Michael Taillard - Corporate Finance For Dummies

Unlike liabilities, equity represents ownership in the company. So, if a company owns $100,000 in assets and $50,000 was funded by loans, then the owner still holds claim over $50,000 in assets, even if the company goes out of business, requiring the owner to give the other $50,000 in assets back to the bank. For corporations, the equity funding varies a bit, however, because the owners of a corporation are the stockholders. The equity funding of corporations comes from the initial sale of stock, which exchanges shares of ownership for cash to be used in the company.

The rest of this chapter discusses the two main ways businesses raise capital.

When a corporation needs money, one of the primary options it has available is to borrow some. Now, I’m not talking about borrowing a few hundred bucks from a friend or family member; I’m talking about borrowing an amount of money sufficient enough to fund the startup of a new company, the expansion of an existing company, the purchase of expensive equipment, or the acquisition of another company. Loan requests are very much defined by the numbers being presented to lenders. How much are you asking, what percentage of the total are you providing yourself, what is the business's history of revenues, how likely are you to repay the debt, and so on. The story you tell here must be entirely nonfiction, written strictly in numbers.

Regardless of what the money’s for, when a corporation wants a loan, it starts by putting together a proposal. For startup companies, this proposal comes in the form of a business plan, but anytime a corporation receives a loan significant enough to influence the capital structure of the company (not lines of credit), it has to present a proposal for the use of the funds. This proposal includes financial information about the corporation, including detailed predictions for future financial well-being, called projections, that prove the company can pay back the loan on time and without risk of default. For more information about business plans, which you can use in many forms of proposals, you may want to read Business Plans For Dummies (Wiley Publishing, Inc.) by Paul Tiffany, PhD, Steven D. Peterson, PhD, and Colin Barrow .

The following sections explain what a corporation must do after its proposal is ready to go, including where to go to ask for money and how to evaluate the worth of a loan and its terms.

After the proposal is in place, corporations have a few options for where to go to ask for the money they need:

Commercial banks: Banks are very common sources for corporate debt financing. These loans work very similar to any other loan, wherein your ability and planned use of the funds will both be evaluated in detail before the bank agrees to offer the loan. The findings of their investigation will determine, in part, the interest rate they will charge, the amount they will loan, and the duration of the loan.

Government loans: These loans are frequently available, but they’re often reserved for special types of corporations (usually in a field that the government is trying to promote), corporations with a special role in the nation (such as defense contractors).

Issuance of bonds: Bonds, which basically act as IOUs, are possibly the most popular form of debt financing. A company goes through an underwriter to have bonds issued, and then private investors purchase those bonds. The company keeps the money raised as capital with a promise that it’ll pay back the bondholders’ money with interest. Bonds come in many different flavors; turn to Chapter 11for more details.

After a potential moneylender receives the corporation’s loan application, an interview process typically occurs, along with an underwriting process during which the potential lender assesses the borrower for risk, financial ability to repay the loan, credit history, and other variables. If the lender approves the loan application, the money is deposited in the corporation’s bank account, making it available for use by the corporation in a manner consistent with the original proposal.

The responsibility for making sure a particular loan is beneficial to a company lies with that company. Every loan, except for those rare federally subsidized loans in which the government pays for the interest, incurs interest, meaning you and your company pay more money back to the lender than the lender originally gave you.

Here’s a quick look at how interest works:

This equation says that the balance ( B ) is equal to the principal amount ( P ) times the rate ( r ) exponentially multiplied by time ( t ). So, if your company borrowed $100 at an interest rate of 10 percent for one year without making any payments, then the amount of money your company owes at the end of that one year looks like this:

The answer, then, is $110 (because $10 is 10 percent of $100 and interest is accrued annually for only one year).

When accepting a loan, the goal of every company is to make absolutely sure that it can generate more returns from spending the money borrowed than the interest rate being charged. After all, by keeping the loan, the corporation agrees to pay back interest as well as the principal. So, if your company spends the money it borrowed in the preceding example on a new machine, it has to generate more than 10 percent profitability from that single machine in order to make the loan worth the 10 percent interest rate. This is a simplified example that doesn’t take several real-world variables into consideration, but before you consider more realistic examples you need to learn about some additional topics.

If a company absolutely must raise capital but can’t generate enough value to pay back the interest rate, it’ll end up losing money on the loan. As a result, it might want to pursue an alternative option for raising capital, such as selling equity.

You have a few different options available when choosing a loan for your company. To make the best choice for your company, you need to be aware of the pros and cons of each loan type. If you’re not sure which one is best for you, ask a professional analyst — not the person trying to sell you the loan. Here are some terms you need to be aware of:

Fixed versus variable rate: When you take out a fixed-rate loan, the percentage interest you pay will always be the same. For example, if you take out a loan with 5 percent APR (annual percentage rate, which is your annual interest rate), then you will always be charged 5 percent interest per year. With a variable rate loan, the interest rate you pay will change; the amount of change depends on the type of loan. Variable rate loans come in many types, and their rates change based on another interest rate, a stock market index, your income, or some other indicator. Some increase gradually over time, while others start low and jump after a period of time (these are called teaser-rates ). While the wide variety of variable rate loan options is great news for the financially inclined, these types of loans can be very dangerous for beginners. The amount of information and the calculations involved in predicting the movement in variable interest rates can be a deceptively daunting task, even for experienced analysts.