Finance for NonFinancial Managers Fifth Edition

1
Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

2
Sources and Forms of Financing

• Chapter Objectives
• Differentiate between internal financing and
  external financing.
• Explain different types of risk-related financing
  options.
• Explain useful strategies when approaching
  lenders.
• Comment on the most important sources and forms
  of short-term financing.
• Discuss the sources of intermediate and long-term
  financing.
• Comment on the different categories of equity
  financing.
• Identify the factors that can influence the
  choice between buying or leasing an asset.

Chapter Reference Chapter 7 Sources and Forms of
Financing
3
Finding Funding Ten-Step Process
2
Identify financial needs
1
4
5
Pinpoint sources of cash
Know your numbers
Identify financing sources
3
Identify financing requirements
9
8
10
7
6
Seek financing synergy
Become credit-worthy
Prepare the investment proposal
Identify forms of financing
Meet investors
4
Sources and Forms of Financing
Financing requirements
Financial needs

• Current assets
• Cash
• Accounts receivable
• Inventory

• Current liabilities
• Suppliers
• Commercial banks
• Factoring companies
• Inventory financing
• Term loans
• Conditional sales contracts

5
Financial Needs
Financial needs Capital assets
700,000 Marketing costs 200,000 Working
capital 170,000 Other assets
40,000 Gross funding requirements 1,110,000
6
Financing Requirements
Total Operating Term Risk
costs line debt capital Capital
Assets 700,000
0 600,000 100,000 Marketing 200,000
0 0 200,000 Working capital
170,000 150,000 0 20,000 Other
assets 40,000 0
0 40,000 Sub-total 1,110,000 150,000 600,00
0 360,000
Amount of financing available using internal and
external conventional sources
Amount of risk capital financing required
Investment required to fund the project
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1. Internal Versus External Financing
Internal financing 1. Income from the
business Net income Add back
amortization Total funds generated by the
business 2. Working capital -
inventory - accounts receivable
External financing 1. Shareholders 2.
Lenders (short- and long-term) 3. Leasing
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2. Risk-Related Financing Options
Business risk uncertainty in the
marketplace Financial risk debt versus
equity Instrument risk quality of security
30
Common Shares
25
Preferred Shares
Subordinated Debt
20
Unsecured Debt
15
Secured Long Term Debt
Secured Short Term Debt (less than 1 year)
10
Government Bonds
5
Low
High
9
3. Useful Strategies When Approaching Lenders
Matching principle
Process that relates financial needs to financing
requirements in terms of length of time (e.g.,
mortgage used to finance a house).
Cs of credit
Factors that investors look at to gauge the
creditworthiness of a business (character,
collateral, capacity, capital, circumstances,
coverage).
Making a company creditworthy
Poor earnings record, questionable management
ability, collateral of insufficient quality or
quantity, slow and past due in trade or loan
payments, poor accounting system, new firm with
no established earnings records, poor moral risk
(character).
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4. Short-Term Financing (12 months)
Reasons for financing
Forms
Sources
Current assets Cash Accounts
receivable Inventory
Chartered banks Suppliers Factoring
companies Confirming institutions Government
agencies
Flexible
Line of credit Seasonal loans Revolving
credit Notes payable Single loan Trade
credit Accounts receivable financing Inventory
Financing (General lien, floor planning, warehouse
financing) Consignment
Current assets Accounts
receivable inventory
Durable
Working capital loans
Chartered banks Government agencies
11
Short-Term Conventional Financing

• Supplier credit
• Cash discounts should be taken when offered by
  suppliers, even if a loan has to be borrowed from
  a bank. This also depends on the size of the
  discount and the cost of funds (interest rate) on
  the bank line of credit.
• Bank line of credit
• Banks may finance 75 of accounts receivable, 50
  of inventories and 90 of marketable securities
  (these margins are indicative only). Types of
  short-term financing include line of credit,
  self-liquidating loans, revolving credit, interim
  financing.

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Short-Term Risk Capital Financing

• Factoring
• Financing can be obtained from a factoring
  company the factor who purchases receivables as
  they occur.
• Asset-based financing
• Similar to a bank line of credit it is subject
  to a ceiling borrowing amount based on
  receivable and inventory margins and also
  involves a security pledge on these assets.

