Chapter 11
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Transcript of Chapter 11
The Essentials of Finance The Essentials of Finance and Accounting for and Accounting for Nonfinancial ManagersNonfinancial Managers
By Edward FieldsBy Edward Fields
Chapter 11Chapter 11
Financing the BusinessFinancing the Business
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Financing the BusinessFinancing the Business
Borrowing money is a positive Borrowing money is a positive corporate strategycorporate strategy Increases growthIncreases growth Finance seasonal slowdownsFinance seasonal slowdowns Invest in opportunitiesInvest in opportunities
Financing strategies must be dynamicFinancing strategies must be dynamic What was beneficial six months ago may What was beneficial six months ago may
no longer be validno longer be valid Financing decisions affect virtually Financing decisions affect virtually
every departmentevery department
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Financing the BusinessFinancing the Business
Budgets grow and people are hired Budgets grow and people are hired because of new financingbecause of new financing
Or, layoffs occur when finances are in Or, layoffs occur when finances are in short supplyshort supply
The main issues affecting financing The main issues affecting financing are:are: MaturityMaturity CostCost Conditions and restrictionsConditions and restrictions Payment schedulePayment schedule CollateralCollateral
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Financing the BusinessFinancing the Business
IMPORTANT:IMPORTANT: There are two classes of There are two classes of
financing:financing: DebtDebt EquityEquity
Debt financing will be explored Debt financing will be explored firstfirst
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Debt FinancingDebt Financing
Debt financing can take one or Debt financing can take one or two forms:two forms: Short term borrowingShort term borrowing Long term borrowingLong term borrowing
Short Term involves loans with a Short Term involves loans with a maturity of one year or lessmaturity of one year or less Used to cover current needsUsed to cover current needs
Seasonal cash flow needsSeasonal cash flow needs Major customer ordersMajor customer orders
These loans are sometimes called These loans are sometimes called working capital loansworking capital loans
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Debt FinancingDebt Financing
Long term loans have maturities Long term loans have maturities longer than one yearlonger than one year
Long term loans intended to Long term loans intended to finance:finance: Major capital expansionsMajor capital expansions R & DR & D Real estateReal estate
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Short Term DebtShort Term Debt There are a number of different short There are a number of different short
term debt financing options such as:term debt financing options such as: Accounts receivableAccounts receivable FactoringFactoring Inventory financingInventory financing Floor planningFloor planning Revolving creditRevolving credit Zero balance accountsZero balance accounts Lines of creditLines of credit Credit cardsCredit cards Compensating balancesCompensating balances
Each will be discussed in the following Each will be discussed in the following slidesslides
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Short Term DebtShort Term Debt Accounts receivable financingAccounts receivable financing
Excellent short term financingExcellent short term financing Assists in cash flowAssists in cash flow Uses all or part of accounts Uses all or part of accounts
receivable as collateralreceivable as collateral Certain invoices Certain invoices (late more than 90 days)(late more than 90 days)
might not be used for collateralmight not be used for collateral The company retains the risk if The company retains the risk if
customers do not paycustomers do not pay Banks typically create a line of credit Banks typically create a line of credit
between 70%-90% of accounts between 70%-90% of accounts receivablereceivable
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Short Term DebtShort Term Debt
FactoringFactoring Company sells accounts receivable Company sells accounts receivable
to bank or factoring companyto bank or factoring company Sold at a discount from face valueSold at a discount from face value Company receives immediate cashCompany receives immediate cash Customers will now pay bank or Customers will now pay bank or
factoring companyfactoring company Expensive form of financingExpensive form of financing May lead customers to misjudge the May lead customers to misjudge the
companies financial conditioncompanies financial condition
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Short Term DebtShort Term Debt
Factoring - con’tFactoring - con’t The factor may call overdue The factor may call overdue
accounts directlyaccounts directly Factoring can cost between 2% and Factoring can cost between 2% and
5% per month5% per month What is the annual cost expressed as a What is the annual cost expressed as a
percentpercent Accounts receivable can be sold as Accounts receivable can be sold as
“with recourse” or “without “with recourse” or “without recourse”recourse”
Selling “without recourse” is more Selling “without recourse” is more expensiveexpensive
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Short Term DebtShort Term Debt
Inventory FinancingInventory Financing Typically only finished goods and raw Typically only finished goods and raw
material qualifymaterial qualify What about WIP?What about WIP?
