Chapter 19

Sources of Intermediate and Long-term

Financing: Debt and Equity

Sources of funds:
1. External
a. Debt
b. Equity
c. Hybrid
2. Internal
a. Operations

Debt Financing
A firm raises money for working capital or expenditures by selling bonds, bills or notes
to individual 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.

Benefits and Drawbacks of Debt

 Benefits
 Control: Taking out a loan is temporary. The relationship ends when the debt is
repaid. The lender does not have any say in how the owner runs his business.
 Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are
not.
 Predictability: Principal and interest payments are stated in advance, so it is easier to
work these into the company's cash flow. Loans can be short, medium or long term.
 Drawbacks
 Qualification: The company and the owner must have acceptable credit ratings to
qualify.
 Fixed payments: Principal and interest payments must be made on specified dates
without fail. Businesses that have unpredictable cash flows might have difficulties
making loan payments. Declines in sales can create serious problems in meeting loan
payment dates.
  Cash flow: Taking on too much debt makes the business more likely to have
problems meeting loan payments if cash flow declines. Investors will also see the
company as a higher risk and be reluctant to make additional equity investments.
 Collateral: Lenders will typically demand that certain assets of the company be held
as collateral, and the owner is often required to guarantee the loan personally.

Sources of financing available in business

1. Short-term – have a maturity of one year or less
2. Intermediate-term financing- have a maturities longer than 1 year but no longer
than 10 years
3. Long-term financing - have a maturities longer than 10 years

Term Loans
A term loan is a loan from a bank for a specific amount that has a specified repayment
schedule and either a fixed or floating interest rate.
3 common characteristics
1. They have maturities of 1 to 10 years.
2. They have repaid in periodic installments (quarterly, semi-annually or annual
payment).
3. They are usually secured by a chattel mortgage on equipment or mortgage on real
property.
Advantage of Term Loans
1. Higher loan limits
2. Straightforward budgeting
3. Lower interest rates
4. Manageable monthly payments
5. Limited total loan costs
Disadvantage of Term Loans
1. Requires higher credit
2. Requires demonstrated profitability
3. Requires a guarantee
4. Complicated process
Bonds or Long-term Debt
A bond is a written agreement or contract between an issuer and the holder that
requires the issuer to pay the holder the bond's par value or face value plus the stated amount
of interest.

Bonds classified according to collateral

1. Debenture bonds – Unsecured loan of the company. Since debentures have no collateral
backing, they must rely on the creditworthiness and reputation of the issuer for support.
2. Subordinated Debenture - is an unsecured loan or bond that ranks below other, more
senior loans or securities with respect to claims on assets or earnings. Subordinated
debentures are thus also known as junior securities.
3. Income Bonds - is a type of debt security in which only the face value of the bond is
promised to be paid to the investor, with any coupon payments paid only if the issuing
company has enough earnings to pay for the coupon payment.
4. Mortgage Bonds - is secured by a mortgage, or a pool of mortgages, that are typically
backed by real estate holdings and real property, such as equipment.
 First Mortgage bonds - a primary loan that pays for the property
 Second Mortgage bonds - made while an original mortgage is still in effect
 General Mortgage bond/Blanket -  a single mortgage that covers two or more
pieces of real estate
 Closed-end mortgage bonds - is a restrictive type of mortgage that cannot be
prepaid, renegotiated, or refinanced without paying breakage costs or other
penalties to the lender.
 Open-end mortgage bonds - allows the borrower to increase the amount of
the mortgage principal outstanding at a later time
 Limited open-end mortgage bond - bonds allow the issuance of additional bonds
up to a limited amount of the same priority using the same mortgaged property
as security.
5. Floating Rate or Variable Rate Bond - the interest paid to an investor adjusts over time

Retirement of Bonds
Refers to the repurchase of bonds from investors that had been previously issued. The
issuer retires bonds at the scheduled maturity date of the instruments. Or, if the bonds are
callable, the issuer has the option to repurchase the bonds earlier; this is another form of
retirement. Once bonds are retired, the issuer eliminates the bonds payable liability on its
books.
Equity Financing
 The process of raising capital through the sale of shares.
Ordinary shares - Also called common shares, are stocks sold on a public exchange. Each
share of stock generally gives its owner the right to one vote at a company shareholders'
meeting. 
Retained Earnings - is the amount of net income left over for the business after it has
paid out dividends to its shareholders. A business generates earnings that can be positive
(profits) or negative (losses).