Download 2016-lecture-15

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Module 6
Financing and Risk
FRE 302 Fall 2016
Lecture 15
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content
Capitalization
 Defined
 Debt
 Equity
 Other Financing Options: Capital lease, Trade Credit, Crowd Funding,
Factoring
Consideration of Owners, Bankers & Investors when Providing Financing
 5Cs
 3Rs
 Risk : Business; Financial
 Optimal Capitalization
 Financing and the Business Plan
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Readings
Factsheets
 Financing the Business p427
Readings
 Financial Risk and Capital Structure p 483
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Capital Structure:
Overview & Options
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What is capitalization?

1.
2.
3.
Capital structure or
capitalization describes
how a firm’s assets are
financed
 where a firm obtains
money to purchase
assets.
Equity Indirect: Net
Income or called Retained
Earnings - Financial
progress
Equity Direct: Investment
of the owner(s) of a
company or other sources
Debt: Financing that a
business owner has
borrowed and must repay
with interest
DEBT (outside)
EQUITY (inside)
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Debt Financing
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Debt Financing Overview

Debt Options( also called loans or liabilities)
 Short Term – less than one year
 Intermediate & Long Term – more than one year

Challenge - determining what type of debt financing to pursue, based on
business type, stage of business, personal finances, capital requirements,
preferences, and the options available to you.

Different types of lenders offer various rates and fees, need to compare
the total package costs.
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Debt Financing - Short Term
Use:
 Finance the day-to-day operations of the business not to purchase
CAPITAL ASSETS
Examples:
 Operating Term Loans, Revolving Lines of Credit, Visa & Master Card,
Production Loan, Overdraft
Characteristics:
 Shows up as a short term liability in balance sheet
 Collateral not required so generally higher interest rate
 Repaying a short term debt consists of
1.
Paying the debt off to a zero balance in a time frame defined by
the bank
2.
Interest charge (an expense as it accumulates over time) usually
paid monthly
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Debt Financing - Intermediate & Long Term
Use:
 Purchase CAPITAL ASSETS that are then used to generate goods/services
Examples:
 promissory note, chattel loan, mortgage
Characteristics
 Shows up as a intermediate and long term liability with portion due this
year as current liability
 Collateral required
 Interest rate increases as loan term increases
 Term of loan related to the useful life of the asset(s)
 Repayment consists of
1.
Repaying the original amount back
2.
Interest expense
Terms agreed upon with bank – length, rate, payment timing
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Debt Financing - Intermediate & Long Term
Parts of a Typical Loan Agreement
 The Note: Specifies the principal and the interest and the timing of
repayment.
 Collateral: Specifies assets assigned and terms under which lender takes
possession of assets.
 Covenants: Specifies actions that the borrower must take. Maintaining
liquidity and equity as measured by financial ratios, maintaining insurance,
file financial reports, pay taxes, etc.
 Borrower Guarantees: Who is liable and for what? Remember the business
structures?
 Events of Default: Exact conditions under which a loan is considered in
default.
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Debt Financing: Pros and Cons
Debt Advantages
 Use of Debt magnifies return on equity

The lender has no say in the management or direction of the business, as
long as the loan payments are made and contracts are not violated.

Loan payments are predictable; they do not change with the fortunes of
the business.

Loan payments can be set up so that they are matched with the seasonal
sales of the business.

Lenders do not share in the business’s profits.
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Debt Financing: Pros and Cons
Debt Disadvantages
 If loan payments are not made, the lender can force the business into
bankruptcy.
 lender can take the home and possessions of the owner(s) to settle a
debt in case of default—when the borrower fails to meet the repayment
agreement. (unlimited liability)
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Use of Debt magnifies financial risk and potential losses

Debt payments increase a business’s fixed costs, thereby lowering profits
and reduces available cash.

Lenders expect regular financial reporting and compliance with the loan
contracts.
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Equity Financing
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Equity Financing

Equity means that, in return for money, an investor will receive a
percentage of ownership in a company but DOES NOT get their original
investment back
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Ex: For a $120,000 investment, an equity investor might want 10 percent
ownership of the company, which would mean 10 percent of the
business’s profits.
Use
Normally no collateral required and thus no registered claim on any of the
assets of the business
 Major considerations of the unsecured
 Frees up assets to be used as security for the loans (debt financing).
 Unsecured as it reflects the faith of the investor in the business
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Equity Financing
Sources:
 Personal savings
 Friends and family members
 Angel Investors
 Partners
 Corporate venture capital
 Venture capital companies
 Public stock sale
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Equity Financing: Pros and Cons
Equity Advantages
 If the business does not make a profit, the investor does not get paid.

