Describe the sources of long-term debt financing

Answer 1

SOURCES OF LONG-TERM DEBT FINANCING

Firms that need cash for long-term purposes, such as acquiring buildings and equipment or financing a business acquisition, and that wish to use debt as a means of obtaining cash, will do one of two things:

1 . Borrow from commercial banks, insurance companies, or other financial institutions.

2 . Issue bonds in the capital markets.

Loans from commercial banks and other financial institutions often require firms to pledge assets as collateral. For example, a firm borrowing to finance the acquisition of equipment would likely pledge the equipment as collateral. If the firm fails to maintain specified levels of financial health while the loan is outstanding or does not pay principal and interest on the loan when due, the lender has the right to seize the collateral and sell it to satisfy the amounts due.

Common terminology refers to the financial contract underlying bank loans as a note, so that these loans usually appear on the balance sheet under the title Notes Payable. Notes of business firms generally have maturity dates less than approximately ten years and arise from borrowing from a single lender. Borrowing from a single lender avoids some of the reporting requirements of more public issues of debt. However, no public market for the debt exists in this case, so the borrower will have difficulty disengaging from the borrowing arrangement prior to maturity.

Most firms issue bonds on the market to satisfy their long-term needs for cash. A bond is a financial contract, similar in concept to borrowing agreements with banks or insurance companies, in which the borrower and the lender agree to certain conditions about repayment of the bonds, operating policies, other borrowing activities while the bonds are outstanding, and other provisions. Bond indenture refers to the financial contract underlying bonds. Bonds appear on the balance sheet under the title Bonds Payable. In contrast to notes, bonds typically carry maturity dates longer than approximately ten years and involve many lenders instead of a single lender. Firms classify the portion of bonds due within the next year as a current liability and the remaining portion as a noncurrent liability. Firms must also disclose a list of their long-term debt obligations in notes to the financial statements.