Introduction to Corporate Finance

PART 1: INTROdUCTION

1-2b dEBT ANd EQUITY: THE TWO FLAVOURS OF CAPITAL

Companies have access to two broad types of capital: debt and equity. Debt capital includes all of a

company’s long-term borrowing from creditors. The borrower is obliged to pay interest, at a specified

annual rate, on the full amount borrowed (called the loan’s principal), as well as to repay the principal

at the debt’s maturity. All of these payments must be made according to a predetermined schedule,

and creditors have a legally enforceable claim against the company. If the company defaults on any of

its debt payments, creditors can take legal action to force repayment. In some cases, this means that

creditors can push the borrowing company into bankruptcy, forcing them out of business and into selling

(liquidating) their assets to raise the cash needed to satisfy creditor claims.

Investors contribute equity capital in exchange for ownership interests in the company. Equity remains

permanently invested in the company. The two basic sources of equity capital are ordinary shares and

preferred shares. Ordinary shareholders (Australian and UK terminology), or common stockholders (US

terminology), bear most of the company’s risk, because they receive returns on their investments only

after creditors and preferred shareholders are paid in full. Similar to creditors, preferred shareholders

are promised a specified annual payment on their invested capital. Unlike debt, preferred shareholders’

claims are not legally enforceable, so these investors cannot force a company to become insolvent if a

scheduled preferred share dividend is not paid. If a company becomes insolvent and has to be liquidated,

preferred shareholders’ claims are paid off before any money is distributed to ordinary shareholders, but

after creditors’ claims have been paid.

1-2c THE ROLE OF FINANCIAL INTERMEdIARIES IN CORPORATE

FINANCE

In Australia and most developed western countries, companies can obtain debt capital by selling

securities, either directly to investors or through financial intermediaries. A financial intermediary is an

institution that raises capital by issuing liabilities against itself, and then uses the capital raised either to

make loans to companies and individuals or to buy various types of investments. Financial intermediaries

include banks, insurance companies, savings and loan institutions, credit unions, mutual funds and

pension funds. But the best-known financial intermediaries are commercial banks, which issue liabilities

such as demand deposits (cheque accounts) to companies and individuals and then lend these funds to

companies, governments and households.

In addition to making corporate loans, financial intermediaries provide a variety of financial services to

businesses. By accepting money in demand deposits received from companies and individuals, banks eliminate

their depositors’ need to hold large amounts of cash for use in purchasing goods and services. Banks also act as

the backbone of a nation’s payments system by facilitating the transfer of money between payers and payees,

providing transaction information, and streamlining large-volume transactions such as payroll disbursements.

The Growing Importance of Financial Markets

The role of traditional intermediaries such as banks as providers of debt capital to companies has been

declining for decades. During 2007–2011, this source of debt capital contracted severely in many

countries as the effects of global financial turbulence spread around the world. Many banks stopped

lending to any customers, especially during the latter part of 2008, and this caused a severe liquidity

crisis for many companies. Recovery, from 2009 onward, has seen some increases in lending, but only

trending towards the levels before 2007.

debt capital
Long-term borrowed money

LO1.2

financial intermediary
An institution that raises
capital by issuing liabilities
against itself, and then uses
the capital raised either to
make loans to companies and
individuals or to buy various
types of investments

equity capital
An ownership interest
purchased by an investor,
usually in the form of
ordinary or preferred shares,
that is expected to remain
permanently invested