Unit 2: Managing Financial Resources and Decisions

Unit 2: Managing Financial Resources and Decisions1Criteria 1.2: Assess the implications of the different sourcesLegal Implications Financial Implications Dilution of control implications, Bankruptcy2Criteria 1-3: select appropriate sources of finance for a business projectChoosing a source: advantages and disadvantages of different sources, Suitability for purpose matching of term of finance to term of project

Long Term SourceLong Term Bank LoansA debt financing obligation issued by a bank or similar financialinstitution to a company or individual that holds legal claimto the borrower's assets above all other debt obligations. The loan is considered senior to all other claims against the borrower, which means that in the event of a bankruptcy the bank loan is the first to be repaid, before all other interested parties receive repayment.

Bank loans are usually secured viaa lien against the assets of the borrower. At the time the loan is made, there typically tend to be no other existing lienson the borrower's assets, or at least not on any of the assets being secured by the bank loan.

The Loan is usually termed between 10 to 25 years depending on the term of the project.

LoanAdvantageDisadvantageSpeed - A bank loan can be secured in a specific time frame

Fees - Some loans carry a prepayment penalty, high penalty rates, other finance chargesUses - A bank loan can be used in a number of ways; money can be borrowed for many large-ticket itemsLimitations - There are a number of limitations on the transaction. Cash Flow - Borrowing too much money can lead to decreased cash flow and payments can even overtake income in some casesLoan ImplicationsLegal Implications : Subject to asset seizure in case of defaultFinancial Implications : Payment of amortization per month/quarter/ annual should be fundedDilution of control implications: No Dilution of Control Bankruptcy Implication: if the borrower should enter a state of bankruptcy in the future, the assets used to secure the bank loan must be used to repay the bank loan before other creditors, preferred stockholders or common stockholders receive any payment.Merchant BankingAmerchantbank deals with the commercial banking needs of internationalfinance, long-term company loans, and stockunderwriting.

A large company that wishes to raise money from investors through thestock marketcan hire a merchant bank to implement and underwrite the process.

The merchant bank determines the number of stocks to be issued, the price at which the stock will be issued, and the timing of the release of this new stock.

The bank then files all thepaperworkrequired with the various market authorities, and is also frequently responsible for marketing the new stock, though this may be a joint effort with the company and managed by the merchant bank. Merchant Bank Advantage/ DisadvantageAdvantageDisadvantageMerchant banks perform functions that cannot be carried out by businesses on their own.Merchant banks are really only for large corporate customers, or extremely wealthy smaller businesses owned by individual clients.Merchant banks have access to traders,financial institutions, and markets that companies or individuals could not possibly reach.Not all deals carried out by merchant banks meet with unqualified success.By using their skills and contacts, merchant banks can get the best possible deals for their clients.There is always risk attached to the kinds of deal that merchant banks undertake.Merchant BankImplicationsLegal Implications : Depends on the type of fund source chosen for the companyFinancial Implications : Depends on the type of fund source chosen for the companyDilution of control implications: No Dilution of Control Bankruptcy Implication: Depends on the type of fund source chosen for the companyCommon SharesEquity Ownership in a corporation providing voting rights, and entitling the holderto a shareof the company's success through dividends and/or capital appreciation.

Characteristics

Term as long as company exists Earning Share in the profit of the company (dividends or gains in stock appreciation)VotingrightsClaim on the company's assets, Privileges to buy additional shares directly from the companyResidual owners of the companyCommon Shares- benefitsAdvantageDisadvantagePotential for delivering very large gainsStockholders are the last to get paid, like all other owners. Potential loss is limited to the total amount of the initial investment.Stockholders do not enjoy all of the rights and privileges that the owners of privately held companies do. Stocks offer limited legal liabilityInvestors in a company may not know all that there is to know about the company.Most stocks are very liquidStock prices tend to be volatile. Stocks have historically offered very high returns in relation to other investments.Stock values can sometimes change for no apparent reasonStocks offer two ways for their owners to benefit, bycapital gainsand withdividendsCommon SharesImplicationsLegal Implications : Each stockholder has the right to vote in the Board election to manage the company.

Financial Implications :Company is not obliged to pay the stock holders dividends. Payment of investment is not obligatory.

