Finance

A multinational corporation (MNC) is present in several countries, which improves the company’s ability to maintain market share and earn higher profits.
As GDP growth migrates from mature economies, such as the US and EU member states, to developing economies, such as China and India, it becomes highly relevant to capture growth in higher growth markets.
Despite the general opportunities a global market provides, there are significant challenges in penetrating these markets. These consist of public relations, ethics, corporate structure, and leadership.
Combining these challenges with the inherent opportunities a global economy presents, companies are encouraged to pursue high value opportunities while carefully controlling the risks involved.

Key Terms

economies of scope: Lowering average cost for a firm in producing two or more products through the common and recurrent use of proprietary know-how or an indivisible physical asset.
economies of scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.
value-chain: The series of operations necessary for a business to operate.

Global Corporations

A global company is generally referred to as a multinational corporation (MNC). An MNC is a company that operates in two or more countries, leveraging the global environment to approach varying markets in attaining revenue generation. These international operations are pursued as a result of the strategic potential provided by technological developments, making new markets a more convenient and profitable pursuit both in sourcing production and pursuing growth.

International operations are therefore a direct result of either achieving higher levels of revenue or a lower cost structure within the operations or value-chain. MNC operations often attain economies of scale, through mass producing in external markets at substantially cheaper costs, or economies of scope, through horizontal expansion into new geographic markets. If successful, these both result in positive effects on the income statement (either larger revenues or stronger margins), but contain the innate risk in developing these new opportunities.

Opportunities

As gross domestic product (GDP) growth migrates from mature economies, such as the US and EU member states, to developing economies, such as China and India, it becomes highly relevant to capture growth in higher growth markets. is a particularly strong visual representation of the advantages a global corporation stands to capture, where the darker green areas reppresent where the highest GDP growth potential resides. High growth in the external environment is a strong opportunity for most incumbents in the market.

GDP Growth Rate by Country

This map highlights where the strongest growth opportunities currently are, as of 2010. In that year China and India had the highest GDP growth rates.

Challenges

However, despite the general opportunities a global market provides, there are significant challenges MNCs face in penetrating these markets. These challenges can loosely be defined through four factors:

Public Relations: Public image and branding are critical components of most businesses. Building this public relations potential in a new geographic region is an enormous challenge, both in effectively localizing the message and in the capital expenditures necessary to create momentum.
Ethics: Arguably the most substantial of the challenges faced by MNCs, ethics have historically played a dramatic role in the success or failure of global players. For example, Nike had its brand image hugely damaged through utilizing ‘sweat shops’ and low wage workers in developing countries. Maintaining the highest ethical standards while operating in developing countries is an important consideration for all MNCs.
Organizational Structure: Another significant hurdle is the ability to efficiently and effectively incorporate new regions within the value chain and corporate structure. International expansion requires enormous capital investments in many cases, along with the development of a specific strategic business unit (SBU) in order to manage these accounts and operations. Finding a way to capture value despite this fixed organizational investment is an important initiative for global corporations.
Leadership: The final factor worth noting is attaining effective leaders with the appropriate knowledge base to approach a given geographic market. There are differences in strategies and approaches in every geographic location worldwide, and attracting talented managers with high intercultural competence is a critical step in developing an efficient global strategy.

Combining these four challenges for global corporations with the inherent opportunities presented by a global economy, companies are encouraged to chase the opportunities while carefully controlling the risks to capture the optimal amount of value. Through effectively maintaining ethics and a strong public image, companies should create strategic business units with strong international leadership in order to capture value in a constantly expanding global market.

21.1.2: Countertrade

Countertrade is a system of exchange in which goods and services are used as payment rather than money.

Learning Objective

Explain the various methods of countertrading

Key Points

Countertrade is the exchange of goods or services for other goods or services. This system can be typified as simple bartering, switch trading, counter purchase, buyback, or offset.
Switch trading: Party A and B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Key Terms

Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.
counter purchase: Sale of goods and services to one company in another country by a company that promises to make a future purchase of a specific product from the same company in that country.
barter: The exchange of goods or services without involving money.

Examples

Bartering: One party gives salt in exchange for sugar from another party.
Switch trading: Party A and Party B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Countertrade means exchanging goods or services which are paid for, in whole or part, with other goods or services, rather than with money. A monetary valuation can, however, be used in counter trade for accounting purposes. Any transaction involving exchange of goods or service for something of equal value.

Bartering

Bartering involves exchanging goods or services for other goods or services as payment.

A newspaper illustration in Harper’s Weekly where two men engaging in a barter. One man offers chickens in exchange for his yearly newspaper subscription.

There are five main variants of countertrade:

Barter: Exchange of goods or services directly for other goods or services without the use of money as means of purchase or payment.
Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.
Counter purchase: Sale of goods and services to one company in aother country by a company that promises to make a future purchase of a specific product from the same company in that country.
Buyback: This occurs when a firm builds a plant in a country, or supplies technology, equipment, training, or other services to the country, and agrees to take a certain percentage of the plant’s output as partial payment for the contract.
Offset: Agreement that a company will offset a hard currency purchase of an unspecified product from that nation in the future. Agreement by one nation to buy a product from another, subject to the purchase of some or all of the components and raw materials from the buyer of the finished product, or the assembly of such product in the buyer nation.

Countertrade also occurs when countries lack sufficient hard currency or when other types of market trade are impossible. In 2000, India and Iraq agreed on an “oil for wheat and rice” barter deal, subject to UN approval under Article 50 of the UN Persian Gulf War sanctions, that would facilitate 300,000 barrels of oil delivered daily to India at a price of $6.85 a barrel, while Iraq oil sales into Asia were valued at about $22 a barrel. In 2001, India agreed to swap 1.5 million tonnes of Iraqi crude under the oil-for-food program.

21.1.3: Multinational Firms

With the advent of improved communication and technology, corporations have been able to expand into multiple countries.

Learning Objective

Explain how a multinational corporation (MNC) operates

Key Points

Multinational corporations operate in multiple countries.
MNCs have considerable bargaining power and may negotiate business or trade policies with success.
A corporation may choose to locate in a special economic zone, a geographical region that has economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Key Term

Multinational corporation: A corporation or enterprise that operates in multiple countries.

Example

McDonalds operates in over 119 different countries, making it a fairly large MNC by any standard

A multinational corporation (MNC) or multinational enterprise (MNE) is a corporation registered in more than one country or has operations in more than one country. It is a large corporation which both produces and sells goods or services in various countries . It can also be referred to as an international corporation. The first multinational corporation was the Dutch East India Company, founded March 20, 1602.

Ford

Ford is a multinational corporation with operations throughout the world.

Corporations may make a foreign direct investment. Foreign direct investment is direct investment into one country by a company located in another country. Investors buy a company in the country or expand operations of an existing business in the country.

A corporation may choose to locate in a special economic zone, a geographical region with economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Multinational corporations are important factors in the processes of globalization. National and local governments often compete against one another to attract MNC facilities, with the expectation of increased tax revenue, employment and economic activity. To compete, political powers push toward greater autonomy for corporations. MNCs play an important role in developing economies of developing countries.

Many economists argue that in countries with comparatively low labor costs and weak environmental and social protection, multinationals actually bring about a “race to the top.” While multinationals will see a low tax burden or low labor costs as an element of comparative advantage, MNC profits are tied to operational efficiency, which includes a high degree of standardization. Thus, MNCs are likely to adapt production processes in many of their operations to conform to the standards of the most rigorous jurisdiction in which they operate.

As for labor costs, while MNCs pay workers in developing countries far below levels in countries where labor productivity is high (and accordingly, will adopt more labor-intensive production processes), they also tend to pay a premium over local labor rates of 10% to 100%.

Finally, depending on the nature of the MNC, investment in any country reflects a desire for a medium- to long-term return, as establishing a plant, training workers and so on can be costly. Therefore, once established in a jurisdiction, MNCs are potentially vulnerable to arbitrary government intervention like expropriation, sudden contract renegotiation and the arbitrary withdrawal or compulsory purchase of licenses. Thus both the negotiating power of MNCs and the “race to the bottom” critique may be overstated while understating the benefits (besides tax revenue) of MNCs becoming established in a jurisdiction.

21.1.4: Direct Investment

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other privileges in that foreign country.

Learning Objective

Explain the effects of foreign direct investment (FDI) for the investor and the host country

Key Points

FDI is the flow of investments from one company to production in a foreign nation, with the purpose of lowering labor costs and gaining tax incentives.
FDI can help the economic situations of developing countries, as well as facilitate progressive internal policy reforms.
A major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions.

Key Term

Foreign direct investment: investment directly into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Example

Intel is headquartered in the United States, but it has made foreign direct investments in a number of Southeast Asian countries where they produce components of their products in Intel-owned factories.

Foreign direct investment (FDI) is investment into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

FDI is done for many reasons including to take advantage of cheaper wages in the country, special investment privileges, such as tax exemptions, offered by the country as an incentive to gain tariff-free access to the markets of the country or the region. FDI is in contrast to portfolio investment which is a passive investment in the securities of another country, such as stocks and bonds.

One theory for how to best help developing countries, is to increase their inward flow of FDI. However, identifying the conditions that best attract such investment flow is difficult, since foreign investment varies greatly across countries and over time. Knowing what has influenced these decisions and the resulting trends in outcomes can be helpful for governments, non-governmental organizations, businesses, and private donors looking to invest in developing countries.

Sao Paulo, Brazil

Sao Paulo, Brazil, is home to a growing middle class and significant direct investments.

Paulista Avenue in Sao Paulo, Brazil.

A study from scholars at Duke University and Princeton University published in the American Journal of Political Science, “The Politics of Foreign Direct Investment into Developing Countries: Increasing FDI through International Trade Agreements,” examines trends in FDI from 1970 to 2000 in 122 developing countries to assess what the best conditions are for attracting investment. The study found the major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions. The researchers conclude that, while “democracy can be conducive to international cooperation,” the strongest indicator for higher inward flow of FDI for developing countries was the number of trade agreements and institutions to which they were party.

21.1.5: Offshoring

Offshoring entails a company moving a business process from one country to another.

Learning Objective

Explain the benefits of offshoring

Key Points

Offshoring is the relocation of certain business processes from one country to the other, resulting in large tax breaks and lower labor costs.
Offshoring can cause controversy in a company’s domestic country since it is perceived to impact the domestic employment situation negatively.
Offshoring of a company’s services that were previously produced domestically can be advantageous in lowering operation costs, but has incited some controversy over the economic implications.

Key Terms

offshoring: The location of a business in another country for tax purposes.
outsourcing: The transfer of a business function to an external service provider.
captive: held prisoner; not free; confined

“Offshoring” is a company’s relocation of a business process from one country to another. This typically involves an operational process, such as manufacturing, or a supporting process, such as accounting. Even state governments employ offshoring. More recently, offshoring has been associated primarily with the sourcing of technical and administrative services that support both domestic and global operations conducted outside a given home country by means of internal (captive) or external (outsourcing) delivery models.The subject of offshoring, also known as “outsourcing,” has produced considerable controversy in the United States. Offshoring for U.S. companies can result in large tax breaks and low-cost labor.

Worldwide Offshoring Business

The worldwide offshoring business is projected to equal $500 billion by 2020.

A chart that shows growth in the worldwide offshoring business.

Offshoring can be seen in the context of either production offshoring or services offshoring. After its accession to the World Trade Organization (WTO) in 2001, the People’s Republic of China emerged as a prominent destination for production offshoring. Another focus area includes the software industry as part of Global Software Development and the development of Global Information Systems. After technical progress in telecommunications improved the possibilities of trade in services, India became a leader in this domain; however, many other countries are now emerging as offshore destinations.

The economic logic is to reduce costs. People who can use some of their skills more cheaply than others have a comparative advantage. Countries often strive to trade freely items that are of the least cost to produce.

Related terms include “nearshoring,” “inshoring,” and “bestshoring,” otherwise know as “rightshoring.” Nearshoring is the relocation of business processes to (typically) lower cost foreign locations that are still within close geographical proximity (for example, shifting United States-based business processes to Canada/Latin America). Inshoring entails choosing services within a country, while bestshoring entails choosing the “best shore” based on various criteria. Business process outsourcing (BPO) refers to outsourcing arrangements when entire business functions (such as Finance & Accounting and Customer Service) are outsourced. More specific terms can be found in the field of software development; for example, Global Information System as a class of systems being developed for/by globally distributed teams.

21.1.6: Outsourcing

Outsourcing business functions to developing foreign countries has become a popular way for companies to reduce cost.

Learning Objective

Explain why companies outsource

Key Points

Outsourcing is the contracting of business processes to external firms, usually in developing countries where labor costs are cheaper.
This practice has increased in prevalence due to better technology and improvements in the educational standards of the countries to which jobs are outsourced.
The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Key Terms

insourcing: The obtaining of goods or services using domestic resources or employees as opposed to foreign.
outsourcing: The transfer of a business function to an external service provider.
offshoring: The location of a business in another country for tax purposes.

Example

Corporations may outsource their helpdesk or customer service functions to 3rd party call centers in foreign countries because these skilled laborers can do these jobs at a lesser cost than their equivalents in the domestic country.

Outsourcing

Overview

Outsourcing is the contracting out of a business process, which an organization may have previously performed internally or has a new need for, to an independent organization from which the process is purchased back as a service. Though the practice of purchasing a business function—instead of providing it internally—is a common feature of any modern economy, the term outsourcing became popular in America near the turn of the 21^st century. An outsourcing deal may also involve transfer of the employees and assets involved to the outsourcing business partner. The definition of outsourcing includes both foreign or domestic contracting , which may include offshoring, described as “a company taking a function out of their business and relocating it to another country. “

Outsourcing

Outsourcing is the process of contracting an existing business process to an independent organization. The process is purchased as a service.

Businessmen talk and shake hands.

The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Reasons for Outsourcing

Companies outsource to avoid certain types of costs. Among the reasons companies elect to outsource include avoidance of burdensome regulations, high taxes, high energy costs, and unreasonable costs that may be associated with defined benefits in labor union contracts and taxes for government mandated benefits. Perceived or actual gross margin in the short run incentivizes a company to outsource. With reduced short run costs, executive management sees the opportunity for short run profits while the income growth of the consumers base is strained. This motivates companies to outsource for lower labor costs. However, the company may or may not incur unexpected costs to train these overseas workers. Lower regulatory costs are an addition to companies saving money when outsourcing.

Import marketers may make short run profits from cheaper overseas labor and currency mainly in wealth consuming sectors at the long run expense of an economy’s wealth producing sectors straining the home county’s tax base, income growth, and increasing the debt burden. When companies offshore products and services, those jobs may leave the home country for foreign countries at the expense of the wealth producing sectors. Outsourcing may increase the risk of leakage and reduce confidentiality, as well as introduce additional privacy and security concerns.

21.1.7: Licensing

When considering strategic entry into an international market, licensing is a low-risk and relatively fast foreign market entry tactic.

Learning Objective

Identify the benefits and risks associated with licensing as a foreign market entry model

Key Points

Foreign market entry options include exporting, joint ventures, foreign direct investment, franchising, licensing, and various other forms of strategic alliance.
Of these potential entry models, licensing is relatively low risk in terms of time, resources, and capital requirements.
Advantages of licensing include localization through a foreign partner, adherence to strict international business regulations, lower costs, and the ability to move quickly.
Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign market, and lower returns due to lower risk.
When deciding to license abroad, careful due diligence should be done to ensure that the licensee is a strong investment for the licensor and vice versa.

Key Terms

licensee: In a licensing relationship, the buyer of the produce, service, brand or technology being licensed.
licensor: In a licensing relationship, the owner of the produce, service, brand or technology being licensed.

When considering entering international markets, there are some significant strategic and tactical decisions to be made. Exporting, joint ventures, direct investment, franchising, licensing, and various other forms of strategic alliance can be considered as market entry modes. Each entry mode has different pros and cons, addressing issues like cost, control, speed to market, legal barriers, and cultural barriers with different degrees of efficiency.

Licensing

The 1933 Fiat 508 was manufactured under a license in Poland by Polski Fiat.

What is Licensing

A licensor (i.e. the firm with the technology or brand) can provide their products, services, brand and/or technology to a licensee via an agreement. This agreement will describe the terms of the strategic alliance, allowing the licensor affordable and low risk entry to a foreign market while the licensee can gain access to the competitive advantages and unique assets of another firm. This is potentially a strong win-win arrangement for both parties, and is a relatively common practice in international business.

Let’s consider an example. The licensor is a company involved in energy health drinks. Due to food import regulations in Japan, the licensor cannot sell the product at local wholesalers or retailers. In order to circumvent this strategic barrier, the licensor finds a local sports drink manufacturer to license their recipe to. In exchange, the licensee sells the product locally under a local brand name and kicks back 15% of the overall revenues to the licensor.

The Pros and Cons

Before deciding to use licensing as an entry strategy, it’s important to understand in which situations licensing is best suited.

Advantages

Licensing affords new international entrants with a number of advantages:

Licensing is a rapid entry strategy, allowing almost instant access to the market with the right partners lined up.
Licensing is low risk in terms of assets and capital investment. The licensee will provide the majority of the infrastructure in most situations.
Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry.
Cultural and linguistic barriers are also significant challenges for international entries. Licensing provides critical resources in this regard, as the licensee has local contacts, mastery of local language, and a deep understanding of the local market.

Disadvantages

While the low-cost entry and natural localization are definite advantages, licensing also comes with some opportunity costs:

Loss of control is a serious disadvantage in a licensing situation in regards to quality control. Particularly relevant is the licensing of a brand name, as any quality control issue on behalf of the licensee will impact the licensor’s parent brand.
Depending on an international partner also creates inherent risks regarding the success of that firm. Just like investing in an organization in the stock market, licensing requires due diligence regarding which organization to partner with.
Lower revenues due to relying on an external party is also a key disadvantage to this model. (Lower risk, lower returns.)

21.1.8: Importing

Imports are the inflow of goods and services into a country’s market for consumption.

Learning Objective

Explain the methodology behind the selection of products to import

Key Points

A country specializes in the export of goods for which it has a comparative advantage and imports those for which it has a comparative disadvantage. By doing so, the country can increase its welfare.
Comparative advantage describes the ability of a country to produce one specific good more efficiently than other goods.
A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically.

Key Terms

import: To bring (something) in from a foreign country, especially for sale or trade.
comparative advantage: The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.

Example

A country in certain tropical areas of the world has a comparative advantage at growing crops like sugar or coffee beans, but it would be much less efficient at growing wheat (due to the climate). Therefore, they should export their sugar/coffee beans and import wheat at a lower cost than trying to grow wheat themselves.

The term “import” is derived from the concept of goods and services arriving into the port of a country. The buyer of such goods and services is referred to as an “importer” and is based in the country of import whereas the overseas-based seller is referred to as an “exporter.” Thus, an import is any good (e.g. a commodity) or service brought in from one country to another country in a legitimate fashion, typically for use in trade. It is a good that is brought in from another country for sale.

Singapore

The Port of Singapore is one of the busiest ports in the world. Singapore has to import most of its food and consumer goods.

A large ship at the Port of Singapore.

Imported goods or services are provided to domestic consumers by foreign producers. An import in the receiving country is an export to the sending country. Imports, along with exports, form the basics of international trade. Import of goods normally requires the involvement of customs authorities in both the country of import and the country of export; those goods are often subject to import quotas, tariffs, and trade agreements. While imports are the set of goods and services imported, “imports” also means the economic value of all goods and services that are imported.

Imports are the inflow of goods and services into a country’s market for consumption. A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically. Comparative advantage is a concept often applied to importing and exporting. Comparative advantage is the concept that a country should specialize in the production and export of those goods and services that it can produce more efficiently than other goods and services, and that it should import those goods and services in which it has a comparative disadvantage.

21.1.9: Joint Ventures

In a joint venture business model, two or more parties agree to invest time, equity, and effort for the development of a new shared project.

Learning Objective

Outline the dynamics of a joint venture

Key Points

Joint business ventures involve two parties contributing their own equity and resources to develop a new project. The enterprise, revenues, expenses and assets are shared by the involved parties.
Since money is involved in a joint venture, it is necessary to have a strategic plan in place.
As the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Key Term

joint venture: A cooperative partnership between two individuals or businesses in which profits and risks are shared.

Example

Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony to develop cellular devices.

Joint Ventures

A joint venture is a business agreement in which parties agree to develop a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets.

Joint Venture

Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony.

When two or more persons come together to form a partnership for the purpose of carrying out a project, this is called a joint venture. In this scenario, both parties are equally invested in the project in terms of money, time and effort to build on the original concept. While joint ventures are generally small projects, major corporations use this method to diversify. A joint venture can ensure the success of smaller projects for those that are just starting in the business world or for established corporations. Since the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties must be committed to focusing on the future of the partnership rather than just the immediate returns. Ultimately, short term and long term successes are both important.To achieve this success, honesty, integrity and communication within the joint venture are necessary.

