Business financing takes the form of supporting an investment with capital funds. Many established organizations accessed financial funding at the initial stage. Thus, business financing is the foundation of every successful organization (Longstaff, 2000). The type of business financing used by the investor depends on the goal of the organization. Debt and equity financing can be used to fund a business investment. Thus, as a financial advisor, I will explain to the client the meaning of debt and equity financing. I will also stress the advantages and disadvantages of each financing option.
Debt financing takes the form of borrowing a principal amount from an institution, bank, government, or individual. The principal amount and the accrued interest are given at an agreed date. Debt financing is a suitable option for small-scale business. Most established organizations utilize debt options during startup (Longstaff, 2000). However, many small business owners do not have the advantage to apply for financial assistance.
As a financial advisor, I will recommend debt financing for small business owners who do not have to stock shares. The benefits of debt financing will be summarized below. The funds received from debt financing will support small business organizations. The interest accrued on the principal amount is shared over a long period. The investor maintains the ownership of the organization. However, debt financing gets its drawbacks. The investor must repay the debt no matter the circumstance. Debt financing increases the interest rate of the organization. The investor could lose his or her assets to repay the loan.
Equity financing involves staking the company’s control to collect business funds. The organization sells shares, bonds and other financial instruments to collect project funds. Established firms with stock shares can use equity financing. With equity financing, the issuer and investor share the risk and liabilities. However, the investor will lose complete control if the firm is bankrupt (Longstaff, 2000). The issuer may collect more revenue that the cost of the project.
Selecting an investment banker
Looking for an investment banker could be tasking, however, the right procedure will influence productivity. However, the investor must examine the points summarized below before picking an investment banker.
- Understand the procedure and practice: You must ask about the processes of investment banking.
- Review the competence of the banker in your business segment: Examine the reputation of the bank.
- Access the services of the bank: Access the organizational culture and how they relate with customers.
- Make sure your goal aligns with the vision of the bank: You must access the risk and return on the investment before accepting a partner.
- Just look for a business partner and not a profit agent: A partner will support the growth of your business.
Historical relationship between risk and return on corporate bonds
Historical evidence suggested that the risk on investment is an elusive theory. This theory correlates the risk and return on corporate bonds. Economists felt that the risk on investment is the standard deviation of a business return. Investors consider lower risk and higher returns to guarantee profitability. Thus, the stock value depends on the relationship between risk and return on investments. Corporate bond has a risk and return on investment. When the risk is elevated, the business may be successful.
Diversification and risk reduction
Diversification correlates assets, risk, and liabilities. Business managers diversify their investments to avoid bankruptcy. Thus, diversification reduces the risk of an investment. The relationship between diversification and risk reduction in a portfolio is summarized below.
Risk reduction = portfolio risk/ asset risk – 1.
Portfolio variance = average asset variance + (asset covariance)
Thus, risk reduction = average asset covariance – 1.
Reference
Longstaff, F. (2000), Arbitrage and the Expectations Hypothesis. Journal of Finance, 55(1), 989–994.