Ch15 — Business Finance — Lesson & Tracker
Progress Tracker
| Concept | Attempts | Correct | Last Tested | Status |
|---|---|---|---|---|
| ShortTermFinancing | 1 | 1 | 2026-04-18 | 🟢 |
| LongTermFinancing | 1 | 1 | 2026-04-18 | 🟢 |
Your Strengths
You handled both financing concepts well in testing. This lesson covers the full chapter so you’re ready for exam questions that go beyond what’s been tested.
Concept Map — Weak → Strong Connections
graph TD CS["Capital Structure<br/>Maximize shareholder wealth"] --> ST["✅ Short-Term Financing<br/>Less than 1 year"] CS --> LT["✅ Long-Term Financing<br/>More than 1 year"] ST --> UNSEC["Unsecured Loans"] UNSEC --> LOC["⚠️ Line of Credit<br/>Not guaranteed — no fee<br/>Bank can refuse"] UNSEC -->|"vs"| RCA["⚠️ Revolving Credit Agreement<br/>Guaranteed in writing<br/>Commitment fee on unused amounts"] LT --> DEBT["Debt Financing<br/>Interest is tax-deductible"] LT --> EQ["Equity Financing<br/>Dividends are NOT deductible"] DEBT -->|"tax advantage"| COST["Debt is cheaper per dollar<br/>but creates fixed obligations"]
Short-Term Financing — Lesson
Source: ShortTermFinancing
Short-term = less than one year. Covers operating expenses: payroll, inventory, utilities.
Three Sources — Full Breakdown
1. Trade Credit (most common form of short-term financing)
The seller grants the buyer time to pay — effectively a free short-term loan from your supplier.
| Form | How It Works |
|---|---|
| Open-Book Credit | Informal — goods shipped with invoice; buyer pays on faith |
| Promissory Note | Legally binding document signed before goods ship; states when and how much |
| Trade Draft / Trade Acceptance | Seller attaches document to shipment; buyer signs to take possession → becomes trade acceptance |
2. Secured Short-Term Loans
Require collateral (accounts receivable or inventory). Borrower signs a promissory note. Lower interest rate than unsecured because lender has recourse if borrower defaults.
3. Unsecured Short-Term Loans
No collateral required. Lender may require a compensating balance — portion of the loan kept on deposit in a non-interest-bearing account, which raises the real cost of borrowing.
Three types:
| Type | What It Is | Key Distinction |
|---|---|---|
| Line of Credit | Pre-approved borrowing ceiling; draw when needed | Not guaranteed — bank can refuse if conditions change |
| Revolving Credit Agreement | Guaranteed credit line | Bank commits in writing; firm pays a commitment fee (0.5–1%) on unused amounts |
| Commercial Paper | Short-term unsecured notes issued by large, creditworthy firms | Sold at discount, repurchased at face value at maturity (≤270 days) |
The distinction that’s been tested: Line of credit ≠ revolving credit agreement. The revolving agreement is guaranteed but costs a commitment fee on unused amounts. A line of credit has no fee but no guarantee either.
Long-Term Financing — Lesson
Source: LongTermFinancing
Long-term = greater than one year. Covers capital expenditures: buildings, machinery, equipment.
Three Sources
1. Debt Financing
Long-term loans: from chartered banks, insurance companies, pension funds. Interest can be fixed or floating (prime rate + X%).
Corporate Bonds: a legal promise to repay principal on a specified date plus interest payments. The bond indenture spells out all terms.
| Bond Type | What Makes It Distinct |
|---|---|
| Callable | Issuer can retire early at call price (face + premium); typically after first 5 years. Used when interest rates fall below the bond’s rate. |
| Serial | Issuer retires portions of the issue in stages over time |
| Convertible | Holder can convert bond to common stock at a specified ratio — bond safety + equity upside |
| Secured | Backed by pledged assets; lower risk to bondholder |
| Debenture | Unsecured — no specific collateral; higher risk → higher interest rate |
Bond ratings (Moody’s / S&P): Low rating = higher default risk = issuer must pay higher interest to attract investors (“junk bonds”).
Bond price and yield:
- Yield = annual interest ÷ current market price
- If stated rate > market rate → bond sells at a premium (above face value)
- If stated rate < market rate → bond sells at a discount (below face value)
Bonds vs. Equity — the critical tax advantage: Bond interest is tax-deductible. Dividends are not. This makes debt financing cheaper per dollar, all else equal — but fixed obligations must be met regardless of profitability.
2. Equity Financing
Common Stock: three values to know:
- Par value: arbitrary value set by board — used by accountants, not investors
- Book value: total shareholders’ equity ÷ shares outstanding — used by analysts
- Market value: current price on the secondary market — what investors actually care about
Retained Earnings: profits not paid as dividends, reinvested into the firm. No borrowing costs, but lower dividends can depress stock prices.
Issuing common stock dilutes management control — every new share issued gives a new owner a vote.
3. Hybrid Financing — Preferred Stock
| Feature | Details |
|---|---|
| Dividend | Fixed, paid before common stockholders |
| Maturity | None — never matures (unlike bonds) |
| Voting rights | None (unlike common stock) |
| Can skip dividend | Yes, in lean years — unlike bond interest |
Preferred stock gives the firm flexibility (can skip dividends) without giving away voting control.
Why Convertible Bonds Appeal to Investors
Standard bond: guaranteed fixed interest, return of principal at maturity. Upside capped. Convertible bond: same bond safety as a floor plus the option to convert to stock if the share price rises significantly.
The investor gets downside protection (bond pays even if stock stagnates) and upside potential (convert to equity if the company’s stock surges). The issuing firm benefits because it can offer a lower interest rate in exchange for giving the investor that conversion option.
Capital Structure — The Core Trade-off
| All Debt | All Equity | |
|---|---|---|
| Cost | Cheapest per dollar (interest is tax-deductible) | Most expensive (dividends not deductible) |
| Risk | Highest (fixed obligations regardless of profit) | Lowest (no fixed obligations) |
| Control | No dilution | Each share issued dilutes management |
Optimal capital structure = the mix that maximizes shareholders’ wealth — somewhere between the two extremes.