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  1. 1. STRATEGIC FINANCING DECISIONS Joan Melgar Fiscal Management
  2. 2. How do firms raise the funding they need? ■They borrow money (debt), ■sell ownership shares (equity), ■and retained earnings (profits). ■The financial manager must assess all these sources and choose the one most likely to help maximize the firm’s value.
  3. 3. Financing Decisions ■refer to the decisions that companies need to take regarding what proportion of equity and debt capital to have in their capital structure.
  4. 4. Topics Included: ■ 8.1 Short–Term Financing and Sources ■ 8.2 Trade Credits ■ 8.3 Short-Term Bank Loans ■ 8.4 Financial plans ■ 8.5 Business and Financial Risk ■ 8.6 Dividend Reinvestment Plans ■ 8.7 Sources of Long–Term Financing ■ 8.8 Equity Financing ■ 8.9Traditional Debts Instrument
  5. 5. 8.1 Short–Term Financing and Sources ■ Short-term financing comes due within one year. ■ The main sources of short-term financing are ■ trade credit ■ bank loans ■ commercial paper
  6. 6. What are the main disadvantages of trade credit? ■ Need for credit management ■ Risk of late payment fees ■ Potential supply chain complications ■ May affect creditworthiness ■ Some suppliers may refuse credit to start-ups ■ Expensive if the payment date is missed
  7. 7. ■ Keynotes: ■ Benefits galore for buyers, and not so shabby for suppliers either. ■ Trade credit helps cement long-term partnerships. It gives both parties reason to pull together. ■ The biggest downside to trade credit is the potential knock-on effect if things don't go to plan. ■ For buyers, the penalty of failing to keep up your side of the deal can add to your costs and sour the relationship. ■ But for suppliers, it could be far worse. If the customer business goes under and debts remain unpaid, suppliers can face an uncertain future.
  8. 8. ■ Cost of Trade Credit Calculator Formula ■ As an example of the use of the calculator, suppose a business offers 2/10 net 30 terms to customers which means a 2% discount (d) is allowed if the customer pays within 10 days (discount days) otherwise full payment is due within 30 days (normal days). If the customer takes the discount then the amount less the discount is paid 20 days early, but a cost equal to the discount is incurred. ■ The cost of trade credit can then be calculated using the formula as follows: ■ d = 2% ■ Normal days = 30 ■ Discount days = 10 ■ Cost of trade credit = (1 + d /(1 - d)) (365 / (Normal days - Discount days)) - 1 ■ Cost of trade credit = (1 + 2% /(1 - 2%)) ^(365 / (30 - 10)) - 1 ■ Cost of trade credit = 44.59% ■ In this example, the cost of having the use of the funds for an additional 20 days is equivalent to an annualized cost of trade credit of 44.59%. This means that if the business is able to borrow the funds at less than 44.59% it should do so rather than offer the early payment discount ■ A similar calculation can be carried out to determine whether or not to take a discount offered by a supplier. In this case if the business does not take the discount and pay early, then it has the use of the funds for a further 20 days, however, this is done at the cost of not taking the discount of 2%. Using the same formula the cost of not taking the discount will be the same as in the example above 44.59%. If the business can borrow at a rate less then this then it should do so and take the early payment
  9. 9. Commercial paper ■ is a money-market security issued by large corporations to obtain funds to meet short-term debt obligations (for example, payroll) and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note.
  10. 10. 8.5 FINANCIAL PLAN ■ A financial plan is a document containing a person’s current money situation and long-term monetary goals, as well as strategies to achieve those goals. A financial plan begins with a thorough evaluation of the person’s current financial state and future expectations and may be created independently or with the help of a certified financial planner.
  11. 11. KEY TAKEAWAYS ■ A financial plan documents an individual’s long-term financial goals and creates a strategy for achieving them. ■ The plan should be comprehensive but also highly individualized, to reflect the individual’s personal and family situations, risk tolerance, and future expectations. ■ The plan starts with a calculation of the person’s current net worth and cash flow and ends with a strategy.
