Mastering Financial Management PDF

Mastering Financial 19 Management Learning Objectives Once you complete this chapter, you will be able to: 19-5 Estimate comnpany value based onthe terms of an equity deal....

Mastering Financial 19 Management Learning Objectives Once you complete this chapter, you will be able to: 19-5 Estimate comnpany value based onthe terms of an equity deal. the cash flow cycle, 19-1 Explain how long-term financial needs,company is appropriate fow and seasonality can cause a profitable to have 19-6 ldentifywhich type of short-term financing a given situation. significant cash shortages. 19-7 ldentify the source of a long-term financing need and classif, 19-2 Distinguish among the three primary types of budgets used equity, secured or unsecured. for a financial plan. it as either debt or 19-3 List the five key considerations for choosinga fom of financing. 19-4 Contrast the advantages and disadvantages of debt versus equity financing. available when managers must ensure that tunds are Introduction needed, that they are obtained at the lowest possible cost, and that they are used as efficiently as possible. Businesses need cash to operate. The most obvious way This involves understanding the various plans and strat to generate cash is bv selling products to customers at egies for the organization and ensuring that financial a profit. But there are a variety of reasons why com resources are available to support them. A financial man panies need to seek additional cash from outside sources. ager must be able to answer a variety of questions related Even profitable businesses sometimes need better cash to short- and long-term financial needs, such as: management and access to additional financing. It is not uncommon for profitable companies to be short of Do we have enough cash to pay salaries, rent, and cash. The ability to access money for business operations other fixed expenses? and growth is important. We will discuss how businesses Can we pay our suppliers on time and maintaina posi develop financial plans and evaluate their financing tive credit rating? options in this chapter on financial management. Do we have enough money to pay for future projects or long-term financial needs? The Need for Financial Management Where should we invest our excess cash to ensure safety but also get a decent returnon investment? 19-1 Explain how long-term financial needs, Are we being adequately compensated for the risks the cash flow cycle,and seasonality we are taking? can cause a profitable company to have Financial managemnent can make the difference significant cash shortages. between success and failure for both large and small Financial management businesses. For example, executives at Cisco Systems financial management all consists of all activities activities related to generating and raising money and using it effectively; related to generating and use aggressive financial planning to anticipate the for larger companies, usually overseen raising money and using technology business's need for financing, Today,. Cisco by the chief financial officer (CFO) lhas billions of dollars on hand to fuel plans for future it effectively. Financial growth. without financial planning, Cisco Systems 338 Part 7: The Financial Side of Business would not be able to fund its research and ment efforts to develop develop- state-of-the-art Cfective financial management also products. Financial management boils down to a few Systems to pay its bills on time, pay enables Cisco components: simple taxes, distribute employee salaries. dividends to its buy other companies that strengthenshareholders, and Understand the company's plans. or complement Convert those plans into its position in the industry. projections that you can Ment has helped Cisco Finally, financial manage analyze. Systerms employ over 75,000 people, record annual revenue Calculate the short- and long-term financial of nearly $50 billion, of the business. needs and become a leader in a very industry. competitive technology Once those needs have been cial manager can create a plan for identified, finan the The need for proactive accessing the funds. a5o apparent during the lastfinancial management was the "Big Three North economic crisis when American linancial problems. General Motorsautomakers ran into to foster innovation through the creation of "concept Tor bankruptcy, but Ford was and Chrysler filed cars" for the future. espite able to keep operating Financial planning is a dynamic activity, and needs Imoil. declining sales and worldwide economic tur can ch¡nge based on a variety of factors. At the execu Executives at Ford used aggressive financial tive level, many larger businesses have a chief financial lanning to anticipate the automaker's need for finan- cing, To avoid the officer (CFO) who manages the business's finances and same fate as General Motors and reports directly to the chief executive officer (CEO). andChrysler. Ford's financial managers issued new equity Some conmpanies use other titles such as vice president in theborrowed money in anticipation of a downturn of finance, treasurer, or controller. Either way, these company's sales and profits. The money Ford randaised kept managers and their stafr are responsible for ensuring the allowed the company has the financial the company operating during the crisis resources it needs, when it dividends profits ofthOnpany the distributed to company to continue to buildfor the uture. Today, Ford remains profitable and continues leeds them. wt dre shareholders Chapter I9: Mastering Financial Management 339  Export Promotion and International Trade Common Reasons for Needing Financing announced its first ever Black Mary Pro- Entrepreneurship Ng A company's financing needs often fall into two broad gram(BEP)? The program is a partnership between the Black-led categories: long-term financing and short-term finan Government of Canada, companies, and Can- adian financial institutions. The BEP consists of three cing. Long-tern financing is monev that is typically used support Canadian to fund projects that are long-term in nature (more than one year). The dollar amonts raiscd and amonts of nique components that businesses, the Black Entrepreneurship Black-owned Program (pro- money involved in long-tern financing can scem almost viding loans), the National | Ecosystem Fund (support for the unreal. For exanple, cosmetics company Revlon Inc. not-for profit organizations), and Black struck a deal for $S50 million in 2020 to refinance some Entrepre- neurship