Chapter 16 Financial Decisions and Risk Management

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Chapter 16Financial Decisions and Risk Management
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Financing

• From the perspective of the corporation that
  needs financing
• Today
• LT Financing Debt versus Equity
• ST Financing
• What Banks Look For
• Forecasting

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Debt Versus Equity

• Debt needs to be repaid
• Interest must be paid fixed amount
• LEVERAGE
• Creditors get first dibs on assets at liquidation
• Creditors get no votes
• Creditors may stipulate constraints on the
  business
• Tax effects .

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Tax considerations

• Tax effects of Interest v Dividends
• Recipient of Interest pays tax on interest income
• Recipient of dividends pays reduced tax (or no
  tax) on dividend income
• Investors want higher interest rate
• Overall, paying interest results in less taxes
• Small Businesses
• Self-financing is mainly through debt
• E.g. suppose I invest 1,000,000 in my own company

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Short-Term Financing

• Why? Cyclical nature of business
• E.g. farmers
• E.g. Christmas season
• E.g. unexpected shock
• Demand loans
• Creditor can call loan whenever it wants
• If loan is called have to scramble to get new
  financing
• Why would a business subject itself to this risk?
  Why would a business borrow this way?

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Short-Term Financing (contd)

• Have to watch your cash flows very carefully, and
  maintain friendly relationships with your banker.

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What Banks Are Looking For

• Financial
• Expected profits cash flow
• Current ratio, Quick Ratio, Debt-Equity Ratio,
  Inventory Turnover, etc.
• Security
• Pledged assets (e.g. mortgage)
• Guarantees (e.g. by owner, by government)
• Fire sale value of assets
• Subjective
• Competence of management
• State of economy
• Threat of competitors

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Forecasting

• Why forecast?
• Plan timing of investments and borrowings
• Give investors information
• How to develop a forecast
• With a history
• Usually use prior year results as a starting
  point
• Then make reasonable adjustments

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Since we have time ..

• Jump back to some material we missed from Chapter
  15

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Who holds investments?

• Individuals - Direct
• publicly-traded
• privately-held
• Individuals through mutual funds
• Want diversified portfolio
• Not enough wealth to do it yourself
• Professionally managed

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Who holds investments?

• Corporations
• holding company
• Insurance companies
• Pension funds
• Venture capitalists

Parent Company
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Subsidiary
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