Business Finance Chapter 4 PDF

BUSINESS FINANCE mandatory payment or dividends. If one owns enough shares of a company, he/she can end up controlling its CHAPTER 4...

BUSINESS FINANCE mandatory payment or dividends. If one owns enough shares of a company, he/she can end up controlling its CHAPTER 4 operating and financing decisions. Controlling shareholders define the direction of a company because they can choose Sources of Long-Term and Short-Term Funds who will manage it. -In 2016, more than ₧70 billion was raised from equity -Equity financing also provides a company with financial financing by Philippine companies through initial public flexibility. If a company is 100% financed by equity or its offerings (IPO), stock rights offerings, and private leverage ratio is very low, it will be attractive to creditors. placements. Private companies had also raised more than When this company is need of financing, it can have more ₧360 billion from issuing debt securities, such as bonds and options as regards financing. It can easily raise funds commercial papers. through debt financing or equity financing, or a combination of both. -Equity financing is a long-term source of funds while the issuance of commercial paper is a form of short-term debt Disadvantages of Equity Financing financing. 1. Cash dividends are not tax-deductible. Unlike interest expense which is tax-deductible interest expense, cash Debt and Equity Financing dividends do nor provide any tax shield. The sources of financing are divided into two major 2. Offering new shares to other investors may dilute the categories : ownership stake, in terms of percentage, of the existing a)Debt Financing shareholders. Issue new shares of stock through private placements. Private placements are limited to a few -Debt financing can be in the form of borrowing from banks investors. Because other shareholders are not given the or other financial institutions or the issuance of debit opportunity to subscribe to these new issues, their securities like commercial papers and bonds. For some percentage stake in a company is reduced or diluted. For companies, it can be in the form of advances from single proprietors, inviting new investors reduce the interest shareholders to expedite the process of raising funds. of the existing proprietors. 3. It is the most expensive source of financing. -Debt financing creates contractual obligation for the a. Most companies opt to have debt financing. If issuing new borrower to pay interest and the principal. Payments have to shares of stock or infusion of fresh equity by proprietors is be made on time because unpaid interest and principal lead cheaper, logic dictates that companies should prefer it as a to penalties and more interest. Despite these features, model of financing. companies still resort to borrowing to fund their working b. Under the Philippine law, a company that is in the process capital requirements and expansions. of liquidation cannot distribute anything to the shareholders unless the claims of the creditors have been satisfied first. If managed properly and taken in reasonable amounts, debt This implies that the shareholders are taking the biggest risk financing can help the company grow. Among the benefits of in the company. In finance, there is a popular statement, debt financing are: “high risk, high return,” in which that for somebody to take more risk , he/she has to be compensated by an expected 1)Interest expense is tax-deductible higher return. 2)Debt financing allows a company to grow without diluting c. Unlike loans, where interest and principal payments are the interest of the controlling shareholders or the proprietor more assured, cash dividends are not guaranteed. If one 3)Creditors generally do not intervene in the decisions of were to analyze the list of priorities of an operating company Management. in terms of payments, the cash dividend payment is probably one of those in the last, if not the last. -These benefits from debt financing can be realized if the d. If the company does not perform well, its shareholders or level of debt incurred by a company is manageable. Too the owners absorb the losses. The reverse , however, is also much debt can expose a company to bankruptcy risk, and true. If a company performs well, its owners can benefit more this may disrupt its operations. Suppliers may decide to stop because everything rebounds to their benefit after paying the delivering merchandise, and manager’s executive time will creditors. This situation amplifies the phrase “high risk, high be spent more on fixing debt problems, rather than improving return.” company’s operations. When the level of debt is too high, and a company is going through financial distress, Packing Order Hypothesis management may even consider using substitutes for raw The packing order hypothesis in corporate finance was materials. This can adversely affect the quality of its product developed based on repeated observations of how and may turn off some customers. companies fund their financing investments. According to this hypothesis, this is how companies fund their b)Equity Financing requirements: -Equity financing also known as internally generated fund refers to the issuance of new stock and retained earnings 1)Internally generated funds. – funds that came from plowed back into company operations. It is the safest source operating cash flows and plowed back earnings of the of financing for a company because it does not require any company.  2)Debt. – when internally generated fund have been requirements is an easy way for a company to raise funds. exhausted, then debt financing is the next alternative. Interest on these advances can be charged by the owner or 3)Equity – more difficult to issue new shares of stocks and shareholder. most expensive. 