Knowledge Hub (identifies barriers to sucCess of its debt and enhance the companv's capital struc and opportunities for growth). ture,' Monev raised that will have to be repaid witlhin Negative Cash FlowCash flow is the movement of one year is considered short-term financing. While there monev into and out of an organization. Remernber. no are manv short-term fìnancing needs, one very obvious all busiess transactions involve an immediate exchange need foraretailer is paving suppliers. Aretailer such as of cash. For exarmple, Canadian outdoor clothing Canadian Tire must pav its suppliers when the bills come and sporting goods company Arc'teryx offers crerl. due or it willsoon be unable to obtain the merchandise it to retailers and wholesalers that carry the companvs needs to meet the needs of its customers. Companies often use outside financing to help fund clothing, footwear, and equipment. Credit purchases made by ArcteryX retailers generally are not paid unti long-ternm investments. For example, building a new fac 30 to 60 days (or more) after the transaction. Selling to tor cam cost hundreds of millions of dollars but allows the company to grow bv selling products made in that other companies oncredit generates what is called trade facility. In addition, the factony is an asset that the com credit. While these sales are profitable, Arcteryx will panv will be able to use for manv vears. This is similar to not receive any financia benefits from the sale until it receives payment from its customers. Arcteryx must pay when vou buv a car or ahouse. Even if vou have a steady its manufacturing expenses before receiving payment income that covers vour monthlv expenses, that income from customers; this means the company has a negative is usually not enough to pavy cash for a car or a house.You cash flow. If this happens all the time, we would say the will look for a loan to help finance those large purchases. company has a negative cash flow cycle. Negative cash Aside from large, long-term financial needs, the flow is not uncommon nor is it a bad thing, because optimal scenario is for companies to have enough incoming cash from revenue to cover daily operations. offering trade credit is often necessary to remain com However. potential cash shortages are common in busi petitive as a supplier. In fact, many big-box retailers refuse to do business with suppliers that demand pav nesses. It is obvious why an unprofitable company might run into a cash shortageit is bringing in less money ment within 30 days after delivery. than is needed to cover its bills. If this company cannot What would happen if Arc'teryx suddenly increased its customer base by 30 percent right before the spring find additional financing, it could be forced to sell off hiking and climbing season? Its business is growing and assets. lay off workers, or even file for bankruptcy. This happens to thousands of businesses each year. its profits are increasing, But it now needs to manufacture It can be difficult to see why a profitable company might be short of cash, especially if it has not made sig nificant invest1nents. You would think that the profits should be building up in the bank account. Eventually that will happen, but in the short term financial man agers must be aware of and manage two coDmOn rea sons a profitable company can face a cash shortage. Jn Canada, there are many prograns providing ARCTERYX. financial assistance to cash flow the movement of money businesses, especially to into and out of an organization underrepresented IDin trade credit a short-term financing ority groups. For exa1ple, source where a company takes delivery of goods but pays for them at a later in May 2021 the federal time Minister of Small Business, 340 Part 7: The Financial Side of Business  Exhibit 19.1 Seasonal Cash Flows when needed, they are obtained at the lowest possible cost, and they are used as efficiently as possible. Com and panies may need additional money to fund long- Cash shortage from Cash surplus from selling producing excess current production plus inventory excess inventory short-term needs, including start-up costs, investments in plants and cquipment, or periods of unprofitability. Howeve, even profitable companies can experience short-term cash shortages due to a negative cash flow Sales cycle and seasonality of revenues. revenues Expenses Planning: The Basis of Sound Financial Management January March June December 19-2 Distinguish among the three primary types of budgets used for a financial plan. extra product, which costs money and could create sig Financial planning is necessary to determine how much nißcant cash shortages in the short term. The good news money is needed to implement an organization's stra that Arcteryx will ultimately receive customer pay tegic and operational goals. A financial plan contains ments for those products. While rapid growth actually goals that are specific, measurable, and can be translated created a cash shortage, returning to a positive cash pos into dollar costs. ition is only a matterof time. Even though it is profitable, Some financial plans address a short-term time Arctervx willneed to seek outside financing to cover this frame of only a few months, while longer-term plans period of negative cash flow. address a planning horizon of one year or longer. Seasonality Many businesses have inconsistent Because the business environment can change quickly. sales throughout the year. For example, spring and most financial managers recognize that onger plans summer are the busiest months for lawnmower sales. tend to be less accurate. As a result, long-term finan A profitable lawnmower manufacturer might not want cial plans must be monitored closely and updated regu to just ramp up production capacity to meet spring larly. Once managers know the business's strategic and and summer demand but rather produce inventory operational plans, those plans can be translated into two at a consistent rate during the year. This means the types of budgets: the operating budget and the capital company would build up excess inventory during the budget. winter months and sell it all in the spring and summer The operating budget typically takes into account: months. This also means the manufacturer would have Sales revenue and expenses from the previous period cash shortages every year during the winter because it Projected revenue and expense growth rates for the is spending cash to produce inventory, but generating upcoming period no sales until spring. When the sales do