Financing Decision

Dr. Md. Rezaul Kabir

Associate Professor
Coordinator, Executive MBA (EMBA) Program
Institute of Business Administration (IBA), University of Dhaka
 Capital

• Businesses need a substantial amount of capital to operate and create

profitable returns.

• Balance sheet analysis is central to the review and assessment of

business capital.

• Split between assets, liabilities, and equity, a company’s balance sheet

provides for metric analysis of a capital structure.
Accounting Equation:

1) Current Liabilities
+2) Long Term Liabilities
1) Current Assets
+ 2) Non-Current
Assets
1) Share Capital
+2) Share Premium
+3) Retained Earnings
Owners’ Equity
• Share Capital = Face value per share x No. of shares outstanding

• Share premium = (Market value – face value) x No. of shares outstanding

• Retained earnings (RE) is the amount of net income left over for the
business after it has paid out dividends to its shareholders.

• Outstanding share = shares that are currently being traded in the

market
Retained Earnings
• Retained Earnings (RE) = BP + Net Income (or Loss) − C − S
• BP=Beginning Period RE
• C=Cash dividends
• S=Stock dividends​

• Retained earnings can be twofold. Retained Earnings are a portion of a

company's profit that is held or retained from net income at the end of a
reporting period and saved for future use as shareholder’s equity.

• Retained earnings are also the key component of shareholder’s equity that
helps a company determine its book value.
Retained Earnings
• Retained Earnings (RE) = BP + Net Income (or Loss) − C − S
• BP=Beginning Period RE
• C=Cash dividends
• S=Stock dividends​

• Retained earnings can be twofold. Retained Earnings are a portion of a

company's profit that is held or retained from net income at the end of a
reporting period and saved for future use as shareholder’s equity.

• Retained earnings are also the key component of shareholder’s equity that
helps a company determine its book value.
Cash dividend
• A cash dividend is the distribution of funds or money paid to
stockholders generally as part of the corporation’s net income.

• Cash dividends are paid directly in money, as opposed to being paid as a stock
dividend or other form of value.

• Cash dividend on both common and preferred shares are announced as

percentage of their face value.

• For example, if a face value of a share is BDT 10 and 10% dividend is announced.
Shareholders will get BDT 1 (10% of BDT 10) for each share they hold.
Stock Dividend
• A stock dividend is a dividend payment to shareholders that is made in shares
rather than as cash.

• The stock dividend has the advantage of rewarding shareholders without

reducing the company's cash balance, although it can dilute earnings per share.

• These stock distributions are generally made as fractions paid per existing share.

• For example, a company might issue a stock dividend of 5%, which will require it
to issue 0.05 shares for every share owned by existing shareholders, so the
owner of 100 shares would receive 5 additional shares.
Owners’ Equity – preferred stock
• The term "stock" refers to ownership or equity in a firm.

• There are two types of equity - common stock and preferred stock.
Preferred stockholders have a higher claim to dividends or asset
distribution than common stockholders.

• The details of each preferred stock depend on the issue.

Preferred share
• Preference shares, more commonly referred to as preferred stock,
are shares of a company’s stock with dividends that are paid out to
shareholders before common stock dividends are issued.

• If the company enters bankruptcy, preferred stockholders are

entitled to be paid from company assets before common
stockholders.

• Cumulative preferred stock is a class of preferred stock whose

dividends accumulate if they are not paid in any year and must be
paid in future.
Owners’ Equity – convertible
preferred stock
• Convertible preferred stocks are preferred shares that include an
option for the holder to convert the shares into a fixed number of
common shares after a predetermined date.

• Most convertible preferred stock is exchanged at the request of the

shareholder, but sometimes there is a provision that allows the
company, or issuer, to force conversion.

• The value of a convertible preferred stock is ultimately based on the

performance of the common stock.
Owners’ Equity – common stock
• Common stock is a security that represents ownership in a corporation.
Holders of common stock elect the board of directors and vote on
corporate policies.

• This form of equity ownership typically yields higher rates of return long
term. However, in the event of liquidation, common shareholders have
rights to a company's assets only after bondholders, preferred
shareholders, and other debtholders are paid in full.

• Common stock is reported in the stockholder's equity section of a

company's balance sheet.
Share buyback
• A share repurchase or buyback is a transaction whereby a company buys
back its own shares from the marketplace.

• A company might buy back its shares because management considers

them undervalued.

• The company buys shares directly from the market or offers its shareholders
the option of tendering their shares directly to the company at a fixed price.

• This act reduces the number of outstanding shares, which increases both the
demand for the shares and the price.
Share buyback
• When a company buys its shares back, the shares are recorded in
‘treasure stock’ in balance sheet

• The journal entry for repurchase is as follows:

Long term liability – Bank loan
• The term loan refers to a type of credit vehicle in which a sum of
money is lent to another party in exchange for future repayment of
the value or principal amount.

• In many cases, the lender also adds interest and/or finance charges
to the principal value which the borrower must repay in addition to
the principal balance.

• Loans may be for a specific, one-time amount, or they may be

available as an open-ended line of credit up to a specified limit.
Long term liability – Debenture
• A debenture is a type of bond or other debt instrument that is
unsecured by collateral.

• Since debentures have no collateral backing, debentures must rely

on the creditworthiness and reputation of the issuer for support.

• Both corporations and governments frequently issue debentures to

raise capital or funds.
Difference between bonds and debentures
Long term liability – Convertible
bond
• A convertible bond is a fixed-income corporate debt security that yields
interest payments, but can be converted into a predetermined number of
common stock or equity shares.

• The conversion from the bond to stock can be done at certain times
during the bond's life and is usually at the discretion of the bondholder.

• As a hybrid security, the price of a convertible bond is especially sensitive

to changes in interest rates, the price of the underlying stock, and the
issuer’s credit rating.
Long term liability – Convertible
bond
• The conversion ratio—also called the conversion premium—determines how many
shares can be converted from each bond.

• This can be expressed as a ratio or as the conversion price and is specified in

the indenture along with other provisions.

• For example, a conversion ratio of 45:1 means one bond—with a $1,000 par value—
can be exchanged for 45 shares of stock.

• Or it may be specified at a 50% premium, meaning if the investor chooses to

convert the shares, he or she will have to pay the price of the common stock at the
time of issuance plus 50%.
 Venture Capital
• Venture capital is a form of private equity and a type of financing that investors
provide to start up companies and small businesses that are believed to
have long term growth potential.

• Venture capital generally comes from well-off investors, investment banks and
any other financial institutions. However, it does not always take a monetary
form; it can also be provided in the form of technical or managerial expertise.

• Venture capital is typically allocated to small companies with exceptional

growth potential, or to companies that have grown quickly and appear poised
to continue to expand.
 Venture Capital - Challenges

• Challenge #1: Raising Another Fund.

