FINANCING A COMPANY
The financing structure of a company is not static. It changes over time in response to the business needs of the company and the relative costs of different types of financing. The financing structure of a closely held company may also often change in response to the needs of its shareholders. The amount of funding a company needs will be determined by the business needs of the company from time to time. If a company seeks to expand its business for which it requires new manufacturing equipment but does not have the money to pay for the required machinery, for example, it will need to fund the acquisition of the machinery. The type of financing arrangement used to obtain the required funding will largely be determined by the relative costs of different types of financing. It is assumed that
Y a company run for profit will seek to minimise the cost of funding its business operations as part of its endeavour to maximise profits. If this is correct, all other things being equal, the structure of a company’s financing will change over time in response to one type of finance becoming less expensive than another. All other things being equal, when interest rates are high, we would expect to see a company that has borrowed a lot of money at an interest rate that varies with market rates seeking to refinance its debt, possibly by raising money from the issue of shares and using that money (equity financing) to reduce its borrowings (debt financing). The cost of funding is a combination of the sums payable to the provider of the funding, such as interest payable to a bank pursuant to a bank loan, and the administration costs of setting up and managing the relationship with the funding provider (referred to as ‘transaction costs’), such as lawyer’s fees for advice and drafting contracts, and other expenses incurred to ensure compliance with applicable laws and regulations. What appears to be a cheap source of funds may turn out to be an expensive funding option if the transaction costs to access it are high. The interest rate payable on money borrowed from a bank or banking syndicate may be higher than the rate payable on money borrowed from members of the public, yet the costs of entering into debt arrangements with the public, typically by the issue of debenture stock, are high. Once transaction costs are taken into account, the bank loan may be the less expensive funding option. A third factor, critical in assessing the relative cost of funding options, is the impact of the proposed financial arrangements on the tax position of the company. The growth of lease financing in the period up to the mid-1980s was driven by tax incentives which made lease financing a relatively inexpensive type of financing arrangement. Corporate tax is a complex subject on which companies seek advice from highly specialised accountants and lawyers. Extremely complicated financing arrangements are often put in place because they are ‘tax efficient’. Even for small, family owned companies, tax efficiency is a significant factor affecting the company’s financing arrangements. The aim in such cases will not necessarily be to minimise the taxes payable by the company, but to arrive at the most tax efficient position for the sole or major shareholders. This involves consideration of the taxes payable by both the company and the shareholder. The financing arrangements of a large listed company are likely to be far more complex than those of a small, closely held company, yet the basic legal framework of corporate financing explained here is the same for all companies limited by shares.