Financial Planning
Outline:
Long-Term Financing
Raising equity capital (Chapter 23)
Debt financing (Chapter 24)
Short-Term Financing
Working capital Management (Chapter 26)
Short-Term Financial Planning (Chapter 27)
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How companies can raise capital
Financing comes basically from two sources:
Internal
Retained earnings
Usually insufficient to satisfy firm’s needs.
External
Private Public
Debt Equity Hybrid
2
Sources of external capital
Capital
Markets
Debt Equity
Supplier Ordinary Preference
Bank Loans Bonds Leases Informal Warrants Informal
Credit Shares Shares
3
Alternative Issue Methods
Private
General Cash
Placement or
Offer
Placing
Rights Issue Public
Issues
4
The Environment for Raising Capital
The Legal
The Financial System
Environment
Ownership Structure
5
Pros and cons of private capital
• Private sources of capital have several advantages:
Terms can be customized.
Easier to renegotiate.
No costly registration with the securities regulator.
No need to reveal confidential information.
• Privately placed debt can also have disadvantages:
Limited investor base
Less liquid.
6
Venture Capital
Start-ups often require venture capital to finance growth. Venture
capital provides entrepreneurs with financing to grow their firms.
Steps to obtaining venture funding:
Prepare a business plan.
Receive first-stage financing.
Receive subsequent staged financing.
Types of Venture Investors
Angel Investors: Investors who finance companies in their earliest
stages of growth
Corporate Venturers: Corporations that offer venture assistance to
finance young, promising companies.
Private Equity: Investors who offer funds to finance firms that do
not trade on stock exchanges.
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Types of Offerings
Seasoned
Initial Public
Equity Offerings
Offerings (IPOs)
(SEOs)
Primary Secondary
Offerings Offerings
When a firm requires more capital than private investors can provide,
it can choose to go public through an Initial Public Offering (IPO).
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Benefits of going public (IPO)
Raise additional capital (for further expansion like new
investments, acquisitions; repay debt).
Allow the owners to sell their stakes (diversification - risk
sharing benefits).
Increase liquidity benefits to shareholders/managers.
Escape control/monitoring of banks.
Enhance company’s image, visibility, status and prestige.
Provide incentive compensation scheme for managers /
employees.
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Costs of going public (IPO)
Issuance costs: investment bank fees; legal, accounting
and administrative expenses; indirect expenses like the
management time spent.
Obligation to disclose new information (information
revealed to competitors).
Ongoing costs of periodic disclosures.
Loss of potential funds by issuing shares at an offer price
set below the true value (Underpricing).
Underwriters can purchase additional shares at the offer
price (Green Shoe Option).
Pressure for good performance from outsiders.
Agency costs of managerial discretion.
Danger of loss of control.
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Investment Banking and the Underwriting
Process
Origination Distribution
Risk-Bearing Certification
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Types of Underwriting Arrangements
Firm Negotiated vs
Commitment Competitive
Best Effort Auction
12
The Underwriting Agreement
Underwriting Overallotment
Spread Option
Green Shoe
Fees
Option
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The cost of equity issues
Spread or
Other Direct Indirect
Underwriting
Expenses Expenses
Discount
Abnormal
Underpricing Green Shoe
Returns
(IPOs; Fig 23.4) Option
(SEOs)
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Financial intermediaries
Banks Banks Insurance
(Commercial) (Investment) Companies
Pension Charitable
Mutual Funds
Funds Foundations
Venture
Hedge Funds
Capital
15
Debt financing
Debt can be:
Short-term / Long-term
Private / Public
Negotiable / Non-negotiable
Major forms of debt
Bank loans (Lines of credit / Loan commitment)
Bonds
Commercial paper
Supplier credit
Lease (Operating lease / Financial lease)
Basic features of debt
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Bond (debt) features
Amount of
Date of Issue Maturity Face Value
Issue
Coupon
Annual
Offer Price Payment Security
Coupon
Dates
Sinking Fund Call Provision Call Price Credit Rating
Covenants /
Options
Indentures
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Different types of bond
Floating Rate Zero-coupon or
Straight-coupon
or Bullet Bond
Pure Discount Income Bond
Bond Bond
Islamic Bond Convertible Deferred-
Put Bond
or Sukuk Bond coupon Bond
Perpetuity Annuity
Bond Bond
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Types of bond options
Callability Convertibility
Exchangeability Putability
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Bond covenants
Asset Covenant: Governs the firm’s
acquisition, use and disposition of assets.