• While Sequoia, Benchmark, Founders Fund, etc. etc. can all basically
raise a new fund in about a week … on any terms … the majority of
firms do struggle to raise additional funds.

• At a minimum, it’s something they think about all the time. If you
can’t raise another fund, you get paid at least something to manage
your existing investments for 10+ years. But the corpus decays over
that time frame.
 Venture Capital - Challenges

• Challenge #2: Winning Deals.

• Simply put, most firms that hustle with a brand eventually see
enough pre-Unicorns to do OK. Then they have to “win” the best
deals. Very early stage, it’s not always necessary, you may be about
finding undiscovered gems. But once a company is hot …
competition is fierce and real … and you got to win.
 Venture Capital - Challenges
• Challenge #3: Not Doing “Pretty Good” Investments.

• Some VC partners never even do 0.5x and throw huge amounts of $$$
down the drain. Just as common though is investing in “pretty good”
companies. Founders are poised. Traction is there. Customers are happy.

• But … it will never be a rocketship. Problem here is, except in very small
funds (<$50m), the exit values on these “Good” investments is never
really high enough to return the fund. And then you can’t raise another
fund.
 Why Cost of Debt is lower than Cost of Equity

 Low Risk (Priority Claim on Income

and Assets)
 Legal Protection

 Tax Benefits
 Example - Gearing
The long-term capital structures of three new businesses, Lee Ltd, Nova Ltd, and IBA Ltd are
as follows:

Lee Ltd Nova Ltd IBA Ltd

£ £
£1 share (OE) 100,000
200,000 300,000
10% loan
200,000 100,000 0

300,000 300,000 300,000

Annual Interest expense 20,000
10,000  Net
0 Profit = EBIT-Interest-Tax
 Gearing Ratio = D/D+E
 of Interest
In their first year operations,Coverage
they eachRatio
make=aEBIT/Interest
profit before interest and taxation [EBIT]
of £50,000. Thetax Return
rate is 30%. Calculate-
on Equity = NP/OE
 Lee Nova IBA

Earnings before Interest and Tax (EBIT) 50,000 50,000 50,000

(-) Interest (10%) . 20,000 10,000 0
Earnings Before Tax (EBT) 30,000 40,000 50,000
(-) Tax (30%) . 9,000 12000 15,000
Net Profit . 21,000 28,000 35,000
.

200,000/300,000 100,000/300,000 0/300,000

Gearing Ratio
=66.67% = 33.33% =0.00%

Interest Coverage Ratio 50000/20000 50000/10000 50000/0

=2.5 times =5 times = NA

Return on Equity 21000/100,000 28000/200,000 35000/300,000

=21% =14% =11.67%
 Lee Ltd Nova Ltd
IBA Ltd
£1 ordinary shares
100,000 200,000 300,000
10% loan
200,000 100,000
Earnings before Interest and Tax (EBIT) 50,000 50,000 50,000
(-) Interest (10%) . 300,00020,000 10,000 300,000
0
Earnings Before Tax (EBT)
300,000 30,000 40,000 50,000
(-) Tax (30%) . 9,000 12000 15,000
Annual Interest expense
Earnings After. Tax/Net Profit
20,000 10,000 (EAT/NP). 21,000
0 28,000 35,000
.
.
Total Payment for Tax if there 50000*30% 50000*30% 15000
were no debt =15000 =15000

Tax savings due to existence of debt 15000-9000 15000-12000 15000-15000

=6000 =3000 =0
(20000-6000)/200000 (10000-3000)/100000
10%
Actual tax Cost of Debt =7% =7%

After tax cost of debt = rd x (1-t) = 10% x (1 – 30%) = 0.10 x ( 1 – 0.30) = 0.07 = 7%
 Business Valuation
• A business valuation is a general process of determining the economic value of a
whole business or a business unit.

• Business valuation can be used to determine the fair value of a business to establish
ownership stake, corporate control, and to determine claim during liquidation.

• Owners will often turn to professional business evaluators to get an estimate of the
business value.

• There are several methods to do business valuation.

• One the best and most commonly used methods is the Discounted Cash Flow (DCF)
method.
 DCF Method

• DCF method is based on projections of future cash flows, which are adjusted to get
the current market value of the company.It takes into consideration of the time
value of money concept.

• DCF analysis finds the present value of expected future cash flows using a discount
rate.

• For firm valuation, free cash flow is calculated from its financial statements. And
then is discounted by required rate of return.

• The required rate of return accounts for all kinds of risk - inflation, default, maturity,
liquidity, economic risk, etc.
 Free Cash Flow (FCF) - 1
• FCF can be calculated by starting with Cash Flows from Operating
Activities on the Statement of Cash Flows because this number will
have already adjusted earnings for interest payments, non-cash
expenses, and changes in working capital.
 Free Cash Flow (FCF) - 2
• The income statement and balance sheet can also be used to
calculate FCF.
 Free Cash Flow (FCF) - 3
• Other factors from the income statement, balance sheet and
statement of cash flows can be used to arrive at the same calculation.
For example, if EBIT was not given, an investor could arrive at the
correct calculation in the following way.
 DCF Firm Valuation Formula
• Firm value = + + + … … … +

• Here, r = WACC

• Since FCF is in the numerator of the equation, if FCF increases, firm

value increases.

• On the other hand, if WACC increases, firm value decreases as WACC

is in the denominator.
 Discount Rate for DCF
• The discount rate used in DCF method is the weighted average cost of
capital (WACC)

• WACC (r) includes to components of capital- cost of equity (re) and

cost of debt (rd).

• When FCF is discounted by WACC, we get the value of the firm

• How to calculate WACC will be discussed later

TYPICAL CAPITAL BUDGETING PROBLEM
Hick Limited is considering investing in a new project, for which the following
information is available:
£ 000
Initial investment 450
Life of project 4 years
Estimated annual cash flows:
Year 1 150
Year 2 300
Year 3 100
Year 4 100
• Residual value 30
• Cost of capital or discount rate is 10%
SOLUTION
Here, Weighted Average Cost of Capital = 10%

150 300 100 130

-450 (1+.10) (1+.1 0)
2
(1+.1 0)
3
(1+.1 0)
4

136.36
247.93
75.131
88.71

Total = 548.21
NPV = Total Discounted Cash Inflows – Investment = 548,210 - 450,000 = 98,210
NPV = 98,210
3 Types of Expenditures
1. Capital Expenditure
2. Revenue/ Operating Expenditure
3. Financing Expenditure

WACC captures Financing Expenditure and the concept of TVM

 Income Statement for the year ended June 30, 2017
Sales Revenue: 220
Cost of Goods Sold (COGS): 125

