week 4 financing an investment

FINANCIAL MANAGEMENT

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Prepared by Tishta Bachoo

Lecture 4 - overview

Types of Financial Decisions: Investment and Financing.

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Financing and InvestmentThere are two fundamental types of financial decisions that the finance team needs to make in a business: Investment FinancingThe two decisions boil down to how to spend money and how to borrow money.

The overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.

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The Financing DecisionWhen a company needs to raise money, it can invite investors to put up cash in exchange for a share of future profits, or it can promise to pay back the investors’ cash plus a fixed rate of interest.

In the first case, the investors receive shares of stock and become shareholders, part owners of the corporation. The investors in this case are referred to as equity investors, who contribute equity financing.

In the second case, the investors are lenders, that is, debt investors, who one day must be repaid.

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Financing Decision

The choice between debt and equity financing is often called the capital structure decision. Here “capital” refers to the firm’s sources of long-term financing. A firm that is seeking to raise long-term financing is said to be “raising capital.”

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Investment An investment decision revolves around spending

capital on assets that will yield the highest return for the company over a desired time period.

In other words, the decision is about what to buy so that the company will gain the most value.

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InvestmentTo do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't investing in things that will help it grow in the future.

On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.

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Financing

There are two ways to finance an investment:

Using a company's own money (Profits, Personal savings

By raising money from external funders.

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Financing There are two ways to raise money from external funders: By taking on debt .

Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing.

Selling equitySelling equity (shares) is basically selling part of your

company. When a company goes public, for example, they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.

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Equity vs Debt Capital

Equity capital: represents the personal investment of the owner (s) of a company.

Debt capital: the financing that a business owner has borrowed and must repay with interest

10Prepared by Tishta Bachoo

Debt Financing: Loans from commercial banks

Short-term loans Commercial loans Lines of credit

Intermediate and long-term loans

Installment loan Term loan

11Prepared by Tishta Bachoo

Advantages of Debt Financing The bank or financial institution has no say in the

way a company is managed and has no ownership rights.

The business relationship ends once the debt is paid.

If you get a low rate interest loan, the debt is easily going to be repaid in installments over a period of time

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Disadvantages of Debt Financing You have to repay the loan, plus interest. Failure to

do so exposes your property and assets to repossession by the bank.

Debt financing is also borrowing against future earnings. This means that instead of using all future profits to grow the business or to pay owners, you have to allocate a portion to debt payments.

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Equity Financing: Public Stock Sale

Advantages Ability to raise large amounts of capital Equity financing does not have to be repaid. You share the risks and liabilities of company ownership

with the new investors. Since you don't have to make debt payments, you can use

the cash flow generated to further grow the company or to diversify into other areas.

Maintaining a low debt-to-equity ratio also puts you in a better position to get a loan in the future when needed.

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Equity Financing: Public Stock Sale

Disadvantages Dilution of ownership, Loss of control, Loss of privacy,

Accountability to shareholdersYou give up partial ownership and, in turn, some level of

decision-making authority over your business Reporting to SEC (Stock Exchange) You have to share a portion of your earnings with the equity

investor. Over time, distribution of profits to other owners may exceed

what you would have repaid on a loan.

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Financing and investment decisions Financing and investment decisions (both long- and

short-term) are of course interconnected. The amount of investment determines the amount of financing that has to be raised, and the investors who contribute financing today expect a return on that investment in the future. Thus, the investments that the firm makes today have to generate future returns for payout to investors.

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Financing and investment decisions Money flows from investors to the firm and back to

investors again. The flow starts when cash is raised from investors. The cash is used to pay for the investment projects needed for the firm’s operations. Later, if the firm does well, the operations generate enough cash inflow to more than repay the initial investment. Finally, the cash is either reinvested or returned to the investors who furnished the money in the first place).

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Financing and investment decisions The firm finances its investments by issuing financial

assets to investors. A share of stock is a financial asset, which has value as a claim on the firm’s real assets and the income that those assets will produce. A bank loan is a financial asset also. It gives the bank the right to get its money back plus interest. If the firm’s operations can’t generate enough income to pay what the bank is owed, the bank can force the firm into bankruptcy and stake a claim on its real assets.

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How do you know which is right for you?

How soon do you need financing? If you need cash as soon as possible, then debt

financing is the way to go. You can get business loans incredibly fast -- in a matter of hours even, if you apply to the right lenders. Meanwhile, equity financing involves finding the right investors, pitching your business, drawing up the legal documents and more.


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How much capital do you need? If you don’t need a lot, or you’re only looking

for a small amount, then debt financing is the better choice. Equity financing rarely comes in small amounts,


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Are you looking for more than just money? If so, equity is probably for you. Debt financing is

transactional. You borrow, then you pay back what you owe. Equity will give you access to an investor’s knowledge, contacts and expertise. You get to establish a relationship that could have a hugely positive effect on your business -- as long as you’ve partnered with the right people.


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Do you mind sharing your business? If you don’t want to lose control over how your

business operates, then equity financing isn’t the way to go.

How big do you want to get in the future? Investors often look for companies with the

potential to grow into national brands or global businesses. If that’s your goal, then equity can help you get there.


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Can we use both financing methods in an investment?

Yes, an investment can be funded to some extent by borrowing a loan (Debt Financing) and to some extent by issuing shares (Equity Financing).

