Read Chapter 16 - Mastering Financial Management

Students,

WHY FINANCIAL MANAGEMENT? Financial management can make the difference between success and failure for both large and small businesses. Managers must find the money needed to keep a business operating and fund all the goals and objectives that a successful business wants to achieve. Fortunately, the number of businesses filing for bankruptcy has decreased compared to the large number of firms filing bankruptcy during the worst part of the recent economic crisis, as illustrated in Figure 16-1.

The Need for Financial Management. Financial management consists of all the activities concerned with obtaining money and using it effectively. To some extent, financial management can be viewed as a two-sided problem:

On one side, the uses of funds often dictate the type or types of financing needed by a business.
On the other side, the activities a business can undertake are determined by the types of financing available.

Financial managers must ensure that funds are available when needed, that they are
obtained at the lowest possible cost, and that they are used as efficiently as possible. They must also ensure that:

Financing priorities are established in line with organizational goals and objectives.
Spending is planned and controlled.
Sufficient financing is available when it is needed, both now and in the future.
A firm’s credit customers pay their bills on time, and the number of past due accounts is reduced.
Bills are paid promptly to protect the firm’s credit rating and its ability to borrow money.
The funds required for paying the firm’s taxes are available when needed to meet tax deadlines.
Excess cash is invested in certificates of deposit (CDs), government securities, or conservative, marketable securities.
Financial Reform After the Economic Crisis. In the wake of the crisis that affected both business firms and individuals, a cry for more regulations and reforms became a high priority. To meet this need, President Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010. Although the U.S. Senate and House of Representatives debate additional regulations, the goals are to hold Wall Street firms accountable for their actions, end taxpayer bailouts, tighten regulations for major financial firms, and increase government oversight. There has also been debate about limiting the amount of executive pay and bonuses, limiting the size of the largest financial firms, and curbing speculative investment techniques that were used by banks before the crisis.
Careers in Finance. The Bureau of Labor Statistics projects there will be about a 7 percent increase in the number of jobs in the financial sector of the economy between now and 2024. There are many different types of positions in finance.A chief financial officer (CFO) is a high-level corporate executive who manages a firm’s finances and reports directly to the company’s CEO or president. People in finance must have certain traits and skills. One of the most important
priorities is honesty. Managers and employees in the finance area must also:a) Have a strong background in accounting or mathematics.b) Know how to use a computer to analyze data.c) Be an expert at both written and oral communication.Depending on qualifications, work experience, and education, starting salaries generally begin at $30,000 to $35,000 a year, but it is not uncommon for college graduates to earn higher salaries.The Need for Financing. Money is needed both to start a business and to keep it going. The original investment of the owners, along with money they may have borrowed, should be enough to open the doors. After that, sales revenues should be used to pay the firm’s expenses and provide a profit. However, income and expenses may vary from month to month or from year to year. Temporary financing may be needed when expenses are high or sales are low. Situations such as the opportunity to purchase a new facility or expand an existing plant may require more money than is currently available within a firm.Short-Term Financing. Short-term financing is money that will be used for one year or less. As illustrated in Table 16-l, there are many short-term financing needs, but three deserve special attention.Certain business practices may affect a firm’s cash flow and create a need for short-term financing. Cash flow is the movement of money into and out of an organization.The goal is to have sufficient money coming into the firm in any period to cover the firm’s expenses during that period. A second major need for short-term financing is speculative production. Speculative production refers to the time lag between the actual production of goods and when the goods are sold. (See Figure 16-2.)A third need for short-term financing is to increase inventory. Firms must build up their inventories before peak selling periods.
Long-Term Financing. Long-term financing is money that will be used for longer than one year.
- Long-term financing is needed to start a business.
- As Table 16-1 shows, it is also needed for business mergers and acquisitions, new product development, long-term marketing activities, replacement of equipment that has become obsolete, and expansion of facilities.
- The Risk–Return Ratio. According to the financial experts, business firms will find it more difficult to raise both short- and long-term financing in the future for two reasons:
- First, financial reform and increased regulations will lengthen the process required to obtain financing.
- Second, both lenders and investors are more cautious about who receives financing.
- As a result, financial managers must develop a strong financial plan that describes how the money will be used and how it will be repaid.
- In developing a financial plan for a business, a financial manager must also consider the risk–return ratio when making decisions that affect the firm’s finances. The risk–return ratio is based on the principle that a high-risk decision should generate higher financial returns for a business, while more conservative decisions (with less risk) often generate lesser returns. Although financial managers want higher returns, they must strive for a balance between risk and return.
- PLANNING—THE BASIS OF SOUND FINANCIAL MANAGEMENT. A financial plan is a plan for obtaining and using the money needed to implement an organization’s goals.
  - Developing the Financial Plan. The three steps involved in financial planning are illustrated in Figure 16-3.
  - Establishing Organizational Goals and Objectives. A goal is an end result that an organization expects to achieve over a one- to ten-year period. An objective is a specific statement detailing what an organization intends to accomplish over a shorter period of time.
  - If goals and objectives are not specific and measurable, they cannot be translated into dollar costs, and financial planning cannot proceed.
  - Budgeting for Financial Needs. Once planners know what the firm’s goals and objectives are for a specific period, they can construct a budget that projects the costs the firm will incur and the sales revenues it will receive. A budget is a financial statement that projects income and/or expenditures over a specified future
  - Usually, the budgeting process begins with the construction of departmental budgets for sales and various types of expenses.
  - Financial managers can combine each department’s budget for sales and expenses into a company-wide cash budget.
  A cash budget estimates cash receipts and cash expenditures over a specified period.
  - Figure 16-4 shows a typical cash budget for a retailer.
  - Most firms use one of two approaches to budgeting.
  In the traditional approach, each new budget is based on the dollar amounts contained in the budget for the preceding year. These amounts are modified to reflect any revised goals, and managers are required to justify only new expenditures. The problem with this approach is that it leaves room for padding budget items to protect the (sometimes selfish) interests of the manager or his or her department.
  