Gross Profit 95

Operating Expenses:
Salary expense 16
Utilities expense 15
Rent expense 16
Depreciation 18
Total Operating Expenses 65
Operating Profit/ Earnings Before Interest & Tax 30
Interest Payment 10
Earnings Before Tax 20
Tax for the year @ 40% 8
Net income after tax 12
Proposed dividends 5
Retained earnings for the year 7
 Income Statement for the year ended June 30, 2017
Sales Revenue: 220
Cost of Goods Sold (COGS): 125

Gross Profit 95

Operating Expenses:
Salary expense 16
Utilities expense OPEX 15
Rent expense 16
Depreciation Partial CAPEX 18
Total Operating Expenses 65
Operating Profit/ Earnings Before Interest & Tax 30
Interest Payment Partial FINEX 10
Earnings Before Tax 20
Tax for the year @ 40% 8
Net income after tax 12
Proposed dividends 5
Retained earnings for the year 7
Typical FCF Calculation
Sales (Revenues from operations)
- COGS (Cost of goods sold-labor, material)
- SG&A (Selling, general administrative costs)
-Depreciation expense
EBIT (Earnings before interest and taxes or Operating Profit)
- Taxes (Cash taxes)
NOPAT (Net Operating Profit After Taxes)
+ Depreciation expense
- CAPEX
- (Change in working capital)
FCF (Free cash flows)
 Components of Capital

• The two components of capital are:

- Equity
- Debt

• To calculate Cost of Capital, we need to know three things:

- Cost of Equity and market value of equity
- Cost of Debt and market value of debt
- Tax rate
 Concept of WACC
The weighted average cost of capital (WACC) is the average return that the company has to pay to its equity and
debt investors. Another way of putting this is that the WACC is the average return shareholders and debt
holders expect to receive from the company.
WACC equation without the impact of Tax (T ):
 WACC (Situation 1)
United Transport Inc. has 3 million shares outstanding; the current market price per share is $10. The company
has borrowed $10 million from a bank at a rate of 8% interest; this is the company’s cost of debt is r d.
The company thinks its shareholders want an annual return on their investment of 20%; this 20% return is the
company’s cost of equity re . To compute United Transport’s WACC we use the formula:

Assets $40m Debt $10m

re= 20% ; rd= 8% Owners’ $30m
Equity
E = 3m shares each worth $ 10 = $30m
Total D & OE $40m
D = $10m

WACC =
 WACC (Situation 1)
United Transport Inc. has 3 million shares outstanding; the current market price per share is $10. The company
has borrowed $10 million from a bank at a rate of 8% interest; this is the company’s cost of debt is r d.
The company thinks its shareholders want an annual return on their investment of 20%; this 20% return is the
company’s cost of equity re . To compute United Transport’s WACC we use the formula:
Assets $40m Debt $10m
re= 20% ; rd= 8%
Owners’ $30m
E = 3m shares each worth $ 10 = $30m Equity
D = $10m Total D & OE $40m

WACC =

= 20% x = 20% x .75 + 8% x .25

= 15% + 2% = 17%
Concept of WACC
The equation of the WACC with tax impact is:
 Effect of Interest & Tax Rate on WACC
• Debt financing has tax advantage. Interest on debt is deducted from EBIT before
charging tax payment. Thus debt financing reduces tax.
• This tax advantage due to debt financing is reflected in Weighted Average Cost of
Capital (WACC):

WACC =

• Here, this (1-T) is the portion by which cost of debt rd is reduced. Thus debt financing
reduces overall WACC.
• However, excessive amount of debt portion in the capital exposes the company to
financial risk i.e. bankruptcy risk.
 WACC (Situation 2)
United Transport Inc. has 3 million shares outstanding; the current market price per share is $10. The company
has also borrowed $10 million from its banks at a rate of 8%; this is the company’s cost of debt is r d. United
Transport’s tax rate of T = 40%.
The company thinks its shareholders want an annual return on their investment of 20%; this 20% return is the
company’s cost of equity rE . To compute United Transport’s WACC we use the formula:

re = 20% ; rd = 8%
E = 3m shares each worth $ 10 = $30m
D = $10m
T= 40%
WACC =
 WACC (Situation 2)
United Transport Inc. has 3 million shares outstanding; the current market price per share is $10. The company
has also borrowed $10 million from its banks at a rate of 8%; this is the company’s cost of debt is r d. United
Transport’s tax rate of T = 40%.
The company thinks its shareholders want an annual return on their investment of 20%; this 20% return is the
company’s cost of equity rE . To compute United Transport’s WACC we use the formula:

Re = 20% ; rd = 8%
E = 3m shares each worth $ 10 = $30m
D = $10m
T= 40%
WACC =
= 20% x
= 15% x .75 + 8% x .6 x .25
= 15% + 4.8% .25
= 15% +1.2% = 16.2%
WACC (Situation 3)
If the company takes loans from a bank to buy back some of the common shares,
then new capital structure stands as:
E= 2,000,000 shares each worth $ 10= $ 20m
D= $10m + $10m = $20m
re= 20%; rd= 8%; T=40%

WACC =
WACC (Situation 3)
If the company takes loans from a bank to buy back some of the common shares,
then new capital structure stands as:
E= 2,000,000 shares each worth $ 10= $ 20m Assets $40m Debt $20m
D= $ 10m + $ 10m = $ 20m Owners’ $20m
Equity
re= 20%; rd= 8%; T=40% Total D & OE $40m

WACC =

= 20% x
= 20% x 0.5 + 4.8% x 0.5
= 10% + 2.4%
= 12.4%
 Cost of Equity (re)

• re is the return required by ordinary shareholders.

• re depends on both business risk and gearing risk.

• Business risk derives from the type of business that the company is engaged in (such
as real estate, supermarkets, air travel, car manufacturing).

• Gearing risk is related to the amount of borrowing in the company’s capital structure.

• The more borrowing there is, the more risk that shareholders are exposed to and the
higher will be their required return.
 Estimating re

• There are two sets of statistics that can be used to estimate re:

1. By using the dividend growth model formula:

re=
Here,
P0 is the share price of the company
D0 is the dividend that has either just been paid or is just about to be paid
g is the future dividend growth rate. Often this is estimated by looking directly at the
historical dividend growth rate and assuming this will continue in the future.
 Example 1

Statistics of a listed company

• Share price = $2.40

• Dividend just paid = $0.22/share
• Historical dividend growth rate = 10% per year.
This is expected to be maintained in the future
 Example 1

• Cost of Equity:
re=

re=

re= 0.2 or 20%

 Estimating re
2. Alternatively, re can be estimated using the capital asset pricing model
(CAPM):
Required rate of return, re = Rf + β(Rm – Rf)
Here,
Rf = risk free rate (govt bills/bonds; no default risk)
Rm = return from the market (historical return of the capital market)
β = it is a measure of volatility and its value for listed companies are available
online.
 Risk free rate (Rf)
• The risk-free rate of return is the interest rate an investor can expect to earn on an
investment that carries zero risk. In practice, the risk-free rate is commonly
considered to equal to the interest paid on a 3-month government

• The risk-free rate is a theoretical number since technically all investments carry
some form of risk. While it is possible for the government to default on its
securities, the probability of this happening is very low.

