4. Types of Financing

• Equity financing

• debt financing

• external financing

  • financial resources are raised via company owner deposits or stockholder equity or by loan capital provi-

    ded by creditors

• internal financing

  • money generated from business divestments, meaning the business uses its profits as a source of capital

• Mezzanine financing

  • a loan that gives the provider of the resources the right to convert the loan to equity interest in the company if it is not paid back in time and in full. It is trea-

    ted in the same way as equity on the balance sheet.

1. External financing with debt refers to funds that are provided for a certain time in return for a rate of interest. This type of arrangement is called a loan with the providers of the resources not being involved in the management of the company.

2. Accrued liability reserves come from the company’s own resources and can be used to finance needed current or future assets.

3. External financing with equity is important when a company is starting up or expanding. Capital required to finance assets is provided from outside the company by existing or new shareholders.

4. Funds from retained earnings as a combination of internal and equity financing refer to the surplus of financial resources flowing into the company from business activities and out of the company for goods used or dividend payments.

• obtain a right to

  • repayment of the capital they provide

  • payment of interest on this capital in agreed amounts and at agreed times

• greater security related to their loaned capital than equity investors

  • claims of creditors shall be settled first when bankrupty

  • require collateral as security for the loan, impose obligations to provide information, and often demand the personal liability of owners or partners of the firm.

• no benefit from profits

• often banks or financial institutions

1. Risk-sharing function: If the investment project fails, the creditor obtains the value of the security (collateral); the position of the creditor in this case is strengthened while that of the borrower and other creditors is weakened.

2. Incentive function: The collateral encourages the borrower to adopt certain behavior. Opportunistic behavior on the part of the borrower is less problematic for the creditor if they can be sure of receiving the value of the collateral; for the borrower there is less incentive to undertake risky actions if he is forced to surrender the collateral in the case that the contract comes to an end.

agreements and legal mechanisms, such as liens on movable property and rights, retention of title, and transfer of title for

security purposes as well as mortgages

• covenants or loan covenants.

  • typically included in a loan agreement and contain strict terms and conditions that have to be followed by the borrower.

  • impose lending conditions such as disclosure of financial information or restrictions of certain business activities that go beyond the fundamental entitlement to repayment of and interest on the capital made available.

• annual financial statements, in particular tax accounts, with explanations and profit and loss statements

• credit status or interim balance sheet at the time of the application

• audit reports by auditors or experts

• excerpts from registers (e.g., commercial register, land registry, cadaster)

• presentation of sales performance/trends, volume of orders, and investment activities

• a financial plan for the duration of the requested loan, or at least for the following few months after the loan application

• a schedule of the available collateral

• business-to-business agreement where a company is allowed to defer payment to a supplier for goods received until a later date. Often the credit supplier will give a discount for earlier payment

a down payment is provided by the buyer prior to receiving their goods or services and funding the full amount. The item is subsequently produced or the goods delivered.

movable assets belonging to a borrower are pledged in return for granting the borrower a short-term loan. Lombard loans can be granted against collateral pledged in the form of securities or commodities.

• long term, bond-like larger-scale form of debt issued with a certificate stating the amount of the security/collateral pledged

• can only be issued to top-rated borrowers

• lenders are usually financial intermediaries

• financing term is usually no longer than 15 years.

Common stocks, also called ordinary shares, entitle shareholders to all typical rights of company owners. Holders of preferred stocks or preference shares have preferential rights over the holders of common stocks. Typically, they are entitled to higher dividend pay-outs or are granted other financial rights. However, in turn, preferred stocks have restricted or no voting rights. Bearer instruments may be transferred by agreement and delivery; registered stocks only through registration in the share register

• finance company is the legal owner of an asset (lessor) during the duration of the lease but the user (lessee) has not only the operational control over the asset but also shares the economic risks and rewards of the underlying asset.

• lessee expects to meet the principal and interest payments of the lease from the cash inflow generated by the asset

  • avoids the need for up-front financing of the investment

• On expiry of the agreed basic rental term of the lease, the lessee typically buys theasset or must return the leased property or renews the lease

An operating lease is a lease agreement that is shorter than the operating life of

the asset

• The lease term is significantly less than the economic life of the asset

• The lessee can terminate the lease at short notice without a significant penalty

• The lessor usually provides the operating know-how and any related services such as insuring and maintaining the equipment

• No substantial transfer of risk and rewards to the lessee