A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time contracts. The JV is dissolved when that goal is reached. Some major joint ventures include Dow Corning, MillerCoors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

21.1.10: Contract Manufacturing

In contract manufacturing, a hiring firm makes an agreement with the contract manufacturer to produce and ship the hiring firm’s goods.

Learning Objective

Compare the benefits and risks of employing a contract manufacturer (CM)

Key Points

A hiring firm may enter a contract with a contract manufacturer (CM) to produce components or final products on behalf of the hiring firm for some agreed-upon price.
There are many benefits to contract manufacturing, and companies are finding many reasons why they should be outsourcing their production to other companies.
Production outside of the company does come with many risks attached. Companies must first identify their core competencies before deciding about contract manufacture.

Key Terms

Contract manufacturing: a business model where a firm hires another firm to produce components or products
Contract manufacturing: Business model in which a firm hires a contract manufacturer to produce components or final products based on the hiring firm’s design.

A contract manufacturer (“CM”) is a manufacturer that enters into a contract with a firm to produce components or products for that firm. It is a form of outsourcing. In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labor, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm.

Contract Manufacturing

Ness Corporation is a contract manufacturer in Seven Hills, Australia.

Benefits

Contract manufacturing offers a number of benefits:

Cost Savings: Companies save on their capital costs because they do not have to pay for a facility and the equipment needed for production. They can also save on labor costs such as wages, training, and benefits. Some companies may look to contract manufacture in low-cost countries, such as China, to benefit from the low cost of labor.
Mutual Benefit to Contract Site: A contract between the manufacturer and the company it is producing for may last several years. The manufacturer will know that it will have a steady flow of business at least until that contract expires.
Advanced Skills: Companies can take advantage of skills that they may not possess, but the contract manufacturer does. The contract manufacturer is likely to have relationships formed with raw material suppliers or methods of efficiency within their production.
Quality: Contract Manufacturers are likely to have their own methods of quality control in place that help them to detect counterfeit or damaged materials early.
Focus: Companies can focus on their core competencies better if they can hand off base production to an outside company.
Economies of Scale: Contract Manufacturers have multiple customers that they produce for. Because they are servicing multiple customers, they can offer reduced costs in acquiring raw materials by benefiting from economies of scale. The more units there are in one shipment, the less expensive the price per unit will be.

Risks

Balanced against the above benefits of contract manufacturing are a number of risks:

Lack of Control: When a company signs the contract allowing another company to produce their product, they lose a significant amount of control over that product. They can only suggest strategies to the contract manufacturer; they cannot force them to implement those strategies.
Relationships: It is imperative that the company forms a good relationship with its contract manufacturer. The company must keep in mind that the manufacturer has other customers. They cannot force them to produce their product before a competitor’s. Most companies mitigate this risk by working cohesively with the manufacturer and awarding good performance with additional business.
Quality: When entering into a contract, companies must make sure that the manufacturer’s standards are congruent with their own. They should evaluate the methods in which they test products to make sure they are of good quality. The company has to ensure the contract manufacturer has suppliers that also meet these standards.
Intellectual Property Loss: When entering into a contract, a company is divulging their formulas or technologies. This is why it is important that a company not give out any of its core competencies to contract manufacturers. It is very easy for an employee to download such information from a computer and steal it. The recent increase in intellectual property loss has corporate and government officials struggling to improve security. Usually, it comes down to the integrity of the employees.
Outsourcing Risks: Although outsourcing to low-cost countries has become very popular, it does bring along risks such as language barriers, cultural differences, and long lead times. This could make the management of contract manufacturers more difficult, expensive, and time-consuming.
Capacity Constraints: If a company does not make up a large portion of the contract manufacturer’s business, they may find that they are de-prioritized over other companies during high production periods. Thus, they may not obtain the product they need when they need it.
Loss of Flexibility and Responsiveness: Without direct control over the manufacturing facility, the company will lose some of its ability to respond to disruptions in the supply chain. It may also hurt their ability to respond to demand fluctuations, risking their customer service levels.

21.1.11: Franchising

Franchising enables organizations a low cost and localized strategy to expanding to international markets, while offering local entrepreneurs the opportunity to run an established business.

Learning Objective

Examine the benefits of international franchising

Key Points

A franchise agreement is defined as the franchiser granting an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products.
Franchising is designed to enable large organizations rapid access to new markets with relatively low barriers to entry.
Advantages of franchising (for the franchiser) include low costs of entry, a localized workforce (culturally and linguistically), and a high speed method of market entry.
Disadvantages of franchising (for the franchiser) include loss of some organizational and brand control, as well as relatively lower returns than other strategic entry models (albeit, with lower risk).

Key Terms

franchisee: A holder of a franchise; a person who is granted a franchise.
franchiser: A franchisor, a company or person who grants franchises.

What is Franchising?

In franchising, an organization (the franchiser) has the option to grant an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products.

In this arrangement, the franchisee will take the majority of the risk in opening a new location (e.g. capital investments) while gaining the advantage of an already established brand name and operational process. In exchange, the franchisee will pay a certain percentage of the profits of the venture back to the franchiser. The franchiser will also often provide training, advertising, and assistance with products.

Why Franchise

Lower Barriers to Entry

Franchising is a particularly useful practice when approaching international markets. For the franchiser, international expansion can be both complex and expensive, particularly when the purchase of land and building of facilities is necessary. With legal, cultural, linguistics, and logistical barriers to entry in various global markets, the franchising model offers and simpler, cleaner solution that can be implemented relatively quickly.

Localization

Franchising also allows for localization of the brand, products, and distribution systems. This localization can cater to local tastes and language through empowering locals to own, manage, and employ the business. This high level of integration into the new location can create significant advantages compared to other entry models, with much lower risk.

Speed

It is also worth noting that franchising is a very efficient, low cost and quickly implemented expansionary strategy. Franchising requires very little capital investment on behalf of the parent company, and the time and effort of building the stores are similar outsources to the franchisee. As a result, franchising can be a way to rapidly expand both domestically and globally.

Starbucks’ Expansion

Starbucks operates with a wide variety of strategic alliances, including a franchising program.

A chart that shows how various forms of strategic alliance can rapidly increase rates of expansion.

Downsides to Franchising

Franchising has some weaknesses as well, from a strategic point of view. Most importantly, organizations (the franchisers) lose a great deal of control. Quality assurance and protection of the brand is much more difficult when ownership of the franchise is external to the organization itself. Choosing partners wisely and equipping them with the tools necessary for high levels of quality and alignment with the brand values is critical (e.g., training, equipment, quality control, adequate resources).

It is also of importance to keep the risk/return ratio in mind. While the risk of franchising is much lower in terms of capital investment, so too is the returns derived from operations (depending on the franchising agreement in place). While it is a faster and cheaper mode of entry, it ultimately results in a profit share between the franchiser and the franchisee.

21.1.12: Exporting

Exporting is the practice of shipping goods from the domestic country to a foreign country.

Learning Objective

Explain how exports are accounted for in international trade

Key Points

This term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country.
In national accounts “exports” consist of transactions in goods and services (sales, barter, gifts or grants) from residents to non-residents.
Statistics on international trade do not record smuggled goods or flows of illegal services. A small fraction of the smuggled goods and illegal services may nevertheless be included in official trade statistics through dummy shipments that serve to conceal the illegal nature of the activities.

Key Terms

export: to sell (goods) to a foreign country
import: To bring (something) in from a foreign country, especially for sale or trade.
exporting: the sale of capital, goods, and services across international borders or territories
exporting: the act of selling to a foreign country

Example

When individuals from Country A purchase goods from Country B, this process is known as exporting for Country B (since their goods are being sold) and importing for Country A (since they are buying the goods).

This term “export” is derived from the concept of shipping goods and services out of the port of a country . The seller of such goods and services is referred to as an “exporter” who is based in the country of export whereas the overseas based buyer is referred to as an “importer”. In international trade, exporting refers to selling goods and services produced in the home country to other markets.

Oil Exports 2006

The map shows barrels of oil exported per day in 2006. Russia and Saudi Arabia exported more barrels than any other oil-exporting countries.

Export of commercial quantities of goods normally requires the involvement of customs authorities in both the country of export and the country of import. The advent of small trades over the internet such as through Amazon and eBay has largely bypassed the involvement of customs in many countries because of the low individual values of these trades. Nonetheless, these small exports are still subject to legal restrictions applied by the country of export. An export’s counterpart is an import.

In national accounts, exports consist of transactions in goods and services (sales, barter, gifts, or grants) from residents to non-residents.The exact definition of exports includes and excludes specific “borderline” cases. A general delimitation of exports in national accounts is as follows: An export of a good occurs when there is a change of ownership from a resident to a non-resident; this does not necessarily imply that the good in question physically crosses any border. However, in specific cases, national accounts impute changes of ownership even though in legal terms no change of ownership takes place (e.g. cross border financial leasing, cross border deliveries between affiliates of the same enterprise, goods crossing the border for significant processing to order or repair). Smuggled goods must also be included in the export measurement.

Export of services consist of all services rendered by residents to non-residents. In national accounts, any direct purchases by non-residents in the economic territory of a country are recorded as exports of services; therefore, all expenditure by foreign tourists in the economic territory of a country is considered part of the export of services of that country. International flows of illegal services must also be included.

National accountants often need to make adjustments to the basic trade data in order to comply with national accounts concepts; the concepts for basic trade statistics often differ in terms of definition and coverage from the requirements in the national accounts:

Data on international trade in goods is mostly obtained through declarations to customs services. If a country applies the general trade system, all goods entering or leaving the country are recorded. If the special trade system (e.g., extra-EU trade statistics) is applied, goods which are received into customs warehouses are not recorded in external trade statistics unless they subsequently go into free circulation in the country of receipt.

21.2: The International Business Environment

21.2.1: Overview of the International Business Environment

International business offers substantial potential risks and returns from an organizational perspective.

Learning Objective

Recognize the complex factors that may impact an organization’s strategic decision to expand internationally

Key Points

The modern economy is globally connected, and growing more so every day. Weighing the pros and cons of international expansion is a key strategic consideration.
The multinational enterprise (MNE) is the primary player in international business. MNEs are present in virtually every industry nowadays.
Entry modes for international businesses include global concentration, global synergies, and other strategic global motivations.
With the complexity of international operating environments, organizations should consider economic, technological, legal, socio-cultural and environmental factors.
Weighing the risks and potential returns and determining a required rate of return for an international expansion is a key aspect of global financial management.

Key Term

MNE: Or a multinational enterprise, MNEs are defined as organizations which operate across multiple political borders.

International business is an enormously relevant facet of the modern economy, and will only become more integrated into core business strategy as technology continues to progress. International business is simply the summation of all commercial transactions that take place between various countries (crossing political boundaries). This is not exclusively limited to the domain of business, as NGOs, governments, and coops also operate across country borders with a variety of objectives (aside from simple profitability).

From a business perspective, the primary incumbent in an international business environment is the multinational enterprise (MNE), which is a company that pursues strategic success in global production and sales (i.e. operating within a number of country borders). The number of examples of this type of firm is constantly growing. From fast food chains like McDonald’s to auto manufacturers like Honda to smartphone designers like Samsung, the number of international players in most markets is constantly on the rise.

Why Expand Globally?

Global expansion is costly and complex. To offset these costs and risks, organizations must have strong reasons for developing a global strategy. These reasons generally fit one (or more) of the following three strategic areas:

Global Concentration – Depending upon the competitive concentration of a given industry in a given region, it may make sense to enter a market where competition is relatively scarce (and demand is high).
Global Synergies – Some organizations have highly developed competencies that are easily scaled. In these situations, global expansion means natural synergy.
Global Strategic Motivations – Other reasons for expansion to a given country may exist strategically, such as developing new sourcing sites for production or acquiring strategic assets in a given region.

External Factors Impacting Expansion

International expansion can be a costly and complex procedure. Before considering such a significant strategic move, management must weigh the external factors that will impact success during a global transition. These include:

Socio-cultural: The social environment of a given region can have a significant impact on success. Food companies are highly impacted by this – certain cultures prefer certain types of foods.
Geographic/Environmental – For example, skiing equipment may not do so well in regions without snow or mountains. Oil companies can only source oil from resource-rich regions.
Legal/Political – Some countries have high barriers to entry, complex tax rates, and/or unclear legislative practices. Ease of doing business is critical here.
Economic – The standard of living is different from region to region, and recognizing the value of a given market in terms of spending power, currency, and market size is critical to deciding upon expansion.
Technology – Access to internet, electricity, clean water and a variety of other technological dependencies must be considered prior to entry if the organizational operations rely on easy access.

Weighing the pros and cons of entering a given reason, and calculating projected cash flows, costs, and required returns on investment are central financial considerations to entering a new international market.

Volume of Merchandise Exports

Despite a dip in 2008 as a result of the banking crisis and subsequent recession, the volume of global exports continues to rise even over this short time period. Globalization is an enormous source of growth.

21.3: Factors Impacting Exchange Rates

21.3.1: Overview of Exchange Rates

An exchange rate between two currencies is the rate at which one currency will be exchanged for another.

Learning Objective

Describe how economic forces influence exchange rates

Key Points

An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
Quotes using a country’s home currency as the price currency are known as direct quotation. Quotes using a country’s home currency as the unit currency are known as indirect quotation. Using direct quotation, if the home currency is strengthening, then the exchange rate number decreases.
There are many factors that impact exchange rates, such as inflation, interest rates, balance of payments, and government policy.

Key Terms

Interest rate parity: a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rate available on bank deposits in two countries.
balance of payment: an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned.
arbitrage: Any market activity in which a commodity is bought and then sold quickly, for a profit which substantially exceeds the transaction cost

Overview of Exchange Rates

In finance, an exchange rate (also known as the foreign-exchange rate, forex rate, or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY ¥) to the United States dollar (US $) means that ¥91 will be exchanged for each US $1 or that US $1 will be exchanged for each ¥91 .

Exchange rates

Exchange rates displayed in Thailand

Quotes using a country’s home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the eurozone) are known as direct quotation or price quotation (from that country’s perspective) and are used by most countries.

Quotes using a country’s home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the eurozone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand, and the eurozone.

Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable), the exchange rate number decreases. Conversely, if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Factors that Impact Exchange Rates

There are many factors that impact exchange rates, such as inflation, interest rates, balance of payments, and government policy.

Inflation deteriorates the purchasing power of a currency. As there is high inflation, the demand for the currency will go down. Decreased demand for a currency makes the price of it will drop. In other words, the currency will depreciate. This is presented by a higher exchange rate if the exchange rate is quoted as home currency / 1 foreign currency.

Uncovered interest rate parity states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged, the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage. In sum, if other things remain unchanged, one currency will appreciate or depreciate if interest rates in the country increase or decrease.

Exchange rates can also be affected by the balance of payment. The balance of payment model holds that a foreign exchange rate must be at its equilibrium level, which is the rate which produces a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange rate reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’s goods (exports) more affordable in the global marketplace while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency toward equilibrium.

Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low, typically by the national central bank engaging in open market operations. It is argued that the People’s Republic of China has succeeded in doing this over a long period of time. In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country’s goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.

21.4: Types of Rates and Transactions

21.4.1: Spot Rates, Forward Rates, and Cross Rates

Spot & forward rates are settlement prices of spot & forward contracts; cross rates are the exchange rate between two unofficial currencies.

Learning Objective

Differentiate between spot rates, forward rates, and cross rates

Key Points

A spot contract is a contract of buying or selling a commodity, security or currency for settlement (payment and delivery) on the spot date, which is normally two business days after the trade date. The settlement price (or rate) is called spot price or spot rate.
A spot contract is in contrast with a forward contract where contract terms are agreed now but delivery and payment will occur at a future date. The settlement price of a forward contract is called forward price or forward rate.
Spot rates can be used to calculate forward rates. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry model.
A cross rate is the currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in.

Key Term

bootstrapping method: In finance, bootstrapping is a method for constructing a (zero-coupon) fixed-income yield curve from the prices of a set of coupon-bearing products (e.g., bonds and swaps).Using these zero-coupon products, it becomes possible to derive par swap rates (forward and spot) for all maturities by making a few assumptions (including linear interpolation). The term structure of spot returns is recovered from the bond yields by solving for them recursively, by forward substitution. This iterative process is called the Bootstrap Method.

Spot Rates

In finance, a spot contract, spot transaction, or simply “spot,” is a contract of buying or selling a commodity, security, or currency for settlement (payment and delivery) on the spot date, which is normally two business days after the trade date. The settlement price (or rate) is called a “spot price” or “spot rate. “

For bonds, spot rates are estimated via the bootstrapping method, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for fixed income securities.

Forward Rates

A spot contract is in contrast with a forward contract where contract terms are agreed now but delivery and payment will occur at a future date. The settlement price of a forward contract is called a “forward price” or “forward rate. ” Depending on the item being traded, spot prices can indicate market expectations of future price movements. In other words, spot rates can be used to calculate forward rates. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry model. For example, on a share, the difference in price between the spot and forward is usually accounted for almost entirely by any dividends payable in the period minus the interest payable on the purchase price.

If the underlying asset is tradeable, the forward price is given by:

Forward rate

On a share, the difference in price between the spot and forward is usually accounted for almost entirely by any dividends payable in the period minus the interest payable on the purchase price.

where F is the forward price to be paid at time, T^ex is the exponential function (used for calculating compounding interests), r is the risk-free interest rate, q is the cost-of-carry, S₀is the spot price of the asset (i.e., what it would sell for at time 0), D_iis a dividend which is guaranteed to be paid at time t_i where 0< t_i< T.

Cross Rates

A cross rate is the currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided in. For example, if an exchange rate between the euro and the Japanese yen was quoted in an American newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of the U.S. However, if the exchange rate between the euro and the U.S. dollar were quoted in that same newspaper, it would not be considered a cross rate because the quote involves the U.S. official currency.

21.5: Managing Exchange Risk

21.5.1: Types of Exchange Exposure: Short-Run, Long-Run, and Translation

Foreign currency exposures are categorized as transaction/ short-run exposure, economic/ long-run exposure, and translation exposure.

Learning Objective

Explain the differences between short-run, long-run and translation exposure

Key Points

A firm has transaction exposure/ short-term exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency.
A firm has economic exposure/ long-term exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm’s position with regards to its competitors, the firm’s future cash flows, and the firm’s value.
A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements.

Key Terms

exchange rate: the amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment
foreign currency exposures: Foreign currency exposure is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are exposed to foreign currency risk which can have severe financial consequences if not managed appropriately
foreign bond: an international debt instrument denominated in the home currecy but issued by a foreign company

Exchange Exposure

Foreign currency exposures are generally categorized into the following three distinct types: transaction (short-run) exposure, economic (long-run) exposure, and translation exposure.

Short-Run

A firm has transaction exposure/ short-term exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency.

Foreign currency exposure

DAX appreciated in the early 2008, presenting a short-run exchange exposure to companies paying DAX to its suppliers.

Long-Run

A firm has economic exposure / long-term exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm’s position with regards to its competitors, the firm’s future cash flows, and ultimately the firm’s value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good.

Translation

A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm’s cash flows, it could have a significant impact on a firm’s reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments. Translation gives special consideration to assets and liabilities with regards to foreign exchange risk, whereas exposures to revenues and expenses can often be managed ex ante by managing transactional exposures when cash flows take place.

21.5.2: Types of Exchange Hedges: Forward, Money Market, and Future

Forwards, money market instruments, and futures are common instruments used to manage exchange risk.

Learning Objective

Describe the different strategies for managing exchange risk

Key Points

In case of exchanges, if the company is going to receive a large sum of foreign currency from customers it bears the risk that the currency will depreciate and the company will go short in a currency forward contract. If the company is going to pay its suppliers, it instead will go long.
Foreign exchange swaps are a common type of money market instrument, involving the exchange of a set of currencies in spot date and the reversal of the exchange at a predetermined time in the future. Their commonest use is for institutions to fund their foreign exchange balances.
Futures are very similar to forwards, except they are exchange-traded, or defined on standardized assets. Futures also typically have interim partial settlements, or “true-ups,” in margin requirements.

Key Terms

underlying assets: In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying.
margin: Collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty.
spot exchange rate: the agreed upon price of buying one currency in terms of another now
forward exchange rate: the agreed upon price to exchange one currency for another at a future date

Managing Exchange Risk

Forward

In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. The party agreeing to buy the underlying assets in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. In the case of exchanges, when entering a forward contract the buyer hopes or expects that a currency is going to appreciate, while the seller hopes or expects that it will depreciate in near future. If the company is going to receive a large sum of foreign currency from customers as payment, it bears the risk that the currency will depreciate and the company will go “short” in a currency forward contract. If the company is going to pay its suppliers with foreign currency, it will instead go “long. “

Foreign exchange rates

The exchange rate of GBP/ USD decreased from 1985 to 1987. One should go long GBP and short USD.