Covenants are Dividend Covenant: restricts the payment
restrictions imposed of dividends.
on the issuer
Financing Covenant: Description of the
amount of additional debt the firm can issue
and the claims to assets that this additional
debt might have in the event of default.
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Bond credit ratings
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Managing Working Capital
Until now, our main focus was on long-term financial
decisions. Now, we pay attention to short-term financing:
It involves cash inflows and outflows within a year.
Working capital management refers to decisions relating to:
target levels of current assets, and
financing of current assets.
Three types of decisions:
Credit management
Inventory management
Cash management
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Elements of Working Capital
Current assets: these are either in the form of cash or
can be converted into cash very quickly
Cash and Marketable securities
Accounts receivables (Trade debtors)
Inventories
Current liabilities: these are expected to come due
within the year
Notes payable / Short-term loans / Bank overdrafts
Accounts payables (Trade creditors)
Current payments of long-term debt
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Financial ratios related to working
capital (1)
Liquidity ratios: a firm’s ability to meet short-
term obligations
Current assets
Current ratio
Current liabilities
Quick assets
Quick ratio
Current liabilitie s
Current assets - Inventorie s
Current liabilitie s
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Financial ratios related to working
capital (2)
Activity ratios: how effectively a firm’s assets
are managed?
Total operating revenues (Sales)
Receivables turnover
Average Receivables
Cost of goods sold
Inventory turnover
Inventory
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Credit management
Firms usually sell goods and services on credit.
Selling on credit results in extra costs being
incurred by the firm:
Credit administration costs
Bad debts
Opportunity costs of cash
However, these costs of selling on credit must be
weighed against all benefits of higher sales.
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Credit policy
The components of credit policy are:
Terms of sale (Which conditions?)
Credit analysis (Which customers?)
Collection policy (How to collect quickly?)
Terms of sale includes conditions like the length of credit
period and the amount of cash discount
Five Cs (Character, Capacity, Collateral, Capital and
Conditions) used to evaluate credit risk
The length of credit period is determined by:
Probability that customer will not pay,
Size of the account,
Extent to which goods are perishable,
…..
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Inventory management
Inventory includes raw materials, work-in-process, and
finished goods.
The goal is to provide the required amount of inventories in
order to sustain business operation at the lowest possible
cost.
Typically, these costs are two types:
Carrying (or Holding) costs, and
Shortage costs.
What would be the optimal (the amount that minimizes total
costs) inventory level?
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Inventory carrying and shortage costs
Shortage
Annual costs
costs Total costs
(€)
Carrying or
Holding costs
0 CA*
Amount of inventory
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Cash management
Finance manager wants to minimize the amount of
cash the firm must hold for conducting its normal
business activities.
At the same time, the firm should have sufficient
cash to meet any unexpected requirement.
Primary reasons for holding cash:
Transactions motive
Precautionary motive
Compensating balances
The cost of holding cash is the opportunity cost of
lost interest.
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Determining the target cash balance
How much cash should be held by a firm?
It involves a trade-off between the opportunity
costs of holding too much cash and the trading
costs of holding too little.
How to help control the cash balance?
Use upper and lower control limits
How to determine the optimal cash balance?
Use the trade-off between opportunity costs and
trading costs
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Determining target cash balance
$ Minimum Total costs of holding cash.
point
Costs of carrying cash
(Opportunity costs)
Costs of not
carrying cash
(Trading costs)
Optimal Size of cash balance ($)
cash
balance
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Cash management techniques
Cash flow synchronization
Accelerating collections
Controlling disbursements
Investing idle cash
Getting available funds to where they are needed
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Short-Term Financial Planning
A company needs to forecast its cash flows to know
whether it will have surplus or deficit in each period, and
then determine whether it is temporary or permanent.
Firms typically require short-term planning for three
reasons:
Is there a seasonal pattern?
Is there a negative cash flow shock?
Is there a sudden cash flow surplus?
Adopt a policy that minimizes transaction costs: follow
Matching Principle – short-term needs should be financed
with short-term debt and long-term cash requirements
should be financed with long-term sources of funds.
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Cash Budget
A cash budget is a primary tool of short-run financial
planning and control. It allows the finance manager to
identify short-term financial needs (and opportunities).
The idea is simple:
Record the estimates of cash receipts and cash
disbursements; and then
Forecast periods of cash surpluses and cash deficits
When there is a cash surplus, decide on the best use of
funds; when there is a cash deficit, take adequate actions
(bank loans, commercial papers).
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