There are no required regular payments in the form of principal or interest,
and dividends for common stockholders are distributed at the discretion of
the board of directors.

The equity investor cannot force the business into bankruptcy in order to
recoup the investment.

The equity investor has an interest in seeing the business succeed and may,
therefore, offer helpful advice and provide valuable contacts.
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Equity Financing: Pros and Cons
Equity Disadvantages
 Through giving up too much ownership, the entrepreneur could lose
control of the business to the equity holders.

Even with small amounts of equity, investors may interfere with the
business via unsolicited advice and/or continuous inquiries.

Equity financing is riskier for the investor, so they frequently wants both to
be able to influence how the company is run and to receive a higher rate of
return than a lender.

The entrepreneur must share profits with other equity investors.

No financial risk & leverage effect
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Other Types of Financing
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Capital Leases
'Capital Lease‘
 On an accounting basis:
 capital leases are considered a purchased asset (own at end of UL, need
credit rating , PV of lease pmt = original cost, sometimes a downpmt)
 operating lease considered a rental

advantages and disadvantages to financial statements for each higher
return on asset ratios would choose an operating lease, as the balance
sheet would not account for the item as an asset, thus reducing the
denominator in the ratio.
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Trade Credit
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Trade credit – is the financing suppliers extend by allowing customers to
pay for goods or services sometime after delivery
Reasons for the wide use of trade credit include:
 convenience to both suppliers and purchasers
 there are no negotiations to be entered into or detailed forms to be
filled out
Common type called open account: where the seller accepts the account
and fills the buyer’s order and sends out an invoice
 Can be terms of
 cash before delivery (CBD)
 cash on delivery (COD)
 cash discounts are offered to induce customers to make prompt
payments
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Factoring

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Factors are firms that provide financing to businesses by purchasing their
accounts receivable
Factors can provide three services:
 1. taking over credit screening and collections
 2. assuming the risk of bad debt
 3. financing by advancing funds that would otherwise be collected later
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Crowd funding
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Funding of a company by pooling contributions of small amounts by many
investors
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Crowd funding?
Crowd funding.. Funding of a company by selling small amounts of equity to
many investors
 http://www.youtube.com/watch?v=8b5-iEnW70k
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Is this equity?
Different or same?
Risky or not?
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Trade Credit or Account Payable
Entrepreneurs frequently benefit from the establishment of trade credit from
vendors.
 By eliminating the need for cash in advance or at the time of purchase,
businesses can hold onto the money for a longer period or will have more
time to generate cash for payment.

negotiate the best possible payment terms with suppliers in advance
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Comparison of Debt, Equity, Crowdfunding
Basis for Comparison
Obligations & /or Payments
Control & Decision Making
Collateral
Profit Sharing
Financial Leverage
Uses & Amounts
Tax Implications
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Consideration of Owners, Bankers &
Investors when Providing Financing
Consideration of Owners, Bankers & Investors when
Providing Financing
5Cs of Credit
1.
2.
3.
4.
5.
Character Past history and habits of borrower in paying bills.
Capital
Borrowers wealth position - net worth. Demonstrates
ability to manage finances and accumulate assets while repaying
debt obligations.
Collateral Pledge of assets to secure against the borrowed monies.
Banks usually defines a percentage Ex: 70% benchmark. If you want
to borrow 105,000 then they need 150,000 of collateral. (also called
security) . Commitment and personal guarantees are important.
Conditions Trends and volatility of the borrower’s industry
Capacity Ability of borrower to generate loan payments on a
consistent basis.
Consider how each of these are assessed?
Balance between the Cs is key!! Less of one means you will need
more of another!
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Consideration of Owners, Bankers & Investors when
Providing Financing
3 R's of credit:
1.
Returns from the investment: Borrower should be able to generate
increased income as a result of the borrowed funds. Earn more than
paying interest expense!
2.
Repayment capacity: Ability of the borrower to payoff the loan in the
time stipulated by the bank. Repaying capacity is the residual after
meeting the requirements of the operating expenses and financial &
Investment activities.
3.
Risk bearing ability: Assessment of the risk-bearing ability of the
borrower. Focus is on two types of risk: Business Risk & Financial Risk.
These risks are not always bad for the business but will certainly create
variability in income and can affect repaying capacity.
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Consideration of Owners, Bankers & Investors when
Providing Financing - Business Risk