• The security with the risk-free rate may differ from investor to investor. The general
rule of thumb is to consider the most stable government body offering T-bills in a
certain currency.
For example, an investor investing in securities that trade in USD should use
the U.S. T-bill rate, whereas an investor investing in securities traded in Euros or
Francs should use a Swiss or German T-bill.
 Why T-Bill rate as Rf?
• The government has little chance or defaulting, even in times of
severe economic stress.

• T-bills are short-term securities that mature in one year or less,

usually issued in denominations of $1,000.

• T-bills are auctioned at or below their par value, and investors are
paid the par value of the security upon maturity.

• Since T-bills are paid at their par value and do not have interest rate
payments, there is no interest rate risk either.
 Market Risk Premium (Rm-Rf)
• The market risk premium is the difference between the expected
return on a market portfolio and the risk-free rate.

• It provides a quantitative measure of the extra return demanded by

market participants for the increased risk.

• Market risk premium describes the relationship between returns

from an equity market portfolio and treasury yields.
 Beta
• Beta is a measure of a stock’s volatility in relation to the overall market.

• By definition, the market, such as the DSEX Index, has a beta of 1.0,
and individual stocks are ranked according to how much they deviate
from the market.

• A stock that swings more than the market over time has a beta above
1.0. If a stock moves less than the market, the stock's beta is less than
1.0. High-beta stocks are supposed to be riskier but provide higher
return potential; low-beta stocks pose less risk but also lower returns.
 Example 2:

• Scenario A • Scenario B

ᵦ= 1.6 ᵦ= 0.5
Rf = risk free rate = 5% Rf = risk free rate = 5%
Rm = return from the market = 15% Rm = return from the market = 15%
Tax rate = 25% Tax rate = 25%
 Example 2:

• The shareholders’ required rate of return in the listed company is

given by the capital asset pricing model (CAPM) equation:

Scenario A Scenario B
re = Rf + β(Rm – Rf) re = Rf + β(Rm – Rf)
= 5% + 1.6 (15% – 5%) = 5% + 0.5 (15% – 5%)
= 21% = 10%
 Cost of Debt (rd)
• The cost of debt is the annual return the debtholders demand during the
lifetime of the debt.

• The annual interest rate mentioned in the contract of the loan is the cost of
debt as the borrower must pay the debtors at this rate annually.

• This rate is fixed based on the credit rating of the borrower.

• Credit ratings of each organization and government are done by the credit
rating agencies. They are usually available online.

• The better the credit rating of an organization, the lower the chance of
default/credit risk, and the lower the interest rate on its loans
 Cost of Capital (rd)
• The total cost of capital is calculated by the weighted average cost of
each of its component.
• Weighted average Cost of Capital (WACC)=
re x () + rd x (1-T) x ()
Here,
E = market value of equity
D = market value of debt
V=E+D
T = tax rate
 Why take market value of capital?
• Assume a firm issued capital at $10 per share 5 years back. Current market
value of the share is $30 and book value is $18 and market required rate of
return is 20%. The investors (existing and new) of the company will expect a
return on $30 and not $18.

• New investors can buy the share of the company at $30 from the market. If
the firm returns 20% on book value i.e. $3.6. The new investor will calculate
his percentage of gain 12% (3.6/30) which is far less than 20%. Why 30 dollar
because the investment by him is 30 and not 10 or 18.

• Since, market required rate of return is 20% and return on investment at

current prices is only 12%, a better situation for existing investor would be to
sell off the securities at $30 and invest in other securities giving more than
12% return. The existing investor will exit from the investment considering it
an overpriced stock and invest in securities which are underpriced or
appropriately priced by the market.
WACC (Situation 4)

You have been called in as a consultant for Herbert plc, a sporting goods retail firm,
which is examining its debt policy. The firm currently has a balance sheet as follows:

Balance Sheet
All amounts in £m
Assets
Current Assets 100
Fixed Assets 500
Total Assets 600

Liabilities & Owners’ Equity

Long term bonds 100
Owners’ Equity (100m Share*5) 500
Total Liability & Owners’ Equity 600
WACC (Situation 4)
The firm's income statement is given as follows (all in £m):
Revenues £250
Cost of goods sold £125
Gross profit £125
Depreciation £25
OPEX £50
EBIT £50
Interest £10
Earning before tax £40
Taxes (40%) £16
Net Income £24
The firm currently has 100m shares outstanding, selling at a market price of £5 per
share and the bonds are selling at their book value. The firm's current beta is 1.12,
the rate of return on government treasury bill is 7% and the market risk premium is
5.5%.
WACC (Situation 4)

a. What is the firm's current cost of equity?

b. What is the firm's current cost of debt? (You may assume the rate of corporation
tax is 40%).
c. What is the firm's current weighted average cost of capital?
d. Assume that management of Herbert plc is considering doing a debt-equity swap
(i.e., borrowing enough money to buy back 70m shares of stock at £5 per share).
It is believed that this swap will lower the firm's rating to C and raise the
interest rate on the company's debt to 15% and the beta of equity is expected
to increase to 2.8. What is the firm's new weighted average cost of capital?
WACC (Situation 4)
Balance Sheet

Assets

Current Assets 100

Fixed Assets 500

Total Assets 600

Liabilities & Owners’ Equity

Long term bonds 100+350=450

Owners’ Equity (100m Share*5) 500-350=150

Total Liability & Owners’ Equity 600

WACC (Situation 4)
The firm's income statement is given as follows (all in £m):
Revenues £250
Cost of goods sold £125
Gross profit £125
Depreciation £25
OPEX £50
EBIT £50
Interest £10+52.5

Earning before tax -£12.5

Taxes (40%)
Net Income
Herbert Plc Solution

a. Current cost of equity = Rf + β (Rm – Rf) = 7% + 1.12 (5.5%) = 13.16%

b. Current pre-tax cost of debt = Interest Expenses/Market value of debt = 10/100

= 10%
The after tax cost of debt = 10% (1 - 0.4) = 6%.

c. The firms current cost of capital (WACC) = D/V r d (1 - T) + E/V re

Where, rd = Pre-tax cost of debt and
rd (1 - T) = After-tax cost of debt.
Thus, WACC = 13.16% (500/600) + 6% (100/600) = 11.97%.
C) WACC=Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1-tax rate)

Here,
Weight of Equity & Debt:

MV of Equity = No. of Shares*MV Per Share

= 100*5
= £ 500

MV of Debt = £ 100 (given)

