Finance for Non-Financial Managers , 6 th edition

1. Finance for Non-Financial Managers, 6th edition PowerPoint Slides toaccompany Prepared by Pierre Bergeron, University of Ottawa

2. Finance for Non-Financial Managers, 6th edition CHAPTER 8 SOURCES AND FORMS OF FINANCING

3. Chapter Objectives Differentiate between internal financing and external financing. Explain different types of risk-related financing options. Explain useful strategies when approaching lenders. Comment on the different categories of equity financing. Discuss the sources of intermediate and long-term financing. Comment on the most important sources and forms of short-term financing. Identify the factors that can influence the choice between buying or leasing an asset. Sources and Forms of Financing Chapter Reference Chapter 8: Sources and Forms of Financing

4. Finding Funding: Ten-Step Process 2 Identify financial needs 1 4 5 Pinpoint sources of cash Identify financing sources Know your numbers 3 Identify financing requirements 9 8 10 6 7 Seek financing synergy Identify forms of financing Become credit-worthy Prepare the investment proposal Meet investors

5. Leasing • Equity • Share capital • Retained earnings • Contributions • Non-current liabilities • Mortgages • Bonds • Non-current assets • Land • Buildings • Equipment • Machinery Sources and Forms of Financing Financing requirements Financial needs • Current assets • Inventories • Trade receivables • Cash • Current liabilities • Suppliers • Commercial banks • Factoring companies • Inventory financing • Term loans • Conditional sales contracts

6. Now, where will the funds come from? “Financing requirements” Financial Needs “Financial needs” Non-current assets $ 700,000 Marketing costs $ 200,000 Working capital $ 170,000 Other assets $ 40,000 Gross funding requirements $1,110,000

7. Financing Requirements Total Operating Term Risk costslinedebtcapital Non-current assets $700,000 0 $600,000 $100,000 Marketing $200,000 0 0 $200,000 Working capital $170,000 $150,000 0 $ 20,000 Other assets $ 40,000 0 0$ 40,000 Sub-total $1,110,000 $150,000 $600,000 $360,000 Amount of financing available using internal and external conventional sources Amount of risk capital financing required Investment required to fund the project

8. 1. Internal Versus External Financing Internal financing 1. Cash flow from the operations Profit for the year Add back: depreciation Total funds generated by the business 2. Working capital - inventories - trade receivables External financing 1. Shareholders 2. Lenders (long- and short-term) 3. Leasing

9. 2. Risk-Related Financing Options Business risk: uncertainty in the marketplace Financial risk: debt versus equity Instrument risk: quality of security 30% Common Shares 25% Preferred Shares Subordinated Debt 20% Unsecured Debt 15% Secured Long Term Debt Secured Short Term Debt (less than 1 year) 10% Government Bonds 5% Low High

10. 3. Useful Strategies When Approaching Lenders Matching principle Process that relates financial needs to financing requirements in terms of length of time (e.g., mortgage used to finance a house). C’s of credit Factors that investors look at to gauge the creditworthiness of a business (character, collateral, capacity, capital, circumstances, coverage). Making a company creditworthy Poor earnings record, questionable management ability, collateral of insufficient quality or quantity, slow and past due in trade or loan payments, poor accounting system, new firm with no established earnings records, poor moral risk (character).

11. 4. Equity Financing Shareholders Funds can be obtained from common shareholders and preferred shareholders. Shareholders benefit from collective and specific rights. Risk capital financing Risk capital investors typically seek returns ranging from a minimum of 25% to 40% per year. The required return on equity relates to the percentage or share ownership. Risk capital can be provided by angels, private investors, institutional investors, government-backed corporations and corporate strategic investors.

12. Government Financing Government financing is a direct or indirect form of financial assistance offered by municipal, provincial, or federal agencies to help businesses carry out capital expenditure projects or expansion of their activities that, without such assistance, would be delayed or even abandoned. The more important federal government financial institutions are: • Industry Canada • Export Development Corporation • Farm Credit Corporation • The Business Development Bank of Canada

13. Term loan Amount of the term loan financing depends on what can be offered as security and is determined by the lender (i.e., bank, trust companies, insurance companies and pension funds). If suitable security is not offered, chances for obtaining a term loan are reduced. Conditional Sales Contract This is an agreement made between a buyer and a seller regarding the purchase of an asset (e.g., truck). 5. Long-Term Conventional Financing

14. Long-Term Conventional Financing (continued) Bonds These are loans that could be secured or unsecurred (20 to 30 years) for which a firm agrees to make payments of interest and principal, usually semi-annually, to the holder of the bond contract. Mortgages Mortgages finance real property, land and buildings. Lenders base the amount of the mortgage on the market value of the property (50% of the market value is a common assessment).

