Choosing the Right Financing Instruments

In Chapter 7, we presented a variety of ways in which firms can raise debt and equity. Debt can be bank debt or corporate bonds, can vary in maturity from short to long term, can have fixed or floating rates and can be in different currencies. In the case of equity there are fewer choices, but firms can still raise equity from common stock, warrants or contingent value rights. While we suggested broad guidelines that could be used to determine when firms should consider each type of financing, we did not develop a way in which a specific firm can pick the right kind of financing.

In this section, we lay out a sequence of steps by which a firm to choose the right financing instruments. This analysis is useful not only in determining what kind of securities should be issued to finance new investments, but also in highlighting limitations in a firm's existing financing choices. The first step in the analysis is an examination of the cash flow characteristics of the assets or projects that will be financed; the objective is to try to match the cash flows on the liability stream as closely as possible to the cash flows on the asset stream. We then superimpose a series of considerations that may lead the firm to deviate from or modify these financing choices.

First, we consider the tax savings that may accrue from using different financing vehicles, and weigh the tax benefits against the costs of deviating from the optimal choices. Next, we examine the influence that equity research analysts and ratings agency views have on the choice of financing vehicles; instruments that are looked on favorably by either or, better still, both groups will clearly be preferred to those that evoke strong negative responses from one or both groups. We also factor in the difficulty that some firms might have in conveying information to markets; in the presence of asymmetric information, firms may have to make financing choices that do not reflect their asset mix. Finally, we allow for the possibility that firms may want to structure their financing to reduce agency conflicts between stockholders and bondholders.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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