3. Advances from customers. There are occasions when a customer advances payment for his/her purchase orders. Sources and Uses of Short-Term Funds The advances may be a percentage of the entire value of the -Short-terms funds are normally used to finance day-to-day order. Customers of this nature are very much welcome operations of a company. It is used for working capital because they can help in financing working capital requirements, such as accounts receivable and inventories. requirements. Discounts can be provided for advance It is used as operating expenses to pay the salaries of payments. employees, utility expenses, business and income taxes and 4. Bank loans. Banks can provide both short-term and security services. It can also be used for bridge financing long-term loans. Some banks also provide credit facilities, where a company has some maturing obligations and does not just to big corporations but even to small and medium not have enough cash to pay such maturing obligations. enterprises. Government banks , such as the Development There are occasions when a company’s management will Bank of the Philippines (DBP) and Land Bank of the decide to borrow a short-term loans to address this problem. Philippines (LBP), offer short-term credit facilities to working There are different sources of short-term financing. These capital loans to small and medium enterprises (SMEs). include bank and nonbank financial institutions. Nonbank There are private banks that also provide working capital financial institutions include lending investors and loans to SMEs. Securing loans from these credit institutions cooperatives. may take some time as they have to conduct credit investigations. They have to evaluate also the loanable value of the collaterals that may be mortgaged to support a loan. The collateral s that can be acceptable to banks include real estate, vehicles and even inventories. 5. Credit cooperatives. To borrow from credit cooperatives, one has t be a member. Credit cooperatives can lend as much as five times equity contributions. A member of a cooperative has a company engaged in another business can potentially borrow in his/her personal capacity and use the proceeds from the loan to his/her company. This practice, however, should not be encouraged because his/her company must be able to raise money based on its own merits. 6. Lending companies. There are small lending companies that cater normally to small and medium enterprises. Compared to banks, the lending process is much faster, but the interest rates are higher. Compared to more informal lending , popularly known as “5-6”, the interest rates are lower. These lending companies can finance working capital requirements. Some of them may require documents such as a purchase order to support a loan application. This purchase order may become basis of a loan release. 7. Commercial papers. They are short-term debt securities issued to the public, normally with tenors for one year. This is a credit facility normally available to big corporations. To issue commercial papers, a company has to hire the services of an investment banker who will underwrite the 1. Suppliers’ credit. Suppliers of raw materials and issue. Since these are issued to the public, commercial merchandise are the best sources of short-term working papers must be registered with the Securities of Exchange capital. This is why a good relationship with the suppliers Commission (SEC). The registration with SEC is supposed have to be nurtured. If the supplier wants the credit terms to to add protection for the public investors. The debt securities be negotiated, the chances of the suppliers agreeing to the that will be issued are also credit-rated by credit rating requested increase if his/her company has been a very good agencies to determine the interest rate that will be charged customer, i.e., paying the obligations on time. Some by the issuer and to guide the investors regarding the default suppliers charge a small interest rate on their deliveries to risk associated with the issue. their customers if not paid on a certain date. They can also 8. Informal lending sources such as “5-6”. This is a very ask their customers to sign promissory notes under certain expensive source of financing and should be avoided. It is circumstances. called as such because for every ₧5 that one borrows, 2. Advances from owners/shareholders. If an owner or a he/she has to return ₧6. This is 20% interest rate is just for controlling shareholder has enough personal assets, one month. Without interest compounding, this translates to advancing funds to his/her company when there are financial an annual interest rate of 240%. Sources and Uses of Long-Term Funds 2. Internally generated funds -Long-terms funds are used for long-term investments, or – Instead of declaring cash dividends or distributing profits to sometimes called capital investments. These include the proprietor, a company can use internally generated funds placement of old equipment, expansion of production for operations or finance other types of capital investments. capacity, and buying a piece of land what will be the site of Based on the corporation code of the Philippines, there is a future expansion. Long-term fund can also be used to limit regarding the amount of retained earnings that a finance permanent working capital requirements. company can keep in its statement of financial position. Retained earnings cannot exceed 100% of the value of ordinary shares or sometimes call paid-in capita. However if the board can make a resolution setting aside a specific amount of retained earnings for expansion, then this is acceptable. 3. Bank loans – Banks are sources of different types of financing. They provide lower interest rates compared to other financial institutions. Still, they have requirements, and a borrower goes through a process, normally a month or three months before a loan gets approved. 