What is business risk?
 Inherent uncertainty faced by the business independent of the way the
business is financed: Price and Production
 Exists in all businesses and cannot be eliminated – can be mitigated
using strategies

How is business risk assessed?
 Use “What-if “scenarios in your net income statement (like in your
business plan!) & Breakeven analysis to review effects of price and
quantity changes on business earnings

Why do businesses take on business risk?
How do businesses get rid of business risk?
Who considers this business risk?
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
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Consideration of Owners, Bankers & Investors when
Providing Financing - Financial Risk

What is financial risk?
 Risk that results from the use of financial leverage
 Financial leverage is the extent to which debt is used by a firm. This
risk results because of the fixed financial obligation associated with
debt financing.
 Financial risk is acquired by choice ( mostly!) and eliminated by?
 Financial risk will increase owners ‘risk over and above the firm’s basic
business risk
 The use of debt (financial leverage) concentrates the firm’s business
risk on its owners. This concentration occurs because debtholders
who receive fixed interest payments bear none of the business risk.

How is financial risk assessed?
 Review of Debt/Equity (higher number higher risk basis fixed debt
obligations); Return on Asset and Return on Equity ratios
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Financial Risk: Example
If you have a brewery that consistently earns ROA of 12 %
Remember: ROA (return on the assets
= ( NI + interest expense)
TA
You have the opportunity to expand your business by buying assets and
the bank indicated they will give you an interest rate of 5 %
Should you take this opportunity?
Consideration of Owners, Bankers & Investors when
Providing Financing - Financial Risk
Why do businesses take on financial risk & leverage?
1.
Because they need money! Consider business structures.
2.
Means of increasing the return to owners because returns are magnified
through the use of financial leverage (ROE)
 variations on ROE are magnified by use of financial leverage > 1
What is the downside of Financial Risk and Leverage?
 Financial Risk & Leverage can magnify loss
 Referred to as double edged sword concept or risk return
tradeoff
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Debt is both good and bad!
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Consideration of Owners, Bankers & Investors when
Providing Financing - Financial Risk & Financial
Leverage
What is an Appropriate Amount of Financial Risk & Leverage?
 Firms must first analyze
 Expected future cash flows/ income accrued: greater and more stable
the expected future cash flows, the greater the debt capacity.
 Percent Earnings (ROA) relative to interest rate charged: greater margin
between ROA and interest rate ( e.g., ROA = 13% and interest rate
offered by bank = 5%), the greater the debt capacity
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Consider a rule to apply to a firm to review how much financial risk &
leverage to take on.
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Consideration of Owners, Bankers & Investors when
Providing Financing - Financial Risk
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How do businesses get rid of financial risk?

Who considers this business risk?
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Financial Risk: Example
BEFORE TAX EFFECTS – USING PRE TAX INCOME
Return on Asset
24%
30%
36%
Return on Equity
24%
30%
36%
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Financial Risk: Example
BEFORE TAX EFFECTS – USING PRE TAX INCOME
Return on Asset
21%
27%
33%
Return on Equity
42%
54%
66%
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Financial Risk: Example

In this example – Financial leverage can be used to make the performance
of a company look dramatically better than what can be achieved by solely
relying on the use of equity financing.
 Advantage: increase the return-on-equity
 Potential Disadvantage: increase in the cost of financial obligations and
magnify losses in downturn
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Financial Risk: Example
What are you really assessing?
Is taking debt and thus obtaining financial risk & leverage a good or not so
good idea? When?
 advantage to the firm to magnify increase of returns to owners
when earnings are high
 disadvantage to the firm magnify decrease of earnings when
earnings are low

