MARIANO MARCOS STATE UNIVERSITY

Graduate School

PHEBE M. PASION BM 213

MMSM Report
CHAPTER V
1. Long term financing
1.1 The capital market
1.2 Obtaining funds from the capital market
1.3 Issuing debt instruments (debt financing)
1.4 Issuing securities (equity financing)
1.6 Lease financing

FINANCING
Financing is a very important part of every business. Firms often need financing to pay for their
assets, equipment, and other important items. Financing can be either long-term or short-term. As is
obvious, long-term financing is more expensive as compared to short-term financing.
The common sources of financing are capital that is generated by the firm itself and
sometimes, it is capital from external funders, which is usually obtained after issuance of new debt
and equity.
A firm’s management is responsible for matching the long-term or short-term financing mix.
This mix is applicable to the assets that are to be financed as closely as possible, regarding timing
and cash flows.

LONG TERM FINANCING

Required amount of fund collected by a business enterprise for meeting up a fund
requirement for acquiring important useable items from which there is a long term benefit
expectation.
To make investment for earning expected return for over long period of time from different
available sources for more than 7/10/15 years’ time period.
Long-term financing is usually needed for acquiring new equipment, R&D, cash flow
enhancement, and company expansion. Some of the major methods for long-term financing are
discussed below.
a. Equity Financing
Equity financing includes preferred stocks and common stocks. This method is less
risky in respect to cash flow commitments. However, equity financing often results in
dissolution of share ownership and it also decreases earnings.
The cost associated with equity is generally higher than the cost associated with
debt, which is again a deductible expense. Therefore, equity financing can also result in an
enhanced hurdle rate that may cancel any reduction in the cash flow risk.

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b. Corporate Bond
A corporate bond is a special kind of bond issued by any corporation to collect
money effectively in an aim to expand its business. This tern is usually used for long-term
debt instruments that generally have a maturity date after one year after their issue date at
the minimum.
Some corporate bonds may have an associated call option that permits the issuer to
redeem it before it reaches the maturity. All other types of bonds that are known as
convertible bonds that offer investors the option to convert the bond to equity.
c. Capital Notes
Capital notes are a type of convertible security that are exercisable into shares. They
are one type of equity vehicle. Capital notes resemble warrants, except the fact that they
usually don’t have the expiry date or an exercise price. That is why the entire consideration
the company aims to receive, for the future issuance of the shares, is generally paid at the
time of issuance of capital notes.
Many times, capital notes are issued with a debt-for-equity swap restructuring.
Instead of offering the shares (that replace debt) in the present, the company provides its
creditors with convertible securities – the capital notes – and hence the dilution occurs later.

THE CAPITAL MARKET

What Are Capital Markets?

Capital market is a market where buyers and sellers engage in trade of financial securities
like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and
institutions.
Capital markets are venues where savings and investments are channeled between the
suppliers who have capital and those who are in need of capital. The entities that have capital
include retail and institutional investors while those who seek capital are businesses, governments,
and people.
Capital markets are composed of primary and secondary markets. The most common capital
markets are the stock market and the bond market.
Capital markets seek to improve transactional efficiencies. These markets bring those who
hold capital and those seeking capital together and provide a place where entities can exchange
securities.

Understanding Capital Markets

The term capital market broadly defines the place where various entities trade different
financial instruments. These venues may include the stock market, the bond market, and the
currency and foreign exchange markets. Most markets are concentrated in major financial centers
including New York, London, Singapore, and Hong Kong.
Capital markets are composed of the suppliers and users of funds. Suppliers include
households and the institutions serving them—pension funds, life insurance companies, charitable
foundations, and non-financial companies—that generate cash beyond their needs for investment.

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Users of funds include home and motor vehicle purchasers, non-financial companies, and
governments financing infrastructure investment and operating expenses.
Capital markets are used to sell financial products such as equities and debt securities.
Equities are stocks, which are ownership shares in a company. Debt securities, such as bonds, are
interest-bearing IOUs.
These markets are divided into two different categories: primary markets—where new
equity stock and bond issues are sold to investors—and secondary markets, which trade existing
securities. Capital markets are a crucial part of a functioning modern economy because they move
money from the people who have it to those who need it for productive use.

