chapter 14 understanding financial contracts. 2 introduction chapter focuses on financial contracts...

Chapter 14Chapter 14

Understanding Financial Understanding Financial ContractsContracts

22

Introduction Introduction

Chapter focuses on financial contracts Chapter focuses on financial contracts between lenders and borrowersbetween lenders and borrowers

Non-traded financial contractsNon-traded financial contracts are tailor- are tailor-made to fit the characteristics of the made to fit the characteristics of the borrowerborrower

In business financing, the differences in In business financing, the differences in contracting can be great, both in terms of contracting can be great, both in terms of how financial instruments are originated and how financial instruments are originated and in the characteristics of the terms of contractin the characteristics of the terms of contract

33

Asymmetric InformationAsymmetric Information

Problems associated with the Problems associated with the availability of information about the availability of information about the borrowers who seek funding.borrowers who seek funding.

44

How Business Obtains How Business Obtains Financing Financing

Businesses need funds for a variety Businesses need funds for a variety of reasonsof reasons Finance permanent assets such as plant Finance permanent assets such as plant

and equipmentand equipment Finance the acquisition of another Finance the acquisition of another

businessbusiness Finance Finance working capitalworking capital—inventory or —inventory or

accounts receivable accounts receivable

55

Financing Small BusinessesFinancing Small Businesses

Small firms—assets less than $10 millionSmall firms—assets less than $10 million Vast majority are privately owned with Vast majority are privately owned with

ownership concentrated in a single familyownership concentrated in a single family Generally do not need external financing Generally do not need external financing

beyond trade credit—delayed payment offered beyond trade credit—delayed payment offered by suppliersby suppliers

Profitable firms may have sufficient capital to Profitable firms may have sufficient capital to be self-financingbe self-financing

Banks are most likely source of external Banks are most likely source of external financing financing

66

Banks Provide FundsBanks Provide Funds

Short-term loan—negotiated contract with short Short-term loan—negotiated contract with short maturitymaturity

Line of CreditLine of Credit Bank extends a credit for specified period of timeBank extends a credit for specified period of time The borrowing firm can draw down funds against L/CThe borrowing firm can draw down funds against L/C Credit RationingCredit Rationing—insures borrower has access to —insures borrower has access to

funds even if bank would prefer to curtail new loansfunds even if bank would prefer to curtail new loans When financing capital assets the maturity of the When financing capital assets the maturity of the

loan is typically less than life span of the assetloan is typically less than life span of the asset

77

Bank Loan OriginationBank Loan Origination

Locate a bank that meets your needs, Locate a bank that meets your needs, usually through a referralusually through a referral

The bank’s loan officer conducts a The bank’s loan officer conducts a complete credit analysiscomplete credit analysis Review borrower’s financial statementsReview borrower’s financial statements Visit the place of businessVisit the place of business Assesses the managerial Assesses the managerial

strengths/weaknesses of borrowerstrengths/weaknesses of borrower Provides an opportunity to develop a one-Provides an opportunity to develop a one-

on-one relationshipon-one relationship

88


99


Obtain additional information about the firmObtain additional information about the firm Obtain Obtain credit reportcredit report on the firm and borrower on the firm and borrower Address any concerns with the borrowerAddress any concerns with the borrower Loan is approved by the bankLoan is approved by the bank

Small loan approved by a loan officerSmall loan approved by a loan officer Larger loans are approved by more senior officersLarger loans are approved by more senior officers Above a certain amount must get approval from Above a certain amount must get approval from loan loan

committeecommittee Borrower and bank negotiate terms of the loan Borrower and bank negotiate terms of the loan Maturity of small business loans rarely exceeds 5 Maturity of small business loans rarely exceeds 5

yearsyears

1010

Features of a Small Features of a Small Business LoanBusiness Loan

During application period and after the loan is During application period and after the loan is granted, develop a relationship between bank granted, develop a relationship between bank and borrowerand borrower

Loans are often Loans are often collateralizedcollateralized Pledging of assets against the loanPledging of assets against the loan Secured lenderSecured lender—bank has the right to petition —bank has the right to petition

the bankruptcy court to sell the asset pledged as the bankruptcy court to sell the asset pledged as collateral to satisfy the loancollateral to satisfy the loan

Unsecured lenderUnsecured lender—have right to proceeds from —have right to proceeds from sale of assets after secured lenders have been paidsale of assets after secured lenders have been paid

Owner may pledgeOwner may pledge personal assets personal assets as collateral as collateral

1111

Features of a Small Features of a Small Business LoanBusiness Loan

Loan can be Loan can be guaranteedguaranteed by the owner by the owner Borrower is personally liable for any unpaid Borrower is personally liable for any unpaid

balancebalance Lender may require a personal financial Lender may require a personal financial

statement of the borrowerstatement of the borrower With very small firms, often loan is With very small firms, often loan is

strictly dependent on creditworthiness strictly dependent on creditworthiness of the individual not the small businessof the individual not the small business

