Financing Organizations
Vysoká škola finanční a správní
Winter Semester 2013
Jaromír R. Stemberg
jaromir@mail.vsfs.cz
Course
•
•
•
•
Eleven lectures + twelve seminars
Seven credits
Ends with the exam
The course explains the nature, advantages, costs
and risks of classic and alternative external sources
of company financing
• It builds on knowledge acquired during previous
studies of corporate finance and accounting
Literature
• Tichý, Jaromír: Zdroje financování podniku.
1. vyd. Praha: EUPRESS, 2012. 100 s.
ISBN 978-80-7408-070-8
• Block, Stanley B., Hirt, Geofrfrey A., Bartley B.R.:
Foundations of Financial Management
13th edition, Boston: McGraw-Hill Irwin 2009
ISBN 978-0-07-128107-2
• Schroeder, R. G.: Financial Accounting Theory And
Analysis: Text And Cases
Hoboken: John Wiley and Sons, 2009
Grading
Exam:
• Credit by David Muir, M.B.A. required
• Pre-term: written test, multiple choice (will be
offered only once) Dec. 18th, 2013 2:30 pm
• Regular term: oral exam
Course Layout
1. Internal sources of financing, working capital management
2. Reasons for financing by external sources
3. Trade credit
4. Bank loans and other services
5. Financial investments, venture capital, silent partner
6. Strategic investments, mergers and acquisitions
7. Capital markets, stock, bonds, derivatives
Quick Review
• Balance sheet, internal and external sources
• Working capital management
Balance Sheet
Assets
Liabilities
Current Assets
Cash and Equivalents
Short-Term Receivables
Inventory
Accruals and Other S/T Assets
Current Liabilities
Short-Term Accounts Payable
Current Tax Payable
Short-Term Loans and Borrowings
Accruals and Other S/T Liabilities
Long-Term Assets
Intangible Fixed Assets
Tangible Fixed Assets
Long-Term Receivables
Long-Term Liabilities
Long-Term Payables
Provisions
Owners’ Equity
Share Capital
Share Premium and Capital Funds
Retained Earnings
Y-T-D Profit (Loss)
Balance Sheet
Assets
Long-Term Assets
Intangible Fixed Assets
Tangible Fixed Assets
Long-Term Receivables
Current Assets
Cash and Equivalents
Short-Term Receivables
Inventory
Accruals and Other S/T Assets
Liabilities
Long-Term Liabilities
Long-Term Payables
Provisions
Current Liabilities
Short-Term Accounts Payable
Current Tax Payable
Short-Term Loans and Borrowings
Accruals and Other S/T Liabilities
Owners’ Equity
Share Capital
Share Premium and Capital Funds
Retained Earnings
Y-T-D Profit (Loss)
Working Capital Structure
+ accounts receivable
+ inventories
+ cash & equivalents
____________________________________________________________________________________________________________________________________________________________________________________________________
= WORKING CAPITAL
- accounts payable
__________________________________________________________________________________________________________________________________________________
= NET WORKING CAPITAL
- cash & equivalents
__________________________________________________________________________________________________________________________________________________
= NON-CASH WORKING CAPITAL
Need for Working Capital
• WC is tied in the flow cycle
• Amount of WC needed can be understood as
- average need per period (year, month)
- instant need
- maximal need during a period (season)
• To know the need for WC is essential for planning,
securing operational financing, budgeting and capital
investment planning
WC Management Goals
• Optimize its volume in respect of operational needs
• WC management represents individual management
of its segments
• Zero non-cash working capital
• Role of financial manager
- WC management is one of the most time-demanding task of
the financial manager‘s team
- good WC management represents significant savings in
financial costs
Need for Working Capital
Material
Production
Finished
goods
10 days
20 days
10 days
Accounts
payable
Accounts
receivable
30 days
40 days
30 days
Payment to
suppliers
need to finance
by working
capital
Payment
from
customers
Working Capital Flow Cycle
Collection
Procurement
Raw material
inventory
Accounts
receivable
WORKING CAPITAL
Production
Logistics
Sales
Warehousing
Inventory
of finished
products
Accounts Receivable Turnover
Accounts receivable / avg daily sales (sales / 365)
Example:
annual sales = 25 000 000 CZK
accounts receivable = 1 800 000 CZK
Calculation:
average daily sales: 25 000 000 / 365 = 68 493
days of sales outstanding: 1 800 000 / 68 493 = 26
Days of sales outstanding (account receivable
turnover) is 26 days
Financing And Its Sources
• Why to borrow?
• Where to borrow?
• How to borrow??
