Question

How does a company utilize stocks and bonds in financing growth? Identify the major sources of external financing for companies.

Answer 1

An optimal capital structure is extremely crucial for an corporation to maximise the wealth of its shareholders.

The various sources of capital available to fund growth projects are equity shares, retained earnings, debt and preferred stock. Everytime a company wants to invest in a new project, it must decide the source of investment it wants to use to fund that project. Some of the factors that companies look at to decide the source for financing growth projects are as follows:

• Expected return on investment from the project
• Comparative cost of capital for different sources of finance (cost of debt, cost of equity, etc)
• Operating risk of the project
• Existing debt to equity ratio and the impact the new financing (under different alternatives) would make to it
• Prevailing situation in the secondary markets. For e.g.- if markets are in a downturn, the company may not be comfortable going for an IPO/FPO/Rights issue

Equity vs Debt

Generally if return on capital is good and existing debt to equity ratio is at comfortable levels (given the operating risk in the business), the company would prefer to finance growth through debt as it has lower cost of capital than equities.

However, if the existing leverage is high or the growth project is risky with lower return on capital, the company would want to fund growth through equities in order to keep the financing risk under control

Major sources of external financing

All sources of finance other than retained earnings are external sources. Let's take a look at major sources below:

• Equity: It includes private equity, angel funding, Venture capital, IPO, FPO, rights issue, etc
• Bank loans such as Project financing, term loans, working capital loans, overdraft facilities, etc
• Issue of fixed income securities, such as debentures, term deposits, bonds, zero-coupon bonds, etc
• Preferred stock
• Finance lease which can be used to fund capital investment in the growth projects. For e.g- Buildings, machines, etc can be taken on finance lease and used in the project