How Corporations Raise CapitalThe large corporation has grown to its present size in part because it has found innovative ways to raise new capital for further expansion. Five primary methods used by corporations to raise new capital are:
Issuing bondsA bond is a written promise to pay a specific amount of money at a certain date in the future or periodically over the course of a loan, during which time interest is paid at a fixed rate on specified dates. Should the holder of the bond wish to get back his money before the note is due, the bond may be sold to someone else. When the bond reaches "maturity," the company promises to pay back the principal at its face value.
Bonds are desirable for the company because the interest rate is lower than in most other types of borrowing. Also, interest paid on bonds is a tax deductible business expense for the corporation. The disadvantage is that interest payments ordinarily are made on bonds even when no profits are earned. For this reason, a smaller corporation can seldom raise much capital by issuing bonds.
Sales of common stockHolders of bonds have lent money to the company, but they have no voice in its affairs, nor do they share in profits or losses. Quite the reverse is true for what are known as "equity" investors who buy common stock. They own shares in the corporation and have certain legal rights including, in most cases, the right to vote for the board of directors who actually manage the company. But they receive no dividends until interest payments are made on outstanding bonds.
If a company's financial health is good and its assets sufficient, it can create capital by voting to issue additional shares of common stock. For a large company, an investment banker agrees to guarantee the purchase of a new stock issue at a set price. If the market refuses to buy the issue at a minimum price, the banker will take them and absorb the loss. Like printing paper money, issuing too much stock diminishes the basic value of each share.
Issuing preferred stockThis stock pays a "preferred" dividend. That is, if profits are limited, the owners of preferred stock will be paid dividends before those with common stock. Legally, the owners of this stock stand next in line to the bondholders in getting paid. A company may choose to issue new preferred stock when additional capital is desired.
BorrowingCompanies can also raise short-term capital -- usually working capital to finance inventories -- in a variety of ways, such as by borrowing from lending institutions, primarily banks, insurance companies and savings-and-loan establishments. The borrower must pay the lender interest on the loan at a rate determined by competitive market forces. The rate of interest charged by a lender can be influenced by the amount of funds in the overall money supply available for loans. If money is scarce, interest rates will tend to rise because those seeking loans will be competing for funds. If plenty of money is available for loans, the rate will tend to move downward.
If the corporate borrower finds that it needs to raise additional money, it can refinance an existing loan. In this transaction the lender is essentially lending more money to its debtor. But if interest rates have gone up during the period since the original loan was secured, borrowers pay a higher rate in order to hold additional funds. Even if the rate has gone down, the lender benefits by having increased the size of its original loan at a lower rate of interest.
Using profitsSome corporations pay out most of their profits in the form of dividends to their stockholders. Investors buy into these companies because they want a high income on a regular basis. But some other corporations, usually called "growth companies," prefer to take most of their profits and reinvest them in research and expansion. Persons who own such stocks are content to accept a smaller dividend or none at all, if by rapid growth the shares increase in price. These persons prefer to take the risk of obtaining a "capital gain," or rise in value of the stock, rather than be assured a steady dividend.
The typical corporation likes to keep a balance among these methods of raising money for expansion, frequently plowing back about half of the earnings into the business and paying out the other half as dividends. Unless some dividends are paid, investors may lose interest in the company.