WC need
Why To Borrow
Own sources
time
Why To Borrow
WC need
Overdraft protection
Fixed loans
Own sources
time
Financial Leverage
2 firms: exactly the same
• Same sector
• Same opportunities
• Same Management…
The only difference: the debt
• L (leveraged firm) has 50% of debt
• U (unleveraged firm) has no debt
Financial Leverage
Firm U
Firm L
100 000
0
100 000
50 000
50 000
100 000
Number of shares
(Price of a share 100)
1 000
500
EBIT
Financial interests
(interest rate 5%)
Net income before tax
EPS before tax
10 000
0
10 000
2 500
Shares (Capital)
Financial debt
Total
Net income after tax
(Tax rate 33%)
EPS after tax
10 000
10 (10 000/1 000)
6 700
6,70
7 500
15 (7 500/500)
5 000
10,00
Financial Leverage
Firm U
Firm L
100 000
0
100 000
50 000
50 000
100 000
Number of shares
(Price of a share 100)
1 000
500
EBIT
Financial interests
(interest rate 5%)
Net income before tax
EPS before tax
0
0
0
2 500
0
0
-2 500
-5
Net income after tax
EPS after tax
0
0
-2 500
-5
Shares
Financial debt
Total
Financial Leverage
For leverage to be profitable,
the rate of return on the investment
must be higher than the cost of the borrowed money
Conclusion
Leverage can create value or destroy it
To create value, the IRR must be higher than the cost of
loan; if not, leverage destroys value.
Financial Markets
How to Borrow
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Suppliers credit
Bank loans
Financial investors
Securities
Bank Loans
• Short Term
• Long Term
• Other Bank Services
Short-Term Loans
Less risk for the bank hence less expensive than
long term loans
• Overdraft protection:
used as needed, interest on used portion only, “commitment
fee“ makes it expensive
• Lombard loan:
collateral, fixed amount for fixed period of time
• Revolving loan:
automatic renewal, behaves like a long-term loan
• Factoring:
purchase of accounts receivable
Long-Term Loans
• Operational Loan:
financing of assets long-term tied in operations
• Investment Loans:
project financing, leasing, capital investments
• Forfaiting:
purchase of long-term receivables
• Mortgage:
long-term loan typically secured by real estate
• Syndicate loan:
cooperation of more banks on a giant project
Other Banking Products
• Bank guarantee
• Letter of credit
• Hedging
Hedging
•
Vyhodnocení rizika: velikost expozice, senzitivita expozice, stanovení několika
scénářů včetně worst-case versus cena za službu hedgingu
Výpočet pravděpodobnosti
dopadu expozice:
Scénář
1
2
3
Celkem
Výsledek
+40
-3
-65
Pravdě
podobnost
30%
30%
40%
Dopad
+12
-1
-26
-15
Risk
Bank monitors “Five C“ of a client:
Charakter
Capital
Capacity
Conditions
Collateral
When to Use What Source
Revenue / Profit
Maturity
IPO
Acquisition
Bank loans, Leasing
Time
Silent partner,
Venture capital,
Business Angel
Crowd financing
EUROSTAT Statistics (2012)
The most serious problems of business beginning:
•
•
•
•
Legislation
Customers
Pricing
Qualified personnel
The most serious problems of further business
development
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Accounts receivable
Payroll cost
Lack of bank financing
Business vs. personal life
Business financing is the 3rd largest problem of
starting enterprise
Financial Investments
• Financial investor, silent partner, business
angel
• Crowd financing
• Venture capital in the Czech Republic
• Criteria and investment process
Crowd-Funding Sites
• Websites to raise money by selling products not yet
fully developed or setting up own fundraising pages
• KickStarter, Indiegogo, RocketHub, GoFoundMe,
Razoo, Crowdrise and many others
• Easy to use, need a good product or idea,
presentation (video)
• Newest way of mass business financing
• Booming as we speak
• Prepayments increase cash but also liabilities
Financial Investor
• Mid-term investment in equity
• Mutual funds or single investors
• Investments into quick-growing firms with interesting
business plan
• Suitable for companies with a good potential for
growth, interesting product, competitive advantage,
market, capable team, and willingness to accept a
financial investor as a business partner
Financial Investors‘ Criteria
• Complex business plan
• Management
• Suitable product
• Quality od revenue
• Market
• Investment horizon
• IRR
• Exit
Investment Process
Phase
Needed information
Duration
(weeks)
I. Preliminary evaluation
of inv. opportunity
• Discretion contract
• Basic company info,
financial plan
1-2
II. Evaluation
• Business plan
2-3
III. Cooperation Agreement
• Term sheet
IV. Due diligence
• Questionaire,
documentation, data room
V. Binding contract of
cooperation + financing
• Binding contract,
• Draft of final contract
1
VI. Contract signature,
release of funds
• Final contract
1
Total
2
1-2
8 - 11
Reasons for Non-Agreement
• Different investment horizon
• Too optimistic business plan
• Company needs short-term financial help
• Personal relationship doesn‘t work
• Owners are not ready to give up 100% ownership
Silent Partner
• A person or a company, not disclosed to others
• More silent partners can invest in one company