So, Weight of Equity: =

Weight of Debt: =
 WACC calculation if total cost of debt was 10% after
new debt; tax = 40%

Market
Weight Cost of Capital Weighted Cost
Value

Equity £500 83.33% 13.16% 0.8333 x 13.16% = 10.97%

Debt £100 16.67% 10% (1 - 0.4) = 0.1667 x 6% = 1.00%
6%
Total (D+E) £600 100% WACC = 11.97%
d.
WACC calculation if total cost of debt was 15% after new debt; tax = 40%
New Beta = 2.80 [Previous beta= 1.12]
The cost of new equity = Rf + β (Rm – Rf) = 7% + 2.80 (5.5%) = 22.40%
The after tax cost of debt = 15% (1 - 0.4) = 9%

Market
Weight Cost of Capital Weighted Cost
Value
Equity £150 25% 22.4% 0.25 x 22.4% = 5.6%
Debt £450 75% 15% (1 - 0.4) = 9% 0.75 x 9% = 6.75%
Total (D+E) £600 100% WACC = 12.35%
c&d
Comparison

Market Value Weight Cost of Capital Weighted Cost

Equity £500 83.33% 13.16% 10.97%

Debt £100 16.67% 10% (1 - 0.4) = 6% 1.00%
Total (D+E) £600 100% WACC = 11.97%

Market Value Weight Cost of Capital Weighted Cost

Equity £150 25% 22.4% 5.6%

Debt £450 75% 15% (1 - 0.4) = 9% 6.75%
Total (D+E) £600 100% WACC = 12.35%
ALTERNATIVE Solution: (i)
WACC calculation if new and old debt had different cost; tax = 40%
d.
New Beta = 2.80 [Previous beta= 1.12]
The cost of new equity = Rf + β (Rm – Rf) = 7% + 2.80 (5.5%) = 22.40%
The after new tax cost of debt = 15% (1 - 0.4) = 9%
Market
Weight Cost of Capital Weighted Cost
Value
Equity £150 25% 22.4% 0.25 x 0.224 = 5.6%
New Debt £350 58.33% 15% (1 - 0.4) = 9% 0.5833 x 0.09 = 5.25%
Old Debt £100 16.67% 10% (1 - 0.4) = 6% 0.1667 x 0.06 = 1%
Total (D+E) £600 100% WACC = 11.85%
ALTERNATIVE Solution: (ii)
d. WACC Calculation if the new debt had the same 10% cost; tax = 40%
New Beta = 2.80 [Previous beta= 1.12]
The cost of new equity = Rf + β (Rm – Rf) = 7% + 2.80 (5.5%) = 22.40%
The after tax cost of debt = 10% (1 - 0.4) = 6%

Market Value Weight Cost of Capital Weighted Cost

Equity £150 25% 22.4% 0.25x.224 = 5.6%
Debt £450 75% 10% (1 - 0.4) = 6% 0.75x.06 = 4.5%
Total (D+E) £600 100% WACC = 10.1%
 Market Value Weight Cost of Capital Weighted Cost
Solution 2 Equity £500 83.33% 13.16% 10.97%
Debt £100 16.67% 6% 1.00%
Total (D+E) £600 100% WACC = 11.97%

c&d Market Value Weight Cost of Capital Weighted Cost

Comparison Equity £150 25% 22.4% 5.6%
Debt £450 75% 9% 6.75%
Total (D+E) £600 100% WACC = 12.35%

Market Value Weight Cost of Capital Weighted Cost

Equity £150 25% 22.4% 5.6%
New Debt £350 58.33% 9% 5.25%
Old Debt £100 16.67% 6% 1%
Total (D+E) £600 100% WACC = 11.85%

Market Value Weight Cost of Capital Weighted Cost

Equity £150 25% 22.4% 5.6%
Debt £450 75% 6% 4.5%
Total (D+E) £600 100% WACC = 10.1%
 Practice Question:
Let's calculate the WACC for retail giant Walmart.
• In October 2018, the risk-free rate as represented by the annual
return on a 20-year treasury bond was 3.3 percent. Beta value for
Walmart stood at 0.51. Meanwhile, the average market return,
represented by average annualized total return for the S&P 500 index
over the past 90 years, was 9.8 percent. Cost of debt is 6.5% and tax
rate is 21%

• The total shareholder equity for Walmart for the 2018 fiscal year was
$77.87 billion (E), and the long term debt stood at $36.83 billion (D).
 Practice Question:

Market
Weight Cost of Capital Weighted Cost
Value
Equity 77.87 Re = 0.033 + 0.51 x 0.679 x 0.06615
(.098-.033) = 6.615% = 4.49%

Debt 36.83 .065 x (1 – 0.21) 0.331 x 0.0136

= 5.14% = 1.7%

Total (D+E) 114.7 100% WACC = 6.19%

 Concept of EVA

• Economic value added (EVA) is a financial measurement of the return

earned by a firm that is in excess of the amount that the company needs
to earn to appease shareholders.

• In other words, it is a measure of an organization’s economic profit that

takes into account the opportunity cost of invested capital and ultimately
measures whether organizational value/shareholders’ wealth has been
created or lost.
 Definition: EVA (2)
• EVA compares the rate of return on invested capital with the opportunity
cost of investing elsewhere. This is important for businesses to keep track
of, particularly those businesses that are capital intensive. When calculating
economic value added, a positive outcome means that the company is
creating value with its capital investments.

• Conversely, a negative outcome would mean that the company is

destroying value with its capital investments and the capital would be
better spent elsewhere. Businesses can use economic value added to assess
managerial performance as it serves as a measure of value creation
for shareholders.
EVA Formula

• The EVA formula is calculated using the following equation:

EVA = NOPAT – ( capital x cost of capital)

• In this formula, NOPAT stands for net operating profit after taxes. It is the
amount of money available for debtholders and shareholders after
paying tax. The figure used for cost of capital is often the weighted
average cost of capital, or WACC.
 XYZ Ltd
Ordinary shares (Cost of Equity or Ke = 15%) 200,000
Loan (Cost of debt or Kd = 10% )
100,000 Total Capital

300,000 50,000
Earnings before Interest and Tax (EBIT)
(-) Interest (100000 * 10%) . 10,000
Earnings Before Tax (EBT) 40,000
(-) Tax (40000 * 30%) . 12000
Accounting Profit/Earnings After Tax/Net Profit (EAT/NP). 28,000
(-) Cost of Equity (200000 * 15%) . 30000
Economic Value Added . -2,000

Accounting Profit doesn’t take Cost of Equity into consideration while EVA
does
 Cost of Capital means Weighted Average Cost of Capital