  12. 12. Understanding the Financial Plan ■ Whether you’re going it alone or with a financial planner, the first step in creating a financial plan is gathering a lot of bits of paper—or, more likely these days, cutting and pasting numbers from various web- based accounts into a document or spreadsheet.
  13. 13. ■ 1.Calculating net worth To figure out your current net worth, list all of the following: Your assets: This may include a home and a car, some cash in the bank, money invested in a 401(k) plan, and anything else of value that you own. Your liabilities: These may include credit card debt, student debt, an outstanding mortgage, and a car loan. In some cases, you may have access to a grace period or moratorium. ■ The formula for your current net worth is your total assets minus your total liabilities.
  14. 14. 2. Determining cash flow ■ You can’t create a financial plan without knowing where your money is going— and when. Documenting transactions—the flow of cash in and out—will help you determine how much you need every month for necessities, how much might be left for saving and investing, and even where you can cut back a little—or a lot. ■ One way to get this done is to skim through your checking account and credit card statements. Collectively, they should provide a fairly complete history of your spending. ■ If your expenses vary a lot seasonally, then it’s best to go through an entire year—counting up all the expenditures in each category and then dividing by 12 to get an average monthly estimate of your spending. This way, you won’t underestimate or overestimate what you spend on utilities, nor will you forget to account for holiday gifts or a vacation. ■ Don’t overlook cash withdrawals that may be used on sundries from shampoo to sodas.
  15. 15. 3.Considering your priorities ■ The core of a financial plan is a person’s clearly defined goals. These may include funding a college education for the children, buying a larger home, starting a business, retiring on time, or leaving a legacy. ■ No one can tell you how to prioritize these goals. However, a professional financial planner may be able to help you choose a detailed savings plan and specific investments that will help you tick them off, one by one. ■ The main elements of a financial plan include a retirement strategy, a risk management plan, a long-term investment plan, a tax reduction strategy, and an estate plan.
  16. 16. Special Considerations of a Financial Plan ■ Financial plans don’t have a set template. A licensed financial planner will be able to create one that fits you and your expectations. Once complete, it may prompt you to make changes in the short term that will help ensure a smooth transition through life’s financial phases. ■ The following elements should be addressed and revised as necessary: ■ Retirement strategy: No matter what your priorities are, the plan should include a strategy for accumulating the retirement income that you need. ■ Comprehensive risk management plan: This includes a review of life and disability insurance, personal liability coverage, property and casualty coverage, and catastrophic coverage. ■ Long-term investment plan: A customized plan based on specific investment objectives and a personal risk tolerance profile. ■ Tax reduction strategy: A strategy for minimizing taxes on personal income to the extent allowed by the tax code. ■ Estate plan: Arrangements for the benefit and protection of your heirs.
  17. 17. ■ What is the Purpose of a Financial Plan? A financial plan is designed to help you make the best use of your money and achieve long- term financial goals, whether they are sending your children to college, buying a bigger home, leaving a legacy, or enjoying a comfortable retirement. ■ How Do I Write a Financial Plan? You can write a financial plan yourself or enlist the help of a professional financial planner. The first step is to calculate your net worth and identify your spending habits. Once this has been documented, you need to consider longer-term objectives and come up with ways to achieve them. ■ What Are the Key Components of a Financial Plan? Financial plans don’t have a set format, although the good ones do tend to focus more or less on the same things. After calculating your net worth and spending habits, you’ll explore your financial goals and figure out ways to make them achievable. Usually, this involves some form of budgeting and creating a means to put money away each month. To ensure that you live comfortably for the rest of your life, it’s generally advisable to devise a retirement, risk management, and long-term investment strategy and keep tax expenses to a minimum.
