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NEW VENTURE FINANCE Determining Financial needs Sources of Financing-Equity Finance-Debt Finance-Bootstrap Finance-Lease Financing-Hire Purchase Institutional Finance in IndiaCHAPTER 8

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Determining Financial NeedsUndercapitalized business Raising too little money by underestimating the business’s

needs May run out of cash, borrowing capacity leading to exit

Overcapitalized business Raising too much money and having excessive cash Sends wrong signals to stakeholders, customers, etc.

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Working Capital:On an average over 60% of the total financing

requirements are invested in Working CapitalPermanent Working Capital:

Needed to produce goods and services at the lowest point of demand.

As the firm grows, this also increasesTemporary Working Capital:

Needed to meet seasonal and cyclical demandIf working capital is too low then:

Stock-out occurs, sales are lostIf working capital is too high then:

Receivables will be too large and customers, clients will delay the payments

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Order materials

Raw material inventory

1 2

Work-in-process

inventory3

Finished goods

inventory4

Accounts receivabl

e 5

PRODUCTION CYCLE

CASH CYCLE

The Cash Flow Cycle – Operations Cycle:

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Short Term Cycle:1) Days in accounts payable = Average accounts payable x 365 days

Cost of goods sold – Labour

2) Days in raw materials inventory= Average raw materials inventory x365DCost of raw materials

3) Days in work-in-progress inventory = Average WIP inventory x 365 daysCost of goods sold

4) Days in finished goods inventory = Average finished goods x365 daysCost of goods sold

5) Days in accounts receivable = Average accounts receivable x 365 daysSales

Short term cycle : 2 + 3 + 4 + 5 – 1

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Order material

s3 4 5

CASH CYCLE

Hypothetical Cash Cycle:

15days 2

30Days 1

45 days 15 days 50 days40 days

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Managing and Controlling the Cash Flow Cycle:

Accounts payable Longer the accounts payable, shorter the cash flow cycle Part of permanent working capital, should be managed Develop cordial relations with vendors that enable them to extend

payments when neededRaw materials inventory

Keep it as low as possible Just-in-time delivery systems, good management system, accurate

sales forecasting, etc.Work-in-progress inventory

Tagging and monitoring all work in processes will help Efficient operations, worker training and incentives, capital

investments, etc.

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Finished goods inventory Develop relationships with buyers If warehouses are available with buyers, then sell the

goods Accurate sales forecasts, management information

system, etc.Accounts receivable

Payment terms, credit limits, collection programmes, etc.

Encourage customers to pay their bills on time Give incentives to them if they pay early without hurting

the margins

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Sources of FinancingEQUITY-BASED FINANCING

Ownership stake in the new venture

Inside Equity: highest risk of loss but highest returns if venture is successful

Owners, Family and friends

Outside Equity: equity from investors who have no personal relationship with venture beyond their investment and profitability

Private investors, venture capitalists, public offerings

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Private investors: “ANGELS” wealthy individuals interested in high risk/high reward opportunities

Relatively accessible and bigger size investment pool Lacks expertise, inability to invest more money

sometimes Overprotectiveness

Public offerings: ultimate source of outside equity and wealth creation

Initial Public Offering (IPO) with the aid of an investment banker

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Venture Capital: outside equity which comes from professionally managed pools of investor money.

Venture capitalists specialize in certain industries Risk capital Can bring additional investment if required, provide advice and contacts

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DEBT-BASED FINANCINGAsset-based debt financing- Collateralized Trade-credit – for period between product or service

delivery to the new venture and when payment is due Short term asset – seasonal accounts receivable Long term asset – equipment or property Eg. – upto 60% debt financing is possible for inventory,

with inventory as collateral Perfect ability to evaluate the collateral is essential

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Cash Flow Financing- Unsecured financing based on the underlying

operations of the business and its ability to generate enough cash to cover the debt

Short term (under 1yr) – working capital Medium term – Line of credit Long term – bond or debenture Banks enter into agreements between lender and

borrower concerning the manner in which the funds are disbursed, employed, managed and accounted. (eg maintain a minimum balance)

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BOOTSTRAP FINANCING

Start-up and early years of the establishment when debt financing and equity financing is more expensive.

Other costs of outside capital are Time required to raise the capital is usually 3-6 months

Decreases a firm’s drive for sales and profitsAvailability of capital increases impulses to spend moreDecreases company’s flexibilityCause more disruption and problems

Entrepreneur will be stressed to earn profits so that he pays back the loans

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LEASE FINANCING“Lease is a contract whereby the owner of an asset

(called lessor) grants to another party (called lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent.”

Alternative to loan financingOwnership rests with the lessor only even after the expiry of

the lease

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Lease Agreement

s

Capital Lease

Operating Lease

Sale and Lease Back

Leveraged Lease

*3 party-involvement – lessor, lessee and lender*Lessor provides an equity portion (say25%) & lender provides the balance

*Firm sells an asset to another party who in turn leases it back to the firm*Receives sales price& economic use of the asset*Lessor gets tax benefits*lessee gets cash flow

*shorter than capital lease*cancellable at option of lessee with prior notice*term shorter than economic life of the asset

*Long term*non-cancellable*period is useful life of the asset*continue to pay rent even after obsolescence

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HIRE PURCHASEHigher purchase is an agreement under which the owner

called “hire vendor” gives delivery of goods to the buyer called “hire purchaser” who pays the price in certain number of installments

The hire vendor retains the ownership of the asset until the last installment is paid

Ownership is then transferred to the hire purchaserAccording to Hire Purchase Act, 1972, “the hire

purchase agreement is an agreement under which the goods are let on hire and the hirer has an option to purchase them in accordance with the terms of the agreement.”

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Procedure for Hire PurchaseModus operandiHire purchase Agreement is made in written between

parties:1. Hire purchase price of the asset2. Cash price at which the goods may be purchased3. Date of commencement of the agreement4. Number and time of installments5. Name of goods with its sufficient identity6. Amount to be paid at the time of signing the agreement7. Signatures of both or all three parties

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Financial Institution

Hire Purchaser

Hire Vendor

3-party Hire Purchaser

1. Vendor receives bills of exchange for purchase of goods from the hirer2. Vendor discounts the bills with financial institution & gets payment for the goods sold under hire purchase3. Financial institution collects payments of the bill

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INSTITUTIONAL FINANCE• Commercial Banks• Industrial Bank of India (IDBI)• Industrial Finance Corporation of India (IFCI)• Industrial Credit and Investor Corporation of India (ICICI)• Industrial Reconstruction Bank of India (IRBI)• Life Insurance Corporation of India (LIC)• Unit Trust of India (UTI)• State Financial Corporations (SFCs)• State Industrial Development Corporation (SIDC)• Small Industries Development Bank of India (SIDBI)• EXIM Bank