Ch14 Sources of financing Flashcards
Common reasons for requiring capital
- ongoing operations
- capital expenditures: building and maintaining plant and equipment
- M&A: to purchase other businesses to accelerate growth
- investment in working capital
- refinancing existing debt or equity
- recapitalization; buy out or monetize investment
- reserve for flexibility and build financial strength
Financing alternatives
- External sources of financing
- Debt
* supplier trade
* factoring (invoice financing)
* customer advances
+ line of credit bank facility
+ asset-based lending
+ securitization
* term loans, mortgages, debentures
* leasing
- Complex instruments
- bond with warrants
- covertible bonds
- convertible preferred shares
- External equity
- common shares
- preferred shares
Angel investors, venture capital, private equity and
public investors
- Internal source of financing
- reinvestment of net earnings
Factors for analyzing financing alternatives
- Features of each financing alternative
- amount
- cost, before and after taxes
*interest, legal fees, commission (initial issue cost)
- term (maturity)
- obligatory payments
- conditions
- financial reporting impact - Stakeholder objectives
- entity financing strategy
- existing owners’ preferences
- conflicts: entity versus existing owners
- impact on other stakeholders
no recourse factoring
the financing firm has no legal rights against the company in the event that the customer fails to pay AR balance, and the financing firm assumes all of the risks and rewards of ownership
Reporting: Dr. Cash
Dr. Financing fee
Cr. AR
recourse factoring
the company compensate the factor for any uncollected accounts
Reporting: (transfer of risks and rewards may not be complete)
Dr. Cash
Dr. Factoring fee expense
Dr. Factoring fee asset
Cr. Factoring loan
Short-term financing alternatives
- Factoring: high cost (net of administration fee)
- Asset-based loan
- ongoing monitoring reports required by lender (increases costs)
- the amount could be reduced any time if eligible balances of receivables and inventories decline
- customer payments must be deposited directly to the lender’s controlled account
- only the amount ofter lender deduction can be received - Credit facility
- usually provides higher than needed funds
- covenant required
Long-term financing (non equity)
- Mortgages: loans secured by real estate
- Debentures: unsecured laons against general credit
- Redeemable loan: borrower has the right to repay the loan prior to maturity
- Retractable loan: lender has the right to demand immediate repayment
- call provision: bond issuer repurchase bonds earlier than maturity
- sinking fund provision: bond issuer is required to deposit money annually with a trustee, ensuring that there will be enough cash to pay off the bond when it comes due
Other long-term financing
- Securitization (limited use)
a new security instrument backed by a pool of cash-generating assets owned by the company, e.g AR, credit card receivables, loan receivables, mortgage receivables.
it’s an asset-backed bond that pays interest and matures in 5-7 years
issued by an entity (backed by a financial institution) that may be a trust or some other form of tax-exempt entity
company sells pool of assest (ARs) to the entity* (with/out recourse) —> entity issues the asset-backed bond to the market
*for reporting, the entity is called “variable interest entity” in that it has a single purpose - to issue bonds backed by the assets
The form of financing may or may not be reported on the company’s balance sheet:
1) Dr. Cash
Dr. Financing fee expense
Cr. AR
or 2) Dr. Cash
Dr. Interest expense
Cr. Aasset-backed loan liability
The company administers customer accounts and collect customer deposits, and remits cash to the issuer.
- not often used (limited by nature and size of the assets) (theory is pool of assets backing the security has a lower risk than cash flows generated by day-to-day operations)
- lower cost than other loans the company pays
Government assistance
- Government grants
- initially recoginized, assuming all conditions will be met, not as an obligation
- in the event that not all requirements are satisfied, the baalance owing will be recognized as an obligation and become payable - Government loans
- variety of programs
- more attractive terms, might be interest-free or competitive rates, often unsecured / no covenants - Government subsidies
- government pays companies in certerina industries to keep prices low - Government guarantee - help provide the lender with added security in case of default
Equity financing
the most expensive form of financing - because equity investors are last in line for claim when a business fails.
the most flexible - because no associated repayment terms or covenants and maximum liabilities limited to amount invested
maintaining control - an important consideration
- dilution: the loss of proportionate ownership
- pre-emptive rights to have first opportunity to purchase any additional shares issued by the company to raise funds
small company entrepreneurs are compensated sufficiently for the ownership dilution if the business becomes a successful large-scale enterprise.
Types of equity financing (1/2)
- Common shares
- voting or non-voting rights to elect BODs (can be 1 share to multiple rights)
- right to receive dividends when declared
- residual claim to income and assets (after all financial stakeholders)
- at least one class of common shares is required
- more than one class is allowed, for non-voting or multiple rights for one share
Types of equity financing (2/2)
- Preferred shares
- a class of ownership that has a higher claim on assets and earnings than owners of common shares
- voting or non-voting
- fixed dividends when declared as a percentage of face value or a fixed dollar amount
- cumulative dividend: any unpaid dividend will be repaid prior to dividends being paid on common shares
- non-cumulative dividend: received only when declared; no payments for any prior periods where dividends were not paid)
- participating with common shareholders on any additional distributions of dividends (or residual amounts upon liquidation) as prescribed by the terms and conditions of the shares
- retractable: right to demand the company repurchase the shares
- redeemable: the company has the right to repurchase the shares
- more common features: non-voting, non-participating with fixed dividend rate
- used sometimes by private companies for tax-planning purpose not for financing
- may have mandatory redemption: the company must buy back - based on GAAP may be recorded as liability
Sources of equity financing (1/4)
- Angel investors
- common or wealthy individuals own funds in startup business
- expecting significant return
Sources of equity financing (2/4)
- Venture capital
- professional investors (fund)
- early-stage companies
- looking for disruptive business ideas: technology, biotechnology, energy, environmental services
- >30% annual ROI is expected
- actively participates in the planning and management of the businesses they finance (BOD seat)
- exit:
* sale of the business to strategic buyer
* sale of their position to private equity
* taking company to public with liquidity to sell their portion
Sources of equity financing (3/4)
- Private equity
- less riskier than VC
- pension funds, wealthy families, investment funds, investment companies (who are interested in investing private companies)
- large $ (millions $ to billions)
- active participation (advisory services in BOD)
Three situations desirable for PE financing:
1. high-growth companies: pick up where VC leave off
2. leveraged buyouts: for special transactions e.g. management buyout or privatization of a public company
3 Turnaround situations: for companies with financial challenges
Exit strategy:
- sell the business to strategic buyer
- take the company public (liquidity to sell their shares)
- introduce more debt to repurchase outstanding shares (PE’s investment)
