Answer to Question #226305 in Economics for EChips

Question

A company’s resources of long-term funds include bonds, preferred stock and common stock. Identify some financing risks associated with these sources and explain how these risks affect the return expected from investments financed by these sources.

Answer 1

When deciding on raising funds, the financial director should take into account what the bulk of the company's fixed costs are connected with and what is the situation with interest payments. Otherwise, there is a risk of seriously undermining the financial stability and profitability of the business. Financing structure issues are important for any manager with the right to make decisions about attracting loans or investments. They are also some of the most difficult. Should you use borrowed capital or be limited to your own? If used, will a bank or a private investor be the lender? If this is a private investor, what conditions to offer him? Etc. The situation is aggravated by the fact that in the case of raising money, the company must be "shown by the face". This is an extremely controversial matter. If the picture turns out to be too good, it would be logical to demand from the investor a lower percentage (the "risk premium" decreases), and this may scare him away. If the picture is not very good, then the matter may not reach the discussion of the conditions at all. According to theory, business risk can be measured in terms of an asset (production risk) or a liability (financial risk). Quantitatively, the risk is measured by the so-called leverage, or leverage (from the English leverage - "leverage"). It is a measure that takes into account the sensitivity of profit to fluctuations in income (production leverage) or interest payments (financial leverage).