materialize, the Changes to revenue resulting from launch of new company would quickly see a build-up in cash-and products or marketing campaigns hopefully show a profit for the year. Assuming this was Changes to expenses resulting from changing material the case, the lawmmower company would need to seek costs, labour costs, or other costs related to ongoing outside financing to cover the short-term cash shortages operations caused by theseasonal fluctuation of its sales revenue. Exhibit 19.1illustrates seasonal cash flows. The operating budget is based on opportunities the company sees in the marketplace to grow its financial plan aplan for obtaining Key Takeaway business profits. and But generate few busi and using the money needed to implement an organization's strategic and operational plans Financial management consists of all activities related nesses can grow without operating budget abudget of togenerating and raising money and using it effectively. the factories and equip expected revenue and expenses from ongoing operations Financial managers must ensure that funds are available ment needed to make and Chapter 19: Mastering Financial Management 341  Company needs $3 million in deliver products. That is where the capital budget $7 million. This means the comes in. Acapital budget typically takes into account: external funds. To create final cash budget, Maple Leaf Cost of adding manufacturing capacity or required for meeting sales projections equipment must determine howit will cOver its $3 million Clothing Cost of replacing obsolete or inefficient manufac There are afew financing Trade credit options that we will dishorscuss:tfal. turing capacity Short-term unsecured loans Major investments in research and development Short-term secured loans (R&D)to create new products or technologies Acquiring new companies or technologies Long-term loans or bonds " Cash received from investment income or the sale of Selling equity (e.g.,common shares) company assets The choice of financing options will affect the A.t cash budget. For exarnple, if Maple Leaf Clothing uses a These two budgets share some characteristics with the income statement and balance sheets that are com $3 million loan, the cash budget nust take into account the loan payments. If Maple Leaf sells shares iin the com- monly used to report financial results. But rather than the funds do not need to be paid back but nou. reporting past results, these budgets help the company pany, management must keep the old and new owners happy. make financial projections about its future. The oper So how does a company decide what external ating budget is essentially aprojected income statement, sources of funds to use? A smaller company might haue and the capital budget is used tocreate a projected bal ance sheet. a limited number of financing options, making its deri. Athird type of budget used in the financial-plan sion fairly simple. Alarge, well-established company ning process is the cash budget. It uses information typically has access to a variety of financing alternatives often using a combination of them to address its finan. from the operating budget, the capital budget, and other information about the company's cash flows to estimate cial needs. cash receipts and cash expenditures over aspecified timne period. At this point, we still are missing some informa tion needed to finalize the cash budget. Key Takeaway The operating budget and capital budget provide two important pieces of the financial planning puzzle: Afinancial plan is necessary to secure money and prop the internal sources of funds and the expected use of erly allocate the funds needed to implement an organ funds. The most important internal source of funds is a ization's strategic and operational plans. To create a company's revenue. Another potential source of internal financial plan, acompany musttranslate its strategic and funds is money received from the sale of assets. If the operational plans into dollar costs. Along with projected internal sources of funds cover the company's cash revenues, these costs become inputs to the operating needs, there is no need for external funds. budget and the capital budget, which helps the company This is rare, especially for growing companies. Even identify how much external funding is required. The company then selects the external sources of funds and it the company generates enough revenue to fund its daily operations, growing the business usually requires finalizes acash budget that projects cash inflows and out investment in new assets or projects, and these typically flows for a specified period of time. need to be financed. A business can raise external funds by borrowing money (debt) from lenders or selling a por tionof the company to investors (equity). The third piece Financing Considerations of the budgeting puzze is capital budget a budget of to calculate the amnount of 19-3 List the five key considerations for expected investments in new assets such as factories, equipment, and major extermal funds required, choosing a form of financing. expenditures for R&D then identify potential A company that needs external financing has many cash budget an estimate of cash sources of those funds. In alternatives, each with different characteristics. Pat receipts and cash expenditures over aspecified time period; based on the activity above, Maple ol a tinancial manager's job is to select the financing operating budget, capital budget, and Leaf Clothing will lave $4 option (or options) that provide the necessary funds other information about timing of the company's cash flows illion from operations at the lowest cost possible while also meeting the stra- the but bas net capital costs of tegic needs of the business. Before we discuss 342 Part 7: The Financial Side of Business  U100000 0100000 0 Strategic Considerations for Making Financing Decisions Before making decision a on external financing, the financial manager must answer five questions, The less obvious is the cost to administer the financing. first question is How much financing do we need? Some financing options are inexpensive to set up, Whether an amount is large or small is all relative while others can be quite complicated and incur sig to the size of the company. $5 million might nificant legal, managerial, and regulatory expenses. seem The fourth question is How might our financing choice like a large sum to a small restaurant but it is pocket impact our operations? Some forms of financing change D104 erates to a company such as