Financing can be called a procedure of advancing funds for business activities, or investing. As a rule, there are monetary institutions that furnish capitals to enterprises, consumers and financiers. Thereby, these market actors pursue their own aims. The method of financing is considered as an important one in the economic realm, whereas the enterprises are able to acquire goods directly.
In a similar vein, financing means a way to take advantage of time value of money (TVM), in order to pay for the started initiative using expected profit. Of course, the process cannot be represented without individuals having extra financial resources, which they are willing to put into operation for earning a profit. Whilst there exists a certain number of people interested in investment activities directed to the same end.
Types of Financing
Considering enterprises, the financing division often includes two types:
- Debt Financing. This variant anticipates a loan that, in the majority of cases, has to be returned with interests. Anyway, it’s still less costly than capital raising because of the tax deduction. Let’s provide an example to illustrate the concept. Population usually understands the essence of this term, as many take out mortgages. By doing so, debt financing should be discharged by individuals. Bank, acting as a loan supplier, thus receives interest. Moreover, businesses can raise debt financing by issuing bonds. For instance, in addition to bonds circulating on the Russian securities market, large Russian enterprises have the opportunity to issue so-called Eurobonds, which are traded on the financial markets of Western Europe. Eurobond issuance requires a lot of preparatory work, but it is more than compensated by the ability to attract a significant amount of financing at very reasonable interest rates.
- Equity Financing. According to this variant, an ownership of the enterprise is expected.The type contemplates the investor contributing financial resources or other property, or buying shares of the enterprise and receiving the right to have a certain amount of future profits (dividends). The share size is determined by the contribution to the authorized capital or the number of shares acquired. Thus, some individuals are pleased, when the share price rises, others prefer secure investment and seek for stable dividends.
So that, by understanding the essence of the above-mentioned financing types, we are able to single out its pros and cons.
Advantages of Debt Financing:
- Interests for paying a debt aren't subject to tax.
- Capital lender cannot control the enterprise, as it doesn’t have an ownership right.
- The completion of a relationship with a debt facility provider happens after returning the loan.
Disadvantages of Debt Financing:
- Recession may cause troubles in taking loans, especially in case of having small entrepots.
- This model isn’t suitable for startups as including debt payments to the monthly expenditures means getting low profit or its absence.
Pros of Equity Financing:
- There is no need to refund money. As long as you’re on the brink of bankruptcy, the depositor ceases to be a creditor, and along with you, suffers losses.
- Calculation is made for the long term. No need to worry, whether a product achieves success in a short time period or not.
- The necessity to provide a monthly payment is eliminated. Therefore, there are financial resources for operational costs.
Cons of Equity Financing:
- Investor consultation is a mandatory step before making any enterprise-related decisions.
- Renunciation of shares in favor of a new partner is expected. The higher risks the company carries, the greater percentage will be given to the funds provider.
Features of Financing
Of course, it should be noted that there is a special indicator that reflects the cost of enterprise financing, taking into account the structure of its capital. It’s called the weighted average cost of capital, or, in short, WACC. In other words, WACC can be considered as the interest rate, the minimum return that an enterprise must generate on its existing capital in order to meet the expectations of all the investors. And the higher the WACC rate is, the more revenue the company has to make to cover it.
This financing indicator is calculated, according to the following formula:
where the metrics signify:
Re - average equity cost of an enterprise;
Rd - debt cost of an enterprise;
E - estimated market price of the enterprise’s equity;
D - estimated market price of the enterprise’s debt;
E/V - financing interest of an equity;
D/V - financing interest of an equity;
Tc - corporate tax rate.
Financing in real life
Let’s consider the preceding information and exemplify the essence of financing activities. Equipment production for the oil and gas industry contemplates a specific environment for assembling the needed parts to meet the customer’s demands. So that the enterprise C. is able to hire new employees for increasing an output and marketologists for promoting and expanding a target audience.
For these aims the factory C. needs capital, amounting to $25 million. Capital mobilization can be carried out in two ways: via debt, or equity financing. The owners are able to receive funds of $25 million in exchange for a 25% stake in the equity-funded enterprise. An investor could have 25% of the business and is entitled to make management decisions along with the holders.
In other cases, if the owners aren’t willing to trade their proprietorship, a debt financing will be an option. Holders can apply to the bank for a $25 million loan at 4% interest, which they must repay within three years.
Therefore, a decision in favor of a certain variant is entirely up to the owner and the financial state of the enterprise.