Primary vs. Secondary Markets

Capital markets are composed of primary and secondary markets. The majority of modern
primary and secondary markets are computer-based electronic platforms.
Primary markets are open to specific investors who buy securities directly from the issuing
company. These securities are considered primary offerings or initial public offerings (IPOs). When a
company goes public, it sells its stocks and bonds to large-scale and institutional investors such as
hedge funds and mutual funds.
The secondary market, on the other hand, includes venues overseen by a regulatory body
like the Securities and Exchange Commission (SEC) where existing or already-issued securities are
traded between investors. Issuing companies do not have a part in the secondary market. The New
York Stock Exchange (NYSE) and Nasdaq are examples of the secondary market.

OBTAINING FUND FROM THE CAPITAL MARKET

What Is Capital Funding?
Capital funding is the money that lenders and equity holders provide to a business for daily
and long-term needs. A company's capital funding consists of both debt (bonds) and equity
(stock). The business uses this money for operating capital. The bond and equity holders expect
to earn a return on their investment in the form of interest, dividends, and stock appreciation.
Understanding Capital Funding
To acquire capital or fixed assets, such as land, buildings, and machinery, businesses usually
raise funds through capital funding programs to purchase these assets. There are two primary
routes a business can take to access funding: raising capital through stock issuance and raising
capital through debt.

There are two key ways a business can access funding: by raising capital through issuing
stock and by raising capital through issuing debt
A. Stock Issuance
A company can issue common stock through an initial public offering (IPO) or by
issuing additional shares into the capital markets. Either way, the money that is provided by
investors that purchase the shares is used to fund capital initiatives. In return for providing
capital, investors demand a return on their investment (ROI) which is a cost of equity to a
business. The return on investment can usually be provided to stock investors by paying

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dividends or by effectively managing the company’s resources so as to increase the value of

the shares held by these investors.
One drawback for this source of capital funding is that issuing additional funds in the
markets dilutes the holdings of existing shareholders as their proportional ownership and
voting influence within the company will be reduced.
B. Debt Issuance
Capital funding can also be acquired by issuing corporate bonds to retail and
institutional investors. When companies issue bonds, they are in effect, borrowing from
investors who are compensated with semi-annual coupon payments until the bond matures.
The coupon rate on a bond represents the cost of debt to the issuing company.
In addition, bond investors may be able to purchase a bond at a discount, and the
face value of the bond will be repaid when it matures. For example, an investor who
purchases a bond for $910 will receive a payment of $1,000 when the bond matures.

Special Considerations

Capital funding through debt can also be raised by taking out loans from banks or other
commercial lending institutions. These loans are recorded as long-term liabilities on a company’s
balance sheet and decrease as the loan is gradually paid off. The cost of borrowing the loan is
the interest rate that the bank charges the company. The interest payments that the company
makes to its lenders are considered an expense on the income statement, which means pre-tax
profits will be lower.

While a company is not obligated to make payments to its shareholders, it must fulfill
its interest and coupon payment obligations to its bondholders and lenders, making capital
funding through debt a more expensive alternative than through equity. However, in the event
that a company goes bankrupt and has its assets liquidated, its creditors will be paid off first
before shareholders are considered.

Cost of Capital Funding

Companies usually run an extensive analysis of the cost of receiving capital through
equity, bonds, bank loans, venture capitalist, the sale of assets, and retained earnings. A
business may assess its weighted average cost of capital (WACC), which weights each cost of
capital funding, to calculate a company’s average cost of capital.
The WACC can be compared to the return on invested capital (ROIC)—that is, the return
that a company generates when it converts its capital into capital expenditures. If the ROIC is
higher than the WACC, the company will move forward with its capital funding plan. If it’s lower,
the business will have to re-evaluate its strategy and re-balance the proportion of needed funds
from the various capital sources to decrease its WACC.