4. Lending companies – These are the same lending companies previously discussed. Some of them provide term loans ranging from two to five years. They can process loan faster, but they charge higher interest rates. 5. Bond Market – This market is gaining more popularity among our big publicly listed companies for their fund-raising activities. Philippine bonds are now traded through electronic platform provided by the Philippine Dealing System Holdings Corporation (PDS Group). To issue bonds, the services of an investment banker are also needed to underwrite the issue. The bonds to be issued have to be registered with SEC, and they have to be credit-rated. Moody;s and Philratings are among the credit rating agencies in the Philippines. Credit rating is important because it will dictate the interest rate that -Long-term investments have to be financed by long-term an issuer can charge to the buyers of the bonds. sources of funds to minimize default risk. The return on When companies have identified good investment long-term investments may not be realized immediately and , opportunities they want to pursue, financing is definitely therefore, require more patient sources of financing. combination of debt and equity. Again, this decision depends on many factors: Sources of Long-Term Funds *access to different form of financing; existing capital 1. Equity structure; the size of the capital investment; bullishness or – can be in a form of fresh equity infusion from the owner in bearishness of the stock market; interest rates; economic a single proprietorship or issuance of new ordinary shares or conditions and risk appetite of management. perpetual preference shares for a corporation. This is the most patient source of capital. The safest source of General Procedures and Flowchart of Bank Loans financing, but it is not always available when company needs General Steps on Loan Application: it. Even big corporations have to identify the right timing 1. The loan applicant approaches an account officer to apply when to issue more shares. In a bull market, companies can for a loan. afford to set higher prices for shares offered to investors 2. The account officer evaluates if the loan applicant allowing them to maximize the amounts they can generate qualifies for any of the banks loan products. from a public offering.. Big companies can list their shares in 3. If qualified, the account officer gives the loan applicant organized stock exchanges like Philippine Stock Exchange the list of requirements. (PSE) through the initial public offering (IPO). 4. The loan applicant completes the requirements and -Since the shares are offered to the public, these shares submits them to the account officer. have to be registered with Securities and Exchange 5. The loan applicant completes the requirement and Commission (SEC). It is required to protect the public submits them to the account officer. interest. In conducting an IPO or stock rights offering, press 6. The credit evaluation department assigns the account to releases have to be made to attract interest from investors, a credit analysis who will evaluate the creditworthiness of the and roadshows are conducted, which may include loan applicant. international roadshows if the shares are intended to be 7. The credit analyst prepares a recommendation and will offered to foreign investors. present it before a loan committee that approves the loan application.  8. If approved, the post-approval requirement will be sent for 2. Provide the collaterals as agreed upon in the loan compliance negotiation with proper documentation. 3. Comply with the provisions of loan covenant, such as maintaining certain liquidity and stability or leverage ratios. 4. Notify the creditors if a company is acquiring another company or if a company is now the subject of acquisition. 5. Do not default on the loans as much as possible. CHAPTER 4 Finance related problems: Where will I put the money? This is called “investment decision.” Where to get the money? This is called “financing decision.” investment decision Individuals and companies choose a wide range of real and Comparison of Bank Loans and Nonbank Loans financial assets. -Since banks are very dominant providers of both short-term and long-term sources of funds, it pays to know some of the Real assets investments include purchasing and machinery general differences of bank loan vis-à-vis loans from other to generate revenues, adding new wing to their office sources, such as those from lending companies and building or factory, and acquisition of license brand. cooperatives. Financial assets investments include investing in the shares of other company, lending money to others and purchasing fixed income instruments, such as government-issued Treasury securities and corporate bonds. financing decision Businesses seek funding sources such as equity infusion by investors or borrow from financial institutions such as bank. The cash inflows in acquiring the funds and outflows related to payment of dividends to the owners and the repayment of principal and interest to creditors occur in long term. BASIC LONG-TERM FINANCIAL CONCEPTS Problems Faced by SMEs in Financing Time value of money must be considered in the making While there seems to be abundance of funds available for appropriate investment and financial decisions. small and medium enterprises (SMEs), the reality is the a. invest peso now and earn a return from this investment SMEs cannot avail most of these facilities for many reasons. b. peso expected to be received in the future is riskier and A survey was conducted by Rafaelita M. Aldaba of the less certain. Philippine Institute for Development Studies (PIDS). This study which became part of PIDS’ discussion, cited the Interest a