Final answer:
Very small companies raise capital from private investors to avoid the risks of an IPO. Small, growing companies may prefer an IPO to avoid the constraints of debt financing. Venture capitalists have better information than bondholders about a small firm's profitability due to greater involvement. The correct option is B)
Step-by-step explanation:
When considering early-stage corporate finance, there are several key points to understand about how companies raise capital:
- Very small companies typically raise money from private investors rather than through an Initial Public Offering (IPO) due to the high risks involved which make their stock less attractive to the public.
- As companies grow and their need for capital increases, they may prefer an IPO to borrowing from a bank or issuing bonds because an IPO provides financing without the obligation to make regular interest payments, allowing for reinvestment into the company.
- When it comes to who has better information about a small firm's potential for profitability, a venture capitalist usually has a more informed perspective compared to a potential bondholder due to their substantial ownership and close involvement in the company.
Venture capitalists can thus help mitigate the issue of imperfect information, often an inherent challenge in evaluating a firm's future performance.
Knowing these elements is critical for understanding why comparing a firm's performance to its cost of capital can be limited, especially when the firm's financial history and potential for profit are not well-known or stable.