Lenders typically finance ½ of the Lenders typically finance ½ of the qualifying collateralqualifying collateral
Good form of financing to cover cost Good form of financing to cover cost of large ordersof large orders
Good to use in seasonal businessGood to use in seasonal business Financing inventory which is then Financing inventory which is then
immediately followed by a period of high immediately followed by a period of high cash flowscash flows
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Short Term DebtShort Term Debt
Floor PlanningFloor Planning Common in retail and high priced Common in retail and high priced
productsproducts Boats, cars, motorcyclesBoats, cars, motorcycles
The vendor and its products must be The vendor and its products must be credit qualifiedcredit qualified
The lender buys the products and The lender buys the products and then places them in retailers storethen places them in retailers store
Lender retains titleLender retains title When sold, the retailer MUST pay the When sold, the retailer MUST pay the
lender to obtain title to transfer to lender to obtain title to transfer to purchaserpurchaser
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Short Term DebtShort Term Debt
Floor Planning – Con’tFloor Planning – Con’t Flooring is often provided by a Flooring is often provided by a
manufacturer through a credit manufacturer through a credit companycompany
Manufacturer will offer bargains and Manufacturer will offer bargains and deals to smooth out manufacturing deals to smooth out manufacturing increasesincreases
Slow moving product is often Slow moving product is often provided to retailer with little to no provided to retailer with little to no interestinterest
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Short Term DebtShort Term Debt
Revolving creditRevolving credit A working capital loan using A working capital loan using
accounts receivable and inventoryaccounts receivable and inventory Loan amount tied to a formula based Loan amount tied to a formula based
on inventory and accounts on inventory and accounts receivable qualityreceivable quality
Not suitable for long term projectsNot suitable for long term projects A lender may require an annual A lender may require an annual
“cleanup” period. (Zero out the loan)“cleanup” period. (Zero out the loan)
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Short Term DebtShort Term Debt
Zero Balance accountsZero Balance accounts A type that may be required by the A type that may be required by the
loan agreementloan agreement The loan and checking account are The loan and checking account are
tied togethertied together When a deposit is made the interest When a deposit is made the interest
and principle are automatically and principle are automatically deducteddeducted
When a check is written the loan When a check is written the loan balance increasesbalance increases
The account balance is typically zeroThe account balance is typically zero
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Short Term DebtShort Term Debt
Line of CreditLine of Credit Not a loanNot a loan An advance arrangement with lenderAn advance arrangement with lender Used if needed and if not needed Used if needed and if not needed
there is no loanthere is no loan Very favorable method of securing Very favorable method of securing
financingfinancing Interest only accrues when funds are Interest only accrues when funds are
usedused A small fee is typically assessed such A small fee is typically assessed such
as 1% of the total lineas 1% of the total line
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Short Term DebtShort Term Debt
Credit CardsCredit Cards Increasingly popularIncreasingly popular
Eliminates accounts receivableEliminates accounts receivable No overdue receivablesNo overdue receivables Customers credit worthiness need not Customers credit worthiness need not
be evaluatedbe evaluated Customers can take as long as they Customers can take as long as they
want to paywant to pay Merchant must pay a fee ranging Merchant must pay a fee ranging
from 2% or morefrom 2% or more Excellent choice or small orders Excellent choice or small orders
(merchant and customer)(merchant and customer)
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Short Term DebtShort Term Debt
Compensating BalancesCompensating Balances A bank strategy that increases the A bank strategy that increases the
effective cost of borrowingeffective cost of borrowing The borrower is required to keep a The borrower is required to keep a
specified amount in their checking specified amount in their checking account at all timesaccount at all times
Example:Example: A company borrows $1M or 1-year at A company borrows $1M or 1-year at