15. Subordinated debt These investors accept a higher level of risk compared with conventional sources and ask coupon interest rates typically ranging from 8% to 12%. The overall rate of return to the investor is higher because participation features at the time of exit increase the rate of return – the minimum expected return is between 12% to 25% per year. Long-Term Risk Capital Financing

16. 4. Short-Term Financing (12 months) Reasons for financing Forms Sources Current assets Inventories Trade receivables Cash Confirming institutions Government agencies Suppliers Factoring companies Chartered banks Flexible Inventory financing (general lien, floor planning, warehouse financing) Consignment Trade credit Trade receivables financing Line of credit Seasonal loans Revolving credit Notes payable Single loan Current assets Inventories & trade receivables Durable Working capital loans Chartered banks Government agencies

17. Supplier credit Cash discounts should be taken when offered by suppliers, even if a loan has to be borrowed from a bank. This also depends on the size of the discount and the cost of funds (interest rate) on the bank line of credit. Bank line of credit Banks may finance 75% of trade receivables, 50% of inventories and 90% of marketable securities (these margins are indicative only). Types of short-term financing include line of credit, self-liquidating loans, revolving credit, interim financing. Short-Term Conventional Financing

18. Factoring Financing can be obtained from a factoring company “the factor” who purchases receivables as they occur. Asset-based financing Similar to a bank line of credit; it is subject to a “ceiling” borrowing amount based on receivable and inventory margins and also involves a security pledge on these assets. Short-Term Risk Capital Financing

19. There are two broad categories of leases: 1. Operating lease (maintenance lease) 2. Financial leases 7. Lease Financing Lease financing is an alternative to the more traditional financing for the acquisition of any asset and it takes place when a lessee pays a lessor for the use of an asset. • Direct lease • Sale and leaseback

20. It is a good source of financing for obtaining assets for firms that have limited capital funds. Leases are quoted at fixed rates (the company avoids the risk of having to refinance at a higher interest rate). The business may conserve existing sources of credit for other uses and usually does not restrict a firm’s borrowing capacity. Leases provide 100% financing as compared to say 75% through conventional financing. All costs, sales taxes, acquisition costs, delivery and installation charges related to the acquisition may be included in the lease payment. The lease-payment is tax deductible. It is a good way of trying machinery and equipment before committing oneself to the purchase. It provides a way to meet seasonal production. Advantages to Leasing

21. Capital cost allowance Tax effects of capital cost allowance represent an advantage to ownership. Key Variables of Leasing Versus Buying • Obsolescence Makes leasing more attractive. • Operating and Represent an expense to ownership and • maintenance charges make leasing more attractive. • Salvage or residual value Advantage to ownership. • Discount rate Different discount rates may be used depending on the degree of risk related to each option. • Tax effects Lease payments are fully tax deductible and make leasing more attractive.

22. About the lease Duration of the lease is 10 years. Annual cost of the lease (before tax) is $170,000. Calculating the Economics of Leasing or Buying • About the financing and the purchase • Cost of the asset is $1,000,000. • Life of the asset is 10 years. • Debt agreement is 100% financing of the asset; a 10-year repayment schedule with 10% interest rate. • Residual value of the asset is nil. • Capital cost allowance is 15%. • Other assumption • Corporate income tax rate is 50%.

23. Computing net cost of owning Application to loan Lease cost @ 50% Total payment Debt repayment CCA Tax deductible expense Tax savings @ 50% Net cost of owning Net advantage of owning Present value @ 10% Interest Principal 3 + 5 6 ÷ 2 2 - 7 8 - 1 175,0 232,5 204,8 179,5 156,1 134,1 113,1 92,8 72,7 52,6 1,413,2 8,9* 31,8* 18,5* 8,2* 0,2* (6,0) (10,9) (14,6) (17,5) (19,8) (1,4) 100,0 93,7 86,8 79,2 70,9 61,7 51,6 40,5 28,2 14,8 627,4 62,7 69,0 75,9 83,5 91,8 101,1 111,1 122,3 134,5 147,9 1,000,0 75,0 138,7 117,9 100,2 85,2 72,4 61,6 52,3 44,5 37,8 785,7 87,5 116,2 102,4 89,7 78,0 67.1 56,6 46,4 36,4 26,3 706,6 75,2 46,5 60,4 73,0 84,7 95,7 106,2 116,3 126,4 136,4 920,8 9,7* 38,5* 24,6* 12,0* 0,3* (10,7) (21,2) (31,3) (41,4) (51,4) (70,8) 162,7 1,627,450 85,0 850,0 Cost of Owning Versus Leasing 1 2 3 4 5 6 7 8 9 10 Year 1 2 3 4 5 6 7 8 9 10 (Expressed in thousands of dollars) *favours owning ( ) favours leasing