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ISSUING DEBT INSTRUMENT (Debt Financing)

What Is a Debt Instrument?

A debt instrument is a tool an entity can utilize to raise capital. It is a documented, binding
obligation that provides funds to an entity in return for a promise from the entity to repay a lender
or investor in accordance with terms of a contract. Debt instrument contracts include detailed
provisions on the deal such as collateral involved, the rate of interest, the schedule for interest
payments, and the timeframe to maturity if applicable.

What Is Debt Financing?

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling
debt instruments to individuals and/or institutional investors. In return for lending the money, the
individuals or institutions become creditors and receive a promise that the principal and interest on
the debt will be repaid. The other way to raise capital in the debt markets is to issue shares of stock
in a public offering; this is called equity financing.

How Debt Financing Works

When a company needs money through financing, it can take three routes to obtain
financing: equity, debt, or some hybrid of the two. Equity represents an ownership stake in the
company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If
the company goes bankrupt, equity holders are the last in line to receive money. The other route is
debt financing—where a company raises capital by issuing debt.

Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes,
to investors to obtain the capital needed to grow and expand its operations. When a company issues
a bond, the investors that purchase the bond are lenders who are either retail or institutional
investors that provide the company with debt financing. The amount of the investment loan—also
known as principal—must be paid back at some agreed date in the future. If the company goes
bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Special Considerations

Cost of Debt

A firm's capital structure is made up of equity and debt. The cost of equity is the dividend
payments to shareholders, and the cost of debt is the interest payment to bondholders. When a
company issues debt, not only does it promise to repay the principal amount, it also promises to
compensate its bondholders by making interest payments, known as coupon payments, to them
annually. The interest rate paid on these debt instruments represents the cost of borrowing to the
issuer.

The sum of the cost of equity financing and debt financing is a company's cost of capital. The
cost of capital represents the minimum return that a company must earn on its capital to satisfy its
shareholders, creditors, and other providers of capital. A company's investment decisions relating to
new projects and operations should always generate returns greater than the cost of capital. If

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returns on its capital expenditures are below its cost of capital, then the firm is not generating
positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance
its capital structure.

The formula for the cost of debt financing is:

KD = Interest Expense x (1 - Tax Rate)

where KD = cost of debt

Since the interest on the debt is tax-deductible in most cases, the interest expense is
calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on
stocks are taxed.

Measuring Debt Financing

One metric used to measure and compare how much of a company's capital is being
financed with debt financing is the debt-to-equity ratio (D/E). For example, if total debt is $2 billion
and total stockholders' equity is $10 billion, the D/E ratio is $2 billion / $10 billion = 1/5, or 20%. This
means for every $1 of debt financing, there is $5 of equity. In general, a low D/E ratio is preferable to
a high one, though certain industries have a higher tolerance for debt than others. Both debt and
equity can be found on the balance sheet statement.

Debt Financing vs. Interest Rates

Some investors in debt are only interested in principal protection, while others want a return
in the form of interest. The rate of interest is determined by market rates and the creditworthiness
of the borrower. Higher rates of interest imply a greater chance of default and, therefore, a higher
level of risk. Higher interest rates help to compensate the borrower for the increased risk. In
addition to paying interest, debt financing often requires the borrower to adhere to certain rules
regarding financial performance. These rules are referred to as covenants.

Debt financing can be difficult to obtain, but for many companies, it provides funding at
lower rates than equity financing, especially in periods of historically low-interest rates. Another
perk to debt financing is that the interest on the debt is tax-deductible. Still, adding too much debt
can increase the cost of capital, which reduces the present value of the company.

ISSUING SECURITIES (Equity Financing)

What Is Equity Financing?

Equity financing is the process of raising capital through the sale of shares. Companies raise
money because they might have a short-term need to pay bills or they might have a long-term goal
and require funds to invest in their growth. By selling shares, they sell ownership in their company in
return for cash, like stock financing.

