© 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.1

Finance for Non-Financial ManagersFifth Edition

Slides prepared by

Pierre G. BergeronUniversity of Ottawa


Chapter Objectives

1. Differentiate between internal financing and external financing.

2. Explain different types of risk-related financing options.

3. Explain useful strategies when approaching lenders.

4. Comment on the most important sources and forms of short-term financing.

5. Discuss the sources of intermediate and long-term financing.

6. Comment on the different categories of equity financing.

7. Identify the factors that can influence the choice between buying or leasing an asset.

Chapter Reference

Chapter 7: Sources and Forms of Financing

Sources and Forms of Financing


Finding Funding: Ten-Step Process

Know your

numbers

1 Identify financial

needs

2

Identify financing

requirements

3

Pinpoint sources of

cash

4

Become credit-worthy

8

Seek financing synergy

7

Prepare the investment proposal

9

Meet investors

10

Identify financing sources

5

Identify forms of financing

6


Current assets

• Cash

• Accounts receivable

• Inventory

Current liabilities

• Suppliers

• Commercial banks

• Factoring companies

• Inventory financing

• Term loans

• Conditional sales contracts

Financial needs Financing requirements

Capital assets

• Land

• Buildings

• Equipment

• Machinery

Leasing

Long-term debts• Mortgages• Bonds

Equity• Capital shares• Retained earnings• Contributions

Sources and Forms of Financing


“Financial needs”

Capital assets $ 700,000

Marketing costs $ 200,000

Working capital $ 170,000

Other assets $ 40,000

Gross funding requirements $1,110,000

Now, where will the funds come from?

“Financing requirements”

Financial Needs


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 $600,000 $360,000Investment required to

fund the project

Amount of financing available using internal

and external conventional sources

Amount of risk capital financing required

Financing Requirements


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

1. Internal Versus External Financing


2. Risk-Related Financing Options

Business risk: uncertainty in the marketplace

Financial risk: debt versus equity

Instrument risk: quality of security

30%

25%

20%

15%

10%

5%

Low

Government Bonds

Secured Short Term Debt (less than 1 year)

Secured Long Term Debt

Unsecured Debt

Subordinated Debt

Preferred Shares

Common Shares

High


3. Useful Strategies When Approaching Lenders

Process that relates financial needs to financing requirements in terms of length of time (e.g., mortgage used to finance a house).

Matching principle

Factors that investors look at to gauge the creditworthiness of a business (character, collateral, capacity, capital, circumstances, coverage).

C’s of credit

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).

Making a company creditworthy


Current assetsCash

Accounts receivable

Inventory

Line of creditSeasonal loansRevolving creditNotes payableSingle loan

Trade creditAccounts receivable financing

Inventory Financing(General lien, floor planning,warehouse financing)Consignment

Reasons for financing Forms Sources

Chartered banks

SuppliersFactoring companies

Confirming institutionsGovernment agencies

Current assets

Accounts receivable

& inventory

Working capital loans Chartered banks

Government agencies

Flexible

Durable

4. Short-Term Financing (12 months)


Supplier creditCash 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 creditBanks 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.

Short-Term Conventional Financing


FactoringFinancing can be obtained from a factoring company “the factor” who purchases receivables as they occur.

Asset-based financingSimilar 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.

Short-Term Risk Capital Financing


Term loanAmount 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 ContractThis is an agreement made between a buyer and a seller regarding the purchase of an asset (e.g., truck).

5. Long-Term Conventional Financing


BondsThese 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.

MortgagesMortgages 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).

Long-Term Conventional Financing (continued)


Subordinated debtThese 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.

Long-Term Risk Capital Financing


6. Equity Financing

ShareholdersFunds can be obtained from common shareholders and preferred shareholders. Shareholders benefit from collective and specific rights.

Risk capital financingRisk 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.


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


There are two broad categories of leases:

1. Operating lease (maintenance lease)

2. Financial leases

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

7. Lease Financing


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 firm’s 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.

Advantages to Leasing


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.

Key Variables of Leasing Versus Buying


A. About the lease

1. Duration of the lease is 10 years.

2. Annual cost of the lease (before tax) is $170,000.

B. About the financing and the purchase

1. Cost of the asset is $1,000,000.

2. Life of the asset is 10 years.

3. Debt agreement is 100% financing of the asset; a 10-year repayment schedule with 10% interest rate.

4. Residual value of the asset is nil.

5. Capital cost allowance is 15%.

C. Other assumption

1. Corporate income tax rate is 50%.

Calculating the Economics of Leasing or Buying


1

2

3

4

5

6

7

8

9

10

Cost of Owning Versus Leasing

Year

1 2 3 4 5 6 7 8 9 10

(Expressed in thousands of dollars) *favours owning ( ) favours leasing

85,0

850,0

Lease cost @ 50%

75,0

138,7

117,9

100,2

85,2

72,4

61,6

52,3

44,5

37,8

785,7

CCA

8,9*

31,8*

18,5*

8,2*

0,2*

(6,0)

(10,9)

(14,6)

(17,5)

(19,8)

(1,4)

Present value

@ 10%

87,5

116,2

102,4

89,7

78,0

67.1

56,6

46,4

36,4

26,3

706,6

Tax savings @

50%

6 ÷ 2

175,0

232,5

204,8

179,5

156,1

134,1

113,1

92,8

72,7

52,6

1,413,2

Tax deductible

expense

3 + 5

75,2

46,5

60,4

73,0

84,7

95,7

106,2

116,3

126,4

136,4

920,8

Net cost of owning

2 - 7

9,7*

38,5*

24,6*

12,0*

0,3*

(10,7)

(21,2)

(31,3)

(41,4)

(51,4)

(70,8)

Net advantage of

owning

8 - 1

162,7

1,627,450

Total payment

Computing net cost of owningApplication to loan

100,0

93,7

86,8

79,2

70,9

61,7

51,6

40,5

28,2

14,8

627,4

Debt repayment

Interest

62,7

69,0

75,9

83,5

91,8

101,1

111,1

122,3

134,5

147,9

1,000,0

Principal

Documents

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron