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1 Module 6 Financing and Risk FRE 302 Fall 2016 Lecture 15 2 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 3 Readings Factsheets Financing the Business p427 Readings Financial Risk and Capital Structure p 483 4 Capital Structure: Overview & Options 5 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) 6 Debt Financing 7 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. 8 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 9 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 10 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. 11 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. 12 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) 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. 13 Equity Financing 14 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 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 15 Equity Financing Sources: Personal savings Friends and family members Angel Investors Partners Corporate venture capital Venture capital companies Public stock sale 16 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. 17 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 18 Other Types of Financing 19 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. 20 Trade Credit 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 21 Factoring 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 22 Crowd funding Funding of a company by pooling contributions of small amounts by many investors 23 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 Is this equity? Different or same? Risky or not? 24 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 25 Comparison of Debt, Equity, Crowdfunding Basis for Comparison Obligations & /or Payments Control & Decision Making Collateral Profit Sharing Financial Leverage Uses & Amounts Tax Implications 26 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! 27 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. 28 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? 29 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 30 31 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 Debt is both good and bad! 32 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 Consider a rule to apply to a firm to review how much financial risk & leverage to take on. 33 Consideration of Owners, Bankers & Investors when Providing Financing - Financial Risk How do businesses get rid of financial risk? Who considers this business risk? 34 35 Financial Risk: Example BEFORE TAX EFFECTS – USING PRE TAX INCOME Return on Asset 24% 30% 36% Return on Equity 24% 30% 36% 36 Financial Risk: Example BEFORE TAX EFFECTS – USING PRE TAX INCOME Return on Asset 21% 27% 33% Return on Equity 42% 54% 66% 37 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 38 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! 39 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. 40 Optimal Capitalization Factors to Consider in the Optimal Capital Structure Decision Making 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 41 Factors to Consider in the Capital Structure Decision Making Risk tolerance - the amount of risk or threat of loss that an individual is willing to sustain. 5Cs 3Rs 42 43 Financing and the Business Plan 44 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? 45 End of slides 46 Questions 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? 47 Questions 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? 48 End of slides 49 Extras leverage example 50 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? 51 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 52 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 53 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 54 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 55 Example: Scenario A & B 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?