• Regulated by the Commercial Code
(Citizens‘ Code starting 2014)
• No new subject
• Right to have access to financial statements and
accounting records
End of Silent Partnership
The contract ceases to exist if:
• It expires
• Both parties mutual agreement
• Silent partner‘s loss exceeds the funds put in
• Bankruptcy of either party
Venture Capital
• Financing into equity
• High risk hence high return expectancy
• Often minority partner with veto power
• Seeks for attractive business plan and good
management
• Exit usually in 3-5 years
Business Angel
• Sole investor
• Usually male 50+
• Reasonably wealthy
• Became rich by own entrepreneurship
• Hobby business
• Invests in something he knows
Business Plan
• Reasons
• What the investors expect
• Business plan preparation
Why Business Plan
• To approach a bank or a financial partner
- many banks made wrong calls in the past
- dot com rush 2004, mortgage rush 2007
• For own use
- to understand the goals and the path
- see problems and barriers
- time set
• For employees
- they understand the consequences
- build team, unify effort
How
• Clear concept, trransparrent
• Visual, interesting, captivating
• Concrete
• Identifies income sources in time
Good Impressions
• Scalability
• Unique selling points
• Trade marks, intellectual property
• Working projects, need of capital for expansion
• Description – advantage – proof
• Barriers of entry
• Investment having direct impact on growth and
advance
• Assertive and capable management
Bad Impressions
• Too sensitive to criticism
• Obsolete business plan
• New money to cover old sins
• Too high reward for owners
• Overstated value of enterprise
• Unrealistic forecast (ice-hockey stick graph)
• Fog
Versions
• Elevator pitch (1 min)
• Executive summary (1 page)
• Abridged version (several pages)
• Full version (full lenth)
Elevator Pitch
Oral short presentation of
- my idea
- how far I am
- who is the team
- what are the markets
- my advantages
- how will be financed, how much I need
- expected returns and when
Full Business Plan
1. Executive summary:
very brief and very concrete
2. Company and team
how long in existence, key players, CVs, contact
3. Idea / product / service
description what, in what sense unique, concrete
results
4. Market and competition
SWOT, demonstrated knowledge of market
situation, advantages / disadvantages over
competition
Full Business Plan
5. Marketing and selling strategy
plan how to attac the market, geography, marketing
campagne, time horizon
6. Finace
current situation, fin. statements incl. cash flow
budget based on plan of sales, capital investments
need for investments, what for, how much, when
expected returns, accented cash flow
7. Conclusion
realistic exit plan, options, summary
8. Appendices
Strategic investments
• Mergers and Acquisitions
• Risks
• Due diligence
M&A
• Strategic investment into other company
- purchase of 100% or less
- becomes daughter (acquisition) or merges with the
investing company
• Buyer
seeks portfolio diversification, market share, know
how, expansion, better utilization of working capital
• Merging company
seeks stability or prestige of a larger company, new
growth possibilities, know how, exit
Acquisitions
The purpose of M&A should be to create value.
 Not to buy earnings or EPS.
 Not to buy growth for the sake of growth.
 Not to buy market share.
 Not to diversify (i.e., reduce risk).
How do managers create value?
1) Managers are entrusted with capital
2) They invest the capital in assets
3) The assets generate earnings (and cash flows)
4) The earnings provide investors with a return on capital
5) Managers create value if the return on capital exceeds the
cost of capital
M&A involves the use of investor capital
• The acquiring firm uses its investors’capital to acquire the
target company (more specifically, the assets of the target
company)
• As with any other use of capital, managers create value for
investors if the merger or acquisition generates returns on
the capital employed that is greater than the returns
investors require to compensate them for the risk of
investing in the target company
Can two firms after acquisition
accomplish things that separate firms
cannot?
• Higher revenue?
• Lower costs?
• Better management of working capital?
Specifically, are the cash flows likely to be greater than the
sum of the cash flows of two separate firms?
i.e., is 1 + 1 > 2?
• If not, the deal does not create value.
• If yes, the incremental cash flows reflect the deal’s
“synergies.”
(Many examples of when 1 + 1 < 2)
What kinds of deals involve positive synergies?
1. Many horizontal deals
– deals involving two firms in same industry
2. Some vertical deals
– deals involving producers with distributors
3. Few conglomerates
– deals involving firms in unrelated industries
Acquisition Criteria – What to Look For
 Strategic Fit
 Recurring Revenue
 Growth Potential
 Cultural Fit
 Management Strength and Retention
Strategic Fit: Ask Yourself
 Increased Market Share?