WACC= Rd + Re Without Tax

o D= Market value of debt

= (1/3)x0.10 + (2/3)x 0.15 WACC 2 o Rd= Cost of Debt

= 13.33% o E= Market value of debt

o Re= Cost of Equity
WACC= Rd x (1-T) + Re With Tax o T= Tax Rate
= (1/3)x0.10x(1-0.3) + (2/3)x 0.15 WACC 2
= 12.33%

WACC[1] WACC[2]
Earnings before Interest and Tax (EBIT) 50,000 50,000
(-) Tax (50000 * .30) . 15,000 15000
Net Operating Profit After Tax (NOPAT) 35,000 35,000
Economic Value Added 35000-(300000*0.1333) 35000-(300000*0.1233)
(NOPAT – capital * cost of capital) = -5,000 = -2,000
.
EVA calculated using WACC[1] doesn’t match with manually calculated EVA in the previous slide
because WACC[1] has been calculated excluding tax rate.
WACC Practice Example:

• Let’s assume the company $100m of debt and $100m of equity and
the cost of equity is 15% and cost of debt is 10%. The tax rate is 40%

• Therefore,
• WACC= ×Re+​×Rd×(1−T)
• = x0.10x(1-.40)
• = .075+.03 = 0.105 = 10.5%
 Financing Alternatives
• The need for cash is often the biggest concern of a business. Cash is required in day-to-day operations, as well as for
financing future growth.

• However, since few businesses experience the luxury of having large on-hand cash reserves waiting for investment,
they frequently seek additional financing.

• The funds needed to finance a firm’s operations or to purchase assets can be obtained from a large variety of
sources.
• One of management’s key responsibilities is to select the right type of financing to ensure the long-term profitability
of the business.

• Management must consider such diverse factors as the firm’s current debt levels, the financing costs, the accepted
risk level, the desire for corporate control, the flexibility to respond to future financing needs, and the pattern of the
capital structure in the industry.

• While the sources for funds are wide-ranging, essentially the options are limited to some basic alternatives. A
business can raise money either internally or externally.
Financing Alternatives
•These two generic headings contain the following subsets:
 Internal Financing
- Improve operating cash flow
- Adjust working capital
- Dispose of fixed assets
 External Financing
- Raise equity
- Take on debt — short-term or long-term financing

A closer look at the five options will be undertaken.

Internal Financing – Improve Operating
Cash Flow
•While this solution may seem to be the most obvious, it is often the most elusive.

•Furthermore, this option lacks the immediacy that is often needed when seeking
additional funds.

•Nevertheless, if it can be carried out, it is a very effective way of generating more

cash.

•A business essentially has two options to increase the positive spread between cash
revenues and cash expenses: it can increase revenues or it can cut back expenses.
Internal Financing – Improve Operating
Cash Flow
•Most businesses constantly seek to increase revenues; alas, in order to do so, they
often must increase expenses disproportionately.

•Costs such as advertising and promotion often rise substantially when the business
attempts to gain market share.

•Thus, while the solution to increase revenues seems to be the perfect solution, it is
often not implementable.

• Cutting cash costs is another way to generate cash.

Internal Financing – Improve Operating
Cash Flow
•Management will often consider laying off employees, cutting back on advertising,
and reducing so-called “luxury” accounts such as travel and entertainment.

•Care must be taken, however, to ensure that these cuts have a marginal effect on
sales.

•For instance, if the advertising budget were to be cut in half, the adverse effect on
sales might more than offset the promotional dollars saved.

•Nonetheless, management should be on the lookout for unnecessary cash expenses

to see if any cash could be kept in the firm.
Internal Financing – Adjust Working
Capital
•The excess of current assets over current liabilities is called working capital and is
another indication of short-term financial strength.

•Working capital is the amount that would remain if all current obligations were
paid (i.e., current liabilities); therefore, this tool assesses the company’s ability to
meet its short-term obligations as they come due.

•The working capital amount should be sufficient to meet these obligations on a

day-to-day basis.

•In an effort to improve a company’s working capital position, management will

examine how much cash can be generated by adjusting receivables, inventory and
payables, it is helpful to have a firm understanding of how the “days” ratios are
calculated (i.e., days of receivables, days of inventory, and days of payables).
 Internal Financing – Adjust Working
Capital
•Accounts Receivable

• An account receivable is established when a customer receives goods with payment

promised at a later date. Essentially, the customer is using the supplier as a source of credit.
• The quicker the customer pays, the less money the supplier has tied up in its customers
hands.
• Thus, in the most extreme case, a cash- strapped business could demand immediate
payment from all its customers and sell all subsequent goods on a COD (cash on delivery)
basis.
• Of course, by doing so, the supplier would likely lose many customers to a competitor with
more generous credit terms.
Internal Financing – Adjust Working
Capital
•Of course, by doing so, the supplier would likely lose many customers to a competitor
with more generous credit terms.

•Hence, a balance must be struck between the need for funds by way of debt collection, and
the potential for lost sales.

•In a more realistic sense, businesses with historically lax credit policies are more likely to
be able to achieve a one-time inflow of cash by decreasing the days that it takes to collect
cash from a credit sale.

•In order to calculate the amount of cash that can be generated from an expedited collection
strategy, either of the following formulas may be used:
Internal Financing – Adjust Working
Capital
• Cash generated by decreasing the days of outstanding receivables =
(days by which outstanding A/R are reduced) × average daily credit sales

For example, assume that Bigco Inc. earned $360,000 in credit sales last year. At year
end, 50 days of accounts receivable were still outstanding.

• If Bigco expected similar credit sales for the upcoming year, and could reduce
its days of outstanding receivables to the industry norm of 30 days, it could
generate $20,000.

(50 days – 30 days) × $360,000 Credit Sales = $20,000

360 days
Internal Financing – Adjust Working
Capital
• A firm with considerable inventory stocks has money tied up in those stocks which could
be put to use elsewhere.

• By reducing the number of days that inventory remains in the possession of the business,
a firm can generate cash.

• In order to calculate exactly how much cash can be generated through an inventory
reduction strategy, the following formulas can be used:
Internal Financing – Adjust Working
Capital
• Cash generated by lowering inventory =
(days by which on-hand inventory is reduced) × average daily COGS

• When determining that an inventory reduction strategy is a good way to generate

additional funds, a business should take care to ensure that inventory levels are not
dropped to a point where stock-outs may result.

• Furthermore, a firm with substantial inventory may do so in order to take advantage of

generous supplier bulk discounts, or to minimize lead-times required for an order.
Internal Financing – Inventory
• Nevertheless, it is quite possible that a firm has considerable excess inventory for
no real justifiable reason and would improve its cash flow immensely by reducing
the number of days of inventory on hand.
• For example, Bigco Inc. noticed that its cost of goods sold for all sales (cash or
credit) totalled $504,000 last year.

• A total of $168,000 (or 120 days) worth of inventory was on hand at year-end.

