dividends. This accumulated profit is used to fund the company's operations, invest in new projects, or build up its financial reserves.
Initial Public Offering (IPO): An initial public offering (IPO) is the first sale of stock by a private company to the public. It marks the transition of a private company into a publicly-traded one, allowing the company to raise capital from public investors for the first time.
Borrowing: Borrowing refers to the act of obtaining funds from a lender, typically a financial institution or an individual, with the understanding that the borrowed amount will be repaid over time, usually with interest. It is a fundamental concept in the context of how businesses raise financial capital, as it allows them to access resources they may not have available internally.
Interest: Interest refers to the cost of borrowing money or the return on an investment. It is a fundamental concept in the context of how businesses raise financial capital, as it represents the price paid for accessing funds or the compensation received for providing them.
Covenants: Covenants are legally binding agreements or promises made between two or more parties, typically in the context of financial contracts or real estate transactions. They establish specific terms, conditions, and restrictions that the parties agree to abide by.
Corporate Stock: Corporate stock refers to the shares of ownership in a corporation that are issued and traded publicly. These shares represent a claim on the corporation's assets and earnings, and provide investors with the opportunity to participate in the growth and success of the company.
Debt: Debt refers to the money that an individual, business, or government owes to another party, typically in the form of a loan that must be repaid with interest. It is a critical component of how businesses raise financial capital to fund their operations and growth.
Bonds: Bonds are a type of debt security that represents a loan made by an investor to a borrower, typically a company or government. They are a financial instrument that allows the issuer to raise capital by promising to repay the loan with interest over a specified period of time.
Dividends: Dividends are cash payments made by a company to its shareholders, typically out of the company's profits or accumulated earnings. They represent a portion of the company's profits that are distributed to its owners or investors.
Collateral: Collateral refers to an asset, such as real estate, equipment, or securities, that a borrower pledges to a lender as security for a loan. It serves as a guarantee that the borrower will repay the loan, and the lender can seize the collateral if the borrower defaults.
Collateral is a crucial concept in the context of how businesses raise financial capital, as it allows them to access loans and other forms of financing that they may not be able to obtain without providing security.
Equity: Equity refers to the fair and impartial treatment of individuals or groups, ensuring that everyone has access to the same opportunities and resources, regardless of their personal circumstances or background. In the context of businesses raising financial capital, equity represents the ownership stake that investors hold in the company.
Profits: Profits refer to the financial gain or surplus that a business generates after deducting all the costs and expenses associated with its operations. It is the difference between the revenue a business earns and the total costs it incurs, representing the net income or earnings that the business retains for its own use or distribution to its owners or shareholders.
Maturity: Maturity, in the context of financial capital, refers to the length of time until a financial instrument, such as a bond or loan, reaches its final repayment date. It represents the duration of a financial obligation and is a crucial factor in determining the risk and value of the instrument.
Maturity is a central concept in understanding how businesses raise financial capital, as it directly impacts the terms and conditions of the financing options available to them.
Leverage: Leverage refers to the use of borrowed funds or financial instruments to increase the potential return on an investment. It allows businesses to amplify their financial resources and undertake projects or investments that may not be possible with their own capital alone.
Capital Structure: Capital structure refers to the mix of debt and equity financing used by a business to fund its operations and investments. It represents the proportions of different types of capital, such as long-term debt, short-term debt, and various forms of equity, that a company employs to finance its assets and activities.