1. Finance for Non-Financial Managers, 6th edition
PowerPoint Slides
to accompany
Prepared by
Pierre Bergeron, University of Ottawa
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2. Finance for Non-Financial Managers, 6th edition
CHAPTER 8
SOURCES AND FORMS OF FINANCING
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3. Sources and Forms of Financing
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.
Chapter Reference
Chapter 8: Sources and Forms of Financing
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4. Finding Funding: Ten-Step Process2 1
Identify financial needs 4 5
Know your numbers
Pinpoint sources of cash
Identify financing sources 3
Identify financing requirements 6 7 8 9 10
Identify forms of financing
Seek financing synergy
Become credit-worthy
Prepare the investment proposal
Meet investors
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5. Sources and Forms of Financing
Financial needs
Financing requirements
Current assets
Inventories
Trade receivables
Cash
Current liabilities
Suppliers
Commercial banks
Factoring companies
Inventory financing
Term loans
Conditional sales contracts
Non-current assets
Land
Buildings
Equipment
Machinery
Leasing
Equity
Share capital
Retained earnings
Contributions
Non-current liabilities
Mortgages
Bonds
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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 $ ,000
Gross funding requirements $1,110,000
Now, where will the funds come from?
“Financing requirements”
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7. Financing Requirements
Total Operating Term Risk
costs line debt capital
Non-current assets $700, $600,000 $100,000
Marketing $200, $200,000
Working capital $170,000 $150, $ 20,000
Other assets $ 40, $ 40,000
Sub-total $1,110,000 $150,000 $600,000 $360,000
Investment required to fund the project
Amount of financing available using internal and external conventional sources
Amount of risk capital financing required
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8. 1. Internal Versus External Financing
Internal financing 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
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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
10%
Secured Short Term Debt (less than 1 year)
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. Risk capital financing
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.
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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
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13. 5. Long-Term Conventional Financing
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).
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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).
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15. Long-Term Risk Capital Financing
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.
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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
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17. Short-Term Conventional Financing
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.
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18. Short-Term Risk Capital Financing
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.
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19. 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.
There are two broad categories of leases:
1. Operating lease (maintenance lease)
2. Financial leases
Direct lease
Sale and leaseback
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20. Advantages to Leasing
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.
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21. Key Variables of Leasing Versus Buying
Capital cost allowance Tax effects of capital cost allowance represent an advantage to ownership.
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.
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22. Calculating the Economics of Leasing or Buying
About the lease
Duration of the lease is 10 years.
Annual cost of the lease (before tax) is $170,000.
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%.
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23. Cost of Owning Versus Leasing
162,7
1,627,450
Total payment
Computing net cost of owning
Application to loan
Year
85,0
850,0
Lease 50%
100,0
93,7
86,8
79,2
70,9
61,7
51,6
40,5
28,2
14,8
627,4
Debt repayment
Interest
75,0
138,7
117,9
100,2
85,2
72,4
61,6
52,3
44,5
37,8
785,7
CCA
175,0
232,5
204,8
179,5
156,1
134,1
113,1
92,8
72,7
52,6
1,413,2
Tax deductible expense
3 + 5
87,5
116,2
102,4
89,7
78,0
67.1
56,6
46,4
36,4
26,3
706,6
Tax 50%
6 ÷ 2
75,2
46,5
60,4
73,0
84,7
95,7
106,2
116,3
126,4
136,4
920,8
Net cost of owning
2 - 7
9,7*
38,5*
24,6*
12,0*
0,3*
(10,7)
(21,2)
(31,3)
(41,4)
(51,4)
(70,8)
Net advantage of owning
8 - 1
8,9*
31,8*
18,5*
8,2*
0,2*
(6,0)
(10,9)
(14,6)
(17,5)
(19,8)
(1,4)
Present 10%
62,7
69,0
75,9
83,5
91,8
101,1
111,1
122,3
134,5
147,9
1,000,0
Principal 1 2 3 4 5 6 7 8 9 10
(Expressed in thousands of dollars) *favours owning
( ) favours leasing
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