Introduction to Business 3e 16 Part VI: Financial Management Copyright © 2004 South-Western. All rights reserved. FinancingFinancing

16–2 Accounting and Financial Management

Copyright © 2004 South-Western. All rights reserved.16–3 Financing

Copyright © 2004 South-Western. All rights reserved.16–4 Learning Goals Identify common methods of debt financing for firms Identify common methods of equity financing for firms Explain how firms issue securities to obtain funds Describe how firms determine the composition of their financing

Copyright © 2004 South-Western. All rights reserved.16–5 Methods of Debt Financing Firms borrow funds (debt financing) to invest in assets such as buildings, machinery, and equipment –Borrowing from financial institutions –Issuing bonds –Issuing commercial paper

Copyright © 2004 South-Western. All rights reserved.16–6 business online

Copyright © 2004 South-Western. All rights reserved.16–7 Interest Rate Charged on Loans under Three Different Scenarios Exhibit Interest Rate Years I2I2 I1I1 I3I3 (Floating rate; period of rising interest rates) (Fixed rate) (Floating rate; period of declining interest rates)

Copyright © 2004 South-Western. All rights reserved.16–8 Methods of Debt Financing Borrowing from financial institutions requires proof of creditworthiness –Planned use of funds –Firm’s financial condition –Industry outlook –Collateral  Asset for which borrowed funds will be used  Accounts receivable

Copyright © 2004 South-Western. All rights reserved.16–9 Methods of Debt Financing Creditworthiness impacts loan terms –Interest rate (usually prime rate + premium)  Fixed versus floating rate

Copyright © 2004 South-Western. All rights reserved.16–10 Methods of Debt Financing Issuing bonds –Indenture explains firm’s obligations to bondholders  States whether bond has call feature –Bondholders can enforce protective covenants to reduce risk of default by the firm

Copyright © 2004 South-Western. All rights reserved.16–11 Methods of Debt Financing Issuing bonds –Long-term debt securities (IOUs) purchased by investors –Par value is amount the bondholder receives at maturity (usually years) –Coupon (interest) rate is fixed for life of the bond and paid semi-annually –Bonds can be secured by collateral or unsecured

Copyright © 2004 South-Western. All rights reserved.16–12 Effect of Interest Rates on Interest Expenses incurred by Firms Exhibit 16.2

Copyright © 2004 South-Western. All rights reserved.16–13 Summary of Risk Ratings Assigned by Bond Rating Agencies

Copyright © 2004 South-Western. All rights reserved.16–14 Methods of Debt Financing Issuing commercial paper –Short-term debt security normally issued by firms that are in good financial condition –Normal maturity between 3 and 6 months –Used as an an alternative to obtaining loans from financial institutions –Minimum denomination is usually $100,000, but typically issued in multiples of $1,000,000

Copyright © 2004 South-Western. All rights reserved.16–15 Methods of Debt Financing Issuing commercial paper (cont’d) –Various financial institutions purchase commercial paper –Interest rates depend on market interest rates at time of issuance

Copyright © 2004 South-Western. All rights reserved.16–16 Providers of Debt Financing Commercial banks Savings institutions (aka “thrifts”) Finance companies –Provide loans to less established firms with higher risk of default - charge higher interest rates Pension funds Insurance companies Mutual funds Bond mutual funds

Copyright © 2004 South-Western. All rights reserved.16–17 Methods of Equity Financing Equity financing –Funds of the firm’s owners that are used to finance activities  Retaining earnings instead of distributing dividends to owners  Larger firms distribute some of their earnings as dividends and retain the rest. –Issuing stock  Common stock versus preferred stock  Common stockholders have voting rights, preferred stockholders usually do not.

Copyright © 2004 South-Western. All rights reserved.16–18 Methods of Equity Financing Issuing stock to venture capital firms –Firm composed of individuals who invest in small businesses and expect a share of the businesses in which they invest. IPO (initial public offering) –“Going public” - the first time a firm issues stock to the public  After an IPO, the firm lists its stock on the secondary market (NYSE or NASDAQ). Stock mutual funds

Copyright © 2004 South-Western. All rights reserved.16–19 Summary of Firm’s Debt and Equity Financing Methods Exhibit 16.4

Copyright © 2004 South-Western. All rights reserved.16–20 How Firms Issue Securities Public Offering –Selling securities (stocks or bonds) to the public Issuing firm is assisted by investment bank –Origination –Underwriting  Investment bank guarantees a price to the issuing firm, no matter what price the securities are sold for  For large issues, an underwriting syndicate may be used. –Distribution  Register with SEC and provide prospectus.

Copyright © 2004 South-Western. All rights reserved.16–21 How Firms Can Benefit from Supplier Financing Exhibit 16.5

Copyright © 2004 South-Western. All rights reserved.16–22 Other Methods of Obtaining Funds Financing from suppliers –Supplier’s willingness to wait for payment, saves the firm some financing costs Leasing –Rent assets for a specified period of time

Copyright © 2004 South-Western. All rights reserved.16–23 How a Firm’s Return on Equity is Dependent on Financial Leverage Exhibit 16.6

Copyright © 2004 South-Western. All rights reserved.16–24 Deciding the Capital Structure Capital structure –The amount of debt versus equity financing used by the firm –Interest payments on debt are tax-deductible –Too much debt increases the firm’s risk of default –Firms may repurchase some of their stock or issue additional shares to revise the capital structure.

Copyright © 2004 South-Western. All rights reserved.16–25 How a Firm’s Interest Expense is Dependent on Financial Leverage Exhibit 16.7

Copyright © 2004 South-Western. All rights reserved.16–26 Small Business Survey Financing Choices of Small Firms

Copyright © 2004 South-Western. All rights reserved.16–27 Dividend Policy Board of directors determines how much of the firm’s earnings should be distributed as dividends or retained to finance future operations –This decision influences the amount of additional financing the firm must obtain Factors that affect dividend policy –Shareholder expectations –Firm’s financing needs

Copyright © 2004 South-Western. All rights reserved.16–28 Chapter Summary Common forms of debt financing include obtaining bank loans, issuing bonds, or issuing commercial paper Common sources of equity financing include retaining earnings and issuing stock Firms hire an investment bank to assist with issuing stocks and bonds Firms may prefer debt financing because interest payments are tax deductible

Copyright © 2004 South-Western. All rights reserved.16–29 How the Demand and Supply of Loanable Funds Affect Interest Rates Exhibit 16A.1a

Copyright © 2004 South-Western. All rights reserved.16–30 How the Demand and Supply of Loanable Funds Affect Interest Rates Exhibit 16A.1b

Copyright © 2004 South-Western. All rights reserved.16–31 Effect of a Change in the Demand for Loanable Funds on Interest Rates Exhibit 16A.2a

Copyright © 2004 South-Western. All rights reserved.16–32 Effect of a Change in the Demand for Loanable Funds on Interest Rates Exhibit 16A.2b

Copyright © 2004 South-Western. All rights reserved.16–33 Effect of a Change in the Supply of Loanable Funds on Interest Rates Exhibit 16A.3

Copyright © 2004 South-Western. All rights reserved.16–34 Effect of a Change in the Supply of Loanable Funds on Interest Rates Exhibit 16A.3

Copyright © 2004 South-Western. All rights reserved.16–35 Summary of Key Factors That Affect Interest Rates Exhibit 16A.4