Credit And Financing Overview

Credit is a longstanding agreement between a borrower and a lender, with the borrower promising to repay the borrowed amount, often with interest. This practice dates back thousands of years.
Credit comes in various forms, such as car loans, mortgages, and credit cards, allowing individuals to buy now and pay later. Credit cards are a common example, where the issuing bank pays the seller on the buyer's behalf, and the buyer repays the bank over time with interest.
Even delayed payments from a seller to a buyer, like a restaurant receiving produce on credit, represent a form of credit.

Frequently employed in the realm of global commerce, a letter of credit is a document issued by a bank, assuring the seller that they will be paid the entire agreed-upon sum by a specified future date, provided the buyer doesn't meet their payment obligation. In essence, the bank becomes financially responsible if the buyer fails to fulfill their payment commitment.

A credit limit represents the maximum amount of credit that a lender (such as a credit card company) will extend (such as to a credit card holder). Once the borrower reaches the limit they are unable to make further purchases until they repay some portion of their balance. The term is also used in connection with lines of credit and buy now, pay later loans.

Financing involves providing funds for business activities, purchases, or investments. Financial institutions, like banks, play a key role in offering capital to help businesses, consumers, and investors achieve their objectives.
It's essential in any economy because it allows companies to acquire things they can't afford immediately. Financing essentially leverages the time value of money, using future expected cash flows for present projects.
It also taps into the surplus funds of some individuals and the financial needs of others, creating a marketplace for capital.

"Equity" signifies ownership in a company. To illustrate, a grocery store owner seeking expansion might sell a 10% share in the company for $100,000, valuing the business at $1 million. Companies opt to sell equity because it transfers the risk to investors; if the business fails, investors lose out.
However, giving up equity means surrendering some control. Equity investors often seek influence in company operations, especially during challenges, and may have voting rights based on their shares. In exchange for their investment, they gain a claim on future profits.
Investors' goals can vary: some want share price growth, while others seek security and income through regular dividends.

Debt, a well-known form of financing, is something many have encountered through car loans or mortgages. It's also commonly used by new businesses. Debt financing involves repayment, often with interest, to lenders who provide the capital.
Collateral may be required by some lenders. For instance, the grocery store owner might need a truck, so they take a $40,000 loan, using the truck as collateral, agreeing to an 8% interest rate, and a five-year repayment period.
Debt is readily accessible for smaller sums, particularly when tied to specific assets that can be used as collateral. While it necessitates repayment, the company maintains ownership and control over its operations, even during challenging times.

The Weighted Average Cost of Capital (WACC) is a blend of the costs associated with different types of financing, weighted according to their usage. It calculates the interest a company owes for each dollar of financing. Companies choose the right mix of debt and equity financing by optimizing each component's WACC, considering default risk and ownership trade-offs.
Debt is typically favored due to tax deductibility and lower interest rates. However, excessive debt increases credit risk, necessitating the inclusion of equity. Investors seek equity for future profit and growth prospects.
WACC is computed using this formula:
WACC = (E / V) * Re + (D / V) * Rd * (1 - Tc)
- E: Market value of equity
- D: Market value of debt
- V: Total firm value (E + D)
- Re: Cost of equity
- Rd: Cost of debt
- Tc: Corporate tax rate