Money Market

As money became a commodity, the money market became a component of the financial markets for assets involved in short-term borrowing, lending, buying, and selling, with original maturities of one year or less. Foreign exchange of currencies are among the more common money market instruments, exchanging a set of currencies in a spot date and the reversal of the exchange of currencies at a predetermined time in the future. The most common use of foreign exchange swaps occurs when institutions fund their foreign exchange balances. A foreign exchange swap consists of two legs: a spot foreign exchange transaction and a forward foreign exchange transaction.These two legs are executed simultaneously for the same quantity, and therefore offset each other. Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency, and a negative (or short) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back and settling the day after.

Futures

In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future delivery date. In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures the underlying item can be any financial instrument (including currency, bonds, and stocks). The party agreeing to buy the underlying asset in the future, the buyer of the contract, is said to be long, and the party agreeing to sell the asset in the future, the seller of the contract, is said to be short. The same mechanism functioning in forward contracts applies to futures.

Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or “true-ups” in margin requirements like futures – such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.

21.6: International Investment and Finance

21.6.1: Funding the International Business

Funding global processes or organizations is a complex financial process with a variety of options, each with varying rates of risk and return.

Learning Objective

Differentiate between funding options for global organizations, and consider the differences between startups and larger established firms

Key Points

Often enough, global organizations have significant capital needs. Procuring capital at a lower weighted average cost of capital (WACC) than the expected return is key to success.
Equity and debt are the primary borrowing devices for most business, including taking out loans, issuing bonds, and releasing company shares for public trade.
Startups engage in a wide variety of interesting funding initiatives, such as pursuing venture capital, angel investors, and crowd-sourced funding.
Procuring funding to start an international business is easier now than ever, with the wide variety of speculators (i.e. venture capitalists) and the high volume of crowd-sourcing platforms.

Key Term

Venture Capital (VCs): A funding option in which groups of speculative investors pursue small, promising entrepreneurial ventures to fund (and thus gain some ownership in).

International businesses often have high capital needs, as global trade can be resource intensive (though it’s worth noting that the digital age has changed this significantly for many industries). Procuring funding in the modern economy can be highly diversified, from borrowing debt from banks to pursuing angel investors to crowd-sourcing funding for a small startup project.

Determining Risk and Return

Understanding the financial needs of the organization and measuring the overall weighted average cost of capital (WACC) for a venture is important in determining the appropriate level of risk and the expected level of return on that risk. Models such as the discounted cash flow analysis to determine a net present value (NPV) of the project being funded is key to successful financial sourcing.

Organizations looking to procure funding should provide prospective investors with a business plan, complete with an assessment of expected demand, estimated profit, and required rates of return. By balancing the expected profit with the cost of getting funded, potential international operations can ensure that the return on investment will justify the expenses involved in global trade.

Funding Sources

International businesses have the same funding sources as most organizations, for larger organizations this primarily revolves around debt and equity. For small organizations, debt and equity are often accompanied by venture capital and crowd-sourcing (particularly in the startup world).

Larger Organizations

From the perspective of larger organizations, formal analyses of projected cash flows (as discussed above) coupled with traditional forms of funding is the most common approach to international business funding. This includes:

Loans – Bank loans are a form of debt, often with a relatively low cost of capital. Loans granted over a given lending period and paid back in installments. In the case of bankruptcy, these debts are among the first repaid upon liquidation of assets (hence the lower risk and lower cost of capital).
Issuing Bonds – Organizations can also issue bonds, which are another form of debt. Bonds debt securities investors can purchase which will mature over time. The rate of return and time to maturation can vary. These are also lower costs of capital as they are paid out before equity in the case of a bankruptcy.
Equity (shares) – Issuing shares is another funding source, particularly for larger and publicly traded organizations. By issuing equity, organizations can essentially sell small fractions of organizational ownership as an asset for investors, who are betting on the success of the organization. These are riskier, most costly and less reliable sources of income compared to debt.

Startups

While smaller organizations have access to debt as well, they generally have less collateral available and therefore very little financial leverage. In these situations, procuring funding for a global venture is exceptionally difficult. The startup world is full of interesting options to procure capital, including:

Venture Capital (VCs) – A popular term in the Silicon Valley and other technology hubs, VCs accumulate capital from a number of speculative investors and seek strong business opportunities still in the startup phase. Winning capital from a VC can be quite lucrative, as the amount of capital invested can be high (high enough to justify international operations). VCs would generally be represented by a board who would assess the viability of the business as an investment, and determine terms (ownership by investors) and returns.
Angel Investors – Angel investors are similar to VCs, but can actually be quite varied in format and motivations. Angel investors are more often individuals with capital to spare who have taken an interest in a particular business or product. They may act as advisers or objective investors, they may simply love the product, or they may have investment incentives (most commonly both).
Crowd-sourcing – Websites like Kickstarter and Indiegogo are unique and modern formats, where potential business ideas can garner capital and support prior to producing a given product or service. This interesting model allows a high number of people to invest a small amount of capital, which cumulatively may be enough to ‘kickstart’ a venture (international or otherwise). Reimbursement in the form of credits, t-shirts, early access to the product, and other incentives are often used to motivated small investments.

The world of business investing is changing and evolving, and reliance on big banks is decreasing for smaller, entrepreneurial ventures. With the barriers to globalization constantly lowered, the capacity to take a relatively small amount of seed capital and offer services digitally across the world is more feasible than ever. Understanding options like crowd-sourcing can substantially lower the risk of borrowing, and enable small organizations to grow.

Startup Financing Cycle

This is an excellent illustration of how funding sources and strategic alliances evolve over time, beginning from the startup stage.

Chapter 20: Mergers and Acquisitions

20.1: Reasons for Business Combinations

20.1.1: Reasons for Combining Businesses

Business combinations seek to unlock value within either firm that would otherwise not be realized if the firms continued separately.

Learning Objective

Describe the reasons two businesses might combine

Key Points

The dominant rationale used to explain merging activity is that acquiring firms seek improved financial performance.
If used in a business application, synergy means that teamwork will produce an overall better result than if each person within the group was working toward the same goal individually.
Positioning involves combining two companies in order to exploit future opportunities.
Gap filling is a reason for merging, referring to the fact that the strength of one company may be the weakness of the other, and vice versa.

Key Terms

Synergy: Benefits resulting from combining two different groups, people, objects, or processes.
statutory merger: A type of merger whereby one of the companies remains a legal entity, rather than a part of an entirely new legal entity.

Reasons For Business Combinations

Business combinations are referred to as mergers. A merger happens when two firms agree to go forward as a single new company, rather than remain separately owned and operated. This kind of action is more precisely referred to as a “merger of equals. ” The firms are often approximately the same size. Both companies’ stocks are surrendered and new company stock is issued in its place. In practice, however, actual mergers of equals don’t happen very often. Usually, one company will buy another and, as part of the deal’s terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it is technically an acquisition. A merger can also be achieved independently of the corporate mechanics through various means – such as triangular merger, statutory merger, etc.

Every merger has specific reasons why the combining of the two companies is a good business decision. The underlying principle is simple: 2 + 2 = 5. In other words, the combination of two companies will be worth more than the sum of its parts. The dominant rationale used to explain merging activity is that acquiring firms seek improved financial performance. The following factors are considered to improve financial performance:

Synergy: Synergy is two or more things functioning together to produce a result not independently obtainable. If used in a business application, synergy means that teamwork will produce an overall better result than if each person within the group was working toward the same goal individually. Synergy can take the form of higher revenues, lower expenses, or a lower overall cost of capital.
Economy of scale: The combined company can often reduce its fixed costs by removing duplicate departments or operations, or lowering the costs of the company relative to the same revenue stream, thus increasing profit margins.
Economy of scope: This refers to the efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products.
Increased revenue or market share: This assumes that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices.
Cross-selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker’s customers, while the broker can sign up the bank’s customers for brokerage accounts.
Taxation: A profitable company can buy a loss maker to use the target’s loss to their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to “shop” for loss-making companies, limiting the tax motive of an acquiring company.
Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term balances out the stock price of a company, giving conservative investors more confidence in investing in the company.
Hiring: Some companies use acquisitions as an alternative to the normal hiring process. This is especially common when the target is a small private company or is in the start-up phase. In this case, the acquiring company simply hires the staff of the target private company, thereby acquiring its talent (if that is its main asset and appeal).
Diversification: A merger may hedge a company against a downturn in an industry by providing the opportunity to make up profits in the industry of the target company.

Additional motives for a merger that may not add shareholder value include:

Manager’s hubris: A manager’s overconfidence about expected synergies from a merger may result in overpayment for the target company.
Empire-building: Managers have larger companies to manage and hence more power.
Manager’s compensation: In the past, the pay of certain executive management teams was based on the total profit of the company, instead of the profit per share. This would give management the incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders).
Positioning: This involves combining two companies in order to exploit future opportunities.
Gap filling: The strength of one company may be the weakness of the other, and vice versa.

20.2: Types of Transactions

20.2.1: Types of Transactions

Transactions can be mergers or acquisitions, made with cash or stock, and they can be friendly or hostile.

Learning Objective

Choose the best strategy and method for completing a merger or acquisition

Key Points

A cash deal is one whereby the acquirer buys the target’s outstanding equity (or assets) with cash. The acquirer may raise cash through a debt or equity offering or internally finance the deal using the firm’s cash on hand.
A stock deal is one whereby the acquirer offers its own shares for the shares of the target. Usually this involves the acquirer floating new shares or using internally held treasury shares.
The ongoing status of the target’s owners dictates whether the transaction is a merger (retained) or acquisition (replaced).
Whether a purchase is perceived as being a “friendly” one or a “hostile” depends significantly on how the proposed acquisition is communicated to and perceived by the target company’s board of directors, employees, and shareholders.

Key Terms

shares in treasury: Stock that is bought back by the issuing company, reducing the amount of outstanding stock on the open market.
liquidation: The selling of the assets of a business as part of the process of dissolving the business.

Basic Strategies of M&A:

The buyer buys the shares, and therefore the control, of the target company. Ownership control of the company in turn conveys effective control over the assets of the company. However, since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
The buyer buys the assets of the target company. The cash the target receives from the sell-off is netted against outstanding liabilities and returned to equity holders (owners). This type of transaction leaves the target company as an empty shell, if the buyer buys out the entirety of the target’s assets (a liquidation). A buyer often structures the transaction in order to “cherry-pick” the assets that it wants and leaves out the assets and liabilities that it does not. A disadvantage of this structure is the tax that many jurisdictions – particularly outside the United States – impose on transfers of individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral.

Basic Methods of Financing M&A:

Cash

Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder’s shareholders. If the buyer pays cash, there are two main financing options:

Cash on hand: The buyer consumes financial slack (excess cash or unused debt capacity) and may decrease its debt rating. There are no major transaction costs.
Issue of stock: The buyer increases financial slack, which may improve its debt rating and reduce the cost of debt (although not WACC as cost of equity will increase). Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting, and registration.

Stock

Payment is made in the form of the acquiring company’s stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the acquired company’s stock. If the buyer pays with stock, the financing possibilities are:

Issue of stock (same effects and transaction costs as described above).
Shares in treasury: The buyer increases financial slack (if they don’t have to be repurchased on the market), which may improve its debt rating and reduce the cost of debt (although not WACC as cost of equity will increase). Transaction costs include brokerage fees if shares are repurchased in the market; otherwise, there are no major costs.

There are some elements to think about when choosing the form of payment. When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid. Therefore, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer’s capital structure might be affected and the control of the buyer modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. This risk is removed with a cash transaction.

In the aftermath of a merger, there will be accounting issues to consider. The balance sheet of the buyer will be modified, and thus the decision maker should take into account the effects on the reported financial results. For example, in a pure cash deal (financed from the company’s current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution in the decision making process.

Hostile vs. Friendly:

Whether a purchase is perceived as being a “friendly” one or a “hostile” depends significantly on how the proposed acquisition is communicated to and perceived by the target company’s board of directors, employees, and shareholders. It is normal for deal communications to take place in a so-called “confidentiality bubble,” wherein the flow of information is restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the companies cooperate in negotiations. In the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target’s board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become “friendly,” as the acquirer secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer through negotiation .

Airline M&A

The aviation industry has seen increased consolidation through M&A activity in the last 20 years. Pictured is a plane belonging to United Airlines, one of the world’s largest carriers, fresh off a 2010 merger with Continental Airlines.

20.3: Preparing for a Merger

20.3.1: Valuing the Target and Setting the Price

To prepare an appropriate bid for a target company, the buyer has to accurately value the target company through the due diligence process.

Learning Objective

Value a target company prior to a merger

Key Points

Due diligence can be defined as the examination of a potential target for merger, acquisition, privatization, or a similar corporate finance transaction –normally by a buyer.
In order to reduce the number of failed mergers and acquisitions, it is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process.
As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right.

Key Terms

discounted cash flow: In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)–the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
intellectual property: Any product of someone’s intellect that has commercial value: copyrights, patents, trademarks, and trade secrets.
Synergy: Benefits resulting from combining two different groups, people, objects, or processes.

Valuation of the Target Company

In order to prepare an appropriate bid in the mergers and acquisition process, the buyer must be able to accurately value the target company. This valuation process is referred to as due diligence. Due diligence can be defined as the examination of a potential target for merger, acquisition, privatization, or a similar corporate finance transaction– normally by a buyer. Due diligence involves a reasonable investigation focusing on material future matters and the asking of certain key questions, including how do we buy, how do we structure the acquisition, and how much do we pay? Moreover, due diligence is an investigation on the current practices of process and policies and an examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The due diligence process framework can be divided into nine distinct areas:

Compatibility audit: This deals with the strategic components of the transaction and, in particular, the need to add shareholder value.
Financial audit.
Macro-environment audit.
Legal/environmental audit.
Marketing audit.
Production audit.
Management audit.
Information systems audit.
Reconciliation audit: This links/consolidates other audit areas together via a formal valuation in order to test whether shareholder value will be added.

In business transactions, the due diligence process varies for different types of companies. Areas of concern other than the ones listed above include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions.

WIPO Headquarters in Geneva

Intellectual property is an asset of a business that must be included in the overall business evaluation. This photo is of the headquarters of the World Intellectual Property Organization in Geneva, Switzerland.

It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions. The five most common methods of valuation are:

Asset valuation
Historical earnings valuation
Future maintainable earnings valuation
Relative valuation (or comparable transactions)
Discounted cash flow valuation

Professionals who value businesses generally do not use just one of these methods, but a combination of them, in order to obtain a more accurate value. As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right. Synergies are different from the “sales price” valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm’s point of view. Synergy creating investments are started by the choice of the acquirer and, therefore, they are not obligatory, making them real options in essence.

20.4: The Role of Investment Bankers in M&A

20.4.1: Overview of Investment Banking Functions in M&A

Many companies looking to expand, or streamline, their business will use investment banks for advice on potential targets and/or buyers.

Learning Objective

Describe the role investment banking plays in the M&A process

Key Points

The Investment bank’s role in mergers and acquisitions falls into one of either two buckets: seller representation or buyer representation (also called target representation and acquirer representation).
One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction.
Banks will also source deals by studying the market themselves and approaching companies with their own strategic ideas.
One of the main roles investment banks play is to introduce new securities to market in order to finance M&A activity.

Key Term

market maker: A person or company who undertakes to quote at all times both a buy and a sell price for a financial instrument.

Role of Investment Banking In M&A

With increasing competitive pressures being placed on businesses and the trend towards globalization, companies are engaging more and more in M&A activity. Many companies looking to expand or streamline their business will use investment banks for advice on potential targets and/or buyers. This normally will include a full valuation and recommended tactics. The investment bank’s role in mergers and acquisitions falls into one of either two buckets: seller representation or buyer representation (also called “target representation” and “acquirer representation”).

Investment Banking

Investment banks, such as Barclays (the headquarters for which is pictured here), play a vital role in the mergers and acquisitions process.

Valuation

One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction. Investment banks are experts at calculating what a business is worth. They are also able to predict how that worth could be altered (i.e., what happens to the value of a company in a number of different scenarios and what those potential futures would mean financially). Financial models are constructed by investment banks to capture the most important fixed and variable financial components that could influence the overall value of a company. These models, depending upon the proposed transaction, can be extremely complex with special variables being added for special areas (i.e., there are different financial factors to consider in different sectors, countries, and markets when predicting or measuring a company’s value).

Because of their expertise in business valuation, investment banks can also provide the service of arbitrage opportunities for their clients. For instance, if a bank has performed valuation on a potential target company that suggests its market value (or the value of its shares in the marketplace) is less than what the business is actually worth, it may facilitate a merger or acquisition of this target company for its client that carries with it substantial profit opportunity.

Buyers Versus Sellers

Investment banks do not just rely on buyers and sellers approaching them. They will also source deals by studying the market themselves and approaching companies with their own strategic ideas (i.e., they might suggest that two companies merge, or that one company acquires, or sells to, another). An investment bank that represents a potential seller has a much greater likelihood of completing a transaction (and therefore being paid) than an investment bank that represents a potential acquirer. This seller representation, also known as “sell-side work,” is the type of advisory assignment that is generated by a company when it approaches an investment bank and asks it to find a buyer of either the entire company or part of its assets. Generally speaking, the work involved in finding a buyer includes writing a “Selling Memorandum” (a detailed sales document) and then contacting potential strategic or financial buyers.

In advising sellers, the investment bank’s work is complete once another party purchases the business up for sale (i.e., once another party buys the client’s company or assets). However, representing a buyer is not always as straight forward. The advisory work itself is simple enough: The investment bank contacts the firm their client wishes to purchase, attempts to structure an acceptable offer for all parties, and make the deal a reality. However, many of these proposals do not work out; few firms or owners are willing to readily sell their business. Because investment banks primarily collect fees based on completed transactions, they are often forced to defend their proposals.

Provision of Financing

Of course, buying a company will require the funds to do so. Options available to a company wishing to raise funds include selling shares in itself or raising debt financing. Investment banks can, yet again, play a role in making this happen. In fact, one of the main roles investment banks play is to introduce new securities to market. Not only can an investment bank determine the best price for new issues–be they equity or debt–by valuing the company and examining the market, but they can also find buyers for those new issues. Therefore, they are referred to as market makers, since they perform the functions of both a buyer and seller.

20.5: Additional Topics in M&A

20.5.1: Other Topics in M&A

M&A also includes the areas of value creation, corporate alliances, private equity, and divestitures.

Learning Objective

Explain why a company may want to divest itself of an acquisition

Key Points

Despite the goal of value creation and synergy, results from mergers and acquisitions are often disappointing compared with results predicted or expected.
A form of corporate cooperation lying between a merger or acquisition and internal growth is called a corporate alliance or strategic alliance.
From an M&A point of view, a private placement is similar to a merger because it usually involves an institution (rather than numerous public investors) acquiring a stake (assets) in a company.
A divestiture is the reduction of some kind of asset for either financial or ethical objectives, or the sale of an existing business by a firm.

Key Terms

distribution channel: The institutional arrangement by which goods or services are conveyed from producer to user.
empirical: Pertaining to, derived from, or testable by observations made using the physical senses or using instruments which extend the senses.
Synergy: Benefits resulting from combining two different groups, people, objects, or processes.

M&A Value Creation

Despite the goal of value creation and synergy, results from mergers and acquisitions are often disappointing compared with results that are predicted or expected. Numerous empirical studies show high failure rates of M&A deals. Some reasons for failed mergers include lack of strategic fit, difference in corporate culture, lack of due diligence, poor integration, over-optimism, and failed valuation leading to too high of a purchase price. Employee turnover also contributes to M&A failures. The turnover in target companies has been found to be double the turnover experienced in non-merged firms for the 10 years following the merger. However, higher success rates have been experienced recently, due to firms gaining more and more experience with the M&A process.

Corporate Alliances

A form of corporate cooperation lying between a merger or acquisition and internal growth is called a corporate alliance, or strategic alliance. This is a relationship between two or more parties to pursue a set of agreed upon goals or to meet a critical business need while remaining independent organizations. Partners may provide the strategic alliance with resources such as products, distribution channels, manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual property. The alliance is a cooperation or collaboration which aims for a synergy where each partner hopes that the benefits from the alliance will be greater than those from individual efforts. The alliance often involves technology transfer (access to knowledge and expertise), economic specialization, shared expenses, and shared risk.