  Zero-base budgeting is a budgeting approach in which every expense in every budget must be justified.

To develop a plan for long-term financing needs, managers often construct a capital budget that estimates a firm’s expenditures for major assets, including new product development, expansion of facilities, replacement of obsolete equipment, and mergers and acquisitions.

Identifying Sources of Funds. The four primary sources of funds, listed in Figure 16-3, are sales revenue, equity capital, debt capital, and proceeds from the sale of assets.
a) Future sales revenue generally provides the greatest part of a firm’s financing.
b) A second type of funding is equity capital. For a sole proprietorship or partnership, equity capital is provided by the owner or owners of the business. For a corporation, equity capital is money obtained from the sale of shares of ownership in the business. Equity capital is used almost exclusively for long-term financing.
A third type of funding is debt capital, which is borrowed money. Debt capital may be borrowed for either short- or long-term use.
Proceeds from the sale of assets are the fourth type of funding. Selling assets is a drastic step. However, it may be a reasonable last resort when sales revenues are declining and equity capital or debt capital cannot be found. Assets may be sold when they are no longer needed or don’t “fit” with the company’s core business.
Monitoring and Evaluating Financial Performance. It is important to ensure that
financial plans are being implemented and to catch potential problems before they
become major ones. To prevent such problems, financial managers should establish a means of monitoring financial performance.
Interim budgets (weekly, monthly, or quarterly) may be prepared for comparison purposes.
These comparisons point up areas that require additional or revised planning—or at least those areas calling for more careful investigation.
FINANCIAL SERVICES PROVIDED BY BANKS AND OTHER FINANCIAL INSTITUTIONS. Banking services can be divided into three broad categories: traditional
services, electronic banking services, and international services.
Traditional Banking Services for Business Clients. Traditional services include
savings and checking accounts, loans, processing credit- and debit-card transactions, and providing professional advice.
Savings and Checking Accounts. Savings accounts provide a safe place to store money and a very conservative means of investing.
The usual passbook savings account earns between 0.10 and 0.50 percent in banks and savings and loan associations (S&Ls) and slightly more in credit unions.
A business with excess cash it is willing to leave on deposit with a bank for a period of time can earn a higher interest rate by buying a certificate of deposit (CD), a document stating that the bank will pay the depositor a guaranteed rate of interest on money left on deposit for a specified period of time.
Business firms (and individuals) also deposit money in checking accounts so that they can write checks for purchases. A check is a written order for a bank or other financial institution to pay a stated dollar amount to the business or person indicated on the face of the check.
Business Loans. Banks, savings and loan associations, credit unions, and other
financial institutions provide short- and long-term loans to businesses.
Short-term loans must be repaid within one year or less.
To help ensure that short-term money will be available when needed, many firms establish a line of credit—a loan that is approved before the money is actually needed. However, a firm may not be able to borrow money if the bank does not have sufficient funds available.
For this reason, some firms prefer a revolving credit agreement, which is a guaranteed line of credit under which the bank guarantees that the money will be available when the borrower needs it.