10%. Bank requires a 10% 10%. Bank requires a 10% compensating balance or $100k. This compensating balance or $100k. This results in an effective interest rate of results in an effective interest rate of 11%11%
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Short Term Debt ReviewShort Term Debt Review
Accounts receivable financingAccounts receivable financing FactoringFactoring Inventory financingInventory financing Floor planningFloor planning Revolving creditRevolving credit Zero balance accountsZero balance accounts Lines of creditLines of credit Credit cardsCredit cards Compensating balancesCompensating balances
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Long Term DebtLong Term Debt
A variety of long term financing options A variety of long term financing options are availableare available
Each will be discussed in the following Each will be discussed in the following slides:slides: Term loansTerm loans BondsBonds DebenturesDebentures Mortgage bondsMortgage bonds Convertible bondsConvertible bonds Senior debtSenior debt Subordinated debtSubordinated debt Junk bondsJunk bonds
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Long Term DebtLong Term Debt
Term LoansTerm Loans Most frequently long term debt optionMost frequently long term debt option A loan from a bank to a company. Typical A loan from a bank to a company. Typical
use is to finance expansion effortsuse is to finance expansion efforts Fixed maturityFixed maturity Five to seven yearsFive to seven years
Will be repaid in monthly installmentsWill be repaid in monthly installments Spreading payments Spreading payments (interest & principal)(interest & principal) over over
time is called amortizationtime is called amortization The amortization of the principal can take The amortization of the principal can take
place over a period longer than the loan place over a period longer than the loan periodperiod
The ending balance is called a balloon paymentThe ending balance is called a balloon payment
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Long Term DebtLong Term Debt
BondsBonds A bond has many characteristics similar to A bond has many characteristics similar to
a term loana term loan A Negotiable instrument that can be bought and A Negotiable instrument that can be bought and
soldsold Usually sold to the public through offerings Usually sold to the public through offerings
registered with the SECregistered with the SEC Typically sold in units of $1,000Typically sold in units of $1,000 A bond selling a face value is selling at A bond selling a face value is selling at parpar The interest rate is called the The interest rate is called the couponcoupon When issued their prices fluctuate with When issued their prices fluctuate with
economic conditionseconomic conditions Bonds are usually interest payments only Bonds are usually interest payments only
with principal repaid at maturitywith principal repaid at maturity
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Long Term DebtLong Term Debt
Debenture bondsDebenture bonds A bond with only “the full faith and credit” A bond with only “the full faith and credit”
of the company as collateralof the company as collateral There is no specific collateralThere is no specific collateral Bond owners are classified as unsecured Bond owners are classified as unsecured
creditorscreditors Mortgage bondsMortgage bonds
Only difference form a debenture is the Only difference form a debenture is the existence of collateralexistence of collateral
Bond owners are classified as secured Bond owners are classified as secured lenders because of the collaterallenders because of the collateral
Because of the collateral, the interest rate Because of the collateral, the interest rate is lower than debenture bondsis lower than debenture bonds
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Long Term DebtLong Term Debt
Convertible bondsConvertible bonds Used by companies with poor credit ratingsUsed by companies with poor credit ratings
Poor credit risk companies bonds would be forced Poor credit risk companies bonds would be forced to offer extremely high interest rates to attract to offer extremely high interest rates to attract financingfinancing
Bond sold at a low rate (7%) rather than a Bond sold at a low rate (7%) rather than a potentially high (12%) ratepotentially high (12%) rate
Bond owner has the right to convert the Bond owner has the right to convert the bond into common stock at a later datebond into common stock at a later date
Bond/common stock holders can share in Bond/common stock holders can share in the reward if the company does wellthe reward if the company does well
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Long Term DebtLong Term Debt
Senior debtSenior debt A debenture that gives holders A debenture that gives holders