Private Equity and M&A

When raising funds for a merger or acquisition, firms may not seek funds from public offerings – either out of necessity or by choice. The company may not be big enough; the markets may not have an appetite for their issues; or the company may simply prefer not to have its stock be publicly traded. In such a case, a firm may choose to raise funds through private placements. The process of raising private equity, or debt, changes only slightly from a public deal. Often, one firm will be the sole investor in a private placement. In other words, if a company sells stock through a private placement, usually only one firm or a small number of firms will buy the stock offered. From an M&A point of view, a private placement is thus similar to a merger because it usually involves an institution (rather than numerous public investors) acquiring a stake (assets) in a company.

Private Equity

Private equity firms, such as NBGI, provide funds for companies unable or uninterested in obtaining funds publicly.

Divestitures

A divestiture is the reduction of some kind of asset for either financial or ethical objectives, or the sale of an existing business by a firm. Firms may have several motives for divestitures:

A firm may divest (sell) businesses that are not part of its core operations so that it can focus on what it does best.
To obtain funds. Divestitures generate funds for the firm because it is selling one of its businesses in exchange for cash.
A firm’s “break-up” value is sometimes believed to be greater than the value of the firm as a whole. In other words, the sum of a firm’s individual asset liquidation values exceeds the market value of the firm’s combined assets.
To create stability.
A division is under-performing or even failing.
A divestiture could be forced on to the firm by the regulatory authorities – for example, in order to create competition.

Often the term is used as a means to grow financially in which a company sells off a business unit in order to focus their resources on a market it judges to be more profitable or promising. Divestment of certain parts of a company can occur when required by the Federal Trade Commission before a merger with another firm is approved. The largest, and likely most famous, corporate divestiture in history was the 1984 U.S. Department of Justice-mandated breakup of the Bell System into AT&T and the seven Baby Bells.

Chapter 19: Overview of Short-Term Financing

19.1: Short-Term Financing

19.1.1: Short-Term Loans

Short-term loans offer individuals and businesses borrowing options to meet financial obligations.

Learning Objective

Classify different types of short term loans

Key Points

Longer term funding is supplied by bonds and equity.
Convenience is main benefit of a credit card to a business or entrepreneur .
Venture capitalists use bridge loans to “bridge” cash flow gaps between successive major private equity financing terms.

Key Terms

London Interbank Offered Rate: the average interest rate estimated by leading financial instiutions in London that they would be charged if borrowing from others
collateral: A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )
benchmark: A standard by which something is evaluated or measured.
venture capital: money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.

Example

In December 2010, Kohlberg Kravis Roberts (KKR) and partners marketed a bridge loan for its upcoming acquisition of Del Monte Foods. As is common in such cases, KKR planned for the newly private company to borrow money by issuing corporate bonds. To ensure the money would be available, KKR sought $1.6 billion in bridge loan guarantees, for which it promised to pay 8.75 percent interest for 60 days and 11.75 percent thereafter. At KKR’s option, these loans could then be replaced with eight-year corporate bonds (in effect, a put option) paying 11.75 percent. In return for the loans and guarantees, KKR was offering roughly 2 percent in fees.

Short Term Loans

Short term loans are borrowed funds used to meet obligations within a few days up to a year. The borrower receives cash from the lender more quickly than with medium- and long-term loans, and must repay it in a shorter time frame.

Examples of short-term loans include:

Overdraft

Overdraft protection is a financial service offered by banking institutions in the United States. An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation, the account is said to be “overdrawn. ” If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate.

Credit Card

A credit card is a payment card issued to users as a method of payment. It allows the cardholder to pay for goods and services based on the holder’s promise to pay for them. The issuer of the card creates a revolving account and grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or as a cash advance to the user. For smaller businesses, financing via credit card is an easy and viable option.

The main benefit to a business or entrepreneur is convenience. Compared to debit cards and checks, a credit card allows small short-term loans to be quickly made to a customer. The customer then need not calculate a balance remaining before every transaction, provided the total charges do not exceed the maximum credit line for the card.

Payday Loans

A payday loan (also called a payday advance) is a small, short-term unsecured loan. These loans are also sometimes referred to as “cash advances,” though that term can also refer to cash provided against a credit card or other prearranged line of credit. The basic loan process involves a lender providing a short-term unsecured loan to be repaid at the borrower’s next pay day. Typically, some verification of employment or income is involved (via pay stubs and bank statements), but some lenders may omit this.

Money Market

The money market developed because parties had surplus funds, while others needed cash. The core of the money market consists of inter bank lending (banks borrowing and lending to each other using commercial paper), repurchase agreements, and similar short-term financial instruments. Because money market securities are typically denominated in high values, it is not common for individual investors to wholly own shares of money market securities; instead, investments are carried out by corporations or money market mutual funds. These instruments are often benchmarked to the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Refund Anticipation Loan (RAL)

A refund anticipation loan (RAL) is a short-term consumer loan secured by a taxpayer’s expected tax refund designed to offer customers quicker access to funds than waiting for their tax refund. In the United States, taxpayers can apply for a refund anticipation loan through a paid professional tax preparation service.

Bridge Loans

A bridge loan is a type of short-term loan, typically taken out for a period of two weeks to three years pending the arrangement of larger or longer-term financing. It is interim financing for an individual or business until permanent or next-stage financing can be obtained. Money from the new financing is generally used to “take out” (i.e. to pay back) the bridge loan, as well as other capitalization needs.

Bridge loans are typically more expensive than conventional financing to compensate for the additional risk of the loan. Bridge loans typically have a higher interest rate, points and other costs that are amortized over a shorter period, as well as various fees and other “sweeteners” like equity participation by the lender. The lender also may require cross-collateralization and a lower loan-to-value ratio. On the other hand, they are typically arranged quickly with little documentation.

Bridge loans are used in venture capital and other corporate finance for several purposes:

To inject small amounts of cash to carry a company so that it does not run out of cash between successive major private equity financing.
To carry distressed companies while searching for an acquirer or larger investor (in which case the lender often obtains a substantial equity position in connection with the loan).
As a final debt financing to carry the company through the immediate period before an initial public offering or acquisition.

Payday Loan store

Payday loan stores offer short term loans

19.1.2: Credit Cards

Credit cards allow users to pay for goods and services based on the promise to pay for them later and the immediate provision of cash by the card provider.

Learning Objective

Evaluate the costs and benefits of a credit card

Key Points

The issuer of the card creates a revolving account and grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or as a cash advance to the user.
The main benefit to each customer is convenience. Credit cards allow small short-term loans to be quickly made to a customer who need not calculate a balance remaining before every transaction, provided the total charges do not exceed the maximum credit line for the card.
Costs to users include high interest rates and complex fee structures.

Key Term

credit card: A plastic card with a magnetic strip or an embedded microchip connected to a credit account and used to buy goods or services. It’s like a debit card, but money comes not from your personal bank account, but the bank lends money for the purchase based on the credit limit. Credit limit is determined by the income and credit history. Bank charge APR (annual percentage rate) for using of money.

Example

For example, if a user has a $1,000 transaction and repaid it in full within this grace period, there would be no interest charged. If, however, even $1 of the total amount remained unpaid, interest would be charged on the $1,000 from the date of purchase until the payment is received.

Credit Cards

A credit card is a payment card issued to users as a system of payment. It allows the cardholder to pay for goods and services based on the promise to pay for them later and the immediate provision of cash by the card provider. The issuer of the card creates a revolving account and grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or as a cash advance to the user. Credit cards allow the consumers a continuing balance of debt, subject to interest being charged. A credit card also differs from a cash card, which can be used like currency by the owner of the card .

Credit card

A credit card is a payment card issued to users as a system of payment.

Credit cards are issued by an issuer like a bank or credit union after an account has been approved by the credit provider, after which cardholders can use it to make purchases at merchants accepting that card.

Benefits to Users

The main benefit to each customer is convenience. Compared to debit cards and checks, a credit card allows small short-term loans to be quickly made to a customer who need not calculate a balance remaining before every transaction, provided the total charges do not exceed the maximum credit line for the card.

Many credit cards offer rewards and benefits packages like enhanced product warranties at no cost, free loss/damage coverage on new purchases and various insurance protections. Credit cards can also offer reward points which may be redeemed for cash, products or airline tickets.

Costs to Users

High interest rates: Low introductory credit card rates are limited to a fixed term, usually between six and 12 months, after which a higher rate is charged. As all credit cards charge fees and interest, some customers become so indebted to their credit card provider that they are driven to bankruptcy. Some credit cards often levy a rate of 20 to 30 percent after a payment is missed. In other cases a fixed charge is levied without change to the interest rate. In some cases universal default may apply – the high default rate is applied to a card in good standing by missing a payment on an unrelated account from the same provider. This can lead to a snowball effect in which the consumer is drowned by unexpectedly high interest rates.

Complex fee structures in the credit card industry limit customers’ ability to comparison shop, help ensure that the industry is not price-competitive and help maximize industry profits.

Benefits to Merchants

For merchants, a credit card transaction is often more secure than other forms of payment, because the issuing bank commits to pay the merchant the moment the transaction is authorized regardless of whether the consumer defaults on the credit card payment. In most cases, cards are even more secure than cash, because they discourage theft by the merchant’s employees and reduce the amount of cash on the premises. Finally, credit cards reduce the back office expense of processing checks/cash and transporting them to the bank.

Costs to Merchants

Merchants are charged several fees for accepting credit cards. The merchant is usually charged a commission of around one to three percent of the value of each transaction paid for by credit card. The merchant may also pay a variable charge, called an interchange rate, for each transaction. In some instances of very low-value transactions, use of credit cards will significantly reduce the profit margin or cause the merchant to lose money on the transaction. Merchants with very low average transaction prices or very high average transaction prices are more averse to accepting credit cards. Merchants may charge users a “credit card supplement,” either a fixed amount or a percentage, for payment by credit card. This practice is prohibited by the credit card contracts in the United States, although the contracts allow the merchants to give discounts for cash payment.

Merchants are also required to lease processing terminals, meaning merchants with low sales volumes may have to commit to long lease terms. For some terminals, merchants may need to subscribe to a separate telephone line. Merchants must also satisfy data security compliance standards which are highly technical and complicated. In many cases, there is a delay of several days before funds are deposited into a merchant’s bank account. As credit card fee structures are very complicated, smaller merchants are at a disadvantage to analyze and predict fees. Finally, merchants assume the risk of chargebacks by consumers.

19.1.3: Factoring Accounts Receivable

Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.

Learning Objective

Explain the business of factoring and assess the risks of the involved parties

Key Points

Debt factoring is also used as a financial instrument to provide better cash flow control especially if a company currently has a lot of accounts receivables with different credit terms to manage.
The three parties directly involved in factoring are: the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor.
There are two principal methods of factoring: recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. Under non-recourse factoring, the factor assumes the entire credit risk.

Key Term

factoring: A financial transaction whereby a business sells its accounts receivable to a third party (called a factor) at a discount.

Factoring

Factoring is a financial transaction whereby a business sells its accounts receivable to a third party (called a “factor”) at a discount. Factoring makes it possible for a business to convert a readily substantial portion of its accounts receivable into cash. This provides the funds needed to pay suppliers and improves cash flow by accelerating the receipt of funds.

Money

Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.

Companies factor accounts when the available cash balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as new orders or contracts. In other industries, however, such as textiles or apparel, for example, financially sound companies factor their accounts simply because this is the historic method of finance. The use of factoring to obtain the cash needed to accommodate a firm’s immediate cash needs will allow the firm to maintain a smaller ongoing cash balance. By reducing the size of its cash balances, more money is made available for investment in the firm’s growth. Debt factoring is also used as a financial instrument to provide better cash flow control, especially if a company currently has a lot of accounts receivables with different credit terms to manage. A company sells its invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its own growth than it would be by effectively functioning as its “customer’s bank. “

Types of Factoring

There are two principal methods of factoring: recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring (i.e., the full amount of invoice is paid to the client in the event of the debt becoming bad). Other variations include partial non-recourse, where the factor’s assumption of credit risk is limited by time, and partial recourse, where the factor and its client (the seller of the accounts) share credit risk. Factors never assume “quality” risk, and even a non-recourse factor can charge back a purchased account which does not collect for reasons other than credit risk assumed by the factor, (e.g., the account debtor disputes the quality or quantity of the goods or services delivered by the factor’s client).

In “advance” factoring, the factor provides financing to the seller of the accounts in the form of a cash “advance,” often 70-85% of the purchase price of the accounts, with the balance of the purchase price being paid, net of the factor’s discount fee (commission) and other charges, upon collection. In “maturity” factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch.

There are three principal parts to “advance” factoring transaction:

The advance, a percentage of the invoice’s face value that is paid to the seller at the time of sale.
The reserve, the remainder of the purchase price held until the payment by the account debtor is made.
The discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses, upon collection, before the reserve is disbursed to the factor’s client.

Parties Involved in the Factoring Process

The three parties directly involved are the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor. The receivable is essentially an asset associated with the debtor’s liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), often, in advance factoring, to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in non-recourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or its financial inability to pay.

Risks in Factoring

The most important risks of a factor are:

Counter party credit risk: risk covered debtors can be re-insured, which limit the risks of a factor. Trade receivables are a fairly low risk asset due to their short duration.
External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, unassigned credit notes, etc. A fraud insurance policy and subjecting the client to audit could limit the risks.
Legal, compliance, and tax risks: a large number and variety of applicable laws and regulations depending on the country.
Operational: operational risks such as contractual disputes.

19.1.4: Commercial Paper

Commercial paper is a money-market security issued (sold) by large corporations to get money to meet short term debt obligations.

Learning Objective

Analyze the commercial paper market

Key Points

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market.
Commercial paper is a lower cost alternative to a line of credit with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit.
Asset-Backed Commercial Paper (ABCP) is a form of commercial paper that is collateralized by other financial assets.

Key Term

money market: A market for trading short-term debt instruments, such as treasury bills, commercial paper, bankers’ acceptances, and certificates of deposit.

Commercial Paper

In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of one to 364 days. Commercial paper is a money-market security issued (sold) by large corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or a corporation’s promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks’ rates.

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market . The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Most of these firms are also dealers in US Treasury securities. Direct issuers of commercial paper are usually financial companies that have frequent and sizable borrowing needs, and find it more economical to sell paper without the use of an intermediary. In the United States, direct issuers save a dealer fee of approximately five basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States .

US Commercial Paper Weekly 2001-2008

United States Commercial Paper outstanding at end of each week from 3 January 2001 to 29 October 2008. Vertical scale shows debt in billions (thousands of millions) of dollars, horizontal scale shows years. Each blue marker indicates commercial paper outstanding at that date which matures after one week.

US Commercial Paper 2001-2007

United States Commercial Paper outstanding at end of each year 2001 to 2007. Vertical scale shows debt in millions of dollars, horizontal scale shows years. All markers indicate commercial paper outstanding, maturing after December 31. Circles on blue line indicate Total commercial paper; triangles diamonds on pink line indicate SEC rule 2a-7 tier-1 commercial paper; triangles on blue line indicate Asset-backed commercial paper; squares on yellow line indicate SEC rule 2a-7 tier-2 commercial paper.

Weekly Commercial Paper Outstandings

Commercial paper is a lower cost alternative to a line of credit with a bank. Once a business becomes established and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a backup. Banks often charge fees for the amount of the line of the credit that does not have a balance.

Advantages and Disadvantages

Advantages of commercial paper include lower borrowing costs; term flexibility; and more liquidity options for creditors due to its trade-ability.

Disadvantages of commercial paper include its limited eligibility; reduced credit limits with banks; and reduced reliability due to its strict oversight.

Asset-Backed Commercial Paper (ABCP)

Asset-Backed Commercial Paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. ABCP is typically a short-term instrument that matures between one and 180 days from issuance and is typically issued by a bank or other financial institution. The firm wishing to finance its assets through the issuance of ABCP sells the assets to a Special Purpose Vehicle (SPV) or Structured Investment Vehicle (SIV), created by a financial services company. The SPV/SIV issues the ABCP to raise funds to purchase the assets. This creates a legal separation between the entity issuing and the institution financing its assets.

19.1.5: Secured vs. Unsecured Funding

A secured loan is a loan in which the borrower pledges an asset (e.g. a car or property) as collateral, while an unsecured loan is not secured by an asset.

Learning Objective

Differentiate between a secured loan vs. an unsecured loan

Key Points

A loan constitutes temporarily lending money in exchange for future repayment with specific stipulations such as interest, finance charges, and fees.
Secured loans are secured by assets such as real estate, an automobile, boat, or jewelry. The secured asset is known as collateral. In the event the borrower does not pay the loan as agreed, he/she may forfeit the asset used as collateral to the lender.
Unsecured loans are monetary loans that are not secured against collateral. Interest rates for unsecured loans are often higher than for secured loans because the risk to the lender is greater.

Key Term

Assets: An asset is something of economic value. Examples of assets include money, real estate, and automobiles.

Examples

A mortgage loan is a secured loan in which the collateral is real estate. If the borrower does not pay back the mortgage within the agreed upon terms, the lender may seize the property. Seizure of real estate for non-payment is also known as foreclosure. A foreclosure is a legal process in which mortgaged property is sold to pay the debt of the defaulting borrower.
A car loan is a secured loan in which the collateral is an automobile, If the borrower does not pay back the car loan within the agreed upon terns, the lender may seize the automobile. Seizure of an automobile for non-payment is also known as repossession. Repossession is a legal process in which property, such as a car, is taken back by the creditor.

Loans

Debt refers to an obligation. A loan is a monetary form of debt. A loan constitutes temporarily lending money in exchange for future repayment with specific stipulations such as interest, finance charges, and/or fees. A loan is considered a contract between the lender and the borrower. Loans may either be secured or unsecured.

Secured Loans

A secured loan is a loan in which the borrower pledges some asset (e.g., a car or property) as collateral. A mortgage loan is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank has the legal right to repossess the house and sell it, to recover sums owed to it.

If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount. Generally speaking, secured debt may attract lower interest rates than unsecured debt due to the added security for the lender. However, credit history, ability to repay, and expected returns for the lender are also factors affecting rates.

There are two purposes for a loan secured by debt. By extending the loan through secured debt, the creditor is relieved of most of the financial risks involved because it allows the creditor to take the property in the event that the debt is not properly repaid. For the debtor, a secured debt may receive more favorable terms than that available for unsecured debt, or to be extended credit under circumstances when credit under terms of unsecured debt would not be extended at all. The creditor may offer a loan with attractive interest rates and repayment periods for the secured debt.

Unsecured Loans

Unsecured loans are monetary loans that are not secured against the borrower’s assets. The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law.

Interest rates on unsecured loans are nearly always higher than for secured loans, because an unsecured lender’s options for recourse against the borrower in the event of default are severely limited. An unsecured lender must sue the borrower, obtain a money judgment for breach of contract, and then pursue execution of the judgment against the borrower’s unencumbered assets (that is, the ones not already pledged to secured lenders). In insolvency proceedings, secured lenders traditionally have priority over unsecured lenders when a court divides up the borrower’s assets. Thus, a higher interest rate reflects the additional risk that in the event of insolvency, the debt may be difficult or impossible to collect.

Unsecured loans are often used by borrowers for small purchases such as computers, home improvements, vacations, or unexpected expenses. An unsecured loan means the lender relies on the borrower’s promise to pay it back. Due to the increased risk involved, interest rates for unsecured loans tend to be higher. Typically, the balance of the loan is distributed evenly across a fixed number of payments; penalties may be assessed if the loan is paid off early. Unsecured loans are often more expensive and less flexible than secured loans, but suitable if the lender wants a short-term loan (one to five years).

In the event of the bankruptcy of the borrower, the unsecured creditors will have a general claim on the assets of the borrower after the specific pledged assets have been assigned to the secured creditors, although the unsecured creditors will usually realize a smaller proportion of their claims than the secured creditors.

In some legal systems, unsecured creditors who are also indebted to the insolvent debtor are able (and in some jurisdictions, required) to set-off the debts, which actually puts the unsecured creditor with a matured liability to the debtor in a pre-preferential position.

19.1.6: Family and Friends

Asking friends and families to invest is one way that start-ups are funded.

Learning Objective

Analyze person to person (P2P) lending

Key Points

Somewhat similar to raising money from family and friends is person-to-person lending. Person-to-person lending is a certain breed of financial transaction which occurs directly between individuals or “peers” without the intermediation of a traditional financial institution.
Lending money and supplies to friends, family, and community members predates formalized financial institutions, but in its modern form, peer-to-peer lending is a by-product of Internet technologies, especially Web 2.0.
In a particular model of P2P lending known as “family and friend lending”, the lender lends money to a borrower based on their pre-existing personal, family, or business relationship.

Key Term

financial institution: In financial economics, a financial institution is an institution that provides financial services for its clients or members.

Investments from Family and Friends

Asking friends and families to invest is another common way that start-ups are funded. Often the potential entrepreneur is young, energetic, and has a good idea for a start-up, but does not have much in the way of personal savings. Friends and family may be older and have some money set aside. While your parents, or other family members should not risk all of their retirement savings on your start-up, they may be willing to risk a small percentage of it to help you out .

