1. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

2. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.2 Chapter Objectives 1.Differentiate between internal financing and external financing. 2.Explain different types of risk-related financing options. 3.Explain useful strategies when approaching lenders. 4.Comment on the most important sources and forms of short-term financing. 5.Discuss the sources of intermediate and long-term financing. 6.Comment on the different categories of equity financing. 7.Identify the factors that can influence the choice between buying or leasing an asset. Chapter Reference Chapter 7: Sources and Forms of Financing Sources and Forms of Financing

3. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.3 Finding Funding: Ten-Step Process Know your numbers 1 Identify financial needs 2 Identify financing requirements 3 Pinpoint sources of cash 4 Become credit- worthy 8 Seek financing synergy 7 Prepare the investment proposal 9 Meet investors 10 Identify financing sources 5 Identify forms of financing 6

4. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.4 Current assets Cash Accounts receivable Inventory Current liabilities Suppliers Commercial banks Factoring companies Inventory financing Term loans Conditional sales contracts Financial needs Financing requirements Capital assets Land Buildings Equipment Machinery Leasing Long-term debts Mortgages Bonds Equity Capital shares Retained earnings Contributions Sources and Forms of Financing

5. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.5 “Financial needs” Capital assets$ 700,000 Marketing costs$ 200,000 Working capital$ 170,000 Other assets$ 40,000 Gross funding requirements$1,110,000 Now, where will the funds come from? “Financing requirements” Financial Needs

6. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.6 TotalOperating Term Risk costs line debt capital Capital 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 Investment required to fund the project Amount of financing available using internal and external conventional sources Amount of risk capital financing required Financing Requirements

7. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.7 Internal financing1. Income from the business Net income Add back: amortization Total funds generated by the business 2. Working capital - inventory - accounts receivable External financing1. Shareholders 2. Lenders (short- and long-term) 3. Leasing 1. Internal Versus External Financing

8. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.8 2. Risk-Related Financing Options Business risk: uncertainty in the marketplace Financial risk: debt versus equity Instrument risk: quality of security 30% 25% 20% 15% 10% 5% Low Government Bonds Secured Short Term Debt (less than 1 year) Secured Long Term Debt Unsecured Debt Subordinated Debt Preferred Shares Common Shares High

9. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.9 3. Useful Strategies When Approaching Lenders Process that relates financial needs to financing requirements in terms of length of time (e.g., mortgage used to finance a house). Matching principle Factors that investors look at to gauge the creditworthiness of a business (character, collateral, capacity, capital, circumstances, coverage). C’s of credit 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). Making a company creditworthy

10. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.10 Current assets Cash Accounts receivable Inventory Line of credit Seasonal loans Revolving credit Notes payable Single loan Trade credit Accounts receivable financing Inventory Financing (General lien, floor planning, warehouse financing) Consignment Reasons for financingFormsSources Chartered banks Suppliers Factoring companies Confirming institutions Government agencies Current assets Accounts receivable & inventory Working capital loansChartered banks Government agencies Flexible Durable 4. Short-Term Financing (12 months)

11. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.11 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 accounts receivable, 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

12. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.12 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

13. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.13 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. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.14 Bonds These are loans that could be secured or unsecured (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). Long-Term Conventional Financing (continued)

15. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.15 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. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.16 6. 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.

17. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.17 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

18. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.18 There are two broad categories of leases: 1. Operating lease (maintenance lease) 2. Financial leases 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 7. Lease Financing

19. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.19  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

20. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.20  Capital cost allowanceTax effects of capital cost allowance represent an advantage to ownership.  ObsolescenceMakes leasing more attractive.  Operating andRepresent an expense to ownership and maintenance chargesmake leasing more attractive.  Salvage or residual valueAdvantage to ownership.  Discount rateDifferent discount rates may be used depending on the degree of risk related to each option.  Tax effectsLease payments are fully tax deductible and make leasing more attractive. Key Variables of Leasing Versus Buying

21. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.21 A.About the lease 1.Duration of the lease is 10 years. 2.Annual cost of the lease (before tax) is $170,000. B.About the financing and the purchase 1.Cost of the asset is $1,000,000. 2.Life of the asset is 10 years. 3.Debt agreement is 100% financing of the asset; a 10-year repayment schedule with 10% interest rate. 4.Residual value of the asset is nil. 5.Capital cost allowance is 15%. C.Other assumption 1.Corporate income tax rate is 50%. Calculating the Economics of Leasing or Buying

22. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 7.22 1 2 3 4 5 6 7 8 9 10 Cost of Owning Versus Leasing Year 1 2 3 4 5 6 7 8 9 10 (Expressed in thousands of dollars)*favours owning ( ) favours leasing 85,0 850,0 Lease cost @ 50% 75,0 138,7 117,9 100,2 85,2 72,4 61,6 52,3 44,5 37,8 785,7 CCA 8,9* 31,8* 18,5* 8,2* 0,2* (6,0) (10,9) (14,6) (17,5) (19,8) (1,4) Present value @ 10% 87,5 116,2 102,4 89,7 78,0 67.1 56,6 46,4 36,4 26,3 706,6 Tax savings @ 50% 6 ÷ 2 175,0 232,5 204,8 179,5 156,1 134,1 113,1 92,8 72,7 52,6 1,413,2 Tax deductible expense 3 + 5 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 - 1 162,7 1,627,450 Total payment Computing net cost of owning Application to loan 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 62,7 69,0 75,9 83,5 91,8 101,1 111,1 122,3 134,5 147,9 1,000,0 Principal