  18. 18. ■https://www.investopedia.com/ter ms/f/financial_plan.asp ■Please watch a short Video
  19. 19. 5 Financial Ratios Used To Measure Business Risk and How To Use Them ■ Why measure business risk? ■ When you run a business, you typically know your destination and what you want to achieve. And there will be financial and business roadblocks that detour your path to success. ■ There are numerous instances where an in-depth view of your business finances can help avoid risks. Everyday business events such as expansion projects, acquisitions, low cash on hand, increased fixed expenses, increased borrowing, and even an increase in sales can be signs that it’s time to reevaluate your business risk. ■ There’s no room for gut feelings and leaps of faith in business. Business owners and managers must use financial ratios to manage business risk effectively and avoid financial setbacks. ■ According to a study by author Steve Martin, the number one quality of successful business people is resourcefulness. This list of financial ratios is an excellent resource for business owners who are ready to take their organization to the next level.
  20. 20. What do financial ratios measure ■ Financial ratios are used to ensure that executives, financial institutions, and stakeholders have an accurate picture of risks associated with an organization. They measure different aspects of your company’s financial health for financial management, market risks, and risks related to investing in a company. ■ Financial ratios can also help navigate the risks of selling a particular product or service for small business owners. According to a study, 60 percent of small business owners admit that they don’t feel knowledgeable about their finances. ■ While financial ratios are primarily useful for those already in business, they can benefit someone looking to start a business as well (such as using benchmarks and hypotheticals to determine if an idea is viable or too risky)
  21. 21. ■ 1. Contribution margin ratio ■ The contribution margin ratio shows the contribution margin (sales – variable costs) as a percentage of your total sales. This formula will tell you how much income there is to cover fixed and variable costs and help your company set profit targets. ■ Contribution margin ratio = contribution margin / sales ■ For example, let’s say you have a product that costs $0 retail, and you have about 30,000 of fixed expenses, including machinery, office expenses, and loan interest. It costs about 8 for labor and manufacturing to make each unit. ■ 1. First, calculate your contribution margin: ■ (Sales – Variable Costs) = (20 – 8) = 12 ■ 2. Now, calculate your contribution margin ratio: ■ (Contribution Margin/Sales) = (12/20) = 60 percent ■ The result of this contribution margin ratio in this example tells us that 60 percent of the sales from each product is available to contribute to your 30,000 of fixed expenses. Now you can quickly determine how many units you need to sell each month to keep your business up and running. ■ In a perfect world, your contribution ratio would be 100 percent. But a good contribution margin is subjective and depends on how much your fixed expenses cost and the number of units you can sell in a given month.
  22. 22. ■ 2. Operating leverage effect (OLE) ratio ■ The operating leverage effect ratio can help you analyze your contribution margin ratio. Use the OLE ratio to measure how your income increases or drops depending on the changes in sales volume to show how much revenue is available to cover non-operating costs. This can help you decide if you need to change your prices and get a glimpse into your company’s future profitability. ■ OLE ratio = contribution margin ratio/operating margin ■ Let’s say that your organization earned 1 million in revenue last year, and it cost you about 300,000 to operate your business. ■ You already know your contribution margin ratio from the previous formula. ■ So let’s start by calculating your operating margin: ■ (Revenue – Operating Costs)/Revenue = (1 million – 300,000)/1 million = 70 percent ■ Calculating your operating leverage effect ratio can help you better understand how much of your costs are going towards operations and how much you have to cover variable expenses. A high OLE indicates a higher profit potential, while a low OLE shows low profitability potential.
  23. 23. ■ 3. Financial leverage ratio ■ The financial leverage ratio is used to measure overall financial risk. By measuring the amount of debt held by your company against its income, you can glean a picture of how investors see your business in terms of financial risk. ■ Financial leverage = operating income/net income ■ For example, if your gross income last year was 3 million, net income was 4 million, and your operating expenses added up to 2 million, this is how you would calculate your financial leverage ratio. ■ 1. First, let’s calculate your operating income: ■ (Gross Income – Operating Expenses) = 1 million ■ 2. Next, find your financial leverage: ■ (Operating Income)/(Net Income) = 1 million/4 million = 25 percent ■ This value shows that your business has financial obligations and may not be ready to take on additional debt until your company can generate more income.
