How are companies financed?

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Bondholders & shareholders provide companies with funds for the operation and expansion of business. However, the companies you transact with everyday fund themselves in a variety of ways, surplus to merely issuing bonds or equity. In-fact when investing in a company you are joining a diverse community of investors, providing finance through a range of channels.

This article will explain how bonds & equities fit into a bigger picture. This article provides a cursory glance at how companies make financing decisions, outlines the lesser known forms of financing and will highlight the relative position of corporate bonds & equities within a broader landscape of financing options.

How do companies make financing decisions?

Managers must select the cheapest combination of funds from a range of funding sources.

Relying too heavily on one source of funding means missing the opportunity of a relatively cheaper source; therefore managers play out a delicate balancing act.

Management can project different ‘Weighted Average Cost of Capitals’ or WACCs. WACCs measure the average cost of financing the business from all available sources of funding. We can think of the WACC as the minimum a company has to pay for its investors to not take their money elsewhere.

A company’s WACC is the sum of:  the cost of each funding source * that source as a % of overall funding. We can state an exemplar company’s WACC as follows:

WACC = (Cost of Equity * % of Equity) + [Cost of Debt * % of Debt*(1-Tax Rate)]

We include the tax rate as companies can write down their tax liabilities by offsetting interest payments on debt.

Management’s goal is to secure the lowest possible WACC across a range of financing sources. The next section will outline some of the different funding sources available.

Sources of finance

With how companies make financing decisions in mind, let’s turn to the different options available to them. We will be primarily focusing on the funding sources available to large, blue-chip companies such as those typically found on WiseAlpha.

Retained earnings

The most obvious source of funds are those generated from within the company itself. This form of financing is often inexpensive, however saving up enough cash to fund large investments may take too much time, wasting the investment opportunity. Furthermore, access to own funds may be limited and companies may wish to keep a buffer of readily available emergency cash.  

Common Equity financing

The most well-known form of financing. Common equity holders buy ownership shares of a business.

Common equity financing can take many forms; mature companies commonly raise capital through an IPO (Initial Public Offering). Younger companies may engage in equity crowdfunding or selling equity to venture capitalists or angel investors. Another option is to issue equity via a ‘rights issue,’ a rights issue is the issue of discounted shares to existing shareholders in proportion to their existing shareholdings.

Employee stock options can function as a form of equity financing, helping companies cover staff costs. Steve Jobs famously took home only $1 a year; however, he was rewarded with generous stock options. The catch? This was at the expense of existing shareholders who had their holdings diluted.

Corporate Bonds

Corporate bonds function like IOUs. Investors provide capital upfront in exchange for regular interest payments and the return of their capital at maturity. Corporate bonds typically have minimum denominations of 100,000 and are traded almost exclusively in the institutional markets.

Corporate Loans

Corporate loans also function like IOUs, much like corporate bonds. Corporate loans differ in that they are arranged directly between banks and corporate borrowers. Consequently, loans are typically much more bespoke compared to bonds; borrowers can renegotiate the terms of loans much more easily than that of bonds. Furthermore, corporate loans do not require the public offering of debt as in the case of bonds, and this reduces the administrative costs associated with their issuance. However, the banks lending via loans often demand higher interest rates and put in place more restrictions on the borrowers than bondholders.

Revolving Credit Facilities (Loans++)

Revolving Credit Facilities (RCFs) are forms of bank loans (above). RCFs are unique in that function somewhat like overdrafts, providing short term credit used by companies to cover operating expenses. The loans ‘revolve’ in the companies can continually tap their RCFs up to a predefined limit (e.g. £100m overdrawn).

Finance Leases

Finance leases are the loaning of an asset. The borrower accounts for the asset on their balance sheet and the subsequent profit/loss stemming from it are attributable to the borrower. The borrower pays a regular rental fee to the lender in exchange for the hire of the asset.

Hybrid  Financing

Hybrid financing sits between debt and equity financing. You might have preferences shares which function as normal shares with fixed dividend, perpetual bonds with no maturity date, bonds with the option to be converted into equity, or an amalgamation of the above.

Straddling the line between debt/equity financing, hybrid financing often takes the form of debt, yet displays equity-like returns and volatility. Hybrid financing has become increasingly popular since the financial capital with banks being required to hold a buffer of ‘regulatory capital.’ Regulatory capital typically takes the form of debt that can be converted into equity or written down in case the bank runs into a period of financial distress. Capital buffers are thought to help prevent the rapid deterioration of banks solvency. Helping to slow the systemically risky outbreak of panic and subsequent bank runs as seen during the financial crisis.

The relative position of corporate bonds & equities.

Bank loans are typically first in line to be repaid in the event of default. Often only pension liabilities sit above them. Within bank loans, RCFs (revolving credit facilities) typically sit at the top.

Beneath bank loans typically sit bondholders. Secured bondholders have claim over assets which can be liquidated to reduce their default exposure. Senior denotes that a bondholder will be paid back before junior bondholders.  Senior Secured bonds have security protections for investors and in the event of the company going bust of falling into financial difficulty bond investors are first in line to reclaim their capital back versus other stakeholders with claims. In this instance, investors will be paid before equity investors, and before those with unsecured bonds or loans.

Towards the bottom of the capital structure sits junior unsecured bonds. Unsecured bonds are not first in line for repayment if the company has financial difficulty and the risk to an investor’s capital can be much higher. However, this higher risk tends to be compensated by higher coupons or returns.

At the bottom sit hybrids and equity. Hybrids straddle the line between debt and equity. Along with equity holders, hybrids are most likely to be completely wiped out in the event of a company becoming distressed, making them high risk investments.

Liberalising corporate finance

Our mission is to liberalise and shape the corporate finance landscape, making it accessible to a broader investment audience. By lowering barriers to entry, we can provide private investors access to assets which used to be the sole preserve of financial institutions. Across the corporate finance landscape, all forms of capital have their place, offering attractive returns to investors and productive capital to businesses.

Private investors can make positive contributions to the economy by investing in large well established blue-chip companies across a range of funding channels, rather than merely being limited to investing in individual companies equity.

Find out more about investing with WiseAlpha. All factual information true at the time of publishing.

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