Question

Explain each of the major financing mechanisms found in financial systems. (typed)

Answer 1

Major financing mechanisms:

Equity financing involves funding through retained earnings , equity capital and issuing shares to raise funds. Cost of equity is usually higher and flotation cost is involved while issue of shares. Companies who go for equity financing go for an IPO. It involves financing by providing partnership or shares to the investors. Angel investors are form of equity financing at the start of business and as the business grows financing is done through IPO(Initial Public offering) and through other forms like convertible preferred stock which converts to ordinary shares after some time.

Debt financing involves bond issue or loans from banks. It is cheaper form of financing but increases risk of the firm. The cost of debt is less because interest on debt payments are tax deductible. Debt reduces the overall cost of capital thereby increasing the firm value. Here the firm has to pay coupons as per conditions laid down by the bond agreement or pay interest and principal as per the terms of the loan.
Benefits of Equity financing:
1. The dividends need not be paid regularly by the firm and can be paid as per the requirements or capability of the firm.
2. It can be permanent in nature.
3. Firms can increase or decrease share price by buying back shares or issuing bonus or extra shares.

Benefits of debt financing:
1. Cost of debt is very low due to the tax benefit it provides.
2. It can be borrowed to the level that it can provide optimum cost of the capital.