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Equity financing comes from many sources; for example, an entrepreneur's friends and
family, investors, or an initial public offering (IPO). Industry giants such as Google and Facebook
raised billions in capital through IPOs.

While the term equity financing refers to the financing of public companies listed on an
exchange, the term also applies to private company financing.

How Equity Financing Works

Equity financing involves the sale of common equity but also the sale of other equity or
quasi-equity instruments such as preferred stock, convertible preferred stock, and equity units that
include common shares and warrants.

A startup that grows into a successful company will have several rounds of equity financing
as it evolves. Since a startup typically attracts different types of investors at various stages of its
evolution, it may use different equity instruments for its financing needs.

For example, angel investors and venture capitalists—who are generally the first investors in
a startup—are inclined to favor convertible preferred shares rather than common equity in
exchange for funding new companies because the former have greater upside potential and some
downside protection. Once the company has grown large enough to consider going public, it may
consider selling common equity to institutional and retail investors.

Later, if the company needs additional capital, it may choose secondary equity
financing such as a rights offering or an offering of equity units that includes warrants as a
sweetener.

Special Considerations

The equity-financing process is governed by rules imposed by a local or national securities

authority in most jurisdictions. Such regulation is primarily designed to protect the investing public
from unscrupulous operators who may raise funds from unsuspecting investors and disappear with
the financing proceeds.

Equity financing is thus often accompanied by an offering memorandum or prospectus,

which contains extensive information that should help the investor make an informed decision on
the merits of the financing. The memorandum or prospectus will state the company's activities,
information on its officers and directors, how the financing proceeds will be used, the risk factors,
and financial statements.

Investor appetite for equity financing depends significantly on the state of the financial
markets in general and equity markets in particular. While a steady pace of equity financing is a sign
of investor confidence, a torrent of financing may indicate excessive optimism and a looming market
top. For example, IPOs by dotcoms and technology companies reached record levels in the late
1990s, before the “tech wreck” that engulfed the Nasdaq from 2000 to 2002. The pace of equity
financing typically drops off sharply after a sustained market correction due to investor risk-aversion
during such periods.

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LEASE FINANCING
Lease financing is one of the important sources of medium- and long-term financing where
the owner of an asset gives another person, the right to use that asset against periodical payments.
The owner of the asset is known as lessor and the user is called lessee.
The periodical payment made by the lessee to the lessor is known as lease rental. Under lease
financing, lessee is given the right to use the asset but the ownership lies with the lessor and at the
end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either
to purchase the asset or to renew the lease agreement.
Finance Lease
It is the lease where the lessor transfers substantially all the risks and rewards of ownership
of assets to the lessee for lease rentals. In other words, it puts the lessee in the same condition as
he/she would have been if he/she had purchased the asset. Finance lease has two phases: The first
one is called primary period. This is non-cancellable period and in this period, the lessor recovers his
total investment through lease rental. The primary period may last for indefinite period of time. The
lease rental for the secondary period is much smaller than that of primary period.
Features of Finance Lease:
From the above discussion, following features can be derived for finance lease:
1. A finance lease is a device that gives the lessee a right to use an asset.
2. The lease rental charged by the lessor during the primary period of lease is sufficient to
recover his/her investment.
3. The lease rental for the secondary period is much smaller. This is often known as peppercorn
rental.
4. Lessee is responsible for the maintenance of asset.
5. No asset-based risk and rewards is taken by lessor.
6. Such type of lease is non-cancellable; the lessor’s investment is assured.
Operating Lease
Lease other than finance lease is called operating lease. Here risks and rewards incidental to
the ownership of asset are not transferred by the lessor to the lessee. The term of such lease is
much less than the economic life of the asset and thus the total investment of the lessor is not
recovered through lease rental during the primary period of lease. In case of operating lease, the
lessor usually provides advice to the lessee for repair, maintenance and technical knowhow of the
leased asset and that is why this type of lease is also known as service lease
Features of Operating Lease
Operating lease has following features:
1. The lease term is much lower than the economic life of the asset.
2. The lessee has the right to terminate the lease by giving a short notice and no penalty is
charged for that.
3. The lessor provides the technical knowhow of the leased asset to the lessee.
4. Risks and rewards incidental to the ownership of asset are borne by the lessor.