Samsung, which gen about $5 million in revenue every 13 minutes. require collateral, which effectively gives others The second question is How long is the money a claim on some or potentially all of a company's for. or what is the financing term? needed assets. Some financing agreements give lenders or Short-term financing is money that is typically paid back within a year or investors some influence over managements deci less, and is used to purchase inventory, pay sions. The last question is What do I think the future 01 or handle unexpected emergencies. salaries, will look like? That is, how will external factors such as Long-term cing is typically paid back over a much longer period finan the economy and competitive environment poten of tially change and impact the business. For example, time and is better suited to fund items, such as business start-up Costs, acquisitions, and purchase in the years following an economic crisis it is difficult of fixed assets such as factories and to accesS many types of financing, and as a result equipmnent. The even some large and well-known businesses face third question is How much will it cost? An obvious the real potential they might have to shut down. In cost is the interest rate that will be charged-some addition,a company's expectations of how economic forms of financing involve high interest rates while conditions and competition might affect its business others appear to have zero interest charged. What is willinfluence its choice of financing. speciic types of financing, it is important to under stand the key strategic considerations for making Advantages and Disadvantages financing decisions. of Debt and Equity Financing Key Takeaway 19-4 Contrast the advantages and disadvan tages of debt versus equity financing. Acompany that needs external funds has many choices, 19-5 Estimate company value based on the each with different characteristics. The job of a financial terms of an equity deal. manager is to select the financing option (or options) that There are two basic funding options: debt financing and provide the necessary funds at the lowest cost possible equity financing (Figure 19.1). while also meeting the strategic needs of the business. Debt financing (borrowing)is commonly used Five key factors impact the financing choice: by companies to support their short- and long-term Amount funding needs. Debt finan " Term cing requires repayment debt financing borrowing money that must be paid back, usually with Cost of the principal borowed interest plus interest over tinme. equity financing money received Influence on company operations Equity financing (selling from the owners or from the sale of shares of ownership in a business External factors shares in the company) is Chapter 19: Mastering Financial Management 343  Figure 19.1 Debt Financing and Equity Financing Equity financing Debt financing tock.com NC225279 Pruitt/Shutters INCOFPORATED UNDER THE Jim com, Sellingownership in the company. stock Borrowing money that must be paid back, usually with interest. Tupungato/Shutter Examples: Examples: Trade credit Venture capital investment Short-term unsecured loans Initial public offering (1PO) Corporate bonds Private placement a form of permanent financing that places fewer pay a company can be risky for investors because they do ment restrictions on the conmpany. The company is not not know whether they will ever get their money back. required to pay dividends to shareholders or repay the Because of these competing interests, the hardest part investment made to the company. However, equity for a business selling stock is setting the share price and financing gives common shareholders voting rights that overall valuation. provide them with a voice in management. Equity is Suppose you want to raise $l million in exchange more costly to a company than debt. Unlike the interest for a portion of the company you started five years ago. on debt, dividends to oWners are not tax-deductible What percentage of the company should the potential expenses and therefore do not provide the tax benefit investor get in exchange for that $l million? Both vou that effectively lowwers the cost of debt. The nature of and the potential investor would-at a minimum-want equity financing means that it is usually reserved for to know the company's: major financing events, such as when a company has Net worth (owners' equity on the balance sheet) plans for rapid expansion that, although it will provide Earnings (net income on the income statement) cash flow for many years to come, should not be financed completely by debt. Whether a large or small company, But determining value goes far beyond that infor managers and owners must carefully consider the long mation, because two companies with identical net term impact of selling a portion of the company to out worth and earnings might be very different. One com side investors. pany might be a manufacturer of DVD players, with Debt and equity financing each have characteris declining product demand and hence declining sales tics that make them more appropriate for some funding and profits. The other might be a successful software situations than others. To help choose the appropriate company that is poised to become the next Microsot. To determine company value, investors want to know funding source, managers can evaluate five key factors listed in Table 19.1. about the company's history and its future prospects. The brighter the future looks for the company, the more Equity Financingand Company Valuation investors are likely to pay for ownership in the company. even if the deal carries some risk. This is the concept Selling shares in the company is a big step for an owner the risk-return ratio, which is the principle that ahigh- because it involves giving up equity (ownership) in the risk decision should generate higher financial returns, company and those shares could become much more and low-risk decisions would be expected to generate valuable in the future. At the same tine, buying part of lower returns. 