Capital Budgeting

Long-Term Financing

Overview of Long-Term Financing, Including Asset-Backed Financing

Long-term financing generally requires that an asset such as real estate be used as collateral to be seized if the debt is not paid on time.

Mortgage financing is a perfect example of long-term financing. Long-term financing is defined as debt with a maturity due date of longer than one year. Long-term financing matches the length of the financing term with the expected useful life of the asset being financed. For example, a mortgage financing period may run between 20 and 30 years. Businesses finance buildings and equipment in a similar manner. When a company seeks a long-term loan, a bank or other financial institution will be asked to underwrite the asset purchased with the loan. In other words, the bank owns the collateral or asset being purchased, while the business uses the asset as long as it continues to make payments on the underlying financing. If the bank determines the business to be a sound risk, a prime rate will be assigned on the loan, which reduces interest. A prime rate is a special interest rate banks give to favored customers.

Most long-term business lending is based on asset-based lending, or secured lending. Asset-based lending is the practice of loaning money secured by an underlying asset that serves as collateral in case the loan is not paid on time. The bank or lending institution can also place a lien on the property. A lien is the creditor's legal right to sell the collateral property of a debtor who does not fulfill obligations of the loan or another contract. For example, Big Systems Inc. has a loan through Brown Bank for $80,000. The loan was secured by Big Systems Inc.'s factory equipment. If Big Systems Inc. fails to make loan payments on time, the collateral used to secure the loan, its factory equipment, can be seized by the bank. Brown Bank can then sell the factory equipment to satisfy the remaining loan balance. However, most banks do not want to possess the collateral because its value has likely depreciated and its market value may be worthless, especially where the value of the collateral is subject to technological obsolescence. A lien continues until the maturity of the contract, or the final payment date of a loan when the principal is due to be paid. If paid by maturity, the debt is considered paid in full, and the lien is removed.

Short-Term/Long-Term Financing

Short- and long-term financing have different requirements, including term length, rates, suppliers, and uses.

Advantages and Disadvantages of Long-Term Financing versus Short-Term Financing and Stock Offerings

Long-term financing provides more financial stability and less frequent loan negotiation than short-term financing and stock offerings do, but long-term financing also lacks flexibility because of its fixed rates, which can affect future financing opportunities.

One of the biggest advantages of long-term financing is that it matches the life of the asset being financed. Long-term financing should never be used to finance short-term financing needs. It is also easier to project earnings and expenses when long-term financing is in place. A company can project what the interest is going to be in the long term. With short-term financing, the borrower has to frequently renegotiate the terms and rates of the agreement, as short-term financing is usually rolled over year after year.

Another advantage of long-term financing is the ability to analyze cost of capital. Cost of capital is the required return that is necessary to make a capital budgeting project make sense to take on. Since the loan information stays the same, the borrower can project and understand the cost of capital more easily. Short-term financing comes with more uncertainties that could cause issues, especially when a company is considering taking on additional projects. However, there are disadvantages to long-term financing. Once the terms are set, it is hard to get out of or renegotiate the loan. For example, if interest rates were going down, it would be hard to get out of the loan in order to get a better rate. Another concern in long-term financing could be the amount of the loan. This becomes an issue when a company finances a loan that is larger than is needed.

Aside from taking out a loan, a company might consider alternative ways, such as offering stocks, to meet its financing needs. However, most private companies in the United States cannot attract investors to sell their shares because such stock is illiquid. A company wishing to sell stock to the public is required to register the stock offering with the Securities and Exchange Commission (SEC), an independent federal government agency responsible for overseeing securities markets, protecting investors, and facilitating capital formation, which can be a very expensive process. Assuming a company has gone public via an initial public offering (an initial sale of equity to public investors) after registering its stock with the SEC, it can continue to issue stock, meaning that it is selling ownership of the company to public investors. The quantity of shares made available for trading when stocks are offered as an alternate source of financing is called float. When the company sells more shares of stock, the amount of influence current stockholders have is diluted. Selling shares can be a good way to raise capital to finance a project. Long-term financing comes with interest payments, while selling stock comes with the paying out of dividends.

Long-term financing has certain advantages and disadvantages when compared with short-term financing and stock offerings. The advantages of long-term financing include stability, which means that a company does not need to search for financing as often as it would if it were using short-term financing. Thus, it will be easier for the company to project its earnings and cash flows because it already knows the interest expense for a period. This kind of projection is not available with short-term financing, as it typically requires frequent renegotiation. Long-term financing is also beneficial for companies determining their cost of capital. Companies are able to better decide which projects will be fruitful in the long run. Obtaining long-term financing is also not as involved as issuing stock offerings. However, long-term financing also has its disadvantages.

Long-term financing may be disadvantageous because it is usually built around a fixed rate. This means that if interest rates in general drop, the company is stuck paying the higher rate. However, this also means that the company is in a better position if interest rates rise and it was able to lock in a lower interest rate for the remainder of the loan term. The other downside to long-term financing is that it can restrict the ability of a company to take out other loans in the future. Banks and other financial institutions look at how much money a business brings in on average and how high its liabilities are. If the company signed up for a 30-year liability, the liability term can affect other financing options available to it in the future.

Differences between Long- and Short-Term Financing

Basis Long-Term Finance Short-Term Finance
Meaning Long-term finance fulfills the financial requirements of an enterprise for a period exceeding one year. Short-term finance fulfills requirements of an enterprise for a period not exceeding one year.
Use It is used to acquire fixed assets such as equipment, plant, machinery, etc. It is used to meet working capital needs.
Example Debentures, long-term borrowing, and loans from financial institutions Trade credit, loans from commercial banks, commercial papers, etc.

Comparing long-term and short-term financing can help demonstrate when and why each is typically used.