Introduction to Corporate Finance

12: Raising Long-Term Financing

where:

Internally generated funding = Cash flow from operations

= (Net income) + Depreciation + (Other non-cash charges) – Dividends

The external financing decision is not simple, however. Management may want to build up or reduce

net working capital over time, and besides, its dividend policy is not fixed, except in the very short term.

Additionally, there are higher legal and transactions costs to raising capital externally than to retaining

internally generated funds. Not surprisingly, the residual nature of external financing needs implies that

the amount required by a given company will be highly variable from year to year.

Internal cash flow is the dominant source of corporate funding in the United States, with businesses

regularly financing two-thirds to three-quarters of all their capital spending needs internally. Over time,

many other countries have also moved in the same direction. However, Chinese corporations still meet

well over half of their total financing needs externally, primarily through bank borrowing, largely because

they are growing faster than they can finance internally.

12-1c RAISING CAPITAL FROM FINANCIAL INTERMEDIARIES OR

ON CAPITAL MARKETS

Does it matter whether a company raises capital by dealing with a financial intermediary or by selling

securities directly to investors? Shouldn’t a bank’s money and an investor’s money be perfect substitutes?

In reality, a corporation’s choice between intermediated and security market financing significantly

influences its ownership structure. Before analysing this issue, we define a financial intermediary and

briefly describe what it does.

What is a Financial Intermediary, and What Does It Do?

A financial intermediary (FI) is an institution, such as a bank, that raises capital by issuing liabilities against

itself – for example, cheque accounts or savings accounts. The intermediary pools the capital that has

been raised and uses it to make loans to borrowers or, where allowed, to make equity investments in

other companies. Borrowers repay their loans to the intermediary and have no direct contact with the

individual savers who provided funds to the intermediary. In other words, both borrowers and savers deal

directly with the intermediary. Because of their role in serving both borrowers and savers, intermediaries

specialise in credit analysis and collection. They offer financial products tailored to the particular needs

of borrowers and savers.

The Role of Financial Intermediaries in US Corporate Finance

A general distrust of concentrated, private economic power has dramatically influenced US financial

regulation. Throughout most of the twentieth century, policymakers discouraged the growth of large

intermediaries (especially commercial banks), in part by imposing on them severe geographical

restrictions. Congress passed the McFadden Act in 1927 to prohibit interstate banking. The tide began to

change when enormous financial institutions formed overseas, making it more difficult for US institutions

to compete. After numerous failed attempts to repeal the McFadden Act, in July 2004, US Congress

finally approved a bill allowing full interstate branch banking. As a result, the number of US banks has

significantly declined, primarily through mergers.

The second pivotal law affecting American US markets was the Glass-Steagall Act, passed in 1933

in response to perceived banking abuses during the Great Depression. This legislation mandated the

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS

LO 12.2

financial intermediary (FI)

An institution, such as a bank,

that raises capital by issuing

liabilities against itself and

lending to borrowers

Glass-Steagall Act

US Congressional act of 1933

mandating the separation of

investment and commercial

banking (act repealed 1999)