344 Part 7: The Financial Side of Business  Table 19.1 Debt vs. Equity Comparison Debt Financing Equity Financing long-term needs. Consider the Financing of all sizes. From microloans of afew hundred dollars to debt Usually for raising larger amounts or for addressing Amount Needed agreements worth billions. Consider the Both short and long term. Some debt arrangements last just afew days, Long term, since selling ownership is amajor transaction that s no Term of Financing while others last 30 years or more. easily reversed. Consider the Cost " Depends on interest rates. The higher the interest rate, the higher the Management can elect to distribute profits to shareholders through of Financing debt servicingcost. dividends, or simply reinvest all profits back into the business to buy new assetsor grow the business. " Interest expenses can be deducted from revenue, lowering the company's profits and therefore taxes. " Dividends are not an expense that can be deducted from revenue as they are paid out of after-tax earnings. "Typically a one-time legal and administrative fee that is high, particu larly if the shares are sold on a public stock exchange and there are ongoing administrative costs. Consider the. Debt must be repaid, regardless of company profitability. Some debt " Does not need to be repaid, which provides financial flexibility for Influence on requires the company to pledge assets as collateral, Collateral could Company. Company indude acounts receivable, inventory, equipment, and buildings. " Majority or large shareholders can exert significant pressure on Operations " Lenders have a priority claim on assets (even ahead of company company management. Owners) if thecompany is unable to make the required payment schedules. Consider External " Economic conditions affect the level of interest rates and availability Economic conditions can affect the availability of equity financing. Factors of debt financing, even for profitable companies.. Economic and competitive conditions affect the price a company " Company must be certain it willhave the resources it needs to repay receives for selling company shares. debt financing, even in periods of poor sales or dedining profits. 0100000 0100000 Effect of the Risk-Return Ratio If youhave ever watched television shows like Shark For example, if you were raising equity funds Tank or Dragons' Den, you have heard hopeful entre and asked for $500,000 for half of your company, preneurs introduce themselves like this: you are saying the company is worth $1 milion. "Im Pete from Pete's Organic Granola and I'm This is because if one half of the company is worth asking for $250,000 in exchange for 25 percent of $500,000, then the other half is assumed to be worth my company." the same amount,and that equals$1 million. "Im Shawn from Mount Everest Sportswear and On the other hand, if youwere asking for I'm askingfor $100,000 in exchange for 5 percent $100,000 for 25 percent of a company,you believe b10d of my company? the company is worth $400,000. Since each quarter These entrepreneurs are attempting to acquire of the company is worth $100,000, all four quarters equity financing by pitching their company to together are worth $400,000. investors and hoping they can make adeal. But even Whenever you know the amount a business owner when investors believe a company has the poten isasking for and the percentage of equity they are 01 tialto become the next big thing, the two parties offering. you can calculate their valuation of the com must negotiate the pricing of the deal. That pricing pany. Simply take the amount of the equity investment is based on the estimated value for the whole divided byy the equity percentage it will buy. Using our company. last example, $100,000 divided by 25% (.25) = S400,000. 01 (Continued) 0100960 01 Chapter 19 Mastering Financial Management 345  OTU0000 0100000 awayfromthe dealtofinda better price. But what But what if the investor makes a counteroffer? There are o They have some uncertainty about whether you determines valuation of a company? many will often will be able to execute on your sales strategy, So factors, andtwo savvyinvestors disagree they will invest the $100,000 you asked for, but for on valuation-something that we witness often o 40 percent equity in the company. It is important for Dragons' Den. Investors look at: 00 you to realize how big of a change this is. Yes, you Sales revenue and revenue growth will be able to get the $100,000 you need to grow " Profits and profit growth the business, but youare giving away a big chunk of. Whether the company has any proprietary prod. the business to do so. uctsor systems that others cannot copy. The strength of the management team, and their The investor is valuing your companyfar differently belief in their ability to achieve the projections than you did: $100,000 divided by 40% (,40) equals a D100 company valuation of $250,000, which is much lower The faster a company is growing its sales and 01 than the $400,000 valuation Vou had in mind. This valu profits, the higher potential return it offers an ation will also affect what the next potential investor is investor. As a result, company ownerS are usually willing to pay, so this first valuation is critical. able to receive a higher price when selling shares of Youwould need to decide whether that is company stock, assuming the investor has faith in 01 a fair value for the company, or whether to walk the management team. 0100e00 0100000 FIQ0000 Short-Term Financing Options Study Tools 19-6 Identify which type of short-term finan cing isappropriate for a given situation. Visit the MindTap to watch videos on company Short-term funding options all fall under the category of financing debt financing. Recall that short-term financing typically must be repaid within one year; if repayment occurs CENGAGE MINDTAP after a one-year time period, it is designated as long term debt. Go tologin.cengage.com to access the digitalresources. Companies often seek short-term debt financing because it is typically easier to obtain than long-term debt financing for three reasons: 1. For the lender, the shorter repayment period means Key Takeaway less risk of default. 2. The dollar amounts are usually lower th¡n those of Funding options fall into two basic categories, debt or long-term loans. equity financing. Each has characteristics that make it more appropriate for certain situations than others. An 3. A close working relationship nornmally exists between advantage of equity financing is that it can be used toraise the short-term borrower and the lender. large sums that do not need to be repaid. However, selling Depending on the type of short-term loan, lenders shares in a company isnot a trivial decision for an owner. may require collateral, which is property, inventory. It often involves giving up or assets that are pledged as security for a loan. In some control along with some cases, the collateral requirement is due to the collateral pledge of specific assets by the borrower to the lender that aportion of the company, lender having concerns about the size of a particular becomes the lender's if the borrower defaults on the repayment of the loan the value of which nay be loan or the general prospects of repayment bythe much higber in the future. borrower. 