External funding is a highly variable figure for the United States corporate sector. Acme can raise its funds from sources outside of the company. There are various types of external financing which the company may use. These sources include debt financing, equity financing, cash flow lending and corporate bond and debentures (Schulz & Wasmeier, 2008). Megginson & Smart (2000) say that external funding is extremely unpredictable in the United States because of the market trends and lending rates. The use of external financing involves high legal and transaction costs. The company should note that the outstanding nature of external funding needs of Acme means that $500M will be exceedingly variable from year to year for the company (Megginson & Smart, 2000).
Sources of external funding
Acme can obtain external financing from debt financing which means borrowing money. Schulz & Wasmeier (2008) says that in the course of debt financing, in return the creditor will receive the promise that the principal and interest on the debt will be repaid by the company. The interest rate to be paid by Acme characteristically includes the so called market rate of interest rate plus a risk premium because Acme is a well established company and certain will be collaterals used to secure the debt. Acme will pay its interest rate depending on the maturity of the loan and the volume of the loan. Apart from specific loan agreements such as mutual or syndicated loans, common types of debt financing that Acme can use includes overdraft funding, and loans against asset (Schulz & Wasmeier, 2008).
Merson (2011) noted that debt finance will allow Acme to raise cash without giving any share capital or equity. This type of external financing can balance interest payments against tax and therefore there is a good reason to expect debt finance to be relatively cheap. Merson (2011) noted that in theory debt finance has a lot in its favor. However in practice, it may not be easy to obtain. Banks lend their money in return for interest. There are several types of debt finance which include overdraft and obtaining loans against assets.
Overdraft funding is uncertain for the bank and Acme. This is because an overdraft can be called in at any time, hence it is a high-risk strategy for the multinational to rely on it for longer-term financing (Merson, 2011). From Acme’s point of view it will pay high interest rates to reflect the risk. Obtaining financing through loans against asset is the most common way a bank can make sure that its position is protected. This implies that if Acme goes under, the bank can lay claim to and sell the asset against which it had secured the debt (Merson, 2011)
Cash Flow Lending
The second type of external financing that can be used by Acme is cash flow lending. Since Acme is an established company with a good track record, the firm can take advantage of cash flow lending. Merson (2011) noted that “in this type of financing, instead of taking security against specific assets, a bank relies on the cash flow that the business expects to generate” (p. 124). In this context, the bank will look for safeguards in the form of guarantees based on such measures as profitability, enterprise value and ratios comparing profit with interest. If the agreements are breached, the bank has the right to recall the loan (Merson, 2011). One disadvantage of this type of financing is that the bank generally puts measures in place that allow it to take control of the company’s cash flow if it defaults on loan repayments. Its advantage is that cash flow lending is more focused than asset based lending on the ability for a business to repay its debts (Merson, 2011).
Corporate Bond and Debentures
Acme can also obtain financing through corporate bond and debentures. Merson (2011) mentioned that a corporate bond or debenture is long-term debt instrument with a maturity date, a redemption value and a coupon. Acme’s bonds will be traded on markets. Merson (2011) noted that the market’s discernment of the riskiness of the debt is mirrored in its market price, which in turn affects the real interest rate earned by the obtainer of the bond. The main disadvantage of this form of financing is that bond markets are regulated, and sourcing money in this way can be costly, and consumes more management time. Its advantage is that a corporate bond will enable Acme to access financing without the help of a bank. This might allow Acme to raise money for a lower interest rate. Merson (2011) says that this type of financing may allow Acme to put its debt out for a longer period than a bank might be prepared to countenance.
The fourth type of external financing that can be used by Acme is equity financing. In the United States this is known as stock ownership. Merson (2011) says that equity financiers of Acme will not be comfortable with security but they look instead at the robustness of the offer, the quality of the prospect, the return it will generate and the company’s ability to repay the investment. Through equity financing, Acme is likely to incur high cost of capital than a debt financing and will likely cause a drop in earnings per share for the company and in turn unenthusiastically impact the company’s share price (Stowell, 2010).
The equity financing option will strengthen the company’s balance sheet and may lead to a higher bond rating from a credit financing agency. This may result in lower future bond financing costs and higher long term value for the company (Stowell, 2010). Debt financing usually has a lower cost of capital, but may weaken Acme’s balance sheet and reduce financial flexibility. Acme and its banker must consider the risk adjusted cost of debt when comparing this form of financing with an equity financing. Equity financing and cash flow lending are the best options for Acme. Cash flow lending is the best option is because it is more centered than asset based lending on the capability of the company to repay its debts.