Assume you are a financial manager of a Fortune 500 company. Your firm is planni
ID: 2654396 • Letter: A
Question
Assume you are a financial manager of a Fortune 500 company. Your firm is planning to expand into new markets; hence, you need to borrow $100 million within the next year. Address the following concerns in detail:
A. Describe the ways you can borrow the $100 million.
B. If you decide to issue debt securities, describe the types of financial institutions that may purchase these securities.
C. Discuss how individuals indirectly provide the financing for your firm when they maintain deposits at depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions.
Explanation / Answer
(A) I can borrow the $100 million by issuing debt or issuing equity.
A company may raise capital in two ways - through equity (ownership capital) and through debt (loan). The equity holders get an ownership interest in the firm which debt holders don't.
Debts are typically raised by issuing a bond. A bond is a debt instrument that is issued at a face value (stated price) with an interest rate (coupon rate) for a fixed term of years. Each year the bondholder receives coupon interest (typically semiannually), and at the end of maturity, receives the face value.
The bondholder may sell the bond before the maturity, either at face value or at a price different from par value.
The interest paid to a bondholder is tax-deductible. Therefore, cost of raising debt capital is relatively cheaper and the preferred source of capital.
Bondholders have the highest level of claims over the assets of a company in case of liquidation. From the retained earnings (Net profit), the bond interests carry highest legal obligation and should be paid first.
On the other hand, a stock is an ownership share in a firm. Each share has a face value and can be traded in the market. Unlike bonds, there is no fixed legal commitment to interest payment every period, nor is there a stated maturity date. Instead, companies pay a dividend on the stocks. But there is no legal commitment to pay dividends.
Like a bond, a stock can be traded in the market as well. Equity being an internal source of funding, cost of equity is highest. This is because, stockholders have only a residual right to the earnings of a firm, after the debtholders have been paid their legal dues. To compensate for this risk, equityholders want higher returns.
(B) If I issue debt securities, the most likely buyers will be:
- Commercial banks, whose business activities include purchase of corporate bonds.
- Other financial institutions which are non-banking financial intermediaries.
- Securities firms which buy corporate bonds (and sells bonds in secondary market)
- Mutual fund firms which buy corporate bonds to diversify their portfolios
(C) By such investments in various financial intermediaries, individuals provide liquidity in financial market. When the public save in these saving schemes, they provide a supply of loanable funds since saving is the source of loanable funds. Higher savings generate higher loanable funds availability, thus creating funding source for my firm when I want to raise funds from markets.