•If Bigco could reduce its inventory levels to the industry average of 90 days, it
could generate $42,000 calculated as follows:
(120 days – 90 days) × $504,000 cost of goods sold = $42,000
360 days
Internal Financing – Inventory
• Accounts Payable

•A payable works in the opposite manner to a receivable.

•Businesses often use suppliers as a source of short-term financing by delaying

payment to the suppliers as long as possible.

•The longer a buyer takes to pay suppliers, the longer the money is available for the
buyer to use elsewhere.

• While payables are a financing source, care must be taken that buyers do not upset quality
suppliers by delaying payment to an unacceptable level.
Internal Financing – Inventory
• Nervous creditors are likely to take drastic action (such as lawsuits) in order to
collect monies owed to them by delinquent payers.

•Furthermore, a business can quickly earn a reputation for being a poor credit risk
which would make finding reliable suppliers willing to offer credit terms much
more difficult.

•As well, some businesses may decide to pay very quickly thereby taking advantage
of supplier credit terms.
Internal Financing – Inventory
• To calculate the cash that can be generated by extending the supplier borrowing
period (i.e. stretching the accounts payable a little longer) either of these two
formulas will work:

Cash generated from stretching accounts payable =

(days by which payables can be stretched) × average daily purchases

•For example, of the $270,000 in credit purchases made by Bigco, the firm still
owed $33,750 by year-end (or a total of 45 days of outstanding accounts payable).

•Bigco was not taking advantage of supplier discounts. If Bigco stretched its payables to the
industry average of 60 days, it could then generate $11,250 in cash.
(60 days – 45 days) × $270,000 credit purchases = $11,250
360 days
Internal Financing – Inventory
• If Bigco combined all three adjustments to working capital, a total of $73,250
could be generated internally.

•Proceeds from working capital adjustments represent a one-time source of cash

(unless similar adjustments can be made in subsequent years).

•Additionally, an implementation strategy may be very difficult to formulate, and

ample time would be needed for results to become evident.

•Nevertheless, it is helpful to see if monies can be raised internally before seeking

external debt or equity financing, particularly if the monies are needed for a short-
term use.
Internal Financing – Reduce Fixed Asset
• Sometimes a firm will raise funds by selling off unneeded fixed assets such as
land, buildings, and equipment. Usually this is an undesirable strategy used by
firms with few other alternatives.

•Often a fair return cannot be obtained for the assets, especially if the money is
needed quickly.

•Furthermore, this is a stopgap solution that can seldom be repeated for future
needs.

•Nevertheless, there are some times when a disposal strategy makes sense.
Internal Financing – Reduce Fixed Asset
•If, for instance, an asset was purchased in anticipation of growth that now seems
unlikely, or if a firm is operating significantly below capacity, or if a firm has a
stake in another company that does not contribute to the main business, the
decision to sell off assets may be prudent.

•A very low asset turnover ratio frequently points to such a scenario.

• When judging the potential return from such a strategy, it is important to be conservative
in the market value assessment of an asset, particularly when disposing of equipment.
• Management must be careful not to hold “fire sales” to solve short-term financing
problems.
Internal Financing – Reduce Fixed Asset
•A redundant, two-year-old piece of production machinery that originally cost
$1,000,000, may have a mere $200,000 resale value once one considers the
machine’s current book value, the state of the industry (which may be operating at
overcapacity), and technological improvements made to similar equipment over
the past few years.
External Financing – Raise Equity
• Infusions of equity are considered long-term sources and thus should be used to
finance long-term ventures.

•Certainly, a firm must have a solid equity base before it can expect to receive any
significant debt financing.

•Often, a debt-to-equity ratio is calculated to determine the likelihood of a

company receiving external financing.

•Typically, a high debt-to-equity ratio indicates a risky company.

External Financing – Raise Equity
•Unfortunately, many firms with a high debt-to-equity ratio arrive that way not
because of their “secure” nature, but rather because successive net losses have
diminished the equity base.

•After all, debt to equity rises not only if debt increases and equity remains
constant, but also if equity goes down and debt remains constant.

•As the debt-to-total assets ratio gets closer and closer to 100 per cent, the business
ownership transfers more and more to the creditors.

•While an 81 per cent debt-to-total assets ratio is acceptable for power companies, a
similar ratio for a gold mine indicates trouble.
External Financing – Raise Equity
•Equity can be raised privately or publicly; however, few businesses qualify for
public issuance.

•When raising private equity, the owner seeks out individual investors: business
contacts, successful college buddies, venture capitalists.

•Public issues occur when monies are raised from the general public or an
investment dealer (who buys securities from the business and then sells them
publicly).

• Equity financing has many advantages. A strong equity base allows the company the
flexibility for future ventures. Furthermore, while dividend payments are paramount for
future investment, in a worst-case scenario, they may be postponed (unlike interest
payments).
External Financing – Raise Equity
•However, there are some disadvantages.

•Investors demand results — equity infusions may put more pressure on the firm to
succeed in the short term rather than developing a competent long-term plan.

•Moreover, the owners of the business must be willing to give up some control over
the business. Last, but certainly not least, equity is more expensive than debt.

•Interest payments are considered an expense and are, therefore, tax deductible
whereas dividends are not expensed.

•Consider the following example: a $100,000 dividend payment is fully realized by

the firm (Scenario A), whereas a $100,000 interest payment, with a tax rate of 40
per cent, is really only costing the company $60,000 (Scenario B).
External Financing – Raise Equity
•In this case, the retained earnings account is increased by $40,000 more if
the firm uses debt rather than equity financing.
External Financing – Take on Debt
•Debt financing is another manner in which businesses can raise funds.

•Both long-term and short-term debt financing are available.

•Businesses should exercise care when selecting the medium of financing.

•Short-term financing should be used only for short-term uses; whereas, long-term
uses ideally should be funded through long-term debt.

•For instance, it would be unwise for a business to fund the purchase of a new plant
with a 90-day note.
External Financing – Take on Debt
•In order to qualify for credit, a business must meet the criteria used by lenders.
These criteria are often referred to as the four C’s of Credit: business Conditions,
Character, Capacity to repay, and Collateral.

•Conditions refer to the environment surrounding the business. In what shape is

the industry? What external forces could affect the business? Is there a target
market for the firm’s product(s)? Prospective borrowers should perform favorably
on these scales.
External Financing – Take on Debt
•Character refers to the professionalism, dependability, accountability, honesty and
reputation of the prospective borrower. Past performance of the business and
previous experiences with the principal borrower affect a lender’s “character”
judgement. For instance, a bank may look unfavorably on a corporation owned by
a sole shareholder that paid out very high dividends despite poor earnings.

