Long Term Finance Corporate Finance Part 2 Section B Episode 11 CMA USA

Welcome back to CMA USA exam coach. In today's episode we are going to introduce a very important concept in corporate finance, long-term finance. Let us start with a simple question. Why do companies need long-term finance? Companies often require large amounts of money to grow, expand operations, acquire fixed assets like land, buildings, or machinery, and undertake long-term projects. These are not short-term needs. They are strategic investments that take years to generate returns. So, it's only logical that companies don't repay these funds immediately. The repayment happens over time. That's why we call it long-term finance. Now, how do we differentiate this from short-term finance? Short-term finance is usually taken for less than one year. It is used to cover temporary cash shortages, pay suppliers, manage inventory, or settle immediate operational expenses. These funds are expected to be repaid quickly, often within the same financial cycle. But long-term finance, that is different. It typically involves a time horizon of more than one year, often five, ten, or even twenty years, and is crucial for building the future of the company. Now let's talk about the sources of long-term finance. We can broadly classify them into two categories, internal sources and external sources. Let's start with internal sources. The most common internal source is retained earnings. Retained earnings are the portion of net profits that a company keeps aside instead of distributing to shareholders as dividends. These funds can be reinvested into the business to finance growth, new projects, or asset purchases. Using retained earnings is a cost-effective way to finance long-term needs because it does not involve interest payments or dilution of control. Now moving to external sources. These are funds raised from outside the organization, and they come in different forms. Let's break them down. The first one is bank loans. Banks provide long-term loans with a fixed interest rate and repayment schedule. These loans are secured against company assets or guaranteed by promoters. The cost of borrowing and terms depend on the company's creditworthiness. The second source is bonds or debentures. These are debt instruments issued by the company to raise funds from investors. Bonds have a fixed interest rate, known as the coupon rate, and a maturity date. It's like taking a loan from the public. Companies must repay the principal along with regular interest, making this a formal and structured method of long-term financing. The third source is preferred shares. Preferred shareholders receive a fixed dividend before common shareholders. These shares may or may not have voting rights. They are a hybrid instrument, somewhere between debt and equity, and they provide a relatively stable source of long-term capital. The fourth source is common shares or equity. When a company issues new equity shares to the public or private investors, it raises long-term capital without any repayment obligation. However, this dilutes ownership and comes with expectations of future returns through capital gains or dividends. Equity is a high-risk, high-return source of long-term finance. So far, we have covered internal and external sources. Now, let's connect this with two important financial concepts, cost of capital and optimal capital structure. Let's start with cost of capital. The cost of capital is the minimum return that a company must earn on its investments to satisfy its investors or creditors. Every source of capital, whether debt or equity, has a cost. For example, interest paid on loans is the cost of debt. Expected return for equity shareholders is the cost of equity. Even retained earnings have an opportunity cost. Companies calculate the weighted average of all these costs, known as the weighted average cost of capital or WACC. The WACC helps companies make decisions. If a project is expected to earn more than the WACC, it is considered profitable. If not, it may destroy shareholder value. And finally, we have the concept of optimal capital structure. This refers to the best possible mix of debt and equity that minimizes the company's overall cost of capital and maximizes its value. Too much debt can increase financial risk. Too much equity can dilute ownership and be expensive in the long run. So, financial managers must find a balance. And that's what we aim to explore in the upcoming episodes. In summary, today we covered the basics of long-term finance, its importance, the difference from short-term finance, the key sources, both internal and external, and introduced the concepts of cost of capital and optimal capital structure. Next episode, we are going to discuss about bonds, a main source of external long-term finance. Thank you for watching. Make sure to like, share, and subscribe for more CMA USA exam-focused content. See you in the next episode.