Achieving the goals of a corporate placement requires that any corporate investment is financed appropriately. Generically, the sources of financing are capital generated by the corporation and capital received from external funders by issuing new debt and equity (and hybrid- or convertible securities). As above, since both hurdle rate and cash flows (and hence the riskiness of the corporation) will be affected, the financing mix will impact the valuation of the company. There are two interrelated considerations here:
Management must identify the "optimal mix" of financing – the capital structure that results in maximum firm value but must also take other factors into account. Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments but results in a dilution of share ownership, control, and earnings. The cost of equity is also typically higher than the cost of debt - which is, additionally, a deductible expense – and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset-liability mismatch or duration gap entails matching the assets and liabilities respectively according to maturity pattern ("Cashflow matching") or duration ("immunization"); managing this relationship in the short-term is a major function of working capital management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate risk.
Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how to allocate the company's resources. However, economists have developed a set of alternative theories about how managers allocate a corporation's finances. One of the main alternative theories of how firms manage their capital funds is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low-interest rates. Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One of the more recent innovations in this area from a theoretical point of view is the Market timing hypothesis. This hypothesis, inspired by the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt, and equity.
Sources of capital include:
Debt capital
Corporations may rely on borrowed funds (debt capital or credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public. Bonds require the corporations to make regular interest payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full. Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges. Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use collateral assets as a form of repaying their debt obligations (or through the process of liquidation).
Equity capital
Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in the value of the company (or appreciate in value) over time to make their investment a profitable purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects (or investments) that earn a positive rate of return for the owners. Investors prefer to buy shares of stock in companies that will consistently earn a positive rate of return on capital in the future, thus increasing the market value of the stock of that corporation. Shareholder value may also be increased when corporations payout excess cash surplus (funds from retained earnings that are not needed for business) in the form of dividends.
Preferred stock
Preferred stock is equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred shares are senior (i.e., higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company).
Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation."
Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferred shares is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.
Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:
- Preference in dividends
- Preference in assets, in the event of liquidation
- Convertibility to common stock.
- Callability, at the option of the corporation
- Nonvoting