The bank charges a commitment fee ranging from 0.25 to 1.0 percent of the unused portion of the revolving credit agreement.

The usual interest is charged for the portion that is borrowed.

Long-term loans are repaid over a period of years. The average length is generally 3 to 7 years but sometimes as long as 15 to 20 years.

Most lenders require some type of collateral for long-term loans. Collateral is real estate or property (e.g., stocks, bonds, equipment, or any other asset of value) pledged as security for a loan.

The Basics of Getting a Loan. According to many financial experts, preparation is the key when applying for a business loan.
To begin the process, you should get to know potential lenders before requesting debt financing. The logical place to borrow money is where your business does its banking.
You may also want to check your firm’s credit rating with a national credit bureau such as D&B (formerly Dun & Bradstreet).
Typically, business owners will be asked to fill out a loan application, and the lender will want to see your current business plan. Most lenders insist that you submit current financial statements that have been prepared by an independent certified public accountant.
Then compile a list of references that includes your suppliers, other lenders, or the professionals with whom you are associated.
You may also be asked to discuss the loan request with a loan officer.
If your loan request is not approved, try to determine why your loan was rejected and determine what you could do to improve your chances of getting a loan the next time you apply.
Credit and Debit Card Transactions. A recent Gallup poll indicates that three out

of four Americans (76 percent) have at least one credit card. And on average,

Americans have 3.4 credit cards. Credit cards are important because when consumers

don’t have the cash to make a purchase, they can use a credit card.

A merchant can convert credit-card sales into cash by depositing charge slips in a bank or other financial institution. In return for processing the merchant’s credit-card transactions, the financial institution charges a fee. Typically, small, independent businesses pay more than larger stores or chain stores.
Do not confuse debit cards with credit cards.
a) A debit card electronically subtracts the amount of a customer’s purchase from his or her bank account at the moment the purchase is made.
b) When you use your credit card, the credit-card company extends short-term financing, and you do not make payment until your next statement.
c) Debit cards are used most commonly to obtain cash at automatic teller
machines (ATMs) and to purchase products and services from retailers.
Electronic Banking Services. An electronic funds transfer (EFT) system is a means of performing financial transactions through a computer terminal. The following four EFT applications are changing how banks help firms do business:
Automatic teller machines (ATMs) are machines that provide almost any service a human teller can provide. Once the customer is properly identified, the machine dispenses cash from the customer’s checking or savings account or makes a cash advance charged to a credit card.
ATMs are located in bank parking lots, supermarkets, drugstores, and even gas stations, and customers have access to them at all times of the day or night.
There may be a fee for each transaction.
Automated clearinghouses (ACHs) process checks, recurring bill payments,
Social Security benefits, and employee salaries.
A point-of-sale (POS) terminal is a computerized cash register located in a retail store and connected to a bank’s computer.
You begin the process by pulling your bank credit or debit card through a magnetic reader.
A central processing center notifies a computer at your bank that you want to make a purchase.
The bank’s computer immediately adds the amount to your account for a credit-card transaction or deducts the amount of the purchase from your bank account if you use a debit card.
The amount of your purchase is added to the store’s account, the store is notified that the transaction is complete, and the cash register prints out your receipt.
Electronic check conversion (ECC) is a process used to convert information from a paper check into an electronic payment for merchandise, services, or bills.

Bankers and business owners generally are pleased with EFT systems because they are fast and eliminate the costly processing of checks. However, some customers are reluctant to use online banking or EFT systems. Some simply do not like “the technology,” whereas others fear that the computer will garble their accounts. In 1978, Congress passed the Electronic Funds Transfer Act, which protects the customer in case the bank makes an error or the customer’s credit or debit card is stolen.

