Debt Financing: Loans and Bonds

Debt Financing

• Businesses get capital by borrowing money which is paid back with interest.
• A Lender (creditor) is paid the initial loan (principal) and interest.
• Lenders assess collateral when determining the amount of debt granted, generally up to 70% of the borrower's assets.

Debt Financing Products

• Available to individual and institutional investors in the form of bonds, bills, and notes.
• Bond: A loan for a defined time; the investor is paid interest, and the business repays at maturity.
• Note: It is a financial contract for a loan that includes due date and interest.
• Bank bill: A loan linked to a bank's cost of funds, specifying a margin above the Bank Bill Swap Bid Rate.
• Regular Loan: Major financial institutions like FCC, RBC, and ATB provide this loan.
• Community bonds: Local investments intended for community projects with beneficial social outcomes.
• Debentures: Loan certificates without collateral, backed by credit instead of specified assets.

Debt Financing and Income Statement

• Debt Proceeds as Cash Inflow: Borrowed debt goes into the financing section as an inflow, not as revenue.
• Principal Repayment as Cash Outflow: Principal payments go into the cash flow statement's financing section as outflows.
• Interest Costs: Interest payments and expenses are non-operating expenses.
• Debt Issuance Costs: Expenses for issuing debt are amortized and recorded as expenses.
• Net Cash Flow: Calculated as (Revenue + Debt Proceeds) - (Total Cost + Cash Outflows).
• Additional Debt Details: Repayment schedules, interest rates, dates, covenants and collateral are disclosed.

Equity Financing

• Involves raising capital by selling business shares to finance long or short-term debt.
• Unlike debt, equity investment carries no fixed payments.
• Equity investors face more risk than debt holders.
• Equity investors are not serviced during poor cash-flow times.
• Equity holders have a share of profit when a business performs well.
• Debt holders are paid first in bankruptcy; equity investors are last to be paid.

Equity Financing and Income Statement

• Record Equity Financing as a Cash Inflow:
  • Record as a cash inflow, not as revenue.
  • Project planned dividends as cash outflows as paid.
• No Tax Deduction for Equity Financing: Does not have interest tax shields unlike debt.
• Exit Strategy Consideration: Potential exit strategies include selling the project, distributing to shareholders, or liquidation.
  • Your business plan should record the initial equity investment as a cash outflow.

Differences between Debt vs. Equity Financing

• Business Control:
  • Debt financing: Lender requires security, posing a risk of bankruptcy
  • Equity financing: Equity holders have control, which can complicate operations and direction.
• Business Risk:
  • Debt financing: Increases risk because of fixed obligations.
  • Equity financing: Reduces risk by having equity holders share in profits and losses.
• Profits:
  • Debt financing: Interest is subtracted, lowering taxable income, but creates a loss and cash-flow pressure.
  • Equity financing: Equity holders share profits, but payments are made only when profits are made.

Dividend Policy

• Distribution of profits to shareholders; undistributed profits are reinvested as retained earnings.
• Businesses pay dividends, after tax using net cash flow.
• Payments to shareholders is a cash outflow that reduces cash for growth.
• High growth startups don't pay dividends, the reinvest net profit back into the business.
• Some investors prefer a regular regular dividend income.
• Some investors allow the business to reinvest and enhance shares.

External Rate of Return (ERR)

• It is a rate of return on an investment where excess cash earns interest at a rate that is pre-determined.
• ERR equates initial equity investment and NPV of received dividends.
• ERR shows the return on shareholder equity ($).
• Terminal Value: Investment's future value.
• Initial Investment: initial cost of the investment.
• n: Number of years.
• Investors compare ERR to minimum acceptable rate of return (MARR).
• MARR: The minimum return accepted for certain investment risks.
• Accept if ERR > MARR.

ERR Example

• Investing $50,000 and generating a terminal value of $75,000 after 5 years results in an ERR of approximately 0.086.
• The amount of my own cash I have to put in is $180 000 - $26 620 = $153 380.
• 153 380(F/P, ie, 2) = 200 000.
• ie = 14.2%.

Contingency Plans

• A contingency plan is a course of action for effective organizational responses.
• Plans are required for critical variables.
  • What happens if sales don't meet the target?
  • Where is the shut-down point?
  • If sales exceed expectations?
• Contingency plans cover capacity, financing, management, and supply shortages.
• The plan discusses the exit strategy if an opportunity is temporary.

Contingency Plans - Examples

• Stables (Boarding & Arena Rentals):
  • Alterations are needed if stables are not full to 70% capacity after the first year.
  • Alterations may include lowering prices if competition is high, or allow for arena rentals, increasing profits.
• Most common contingency strategies:
  • Reduce price to make the product more appealing.
  • Increase in trade shows, advertisement and marketing.
  • Target a new market for your products and services
  • Switch to products with more stable markets
  • Exit the business
• SGM Grain marketing app:
  • If it becomes unprofitable you must enhance marketing by attending tradeshows, radio ads, and social media.
• Langham Loaders (Grain Loading Facility):
  • Uncontrollable weather may affect the biggest threat of production levels.
  • Proactively forecast production levels for years.
  • Lower price to encourage more producers during years with production.
  • The business may discontinue seasonal positions if business becomes unprofitable.
  • If Langham Loaders cannot cover costs after 5 years, the business will shut down.
• Works and Days Winery:
  • Can reduce wine production that isn't selling and increase in wines that are selling well.
  • Can increase marketing budget for attempt to increase sales through public visibility and halt overproduction.
  • Can move to a rural location, this will lower overhead costs and taxes.
  • Shut down the winery on the seasonal basis.
• Ancient Oils (Camelina oil plant):
  • Seek other markets if sales are not met with in two years.
  • Ancient Oils can invest in Radio and magazine ads.
  • If sales expectation are not met you can choose to change the oilseeds process.
  • Substitute soybean to create biodiesel.