Sources of Long-Term Capital
Corporations have greater access to long-term funds than do partnerships or sole proprietors. But all three can choose between equity and debt financing. Let’s look at corporate financing first.
• Sources for Corporations •
Corporate long-term capital (mostly for larger firms) is available in the public securities market through stock issues and bond issues. Stocks and bonds will be discussed briefly here and more fully in chapter 21.
As chapter 5 showed, common stock represents ownership shares in a corporation. It confers to common shareholders voting rights and the right to residual earnings. Preferred stock represents shares of corporate ownership that usually do not confer voting rights but do give preference with respect to dividends and assets. A corporation that needs additional financing for the long run may also issue bonds. A bond is a written promise that the borrower (the firm) will pay the lender, at some stated future date, a sum of money (the principal) and a stated rate of interest. (Junk bonds are bonds rated at less than investment grade by rating agencies such as Standard & Poor’s. There is a high degree of risk that the bonds may not be paid off by the firm issuing them.)
A major decision to be made in issuing bonds is selecting the method to pay off bondholders. One method is debt replacement. This means relying on the firm’s ability to exchange maturing bonds for new bonds or stocks. That way, profits can be reinvested for additional growth. Another method is to set up a sinking fund. A sinking fund is money put aside each year from profits to pay off bonds when they mature. This is more likely to be done by a firm that is not expanding or that finds this investor protection feature the only way to attract bond investors.
A firm can also raise funds internally by retaining earnings. A profitable firm has the option either of using its profits to pay dividends or of reinvesting them in operations. Plowing back profits permits growth without the use of new equity or debt funds.
Some common shareholders may favor retaining earnings, and some may not. Investors who view the firm’s stock as a growth stock expect it to appreciate over time. They don’t demand immediate dividends. Others may want regular dividend checks, not profits that stay in the business.
If profits generate enough retained earnings to cover all capital spending, the firm may not have to raise funds through stocks or bonds. Generally, though, businesses do spend more on capital investments than they retain from earnings. Outside funds are therefore usually required.
To raise the equity money they need to expand, many firms today use initial public offerings (IPOs). An IPO is an offering in which stock of a company whose stock has not yet been traded publicly is offered to investors.
Experts called investment banks help the corporation make this offering. First, they help determine what the total value of the company should be. Then they agree to sell part of the firm’s common stock to the public. If they price the shares of stock correctly, everyone gains. The new shareholders get shares of stock that should appreciate in the future. The company gets equity funds to invest. The investment bank typically receives the difference, or spread, between the price it pays for the stock and the price at which the stock is resold to the public. Salomon Brothers and Goldman Sachs are examples of investment banks.
When biotech firm Alteon, Inc., had its IPO in 1991, the initial shares were sold to investors for $15 each. The stock immediately shot up to almost $29 per share. Some analysts believe that the firm’s first offering therefore should have been at least $20 or $25 per share. That way the company would have obtained more funds from the IPO.2
A venture capitalist is a financial institution that specializes in financing small, growing firms. Before offering financing, the institution examines the applicant firm carefully. It looks for a well-thought-out and detailed business plan and a financial prospectus (a document that sets out certain financial information, such as the risks involved in investing in the business). If it decides to invest, the venture capitalist generally gets equity ownership in the new venture. If certain conditions aren’t met, the venture capitalist may actually take over the firm.
Firms (large and small) can avoid the need for some financing by leasing instead of buying their land, buildings, or equipment. A lease is an agreement to obtain the use of an asset for a period of time in return for stated payments.
Syntex Corporation, a multinational drug company, leases computers as a means of keeping up with changing computer technology. The lease arrangement lets the firm trade in old computers for new ones without the problem of disposing of the old ones.