Financial Burden on the Firm

Retained Earnings.

Common stock.

People who purchase common stock seek profit in the forms of both dividends and appreciation. Overall, shareholders hope for an increase in the market value of their stock because the firm has profited and grown. By selling shares of stock, the company gets the funds it needs for buying land, buildings, and equipment.

It should be noted that the use of equity financing via common stock can be expensive because paying dividends is more expensive than paying bond interest. Why? Because interest paid to bondholders is a business expense and, hence, a tax deduction for the firm. Stock dividends are not tax-deductible.

Another approach to equity financing is the use of retained earnings. Retained earnings are profits not paid out in dividends. The use of retained earnings means that the firm will not have to borrow money and pay interest on loans or bonds.

A firm that has a history of eventually reaping much higher profits by successfully reinvesting retained earnings may be very attractive to some investors. However, more retained earnings means smaller dividends paid to shareholders, which may decrease the demand for - and thus the price of - the company's stock.

If equity funding can be so expensive, why don't firms rely entirely on debt financing? Because long-term loans and bonds carry fixed interest rates and represent a fixed promise to pay, regardless of changes in economic conditions. If the firm defaults on its obligations, it may lose its assets and even go into bankruptcy.

When borrowers increase their indebtedness to make other investments, they are said to be more highly leveraged, and they have a higher risk of default.

Because of the risk of default, debt financing appeals most strongly to companies in industries that have predictable profits and cash flow patterns. The additional source of equity financing is venture capital. Venture capital refers to funds invested by outside investors in new, small, or struggling businesses with potential for rapid growth in exchange for an ownership share in the business.

Hybrid Financing: Preferred Stock

A middle ground between debt financing and equity financing is the use of preferred stock. Preferred stock is a hybrid because it has some of the features of corporate bonds and some of the features of common stocks. As with bonds, payments on preferred stock are for fixed amounts - for example, $ 6 per share per year. Unlike bonds, however, preferred stock never matures but can be held indefinitely, like common stock. In addition, preferred stocks have first rights (over common stock) to dividends.

A major advantage of preferred stock to the issuing corporation is its flexibility. Because preferred stockholders have no voting rights, preferred stock secures funds for the firm without relinquishing control. Furthermore, preferred stock does not require repayment of principal or the payment of dividends in lean times.

Дата добавления: 2015-01-03