FRtR > Outlines > American Economy (1991) > From Small Business to the Corporation: The American Free Enterprise System > How corporations raise capital
An Outline of the American Economy (1991)
4/12 From Small Business to the Corporation: The American
Free Enterprise System
7/12 How corporations raise capital
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The 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 bonds
A 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 stock
Holders 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 stock
This 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.
Borrowing
Companies 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 profits
Some 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.
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