  24. 24. ■ 4. Degree of combined leverage ratio ■ Separately calculating operating and financial leverage is most common. Still, if you want to see how the two ratios relate to each other, you should also calculate a combined leverage ratio. This ratio measures business and financial risk in one balance to get an idea of your total risk. ■ Combined leverage ratio = operating leverage ratio X financial leverage ratio ■ To calculate your company’s combined leverage ratio, simply input your figures for your operating leverage ratio and financial leverage ratio and multiply to get your result. For this example, let’s say that your business has no debt and a financial leverage ratio of 80 percent: ■ (Operating Leverage Ratio) x (Financial Leverage Ratio) = (1) x (0.8) = 80 percent ■ It doesn’t give the entire picture, but it does provide a simple at-a-glance look at your business and financial risk.
  25. 25. 5.Debt-to-equity ratio ■ Banks, financial institutions, and investors typically use the debt-to-equity ratio to determine the risk of loaning money to an organization. Knowing your debt to capital ratio is essential for a business owner to see the distribution of resources and adjust spending and borrowing as needed. ■ Debt-to-equity ratio = (total liabilities)/(shareholders’ equity) ■ You can find these values on your corporate balance sheet, or you can calculate them on your own. What’s more important than knowing how to calculate this ratio is interpreting it. ■ Let’s say your total liabilities, including current and long-term liabilities add up to ■ 1,865,000, and your shareholders’ equity adds up to 620,000. Now, let’s determine your debt-to- capital ratio: ■ (Total Liabilities)/(Shareholders’ Equity) = 1,865,000/620,000 = 3.01 ■ The goal isn’t necessarily to have a low debt-to-equity ratio. It can be a sign that your allocation of resources isn’t optimized and could generate more revenue or spend less in certain areas. It could also show investors that your business is not taking advantage of growth opportunities. ■ However, a significantly high debt-to-equity ratio can mean that your company is borrowing too much and unable to keep pace with your spending.
  26. 26. Example of a DRIP ■ For a DRIP example, let's say an investor owns 100 shares of a company's stock and has elected to have dividends reinvested. The company announces a $0.20 per share quarterly dividend and the stock price is $20 per share at the time of the dividend. Instead of receiving $20 in cash, the investor receives 1 additional share of stock. ■ Here's the calculation for the DRIP stock example above ■ 100 shares x $.20 dividend = $20 reinvestment to buy 1 share at $20/share ■ Important: Investors should note that a DRIP reinvestment can result in the purchase of fractional shares. Based upon the above example, if a shareholder owned 100 shares of company stock, the dividend payout was $.20 per share, and the share price at the time of the dividend was $22, the dividend would buy 0.91 share, or slightly less than one additional share for the investor.
  27. 27. Long Term Financing ■ Long-term financing means financing by loan or borrowing for a term of more than one year by issuing equity shares, a form of debt financing, long-term loans, leases, or bonds. It is usually done for big projects financing and expansion of the company; such long-term financing is generally of high amount. ■ The fundamental principle of long-term finances is to finance the strategic capital projects of the company or to expand the company’s business operations. ■ These funds are normally used for investing in projects that will generate synergies for the company in the future years. ■ E.g.: – A 10-year mortgage or a 20-year lease
  28. 28. ■What Is Equity Financing? ■ Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares are also purchasing ownership rights to the company.
  29. 29. Major Sources of Equity Financing ■ When a company is still private, equity financing can be raised from angel investors, crowdfunding platforms, venture capital firms, or corporate investors. Ultimately, shares can be sold to the public in the form of an IPO.
  30. 30. 1. Angel investors ■ Angel investors are wealthy individuals who purchase stakes in businesses that they believe possess the potential to generate higher returns in the future. The individuals usually bring their business skills, experience, and connections to the table, which helps the company in the long term.
  31. 31. 2. Crowdfunding platforms Crowdfunding platforms allow for a number of people in the public to invest in the company in small amounts. Members of the public decide to invest in the companies because they believe in their ideas and hope to earn their money back with returns in the future. The contributions from the public are summed up to reach a target total.