Dilution of control implications: Diluted Control

Bankruptcy Implication: Last to be paid from the residual asset of the companyPreferred SharesA stock that enjoys preference over common stockholders in terms of payment of dividend and in terms of distribution of assets in case of liquidation of the firm

Characteristics

Hybrid characteristic - Has features of both common stock and a bondTerm - Has infinite life (like common stock)Earnings - Pays a fixed rate of dividend each year (like coupon on a bond)Dividends cannot be deducted from firms income for tax purposesCumulative DividendPreferred SharesAdvantageDisadvantageGets dividends ahead of the other types of stocks. Most types of preferred stocks do not have a maturity date, and those that do have a maturity date usually mature in about 30 years, or even longerCompany is obliged to pay preferred stocks investors first before the common shareholders. Preferred stocks are callable so the issuer may call the stocks when it sees fit. For instance, if you have a high rate preferred stock mutual fund and the rates suddenly plummet, the issuer may call the stocks by buying them back. Preferred stocks Enjoy a better tax rate compared to bonds and bond funds.Low-rate investment for a long time because of the fixed income nature compared to Common StocksUsually have higher yields compared to bondsFixed dividend payments. Preferred SharesImplicationsLegal Implications : Stockholder do not have the right to vote the Board of the company.

Financial Implications :Company is obliged to pay the stock holders dividends. Dividend is cumulative if not paid .Payment of investment is not obligatory.

Dilution of control implications: Control over the company is not diluted

Bankruptcy Implication: Among the first to be paid from the residual asset of the companyStock Rights (warrants and options)Rights are either options or warrant. They give an investor the option to purchase a share of stock at a given price at some point in the future. An option is issued by the market exchange; a warrant is issued by the company offering the stock.Companies offer Rights on their shares when they want to boost investor confidence. They are predicting the value of their stock will go up.Scrip Issue/ Stock Dividends/ Stock SplitThe organization recapitalizes its earnings and issues new shares, which has no effect on its total assets and liabilities.

Stock dividends are usually expressed as a percentage of the number of shares that the company has outstanding.

a stock split is a proportionate increase in the number of outstanding shares that doesn't affect the issuing company's assets, liabilities, equity or earnings. Short TermOverdraft Facility/ Working Capital LineA good credit score, the interest rate and the maximum line of credit that you can get depends on your companys relationship with the lender. One advantage that this type of credit facility has over other types of working capital loans is that the borrower only pays for the interest applicable to the amount that has been overdrawn. The rates are typically set between 1 and 2 percent above the prime rate of the bank.Over draft benefitsAdvantageDisadvantageFlexible An overdraft is there when you need it, and costs nothing (apart from possibly a small fee) when you do not.

Cost Overdrafts carry interest and fees; often at much higher rates than loans.

Quick Overdrafts are easy and quick to arrange, providing a good cashflow backup with the minimum requirement.Recall Unless specified in the terms and conditions, the bank can recall the entire overdraft at any time. Security Overdrafts may need to be secured against your business assets, which put them at risk if you cannot meet repayments.Over draftLegal Implications : Need to fill-up promise to pay requirements and other repayment term documentsFinancial Implications :Company is obliged to pay the repayment charges. Penalties and other charges are extra burden if not paid on timeDilution of control implications: Control over the company is not dilutedBankruptcy Implication: Among the first to be paid from the residual asset of the companyFactoringA working capital debt where the value of the loan is based on future credit card receipts. This particular debt is only appropriate for businesses that accept credit card payments.

Factoring benefitsAdvantageDisadvantage. Establish a strong foundationCostMaximise profitabilityPossible harm to customer relationCapture growth opportunitiesCompany image distortionFactoring may impose constraints on the way you do businessFactoring- ImplicationsLegal Implications : Need to fill-up factoring contractsFinancial Implications : Company has to shoulder the 10% to 30% reduction of collectiblesDilution of control implications: Control over the company is not diluted; Some accounts receivable policies may be controlled by the factoring companyBankruptcy Implication: Non-recourse to collectible accounts receivable