•Capacity to repay has a dual meaning. First, would the business have sufficient
cash flow to make all necessary principal and interest payments? Interest coverage
ratios are often used to answer this question. Second, what seems to be
management’s ability to use the additional financing wisely and prudently? Is the
firm capable of making money?
External Financing – Take on Debt
•Collateral is the pledge offered by a business in exchange for funds. If a business
stops operating or is liquidated, ownership of the physical assets used as collateral
would be rightly transferred to the lender.

•When determining the value of an asset used for collateral, the lender will likely
not use the asset’s book value, but rather its liquidation value.

•Lenders make an educated guess as to the net realizable value of the asset and
discount accordingly.
External Financing – Take on Debt
•Thus, a piece of machinery with a book value of $500,000 may be discounted by
50 per cent because of the difficulty involved in the resale of the equipment.

•Loans that require a collateral pledge are considered secured unlike unsecured
loans which are based on the faith and trust of the borrower.

•Firms with a high debt-to-equity ratio will usually have to secure the loan since
lenders worry about receiving payment, as there would be less money to go around
should the business fail and become insolvent.
External Financing – Take on Debt
•Short-term Financing

•Short-term financing, generally used to categorize loans that are less than two
years in duration, is usually handled by chartered banks.

•Firms with good credit ratings may be able to use options such as a line of credit,
revolving credit, or interim financing.

•An operating line of credit is an agreement between the borrower and the bank
whereby a temporary short-term loan is granted to a firm.
External Financing – Take on Debt
•The business uses these funds, as needed, to help finance day-to-day operations.
This method is usually desired for seasonal businesses who, needing to produce for
a peak season, experience a cash strain for only a limited time period during the
year.

•Revolving credit is similar in nature. Here the bank sets a maximum amount which
the firm may borrow. The business then uses the funds to help finance day-to-day
operations. Interest is paid only on the outstanding balance; however, the banks
usually charge a higher rate of interest to compensate for the additional risk.
External Financing – Take on Debt
•Interim financing (alias bridge financing) is a temporary loan that allows a
business to start a long-term project (such as a new plant construction) before the
balance of financing (such as a mortgage payment) is in place. A strong working
relationship with the financial institution is usually required for such an option.

•These three short-term loans may either be secured or unsecured.

•Unsecured loans are larger risks for the bank and are, therefore, offset with higher
interest rates.

•However, they offer the businesses greater flexibility in their operations.

External Financing – Take on Debt
• Firms unable to obtain unsecured credit because of low credit standing or an
unproven track record, will have to pledge some assets as security.

•Secured loans are more common, especially with small businesses.

•Short-term assets such as accounts receivable and inventory are often used for
collateral (since non-current assets are usually financed by long-term secured
mortgages).

•For instance, a loan may be tied to accounts receivable whereby the bank agrees to
allow a revolving credit line up to a maximum of 75 per cent of receivables.

•The borrower is obliged to inform the bank, on a continuous basis, of the status of
the accounts receivable.
External Financing – Take on Debt
•Long-term and Intermediate Financing

•Loans that are to be paid off over several years are usually referred to as long-term
loans.

•Long-term debt usually finances long-term assets such as land, major equipment
purchases, and buildings. Mortgages are the most common form of long-term debt.

•The mortgaged asset is used to secure the loan.

•Payment terms are pre-scheduled and include both interest and principal
components.
External Financing – Take on Debt
•Interest rates are usually a few percentage points above the prime rate.

•Sometimes loans of two to five years are referred to as intermediate financing.

•This medium-term financing is usually sought by businesses needing an on-going

cash inflow, or assets with a relatively short useful life, such as equipment. Term
loans used to finance equipment purchases are considered intermediate.

•These are loans tailored to suit the needs of the borrower and are usually
accompanied by covenants.

•A business may have to pledge that no additional borrowing will take place, or that
salaries of the company executives cannot increase unless approved by the lender.
External Financing – Take on Debt
•Larger, stable, established firms can often borrow from the general public by issuing bonds.

•Unfortunately, this long-term option is not available to the majority of businesses.

•While debt financing is cheaper than equity financing, the firm’s decision-making flexibility is
somewhat restricted.

•Risk-averse creditors, who now have a stake in the business, will often guard their investment by
placing strict covenants on the borrower, thereby limiting future decisions to more conservative
options.

•Borrowers must ensure that cash flow is always sufficient to make debt payments, lest they risk
provoking a nervous creditor into calling the loan.

•Nevertheless, with proper management, debt, in moderation, is a useful and often necessary tool for
all businesses.
Case in Point

•At the risk of oversimplifying, a parallel can be drawn between a business’s need
for more cash and a student’s need for more cash (particularly as the school year
closes).

•Let’s assume you realize that only $50 is left in your savings account, yet you still
have a month of school.

•You suddenly take on the role of financial manager. How could you generate
funds?
Case in Point
1. You may wish to generate the funds internally by improving “net income”.

You seek additional revenue: you may get a part-time job or you may buy more lottery
tickets. You may try to cut back on expenses.

For instance, your entertainment budget, which was $75 per week in September is now
cut back to $25 per month.

The food bills are altered so that macaroni and cheese now becomes a “treat”.
Case in Point
2. You may try to generate funds internally by manipulating your “working capital”.

You could reduce your “days of receivables” by getting on the phone and asking all your
friends (customers) to pay back the money they owe you.

You could reduce your “inventory”. Instead of buying $20 worth of groceries, you scrounge
the kitchen and eat whatever is left over (thereby generating $20). You could stretch your
“payables” by not paying back all those people to whom you owe money until the school
year is out (suppliers).

Care must be taken that you do not alienate all your suppliers and buyers. You must try to
avoid food stock-outs or else you will go hungry.
Case in Point
3. You may try to dispose of any “fixed assets”. You could sell your old car, your
stereo or any other personal item that has value.

You would rather seek other means since this cash crunch is only short-term.

4. You may go (further) into debt. You may increase your debt on your credit card
bills.

You may seek additional loans from home. However, this option may be tricky if
you already owe significant amounts of money since the people from whom you are
borrowing worry about your capacity to repay.

They may notice a poor “debt-to-equity” ratio and request some equity contribution
from you.
Case in Point
5. You may try and raise equity. You increase your personal investment in the
business (i.e., your school year) by throwing in the money that you had saved for
your vacation.

You may seek additional financing from an outside investor who feels your
education is a worthy investment (i.e., call Mom with a heart-warming plea).

However, you may no longer have complete control of your finances. For instance,
the additional investors may want proof that the funds are necessary for survival
and are not just “comfort dollars” so that you may attend a Blue Jays’ game.
Conclusion
•Finding the proper financing is often “easier said than done.”

•Many businesses have to forgo potentially excellent opportunities because of a

lack of cash.

•Nevertheless, if all avenues are explored, a solution that is beneficial in both the
short term and the long term can probably be found.
Thank you for your attention!
Any questions?