In this case, the capital cost components must be added where the contribution of each capital source is weighted by the proportion of total funding it provides. This is known as:


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WACC = (Proportion of total funding that is equity funding ) x (Cost of equity) + [(Proportion of total funding that is debt funding) x (Cost of Debt) x (1 – Corporate tax rate)]

Weighted Average Cost of Capital (WACC)

A firm's cost of capital from various sources usually differs somewhat between the different sources of capital. Cost of capital may differ, that is, for funds raised with bank loans,, or equity financing. As a result, Weighted average cost of capital (WACC) represents the appropriate cost of capital for the firm as a whole. WACC is simply the arithmetic average (mean) capital cost, where the contribution of each capital source is weighted by the proportion of total funding it provides.


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Question 1 ABC Ltd is looking for ways to gain public confidence

back again. The company is planning to pay dividends of $30M in total to its shareholders and invest in new assets worth $60M. The company’s net cash from operations equals $50M and they plan on borrowing $20M this year. Can they do it? What options can the company consider?

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Answer to Q1

No, they cannot do it.

Capital Held = $50M + $20M = $70MInvestment & Dividends= $60M + $30M =$90MCapital < Investment by $20M

The options they have: Raise more capital thus more debt Invest less in new assets Pay less dividends to shareholders

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Question 2- Equity Financing

Jack invests $500,000 in a startup technology company acquiring 10,000 of the firm’s 200,000 total shares outstanding.

After a year, the technology company grows and needs additional capital. The firm’s management decides to raise the funds by issuing new stocks and giving a percentage of ownership to more investors in exchange for cash.

Jack agrees to invest $300,000 at a share price of $60. How many shares Jack will acquire?

Before the stock issuance, Jack controlled 5% of the company (10,000 shares of the firm’s 200,000 total shares outstanding).

After the equity financing, Jack will control what % of the company?

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Answer to Q2 Jack agrees to invest $300,000 at a share price of $60. How many

shares Jack will acquire? $300000/$60 = 5000 shares

After the equity financing, Jack will control what % of the company? Before the stock issuance, Jack controlled 5% of the company

(10,000 shares of the firm’s 200,000 total shares outstanding). After the issuance, Jack holds a total of 15,000 shares

(10000shares + 5000 new ones) out of 200 000 shares. Therefore, he controls 7.5% of the company (15000 shares /

200000 total shares)

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Question 3Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.

Corporation ABC then borrows a loan of $400,000 in from the bank at a 5% interest rate so ABC's cost of debt is 5%.

Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%.

Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).


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Answer to Q3WACC = [(Proportion of total funding that is equity funding ) x (Cost of equity)] + [(Proportion of total funding that is debt funding) x (Cost of Debt) x (1 – Corporate tax rate)]Proportion (%) of equity funding: $600 000/ $1 000 000 = 60%Proportion (%) of debt funding: $400 000/ $1 000 000 = 40%Cost of Equity: 6%Cost of Debt: 5%Corporate Tax Rate: 35%WACC= (60% x 6%) + [(40% x 5%) x (1 – 35%)]

= 0.036 + [0.02 x 0.65]

= 0.049 or 4.9%

Corporation ABC's weighted average cost of capital is 4.9%.This means for every $1 Corporation ABC raises from external funders, it must pay them almost $0.05 in return.


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Question 4 Steven approached a bank for financing for his business

venture, the development of a wireless golf buggy. On 1 July 2014, he borrowed $200 000 at an annual interest rate of 12%. The loan is repayable over 5 years in annual instalments of $55,480, principal and interest due on 30 June each year. The first payment is due on 30 June 2015. His wireless golf buggy entity’s year end will be 30 June. Prepare a loan schedule for the 5 Years 2014- 2019. Round all calculations to the nearest dollar


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Answer to Q4


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Question 5 Francis approached a bank for financing for his business

venture, the development of a wireless golf buggy. On 1 July 2015, he borrowed $100 000 at an annual interest rate of 10%. The loan is repayable over 5 years in annual instalments of $26,380, principal and interest due on 30 June each year. The first payment is due on 30 June 2016. His wireless golf buggy entity’s year end will be 30 June. Prepare a loan schedule for the 5 Years 2015- 2020. Round all calculations to the nearest dollar


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Answer to Q5


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Question 6Assume newly formed Corporation XYZ needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company raises 40% of the capital from issuing shares and expect it would be able to pay 6% to shareholders as their return.

Corporation XYZ then borrows 60% of the capital from the bank at a 12% interest rate.

Corporation XYZ's corporate tax rate is 30 %.

Now we have all the ingredients to calculate Corporation XYZ's weighted average cost of capital (WACC).


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Answer to Q6

Proportion (%) of equity funding: 40 % Proportion (%) of debt funding: 60% Cost of Equity: 6% Cost of Debt: 12% Corporate Tax Rate: 30% WACC= (40% x 6%) + [(60% x 12%) x (1 – 30%)]

= 0.024 + [0.0504]

= 0.074 or 7.4 %

Corporation XYZ's weighted average cost of capital is 7.4 %. This means for every $1 Corporation XYZ raises from external

funders, it must pay them almost $0.074 in return.


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END OF SESSION

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Next week …

Business Valuation

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week 4 financing an investment

Economy & Finance