Sources of Financing
A source or sources of financing relate to where a company receives money to fund its operations. A company can obtain funding from both internal and external sources.
Within the financial infrastructure, managers must make decisions about how a firm uses money and from where to obtain that money. Financial managers try to establish the optimal mix of capital from different sources, whether from liabilities or owner’s equity.
Corporations can also sell bonds to raise cash. Like commercial paper, a bond is a debt security.
Whereas commercial paper usually reaches maturity in 2 to 270 days, bonds have maturities that can range from one to thirty years.
Sell Commercial Papers
Commercial paper is a short-term debt security. As a lower-cost alternative to bank loans, large corporations often use the sale of commercial paper to provide short-term financing.
A large corporation might sell commercial paper with a face value of $1,000,000 and a maturity of 60 days. An investor with spare cash would buy the commercial paper at a discount to its face value, say $995,000. Once the commercial paper matures after 60 days, the company owes the investor $1,000,000.
The difference between the face value of the commercial paper and the discounted price at which it was sold is essentially an interest payment by the company.
Seek Bank Loans
A common way for a company to get additional funds is by borrowing money from a bank. Bank loans are an especially important source of funds for small businesses that are not large enough to take advantage of other external financing options.
Use Retained Earnings
A business can use cash generated by its sales (retained earnings) to finance its operations.
A growing company that can’t cover the cost of its investment needs with retained earnings (e.g., build a new factory, develop a new product) must seek financing from an external source.
Float Common and Preferred Stock
A firm can obtain external financing by floating common or preferred stock. When investors purchase newly issued shares of stock, they give the firm cash in exchange for partial ownership of the firm. Ownership shares can be sold to the investing public or sold to a small number of private investors.
What Are The Different Types Of Financial Instruments That Exist And Why Are There So Many?
the reason there are so many different types of financial instruments is that they all address different risks and have their own benefits and drawbacks. For example, there are stocks and bonds and options and commodities, foreign exchange contracts and more. As I said, they all address different things that different companies might need.
For example, an airline company might be worried about rising fuel costs, so they’ll be interested in buying barrels of oil, which is a commodity, or they’ll buy an option related to oil prices, which is a derivative. A company that’s worried that they have to sell products in different countries and those currencies might depreciate relative to the dollar might buy foreign exchange contracts. A company that needs cash now, but thinks interest rates might rise in the future and is worried about those interest expenses might issue a bond, which is long-term debt. Or a company that needs cash now, but doesn’t want to deal with interest rates might issue stock to its customers or to its new shareholders, which would bring in stock but not have any interest expense.
So, there’s all sorts of different reasons that they might use them all, but they all address slightly different needs.
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