346 Part 7: The Financial Side of Business  A company seeking three common options: tradeshort-term financing has credit, unsecured loans Long-Term Financing Options (including lines of credit), and secured trade credit, is when a company takes loans. The first. 19-7 Identify the source of a long-term finan but pays for them at a later time. Trade delivery of goods cing need and classify it as either debt or credit involves no contract or loan agreement, just the equity, secured or unsecured. invoice a nrovvdes the buyer after merchandise is delivered.sellerThe Sources of long-term financing vary with the size and time betvween delivery and the due date is called the pay type of business. Long-term financing is obviously ment term, which is commonly 10 to 30 davs, but can necded to start a new business, but it can also be used for be longer. Trade credit is a major source of new product development, expansion of facilities, pur short-term financing: 70 to 90 percent of all transactions betwecen chasing other businesses, and other investrments aimed businesses involve some trade credit. It is interest free at growing the company. See Table 19.2 to learn more and usually requires no collateral. about the three primary forms of long-term financing. The second source of short-term financing is unsecured loans. Banks and other financial institu Long-Term Loans tions offer short-term loans not secured by collateral at interest rates that vary based on the business's credit When applying for a long-term loan, companies must rating. The lowest rate charged by banks for short-term be able to show the lender what willbe done with the loans is called the prime rate. Acommon form of short money and how the company plans to repay the loan term bank loan is a line of credit, which operates much according to the agreed terms. This preparation begins like a credit card. The business has access to a fixed before the company applies for the loan. While there may amount of funds that it can borrow against as needed. As be many potential lenders that can provide the money the business pays back those funds, it has the ability to needed,most often the company willtry to borrow from then borrow again up to its credit limit. the bank where it does its business. For the bank to be The third source, secured loans, are loans from willing to lend to the company, it will have had to main banks and financing companies that are secured by col tain a good relationship with the bank. lateral such as inventory or accounts receivable balances. Typically, the lender will want to see a current busi These assets serve as collateral because they represent ness plan that explains what the business is, how much an expected source of cash flow for the business. Secured funding is required, and how the loan will be repaid. loans provide companies that may have less credit his This plan includes current and projected (or pro forma) financial statements. tory with a lender or those with weaker credit ratings Lenders review this information to determine the (therefore unable to access unsecured loans) access to creditworthiness of the business. The criteria used to short-term financing they otherwise would not have which means that this type of financing usually carries a assess the creditworthiness of a client are commonly called the 5 C's of credit. To learn more about how higher interest rate. lenders evaluate creditworthiness of a client, take a look During the economic crisis, many companies found at Table 19.3. it very difficult to find short-term financing to fund their unsecured loans short-term loans from a bank or financing company that daily operations as the banking system struggled with less Corporate Bonds are not secured by collateral liquidity. The overall result was decreased availability of line of credit a flexible borrowing short-term lines of credit. Today, the amount of available In addition to traditional option between a financial institution and its customers that allows customers short-term financing has increased due to the recovering loans, larger companies may to access funds at any time as long economy and various Bank of Canada actions designed choose to issue corporate as they do not exceed the maximum amount as specified in the agreement to increase money supply and availabilityof credit. bonds (or, more simpl,. secured loans short-term loans bonds). Abond issue occurs from a bank or financing company that when the company sells a are secured by collateral Key Takeaway large quantity of debt on the open arket to investors, long-term loan a loan made by a bank or other financial institution that must be repaid with interest Typically, short-term debt financing is money that will be usually in denominations corporate bonds long-term repaid within one year. A company seeking short-tern of $1,000 (called the face debt obligations (liabilities) issued by corporations that promise to make financing has three common alternatives: trade credit, value). One reason a con payments over a specified period unsecured loans, and secured loans. pany might consider issuing Chapter 19: Mastering Financial Management 347  Table 19.2 Three Forms of Long-Term Type of Financing Financing Cost Repayment Period Long-Term Loans Loans from banks and other financial institutions, Must be repaid with interest. Interest rates typically abit higherrthan on " Debt " Usually 3-7 years short-term loans " Rates charged depend on economic( conditions and " Unsecured for large, well-established businesses "Sometimes longer periods of 15-20 years stability of the borrower financal Secured for start-ups and smaller businesses available Corporate Bonds (or, more simply, bonds) Along-term debt obligation (liability) issued by the Company and sold to investors " Debt " Interest rates typically higher than on short-term loans, nd " Typically 10-30 years are higher the longer the term " Usually unsecured but not always. Rates charged depend on economic conditions and finanr stability of the borrower Shares or Equity Shares of ownership in acompany that are sold to investors " High initial cost " Equity " None Shareholders own aportion of the company " Equity or shares can be sold to other investors, " Ongoing costs are minimal which means