International Banking Services. Depending on the needs of an international firm, a bank can help by providing a letter of credit or a banker’s acceptance.
A letter of credit is a legal document issued by a bank or other financial institution guaranteeing to pay a seller a stated amount for a specified period of time—usually 30 to 60 days. Certain conditions, such as delivery of the merchandise, may be specified before payment is made.
A banker’s acceptance is a written order for a bank to pay a third party a stated amount of money on a specified date. No conditions are specified. It is simply an order to pay without any strings attached.
Banks and other financial institutions provide for currency exchange. To make payment, you can use either currency and, if necessary, the bank will exchange one currency for the other to complete your transaction.
SOURCES OF SHORT-TERM DEBT FINANCING. The decision to borrow money
does not necessarily mean that a firm is in financial trouble. On the contrary, astute financial management often means regular, responsible borrowing of many different kinds to meet
different needs.
A. Sources of Unsecured Short-Term Financing. Short-term financing is usually easier to obtain than long-term debt financing for three reasons.

For the lender, the shorter repayment period means less risk of nonpayment.
The dollar amounts of short-term loans are usually smaller than those of long-term loans.
A close working relationship normally exists between the short-term borrower and the lender.

Most lenders do not require collateral (real estate or property pledged as security for a loan) for short-term financing. If they do, it is usually because they are concerned about the size of a particular loan, the borrowing firm’s poor credit rating, or the general prospects of repayment. Unsecured financing is financing that is not backed by collateral. A company seeking unsecured short-term financing has several options.

Trade Credit. Manufacturers and wholesalers often provide financial aid to retailers by allowing them 30 to 60 days (or more) in which to pay for merchandise. Trade credit is a type of short-term financing extended by a seller who does not
require immediate payment after delivery of merchandise.
It is the most popular form of short-term financing; 70 to 90 percent of all transactions between businesses involve some trade credit.
The seller may offer a cash discount to encourage prompt payment.
Cash-discount terms are specified on the invoice. For instance, “2/10, net 30” means that the customer may take a 2 percent discount if it pays the invoice within ten days of the invoice date. If payment is made between 11 and 30 days after the date of the invoice, the customer must pay the entire amount.
As long as payment is made before the end of the credit period, the retailer maintains the ability to purchase additional merchandise using the trade-credit arrangement.
Promissory Notes Issued to Suppliers. A promissory note is a written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date. Although repayment periods may extend to one year, most short-term promissory notes are repaid in 60 to 180 days.
A promissory note offers two important advantages to the firm extending the credit:

A promissory note is a legally binding and enforceable document.

A promissory note is a negotiable instrument. This means that the firm extending credit may be able to discount or sell the note to its own bank. If the note is discounted, the dollar amount received by the company extending credit is slightly less than the maturity value because the bank charges a fee for the service. The supplier recoups most of its money immediately, and the bank collects the maturity value when the note matures.

Unsecured Bank Loans. Banks and other financial institutions offer unsecured short-term loans to businesses at interest rates that vary with each borrower’s credit rating.

The prime interest rate is the lowest rate charged by a bank for a short-term loan. Figure 16-5 traces the fluctuations in the average prime rate charged by U.S. banks from 1990 to March 2017.

The lowest rate is generally reserved for large corporations with excellent credit ratings.

Organizations with good to high credit ratings may pay the prime rate plus “2” percent; firms with questionable credit ratings may have to pay the prime rate plus “4” percent.

If the banker feels loan repayment may be a problem, the borrower’s loan application may be rejected.

When a business obtains a short-term bank loan, interest rates and repayment terms may be negotiated.

As a condition of the loan, a bank may require that a compensating balance be kept on deposit at the bank. Compensating balances are typically 10 to 20 percent of the borrowed funds.

The bank may also require that every commercial borrower clean up (pay off completely) its short-term loans at least once each year and not use it again for a period of 30 to 60 days.

Commercial Paper. Commercial paper is a short-term promissory note issued by a large corporation. The maturity date for commercial paper is normally 270 days or less.

Commercial paper is secured only by the reputation of the issuing firm; no collateral is involved.

The interest rate a corporation pays when it sells commercial paper is tied to its credit rating and its ability to repay the commercial paper. In most cases, corporations selling commercial paper pay interest rates slightly below the
interest rates charged by banks for short-term loans.

Although it is possible to purchase commercial paper in smaller denominations, larger amounts ($100,000 or more) are common.

Money obtained by selling commercial paper is most often used to purchase inventory, finance a firm’s accounts receivable, pay salary and other necessary expenses, and solve cash-flow problems.