 Expand or Strengthen Service Offerings?
 Expand Geographic Presence?
 New Vertical Market?
 Absorb a Competitor?
Recurring Revenue
• 80% or more Recurring
• Unique skills or services giving rise to
new recurring revenue
Growth Potential
• Capable of meeting 20/20 goal
– 20% revenue growth
– 20% profit growth
• In service sector with growth potential
Cultural Fit
• Single most important factor
• What describes the culture?
– Customer Oriented
– Accountability
– Incentive Based
– Financially well-run
– Ethic
– Employee Satisfaction
Management Strength and Retention
• No Management Rebuilding
• Current Management:
– Capable
– Willing to Stay
Risks
• Management risk
• Employees risk
Due Diligence
• Legal
• Accounting
• Sales
• Projects
Employees‘ Reaction Risk
• Employees tend to apprehend changes negatively
• The best ones are the first ones to be headhunted
• Merging cultures may be tricky
Solution:
• Thorough preparation by the HR, confidential
• After announcement, concrete communication
followed by quick action towards stabilization
Time Value of Money
• Future Value
• Net Present Value
• IRR
Time Value of Money Principle
Time is money and value of money changes as time passes.
$1 invested today can generate profit, uninvested looses its
value with inflation
$1 today ≠ $1 in one year
Future and Present Value
Future value:
Present value:
Net present value:
FV:
PV:
i:
I0:
Future Value
Present Value
interest
Initial investment
FVn = PV * (1 + i)
n
PV = FVn * 1/(1 + i)
n
n
NPV = FVn * 1/(1 + i) - I0
Internal Rate of Return
IRR is a discont rate for NPV = zero.
Represents rentability percentage rate of a concrete project,
activity, or business conduct.
n
FVn * 1/(1 + i) - I0 = 0
For investment longer than two years is not possible to calculate
directly. Use narrowing margins method. Must contain positive and
negative values.
What‘s IRR of a project with initial investment of $1.000 and 1st year profit of $452,
2nd year $500 and 3rd year $278?
Capital Markets
• Securities
• Security Markets Trading
Securities
• Securities
- bonds
- shares
• Advantages / disadvantages
- attractive for investors (liquidity)
- less expensive source of financing
- high initial costs
• Capital markets
- NYSE ($22 trillion per year)
- European: London (7 trillion), Frankfurt (3 trillion)
- Central-East Europe: Warsaw (tens of IPOs yearly, pension funds),
Prague (0,04 trillion = 6 hrs of NYSE trading)
• Primary and secondary trade
Balance Sheet
Assets
Liabilities
Current Assets
Cash and Equivalents
Short-Term Receivables
Inventory
Accruals and Other S/T Assets
Current Liabilities
Short-Term Accounts Payable
Current Tax Payable
Short-Term Loans and Borrowings
Accruals and Other S/T Liabilities
Long-Term Assets
Intangible Fixed Assets
Tangible Fixed Assets
Long-Term Receivables
Long-Term Liabilities
Long-Term Payables
Provisions
Owners’ Equity
Share Capital
Share Premium and Capital Funds
Retained Earnings
Y-T-D Profit (Loss)
Bonds
• Marketable debt contract
- par value, cupon rate, maturity date
- investor: no voting right, no management participation
- issuer: received funds are listed as debt
- debt: secured (senior, junior), unsecured
• Paper form / dematerialized
• Retirement
- sinking fund
- call option
- conversion
Bond Price Calculation
• Sum of incoming coupon payments plus par value converted
to present value
• „i“ in PV calculation consists of risk free + risk premium
• Rating - worse rating increases risk premium
• Rating agencies S&P, Moody, www.rating.cz
Rating Examples
EBIT / fin. exp. cover
x
AAA
25,5
BBB
6,5
CCC
0,9
EBITDA / fin. exp. cover
x
23,8
4,7
0,4
Operating profit / tot. debt
%
203,3
35,9
5,0
Operating cash flow / tot. debt
Total debt / EBITDA
%
x
127,6
0,4
17,3
2,2
-2,1
7,9
Recovery of investments
Tot. liability / tot. assets
%
%
27,6
12,4
13,4
42,5
3,2
113,5
Example of Bond Price
(Par value 1.000; maturity 5 years; coupon rate 10%)
Year
Payment
5%
10%
15%
1
100,00
95,24
90,91
86,96
2
100,00
90,70
82,64
75,61
3
100,00
86,38
75,13
65,75
4
100,00
82,27
68,30
57,18
5
100,00
78,35
62,09
49,72
5
1 000,00
783,53
620,92
497,18
1 216,47 1 000,00
832,39
Total