Trade CreditA loan that is provided by a present or potential supplier is called a trade creditor working capital loan. More often than not, suppliers will offer a trade credit facility if you place bulk orders from them. However, before you can secure such a loan, you can expect that the trade creditor will thoroughly check on your companys credit history.Trade CreditAdvantageDisadvantageReduced Capital RequirementsCost and Penalty clausesImproved cash flowsCredit worth in case of defaultIncreased business focusTrade Credit - ImplicationsLegal Implications : Can be sued in case of non-payment; Financial Implications : Company has to shoulder the penalties of non-payment on time but have discount for prompt paymentsDilution of control implications: Control over the company is not dilutedBankruptcy Implication: Suppliers must file case for first payment in case of bankruptcy.Asset LeaseAn Asset Lease enables the customer to have the use oftheirbusiness equipmentand the benefits of ownership, while the financier retains actual ownership of the equipment.The financier purchases theequipment on behalf of the customer, who thenpays the financier a fixed monthly lease rentalfor the term of the lease.At the end of thelease the customer can either pay a residualon the lease and take ownership of the equipment,sellthe equipmentor re-finance the residual and continue the lease.Asset LeaseAdvantageDisadvantageFlexible contract terms

Lease Termination Charges

Fixed interest rates and monthly lease rentalsCosts are known in advance

The cost of leasing overtime can surpass the cost of buying. You are essentially renting the item and you never own it, even after you have spent a significant sum of money on it.

Tax deductions for the lease payments can be claimed

Ability to make advance lease payments for tax deduction or cash-flow purposes

Qualifying for a lease program can be difficult for those who have a bad credit or employment history. These factors will not matter as much when you are buying something.

Asset LeaseLegal Implications : Lease agreement is requiredFinancial Implications : GST is charged on the monthly lease rental and onthe residual value at the end of the lease. The customer can claim the lease rentals as a tax deduction.Dilution of control implications: Control over the company is not diluted but pull-out of asset in case of default that may hamper operationsBankruptcy Implication: Suppliers must file case for first payment in case of bankruptcy.Lease PurchaseACommercial Hire Purchaseis a finance product where the customer hires theirbusiness equipmentfrom the financier for a fixed monthly repayment over a set period of time.Under a Commercial Hire Purchase arrangement the financier agrees to purchase the equipment on behalf of the customer, and then hire it back to them over a set period of time.The customer has the use of thebusiness equipmentfor the term of the contract but does notown it.At the end of the contract term when the total price of theequipment (minus any residual) and the interest charges have been paid in full, the customer takes ownership of the equipment.

Lease PurchaseAdvantageDisadvantageFlexible contract termsObligation to continue making paymentsFixed interest rates and monthly lease rentals; Costs are known in advanceObsolete or Depreciated asset after termTax deductions for the depreciation can be claimedMaintenance ClauseAbility to structure your repayments to suit cash-flow trendsA residual can be applied tocontract, lowering monthly paymentsDeposit (either cash or trade-in) may be usedLease PurchaseLegal Implications : Agreement is required; Financial Implications : Tax Credits can be enjoyed; The customer can claim depreciation of their equipment as a tax deduction.Dilution of control implications: Control over the company is not diluted but pull-out of asset in case of default that may hamper operationsBankruptcy Implication: None

SeatworkPer GroupAdvantages/ DisadvantagesSource of FinancePriority of AccessType of Project (Short or Long)Sales IncreaseUse of Retained EarningsSale of AssetsLong Term LoansMerchant BankingGrantsSale of SharesIssue of RightsScrip IssueAdvantages/ DisadvantagesSource of FinancePriority of AccessType of Project (Short or Long)Short Term LoansOverdraftFactoringTrade CreditLeasingLease PurchaseWorking Capital MgtMergerTakeoverVenture CapitalistsAngel InvestorsSuitability for PurposeTerm/ ProjectShort Term ProjectLong Term ProjectShort Term FinanceLong Term FinanceSuitability for PurposeTerm/ ProjectShort Term ProjectLong Term ProjectShort Term FinanceSTL/ MTL, Sales, Retained Earnings, Sale of Assets, Over Draft, Factoring, Leasing, WC Mgt, Sale of Assets, Factoring, Leasing, WC MgtLong Term FinanceLTL, VCs, Angels, Grants, Rights, Scrip issue, LTL, Shares, VCs, Angels, merchant banks, Merger, Takeover, Sale of Company