Trade off and interaction of business and financial risk!
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Consideration of Owners, Bankers & Investors when
Providing Financing : Comparing Business & Financial Risk
Basis for Comparison
Business Risk
Financial Risk
Definition
risk of insufficient profit to
meet expenses
risk arising due to the use of
debt financing in the capital
structure.
Evaluation
Variability in Net Income &
Breakeven Analysis
Debt to Equity
Connected with
Economic environment
Use of debt financing
Minimization
The risk can be mitigated
but not eliminated.
If the firm does not use debt
funds, there will be no risk.
Reviewed or Results in the
Difference in net operating
income and net cash flows.
Difference in the return of
equity.
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Optimal Capitalization
Factors to Consider in the Optimal Capital Structure
Decision Making
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Sales Activity - High and relatively stable sales activity is in a better position to
utilize financial leverage
 Use financial statements and ratios
Business Risk - Price and quantity variations
 Use Market Analysis: Competitive & Industry to review net income and
breakeven valuation/variations
Growth Rate & Capital Required - Faster growing &/or capital intense firms are
likely to rely more heavily on the use of financial leverage, because these types
of companies tend to need more financing at their disposal.
 Use financial statements and ratios
Taxes – Firms in a higher tax bracket tends to utilize more debt to take
advantage of the interest tax shield benefits.
Profit level - Less profitable tends to use more financial leverage, because a
less profitable company is typically they do not have retained earning available
Access to Equity - Equity funds can be restricted basis industry or firm size.
Business Structure - Consider liability, profit level and sharing of control tradeoffs
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Factors to Consider in the Capital Structure Decision
Making
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
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Risk tolerance - the amount of risk or threat of loss that an individual is
willing to sustain.
5Cs
3Rs
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Financing and the Business Plan
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Having an Strong Business Plan Goes a Long Way

When you seek financing for your business, the quality of your business
plan could make the difference between success and failure.

Lenders and investors alike will need to recover their principal plus
interest, or investment plus a rate of return.

If your business plan realistically, clearly, and convincingly demonstrates
that you can and will achieve your goals, your chances of obtaining
financing will greatly increase.

How do you build a
 Strong Business plan ?
 Strong Financial Plan?
 Strong Marketing Plan?
 To support your financing options?
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End of slides
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Questions
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Describe each of the 5cs
How is debt different from equity?
Explain the three trade-offs that guide the choice between debt financing
and equity financing.
If you were starting a new business, where would you start looking for
capital?
What advice would you give an entrepreneur who was trying to finance a
start-up
How are each of the 5Cs assessed ?
Difference of financial risk and business risk? How are each assessed?
Mitigated? Use by businesses?
Is debt good or bad? Any rule on this?
Explain the effect of leverage on expected ROE and risk
Long term debt cannot be used for start up expenses. True or False?
Explain?
Equity – always a good thing?? Or not?
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Questions
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What businesses should be highly leveraged? not highly leveraged?
How do you decide on the capitalization?
What is the risk and return trade-off in business planning assessment?
How does business structure come into play in capitalization?
What business type and sector gets lots of bank loans ? Why?
What business type and sector gets lots of equity? Why?
Can you define a decision rule for a business re: leverage usage?
What are the pros and cons of debt and equity financing?
What are the sources of capital for a small to medium business?
Is net income considered a source of financing?
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End of slides
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Extras leverage example
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Example: Data for scenario A & B
Firm A
Firm B
$0
$350,000
Equity
$400,000
$50,000
Total Assets
$400,000
$400,000
10%
10%
Debt
Bank interest rate
for loan
HOW ARE EACH CAPITALIZED?
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Example: Scenario A
Firm A
Firm B
NI before the interest charge is taken
off
$60,000
$60,000
Interest cost (borrowing rate * debt)
$0
$35,000
$60,000
$25,000
Net Income after interest charge is
taken off
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Example: Scenario A
A
B
0:1
7:1
15.00%
50.00%
15.00%
15.00%
No loan
10%
Leverage Ratio
= Debt to Equity
Return to Equity
= Net Income /OE
Return on Assets
=Net Income plus interest exp.
total assets
Interest rate for a bank loan
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Example: Scenario B
Data is the same now except for Net Income (accrued) before the
interest charge is taken off has decreased to 30,000
Firm A
Firm B
$30,000
$30,000
Interest cost (borrowing
rate * debt)
0
$35,000
Net Income after interest
charge is taken off
$30,000
($5,000)
Net Income before the
interest charge is taken off
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Example: Scenario B
A
B
0:1
7:1
Return to Equity
7.5%
-10.00%
Return on Assets
7.5 %
7.5%
Interest rate
for bank loan
No loan
10%
Leverage Ratio
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Example: Scenario A & B
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So what is exactly happening in firm A and B and why?
Who is using their assets more productively?
Who is using debt more productively?
Who would you invest in?