There are other factors that a company must consider when choosing between different methods of financing, including: its level of existing debt; the assets it has available to grant security over; any restrictions on its flexibility to borrow; its particular objectives; and current market conditions. These factors can affect the ‘cost of borrowing’, i.e. the size of the interest payments it will have to make to compensate a lender for the risk of giving the loan. Lenders may be unwilling to lend to riskier borrowers, or may only be willing to lend if those borrowers are willing to make high interest payments (lenders may feel that the risk is worth the potential for a high financial return).
- The extent to which a borrower has valuable assets over which security can be taken can determine whether (and if so, on which terms) a lender will be willing to lend.
- The amount of debt a company has already taken on may affect the viability of different methods of financing.
- If a company has a high ratio of debt in comparison to equity, this means it is ‘highly geared’ and indicates it may lack sufficient assets to support debt repayments if additional debt is taken on. Lenders may therefore perceive highly geared companies as more risky borrowers and consequently charge them higher interest rates (or even refuse to lend them capital).
- Demand: if the value of a company is low, or it lacks a high profile or strong reputation, it may be unable to sell a sufficient number of shares or bonds at a price high enough to raise the required level of capital.
- Market Conditions: during an economic downturn, businesses in general perform less well (in part due to a decrease in consumer spending). This can reduce the willingness of investors to lend money at viable interest rates or invest in shares due to the increased risk of businesses becoming insolvent or underperforming.
- Interest Rates: interest rates are typically higher for borrowers with lower credit ratings. This is because lenders may demand a higher premium to compensate them for the increased risk of the borrower defaulting. Therefore, debt financing may be less viable for companies with low credit ratings due to the potentially high cost of borrowing.
- Banks: issuing bonds may not be viable if investment banks are unwilling to underwrite the issue (which may be the case for firms with low credit ratings). In addition, banks may refuse to lend to firms lacking assets that can be used as collateral.
- Credit Rating Agencies: these assess the likelihood of organisations or sovereigns being able to repay their debts. If a company has a high credit rating, its debt is perceived as a less risky investment and the company can typically borrow at a lower interest rate as a consequence. The main agencies that rate the credit of organisations and sovereigns are Moody’s, Standard and Poor’s and Fitch.
Restrictions / Flexibility
- Existing debt agreements or a company’s Articles of Association may prohibit it from taking on further debt.
- Existing shareholders may not approve a new share issue (a rights issue), especially if the company’s earnings-per-share figure suggests that not enough profit is being generated to provide sufficient returns to all shareholders if additional shareholders are introduced. The company’s Articles of Association may also place some restriction upon share issues.
- If businesses wish to remain flexible, issuing shares or bonds may be preferable as the terms upon which loans can be obtained from banks may be more restrictive. This is not always the case however, depending on the terms of a bond or share issue.
- Articles Of Association: a document drawn up by the founders of a company at the time it is incorporated. It defines the duties, obligations, rights, powers and limitations of the company, directors, shareholders and other members.
- Rights Issue: where existing shareholders receive the option to purchase additional shares, usually at a discount, in proportion to their existing shareholding. This option enables companies to raise new capital whilst affording existing shareholders the opportunity to retain the proportion of ownership that they had held before the new share issue.
- If a business requires short-term funding or immediate access to capital, taking a loan or using cash reserves may be preferable to issuing equity or bonds, which in contrast is generally a long-term commitment and can take a long time to set-up.
By Jake Schogger - City Career Series