Family

Asking friends and families to invest is another common way that start-ups are funded.

Sometimes friends your own age are willing to work for little or no wages until your cash flow turns positive. The term “sweat equity” is often used for this type of contribution as the owner will often reward such loyalty with a small percentage ownership of the organization in lieu of cash. A variation on this is barter or trade. This is a method by which you could provide a needed service such as consulting or management advice in return for the resources needed for your start up. This needs to be accounted for in your accounting records also.

Person-to-Person Lending

Somewhat similar to raising money from family and friends is person-to-person lending. Person-to-person lending (also known as peer-to-peer lending, peer-to-peer investing, and social lending; abbreviated frequently as P2P lending) is a certain breed of financial transaction (primarily lending and borrowing, though other more complicated transactions can be facilitated) which occurs directly between individuals or “peers” without the intermediation of a traditional financial institution. However, person-to-person lending is for the most part a for-profit activity, which distinguishes it from person-to-person charities, person-to-person philanthropy, and crowdfunding.

Lending money and supplies to friends, family, and community members predates formalized financial institutions, but in its modern form, peer-to-peer lending is a by-product of Internet technologies, especially Web 2.0. The development of the market niche was further boosted by the global economic crisis in 2007 to 2010 when person-to-person lending platforms promised to provide credit at the time when banks and other traditional financial institutions were having fiscal difficulties.

Many peer-to-peer lending companies leverage existing communities and pre-existing interpersonal relationships with the idea that borrowers are less likely to default to the members of their own communities. The risk associated with lending is minimized either through mutual (community) support of the borrower or, as occurs in some instances, through forms of social pressure. The peer-to-peer lending firms either act as middlemen between friends and family to assist with calculating repayment terms, or connect anonymous borrowers and lenders based on similarities in their geographic location, educational and professional background, and connectedness within a given social network.

In a particular model of P2P lending known as “family and friend lending”, the lender lends money to a borrower based on their pre-existing personal, family, or business relationship. The model forgoes an auction-like process and concentrates on formalizing and servicing a personal loan. Lenders can charge below market rates to assist the borrower and mitigate risk. Loans can be made to pay for homes, personal needs, school, travel, or any other needs.

Advantages and Criticisms

One of the main advantages of person-to-person lending for borrowers has been better rates than traditional bank rates can offer (often below 10%). The advantages for lenders are higher returns that would be unobtainable from a savings account or other investments.

As person-to-person lending companies and their customer base continue to grow, marketing expenses and administrative costs associated with customer service and arbitration, maintaining product information, and developing quality websites to service customers and stand out among competitors will rise. In addition, compliance to legal regulations becomes more complicated. This causes many of the original benefits from disintermediation to fade away and turns person-to-person companies into new intermediaries, much like the banks that they originally differentiated from. This process of reintroducing intermediaries is known as reintermediation.

Person-to-person lending also attracts borrowers who, because of their past credit status or the lack of thereof, are unqualified for traditional bank loans. The unfortunate situation of these borrowers is well-known for the people issuing the loans and results in very high interest rates that verge on predatory lending and loan sharking.

19.1.7: Commercial Banks

A commercial bank lends money, accepts time deposits, and provides transactional, savings, and money market accounts.

Learning Objective

Sketch out the role of commercial banks in money lending

Key Points

Commercial banks may provide a secured loan, which are monetary loans that have borrower collateral pledged against their repayment.
Commercial banks may also provide unsecured loans, which are monetary loans that are not secured against the borrower’s assets (i.e., no collateral is involved).
Accessing funds through a commercial bank is a very common way of accessing funds when in need, particularly in the case of small or entrepreneurial businesses.

Key Term

collateral: A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )

A commercial or business bank , is a type of financial institution and intermediary that lends money, accepts time deposits, and provides transactional, savings, and money market accounts.

Commercial banks

A commercial bank (or business bank) is a type of financial institution and intermediary.

Commercial banks engage in the following activities: the processing of payments; accepting money on term deposit; lending money by overdraft, installment loan, or other means; providing documentary and standby letters of credit guarantees, performance bonds, securities underwriting commitments and other forms of off- balance sheet exposures; and the safekeeping of documents and other items in safe deposit boxes.

Commercial banks provide a number of loans. A secured loan is when a borrower pledges some asset (e.g., a car or property) as collateral for it, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral. In the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally lent to the borrower.

Commercial banks may also provide unsecured loans, which are monetary loans that are not secured against the borrower’s assets (i.e., no collateral is involved). Some examples of unsecured loans include credit cards and credit lines.

An overdraft is an example of an unsecured loan. An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation, the account is said to be “overdrawn”. If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the positive balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply.

Accessing funds through a commercial bank is very typical, and a common way of accessing funds when in need, particularly in the case of small or entrepreneurial businesses.

19.1.8: Trade Credit or Accounts Payable

Trade credit is the largest use of capital for a majority of B2B sellers; Accounts Payable is money owed by a firm to its suppliers.

Learning Objective

Explain the process of using and recording accounts payable

Key Points

There are many forms of trade credit in common use; often industry-specific. They all benefit from their collaboration to make efficient use of capital to accomplish various business objectives.
An accounts payable is recorded in the Account Payable sub-ledger at the time an invoice is vouchered for payment.
Commonly, a supplier will ship a product, issue an invoice, and collect payment later, which describes a cash conversion cycle, or a period of time during which the supplier has already paid for raw materials but hasn’t been paid in return by the final customer.

Key Term

supplier: One who supplies; a provider.

Trade Credit

Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings. Trade credit for Wal-Mart is eight times the amount of capital invested by shareholders.

For many borrowers in the developing world, trade credit serves as a valuable source of alternative data for personal and small business loans.

There are many forms of trade credit in common use; often industry-specific. They all benefit from their collaboration to make efficient use of capital to accomplish various business objectives.

Accounts Payable (A/P)

Accounts Payable (A/P and also known as creditors) is money owed by a business to its suppliers. An accounts payable is recorded in the A/P sub-ledger at the time an invoice is vouchered for payment. Payables are often categorized as Trade Payables, payables for the purchase of physical goods that are recorded in Inventory, and Expense Payables, payables for the purchase of goods or services that are expensed. Common examples of Expense Payables are advertising, travel, entertainment, office supplies, and utilities. A/P is a form of credit that suppliers offer to their customers by allowing them to pay for a product or service after it has already been received .

Credit

Accounts Payable (also known as Creditors) is money owed by a business to its suppliers.

In households, these payables are ordinarily bills such as utility, rent, etc. Households usually track and pay on a monthly basis manually by using checks, credit cards, or online banking. In a business, there is usually a much broader range of suppliers to pay, and accountants or bookkeepers usually use accounting software to track the flow of money into this liability account when they receive invoices and out of it when they make payments. Increasingly, large firms often use specialized automation solutions (commonly called ePayables) to automate the paper and manual elements of processing an organization’s invoices.

Commonly, a supplier will ship a product, issue an invoice, and collect payment later, which describes a cash conversion cycle, a period of time during which the supplier has already paid for raw materials but hasn’t been paid in return by the final customer. When the invoice is received by the purchaser, it is matched to the packing slip and purchase order, and if all is in order, the invoice is paid. This is referred to as the three-way match. The three-way match can slow down the payment process, so the method may be modified. For example, three-way matching may be limited solely to large-value invoices, or the matching is automatically approved if the received quantity is within a certain percentage of the amount authorized in the purchase order.

Chapter 18: Working Capital Management

18.1: The Importance of Cash

18.1.1: Reasons for Maintaining Cash on Hand

The main reason a business maintains cash on hand is to meet financial obligations.

Learning Objective

Explain the importance for always having cash on hand

Key Points

Liquidity is the ability to meet obligations when they come due without incurring unacceptable losses.
Banks can generally maintain as much liquidity as desired, because bank deposits are insured by governments in most developed countries.
Banks can attract significant liquid funds to generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.
Cash is the most liquid asset and can be used immediately to perform economic actions like buying, selling, or paying debt, and meeting immediate wants and needs.
Bank can attract significant liquid funds to generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.

Key Terms

liquidity: Availability of cash over short term: ability to service short-term debt.
money market: A market for trading short-term debt instruments, such as treasury bills, commercial paper, bankers’ acceptances, and certificates of deposit

In business, economics, or investment, market liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, paying debt, and meeting immediate wants and needs.

In bookkeeping and accounting, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near immediately (as in the case of money market accounts). Cash is seen as a reserve for payments and as a way to meet financial obligations.

Cash

A business’s cash account is how much currency it has on hand at a given time.

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients’ deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a central bank, such as the U.S. Federal Reserve Bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally mandated requirements intended to help banks avoid a liquidity crisis.

18.1.2: Defining the Cash Flow Cycle

The cash flow cycle measures how long it takes for a firm to recover cash that it invests in ongoing operations.

Learning Objective

Define the cash flow cycle

Key Points

In management accounting, the cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.
It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks. While a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.
The term “cash conversion cycle” refers to the timespan between a firm’s disbursing and collecting cash.
Since a retailer’s operations consist of buying and selling inventory, the equation models the time between (1) disbursing cash to satisfy the accounts payable created by purchase of inventory, and (2) collecting cash to satisfy the accounts receivable generated by that sale.

Key Terms

retail: The sale of goods directly to the consumer; encompassing the storefronts, mail-order, websites, etc., and the corporate mechanisms, branding, advertising, etc. that support them, which are involved in the business of selling and point-of-sale marketing retail goods to the public.
cash flow: The sum of cash revenues and expenditures over a period of time.
balance sheet: A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.

Cash flow cycle also is called “cash conversion cycle” (CCC). In management accounting, the CCC measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Cash Conversion Cycle

The cash conversion cycle refers to the time frame between a firm’s cash disbursement and cash collection. However, the CCC cannot be directly observed in cash flows, because these are also influenced by investment and financing activities; it must be derived from statement of financial position or balance sheet data associated with the firm’s operations.

Retail

Although the term “cash conversion cycle” technically applies to a firm in any industry, the equation is formulated to apply specifically to a retailer. Since a retailer’s operations consist of buying and selling inventory, the equation models the time between the following:

Disbursing cash to satisfy the accounts payable created by purchase of inventory; and
Collecting cash to satisfy the accounts receivable generated by that sale.

The CCC must be calculated by tracing a change in cash through its effect upon receivables, inventory, payables, and finally back to cash, thus, the term cash conversion cycle, and the observation that these four accounts “articulate” with one another.

The equation describes a firm that buys and sells on account. Also, the equation is written to accommodate a firm that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g., changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and collecting cash would be directly measurable as sale of inventory.

However, for a firm that buys and sells on account, Increases and decreases in inventory do not occasion cash flows but accounting vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books.

18.1.3: Calculating the Cash Flow Cycle

Cash flow cycle = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

Learning Objective

Calculate a company’s cash flow cycle

Key Points

Cash flow cycle = Inventory conversion period + Receivables conversion period – Payables conversion period.
Inventory conversion period = Avg. Inventory / (COGS / 365); Receivables conversion period = Avg. Accounts Receivable / (Credit Sales / 365); Payables conversion period = Avg. Accounts Payable / (Purchases / 365).
There are five important intervals, referred to as conversion cycles (or conversion periods).
Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales.

Key Term

Credit Sales: Credit Sales are all sales made on credit.

Cash Flow Cycle

The cash flow cycle is also called cash conversion cycle (CCC).

CCC=# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

=Inventory conversion period + Receivables conversion period – Payables conversion period

Inventory conversion period = Avg. Inventory / (COGS / 365)

Receivables conversion period = Avg. Accounts Receivable / (Credit Sales / 365)

Payables conversion period = Avg. Accounts Payable / (Purchases / 365)

There are five important intervals, referred to as conversion cycles (or conversion periods):

The Cash Conversion Cycle emerges as interval C→D (i.e., disbursing cash→collecting cash).
The payables conversion period (or “Days payables outstanding”) emerges as interval A→C (i.e., owing cash→disbursing cash)
The operating cycle emerges as interval A→D (i.e., owing cash→collecting cash)
The inventory conversion period or “Days inventory outstanding” emerges as interval A→B (i.e., owing cash→being owed cash)
The receivables conversion period (or “Days sales outstanding”) emerges as interval B→D (i.e., being owed cash→collecting cash)

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period. )

Hence, interval {C → D}=interval {A → B}+interval {B → D}–interval {A → C}

In calculating each of these three constituent conversion cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE).

We estimate its LEVEL “during the period in question” as the average of its levels in the two balance sheets that surround the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).

Inventory conversion period: Rate = COGS, since this is the item that (eventually) shrinks inventory.
Receivables conversion period: Rate = revenue, since this is the item that can grow receivables (sales).
Payables conversion period: Rate = [inventory increase + COGS], since these are the items for the period that can increase “trade accounts payables” (i.e., the ones that grew its inventory).

Aims of CCC

Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.

18.1.4: Components of the Cash Budget

The cash budget includes the beginning balance, detail on payments and receipts, and an ending balance.

Learning Objective

Identify the different components of a cash budget

Key Points

The cash flow budget helps the business determine when its income will be sufficient to cover its expenses and when the company will need to seek outside financing.
Components – major classes include cash receipts and payments.
Cash receipts include cash generated from operations, cash receipts from customers, proceeds from the sale of equipment, dividends received, and other income.
Cash payments include cash paid to suppliers, cash paid to employees, purchase of assets, payments related to mergers and acquisitions, interest paid, income taxes paid, dividends paid, and other payments.

Key Terms

mergers and acquisitions: Mergers and acquisitions (abbreviated M&A) is an aspect of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly, whether in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity, or using a joint venture.
stockholders: A shareholder or stockholder is an individual or institution (including a corporation) that legally owns a share of stock in a public or private corporation.

Cash Budget

A cash budget is a prediction of future cash receipts and expenditures for a particular time period, usually in the near future. The cash flow budget helps the business determine when its income will be sufficient to cover its expenses and when the company will need to seek outside financing.

A Sample Balance Sheet

One of the assets listed is cash, which factors into the overall budget.

Components: Major classes include cash receipts and payments.

Cash Balance, Beginning of the Year

Cash Receipts

Cash generated from operations
Cash receipts from customers – Collecting the accounts receivable. Accounts receivable, also known as Debtors, is money owed to a business by its clients (customers) and shown on the business’s balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered.
Proceeds from the sale of equipment
Dividends received: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders.
Other income: Other investment or other interest income, etc.

Cash Payments

Cash paid to suppliers
Cash paid to employees – Salary, wages expenses.
Purchase of asset – Equipment, machine, real estate, etc.
Payments related to mergers and acquisitions
Interest paid – Interest of short-term or long-term debt.
Income taxes paid
Dividends paid – Paying dividends to shareholders or investors.
Debt paid – Short term or long term debt principle.
Other payment – Which includes Advertising, Selling expenses, Administrative expense, Insurance expenses, Rent expenses, etc.

Net increase in cash and cash equivalents

Cash balance, end of year

18.2: Cash Management

18.2.1: Managing Float

Float is the term used to represent duplicate money present between the time a deposit is made and when the deposit clears the bank.

Learning Objective

Discuss how to use float to improve a company’s operations

Key Points

Float is most apparent in the time delay between a check being written and the funds to cover that check being deducted from the payer’s account.
Bank float is the time it takes to clear the funds, from the time they were deposited to the time they were credited to the depositing bank. Customer float is defined as the span of time between the deposit to the time the funds are released for use by the depositor.
When managing cash disbursements, a company should endeavor to increase the amount of time present in the disbursement cycle.

Key Term

check kiting: a form of check fraud, involving taking advantage of the float to make use of non-existent funds in a checking or other bank account.

Managing Float

The term float is used in finance and economics to represent duplicate money present in the banking system during the time between when a deposit is made in the recipient’s account and when the money is deducted from the sender’s account. Float is also associated with the amount of currency available to trade – i.e., countries can manipulate the worth of their currency by restricting or expanding the amount of float available to trade. Float is most apparent in the time delay between a check being written and the funds to cover that check being deducted from the payer’s account. Once the recipient, or payee, deposits the check in the corresponding account, the bank immediately credits (increases) the payee’s account, assuming that the payer’s bank will ultimately send the funds to cover the check. Until the payer’s bank actually sends the funds, both the payer and the payee have the same money in their accounts. Once the payee’s bank notifies the payer’s bank of a pending check, the duplicate funds will be removed from the payer’s account and the checks will be considered to have cleared the bank. In check clearing, bank float and customer float are present.

Bank float is the time it takes to clear the funds, from the time they were deposited to the time they were credited to the depositing bank. Customer float is defined as the span of time between the deposit to the time the funds are released for use by the depositor. The difference between the bank float and the customer float is called negative float. Negative float is used by the bank as the overnight investable funds. Float can cause marginal changes in the money supply. Before electronic check clearing, bad weather or communication problems often caused float to significantly increase, as the clearing of checks was delayed. Another aspect of float time is its use to defraud, commonly known as check kiting.

Float In Relation To Cash Management

Floating Cash

In cash management, float can be utilized to make use of cash on hand for as long as possible.

When managing cash disbursements, a company should endeavor to increase the amount of time present in the disbursement cycle. In other words, it is appropriate to delay making payments until they come due in order to have use of available cash for as long as possible. Some methods for accomplishing this include mailing checks far away from those waiting to receive payment, disbursing checks from a remote bank, or purchasing with credit cards. Methods such as these present a company with three types of float to take advantage of:

Mail Float: Time spent in the mail.
Clearance Float: Time spent trying to clear the bank.
Processing Float: Time required to process cash flow transactions.

18.2.2: Managing Collections

A company must balance its need for quick cash collections with the needs and desires of its customers.

Learning Objective

Describe the different strategies for managing a company’s collections

Key Points

Specific collection techniques include letters, telephone calls, faxes, emails, and legal action.
Wherever possible, a company should try to collect payment immediately as products or services are delivered.
A company may set up a lock box service with their bank for receiving customers’ payments.

Key Terms

lockbox: a service offered to organizations by commercial banks that simplifies collection and processing of account receivables by having those organizations’ customers’ payments mailed directly to a location accessible by the bank
invoicing: the production of a commercial document issued by a seller to the buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer.

Managing Cash Collections

The cash receipts cycle requires a diligent collection process. A company must balance this need for quick cash collections with the needs and desires of its customers. For example, customers who are important to a firm’s business should be treated carefully as opposed to customers who mean little or nothing to its future. Therefore, collection efforts must be customer specific in order to be effective. Specific collection techniques include letters, telephone calls, faxes, emails, and legal action. An example of a collection letter follows:

Our records indicate that a balance of $ 4,650.30 is over 90 days past due. We have sent monthly statements and reminders several times, but we have yet to receive payment or any explanation as to why payment should not be made. Please review this matter immediately. I will call you in the next five days to arrange payment.

The overall collection process should be pro-active and preventive. For example, wherever possible a company should try to collect payment immediately as products or services are delivered, i.e., receive payment in cash. This eliminates the need for invoicing and follow up collection techniques. A firm should always require deposits from customers that have a history of making late payments. It should use credit applications to weed out bad customers, and include a clause in the credit application that states all collection costs are reimbursed by the customer on delinquent accounts.

Example Collection Letter

A sample collection settlement letter.

Lock Box Banking

Lock box banking is a service offered to companies by commercial banks that simplifies collection and processing of account receivables. In general, a lockbox is a Post Office box that is accessible by a bank. A company may set up a lock box service with their bank for receiving customers’ payments. The company’s customers send their payments to the PO box, and the bank subsequently collects and processes these payments directly and deposits them to the company’s account. Because the bank is making the collection, the funds that have been received are immediately deposited into the company’s account without first being processed by the company’s accounting system, thereby speeding up cash collection. Another benefit of the lockbox service is that a company can maintain special mailboxes in different locations around the country. A customer then sends payment to the closest lockbox.

18.2.3: Managing Disbursements

How a company manages various disbursements and current assets can have a significant impact on its cash flows.

Learning Objective

Identify different strategies for managing a company’s disbursements

Key Points

One obvious trend in payroll management is to implement a flexible work force since the flow of work fluctuates.
Purchasing practices, such as renting as opposed to buying or buying out of season, can help a company maintain and generate cash flow.
Inventories have several hidden costs that can drain cash flow, including storage, insurance, spoilage, handling, taxes, and financing.
A company should make sure it does not over insure the business.

Key Term

outsourcing: The transfer of a business function to an external service provider.

Managing Cash Disbursements

Cash Disbursements

Cash payments are vitally important to manage in order to maintain a successful business.

How a company manages various disbursements and current assets can have a significant impact on its cash flows. There are several problem areas to watch out for, such as payroll, purchasing, inventories, and insurance.

