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Winsem2012 13 cp1056-08-jan-2013_rm01_lecture-2--financing-the-corporate-venture

  1. Financing the Corporate Venture
  2. How to finance? • Prior to WWI, companies were owned and operated by the founders. • Funds for various expenditures (replacement of worn-out equipment, modest plant expansions) from the company earnings. • After WWII, internal funds not sufficient to meet company needs. – Mergers – Acquisitions – Joint ventures – Alliances • External sources the only option for large-scale projects.
  3. Business Plans • A business plan must be developed before any funds are sought for a new product or venture. • Business Plans minimally consist of the following information along with a projected timetable: – Perceived goals and objectives of the company – Market data • Projected share of the market • Market Prices • Market Growth • Market the company serves • Competition, both domestic and global • Project and/or product life
  4. Business Plans – Capital requirements • Fixed capital investment • Working capital • Other capital requirements – Operating expenses • Manufacturing expenses • Sales expenses • General overhead expenses – Profitability • Profit after taxes • Cash flow • Payout period • Rate of return • Returns on equity and assets • Economic value added
  5. Business Plans – Projected risk • Effect of changes in revenue • Effect of changes in direct and indirect expenses • Effect of cost of capital • Effect of potential changes in market competition – Project life: • Estimated life cycle of the product or venture • The business plan is then submitted to the sources of capital funding, e.g., investment banks, insurance companies.
  6. Sources of Funds • The funding available for corporate ventures may be obtained from internal or external sources. • Internal financing is “owned” capital – could be loaned or invested in other ventures to receive a given return. • Internal funds may be retained earnings or reserves. • Retained earnings of a company are the difference between the after-tax earnings and the dividends paid to stockholders. • Usually not all after-tax earnings are distributed as dividends. • The part retained by company is used for R&D expenditures or for capital projects. • Reserves are to provide for depreciation, depletion and obsolescence. • Inflation cuts severely into reserves.
  7. Sources of Funds • Three sources of external financing: – Debt – Preferred stock – Common stock • A new venture with modest capital requirements could be funded by common stock. • In contrast, a well-established business area may be financed by debt.
  8. Debt • Debt may be classified as: – Current debt: maturing up to 1 year – Intermediate debt: maturing between 1 and 10 years – Long-term debt: maturing beyond 10 years • Current debt: Suppose a company wants to take a loan it will pay off in 90-120 days. – It can obtain a commercial loan from a bank. – It can borrow from the open market using a negotiable note called commercial paper. – Open-market paper or banker’s acceptance: The company could sign a 90-day draft on its own bank paid to the order of the vendor; the company will pay a commission to its own bank to accept in writing the draft.
  9. Debt • Intermediate debt: – This form of debt is retired in 1-10 years – Three types: • Deferred payment contract: borrower signs a note that specifies a series of payments to be made over a period of time. • Revolving credit: the lender agrees to loan a company an amount of money for a specified time period. A commission or fee is paid on the unused portion of the total credit. • Term loans: divided into installments that are due at specified maturity dates. Monthly, quarterly, semiannual or annual payments.
  10. Debt • Long-term debt: – Bonds are special kinds of promissory notes. – Four types of bonds in the market: • Mortgage bonds – backed by specific pledged assets that may be claimed particularly if the company goes out of business. • Debenture bonds – only a general claim on the assets of a company. Not secured by specific assets but by the future earning power of the company. • Income bonds –interest is paid not on loan taken but on earnings in that period; used to recapitalize after bankruptcy and the company has uncertain earning power. • Convertible bonds – hybrids that can be converted to stock. Bonds are safe investments in periods of low inflation or deflation. Stocks reflect the inflationary trend and retain purchasing power.
  11. Stockholders’ Equity • This is the total equity interest that stockholders have in a corporation. • Two broad classes: – Preferred stock • These stockholders receive their dividends before common stockholders. • These stockholders recover funds before common stockholders in case of company liquidation. • Have no vote in company affairs. – Common stock • Common stockholders are at greatest risk because they are the last to receive dividends for use of their money. • Have a voice in company affairs at the company annual meetings.
  12. Debt versus Equity Financing • The question is a complex one and depends on other issues: – State of the economy – Company’s cost of capital, i.e. cost of borrowing from all sources. – Current level of indebtedness • If a company has a large proportion of its debt in bonds, it may not be able to cover the interest on bonds. • A high debt/equity ratio is a weakness. • Many capital-intensive industries like chemicals, petroleum, steel etc have ratios of 2 or 3 to 1. • They may have to liquidate some of their assets to survive. • On the other hand, if ratio is 1 to 1, chance of a takeover. • A company must have a debt/equity ratio similar to successful companies in the same line of business.
  13. In Conclusion • The largest holders of corporate securities are “institutional” investors. • These include – Insurance companies – Educational organizations – Philanthropic organizations – Religious organizations – Pension funds • They may purchase securities in a “private” placement or in the open market as initial public offerings (IPO).