Sources of Secured Short-Term Financing. If a business cannot obtain enough capital through unsecured financing, it must put up collateral to obtain additional short-term financing. Almost any asset can serve as collateral. However, inventories and accounts receivable are the assets most commonly pledged for short-term financing.

Loans Secured by Inventory. Finished goods, raw materials, and work-in-process inventories may be pledged as collateral for short-term loans. Lenders prefer the much more salable finished goods to raw materials or work-in-process inventories.

A lender may insist that inventory used as collateral be stored in a public warehouse.

The receipt issued by the warehouse is retained by the lender. Without this receipt, the public warehouse will not release the merchandise.

The lender releases the warehouse receipt—and the merchandise—to the borrower when the borrowed money is repaid.

In addition to paying the interest on the loan, the borrower must pay for storage in the public warehouse. As a result, this type of loan is more expensive than an unsecured short-term loan.

Loans Secured by Receivables. Accounts receivable are amounts owed to a firm by its customers. A firm can pledge its accounts receivable as collateral to obtain short-term financing, and a lender may advance 70 to 80 percent of the dollar amount of the receivables.

A lender first conducts a thorough investigation to determine the quality of the receivables—the credit standing of the firm’s customers, coupled with their ability to repay their credit obligations when due.

Like most business loans, the borrower and the lender negotiate interest rates and repayment terms.

Factoring Accounts Receivable. Accounts receivable can be sold to a factoring
company, or factor. A factor is a firm that specializes in buying other firms’ accounts receivable. The factor buys the accounts receivable for less than their face value, but it collects the full dollar amount when each account is due. The factor’s profit is the difference between the face value of the accounts receivable and the amount the factor has paid for them. The amount of profit the factor receives is based on the risk the factor assumes. Risk in this case is the probability that the accounts receivable will not be repaid when they mature.

Even though the firm selling its accounts receivable gets less than face value, it
receives needed cash immediately and it has shifted the task of collecting and the risk
of nonpayment to the factor, which now owns the accounts receivable. Generally, customers whose accounts receivables have been factored are given instructions to make their payments directly to the factor.

Cost Comparisons. Table 16-2 compares the various types of short-term financing.

SOURCES OF EQUITY FINANCING. Sources of long-term financing vary with the size and type of business. A sole proprietorship or partnership acquires equity capital (sometimes referred to as owners’ equity) when the owner or owners invest money in the business. For corporations, equity-financing options include the sale of stock and the use of profits not distributed to owners. All three types of businesses can also obtain venture capital.

Selling Stock. Some equity capital is used to start every business—sole proprietorship, partnership, or corporation. In the case of corporations, stockholders who buy shares in the company provide equity capital.

Initial Public Offering and the Primary Market. An initial public offering (IPO) occurs when a corporation sells common stock to the general public for the first time.

Established companies that plan to raise capital by selling subsidiaries to the public can also use IPOs. Monies from the IPO will be used to increase the parent company’s cash balance and provide funding for growth opportunities and expansion.

In addition to using an IPO to increase the cash balance for the parent company, corporations often sell shares in a subsidiary when shares can be sold at a profit or when the subsidiary no longer fits with its current business plan.

Some corporations will sell a subsidiary that is growing more slowly than the rest of the company’s operating divisions.

When a corporation uses an IPO to raise capital, the stock is sold in the primary market. The primary market is a market in which an investor purchases financial securities (via an investment bank) directly from the user of the securities.
An investment banking firm is an organization that assists corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities.
Although a corporation can have only one IPO, it can sell additional stock
after the IPO assuming that there is a market for the company’s stock.
Even though the cost of selling stock (often referred to as flotation costs) is high, the ongoing costs associated with this type of equity financing are low for two reasons.

The corporation doesn’t have to repay money obtained from the sale of stock.

The corporation is under no legal obligation to pay dividends to stockholders. A dividend is a distribution of earnings to the stockholders of a corporation. For any reason (e.g., if a company has a bad year), the board of directors can vote to omit dividend payments. Earnings are then retained for use in funding business operations.

The Secondary Market. Although a share of corporate stock is only sold one time in the primary market, the stock can be sold again and again in the secondary market. The secondary market is a market for existing financial securities that are traded between investors. Although a corporation does not receive money each time its stock is bought or sold in the secondary market, the ability to obtain cash by selling stock investments is one reason why investors purchase corporate stock. Without the secondary market, investors would not purchase stock in the primary market because there would be no way to sell shares to other investors. Usually, secondary-market transactions are completed through a securities exchange or over-the-counter (OTC) market.