  32. 32. 3. Venture capital firms ■ Venture capital firms are a group of investors who invest in businesses they think will grow at a rapid pace and will appear on stock exchanges in the future. They invest a larger sum of money into businesses and receive a larger stake in the company compared to angel investors. The method is also referred to as private equity financing.
  33. 33. 4. Corporate investors ■ Corporate investors are large companies that invest in private companies to provide them with the necessary funding. The investment is usually created to establish a strategic partnership between the two businesses.
  34. 34. 5. Initial public offerings (IPOs) ■ Companies that are more well- established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public for trading in the capital markets.
  35. 35. Advantages of Equity Financing ■ 1. Alternative funding source ■ The main advantage of equity financing is that it offers companies an alternative funding source to debt. Startups that may not qualify for large bank loans can acquire funding from angel investors, venture capitalists, or crowdfunding platforms to cover their costs. In this case, equity financing is viewed as less risky than debt financing because the company does not have to pay back its shareholders. ■ Investors typically focus on the long term without expecting an immediate return on their investment. It allows the company to reinvest the cash flow from its operations to grow the business rather than focusing on debt repayment and interest. ■ 2. Access to business contacts, management expertise, and other sources of capital ■ Equity financing also provides certain advantages to company management. Some investors wish to be involved in company operations and are personally motivated to contribute to a company’s growth. ■ Their successful backgrounds allow them to provide invaluable assistance in the form of business contacts, management expertise, and access to other sources of capital. Many angel investors or venture capitalists will assist companies in this manner. It is crucial in the startup period of a company.
  36. 36. Disadvantages of Equity Financing ■ 1. Dilution of ownership and operational control ■ The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends. Many venture capitalists request an equity stake of 30%-50%, especially for startups that lack a strong financial background. Many company founders and owners are unwilling to dilute such an amount of their corporate power, which limits their options for equity financing. ■ 2. Lack of tax shields ■ Compared to debt, equity investments offer no tax shield. Dividends distributed to shareholders are not a tax- deductible expense, whereas interest payments are eligible for tax benefits. It adds to the cost of equity financing. ■ In the long term, equity financing is considered to be a more costly form of financing than debt. It is because investors require a higher rate of return than lenders. Investors incur a high risk when funding a company, and therefore expect a higher return.
  37. 37. What Is a Debt Instrument? ■ Debt instruments are fixed-income assets that legally obligate the debtor to provide the lender interest and principal payments. ■ When a company wants to raise capital, they can opt to raise capital by using internally generated funds, equity financing, and debt financing. ■ Debt financing can be a great source of risk for businesses, primarily through increased liquidity and solvency risk.
  38. 38. Types of Debt Instruments ■ There are two types of debts instruments, which are as follows: ■Long-term ■Medium & Short-term
  39. 39. Common Debt Instruments ■ 1 – Long-Term Debt Instruments ■ The company uses these instruments for its growth, heavy investments, future planning. These are those instrument which generally has a period of financing of more than 5 years. These instruments have a charge on the companies assets and also bears an interest paid regularly.
  40. 40. 1 – Debentures ■ A debenture is the most used and most accepted source of long-term financing by a company. These carry a fixed Interest Rate on the finance raised by the company through this mode of the debt instrument. These are raised for a minimum period of 5 years. ■ Debenture forms part of the capital structure of the company but is not clubbed with calculating share capital in the balance sheet.
  41. 41. 2 – Bonds ■ Bonds are just like debentures, but the main difference is that bonds are used by the government, central bank & large companies, and also these are backed by securities, which means these have a charge over the company’s assets. These also have a fixed interest rate, and the minimum period is also at least 5 years. ■ https://www.wikihow.com/Calculate-Bond-Value
  42. 42. 3 – Long-Term Loans ■ It is another method that is used by companies to get loans from banks, financial institutions ■ . It is not as much a favorable option method of financing as the companies have to mortgage their assets to banks or financial institutions. And also, the Interest rates are too high as compared to Debentures.