priority over all other debentures in priority over all other debentures in the receipt of interest and assets in the receipt of interest and assets in the event of bankruptcythe event of bankruptcy
Subordinated debtSubordinated debt Holders of this debt have a priority Holders of this debt have a priority
below holders or senior debtbelow holders or senior debt Holders of this debt will receive an Holders of this debt will receive an
interest rate higher than holders of interest rate higher than holders of senior debtsenior debt
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Long Term DebtLong Term Debt
Junk BondsJunk Bonds The creditworthiness of most The creditworthiness of most
companies and their securities is companies and their securities is rated rated (Standard & Poor’s, Moody’s)(Standard & Poor’s, Moody’s)
Bonds with the three or four highest Bonds with the three or four highest ratings are investment graderatings are investment grade
Investment grade bonds Investment grade bonds recommended for pension funds and recommended for pension funds and very conservative investorsvery conservative investors
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Long Term DebtLong Term Debt
Junk Bonds – con’tJunk Bonds – con’t Bonds that do not receive the high Bonds that do not receive the high
ratings have a much smaller pool of ratings have a much smaller pool of investors and must pay higher ratesinvestors and must pay higher rates
Known as “high yield bonds”Known as “high yield bonds” Bonds with very low ratings must Bonds with very low ratings must
pay very high rates pay very high rates (risk vs. reward)(risk vs. reward)
Bonds with a very high yield and low Bonds with a very high yield and low quality status and knows as “junk quality status and knows as “junk bonds”bonds”
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Long Term Debt ReviewLong Term Debt Review
Term loansTerm loans BondsBonds DebenturesDebentures Mortgage bondsMortgage bonds Convertible bondsConvertible bonds Senior debtSenior debt Subordinated debtSubordinated debt Junk bondsJunk bonds
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EquityEquity
Selling common and preferred Selling common and preferred shares is essentially a permanent shares is essentially a permanent form of financingform of financing
Requires no repaymentRequires no repayment Equity financing may also be Equity financing may also be
issued for the purpose of:issued for the purpose of: Expanding stock ownershipExpanding stock ownership Reducing concentration of voting Reducing concentration of voting
powerpower
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EquityEquity
There are three important There are three important categories under the heading of categories under the heading of stockholders equity:stockholders equity:
1.1. Venture capitalVenture capital
2.2. Preferred stockPreferred stock
3.3. Common stockCommon stock
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EquityEquity Venture capitalVenture capital
Suppliers of venture capital are usually Suppliers of venture capital are usually financing an idea not yet implementedfinancing an idea not yet implemented
Company founders must have solid Company founders must have solid credentialscredentials
Companies are usually not candidates for Companies are usually not candidates for bank loansbank loans
Venture capital investors want some Venture capital investors want some ownership in the companyownership in the company
Venture capital investors will be intimately Venture capital investors will be intimately involved in how their money is spentinvolved in how their money is spent
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EquityEquity
Preferred stockPreferred stock A hybrid class of equity usually A hybrid class of equity usually
associated the mature businessesassociated the mature businesses Shareholders receive an indicated, Shareholders receive an indicated,
not guaranteed, dividendnot guaranteed, dividend When cash is tight, preferred receive When cash is tight, preferred receive
dividends before common dividends before common stockholdersstockholders
Generally not entitled to voteGenerally not entitled to vote May have the option to convert their May have the option to convert their
preferred shares into common sharespreferred shares into common shares
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EquityEquity
Common stockCommon stock When a company is going public for When a company is going public for
the first time they will have an IPOthe first time they will have an IPO A means to raise cashA means to raise cash Going public is expensiveGoing public is expensive
SEC filingsSEC filings Legal expensesLegal expenses
Common holders voteCommon holders vote