External sources for financing Pearlparadise.com

Let’s use Portia as an ongoing example. Portia can consider using external financing, which refers to funds invested by outside investors and lenders. External financing is divided into equity and debt financing. Portia can either borrow money with the agreement to repay the borrowed sum plus interest or can obtain funds in exchange for equity, or use a combination of equity and debt financing.

Portia can consider debt as a source of external financing. Debt financing increases her financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, equity investors are not entitled to more than what is earned by the enterprise.

When borrowing from the bank, an entrepreneur has number of options. The following types of loans are generally available:

Lines of credit – this is when bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed, but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for the financing of equipment. The loan is generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

Portia can also consider equity financing. Private equity investors include venture capital firms and business angels. Venture capital firms raise a fund and then select portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses.

In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because the venture capital firm would like to have the senior claim on assets in case of liquidation but still wants to have an option to convert it to common stock if the business becomes successful.

Business angels, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.

There are also government supported financing options available to Portia which are specific to Portia’s location.

Further, Portia can use personal sources of funds. The “personal” sources could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If Portia’s business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. An agreed upon deal should be put in writing since memory is not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Overall, Portia has a number of the sources of external financing to choose from. Portia needs to evaluate upsides and downsides of each option and consider all options in light of the unique situation of the business to choose the best option or combination of options.

 

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Sources of financing

When it comes to sources of financing, firms at any stage of the company’s life cycle have three options from which to choose:

  1. Internal financing – using retained profits.
  2. External financing – using funds invested by outside investors and lenders. Investors include the common stockholders, venture capitalists and entrepreneurs.
  3. Spontaneous financing – such as accounts payable, which increase automatically with increases in sales. Accounts payable, which is also called trade credit, are funds payable to suppliers.

Further, an entrepreneur needs to take into account certain variables when making a decision on optimal sources of financing. Particularly, entrepreneurs need to decide if they are willing to give up part of the voting control which will be inevitable if equity financing is chosen. Entrepreneurs also need to decide if they are willing to take on bigger financial risk which is inevitable when debt financing is selected.

Debt financing increases financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, an equity investor is not entitled to more than what is earned by the enterprise.

Personal Sources of Financing

It is most likely that entrepreneurs will have to invest some of his or her “personal” money or money from “personal” sources to ensure that others will even consider investing in the enterprise. The “personal” sources of financing could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If the business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage important relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. Agreed upon deals should be put in writing since memories are not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Bootstrapping

Bootstrapping is usually a strategy that entrepreneurs follow to survive at the beginning stages of business establishment and growth.A bootstrapping or bootstrap financing refers to a situation when entrepreneur uses his or her initiative to find capital or use capital more efficiently to survive.

It includes minimization of the company’s investments and refers to such situations as leasing instead of buying, adapting just-in-time inventory system, operating business from home, obtaining free publicity instead of paying for advertising and using other people’s resources as much as possible, while paying as little as possible.

Other examples of bootstrap financing include factoring and trade credit. Factoring refers to the situation when the business sells its accounts receivable to a financial institution at a discount rate. Factor refers to the financial institution which business is to purchase accounts receivable from other companies. Trade credit refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30 days or less commonly for 60 or 90 days interest free credit.

Borrowing from the Bank

When borrowing from the bank, an entrepreneur has a number of options. The following types of loans are generally available:

Lines of credit – this is when the bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such an arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for financing of equipment. The loan generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

When banks consider loaning money, they generally will have to consider certain requirements before they will even consider loaning the funds. Such requirements include the request of a business plan to learn whether or not the entrepreneur have their “own skin in the game”.

Other considerations include the entrepreneur’s own net worth which refers to personal assets less personal liabilities. The projected annual income of the entrepreneur is also considered.

If the company is not a start up, the historical financial statements may be requested. Further, pro forma financial statements may be requested which include pro forma income statements, balance sheets and cash flow statements.

It is advisable for the entrepreneur to cultivate a good relationship with the banker since intuitive judgments also play a role when bankers decide whether or not they should lend money to the particular borrower. However, this is only valuable if all other considerations discussed above are attended to.

Banks use different methods to evaluate the appropriateness of the potential borrower. One of such methods, the five C’s method, is discussed below.

Five Cs of credit:

  1. Capital – businesses position with regards to debt versus equity
  2. Collateral – whether or not the entrepreneur has assets that can be sold to cover debt
  3. Character – borrower’s history of meeting obligations
  4. Capacity – ability to repay the loan. This is judged by such indicators as projected cash flows
  5. Conditions – conditions surrounding this particular lending opportunity such as market conditions and transaction conditions

Venture Capital

In exchange for investment, venture capitalists obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because venture capital firm would like to have the senior claim on assets in case of liquidation but still have an option to convert it to common stock if the business becomes successful.

Angel Investors

Angel Investors, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. Very small percentage of start ups manage to get such funding. Therefore, entrepreneur should have other options available as well.

Government Programs

There are also government supported financing options available which are specific to an entrepreneur’s location.

Other

Other less feasible options exist. One example is to obtain funding from large corporation which is willing to invest in the enterprise.

