Business Financing and the Capital Structure
Business Financing and the Capital Structure
Explain the process of financial planning used to estimate asset investment requirements for a corporation. Explain the concept of working capital management. Identify and briefly describe several financial instruments that are used as marketable securities to park excess cash. As a business owner, it is important to know the value of your assets as they can be used as leverage for obtaining loans and can be used to estimate your ability to repay your debts. Calculate your current assets, long-term investments, fixed assets and intangible assets and add them up to get your total business assets. Pledgeable assets support more borrowing, which allows for further investment in pledgeable assets. The trade-off between liquidation costs and underinvestment costs implies that low-liquidity firms exhibit negative investment sensitivities to liquid funds, whereas high-liquidity firms have positive sensitivities.
If real assets are not divisible in liquidation, firms with high financial liquidity optimally avoid external financing and instead cut new investment. If real assets are divisible, firms use external financing, which implies a lower sensitivity. In addition, asset redeployability decreases the investment sensitivity. Financial management includes management of assets and liabilities in the long run and the short run. The management of fixed and current assets, however, differs in three important ways: Firstly, in managing fixed assets, time is very important; consequently discounting and compounding aspects of time element play an important role in capital budgeting and a minor one in the management of current assets. Secondly, the large holdings of current assets, especially cash, strengthen firm’s liquidity position but it also reduces its overall profitability.
Thirdly, the level of fixed as well as current assets depends upon the expected sales, but it is only the current assets, which can be adjusted with sales fluctuation in the short run. Marketable securities replenish cash quickly and earn higher returns than cash, but come with risks; maturity, yield, and liquidity should be considered. Marketable securities are the securities that can be easily liquidated without any delay at a reasonable price. Firms will maintain levels of marketable securities to ensure that they are able to quickly replenish cash balances and to obtain higher returns than is possible by maintaining cash. There are four factors that influence the choice of marketable securities. These include risks, maturity, yield, and liquidity. Assume that you are financial advisor to a business. Describe the advice that you would give to the client for raising business capital using both debt and equity options in today’s economy. Some business owners say ratios are an accountant’s problem.
That’s not smart, says Dileep Rao, president of Minneapolis’ InterFinance Corp, a venture-finance consulting firm, and professor at the University of Minnesota’s Carlson School of Management. “Running your business without knowing your numbers is like driving a car without being able to see your direction or speed,” says Rao. “It’s only a matter of time before you crash.”(Rao, 2011) The terms “debt” and “equity” get tossed around so casually that it’s worth reviewing their meanings. Debt financing refers to money raised through some sort of loan, usually for a single purpose over a defined period of time, and usually secured by some sort of collateral. Equity financing can be a founder’s money invested in the business or cash from angel investors, venture capital firms, or, rarely, a government-backed community development agency—all in exchange for a portion of ownership, and therefore a share in any profits. Equity typically becomes a source of long-term, general-use funds.
The share of any hard assets, such as property and equipment, that you own free and clear also counts as equity. Striking the right balance between debt and equity financing means weighing the costs and benefits of each, making sure you’re not sticking your company with debt you can’t afford to repay and minimizing the cost of capital. Choosing debt forces you to manage for cash flow, while, in a perfect world, taking on equity means you’re placing a priority on growth. But in today’s credit markets, raising equity may simply mean you can’t borrow any more. Until recently, bank credit was a financing mainstay. But experiences like Flipse’s underlie a point made by the Federal Reserve Board’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices, released in November. According to loan officers, small-company borrowers were tapping sources of funding other than banks. They were being driven away for many reasons.
Banks “continued to tighten standards and terms…on all major types of loans to businesses,” though fewer were doing so than in late 2008, when tightening was nearly universal. Interest rates on small business loans were on the rise at 40% of the banks surveyed, even as the prime rate reached historic lows. One in five banks had reduced small companies’ revolving credit lines. One in three had tightened their loan standards, and 40% had tightened collateral requirements. Partly because of the plunging value of the real estate securing many commercial loans, pressure from bank examiners for tighter standards continued to build. Meanwhile, home equity loans, another popular source of small business cash, had evaporated. Many recession-weary business owners knew they had essentially become unbankable: Loan officers surveyed said far fewer firms were seeking to borrow. Those few who could borrow were repelled by higher rates. All of a sudden, equity financing looked better. Explain why a business may decide to seek capital from a foreign investor indicating the risk and rewards for such a decision. Provide support for rationale.