A securities exchange is a marketplace where member brokers meet to buy and sell securities. Generally, securities issued by larger corporations are traded at the New York Stock Exchange (NYSE) or at regional exchanges located in different parts of the country. Securities of very large corporations may be traded at more than one of these exchanges. Securities of firms may also be listed on foreign securities changes.

Stocks issued by several thousand companies are traded in the OTC market. The over-the-counter (OTC) market is a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange. Many stocks are traded through an electronic exchange called the Nasdaq.

The Nasdaq is now one of the largest securities markets in the world and is known for its forward-looking, innovative growth companies, including Microsoft, Cisco Systems, and Apple.

There are two types of stock: common and preferred. Each has advantages and disadvantages as a means of long-term financing.

Common Stock. A share of common stock represents the most basic form of
corporate ownership. In return for the financing provided by selling common stock, management must make certain concessions to stockholders that may restrict or change corporate policies.

Every corporation must hold an annual meeting, at which the holders of
common stock may vote for the board of directors and approve or disapprove major corporate actions.

Few investors will buy common stock unless they believe their investment will increase in value.

Preferred Stock. The owners of preferred stock must receive their dividends
before holders of common stock receive theirs. Preferred stockholders know the dollar amount of their dividend because it is stated on the stock certificate.

Preferred stockholders also have first claim (after creditors) on assets if the corporation is dissolved or declares bankruptcy.

The board of directors must approve dividends on preferred stock, and this type of financing does not represent a debt that must be legally repaid.

In return for preferential treatment, preferred stockholders generally give up the right to vote at a corporation’s annual meeting.

Although a corporation usually issues one type of common stock, it may issue many types of preferred stock with varying dividends or dividend rates.

Retained Earnings. Most large corporations distribute only a portion of their after-tax earnings to shareholders. The portion of a corporation’s profits not distributed to stockholders is called retained earnings.Because retained earnings are undistributed profits, they are considered a form of equity financing.

The amount of retained earnings in any year is determined by corporate management and approved by the board of directors.

Most small and growing corporations pay no cash dividend—or a very small dividend—to their shareholders. All or most earnings are reinvested in the business for research and development, expansion, or the funding of major projects. Reinvestment tends to increase the value of the firm’s stock while it provides essentially cost-free financing for the business.

More mature corporations may distribute 40 to 60 percent of their after-tax profits as dividends. Utility companies and other corporations with very stable earnings often pay out as much as 80 to 90 percent of what they earn.

For a large corporation, retained earnings can amount to a hefty bit of financing.

Venture Capital and Private Placements. To establish a new business or expand an existing one, an entrepreneur may try to obtain venture capital. Venture capital is money invested in small (and sometimes struggling) firms that have the potential to become very successful.

Most venture capital firms do not invest in the typical small business but in firms that have the potential to become extremely profitable.

Generally, a venture capital firm consists of a pool of investors, a partnership established by a wealthy family, or a joint venture formed by corporations with money to invest. In return for financing, these investors generally receive an equity or ownership position in the business and share in its profits.

Another source of capital for a startup business is an angel investor. An angel investor provides financial backing for small business startups or entrepreneurs.

Often, an angel investor may be an entrepreneur’s family member or a wealthy friend and provides the financial support needed to start a business.

Unlike venture capitalists, angel investors are often focused on helping a business or an entrepreneur succeed rather than earning large profits.

Angel investors often provide more favorable financial terms when compared with venture capitalists, bankers, and other financial institutions.

In return for providing needed financing, an angel investor can become an owner with equity in the firm.

Another method of raising capital is through a private placement—when stocks and other corporate securities are sold directly to insurance companies, pension funds, or large institutional investors.

When compared with selling stocks and other corporate securities to the
public, there are often fewer government regulations, and the cost is generally less.

Typically, terms between the buyer and seller are negotiated when a private placement is used to raise capital.

SOURCES OF LONG-TERM DEBT FINANCING. Businesses borrow money on a
short-term basis for many valid reasons. There are equally valid reasons for long-term borrowing. Successful businesses often use the financial leverage created by borrowing money to improve their financial performance. Financial leverage is the use of borrowed funds to increase the return on owners’ equity. The principle of financial leverage works as long as a firm’s earnings are larger than the interest charged for the borrowed money. Table 16-3 illustrates how financial leverage can increase a firm’s return on owners’ equity.