 

Leveraged Buyouts (LBOs)

Leveraged buyouts (LBOs) are also called “bootstrap” transactions or highly-leveraged transactions (HLT). It occurs when a lot of debt, which is also referred to as leverage or borrowing, is used to acquire an organization or controlling percentage of shares of the organisation. As much as 90% or more of debt is used to finance a leveraged buyout.

The assets of the target company are typically used as collateral to finance the merger. Leveraged buyouts often involve situations when a public company is taken private. LBOs are examples of financial mergers.

Due to the nature of the acquisition, certain organizations are especially attractive candidates for leveraged buyouts. Such characteristics include under priced stock, healthy liquidity position, low debt level, inefficient current management of the organization which can be rectified by the new owners, consistent stable earnings of the target company, strong cash flow or the possibility of stronger cash-flows and a good position within the industry and availability of assets to account for sufficient collateral.

Repurchase of stock is sometimes undertaken by companies to decrease attractiveness of the company as a leveraged buyout target. Takeovers can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another strategy that management of the target company may use to protect itself against hostile takeover via leveraged buyout is defensive acquisition. The purpose of such an action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such an acquisition through debt. Due to increased debt of the target company, the acquiring company, which previously planned the hostile takeover, may lose interest in acquiring a highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with acquiring company which pursues hostile takeover.

The nature of leveraged buyouts changed over the last 30 years. Whereas before, LBOs were mostly used to finance hostile takeovers, currently leveraged buyouts are predominantly used to finance management buyouts.

 

Purchase versus Lease Decision

When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Financial Lease (Capital Lease)

Finance lease (also called financial lease or capital lease) refers to the lease of the asset where the useful life is closely aligned to the term of the lease. The lease term is longer than operating lease. Finance leases are usually leases for an asset which does not become technologically obsolete. Under a capital lease, the lessee is usually responsible for all maintenance and other costs. Comparatively, under an operational lease, lessor is usually responsible for such costs.

A lessor purchases an asset selected by the lessee. The lessee will be able to use the asset during the duration of the lease agreement as long as contractual, periodic and timely payments are made by lessee to the lessor.

At the end of the term, the lessee may have a purchase option which allows the lessee to acquire an ownership of the asset. The lessee is not allowed to cancel the lease which makes a financial lease similar to long-term debt. If a lessee misses contractual or periodic payments, the lessee may be forced into bankruptcy.

Because under a finance lease, the lessee may have some ownership of the asset with some risks and benefits that comes with ownership, a finance lease must be recorded as a capitalized lease. This refers to recording the present value of all contractual payments and assets and corresponding liabilities on the balance sheet.

Under a finance lease, the firm benefits from the tax-deductibility of the interest paid on the leased asset as well as from depreciation of the leased asset which is recorded as an expense on the firm’s income statement.

This leads to increases in the debt/equity ratio and therefore an increase in financial leverage compared to an operational lease. It also leads to a decrease in working capital due to an increase in current liabilities.

Moreover, part of the payments due to a financial lease are recorded as a reduction in lease liability under operating cash flows and part is recorded as lease interest payments under financing cash flows. This leads to an increase in operating cash flow compared to records under operating lease where only operating cash flow is affected.

Because firms have an incentive to report leases as operational leases, certain regulatory rules were established by Financial Accounting Standards Board (FASB) which specify which assets can qualify for operational leases. The following is a list of characteristics of financial leases. If even one of such characteristic is met than an asset should be recorded as financial lease.

  • A lease term is 75% or more of the useable life of the asset.
  • At the commencement of the lease agreement, the present value of the lease payments is equal to 90% or more of the fair market value of the leased asset.
  • Ownership of the asset is transferred to the lessee at the maturity of the lease agreement.
  • A lease agreement contains an option to purchase the asset at the “bargain price” which must be the fair market value.

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Weighted Marginal Cost of Capital (WMCC) and Investment Opportunities Schedule

By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.

Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).

Test yourself


ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.

What are the weights that ABC will have for each source of capital?

SOLUTION:

Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.

Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).

$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)

Therefore, the weights are as follows:

Long-term debt – 40%

Retained earnings – 35%

Common stock – 30%

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Weighted Marginal Cost of Capital (WMCC)

Weighted Marginal Cost of Capital – WMCC – is the WACC applicable to the next dollar of the total new financing. Related to the concept is the break point concept. Weighted average cost of capital (WACC) may change over time due to changes in the volume of financing. This occurs as the volume of financing increases, the risk increases and providers of funds require higher return on the funds that they make available.

The WACC of the next dollar of the total financing may be different from the WACC of the last dollar of the total financing.

Related articles: Break Point, Weighted Average Cost of Capital (WACC)

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Long term sources of finance

Here we will focus only on the long term sources of finance because only long-term sources provide permanent financing. Long-term sources of finance (also called long-term sources of capital) refer to long-term debt and equity on the balance sheet. They include long-term debt, preferred stock and common stock equity, which in turn include issues of new common stock and retained earnings.

