SOURCES OF LONG-TERM FINANCING

A. DEBT FINANCING

Advantages:

1. Basic control of the firm is not shared with the creditor.

2. Cost of debt is limited. Creditors usually do not participate in the superior earnings of the firm.
3. Interest paid is tax deductible, thereby reducing cost of capital.
4. The financial obligations are clearly specified and of a fixed nature.

Disadvantages:

1. Since debt requires a fixed charge, there is a risk of not meeting this obligation if the earnings of the firm
fluctuate.
2. Debt adds risk to a firm.
3. Debt usually has a maturity date.
4. Debt is a long-term commitment, a factor that can affect risk profiles.

B. EQUITY FINANCING - major source is common stocks and retained earnings.

Advantages of common stock as source of funds:

1. Common stock does not require a fixed dividend - dividends are paid from profits when available.
2. There is no fixed maturity date for repayment of the capital.

Disadvantages of common stock as source of funds:

1. As more shares are sold, the stockholders’ control (voting rights) and share in earnings are usually diluted.
2. Common stock cash dividends are not tax deductible.

C. HYBRID FINANCING - sources of funds that possess a combination of features; these include preferred stock, leasing,
and option securities such as warrants and convertibles.

Preferred Stock - a hybrid security because some of its characteristics are similar to those of both common stocks and
bonds. Legally, like common stock, it represents a part of ownership of equity in a firm. However, as in bonds, it has only
a limited claim on a firm’s earnings and assets.

Features of Preferred Stock Issues

A. Priority to assets and earnings - the claims of preferred stockholders must first be satisfied before the common
stockholders receive anything.
B. Preferred stocks always have par value, which is important in determining the amount due to Preferred
Stockholders in case of liquidation and in computing the preferred dividends.

Disadvantages

1. Preferred dividends are not tax deductible, hence, cost for the company is higher than that of bonds.