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5. Long-Term Conventional Financing

• Term loan
• Amount of the term loan financing depends on what
  can be offered as security and is determined by
  the lender (i.e., bank, trust companies,
  insurance companies and pension funds). If
  suitable security is not offered, chances for
  obtaining a term loan are reduced.
• Conditional Sales Contract
• This is an agreement made between a buyer and a
  seller regarding the purchase of an asset (e.g.,
  truck).

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Long-Term Conventional Financing (continued)
Bonds These are loans that could be secured or
unsecured (20 to 30 years) for which a firm
agrees to make payments of interest and
principal, usually semi-annually, to the holder
of the bond contract. Mortgages Mortgages
finance real property, land and buildings.
Lenders base the amount of the mortgage on the
market value of the property (50 of the market
value is a common assessment).
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Long-Term Risk Capital Financing

• Subordinated debt
• These investors accept a higher level of risk
  compared with conventional sources and ask coupon
  interest rates typically ranging from 8 to 12.
  
• The overall rate of return to the investor is
  higher because participation features at the time
  of exit increase the rate of return the minimum
  expected return is between 12 to 25 per year.

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6. Equity Financing
Shareholders Funds can be obtained from common
shareholders and preferred shareholders.
Shareholders benefit from collective and specific
rights. Risk capital financing Risk capital
investors typically seek returns ranging from a
minimum of 25 to 40 per year. The required
return on equity relates to the percentage or
share ownership. Risk capital can be provided by
angels, private investors, institutional
investors, government-backed corporations and
corporate strategic investors.
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Government Financing
Government financing is a direct or indirect form
of financial assistance offered by municipal,
provincial, or federal agencies to help
businesses carry out capital expenditure projects
or expansion of their activities that, without
such assistance, would be delayed or even
abandoned. The more important federal
government financial institutions are

• Industry Canada
• Export Development Corporation
• Farm Credit Corporation
• The Business Development Bank of Canada

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7. Lease Financing
Lease financing is an alternative to the more
traditional financing for the acquisition of any
asset and it takes place when a lessee pays a
lessor for the use of an asset.

• Direct lease
• Sale and leaseback

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Advantages to Leasing

• It is a good source of financing for obtaining
  assets for firms that have limited capital funds.
• Leases are quoted at fixed rates (the company
  avoids the risk of having to refinance at a
  higher interest rate).
• The business may conserve existing sources of
  credit for other uses and usually does not
  restrict a firms borrowing capacity.
• Leases provide 100 financing as compared to say
  75 through conventional financing.
• All costs, sales taxes, acquisition costs,
  delivery and installation charges related to the
  acquisition may be included in the lease payment.
  
• The lease-payment is tax deductible.
• It is a good way of trying machinery and
  equipment before committing oneself to the
  purchase.
• It provides a way to meet seasonal production.

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Key Variables of Leasing Versus Buying

• Capital cost allowance Tax effects of capital
  cost allowance represent an
  advantage to ownership.

• Obsolescence Makes leasing more attractive.

• Operating and Represent an expense to
  ownership and
• maintenance charges make leasing more
  attractive.

• Salvage or residual value Advantage to ownership.

• Discount rate Different discount rates may be
  used depending on the degree of risk
  related to each option.

• Tax effects Lease payments are fully tax
  deductible and make leasing more attractive.

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Calculating the Economics of Leasing or Buying

• About the lease
• Duration of the lease is 10 years.
• Annual cost of the lease (before tax) is 170,000.

• About the financing and the purchase
• Cost of the asset is 1,000,000.
• Life of the asset is 10 years.
• Debt agreement is 100 financing of the asset a
  10-year repayment schedule with 10 interest
  rate.
• Residual value of the asset is nil.
• Capital cost allowance is 15.

• Other assumption
• Corporate income tax rate is 50.

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Cost of Owning Versus Leasing
1 2 3
4 5 6
7 8 9
10
Year
1 2 3 4 5 6 7 8 9 10
(Expressed in thousands of dollars) favours
owning
( ) favours leasing