Reading: Lesson 7 - Short- and Long-Term Debt Financing

8.7.A - Short- and Long-Term Debt Financing

1. DEBT CAPITAL

1. Businesses often borrow capital to expand the business, purchase or build new facilities, purchase equipment, pay operating expenses, or replenish inventory of products for sale. Much of this debt capital is available as a result of the savings of other individuals and businesses. Every day, millions of people and businesses deposit their savings in banks and other financial institutions that then lend the funds to businesses. Because a business can borrow money for just a few days or for many years, debt capital is classified as either short-term or long-term.
   
2. Short-term debt is a loan that must be repaid with interest within a year. The loan period may be as short as 30, 60, or 90 days. Short-term debt capital is usually obtained from a bank or other lending institution but may be obtained from other businesses as well.
   
3. Before lending, banks want to be fairly certain that the borrowers will repay their loans. The business will need to supply adequate financial information, and the bank will usually obtain a financial report on the business from a company such as Dun & Bradstreet. If it is satisfied with the information and considers the business a good credit risk, the bank will grant a loan for a specific dollar amount and a set time period. To allow the business flexibility to choose when to access the borrowed money, the bank may approve a line of credit. A line of credit is the authorization to borrow up to a maximum amount for a specified period of time. For example, a business may be allowed a line of credit up to $150,000 for a year. Whenever it needs to borrow, it may do so up to the $150,000 limit. Should the business borrow $50,000 one month, the business could still borrow an additional $100,000 during the year.
   
4. Another form of debt capital similar to an open line of credit is a business credit card, often used by small businesses. The credit card is issued by the bank with a set credit limit. The card can be used to finance purchases as long as the limit is not exceeded. Both the open line of credit and the credit card carry an interest rate that is often lower than similar interest rates charged to consumers for short-term loans and personal credit cards. Normally, businesses have to pay the interest due on the amount borrowed on a monthly basis and may have a specific payment schedule for the principal as well. Businesses with a good credit history may not have to pay the principal of the loan until the end of the term of the loan. When a business wants to borrow money from a lending institution, whether or not the business has a line of credit, it must sign a promissory note. A promissory note is an unconditional written promise to pay to the lender a certain sum of money at a particular time, or on demand if certain adverse conditions arise. If the bank has some doubt about the ability of the firm to repay a loan, it may require the business to pledge receivables, inventory, or some other asset as security for the loan. Security, sometimes called security collateral, is something of value pledged as assurance of the fulfillment of an obligation. If the loan is not repaid, the bank can claim the property pledged as security and sell it to obtain the value of the unpaid loan.
   
5. A business may have access to other sources of short-term capital, depending on the type of business. Investment businesses and insurance companies often provide business financing. Federal agencies such as the Small Business Administration (SBA) can assist business owners in locating financing sources. The SBA may also help guarantee repayment of a percentage of the loans to obtain a lower interest rate. Some states, counties, and cities offer loans at favorable rates to encourage businesses to locate in a particular area or to encourage businesses not to leave. Trade credit is a common form of short-term financing for businesses. Trade credit is obtained when a business buys goods and services that do not require immediate payment. Vendors often provide trade credit as an incentive for a business to purchase their products and services. Trade credit is usually extended for a period of 30 to 60 days and may even be interest free. As an incentive for early payment, the vendor may offer a cash discount of 1 or 2 percent of the total sale if the bill is paid quickly, such as within 10 days. Terms of trade credit are often shown on the invoice in a form such as 2/10, net 30. Those terms mean that the purchaser can receive a 2 percent discount if the bill is paid within 10 days of the invoice date. Otherwise the bill must be paid in full within 30 days. A factor is a firm that specializes in lending money to businesses based on the business’s accounts receivable. Rather than lending the business cash, the factor usually purchases the company’s accounts receivable at a discount and then accepts the funds provided when customers pay their bills, even if the original receivable is not fully repaid. In a similar manner, a sales finance company provides capital to a business based on debts owed by customers. A sales finance company may lend money to a business and use the business’s sales contracts as security for the loan. As an alternative, the sales finance company purchases contracts at a discount from businesses that need cash or that do not care to handle credit and collections.
   
