 |  Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e Peter Rose,
Texas A & M University
Business Borrowing
Chapter SummaryThis chapter focused upon businesses raising funds by borrowing in the open market and
by seeking loans extended by banks and other financial institutions.
- The majority of funds drawn upon by business firms to meet their working capital and other
investment needs normally come, not from the financial marketplace, but from inside the
individual business firm. In most periods half or more of business capital requirements are
supplied by earnings and noncash depreciation expenses (i.e., internal cash flow).
- Roughly a quarter to slightly less than one-half of business investment needs in recent
years have been met by selling securities in the financial markets. The financial system
is a backstop for the operations of business firms for those periods when internally generated
cash fails to increase fast enough to support the growth of sales.
- The financial markets provide both short-term working capital to meet current expenses
and long-term funds to support the purchase of buildings and equipment. The principal
external sources of working capital include trade credit (accounts payable), bank loans
and acceptances, short-term credits from nonbank financial institutions (such as finance
companies), and sales of commercial paper in the open market.
- For businesses in need of long-term funding, the principal funds sources are the sale of
bonds and notes, term loans from banks, the issuance of common and preferred stock,
and commercial mortgages, with open-market business borrowing generally growing
and bank borrowing declining in overall importance in recent years.
- Corporate bonds have original maturities of more than five years; notes carry maturities
of five years or less. There is a trend toward shorter maturities of corporate securities
due to inflation and rapid changes in technology. Indexing of corporate bond rates to
broader movements in the economy has also become somewhat more common.
- A wide variety of different bond and note issues have been developed to provide investors
with varying degrees of security and risk protection, including debentures, zero
coupon bonds, equipment trust certificates, mortgage bonds, and industrial development
bonds. Each type of bond is accompanied by an indenture, spelling out the rights and
obligations of borrowers and investors.
- Corporate notes and bonds are purchased by a wide range of investors today, but the
dominant buyers are life insurance companies, pension funds, and savings banks. New
corporate bonds may be offered publicly in the open market, where competitive bidding
takes place, or in a private sale to a limited group of investors. Public sales account for
the largest portion of annual long-term borrowings, but the private market appeals to
many smaller firms unable to tap the open market for funds and to companies with
unique financing needs or lower credit ratings. Public sales offer the advantage of competition,
as investment bankers bid against each other to underwrite a new security issue.
The use of competitive bidding tends to result in higher security prices and lower
interest costs to businesses in need of funds.
- The corporate bond market has faced competition in recent years from both domestic
and foreign commercial banks making long-term business loans. These term loans are
generally used to purchase equipment. Most such loans carry floating interest rates tied
to the prime lending rate, or some other base rate (such as LIBOR).
- Commercial banks have always been a leading financial institution in extending both
short-term and long-term loans to business firms. These loans support the construction of office buildings, shopping centers, and other commercial structures and provide working
capital to support daily operations. Banks generally specialize in short-term mortgages
that finance business construction, while long-term commercial mortgage financing is
provided mainly by insurance companies, savings banks, and pension funds. Bankers’
overall role in providing credit to the business sector has been declining in recent years
as more firms turn to the open market to raise funds. Instead, banks have increasingly
come to play a supporting role in guaranteeing and monitoring corporate debt.
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2003 McGraw-Hill Higher Education