payment fee or rent for the use of money following: -basic finance-related computation of interest 1. Limited track record -computed on the principal amount 2. Limited acceptable collateral 3. Inadequate financial statements SIMPLE AND COMPOUND INTEREST 4. Lack of business plans Simple Interest - computed on the principal amount or The potential creditors of these SMEs cited the following original amount reasons for rejecting the loan applications: Compound Interest 1. Poor credit history -computed on the principal amount and the accumulated 2. Insufficient collateral interest 3. Insufficient sales, income and cash flows 4. Unstable business type 5. Poor business plans Duties of Borrowers to Creditors 1. Pay the creditors based on the payment schedule agreed upon. SIMPLE INTEREST choose to get the present values since the decisions are I=PxRxT made today. Where: 𝑃𝑉 = 𝐹𝑉 × 1/ (1+𝑟) x t I = Interest P = Principal A present value table can also be developed using the R = Interest Rate present value interest factors. Simply find the intersection of T = Time Period the relevant time period (T) presented in the rows of the table and the relevant rate (R) presented in the columns of COMPOUND INTEREST the table. The usual assumption in most business transactions is to use compound interest. Compound interest is simply earning interest on interest. This means that the basis for the computation of the applicable interest for a certain period is not only the original principal, but also any interest earned in the previous assuming all cash flows would be paid or received in a lump sum upon maturity. COMPOUND INTEREST A = P (1 + r/n) ^nt where: P = principal r =rate per compounding period n = number of compounding periods per unit of time t = time ( in years) FUTURE VALUE OF MONEY Future value (FV) is the equivalent amount of money in the MULTIPLE CASH FLOWS future of a specific present amount. It can also be If multiple cash flows occur at different times, it will become understood as the amount of money after the interest more challenging to compare these cash flow streams. compounds. Practically, it is the amount after the invested getting their present value becomes more imperative in order money has grown over time at some given interest rate. to make an appropriate decision. You would simply have to get the present value of individual cash flows and add them FV = Initial Value x (1+r)^t together. Since the present value refers to the same date (today), these are value-additive. Using the Future Value Interest Factor ( FVIF) table, find the intersection of the relevant period (T) presented in rows of STEPS IN ADDRESSING PROBLEMS: the table and the applicable interest rate ® presented in 1. Draw a timeline illustrating the relevant cash flows columns of the table. and the timing of these cash flows; 2. Compute for the present values of each cash flows using the appropriate interest (discount) rate; and 3. Add the individual present values and compare the sum to the cash price. ANNUITIES Annuity - a series of cash flows payments. Instead of computing the individual present values by multiplying each cash flow by the relevant present value interest factor, an easier way is to multiply the equal cash flow stream by the present value interest factor, an annuity (PVIFA). PRESENT VALUE OF ANNUITY C x [ 1/R - 1/ R(1+R)^t ] Where: C = Equal Cash Flow Stream R = Interest Rate PRESENT VALUE OF MONEY T = Time Period The present value (PV) is the present amount today that is equivalent to a specific amount paid out over a period of PRESENT VALUE INTEREST FOR AN ANNUITY TABLE time. To make the cash flows comparable, we either determine their future value at a common future date or Present Value Interest Factor for an Annuity (PVIFA) compute their present value today. Most decision-makers PVIFA = ( 1/R - 1/R(1+R)^t )  Equal Regular Payments (Principal and Interest Combined) Some loans require equal regular payments, in this case, how is the regular payment (C) determined? Let us go back to the Equations on PVA: Present Value of an Annuity = C x [ 1/R - 1/ R(1+R)^t ] Present Value of an Annuity = C x PVIFA C = Present Value of an Annuity/ PVIFA PVIFA TABLE EFFECTIVE ANNUAL INTEREST RATE Effective annual rate (EAR) is an interest that determines the actual return on an investment or the precise amount of interest due on a credit or loan. It is an interest rate adjusted for compounding over a given period. Effective Annual Rate = (1 = R/M)^M - 1 where: R = Annual Interest Rate M = Frequency of Compounding An annual rate of 12% will translate into the following effective annual rates: Annual Compounding = [1 + (12%/1]^1 - 1 = 12% Semi-annual Compounding = [1 + (12%/2]^2 - 1 = 12.36% Quarterly Compounding = [1 + (12%/4]^4 - 1 = 12.55% Monthly Compounding = [1 + (12%/12]^12 - 1 = 12.68% LOAN AMORTIZATION The process of obtaining properties by taking out a loan is called a mortgage. A mortgage loan is commonly applied in purchasing real estate if a buyer is unable to pay in full. A mortgage loan process requires a down payment and makes the property collateral. A down payment is an initial payment made to secure the purchase, and an agreement will be made to pay the rest of the amount. After making a down payment, the remaining amount will be under the mortgage loan. The mortgage loan amount will be paid through monthly payments called amortization. A classic example of a business transaction that regularly pays out an equal cash flow stream is an amortization loan. Most housing and car loans are amortizing loans that require the borrower to pay that equal amount either annually, semi-annually, quarterly or most of the time, monthly. Equal Principal Payments The principal payment is usually fixed for long-term corporate loans. The interest expense is adjusted based on the declining principal balance.