Many investors choose to place a portion of their portfolios in foreign securities. This decision involves an analysis of various mutual funds, exchange-traded funds (ETF), or stock and bond offerings. However, investors often neglect an important first step in the process of international investing. When done properly, the decision to invest overseas begins with a determination of the riskiness of the investment climate in the country under consideration. Country risk refers to the economic, political and business risks that are unique to a specific country, and that might result in unexpected investment losses. This article will examine the concept of country risk and how it can be analyzed by investors. There are many excellent sources of information on the economic and political climate of foreign countries. Newspapers, such as the New York Times, the Wall Street Journal and the Financial Times dedicate significant coverage to overseas events.
There are also many excellent weekly magazines covering international economics and politics; the Economist is generally considered to be the standard bearer among weekly publications. For those seeking more in-depth coverage of a particular country or region, two excellent sources of objective, comprehensive country information are the Economist Intelligence Unit and the Central Intelligence Agency (CIA) World Fact Book. Either of these resources provides an investor with a broad overview of the economic, political, demographic and social climate of a country. The Economist Intelligence Unit also provides ratings for most of the world’s countries. These ratings can be used to supplement those issued by Moody’s, S&P, and the other “traditional” ratings agencies. Finally, the internet provides access to a host of information, including international editions of many foreign newspapers and magazines.
Reviewing locally produced news sources can sometimes provide a different perspective on the attractiveness of a country under consideration for investment. It is important to remember that diversification, which is a fundamental principle of domestic investing, is even more important when investing internationally. Choosing to invest an entire portfolio in a single country is not prudent. In a broadly diversified global portfolio, investments should be allocated among developed, emerging and perhaps frontier markets. Even in a more concentrated portfolio, investments should still be spread among several countries in order to maximize diversification and minimize risk. After the decision on where to invest has been made, an investor has to decide what investment vehicles he or she wishes to invest in.
Investment options include sovereign debt, stocks or bonds of companies domiciled in the country(s) chosen, stocks or bonds of a U.S.-based company that derives a significant portion of its revenues from the country(s) selected, or an internationally focused exchange-traded fund (ETF) or mutual fund. The choice of investment vehicle is dependent upon each investor’s individual knowledge, experience, risk profile and return objectives. When in doubt, it may make sense to start out by taking less risk; more risk can always be added to the portfolio at a later date. In addition to thoroughly researching prospective investments, an international investor also needs to monitor his or her portfolio and adjust holdings as conditions dictate.
As in the U.S., economic conditions overseas are constantly evolving, and political situations abroad can change quickly, particularly in emerging or frontier markets (Forbes, 2011). Situations that once seemed promising may no longer be so, and countries that once seemed too risky might now be viable investment candidates. Explain the historical relationships between risk and return for common stocks versus corporate bonds. Explain how diversification helps in risk reduction in a portfolio. Support response with actual data and concepts learned in this course.
Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks. Bonds issued by companies represent the largest of the bond markets, bigger than U.S. Treasury bonds, municipal bonds, or securities offered by federal agencies (Worldbank, 2013).
The risk associated with corporate bonds depends on the financial stability and performance of the company issuing the bonds, because if the company goes bankrupt it may not be able to repay the value of the bond, or any return on investment. Assess the risk by checking the company’s credit rating with ratings agencies such as Moody’s and Standard & Poor’s. Good ratings are not guarantees, however, as a company may show an excellent credit record until the day before filing for bankruptcy. When you purchase stock in a company during a public offering, you become a shareholder in the company. Some companies pay dividends to shareholders based on the number of shares held, and this is one form of return on investment.
Another is the profit realized by trading on the stock exchange, provided you sell the shares at a higher price than you paid for them. The risks of owning common stock include the possible loss of any projected profit, as well as the money paid for the shares, if the share price drops below the original price. Corporate bonds hold the lowest risk of the three types of investments, provided you choose the right company in which to invest. The main reason for this is that in the event of bankruptcy, corporate bond holders have a stronger claim to payment than holders of common or preferred stocks. Bonds carry the risk of a lower return on investment, as the performance of stocks is generally better. Common stocks carry the highest risk, because holders are last to be paid in the event of bankruptcy. Preferred stocks generally have higher yields than corporate bonds, lower risk than common stocks, and a better claim to payment in the event of bankruptcy.
Dileep Rao. 2011, “InterFinance ” Cambridge, Massachusetts, The MIT Press. Forbes. 2011, ” Small Business Loans: A Great Option “. Retrieved on 6/19/2013 from http://www.forbes.com/sites/ryancaldbeck/2012/11/14/small-business-loans-a-great-option-unless-you-actually-need-money/ “Foreign direct investment, net inflows (BoP, current US$) | Data | Table” . Data.worldbank.org. Retrieved 6/19/2013 from http://data.worldbank.org/indicator/BX.KLT.DINV