the company can outlive the original Company can choose whether or not to pay ividends to OWners shareholders bonds is that it enables the company toborrow a large Pay interest each year until maturity amount of money from a number of investors rather than Repay the face value of the bond at maturity trying to borrow all of its needs from one lender. In some For bond investors, the interest rate on corporate cases, the amount that is needed is more than one lender bonds is an example of the risk-return ratio discussed might be comfortable with providing earlier in this chapter. Simply put: Investors expect more Typically, the company will pay interest to the interest if there is more risk. bondholders twice annually. When the bond matures, For example, in 2013 Apple raised $17 bllion in called the maturity date,the company will pay the last funds by selling 3-, 5-, 10-, and 30-year bonds. This debt interest payment and return the face value/amount bor was considered low risk and, as a result, investors were rowed on each bond to the bondholders. Interest rates willing to accept a lower interest rate. The 10-year bond for bonds vary with interest rates in the economy and had an interest rate of 2.42 percent, which was only the financial health of the company issuing the bond. Specific factors that increase or decrease the interest 0.75 percent higher than the much saferU.S. govenment bonds. At that time Apple had more than $140 billion in rate that a company must pay when it issues bonds, in cash, which meant the company clearly did not need the comparison tothe interest rate in the economy at the cash to fund its business. Instead, the money was used to time the bonds are issued, include the corporation's pay shareholders some dividends. Figure 19.2 illustrates ability to: the risk-return ratio for bond investors. Table 19.3 The 5 Cs of Credit Item to Consider Why Is This Important? Character The borrower's history and attitude toward credit obligations. Capacity The financial ability to meet the credit obligations that the company currently has plus the proposed new make regular loan payments. loan(sua The term capital as used here refers to the borrower's assets or the net worth of the Capital individual or business applyling t0de Collateral Real estate or property including stock, bonds, equipment, or any other asset pledged as security for aloan. Conditions General economic conditions that can affect aborrower's ability to repay aloan or other credit obligation. 348 Part 7: The Financial Side of Business  Figure 19.2 The Risk-Return Ratio for Bond Investors More Risk Less Risk Bonds with Bonds with less more risk have risk have lower lower Interest Rates higher higher interest interest rates rates When a corporation issues an IPO to raise capital, the Selling Common Shares (Stock) shares are considered to be sold in the "primary market," There are anumber of waysto sellownershipin aconpany. where investors buy shares directly from the issuer of those Tipically. we think of companiesselling their shares to the securities. The issuing cornpany willoften use the services public, and these shares being traded among investors on of an investment banker (an organization that assists astock exchange, but there are more altematives available: corporations in raising funds, usually by helping to sell Angel intestors (also called private investor or angel new issues of shares. bonds, or other financial securities). funder): Wealthy individuals who invest money in which will advise the company on everything including exchange for ownership in the company. Angels look the amount to be issued, the price the shares should be for companies that show potential but might be over offered at, and the preparation and filing of the required looked by banks and other types of investors. Sale of documentation. A share is sold only one time in the pri stock to an angel investor is done as a private trans mary market, but the share can be sold again and again in action between the investor and the company. This is the "secondary market" where existing financial securities more typical for a new start-up company. are traded between investors. Once the share has been issued the company will not receive any additional funds Venture capital (VC): Venture capital organizations each time its shares are bought or sold in the secondary raise large pools of money from private and institu market, but without the secondary market investors would tional investors and invest in companies that have be reluctant to buy shares in the first place as they would the potential to become large and successful. For example, Peloton Interactive Inc., a start-up that not be able to easily sell shares to other investors. Simply makes web-connected home-fitness equipment and put, secondary markets offer liquidity to investors. Usually. content, raised $550 million in afunding round led by secondary-market transactions are completed through a VC firm TCV in 2018.4 VCs are extremely selective, securities exchange (or stock market, such as the Toronto and access to VC funding is highly competitive. Stock Exchange), or the over-the-counter (OTC) market (investors trade stocks and other financial instruments dir Private placement: Shares sold directly to large insti ectly between two parties without a central exchange). tutional investors, such as insurance companies and pension funds. When compared to selling shares to the general public, there are often fewer regulations and the cost is generally less when shares are sold Key Takeaway using a private placement. This type of transaction is Sources of long-term financing vary with the size and type more typical for a larger, more mature company. of business. The three primary sources of long-term finan Initial public offering (IPO): An initial public cing are long-term loans (loans from commercial banks and offering (IPO) is the term used to signify when other financial institutions initial public offering (|PO) a a company sells common shares (stock) to the that must be repaid with corporation's first sale of common general public for the first time. Many private interest), corporate bonds shares to the general public companies "go public" to raise capital in the open (long-ternm debt obligations common shares (stock) a form of ownership in a company that can be market. Usually, a high-growth company has an IPO issued by corporations that sold to investors as a type of long-term because it needsto raise funds to finance continuing promise to make payments financing