  43. 43. 4 – Mortgage ■ Under this option, the company can raise funds by mortgaging their assets with anyone either from other companies, individuals, banks, financial institutions. These have a higher rate of interest in funding the companies. The interest of the party providing funds is secured as they have a charge over the asset being mortgaged.
  44. 44. 2 – Medium & Short-Term Debt Instruments ■ These are those instruments which generally used by the companies for their day to day activities and working capital requirements of the companies. The period of financing in this case of Instruments are generally less than 2-5 years. They don’t have any charge over the companies assets and also don’t have a high-interest liability on the companies.
  45. 45. 1 – Working Capital Loans ■ Working capital loans are the loans that are used by the companies for their day-to-day activities like clearing of creditors outstanding, payment for the rent of the premises, purchase of raw material, and repairs of machinery. These have interest charges on the monthly limit used by the company during the month from the limit allowed by financial institutions.
  46. 46. 2 – Short-Term Loans ■ Banks and financial institutions also finance these, but they do not charge interest monthly; they have a fixed rate of interest, but the period for funds transferred is for less than 5 years.
  47. 47. 3– Treasury Bills are short-term debt instruments that mature within 12 months. They are redeemed at maturity in full, and if sold before maturity, then they can be sold at a discounted price. The interest on these T-bills is covered in the issue price as they were issued at a premium and redeemed at par value.
  48. 48. Advantages ■ Tax Benefit for Interest Paid:- In debt financing, the companies get the benefit of interest deduction from the profit before calculation of tax liability. ■ Ownership of Company:- One of the major advantages of debt financing is that the company does not lose its ownership to the new shareholders as the debenture does not form part of the share capital. ■ Flexibility in Raising Funds:- Funds can be raised from debts instruments more easily as compared to equity funding as there is a fixed rate of interest payment to the debt holder at ■ Easier Planning for Cashflows:- The companies know the payment schedule of the funds raised from debt instruments such as there is an annual payment of interest and a fixed time period for redemption of these instruments, which helps companies to plan well in advance regarding their cashflow/funds flow status. ■ Periodic Meetings of Companies:- The companies raising funds from such instruments are not required to sent notices, mails to debt holders for the regular meetings, as in the case of equity holders. Only those meeting which affects the interest of the debt holders would be sent to them.
  49. 49. Disadvantages ■ Repayment:- They come with a repayment tag on them. Once funds are raised from debt instruments, these are to be repaid on their maturity. ■ Interest Burden:- This instrument carries an interest payment at a regular interval, which needs to be met for which the company needs to maintain sufficient cash flow ■ Interest payment reduces the company profit by a significant amount. ■ Cashflow Requirement:- The company needs to pay interest as well as the principal amount for the company has kept the cashflows for making these payments well in time. ■ Debt-Equity Ratio:- The companies having a larger debt-equity Ratio are considered risky by the lenders and investors. It should be used up to such an amount, which does not fall below that risky debt financing ■ Charge Over the Assets:- It has a charge over the companies assets, many of which require the company to pledge/mortgage their assets in order to keep their interest/funds safe for redemption.
  50. 50. References ■ https://www.fe.training/free-resources/valuation/financing-decisions/ ■ https://corporatefinanceinstitute.com/resources/knowledge/strategy/strategic-financial- management/ ■ https://opentextbc.ca/businessopenstax/chapter/obtaining-short-term-financing/ ■ https://www.iwoca.co.uk/finance-explained/trade-credit/ ■ https://www.double-entry-bookkeeping.com/accounts-receivable/cost-of-trade-credit- calculator/ ■ https://www.thebalancesmb.com/how-to-calculate-interest-rates-393165 ■ https://www.youtube.com/watch?v=w3Npiif5gNs ■ https://www.investopedia.com/terms/f/financial_plan.asp ■ https://www.6clicks.com/blog/business-risk-vs-financial-risk ■ https://articles.bplans.com/financial-ratios-explained/ ■ https://www.wallstreetmojo.com/long-term-financing/ ■ https://corporatefinanceinstitute.com/resources/knowledge/finance/equity-financing/