Three Key Questions for Long-Term Financing

Long-term financing involves securing capital for an extended duration, typically exceeding one year. This type of funding is generally utilized for substantial investments, such as acquiring significant assets, undertaking large-scale projects, or funding business expansion initiatives. Financial managers play a strategic role in these decisions, carefully evaluating options to ensure the business has the necessary resources for sustained growth and stability. Their choices influence the company’s financial structure and capacity to pursue future opportunities.

Optimal Cost of Capital

A primary consideration for financial managers is determining the optimal cost associated with long-term financing. This involves evaluating various capital sources, including debt, equity, and retained earnings, each carrying distinct cost implications. Debt financing, such as term loans or corporate bonds, incurs interest expenses that are generally tax-deductible for the business, effectively reducing the net cost of borrowing.

Equity financing, through the issuance of common or preferred shares, does not involve interest payments but carries the expectation of returns for investors, often in the form of dividends. Unlike interest on debt, dividends paid to shareholders are not tax-deductible expenses for the company. Retained earnings, which are profits reinvested into the business, represent an internally generated source of capital with an implicit cost related to the foregone opportunity of distributing those earnings to shareholders. Financial managers aim to achieve a Weighted Average Cost of Capital (WACC), which represents the average rate a company expects to pay its capital providers, reflecting the proportional cost of its debt and equity financing.

Impact on Control and Risk

Another fundamental question financial managers address is how a financing decision will affect the company’s control structure and financial risk profile. Equity financing, particularly through issuing new common stock, can dilute the ownership stake of existing shareholders, potentially diminishing their control over the company. Conversely, debt financing generally avoids ownership dilution but introduces increased financial leverage. This means the company takes on fixed obligations for interest payments and principal repayment, which can elevate the risk of financial distress or bankruptcy if earnings are insufficient.

Lenders often impose debt covenants in loan agreements, which are conditions that restrict or guide the borrower’s business activities to protect the lender’s interests. These may include maintaining specific financial ratios or restricting certain actions like taking on additional debt or paying excessive dividends. Adherence to these covenants is continuously monitored, and a breach can lead to penalties or even default.

Flexibility for Future Needs

Financial managers also consider whether a chosen financing method provides sufficient flexibility for future growth and unforeseen circumstances. The repayment terms of long-term debt, for example, can vary significantly. Longer repayment terms can lead to lower monthly payments, which helps preserve cash flow, but they also mean higher overall interest costs over the life of the loan. Structured repayment schedules provide predictability, aiding in cash flow management.

Some financing instruments, such as convertible debt, offer embedded flexibility. Convertible bonds, for instance, begin as debt instruments with regular interest payments but can be converted into a predetermined number of shares of the issuing company’s common stock. This option provides investors with the security of debt while allowing them to participate in potential stock price appreciation. For the company, it can be a way to raise capital with a lower initial interest rate and defer equity dilution until a later, potentially more favorable, time. However, any financing agreement, particularly those involving restrictive covenants, must be carefully reviewed to ensure it does not unduly limit the company’s ability to pursue new investment opportunities, adapt to changing market conditions, or raise additional capital in the future.