Payroll

Payroll is a hefty cash outflow and requires special attention. One obvious trend in payroll management is to implement a flexible work force, since the flow of work fluctuates. Outsourcing and temporary workers are often part of a flexible workforce. However, a company must retain a full-time workforce for core activities. A firm can also increase payroll float times by simply distributing payroll checks after the point when banks will clear checks.

Purchasing

Flexible purchasing practices can help a company maintain and generate cash flow. A company may consider renting certain items as opposed to purchasing. A manager may ask, do we really need this item, and how often will we use it? If practical, a firm can order items out of season when prices are low. Finally, a firm may consider using credit cards to make purchases since this will allow more time for making payment.

Inventory

Inventories have several hidden costs that can drain cash flow. These costs include storage, insurance, spoilage, handling, taxes, and financing. A company should get rid of inventory that is not moving. Obsolete inventory should be removed immediately. A firm may also find new ways of disposing of inventory. For example, it is better to sell inventory at costs than not at all. The overall objective is to maintain inventory levels at a profitable level.

Insurance

A company should make sure it does not over insure the business. A firm should purchase insurance in group packages to obtain the lowest premiums. It should start by covering the largest risks first. It should then structure as high a deductible as is affordable. A company should avoid duplication and excessive insurance and shift certain costs, such as health insurance, to the employee through higher payroll deductions. Insurance should be used to cover risks that are material but occur infrequently.

18.3: Securities Management

18.3.1: Managing Marketable Securities

Marketable securities are an investment option for organizations with strong liquidity and some potential strategic purposes in risk aversion.

Learning Objective

Understand the various forms of marketable securities, and their value in corporate finance

Key Points

Marketable securities are listed on the balance sheet as cash and cash equivalents, short term investments, and long term investments.
The primary purpose of investing in marketable securities is the opportunity to capture returns on existing cash, while still maintaining easy access to cash flow (due to the high liquidity).
Marketable securities include debt securities, equity securities, and derivatives. Debt securities tend to be longer term, lower risk, and lower return.
Equity primarily refers to stock and preferred stock, which can be used as a basic investment device to capture returns on existing cash (with higher risk than debt securities).
Derivatives are a bit more complex. Derivatives are often used in hedging, which is the process of investing existing cash to offset external risks such as variances in commodity prices, interest rates, and foreign currency fluctuations.

Key Term

derivatives: An investment option valued at the performance of an underlying asset.

What Are Marketable Securities?

This is a broad term that encompasses investments a business may make within the securities market. The advantages of these types of securities can vary depending on the business, but generally they are valuable investments with reasonably high returns that are still easily translated into cash. It is also worth noting that these types of investments can be used to hedge various types of risks. These types of investments are reported on a balance sheet as cash and cash equivalents due to their liquidity (as well as short term investments and, in some instances, long term investments), and can provide businesses with rapid access to capital.

Marketable Securities

This image depicts a balance sheet from Proctor & Gamble, where the cash and cash equivalents, short term investments, and long term investments underline the various line items that may depict marketable securities.

This image depicts a balance sheet from Proctor & Gamble, where the cash and cash equivalents, short term investments and long term investments underline the various line items that may depict marketable securities.

Types of Marketable Securities

Marketable securities can include a variety of business investments, most of which are easily exchanged via a public exchange. These include debt securities, equity securities, and derivatives. Each of these investment types have different degrees of risk (and respective return), as well as relatively different functions from a strategic investing point of view.

Debt Securities

The most common types of debt securities are corporate bonds, government bonds, and money market instruments. Bonds function on fixed term contracts, generally long term, offering a fixed rate of return at an extremely low level of risk. The reason the risk is so low on these particular instruments is due to the fact that in the circumstance of a bankruptcy or default on payments on behalf of the representing organization (in commercial bonds the company who issued it, and on government bonds the government that issued it), the holder of a debt security will be among the first stakeholders paid out when assets are liquidated.

Equity Securities

Another common instrument of investment for organizations investing in cash equivalents is common and preferred stock. Buying equity in other organizations can provide a variety of benefits, depending on the scale of the investment being made. Equity investments tend to yield higher returns (at higher risk), while also granting shareholders a percentage of ownership over the organization being invested in.

Derivatives

Perhaps the most interesting marketable securities (and often the highest risk) are derivatives. As the name implies, derivatives derive their value from the performance of an underlying asset. These underlying entities can be indexes, assets, interest rates, or a variety of other financial devices. The reason they can be so dangerous is due to the fact that, as derivatives of another asset, they can be subjected to an amplification of the risk the underlying asset is subjected to. The 2008 economic recessions is largely due to the irresponsible utilization of derivatives (in that case, primarily those reliant upon debts, such as home mortgages).

However, at the business level, derivatives have unique value due to the ability to hedge against various risks. Hedging is the process of purchasing derivatives counter to business risks being experienced, in order to offset any fluctuation in the external environment which may adversely effect profitability. This sounds confusing, but is actually much simpler than it seems. Let’s take a couple examples:

Hedging against foreign currency risk – When operating in a global market different than that of the home office, it is common to encounter the risk of fluctuating currencies. Let’s say that a company operating in both the United States and Australia (headquartered in the United States) is worried about exposure to the Australian dollar. They obtain 50% of their revenue in Australian dollars, and therefore have a great deal of short term assets in Australian dollars. By purchasing derivatives, the organization can profit from a decrease in value for the Australian dollar to offset what would have been lost in the valuation of their short term assets.
Hedging against commodity prices – Let’s consider another example, but this time with inventory. You own a coffee shop, so naturally you’re buying a lot of coffee beans. You budget $500,000 for the purchase of coffee beans over a given quarter for all of your many successful locations. However, you buy them in batches over time. If the price of coffee beans spikes up, you’re $500,000 won’t buy you nearly as many coffee beans as you projected you would need. As a clever investor, you purchased derivatives in coffee beans to make sure you would offset this loss with profits in the exchange market.

18.4: Accounts Receivable

18.4.1: Defining Accounts Receivable

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit.

Learning Objective

Describe when a business can recognize revenue

Key Points

In most businesses, accounts receivable is executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe.
Account receivables are classified as current assets assuming that they are due within one year.
Revenue has a big impact on bottom-line profitability, so managers may be tempted to “manage” revenue recognition.

Key Term

accrual accounting: A method of accounting in which funds are recorded when they are earned and deductions are claimed when expenses are incurred.

Defining Accounts Receivable

Every business sells products or services to its customers. Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most businesses, accounts receivable is executed by generating an invoice and either mailing or electronically delivering it to the customer. In turn, the customer must pay the invoice within an established timeframe, which is called the credit terms or payment terms. The accounts receivable departments use the sales ledger, which normally records:

The sales a business has made
The amount of money received for goods or services
The amount of money owed at the end of each month (debtors)

Bookkeeping

On a company’s balance sheet, accounts receivable is the money owed to that company by entities outside of the company. The receivables owed by the company’s customers are called trade receivables. Account receivables are classified as current assets assuming that they are due within one year. These are the funds management is concerned with when considering working capital requirements.

Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account. The first method is the allowance method, which establishes an allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways:

By reviewing each individual debt and deciding whether it is doubtful (a specific provision)
By providing for a fixed percentage (e.g. 2%) of total debtors (a general provision)

The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

Revenue Recognition

A company has a choice of when to actually recognize revenue via various accounting methods. Revenue has a big impact on bottom-line profitability, so managers may be tempted to “manage” revenue recognition. Under accrual accounting, a firm can recognize revenue when it has:

Delivered goods and the title is transferred to the buyer
Performed all, or a substantial portion of, the services to be provided
Incurred a substantial majority of the costs, and the remaining costs can be reasonably estimated
Received either cash, a receivable, or some other asset for which a reasonably precise value can be assigned or collectibility is reasonably assured

Managers can sometimes tweak the period in which revenue is recognized to create a more attractive financial statement for a given circumstance .

Accrual Recognition

This chart lays out methods for accruing revenue and expenses in accounting.

18.4.2: Setting a Credit Policy

To establish a credit policy, a company must establish credit standards, credit terms, and a collection policy.

Learning Objective

Analyze a potential borrower using the “Five C’s of Credit”

Key Points

Management must decide on credit standards, which involves decisions on how much credit risk to assume.
Another important factor in determining credit standards involves a company evaluating the credit worthiness of an individual or business.
After establishing credit standards, the firm must decide on the length of the period before payment must be made and whether or not they will offer a discount for early payments.
The last step is to establish a collection policy.

Key Terms

collateral: A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )
bad-debt losses: losses resulting from an uncollectible debt.
collection policy: the set of rules for receiving accounts payable or debt
credit period: the amount of time required to receive payment for debt extended

Setting a Credit Policy

There are three steps a company must undergo when developing a credit policy:

Establish credit standards.
Establish credit terms.
Establish a collection policy.

Management must decide on credit standards, which involves decisions on how much credit risk to assume. These decisions play a large role in determining how much money a firm ties up in its receivables. A restrictive policy will most likely result in lower sales, but the firm will have a smaller investment in receivables and incur less bad-debt losses. Less restrictive policies will generate higher sales as well as a higher receivables balance, but the company will most likely incur more bad-debt losses and a high opportunity cost of holding capital in accounts receivables.

Credit Score Factors

This chart depicts the factors that go into an individual’s credit score.

Another important factor in determining credit standards involves a company evaluating the credit worthiness, or credit score, of an individual or business. This refers to the risk that the buyer will default on extended credit by failing to make payments which it is obligated to do. Potential losses not only include the selling price, but can also include disruption to cash flows and increased collection costs. To reduce its risk, the seller may perform a credit check on the buyer or require the buyer to put up collateral against credit extended.

Other Facets of Credit Policies

After establishing credit standards, the firm must decide on the length of the period that would be allowed before payment must be made and whether or not they will offer a discount for early payments. If a discount is offered, the amount of the discount must also be determined. There are many purposes for discounting, such as to move out-of-date stock, to reward valuable customers, as a sales promotion, or to reward behaviors that benefit the discount issuer. Some common types of discounts include:

Prompt payment discount.
Preferred payment discount (such as cash over credit card).
Partial payment discount.
Seasonal discount (for orders placed in a slack period for example).
Trade discount (usually given when the buyer agrees to perform some function).
Quantity discount.

The last step is to establish a collection policy. Collection policies vary widely among industries. Some companies do nothing when their customers don’t pay. Others send out a reminder notifying customers that their payment is late. Some companies may even take legal action at the first late payment.

The Five C’s Of Credit

Character: Is the borrower trustworthy with a history of meeting its debt obligations?
Capacity: Will the borrower have enough cash flow to make its payments?
Capital: Does the borrower have enough capital to justify the loan?
Collateral: Does the borrower have any assets that can secure the loan?
Conditions: How are both the borrower and the economy performing and how are they expected to perform?

18.4.3: Terms of Trade

Terms of trade credit include the amount of time allowable for payment to be received, including any potential discounts.

Learning Objective

Differentiate different types of transaction by the terms of trade

Key Points

Credit terms are often quoted “net X” with X being a certain number of days.
An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date the invoice is issued.
The debtor is free to pay before the due date, and many businesses can offer a discount for early payment.
A discount stated as 2/10, net 30 means that the buying firm will receive a two percent discount if it pays by the tenth day, or else they will pay the full amount in 30 days.

Key Term

franchising: The establishment, granting, or use of a franchise.

Terms of Trade

Credit terms are often quoted as “net X” with X being a certain number of days. An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date the invoice is issued. Transit time is included when counting the days, i.e. a purchase in transit for 7 days before receipt has just 23 additional days until payment is due to the seller.

Other common payment terms include Net 45, Net 60 and 30 days end of month. Net 30 is a term that most business and municipalities (federal, state and local) use in the United States. Net 10 and Net 15 is widely used as well. Net 60 is less used because of its longer payment terms.

The debtor is free to pay before the due date, and some businesses offer a discount for early payment. A discount can be offered and stated as “2/10, net 30”. This means that the buying firm will receive a two percent discount if it pays by the tenth day, otherwise they will pay the full amount in 30 days.

Let’s consider a potential case of the operator of an ice cream stand. The operator may sign a franchising agreement, under which the distributor agrees to provide ice cream stock under the terms “Net 60” with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10 days. This means that the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a check for all or part of the invoice, and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days.The ice cream distributor can do the same thing, receiving trade credit from milk and sugar suppliers on terms of Net 30, 2% discount if paid within ten days. Under this agreement, they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First, they have a substantial markup on the ingredients and other costs of production of the ice cream they sell to the operator. The markup is the portion of selling price added to the cost of obtaining the inventory. . In addition, it is not in the distributor’s best interest for customers to go out of business due to cash flow instabilities, so its financial terms aim:

Markup

This equation shows the finding of selling price for a vendor by adding its markup to its cost.

To allow start-ups the ability to manage their inventory investments – effectively giving them a short-term business loan.
By tracking which customers pay, and when, the distributor can identify problems that are developing and take steps to reduce or increase its amount of trade credit.

18.4.4: Collecting Receivables

Companies use different methods to collect their outstanding receivables, like sending out reminders or employing a collection agency.

Learning Objective

Describe the different ways a company can analyze its collections

Key Points

Collecting on accounts receivable is the final step in the credit extension process, and arguably the most difficult.
Accounts receivable days and an aging schedule are tools used to monitor accounts receivable.
The accounts receivable days is the average number of days that it takes a firm to collect on its sales. The aging schedule categorizes accounts by the number of days they have been on the books.
A company may protect against bad-debts losses by purchasing trade credit insurance.

Key Terms

creditors: a person or institution to whom money is owed.
subsidiary: A company owned by the parent company or holding company

Collection Policy

Collecting upon accounts receivable is the final step in the credit extension process, and arguably the most difficult. In dealing with collections, it is important for a firm to start by monitoring its accounts receivable in order to determine whether its policy is working to the best advantage of the company. Accounts receivable days and an aging schedule are the most common monitor tools used.

Accounts Receivable Days

The accounts receivable days is the average number of days that it takes a firm to collect on its sales. By comparing this number to the number in the credit policy, a business can determine whether its policy is effective or not. The accounts receivable days is important because investors utilize this measure to evaluate a firm’s credit management policy. This method does have its weaknesses. Seasonal sales patterns may cause accounts receivable days to change depending on when the calculation occurs. Therefore, management can potentially manipulate accounts receivable days to hide important information.

Aging Schedule

The other method commonly used is an aging schedule which categorizes accounts by the number of days they have been on the books. It can be constructed in one of two ways: using the number of accounts or using the dollar amount of the outstanding accounts receivable. If the percentages in the lower half of the schedule begin to increase, the firm needs to evaluate the effectiveness of its credit policy. Payment patterns provide information on the percentage of monthly sales that the firm collects each month after the sale. The payment pattern can be used to forecast the working capital needs for the business.

Receivable Turnover Ratio

Another way to evaluate a credit policy is to look at the receivable turnover ratio. This is a financial ratio that measures the number of times, on average, receivables are collected during a period.

Collecting Receivables

Collection Letter

This is an example of a letter from a collection agency offering to settle a debt.

There are several methods companies can use to collect their outstanding receivables. Some do nothing, some send out reminders notifying customers of late payment, and some take legal action – sometimes at the first late payment. If firms so choose, they can utilize a collection agency. A collection agency is a business that pursues payments of debts owed by individuals or businesses. Most collection agencies operate as agents of creditors and collect debts for a fee or percentage of the total amount owed. There are many types of collection agencies. First-party agencies are oftentimes a subsidiary of the original company to whom the debt is owed. Third-party agencies are separate companies contracted by a business to collect debts on their behalf for a fee. A company may protect against bad-debts losses by purchasing trade credit insurance. This is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their accounts receivables from loss due to credit risks like protracted default, insolvency, or bankruptcy.

18.5: Inventory Management

18.5.1: Inventory Types

Most manufacturing organizations usually divide their inventory into raw materials, work in process, finished goods, and goods for sales.

Learning Objective

Differentiate the different types of inventory based on it stage of proudction

Key Points

1. Raw materials: Materials and components scheduled for use in making a product.
2. Work in process, WIP: Materials and components that have began their transformation to finished goods.
3. Finished goods: Goods ready for sale to customers.
4. Goods for resale – returned goods that are salable.

Key Term

supply chain: A system of organizations, people, technology, activities, information, and resources involved in moving a product or service from supplier to customer.

Most manufacturing organizations usually divide their inventory into raw materials, work in process, finished goods, and goods for sales. A good purchased as a “raw material” goes into the manufacture of a product. A good only partially completed during the manufacturing process is called “work in process. ” When the good is completed as to manufacturing but not yet sold or distributed to the end-user, it is called a “finished good. “

Manufacturing process

From raw materials to work in process to finished goods.

1. Raw materials: Materials and components scheduled for use in making a product.

2. Work in process, WIP: Materials and components that have began their transformation to finished goods. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage. The term is used in production and supply chain management. Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of shelf life of the products. A queue leading to a production step shows that the step is well buffered for shortage in supplies from preceding steps, but may also indicate insufficient capacity to process the output from these preceding steps. Just-in-time (acronym: JIT) production is a concept to reduce work in process with respect to a continuous configuration of product. Sometimes, outside of a production and construction context “work in process” is used erroneously where the status “work in progress” would be correctly used to describe more broadly work that is not yet a final product.

3. Finished goods: Goods ready for sale to customers. Finished goods is a relative term. In a supply chain management flow; the finished goods of a supplier can constitute the raw material of a buyer.

4. Goods for resale: Returned goods that are salable.

18.5.2: Inventory Techniques

FIFO, LIFO, and average cost methods are accounting techniques used in managing inventory.

Learning Objective

Differentiate between the different type of inventory accounting techniques

Key Points

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold.
LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
Average cost method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

Key Term

taxable income: Taxable income refers to the base upon which an income tax system imposes tax.

FIFO, LIFO, and average cost methods are accounting techniques used in managing inventory involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components. These methods are used to manage assumptions of cost flows related to inventory.

Inventory

Inventories U.S. Army unit badges from a wall of military uniform items

FIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first served (FCFS) behavior, where the persons leave the queue in the order they arrive, or waiting one’s turn at a traffic control signal.

LIFO

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States,

LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Average Cost

Average cost method is quite straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. There are two commonly used average cost methods: Simple weighted average cost method and moving average cost method.

Weighted average cost method:

It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Moving average cost method:

Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods. Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold, and the Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold. At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

18.5.3: ABC Technique

The ABC analysis is an inventory categorization technique often used in material management wherein accuracy and control decreases from A to C.

Learning Objective

Differentiate different types of inventory items based on ABC inventory analysis

Key Points

A items: very tight control and accurate records; B items: less tightly controlled and good records; C items: simplest controls possible and minimal records.
The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls.
The ABC analysis suggests that inventories of an organization are not of equal value.

Key Term

Just in Time: Just in time (JIT) is a production strategy that strives to improve a business return on investment by reducing in-process inventory and associated carrying costs.

The ABC analysis is a business term used to define an inventory categorization technique often used in material management. It is also known as “Selective Inventory Control. ” Policies based on ABC analysis:

A ITEMS: very tight control and accurate records
B ITEMS: less tightly controlled and good records
C ITEMS: simplest controls possible and minimal records

The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls.

The ABC analysis suggests that inventories of an organization are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) in order of their estimated importance.

A items are very important for an organization. Because of the high value of these A items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g., “Just- in- time”) to avoid excess capacity.

B items are important, but of course less important, than A items and more important than C items. Therefore, B items are intergroup items.

C items are marginally important.

The following is an example of the Application of Weighed Operation based on ABC class in the electronics manufacturing company with 4,051 active parts.

ABC analysis

Actual distribution of ABC class in the electronics manufacturing company with 4051 active parts.

Using this distribution of ABC class and change total number of the parts to 4,000.

ABC techniques

Distribution of ABC class

Uniform Purchase: When you apply equal purchasing policy to all 4,000 components, example weekly delivery and re-order point (safety stock) of two-week supply assuming that there are no lot size constraints, the factory will have a 16,000 delivery in four weeks and the average inventory will be 2.5 weeks supply.
Weighed Purchase: In comparison, when weighed purchasing policy applied based on ABC class, example C class monthly (every four weeks) delivery with re-order point of three-week supply, B class Bi-weekly delivery with re-order point of two-week supply, A class weekly delivery with re-order point of one-week supply, total number of delivery in four weeks will be (A 200×4=800)+(B 400 x2=800) + (C 3400×1=3400)=5000 and average inventory will be (A 75%x1.5weeks)+(B 15%x3weeks)+ (C 10%x3.5weeks)= 1.925 week supply.

By applying weighed control based on ABC classification, required man hours and inventory level are drastically reduced.

18.5.4: Seasonal Production

Seasonal trends and internal projections of consumption in certain goods can have a significant impact on opportunity cost and potential profit for an organization.