6. Long-term debt is capital borrowed for longer than a year. It is usually used when large expenditures are needed for assets that will have a long life, such as land, buildings, and expensive equipment. A business often obtains this type of debt capital by obtaining term loans or issuing bonds.
   
7. A term loan is medium or long-term financing used for operating funds or the purchase or improvement of fixed assets. Term loans, or long-term notes, are written for periods of 1 to 15 years or longer. They are a significant source of capital for most businesses. Because term loans extend for a long period, lending institutions require the principal and interest to be repaid on a regular basis, usually each year, over the life of the note. As an alternative to borrowing large sums of money, a company may prefer to lease a building or an expensive piece of equipment. A lease is a contract that allows the use of an asset for a fee paid on a schedule, such as monthly. The lease may be obtained from the building owner, the equipment manufacturer, a finance company that handles that type of leasing, or a bank. Leasing is a practical substitute for long-term financing, especially when financing is difficult to obtain. The maintenance of the equipment and the costs of insuring it are usually not included in the lease agreement. When businesses lease buildings and equipment, they know exactly what the monthly payment will be and how long the lease will last. They do not have to obtain the large amount of financing that would be needed to purchase the buildings or equipment. The building or equipment leased is not owned by the business, so it cannot be valued as an asset. It is returned to the owner at the end of the lease unless the lease is renewed.
   
8. A bond is a long-term debt instrument sold by the business to investors. It contains a written promise by the business to pay the bondholder a definite sum of money at a specified time. The business receives the amount of the bond when it is initially sold. It must then pay the bondholder the amount borrowed—called the principal or par value—at the bond’s maturity or due date. Bonds also include an agreement to pay interest at a specified rate at certain intervals. Bonds are debt capital and do not represent a share of ownership in a corporation. Rather, they are debts the corporation owes to bondholders. People buy bonds as investments. But bondholders are creditors, not owners, so they have a priority claim against the earnings of a corporation. Bondholders must be paid before stockholders are paid their share of the earnings. Because bonds are negotiable financial instruments, they can be bought and sold by investors. Based on the interest rate of the bond, economic factors, and the financial health of the company, the value of the bond may increase or decline during the time it is traded.
   
9. There are two general types of bonds: debenture and mortgage bonds. Debentures are unsecured bonds. No specific assets are pledged as security. Debentures are backed by the financial strength and credit history of the corporation that issues them. Public corporations, such as city, state, and federal governments, usually issue debentures when they need to borrow money. Reputable, successful corporations generally find it relatively easy to sell debentures. However, relatively unknown or financially weak firms usually find it easier to attract investors with secured bonds. A mortgage bond is secured by specific long-term assets of the issuer. Property used as security includes real estate, equipment, and stocks and bonds held in other companies. If the company does not pay the principal and interest when due, creditors can force the company to sell the security property to recover the amount of the outstanding debt. Often, however, property cannot be sold for the amount of the loan. In some cases, a bond contract may have a provision that allows bondholders to claim assets other than the assets originally used as security. Businesses issue debentures and mortgage bonds when they need funds for an extended period. Special features may be attached to these bonds to attract investors. For example, a mortgage bond may have a convertible feature to make it appealing to bond buyers. A convertible bond permits a bondholder to exchange bonds for a predetermined number of shares of common stock at a later date.
   

1. Companies consider three important factors when deciding how to get the capital they need: (1) the original cost of obtaining the capital, (2) the interest rate, and (3) the power that the contributors of capital will have over business operations.
   
2. It can be costly for a business to obtain capital by selling bonds, long-term notes, and new stock issues. For example, to launch a new bond issue, the business must file forms, obtain approval from government authorities, make agreements, print bonds, find buyers, and keep careful records. These costs are usually so high that only large or highly successful firms even consider obtaining capital by issuing new stock or bonds. It is far less costly to obtain capital from a simple loan or line of credit.
   