The most obvious danger when using financial leverage is that the firm’s earnings may be lower than expected. If this situation occurs, the fixed interest charge actually works to
reduce or eliminate the return on owners’ equity. Of course, borrowed money eventually must be repaid.

For a small business, long-term debt financing is generally limited to loans. Large corporations have the additional option of issuing corporate bonds.

Long-Term Loans. Many businesses finance their long-range activities with loans from commercial banks and other financial institutions. (See Table 16-1.)
Term-Loan Agreements. A term-loan agreement is a promissory note that
requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual a) Repayment may be as long as 15 to 20 years, but long-term business loans are normally repaid in 3 to 7 years. b) The interest rate and other specific terms are often based on such factors as the reasons for borrowing, the borrowing firm’s credit rating, and the value of c) Although long-term loans may occasionally be unsecured, the lender usually requires some type of collateral. d) Lenders may also require that borrowers maintain a minimum amount of working capital.
Corporate Bonds. In addition to loans, large corporations may choose to issue bonds in denominations of $1,000 to $50,000. One of the reasons why corporations sell bonds is so that they can borrow a lot of money from a lot of different bondholders and raise larger amounts of money than could be borrowed from one lender. A corporate bond is a corporation’s written pledge that it will repay a specified amount of money with interest.

Interest rates for corporate bonds vary with the financial health of the company
issuing the bond. Specific factors that increase or decrease the interest rate that a corporation must pay when it issues bonds include:
- The corporation’s ability to pay interest each year until maturity
- The corporation’s ability to repay the bond at maturity
The maturity date is the date on which the corporation is to repay the borrowed money. Today, most corporate bonds are registered bonds. A registered bond is a bond registered in the owner’s name by the issuing company. Many corporations do not issue actual bonds; instead, the bonds are recorded electronically. Until a bond’s maturity, a corporation pays interest to the bond owner at the stated rate. On the maturity date, a registered owner will receive cash equaling the face value of the bond.
- Types of Bonds. Corporate bonds are generally classified as debentures, mortgage bonds, or convertible bonds. Most corporate bonds are debenture bonds. See Fig. 16-7 A debenture bond is a bond backed only by the reputation of the issuing A mortgage bond is a corporate bond secured by various assets of the issuing firm. Typical corporate assets that are used as collateral for a mortgage bond include real estate, machinery, and equipment that are not pledged as collateral for other debt obligations. A convertible bond can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. A corporation can gain in three ways by issuing convertible bonds.
First, convertibles usually carry a lower interest rate than nonconvertible bonds.

Second, the conversion feature attracts investors who are interested in the speculative gain that conversion to common stock may provide.

Third, if the bondholder converts to common stock, the corporation no longer has to redeem the bond at maturity.
- Repayment Provisions for Corporate Bonds Maturity dates for bonds generally range from 10 to 30 years after the date of issue.Some bonds are callable before the maturity date; that is, a corporation can buy back or redeem them.
Corporations usually pay the bond owner a call premium.

The amount of the call premium is specified, along with other provisions, in the bond indenture. The bond indenture is a legal document that details all the conditions relating to a bond issue.
- A corporation may use one of three methods to ensure that it has sufficient funds available to redeem a bond issue.
It can issue the bonds as serial bonds—bonds of a single issue that
mature on different dates.

It can establish a sinking fund—a sum of money to which deposits are made each year for the purpose of redeeming a bond issue.

It can pay off an old bond issue by selling new bonds.
- A corporation that issues bonds must also appoint a trustee—an individual or an independent firm that acts as the bond owner’s representative. The corporation must report to the trustee periodically regarding its ability to make interest payments and eventually redeem the bonds.
- Cost Comparisons. Table 16-4 compares the different types of long-term equity and debt financing.
- Selling common stock is generally a popular option for most financial managers. Once the stock is sold and upfront costs are paid, the ongoing costs of using stock to finance a business are low.
- The type of long-term financing that generally has the highest ongoing costs is a long-term loan (debt).
- To a great extent, firms are financed through the investments of individuals—money deposited in banks or used to purchase stocks, mutual funds, and bonds.