1212

Restrictive CovenantsRestrictive Covenants

Loan may contain restrictive Loan may contain restrictive covenantscovenants CovenantCovenant—promises that the company —promises that the company

makes to the bank regarding their future makes to the bank regarding their future actions and strategiesactions and strategies

The bank may require an The bank may require an auditedaudited financial financial statement to verify the convents have not statement to verify the convents have not been brokenbeen broken

More restrictive covenants are linked to More restrictive covenants are linked to actions indicating the company has become actions indicating the company has become riskierriskier

1313

Financing Midsize Financing Midsize BusinessesBusinesses

Assets between $10 million and $150 millionAssets between $10 million and $150 million Large enough to no longer be bank-Large enough to no longer be bank-

dependent for external debt financing, but dependent for external debt financing, but not large enough to issue not large enough to issue traded traded debt in the debt in the public bond marketpublic bond market

Some are likely to be publicly owned—issue Some are likely to be publicly owned—issue equity traded in the over-the-counter marketequity traded in the over-the-counter market

Can either be owner managed or managed Can either be owner managed or managed by someone other than the ownerby someone other than the owner

1414


For short-term debt, principally rely on For short-term debt, principally rely on commercial bankscommercial banks Depending on size of debt and bank, can use Depending on size of debt and bank, can use

either local or non-local bankseither local or non-local banks Typically have covenants placed on the loan Typically have covenants placed on the loan

and may pledge collateraland may pledge collateral Revolving Line of CreditRevolving Line of Credit--access to --access to

longer-term debt financing through their longer-term debt financing through their commercial bank that combines an L/C commercial bank that combines an L/C with intermediate-term loanwith intermediate-term loan

1515


Long-term debt financing is often Long-term debt financing is often provided by non-bank institutionsprovided by non-bank institutions Mezzanine debt funds provide loans to Mezzanine debt funds provide loans to

smaller midsize companiessmaller midsize companies Private Placement Market (Figure 14.2)Private Placement Market (Figure 14.2)

Generally a bond issue in excess of $10 millionGenerally a bond issue in excess of $10 million Bonds do not have to be registered with the SECBonds do not have to be registered with the SEC Avoids public disclosure of informationAvoids public disclosure of information Sold only to financial institutions and high net Sold only to financial institutions and high net

worth investorsworth investors

1616

Private Placement Private Placement OriginationOrigination

1717

Financing Large BusinessesFinancing Large Businesses

Firms with assets in excess of $150 Firms with assets in excess of $150 millionmillion

Becomes cost effective to enter the Becomes cost effective to enter the publicpublic bond market bond market

These bond issues are These bond issues are liquid assetsliquid assets that are traded in the secondary marketthat are traded in the secondary market

Therefore, can be issued at a lower Therefore, can be issued at a lower yield than a nontraded instrumentyield than a nontraded instrument

1818


Large businesses can afford the high distribution Large businesses can afford the high distribution and underwriting costs of a public issueand underwriting costs of a public issue Additional costs to sell to a wider range of investorsAdditional costs to sell to a wider range of investors Substantial costs associated with registering the bond Substantial costs associated with registering the bond

with the SECwith the SEC Securities Underwriting (Figure 14.3)Securities Underwriting (Figure 14.3)

Issuer selects an Issuer selects an underwriterunderwriter, generally an , generally an investment bank, to assist in issuing and marketing investment bank, to assist in issuing and marketing the bondthe bond

Underwriters actively market their services to Underwriters actively market their services to companies large enough to issue in the public marketcompanies large enough to issue in the public market

1919

Securities UnderwritingSecurities Underwriting

2020

Shelf RegistrationShelf Registration

Permits the issuer of a public bond to Permits the issuer of a public bond to register a dollar capacity with the SECregister a dollar capacity with the SEC

Draw down on this capacity at any timeDraw down on this capacity at any time This avoids additional registration This avoids additional registration

requirementsrequirements Permits issuers to respond Permits issuers to respond

instantaneously to changing market instantaneously to changing market conditionsconditions

2121


Large companies with good credit ratings tend Large companies with good credit ratings tend to rely on the to rely on the commercial papercommercial paper market for market for short-term financingshort-term financing

Some very large businesses also issue Some very large businesses also issue medium-term notesmedium-term notes, which are like , which are like commercial paper, except maturities range commercial paper, except maturities range from one year to five yearsfrom one year to five years

Also issue Also issue equitiesequities, through underwriters, , through underwriters, which is another form of external which is another form of external long-term long-term financingfinancing

chapter 14 understanding financial contracts. 2 introduction chapter focuses on financial contracts...

Documents