Learning Objective

Recognize the relevance in time of year to overall demand

Key Points

Many industries do better in some months than others, for a wide variety of reasons. This can have opportunity costs from a production and inventory stand point, if not planned for properly.
Timing, uncertainty, economies of scale, and potential appreciation are all good reasons to have extra inventory on hand.
When it comes to seasonality of demand, production and inventory can be managed based upon data points from the past.
Perishable goods, from food to fashion to technology, are worth noting when it comes to seasonal production and storage. Minimizing over production by making accurate projections can create serious cost savings.

Key Terms

perishable goods: Goods that will expire. This isn’t just limited to food, clothes go out of fashion and technology becomes rapidly outdated.
seasonality: From the business perspective, this refers to fluctuations in demand based upon time of year.

Many industries are subject to dips and rises and demand as a result of seasonality. Logically, sourcing the same amount of a given product each month for inventory is not a practical choice in these industries. Inventory management in seasonally impacted businesses can become quite complex, as the accuracy of inaccuracy of forecasts can have substantial impacts on overall profitability.

Reasons to Keep Inventory

In an ideal world, a business would avoid the need for inventory through perfect operational management and completely accurate projections. Of course, this is impossible. As a result, business must balance risk and opportunity to ensure that inventory is available when it is needed and waste is minimized. Inventories are kept due to:

Time – No supply chain is perfect, and often enough time lags can ruin potential business opportunities. Playing it safe and have certain items in stock ahead of time can avoid opportunity costs.
Uncertainty – Supply and demand are not perfectly predictable. Uncertainty means keeping enough on hand to fill fluctuations in demand.
Economies of scale – Many business exist solely because they take the risk of buying a high volume a given product at a lower price in hopes of marking up the price and selling each one individually to customers. This is called economies of scale, and by nature it requires some storage and inventory. Grocery stores function this way.
Appreciation in Value – Some business keep inventory as an investment. Fine wines and cheese, for example, will appreciate in value over time. The downside is it will cost money to keep them (both require appropriate temperature conditions, for example).

Determining Seasonality

Among the many reasons to keep inventory is planning for seasonality. Businesses should first measure whether or not consumer demand and subsequent inventory requirement are subjected to predictable seasonal trends. There are a number of ways to do this utilizing existing historical sales data as well as data from external research on the industry itself. There are countless models and methods of organizing seasonal data to determine, but from the managerial frame mostly analysts preferred distribution of data should ultimately communicate the same correlations (or lack thereof) for differences in sales on a monthly basis.

Once seasonality is determined, business should measure the fluctuations from year to year and the opportunity costs of having too much or too little on hand. Once this is accomplished, the business can order the ideal amount based on data-driven projections to capture as much opportunity as possible without taking the risk of over ordering (and thus overpaying for storage).

Perishable Goods

An important aspect of seasonal inventory management is the concept of perishable goods. From food to fashion to technology, many goods simply either go bad or lose most of their value for no other reason that culture has passed it by. This is called a perishable good. Perishable goods have an even greater opportunity cost when it comes to mismanaging (and erroneously predicting) demand. If too much of a perishable good is ordered, not only will it cost the organization in unnecessary inventory fees, but also adds the risk of never been sold at all (a complete sunk cost at that point).

As a result, understanding the shelf life of a good, the risk of over or under stocking, and recognizing the ebb and flow of seasonal demand can add a great deal to the profitability of an organization.

Seasonality Plot Example

In this chart, consumption (demand) of electricity over a twelve month time frame is illustrated over time. Higher capacities are required in certain months (in this case – August) and capacity must be expanded to take this into account.

18.5.5: Impact of Inflation on Inventory Management

High inflation encourages companies to keep a high level of inventories.

Learning Objective

Explain how inflation influences inventory levels

Key Points

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. It reflects an erosion in the purchasing power of money.
If inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Therefore, high inflation encourages companies to keep a high level of inventories.
The Mundell-Tobin effect also suggests a rise in inventory level in case of high inflation.

Key Terms

purchasing power: Purchasing power (sometimes retroactively called adjusted for inflation) is the amount of goods or services that can be purchased with a unit of currency.
physical capital: In economics, physical capital, or just capital refers to a factor of production (or input into the process of production), such as machinery, buildings, or computers.

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money–a loss of real value in the internal medium of exchange and unit of account in the economy.

Inflation’s effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money; uncertainty over future inflation which may discourage investment and savings; and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Therefore, high inflation encourages companies to keep a high level of inventories.

Inflation

Inflation in France in 2002

The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall. Nobel laureate James Tobin noted that moderate inflation would cause businesses to substitute investment in physical capital (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower, because the investments with higher rates of return were already being made before. ) To put it in a word, companies purchase more inventories in case of high inflation. The two related effects are known as the Mundell-Tobin effect. Unless the economy is already over-investing according to models of economic growth theory, that extra investment resulting from the effect would be seen as positive.

18.5.6: Inventory Costs

Inventory costs depends on methods used, which include Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.

Learning Objective

Identify the different types of assumptions a company can make when valuing its inventory

Key Points

There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of ‘adjusting’ assumptions may be used. These include: Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.
Specific identification requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory.
Weighted Average Cost is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases.
Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated.
FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.
LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.

Key Term

ABC analysis: The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on ABC analysis: A ITEMS, very tight control and accurate records; B ITEMS, less tightly controlled, and good records; and C ITEMS, simplest controls possible and minimal records.

Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.

Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.

Inventory

The inventory costs depend on which method is used.

There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of ‘adjusting’ assumptions may be used. These include:

Specific Identification

Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at the yearend inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.

This method is also a very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These number will need to be estimated, therefore reducing the specific identification’s benefit of being extremely specific.

Weighted Average Cost

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Moving-Average Cost

Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.

Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold. The Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold.

At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

FIFO and LIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970’s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

18.5.7: Economic Order Quantity Technique

Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs:
.

Learning Objective

Calculate a company’s optimal order quantity

Key Points

Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs.
EOQ determines the optimal number of units to minimize the total cost associated with the purchase, delivery, and storage of the product.
Q* = (DS/H)^1/2 where Q = order quantity, Q*= optimal order quantity, D = annual demand quantity, S = fixed cost per order, H = annual holding cost per unit.

Key Term

holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.

Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as “Barabas EOQ Model” or “Barabas Formula. ” The model was developed by Ford W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis.

We want to determine the optimal number of units to order so that we minimize the total cost associated with the purchase, delivery, and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order, and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, though this number can be determined from the other parameters.

Underlying assumptions are:

The ordering cost is constant.
The rate of demand is known, and spread evenly throughout the year.
The lead time is fixed.
The purchase price of the item is constant (i.e., no discount is available).
The replenishment is made instantaneously; the whole batch is delivered at once.
Only one product is involved.

Variables for the function are: Q = order quantity, Q*= optimal order quantity, D = annual demand quantity, S = fixed cost per order (not per unit, typically cost of ordering and shipping and handling. This is not the cost of goods), H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration, insurance, etc., usually not related to the unit cost).

The single-item EOQ formula finds the minimum point of the following cost function:

Economic order quantity

Economic order quantity function solving for Q.

Total Cost = purchase cost + ordering cost + holding cost

Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity. This is P×D.
Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to order D/Q times per year. This is S × D/Q.
Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is H × Q/2.

To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q (assume all other variables are constant) and set to 0:

Equation

Equation to determine the minimum point of the total cost curve.

Solving for Q gives Q* (the optimal order quantity):

Equation 3

Equation solving for Q*

18.5.8: Just-in-Time Technique

Just in time (JIT) is a production strategy that strives to reduce in-process inventory and carrying costs in a manufacturing system.

Learning Objective

Discuss the benefits and disadvantages of using a Just-In-Time (JIT) inventory system

Key Points

JIT focuses on continuous improvement and can improve a manufacturing organization’s return on investment, quality and efficiency.
JIT relies on efficient coordination of elements in the inventory chain.
There are many benefits of JIT. It improves the flow of goods from warehouse to shelves, reduces set up time and efficiently uses human resources.

Key Term

carrying costs: carrying cost refers to the total cost of holding inventory. This includes warehousing costs such like utilities and salaries; financial costs like opportunity cost; and inventory costs related to perishability, shrinkage and insurance.

Just in time (JIT) is a production strategy striving to improve a business return on investment by reducing in-process inventory and associated carrying costs. To meet JIT objectives, the process relies on signals or Kanban between different points in the process. Kanban are usually “tickets” but can be simple visual signals, like the presence or absence of a part on a shelf. Implemented correctly, JIT focuses on continuous improvement and can improve a manufacturing organization’s return on investment, quality and efficiency. To achieve continuous improvement, key areas of focus are:

flow
employee involvement
quality.

Noticing that stock depletion requires personnel to order new stock is critical to the inventory reduction at the center of JIT. But JIT relies on other elements in the inventory chain. Therefore, JIT is best implemented as one part of an overall lean manufacturing system.

Benefits of JIT:

Reduced setup time. Cutting setup time allows the company to reduce or eliminate inventory for “changeover” time.
The flow of goods from warehouse to shelves improves. Small or individual lot sizes reduce lot delay inventories, which simplifies inventory flow and its management.
Employees with multiple skills are used more efficiently. Having employees trained to work on different parts of the process allows companies to move workers where they are needed.
Production scheduling and work hour consistency are synchronized with demand. If there is no demand for a product at the time, it is not made. This saves the company money, either by not having to pay workers overtime or by having them focus on other work.
Increased emphasis on supplier relationships. A company without inventory does not want a supply system problem that creates a part shortage. This makes supplier relationships extremely important.
Supplies come in at regular intervals throughout the production day. Supply is synchronized with production demand and the optimal amount of inventory is on hand at any time. When parts move directly from the truck to the point of assembly, the need for storage facilities is reduced.
Minimizes storage space needed.
Smaller chance of inventory breaking/expiring.

Drawbacks

Just-in-time operation can leave suppliers and downstream consumers open to supply shocks and large supply or demand changes. In addition, very low stock levels means shipments of the same part can come in several times per day. This means firms favoring JIT are especially susceptible to flow interruption.

18.5.9: Benefits of Inventory Management

Improved inventory management can lead to increased revenue, lower handling and holding costs, and improved cash flows.

Learning Objective

Discuss the benefits of inventory management

Key Points

Inventory management is primarily about specifying the shape and percentage of stocked goods.
Inventory management leads to optimal inventory levels.
Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.
Inventory management can also help companies improve cash flows.

Key Terms

ABC analysis: The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on ABC analysis: A ITEMS, very tight control and accurate records; B ITEMS, less tightly controlled, and good records; and C ITEMS, simplest controls possible and minimal records.
holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.

Inventory management

Female clerk doing inventory work using a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand.

The intent of inventory management is to continuously hold optimal inventory levels. The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods, and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.

Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs. Inventory management involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. All of these practices leads to optimal product storage, helping minimize holding and handling costs.

Inventory management also can help companies improve cash flows. Companies with effective inventory management do not have to spend large capital balances for purchasing enormous amounts of inventory at once. This also saves handling and holding costs.

18.5.10: Dangers Involved in Inventory Management

Excessive inventory means idle funds which earn no profits; inadequate inventory means lost sales.

Learning Objective

Discuss the difficulties of managing inventory

Key Points

Excessive inventory means the firm has idle funds which earn no profits for the firm. In addition, excessive inventory incurs extra handling and holding costs.
Inadequate inventory means the firm does not have sufficient raw materials for production. This also means insufficient ample goods to sell for merchandising companies.
Inventory management will be more complicated as moderate inflation and seasonality get involved.

Key Terms

holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.
seasonality: Variation with the seasons

Inventory management is primarily about specifying the size and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods.

The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.

Inventory control

Inventory control – inventory cost elements (holding cost, order cost, total)Parameters: Order-cost (C) 10, demand (D) 1000, holding cost (i) 20% (of price), price (p) 10 => EOQ = 100

Excessive inventory means the firm has idle funds which earn no profits for the firm. In addition, excessive inventory incurs extra handling costs and holding costs. However, it is not well advised for the firm to keep low inventory levels, since inadequate inventory means the firm does not have sufficient raw materials for production. When items are required on a breakdown basis and find out that there is not enough stock as a result of reducing it, this could lead to loss of production. Inadequate inventory also means not ample goods to sell. The company, as a result, faces the risk of losing customers to competitors.

Inventory management will be more complicated as moderate inflation and seasonality gets involved. Inflation encourages the firm to purchase more inventory, exposing them to excessive inventory. Without an accurate sales forecast, companies operating in sectors affected by seasonality face shortage during high time and excess of inventory during low time of the year.

Chapter 17: Introduction to Working Capital

17.1: Working Capital

17.1.1: Calculating Working Capital

Working Capital = current assets – current liabilities.

Learning Objective

Calculate a company’s working capital

Key Points

WC is current assets minus current liabilities. Companies want positive WC.
WC is an signal of whether or not the company has enough assets to turn into cash to pay upcoming expenses or debts.
WC is a measurement of liquidity and is not a guarantee that a company can pay for its liabilities.

Key Terms

Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.
liquidity: Availability of cash over short term: ability to service short-term debt.
current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Working capital can be found through the following formula:

WC=CA-CL (Working Capital = current assets – current liabilities)

Current assets (CA) is an accounting term that refers to assets that can easily be turned into cash. For example, cash is a current asset, but so are most accounts receivable.

Current liabilities (CL) is an accounting term similar to CA: CL is the amount of liabilities that are expected to be settled in cash within a year (or the operating cycle of the company).

The difference between the two (WC) is a measurement of liquidity. It signals whether or not the company has enough assets to turn into cash to pay off upcoming liabilities. It is not a perfect signal, however.

Since most expenses and debt must be paid in cash , having positive WC shows that the company has the ability to pay off expenses and debt that will arise or come due in the short-term.

Buying Food

Most purchases, including food, must be made with a specific asset–cash. Not all current assets can be used to pay off expenses of debts.

WC, though, does not guarantee that a company can pay off all short-term expenses or liabilities. Simply having positive WC does not mean necessarily that a company will be able to pay off all expenses. Suppose that a company has current assets of $100: $20 of cash and $80 of accounts receivable. They also have $50 of current liabilities. That means that they have WC of +$50. One of their accounts payable comes due tomorrow, so the company owes $40. They have $20 of cash on hand, but can’t get the other $20 by tomorrow because they can’t collect $20 of accounts receivable by tomorrow. The company cannot pay a short-term expense, even though a positive WC says that the company should be able to pay off most expenses and loans in the short-term.

WC is not a guarantee that the company will have enough cash for each expense, merely that they have operating liquidity.

17.1.2: Controlling the Components of Working Capital

Working capital (WC) can be controlled by changing the levels of current assets and/or current liabilities through a number of mechanisms.

Learning Objective

Discuss how a company can adjust its working capital

Key Points

Increasing current assets or decreasing current liabilities increases WC, and vice versa.
Four common mechanisms for controlling WC are cash management, inventory management, debtors management, and financing management.
Having too little WC impairs a company’s ability to meet it’s financial obligations, while having too much WC can also be bad because it means that there are assets that are not being invested in the long-term.

Key Terms

Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.
current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

Controlling the Components of Working Capital

Each company has different demands for how much Working Capital (WC) they need, but all companies prefer to have positive WC (recall that WC = current assets – current liabilities). Having too little WC impairs a company’s ability to meet it’s financial obligations. It is hard to pay expenses or debts that come due in the short-term. Having too much WC can also be bad because it means that there are assets that are not being invested. Holding too many short term assets slows future growth of the company. Thus, managing WC to an acceptable level is one of the most important jobs of management .

Walmart CFO

Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.

WC can be adjusted by increasing or decreasing its two components: current assets (CA) and current liabilities (CL). Increasing CA or decreasing CL increases WC, and vis versa. Management can enact a number of policies, some of which are highlighted below:

Cash management: Identify the cash balance that allows the business to meet day to day expenses, but reduces cash holding costs. Cash is a CA.
Inventory management: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials–and minimizes reordering costs–and hence increases cash flow. Inventory is a CA.
Debtors management: Identify the appropriate credit policy, such as credit terms, that will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). Credit extended to customers (accounts receivable) is a CA.
Financing management: Identify the appropriate source of financing. Short-term financing (as well as long-term financing that comes due in the next year or operating cycle) is a CL.

By adjusting these four primary influencers on CA and CL, management can change WC to a desirable level.

17.1.3: Importance of Working Capital

Working capital (WC) is a measurement of a company’s operating liquidity.

Learning Objective

Discuss why working capital is important to businesses

Key Points

WC is important for large companies’ ability to borrow, increase their share price, pay expenses and short-term debts.
WC is important for small companies that cannot access financial markets to borrow, and for start-ups that need to survive until they break even.
WC cannot guarantee whether a company is financially sound, but it gives some insight.

Key Terms

operating liquidity: The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating expenses.
working capital: A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied to its operation.

Working capital (WC) is an important metric for all businesses, regardless of their size. WC is a signal of a company’s operating liquidity . Having enough WC means that the company should be able to pay for all of its short-term expenses and liabilities.

Cash

Liquidity is a measurement of a company’s ability to quickly turn assets into cash.

Large companies pay attention to WC for the same reason as small ones do: WC is a measure of liquidity, and thus is a measure of their future credit-worthiness. Companies who want to borrow by issuing bonds or purchasing commercial paper (a market of large, short-term loans for big companies) will find it more expensive if they do not have enough WC. If they are a public company, their stock price may fall if the market doesn’t believe they have adequate WC.

For small businesses and start-ups, unable to access financial markets for borrowing, WC has more dire implications. WC can also be described as the amount of money that a small business or start-up needs to stay in operation. Start-ups need to pay attention to their WC because it is the amount of money they need to keep the business running until they break-even (start earning a net profit).

On one hand, WC is important to because it is a measure of a company’s ability to pay off short-term expenses or debts. On the other hand, too much working capital means that some assets are not being invested for the long-term, so they are not being put to good use in helping the company grow as much as possible.

WC is only one measure of a company’s operating liquidity. It is not the only measure, and it is certainly not a guarantee of a company’s ability to pay. A company may have positive WC, but not enough cash to pay an expense tomorrow. Similarly, a company may have negative WC, but may be able to adjust some of their debt into long-term debt in order to reduce their current liabilities.

WC is an important metric, but is not the whole story of a company’s financial health.

17.2: Approaches to Working Capital Financing

17.2.1: Understanding the Needs of the Business

Working capital needs will vary depending on the type of the business and its operational requirements.

Learning Objective

Describe the goals of a business in the context of ts working capital needs

Key Points

Sufficient working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term and long-term debt and upcoming operational expenses.
The management of working capital involves managing inventories, accounts receivable and payable, and cash.
When calculating working capital we think in terms of net working capital, which is calculated as current assets minus current liabilities.
In any company, large or small, there is an inherent tradeoff between liquidity and profitability.

Key Term

inventory: The stock of an item on hand at a particular location or business

Understanding the Business Needs

Working capital is a financial metric which represents the operating liquidity available to a business. Working capital is considered a part of operating capital along with fixed assets, such as plant and equipment. Sufficient working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term and long-term debt and take care of upcoming operational expenses. However, too much working capital can carry with it a higher cost of capital. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Calculation of Working Capital

When calculating working capital, we think in terms of net working capital, which is calculated as current assets minus current liabilities. This is the figure commonly used in valuation techniques such as discounted cash flows. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

Accounts receivable (current asset)
Inventory (current asset)
Accounts payable (current liability)

A company ideally wants accounts receivable to be collected as quickly as possible in order to have as much use of the funds as possible. Conversely, a firm strives to put off the settlement of accounts payable as long as possible for the same reason. The current portion of debt is also critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit. Inventory is a special case in which even non-financial managers have a stage. Too much inventory on hand will reduce the risk of a company failing to satisfy customer needs, but it can also reduce profitability. An example of reduced profitability would be in the computer industry, where inventories regularly lose value because of the fast-moving nature of the industry.

Inventory Software

This is an example of modern inventory software that enables managers to precisely track orders and inventory levels.

Profitability and Liquidity Tradeoff

In any company, large or small, there is an inherent tradeoff between liquidity and profitability. Large companies possess resources to help them manage this tradeoff, such as an accounting department, negotiating power with their suppliers, or access to the capital markets. For the entrepreneur, however, who is often resource-starved and doesn’t have enough operating history to secure additional credit, managing this tradeoff can feel like walking a tightrope. Consider the case of a new customer for a small company. This new customer has the potential to offer huge growth in the company’s sales, but this growth in sales will be accompanied by a subsequent growth in variable costs. The company may not have the resources, i.e., working capital, to meet these variable costs that come with increased sales.

17.2.2: Long-Term Approach

Recognize the broader objectives of working capital, as well as how organizations can consider a long-term perspective when viewing the utilization of working capital.

