Financing the Corporate Venture

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.

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

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

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.

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.

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.

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.

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.

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.

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.

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.

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).