growth. AnIPO often enables existing shareholders, over a specified period), and investment banker an usually employees, fanmily, and friends who bought common shares (shares of organization that assists corporations in raising funds, usually by helping to the shares privately, to earn big profits on their Ownershipinacompuny that sell new issues of stocks, bonds, or other financial securities investment. caube soldto iivestors). Chapter |9: Mastering Financial Management 349  Chapter Summary operations LO19-1 Explain how long-term financial needs, 4. Influence on company the cash flow cycle, and seasonality can cause 5. External factors a profitable company to have significant cash shortages. L.O 19-4 Contrast the advantages and disadvan. financing. Financial management consists of all activities related to generating tages of debt versusequity debt or eguity and raising money and using it effectively. Financial managers must Funding options fall into two basic categories, ensure that funds are available when needed, are obtained at the financina. Each has characteristics that make it more appropriate for lowest possible cost, and are used as efficiently as possible. Companies certain situations than others. An advantage of equity financing is may need additional money to fund long- and short-term needs, that it can be used to raise large sums that do not need to be repaid including start-up costs, investments in plants and equipment, or However, sellingshares in a company is not atrivial decision for an periods of unprofitability. Owner. Those shares could become much more valuable in the fitre LO 19-2 Distinguish among the three primary LO19-5 Estimate company value based on the types of budgets used for a financial plan. terms of an equity deal. Once a decision is made to sell shares, the value of the company can Afinancial plan is necessary to determine how much money is needed to implement an organization's strategic and operational plans. To be estimated by taking the equity investment amount and dividing it create a financial plan, a company must translate its strategic and by the equity percentage it willbuy. operationalplans into dollar costs. These costs are typically put into an operating budget and a capital budget, which helps the company LO 19-6 Identify which type of short-term identity how much external financing might be necessary. The com financing is appropriate for a given situation. pany then selects external sources of funding and finalizes a cash Typically,short-term debt financing is money that will be repaid within budget that projects cash inflows and outflows for a specified period. one year. Acompany seeking short-term financing has three common alternatives: trade credit, unsecured loans, and secured loans. LO 19-3 List the five key considerations for choosinga form of financing. LO19-7 ldentify the source of a long-term financing need and classify it as either debt or Acompany seeking external funds has many alternatives, each with different characteristics. The job of a financial manager is to select the equity, secured or unsecured. financing alternatives that provide the necessary funds at the lowest Sources of long-term financing vary with the size and type of busi cost possible while also meeting the strategic needs of the business. ness. The three primary sources of long-term financing are long-term Five key considerations for choosing financing options are: loans (loans from commercial banks and other financial institutions 1. Amount that must be repaid with interest), corporate bonds (long-term debt obligations issued by corporations that promise to make payments 2. Term Over a specified period), and common shares (shares of ownership in a 3. Cost company that can be sold to investors). Exercises Use the internet, magazines, newspapers, books, the company pay dividends? How many common shares are and personal experiences to complete the following outstanding? Would you invest in either of these companies? Explain your reasoning. exercises. 4. The criteria used to assess the creditworthiness of a client are the 1. At some point you might need a personal loan-for instance, to SCs of credit (character, capacity, collateral, capital, and condi purchase a new electric car. Research the personal loan require tions). Use these same criteria to assess your personal credit ments at Canadian financial institutions. Compare the options worthiness. Where is the most significant opportunity for you to available toyou (e.g., fixed-rate or variable-rate loans). improve your creditworthiness? 2. Examine the trends in the initial public offering (IPO) marketplace 5. The reality TV show Dragons Den provides entrepreneursa over the past five years. Select one successful IPO launch and one chance to pitch their business ideas to a panel of venture capita that launched but filed. What lessons can you learn from these ists in exchange for potential investment financing. Research companies? some of the biggest Dragons' Dern success stories. How much 3. Analyze the share price movements of two companies in dif capitalwas invested? How was the equity orownership pOSItion ferent industries over the past year. Visit the websites of these negotiated? Would you have accepted the deal? Explain your companies to view their investor relations information. Does answer. Part 7: The Financial Side of Business 350 Review Questions 1. What is financial management? why. o list the responsibilities of the financial manager I. Which is more costly to a company, equity or debt? Explain 8. lo determine the valuation of a company, what are some primary 3. What is the purpose of a financial plan? factors investors consider? A What are the three different types of budgets? Describe each 9. Why is short-term debt financing easier to obtain than long-term -What are five key factors that affect the choice of debt financing? C Differentiate between debt financing and financing? equity financing 10. What are three primary sOurces of long-term financing? Explain each Key Terms capital budget, p. 342 financial plan, p. 341 cash budget, p. 342 initial public offering (IPO), p. 349 cash flow, p. 340 investment banker, p. 349 collateral, p. 346 line of credit, p. 347 common shares (stock), p. 349 long-term loan, p. 347 corporate bonds, p. 347 operating budget, p. 341 debt financing, p. 343 secured loans, p. 347 dividends, p. 339 trade credit, p. 340 equity financing, p. 343 unsecured loans, p. 347 financial management, p. 338 Chapter 19: Mastering Financial Management 351