3. Interest rates can fluctuate monthly, weekly, or even daily. Borrowing when rates are low costs less than borrowing when rates are high. If a business needs money when interest rates are high, it will usually borrow for a short time with the hope that rates will drop. If rates drop, it can then issue longer-term obligations, such as bonds, and use a portion of the capital obtained to pay off short- term obligations. In this way, a company has to pay high interest rates for only a short time. In following this plan, however, a business exposes itself to possible difficulty in obtaining funds when short-term obligations become due, and to the possibility that interest rates may rise even higher.
   
4. If short-term creditors contribute capital, they usually have no control over the management and operations of the business. If the obligations are not paid, creditors can take legal action to recover the amount due. Otherwise, owners and managers of the business are relatively unrestricted by short-term creditors. If the company obtains capital from mortgage bonds, however, the holders usually have a formal lien (claim) on at least part of the assets of the company. This lien may impose limitations on the use of the identified assets, and the agreement under which the mortgage bonds were issued may limit the use of the money the company receives from the bonds.
   
5. If new stockholders or new partners contribute equity capital, they gain a voice in the management of the business. In most states, stock can be issued without voting rights, but evidence shows that such stock is more difficult to sell. Of course, if existing stockholders or partners provide the additional funds, the control of the company will not be affected as long as the existing stockholders contribute in proportion to current holdings. If the company increases the number of shares of stock by selling new shares, it must divide earnings among a greater number of shareholders. For example, when the number of shares increases from 2,000 to 2,500, the distribution of $13,000 in dividends changes from $6.50 per share ($13,000/2,000) to $5.20 per share ($13,000/2,500). The original owners will not wish to give up any of their profits or voice in management unless it is profitable to do so. An increase in shareholders would need to be offset by an increase in earnings.
   

3. SOURCES OF OUTSIDE CAPITAL

1. When a business decides to obtain capital, it must find sources willing to provide the financing. Some common sources of capital are shown in the Figure below. The particular source a business selects depends, in part, on such factors as the amount of capital needed and the risk involved. Companies with a poor performance record find it hard to sell stocks or bonds to potential investors. A newly formed company has similar difficulties in securing a loan. Many banks avoid doing business with these types of organizations because of the added uncertainty in operations. When they do agree to provide financing, interest rates and other requirements are much higher than for successful, established firms. 
   

   
   

2. Many commercial banks do not generally become involved in helping large corporations raise capital by selling stocks and bonds. For these services, a corporation may turn to an investment bank—an organization that helps a business raise large sums of capital through the sales of stocks and bonds. Investment banks are also known as underwriters. Investment banks can assist a growing, privately held company through an initial public offering. An initial public offering (IPO) is the first time that a company sells stock to the public. Investment banks provide a variety of financial and investment services for their clients regarding large capital projects. The process of selling securities is simple but expensive. Assume a corporation wishes to raise $50 million by selling bonds. It first finds a willing investment bank. The bank offers advice, buys the bonds at a price below the expected market value, then sells the bonds to investors through its marketing channels. The bank’s profit would be the difference between what it paid the corporation for the bonds and the selling price received from the bond purchasers minus the costs incurred in the selling activities.
   
3. Some corporations may wish to sell only a small number of additional shares of stock. In that case, a corporation can handle the sale itself. It can make the sale of additional shares attractive to current employees and stockholders by offering stock options. A stock option is a right granted by a corporation that allows current stockholders to buy additional shares when issued at a fixed price for a specific period of time. These options give current stockholders the opportunity to buy enough stock to maintain the same percentage of ownership in the company as they had before the new stock was issued. Often the stock option is offered at a lower price to attract more funds to the corporation without the additional expense of selling through an investment bank. If stockholders do not wish to take advantage of their stock rights, they often can sell these options to others within a stated period of time. Employers also can offer employees stock options as part of an employee stock ownership plan (ESOP), which is a plan that allows employees to become owners of the company they work for through the incremental purchase of stock.
   
4. Venture capital is financing obtained from an investor or investment group that provides large sums of money to promising new or expanding small companies. Venture capitalists often ask for a percentage of ownership rights in the company in return for the investment. These investors expect some of the businesses to fail, but they accept the risks in the expectation that others will be successful enough to more than offset losses. They demand a carefully developed business plan that shows a high potential for success. Venture capitalists, many of whom are former entrepreneurs, have helped many small firms become large successful firms.