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5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.
ADVANTAGES AND DISADVANTAGES OF LEASE FINANCING
At present leasing activity shows an increasing trend. Leasing appears to be a cost-effective
alternative for using an asset. However, it has certain advantages as well as disadvantages. \
ADVANTAGES TO THE LESSOR
The advantages of lease financing from the point of view of lessor are summarized below
a. Assured Regular Income:
- Lessor gets lease rental by leasing an asset during the period of lease which is an
assured and regular income.
b. Preservation of Ownership:
- In case of finance lease, the lessor transfers all the risk and rewards incidental to
ownership to the lessee without the transfer of ownership of asset hence the
ownership lies with the lessor.
c. Benefit of Tax:
- As ownership lies with the lessor, tax benefit is enjoyed by the lessor by way of
depreciation in respect of leased asset.
d. High Profitability:
- The business of leasing is highly profitable since the rate of return based on lease
rental, is much higher than the interest payable on financing the asset.
e. High Potentiality of Growth:
- The demand for leasing is steadily increasing because it is one of the cost efficient
forms of financing. Economic growth can be maintained even during the period of
depression. Thus, the growth potentiality of leasing is much higher as compared to
other forms of business.
f. Recovery of Investment:
- In case of finance lease, the lessor can recover the total investment through lease
rentals.
ADVANTAGES TO THE LESSEE
The advantages of lease financing from the point of view of lessee are discussed below:
a. Use of Capital Goods:
- A business will not have to spend a lot of money for acquiring an asset but it can use
an asset by paying small monthly or yearly rentals.
b. Tax Benefits:
- A company is able to enjoy the tax advantage on lease payments as lease payments
can be deducted as a business expense.
c. Cheaper:

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- Leasing is a source of financing which is cheaper than almost all other sources of
financing.
d. Technical Assistance:
- Lessee gets some sort of technical support from the lessor in respect of leased asset.
e. Inflation Friendly:
- Leasing is inflation friendly, the lessee has to pay fixed amount of rentals each year
even if the cost of the asset goes up.
f. Ownership:
- After the expiry of primary period, lessor offers the lessee to purchase the assets—
by paying a very small sum of money.
DISADVANTAGES TO THE LESSOR
Lessor suffers from certain limitations which are discussed below:
a. Unprofitable in Case of Inflation:
- Lessor gets fixed amount of lease rental every year and they cannot increase this
even if the cost of asset goes up.
b. Double Taxation:
- Sales tax may be charged twice: First at the time of purchase of asset and second at
the time of leasing the asset.
c. Greater Chance of Damage of Asset:
- As ownership is not transferred, the lessee uses the asset carelessly and there is a
great chance that asset cannot be useable after the expiry of primary period of
lease.
DISADVANTAGES TO THE LESSEE
a. Compulsion:
- Finance lease is non-cancellable and even if a company does not want to use the
asset, lessee is required to pay the lease rentals.
b. Ownership:
- The lessee will not become the owner of the asset at the end of lease agreement
unless he decides to purchase it.
c. Costly:
- Lease financing is more costly than other sources of financing because lessee has to
pay lease rental as well as expenses incidental to the ownership of the asset.
d. Understatement of Asset:
- As lessee is not the owner of the asset, such an asset cannot be shown in the
balance sheet which leads to understatement of lessee’s asset.

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REFERENCES:
https://www.slideshare.net/SumitJohir/long-term-financing-104079062
https://www.investopedia.com/terms/c/capitalmarkets.asp
https://economictimes.indiatimes.com/definition/capital-market
https://www.investopedia.com/terms/c/capital-funding.asp
https://www.investopedia.com/terms/d/debtinstrument.asp
https://www.investopedia.com/terms/d/debtfinancing.asp
https://www.investopedia.com/terms/e/equityfinancing.asp
https://www.investopedia.com/terms/c/capitallease.asp

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