Financing

Financing is the provision of funds to a firm so they can expand their activities based on the promise that the funds will be paid back with interest or the financier will acquire a stake in the firm. There are two main agreement under which the financing is provided:

  • Debt Financing: The funds are provided to the firm under the condition that they will be paid back with interest by a certain date.
  • Equity Financing: The funds do not need to be paid back by the firm bit the financier acquires a stake (equity)in the firm and receives a share of the firms profits.[1]

Debt Financing

Under a debt financing model, a firm would approach a lending institution such as a commercial bank and request a certain amount of funds in order to expand the operations of their company. If a firm wanted to expand the size of their wind farm or solar array, the firm could seek debt financing in order to have the money to invest in the expansion. If the firm expanded its operations and increased its profit accordingly, the firm would pay back the amount borrowed with interest by the date set when the funds were borrowed.

One downside of the debt financing model is that is borrowing terms can be very tough, if there is a very high interest rate or short payback period, then firms will be less likely to borrow because they might not be able to make the repayment in time or be able to afford the interest payments. A firm will weigh the expected profits from an expansion against the terms of the debt to determine if it is a viable option.[2]

For example, a firm would borrow a certain amount of funds at a 3% interest rate and 5 year term but if the interest rate was higher or if the term was shorter, then the firm might not be able to access that financing as they could not generate enough revenue to make payments.

Equity Financing

Equity financing is the other major way that firms can acquire financing. Instead of taking on debt, a firm will sell a portion of its control to the financier. This method has both pros and cons. While it is less risky than the debt model because the firm does not have to worry about paying back the funds, under an equity agreement, the firm looses some of its control to the financier. In this scenario the financier bears all of the risk because they only receive profits in return and if the firm fails to perform then profit will not be generated and the financier will be out of luck.[1][3]

If a firm sells a 20% stake to acquire financing for an expansion project then the financier who buys that stake can contribute to the decision making process within the firm. In some cases this can be a bad thing for the owner of the firm as the financier might not agree with the owner and cause trouble. Often, firms and the owners of such will reserve the majority share of the firm to ensure that they cannot be overridden by investors who buy stakes in the firm. These owners will often sell 49.9% of the firm in order to raise as much funding as possible while still controlling the decision making process.

Low Risk

Investors will be attracted to firms that have a low risk of defaulting on a loan, an investor wants to make their money back an will seek to minimize the risk and maximize the profit from a financing scheme. Companies that generate renewable energy often have purchase power agreement that guarantee the price of their product and as a result ensure a certain level of profit to investors. Investors will be more attracted to theses firms as they are less susceptible to fluctuations in the price for their electricity and will generate a minimum level of profit, thus reducing the uncertainty and risk.[4]

References

  1. 1.0 1.1 Investopedia. "Financing." [Online], Available: http://www.investopedia.com/terms/f/financing.asp [Sep 11, 2016].
  2. R. A. Brealey and S. C. Myers. Principles of Corporate Finance. USA: Irwin McGraw-Hill, 2000, pp. 475.
  3. R. A. Brealey and S. C. Myers. Principles of Corporate Finance. USA: Irwin McGraw-Hill, 2000, pp.8.
  4. Verbruggen, A., W. Moomaw, J. Nyboer, 2011: Annex I: Glossary, Acronyms, Chemical Symbols and Prefixes. In IPCC Special Report on Renewable Energy Sources and Climate Change Mitigation [O. Edenhofer, R. Pichs- Madruga, Y. Sokona, K. Seyboth, P. Matschoss, S. Kadner, T. Zwickel, P. Eickemeier, G. Hansen, S. Schlömer, C. von Stechow (eds)], Cambridge University Press, Cambridge, United Kingdom and New York, NY, USA.

Authors and Editors

Lyndon G., Jason Donev
Last updated: September 17, 2016
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