Achieving the objectives of a corporate placement hinges on the appropriate financing of any corporate investment. Typically, financing sources include capital generated by the corporation itself and capital obtained from external funders through the issuance of new debt and equity (including hybrid or convertible securities). The financing mix impacts the company's valuation, influencing both hurdle rates and cash flows, thereby affecting the corporation's risk profile. Here, two interrelated considerations arise:

  1. Optimal Mix of Financing: Management must identify the "optimal mix" of financing – the capital structure that maximises firm value while considering additional factors. Financing a project through debt results in a liability that requires servicing, impacting cash flow independent of the project's success. Conversely, equity financing poses less risk regarding cash flow commitments but results in dilution of share ownership, control, and earnings. The cost of equity is typically higher than the cost of debt, which is additionally a deductible expense. Consequently, equity financing may lead to an increased hurdle rate, potentially offsetting any reduction in cash flow risk.

  2. Matching Long-term Financing Mix: Management must closely match the long-term financing mix to the assets being financed, in terms of both timing and cash flows. Managing potential asset-liability mismatches or duration gaps entails aligning assets and liabilities according to maturity patterns (cash flow matching) or duration (immunisation). Managing this relationship in the short term is a key function of working capital management. Additional techniques such as securitisation or hedging using interest rate or credit derivatives are also common.

Much of this theory falls under the Trade-Off Theory, where firms balance the tax benefits of debt with the bankruptcy costs of debt when allocating resources. Alternative theories about capital fund management include:

  • Pecking Order Theory (Stewart Myers): Firms avoid external financing when internal financing is available and avoid new equity financing when they can engage in new debt financing at reasonably low interest rates.

  • Capital Structure Substitution Theory: Management manipulates the capital structure to maximise earnings per share (EPS).

  • Right-financing: Investment banks and corporations enhance investment returns and company value over time by determining optimal investment objectives, policy frameworks, institutional structures, financing sources (debt or equity), and expenditure frameworks within given economic and market conditions.

  • Market Timing Hypothesis: Inspired by behavioural finance literature, this hypothesis states that firms seek the most cost-effective type of financing regardless of current levels of internal resources, debt, and equity.

Sources of Capital:

  1. Debt Capital: Corporations may rely on borrowed funds (debt capital or credit) to sustain ongoing business operations or fund future growth. Debt can take various forms, including bank loans, notes payable, or bonds issued to the public. Bonds necessitate regular interest payments (interest expenses) until maturity, at which point the obligation must be repaid in full. Debt payments can also be made via sinking fund provisions, where annual instalments of borrowed debt are paid above regular interest charges. Callable bonds allow corporations to repay the obligation in full whenever it is in their best interest. If interest expenses cannot be met through cash payments, collateral assets may be used to repay debt obligations or through liquidation.

  2. Equity Capital: Corporations can sell shares to investors to raise capital. Investors expect an upward trend in the company's value over time, making their investment profitable. Shareholder value increases when corporations invest equity capital and other funds into projects that earn a positive rate of return. Investors prefer companies that consistently earn a positive return on capital, increasing the market value of the company's stock. Shareholder value can also increase when corporations payout excess cash surplus in the form of dividends.

  3. Preferred Stock: Preferred stock is an equity security with features not possessed by common stock, combining properties of both equity and debt instruments, and is considered a hybrid instrument. Preferred shares are senior to common stock but subordinate to bonds regarding claims on assets. Preferred stock usually carries no voting rights but may include dividends and priority in dividend payments and liquidation. Terms are detailed in a "Certificate of Designation."

    Similar to bonds, preferred stocks are rated by major credit-rating companies. Preferred shares generally receive lower ratings as preferred dividends lack the guarantees of bond interest payments and are junior to all creditors.

    Preferred stock typically features:

    • Preference in dividends

    • Preference in assets upon liquidation

    • Convertibility to common stock

    • Callability at the corporation's option

    • Non-voting rights