Permanent financing generally refers to financing long-term fixed assets, such as machinery or factory. If the pay-off from the asset is over the long-term period (longer than 1 year), the long-term sources of finance should be used to ensure it is less risky to finance such assets. For example, if long-term debt (one of the long-term sources of finance) rather than short-term debt is used, business can be more certain money will be available to cover obligations as they come due.

While focusing on the long-term sources of finance, we will need to focus on the specific cost of finance. We will need to obtain the specific cost of each of the long-term sources of finance, which refers to the after-tax cost of using each of the sources today.

Read related article: Cost of Long Term Debt 

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The cost of capital

What is the cost of capital? It is the required rate of return a business must earn on its investments (capital budgeting projects) to maintain the market value of the firm’s shares and to attract funds.

It is a measure used to determine whether or not certain project will decrease or increase the firm’s value in the market place and, consequently, whether or not it should be recommended.

If NPV is more than zero and IRR is greater than the cost of total capital, then a proposed project will increase the market value of the firm and it should be recommended.

If, however, NPV is less than zero and IRR is lower than the cost of all capital, then a proposed project will decrease the market value of the firm and it should not be recommended.

Therefore, if a firm’s risk is assumed to be constant, than any projects with the rate of return higher than the cost of all capital will increase the market value of the firm and any projects with the rate of return below the cost of capital of the enterprise will decrease market value of the firm.

In the discussions that follow we assume that the cost of all capital is measured on the after-tax basis and that a firm’s acceptance of the project does not affect FINANCIAL and BUSINESS RISKS.

FINANCIAL RISK is the chance that a firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by a firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK is the chance that a firm will not be able to cover its operating costs. There are three factors that affect business risk. These are increases in operating leverage, revenue instability and cost instability.

1 – Increase in operating leverage refers to higher use of fixed operating costs.

2 – Increase in revenue instability (or decrease in revenue stability) refers to deterioration of stability of sales of the firm.

3 – Lastly, increase in cost instability (decrease in cost stability) refers to how predictable are costs of the firm, such as labour and raw materials’ costs.

Business risk must be taken as is and the capital structure mix the firm chooses does not influence it.

Firms usually try to maintain an optimal mix of financing (debt and equity) referred to as the target capital structure. Firms have various sources of capital and the cost of capital may be different for each source of financing. When determining the cost of capital, it is helpful to determine an average cost of all sources of capital, which is called the weighted average cost of capital (WACC).

 

Optimal capital structure

Theoretically, enterprises should try to maintain a certain optimal capital structure, a perfect mix of financing (debt and equity), which results in the lowest possible weighted average cost of capital. At this combination of debt and equity, the stock price is at the maximum. Therefore, attainment of the optimal structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. The optimal structure is also referred to as the target capital structure. However, it is important to note the optimal structure exists only in theory.

Theory does not yet offer a methodology that would allow firms’ financial managers to find the optimal capital structure. However, financial managers can determine the approximate optimal structure range, which is close to what they believe the optimal structure for the firm is.

As per above, an optimal structure maximizes the value of the firm. To find the value of the firm, we can use the following formula:

V=EBIT*(1-T)/ra

Which simplifies into:

V=NOPAT/ra

Where:

V = is the value of the firm

EBIT = is earnings before interest and taxes (see the income statement for how it is calculated)

NOPAT = is the net operating profit after taxes (calculated by formula EBIT*(1-T)/ra)

ra = is the weighted average cost of capital (WACC)

If we assume that NOPAT is consistent, then the value of the firm is affected by WACC (ra, weighted average cost of capital). WACC is affected by both, the cost of debt and equity.

The cost of equity


The cost of equity is higher than the cost of debt and increases as financial leverage increases. This is because equity suppliers will demand higher return for increasing financial risk due to increasing financial leverage.

The cost of debt


The cost of debt initially is relatively low. The major reason for this is due to the fact that interest on debt is tax deductible. This tax deductibility of interest paid on debt is also commonly called the tax shield. However, as debt increases, at certain debt ratio lenders will begin to require higher and higher interest payments from the borrower. This is undertaken in order to compensate for increasing risk due to increasing financial leverage.

There are two other costs of debt that the firm needs to consider:

(1) Debt increases the probability of bankruptcy. This is because lenders can force the firm into bankruptcy if the firm cannot meet its financial obligations to the lender.

(2) Another aspect to consider is the agency cost. This refers to the fact that lenders usually protect themselves from increases in risk of the borrower by imposing different loan provisions, which place constraints on actions and choices of the firm. Such provisions commonly include, but are not limited to, minimum levels of liquidity to be maintained, limits on compensation of the executives and limitations on asset acquisitions.

***

As debt increases from a zero point onwards, WACC initially decreases to the theoretical optimal capital structure point. Thereafter, the increasing equity cost and increasing cost of debt causes WACC to start increasing again. Therefore the theoretical optimal capital structure is obtained at the point where the WACC is the lowest.

In other words, the theoretical optimal capital structure occurs at the point where the benefits from using debts are in equilibrium (in balance) with the costs of using debt. The optimal capital structure can also be seen as the balance between risk and return where the firm’s stock price is maximized.