introduction to business 3e 16 part vi: financial management copyright © 2004 south-western. all...

Copyright © 2004 South-Western. All rights reserved.

Jeff MaduraIntroduction to

Business 3e

Introduction to Business 3e

1616Part VI: Financial ManagementPart VI: Financial Management

FinancingFinancingFinancingFinancing

Copyright © 2004 South-Western. All rights reserved. 16–2

Accounting and Financial Accounting and Financial ManagementManagement


FinancingFinancing


Learning GoalsLearning Goals• Identify common methods of debt financing for firms

• Identify common methods of equity financing for firms

•Explain how firms issue securities to obtain funds

•Describe how firms determine the composition of their financing


Methods of Debt FinancingMethods of Debt Financing•Firms borrow funds (debt financing) to invest in assets such as buildings, machinery, and equipment– Borrowing from financial institutions– Issuing bonds– Issuing commercial paper


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Interest Rate Charged on Loans Interest Rate Charged on Loans under under

Three Different ScenariosThree Different Scenarios

Exhibit 16.1

1 2 3 4 5

Inte

rest

Rat

e

Years

I2

I1

I3

(Floating rate; period of rising interest rates)

(Fixed rate)

(Floating rate; period of declining interest rates)


Methods of Debt FinancingMethods of Debt Financing•Borrowing from financial institutions requires proof of creditworthiness– Planned use of funds– Firm’s financial condition– Industry outlook– Collateral

Asset for which borrowed funds will be used Accounts receivable


Methods of Debt FinancingMethods of Debt Financing•Creditworthiness impacts loan terms

– Interest rate (usually prime rate + premium) Fixed versus floating rate


Methods of Debt FinancingMethods of Debt Financing• Issuing bonds

– Indenture explains firm’s obligations to bondholdersStates whether bond has call feature

– Bondholders can enforce protective covenants to reduce risk of default by the firm


Methods of Debt FinancingMethods of Debt Financing• Issuing bonds

– Long-term debt securities (IOUs) purchased by investors

– Par value is amount the bondholder receives at maturity (usually 10-30 years)

– Coupon (interest) rate is fixed for life of the bond and paid semi-annually

– Bonds can be secured by collateral or unsecured


Effect of Effect of Interest Interest Rates on Rates on Interest Interest

Expenses Expenses incurred by incurred by

FirmsFirms

Exhibit 16.2


Summary of Risk Ratings Summary of Risk Ratings Assigned Assigned

by Bond Rating Agenciesby Bond Rating Agencies


Methods of Debt FinancingMethods of Debt Financing• Issuing commercial paper

– Short-term debt security normally issued by firms that are in good financial condition

– Normal maturity between 3 and 6 months– Used as an an alternative to obtaining loans

from financial institutions– Minimum denomination is usually $100,000,

but typically issued in multiples of $1,000,000


Methods of Debt FinancingMethods of Debt Financing• Issuing commercial paper (cont’d)

– Various financial institutions purchase commercial paper

– Interest rates depend on market interest rates at time of issuance


Providers of Debt Providers of Debt FinancingFinancing

• Commercial banks• Savings institutions (aka “thrifts”)

• Finance companies– Provide loans to less

established firms with higher risk of default - charge higher interest rates

• Pension funds• Insurance companies

• Mutual funds• Bond mutual funds


Methods of Equity Methods of Equity FinancingFinancing

•Equity financing– Funds of the firm’s owners that are used to

finance activities Retaining earnings instead of distributing

dividends to owners Larger firms distribute some of their

earnings as dividends and retain the rest.

– Issuing stock Common stock versus preferred stock Common stockholders have voting rights,

preferred stockholders usually do not.


Methods of Equity Methods of Equity FinancingFinancing

• Issuing stock to venture capital firms– Firm composed of individuals who invest in

small businesses and expect a share of the businesses in which they invest.

• IPO (initial public offering)– “Going public” - the first time a firm issues

stock to the public After an IPO, the firm lists its stock on the

secondary market (NYSE or NASDAQ).

•Stock mutual funds


Summary of Firm’s Debt and Summary of Firm’s Debt and Equity Financing MethodsEquity Financing Methods

Exhibit 16.4


How Firms Issue SecuritiesHow Firms Issue Securities• Public Offering

– Selling securities (stocks or bonds) to the public

• Issuing firm is assisted by investment bank– Origination– Underwriting

Investment bank guarantees a price to the issuing firm, no matter what price the securities are sold for

For large issues, an underwriting syndicate may be used.

– Distribution Register with SEC and provide prospectus.


How Firms Can Benefit from Supplier How Firms Can Benefit from Supplier FinancingFinancing

Exhibit 16.5


Other Methods of Obtaining Other Methods of Obtaining FundsFunds

•Financing from suppliers– Supplier’s willingness to wait for payment,

saves the firm some financing costs

•Leasing– Rent assets for a specified period of time


How a Firm’s Return on Equity is How a Firm’s Return on Equity is Dependent on Financial LeverageDependent on Financial Leverage

Exhibit 16.6


Deciding the Capital Deciding the Capital StructureStructure

•Capital structure– The amount of debt versus equity financing

used by the firm– Interest payments on debt are tax-deductible– Too much debt increases the firm’s risk of

default– Firms may repurchase some of their stock or

issue additional shares to revise the capital structure.


How a Firm’s Interest Expense How a Firm’s Interest Expense is Dependent on Financial is Dependent on Financial

Leverage Leverage

Exhibit 16.7


Small Business SurveySmall Business SurveyFinancing Choices of Small Firms


Dividend PolicyDividend Policy•Board of directors determines how much of the firm’s earnings should be distributed as dividends or retained to finance future operations– This decision influences the amount of

additional financing the firm must obtain

•Factors that affect dividend policy– Shareholder expectations– Firm’s financing needs


Chapter SummaryChapter Summary• Common forms of debt financing include obtaining bank loans, issuing bonds, or issuing commercial paper

• Common sources of equity financing include retaining earnings and issuing stock

• Firms hire an investment bank to assist with issuing stocks and bonds

• Firms may prefer debt financing because interest payments are tax deductible


How the Demand and Supply of How the Demand and Supply of Loanable Funds Affect Interest Loanable Funds Affect Interest

RatesRates

Exhibit 16A.1a


How the Demand and Supply of How the Demand and Supply of Loanable Funds Affect Interest Loanable Funds Affect Interest

RatesRates

Exhibit 16A.1b


Effect of a Change in the Effect of a Change in the Demand for Loanable Funds on Demand for Loanable Funds on

Interest RatesInterest Rates

Exhibit 16A.2a


Effect of a Change in the Effect of a Change in the Demand for Loanable Funds on Demand for Loanable Funds on

Interest RatesInterest Rates

Exhibit 16A.2b


Effect of a Change in the Supply Effect of a Change in the Supply of Loanable Funds on Interest of Loanable Funds on Interest

RatesRates

Exhibit 16A.3


Summary of Key Factors That Summary of Key Factors That Affect Interest RatesAffect Interest Rates

Exhibit 16A.4

introduction to business 3e 16 part vi: financial management copyright © 2004 south-western. all...

Documents

funds debt financing

established firms

firms obligations

firms owners

ownerslarger firms

commercial paperinterest

firm issues stock

higher risk of default