Learning Objective

Identify the primary objectives of working capital, and how a longer-term perspective can offer insights

Key Points

Working capital demonstrates the current operating liquidity of a given organization through subtracting the current liabilities from the current assets.
The primary objectives of working capital are profitability and liquidity.
Short-term planning is predominately what is used when discussing working capital management, as working capital is intrinsically a short-term assessment.
However, some long-term perspectives can be utilized when approaching working capital. This includes how working capital is considered strategically, and the organizational policies around availability and utilization of working capital.

Key Term

Working capital: The total available cash and cash equivalents after subtracting current liabilities from current assets.

Working Capital

Working capital is a calculation of the overall operating liquidity an organization has access to at a given moment, derived through a simple calculation from the balance sheet:

Working Capital = Current Assets – Current Liabilities

Current assets are items a business owns that are either current cash, or assets that can be rapidly converted to cash, such as accounts receivables, cash, cash equivalents, short-term investments, and inventory. Current liabilities are debts owed in the short term, such as accounts payable, short-term debts, and other obligations within a short operational cycle.

When you subtract what is owed in the short term from what is available, an organization can project how much free working capital is on hand during the operating cycle.

Long Term Planning

This free working capital can be utilized in a variety of ways. Working capital under-utilized incurs the opportunity costs associated with the time value of money, and organizations must use financial planning to ensure appropriate utilization of this capital over the longer term.

While short-term planning is predominately what is used in respect to working capital (due to the short term nature of the inputs and outputs involved), it is reasonable to set long-term polices and strategies for incorporating changes in working capital into financial strategy. The primary benefits of leveraging working capital are liquidity and profitability, each of which can be viewed through a longer term lens.

Liquidity

When discussing long-term objectives, the focal point is broader strategy (as opposed to tactics). From a strategic perspective, there is a certain amount of liquidity business would like to maintain at any given moment to ensure that they can capture external opportunities in the market. Having easily accessible working capital at any given moment enables organizations to minimize the opportunity cost of foregone opportunities, and careful regulation of working capital strategic criteria can ensure the appropriate amount is available.

Profitability

The other broader objective of working capital is how effectively it is utilized over a given time period. From the long-term perspective, this profitability metric will be quite a bit different than the short term. From a longer-term perspective, working capital profitability decisions revolve around how much should be available within any short-term time frame in order to maximize the return (on average) of existing working capital. By looking at differences in working capital availability over a long period of historical data, the organization can make rough estimations of the optimal amount of working capital availability that allows optimal growth.

Despite the potential advantages of longer-term planning in working capital, it is still largely a field of shorter term decision making. Generally, working capital should be considered within a one year or less time frame, making it more often a shorter term decision.

17.2.3: Short-Term Approach

Decisions relating to working capital are usually short-term, since it is the difference between current assets and current liabilities.

Learning Objective

Explain how the cash conversion cycle influences working capital management

Key Points

The main considerations for working capital are cash flow / liquidity and profitability / returns on capital.
The most widely used measure of cash flow is the net operating cycle or cash conversion cycle.
The cash conversion cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.
The aim of the study and calculation of the cash conversion cycle is to change the policies relating to credit purchase and credit sales.

Key Term

discounting: The process of finding the present value using the discount rate.

Short-Term Approach to Working Capital Management

Working capital is the amount of capital that is readily available to an organization. Working capital is the difference between cash resources or assets readily convertible into cash (current assets) and cash obligations (current liabilities). As a result, the decisions relating to working capital are almost always current, i.e., short term, decisions. In other words, working capital management differs from capital investment decisions – specifically in terms of discounting and profitability. Working capital management applies different criteria in decision making. The main considerations are cash flow / liquidity and profitability / returns on capital. The most widely used measure of cash flow is the net operating cycle or cash conversion cycle. This measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.

The cash conversion cycle indicates the firm’s ability to convert its resources into cash and informs management of the liquidity risk entailed by growth . Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at shortening the cash conversion cycle as much as possible. However, shortening the cycle creates its own risks. While a firm could even achieve a negative cash conversion by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not typically sustainable. The aim of the study and calculation of the cash conversion cycle is to change the policies relating to credit purchase and credit sales. A firm can change its standards for payment on credit purchases and getting payment from debtors on the basis of cash conversion cycle. If the firm is in an effective cash liquidity position, it can maintain its past credit policies.

Cash Conversion Cycle

Above is a chart showing a sample cash conversion cycle.

17.2.4: Choosing a Policy

A firm will use a combination of policies for managing working capital, focusing on cash flow, liquidity, profitability, and capital return.

Learning Objective

Describe refinancing risk and how it influence working capital policy

Key Points

Working capital policies aim at managing current assets – generally, cash and cash equivalents, inventories, and debtors – and short term financing, such that cash flows and returns are acceptable.
One of the objectives within working capital management and general financing decisions is to match the maturity of liabilities with the life expectancy of assets.
If the maturity of liabilities is less than the life expectancy of assets, a firm faces refinancing risk since it will have to raise new capital to pay off liabilities.

Key Term

credit policy: Credit terms given to customers that affect sales and collection practices.

Choosing a Policy

Guided by criteria measuring cash flow, liquidity, profitability, and return on capital, the management of a firm will use a combination of policies and techniques for the management of working capital. These policies aim to manage the current assets – generally, cash and cash equivalents, inventories and debtors – and the short term financing, such that cash flows and returns are acceptable. As with any decision involving the management of capital, the firm’s goal should be to minimize the overall cost of capital and maximize value to the shareholders . In order to effectively manage cash flow, a firm should identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs – i.e., the opportunity cost of holding cash as opposed to investing it.

Policies Regarding Liquidity

This chart lays out sample working capital issues and some possible solutions.

A company should also identify the level of inventory which allows for uninterrupted production, but reduces the investment in raw materials – and minimizes reordering costs – and therefore increases cash flow. Another area of concern for a firm will be managing debtors. Management should identify the appropriate credit policy so that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and return on capital. Moreover, management should implement appropriate credit scoring policies and techniques so that the risk of default on any new business is acceptable given these criteria.

A final area management should be concerned with when deciding on a working capital policy is short-term financing. A firm should identify the appropriate source of financing, given the cash conversion cycle. Inventory is ideally financed by credit granted by the supplier. However, it may be necessary to utilize a bank loan.

Refinancing Risk

One of the objectives within working capital management and general financing decisions is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. If the maturity of liabilities is less than the life expectancy of assets, a firm faces refinancing risk since it will have to raise new capital to pay off liabilities. If the maturity of liabilities is longer than the life expectancy of assets, then there should be sufficient working capital available to pay off debts. The mismatching of liabilities with assets can occur if financing is not available.

For example, suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. For example, suppose a company expects long-term interest rates to fall. The firm may want to finance assets with short-term maturities since it can refinance in a few years at much lower rate.

17.3: Overview of the Working Capital Financing Decision

17.3.1: Evaluating Interest Rates

Management of working capital requires evaluating factors affecting cash flows — including the evaluation of appropriate interest rates.

Learning Objective

Evaluate a company’s interest rates based on its stage of development

Key Points

The interest rate most commonly used in working capital management is the cost of capital.
Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions.
Working capital decision criteria that focus on interest rates include debtors management and short-term financing.
The discount rates typically applied to different types of companies show significant differences.

Key Terms

cash conversion cycle: how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.
credit rating: An estimate, based on a company or person’s history of borrowing and repayment and/or available financial resources, that is used by creditors to determine the maximum amount of credit it can extend to a without undue risk.
cost of capital: The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

Evaluating Interest Rates

The management of working capital takes place in the realm of short-term decision-making. These decisions are, therefore, based primarily on profitability, cash flows and their management. Many criteria go into the management of cash flows and subsequently the management of working capital — including the evaluation of appropriate interest rates.

The interest rate most commonly used in working capital management is the cost of capital. The cost of capital, in a financial market equilibrium, will be the same as the market rate of return on the financial asset mixture the firm uses to finance capital investment. In other words, a company’s cost of capital is the cost of obtaining funds for operation through the sale of equity or debt in the marketplace. In market equilibrium, investors will determine what return they expect from providing funds to a company. The return expected on debt depends upon the credit rating of the company, which takes into account a number of factors to determine how risky loaning funds to a company will be. The return expected from equity also involves a number of factors, usually centered around the operation of the company and its prospects for profitability. Some conventional rates of return expected for various types of companies include:

Startups seeking money: 50% – 100%
Early startups: 40% – 60%
Late startups: 30% – 50%
Mature companies: 10% – 25%

When evaluating short-term profitability, company’s may use measures such as return on capital. ROC is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

As mentioned, working capital decisions are made with the short-term in mind. Thus, working capital policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Decision criteria that focus on interest rates include debtors management and short-term financing.

Debtors management involves identifying the appropriate credit policy — i.e. credit terms which will attract customers — such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and, hence, return on capital (or vice versa). Interest rates can affect this decision because of the time value of money. If inflation is at a high level or there are opportunities foregone because of lack of working capital, a firm will more than likely have a stricter credit policy.

Short-term financing involves identifying the appropriate source of financing, given the cash conversion cycle. For instance, inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan or to “convert debtors to cash.”. Another possible solution is to use services from companies sell outstanding invoices to raise working capital for their clients. Obviously interest rates will play a vital role in determining whether an option such as a bank loan is viable for obtaining short-term financing.

Interest

Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

17.3.2: Decision Criteria

The main considerations of working capital management decisions are (1) cash flow/ liquidity and (2) profitability/return on capital.

Learning Objective

Identify which factors influence a company’s working capital management decisions

Key Points

The decisions relating to working capital are always current (i.e., short-term decisions.
The most useful measure of profitability is return on capital (ROC).
One measure of cash flow is provided by the cash conversion cycle (CCC)–the net number of days from the outlay of cash for raw material to receiving payment from the customer.
The most useful measure of profitability is return on capital (ROC).

Key Terms

liquidity: Availability of cash over short term: ability to service short-term debt.
working capital: A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied to its operation.

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (current assets), and cash requirements (current liabilities). As a result, the decisions relating to working capital are always current (i.e., short-term decisions). In addition to the time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also “reversible” to some extent.

Working capital management decisions are, therefore, not made on the same basis as long-term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow/liquidity and (2) profitability/ return on capital (of which cash flow is generally the most important).

1. Cash Conversion Cycle (CCC)

One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the interrelatedness of decisions regarding inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

Cash cycle

Cash conversion cycle is a main criteria for working capital management.

2. Return On Capital (ROC)

In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE) shows this result for the firm’s shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are, therefore, useful as a management tool, in that they link short-term policy with long-term decision making.

Credit
policy

Another factor affecting working capital management is credit policy of the firm. It includes buying of raw materials and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.

17.3.3: Identifying Varying Conditions

Management uses policies and techniques for the management of working capital such as cash, inventory, debtors and short term financing.

Learning Objective

Identify the four main areas of variability of working capital management

Key Points

The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence increases cash flow.
Identify the appropriate credit policy and the appropriate source of financing, given the cash conversion cycle.

Key Terms

Work in process: Work in process (WIP) or in-process inventory includes the set at large of unfinished items for products in a production process. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage.
Finished good: Finished goods are goods that have completed the manufacturing process but have not yet been sold or distributed to the end user.

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

There are four main areas of variability that must be managed

1. Cash management

Identify the cash balance that allows for the business to meet day-to-day expenses, but reduces cash holding costs.

2. Inventory management

Identify the level of inventory that allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow. Besides this, the lead times in production should be lowered to reduce work in process (WIP) and similarly, the finished goods should be kept on as low level as possible to avoid over production.

Inventory

Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow.

3. Debtors management

Identify the appropriate credit policy (i.e., credit terms which will attract customers such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on capital or vice versa).

4. Short-term financing

Identify the appropriate source of financing, given the cash conversion cycle. The inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring. “

17.3.4: Calculating Expected Value

The main accounts which affect the value of working capital are accounts receivable, inventory, and accounts payable.

Learning Objective

Calculate a company’s working capital

Key Points

Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Current assets and current liabilities include three accounts which are of special importance: accounts receivable, inventory, and accounts payable.
Working capital is equal to accounts receivable plus the value of inventory, minus accounts payable.

Key Terms

M&A: Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.
balance sheet: A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity – including a governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques, such as DCFs (Discounted Cash Flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a “working capital deficit. “

A company can be endowed with assets and profitability but short on liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Calculation

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

accounts receivable (current asset)
inventory (current assets)
accounts payable (current liability)

Therefore, in this context, we calculate available working capital using the following formula:

Working Capital Equation

Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.

These values can be readily found on a company’s balance sheet. The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

As an example, imagine a company has accounts receivable of $10,000, current inventory that has a value of $5,000, and accounts payable of $7,000. We can find working capital by:

Working Capital = $10,000 + $5,000 – $7,000 = $8,000

An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities, for example, has paid off some short-term creditors.

Implications on M&A

The common commercial definition of working capital for the purpose of a working capital adjustment in a mergers and acquisitions transaction (i.e., for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets – Current liabilities (excluding deferred tax assets/liabilities, excess cash, surplus assets, and/or deposit balances).

Cash balance items often attract a one-for-one purchase-price adjustment.

Chapter 16: Options and Corporate Finance

16.1: Convertible Securities

16.1.1: Overview of Convertible Securities

Convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock.

Learning Objective

Discuss the advantages and disadvantages of convertible bonds

Key Points

A convertible bond is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.
Convertible preferred stocks are securities that contain a provision in which the holder may convert the preferred into the common stock of the company under certain conditions.
Convertible arbitrage involves the simultaneous purchase of convertible securities and the short sale of the same issuer’s common stock.
Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed.

Key Term

debt gearing: debt techniques used to multiply gains or losses; also known as leverage.

Overview Of Convertible Securities

Convertible securities can be bonds or preferred stocks that pay regular interest and can be converted into shares of common stock (sometimes conditioned on the stock price appreciating to a predetermined level).

A convertible bond (CB) is a type of bond that can be converted into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt and equity-like features. Although a CB typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company’s equity value. The investor receives the potential upside of conversion into equity while protecting the downside with cash flow from coupon payments and the return of principal upon maturity. Convertible bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert. Convertible bond markets in the United States and Japan are of primary global importance because they are the largest in terms of market capitalization.

Convertible bonds have all the features of typical bonds, plus the following additional features:

Conversion price: The nominal price per share at which conversion takes place.
Conversion ratio: The number of shares each convertible bond converts into.
Parity (Conversion) value: Equity price × Conversion ratio.
Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value.
Call features: The ability of the issuer (on some bonds) to call a bond early for redemption.
Put features: The ability of the holder of the bond (the lender) to force the issuer (the borrower) to repay the loan at a date earlier than the maturity.

Convertible preferred stocks are securities that contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions – among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share or a certain price per share for the common stock.

Convertible Arbitrage

Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer’s common stock. The premise of this strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from illiquidity to market psychology. In particular, the equity option embedded in the convertible bond may be a source of cheap volatility, which convertible arbitrageurs can then exploit. Under normal market conditions, the arbitrageur expects the combined position to be insensitive to small fluctuations in the price of the underlying stock.

Arbitrage

Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. This diagram illustrates an arbitrage opportunity in foreign currency exchange.

Advantages and Disadvantages Of Convertibles

From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing CBs is that, if the bonds are converted to stocks, the company’s debt vanishes. Additional advantages for issuers include:

Lower fixed-rate borrowing costs.
Locking into low fixed-rate long-term borrowing.
Deferral of voting dilution.
Increasing the total level of debt gearing.
Tax advantages: a high tax-paying shareholder can benefit from the company securitizing gross future income on a convertible income that it can offset against taxable profits.

Convertible bonds are safer for the investor than preferred or common shares; they provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor. At the same time, CBs can provide the possibility of high equity-like returns. Also, CBs are usually less volatile than regular shares.

A primary disadvantage of convertible bonds is their liquidity risk. In theory, when a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income instrument. However, CBs can decline in value more than stocks due to their liquidity risk. Moreover, in exchange for the benefit of reduced interest payments, the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. Convertible securities also bring with them the risk of diluting control of the company and forced conversion, which occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. This feature caps the capital appreciation potential of a convertible bond.

16.2: Options

16.2.1: Defining Options and Their Valuation

Options give the owner the right, but not the obligation, to buy or sell an underlying asset or instrument.

Learning Objective

Discuss the factors that influence the values of different types of options

Key Points

An option that conveys the right to buy something at a specific price is called a call; an option that conveys the right to sell something at a specific price is called a put.
Today, many options are created in a standardized form and traded through clearinghouses on regulated options exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller.
The most common options are European, which may only be exercised on expiration, and American, may be exercised on any trading day on or before expiration.
Nearly all stock and equity options are American options, while indexes are generally represented by European options.

Key Terms

stochastic: Random, randomly determined, relating to stochastics.
in the money: For a call option, when the option’s strike price is below the market price of the underlying asset. For a put option, when the strike price is above the market price of the underlying asset.
out of the money: A call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.

Options are a type of derivative that give the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller incurs a corresponding obligation to fulfill the transaction, that is to sell or buy, if the long holder elects to “exercise” the option prior to expiration. The buyer pays a premium to the seller for this right. An option that conveys the right to buy something at a specific price is referred to as a call; an option that conveys the right to sell something at a specific price is called a put.

The value of an option is commonly deconstructed into two parts. The first of these is the “intrinsic value,” which is defined as the difference between the market value of the underlying asset and the strike price of the given option. The second part depends on a set of other factors which, through a multi-variable, non-linear interrelationship, reflect the discounted expected value of that difference at expiration. Today, many options are created in a standardized form and traded through clearinghouses on regulated options exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller – one or both of which may be a dealer or market-maker.

Contract Specifications

Every financial option is a contract between two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:

Whether the option holder has the right to buy (a call option) or the right to sell (a put option).
The quantity and class of the underlying asset (e.g., 100 shares of XYZ Co. B stock).
The strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise.
The expiration date, which is the last date the option can be exercised.
The settlement terms – for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount.
The terms by which the option is quoted in the market to convert the quoted price into the actual premium – the total amount paid by the holder to the writer.

Option Styles

Naming conventions are used to help identify properties common to many different types of options. These include:

European option – may only be exercised on expiration.
American option – may be exercised on any trading day on or before expiration.
Bermudan option – may be exercised only on specified dates on or before expiration.
Asian option – the payoff is determined by the average underlying price over some preset time period.
Barrier option – any option with the general characteristic that the underlying security’s price must pass a certain level or “barrier” before it can be exercised.
Binary option – an all-or-nothing option that pays the full amount if the underlying security meets the defined condition on expiration, otherwise it expires worthless.
Exotic option – any of a broad category of options that may include complex financial structures.
Vanilla option – any option that is not exotic.

Nearly all stock and equity options are American options, while indexes are generally represented by European options.

Valuation

The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. In general, standard option valuation models depend on the following factors:

The current market price of the underlying security,
The strike price of the option, particularly in relation to the current market price of the underlying (in the money vs. out of the money),
The cost of holding a position in the underlying security, including interest and dividends,
The time to expiration together with any restrictions on when exercise may occur, and
An estimate of the future volatility of the underlying security’s price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates.

Black-Scholes Model

In 1973, Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option, Black and Scholes produced a closed-form solution for a European option’s theoretical price. At the same time, the model generates hedge parameters necessary for effective risk management of option holdings. The application of the model in actual options trading can be clumsy because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate. Nevertheless, the Black-Scholes model is still one of the most important methods and foundations for the existing financial market in which the result is within the reasonable range.

European Call Surface

A European call valued using the Black-Scholes pricing equation for varying asset price S and time-to-expiry T. In this particular example, the strike price is set to unity, the risk-free rate is 0.04 and the volatility is 0.2.

The Black–Scholes equation is a partial differential equation that describes the price of the option over time. The key idea behind the equation is that one can perfectly hedge the option by buying and selling the underlying asset in just the right way and consequently “eliminate risk. ” This hedge, in turn, implies that there is only one right price for the option.

Valuation of a Call Option

Where: N is the cumulative distribution function of the standard normal distribution; T – t is the time to maturity; S is the spot price of the underlying asset; K is the strike price; r is the risk free rate; and omega is the volatility of returns of the underlying asset.

Value of a Put Option

16.3: Warrants

16.3.1: Overview of Warrants

A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date.

Learning Objective

Differentiate warrants from other type of convertibles

Key Points

A warrant’s “premium” represents how much extra you have to pay for your shares when buying them through the warrant as compared to buying them the regular way.
Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public options exchange.
A warrant’s lifetime is measured in years (as long as 15 years), while options are typically measured in months.
The market value of a warrant can be divided into two components: intrinsic value and time value.
Warrants are often used as deal sweeteners, in order to entice hesitant investors.

Key Terms

intrinsic: Innate, inherent, inseparable from the thing itself, essential.
stockbroker: A person who buys and sells shares (stock) on a stock exchange on behalf of clients. May also provide investment advice and/or company information, depending on the level of service offered (or chosen by the client).
portfolio: The group of investments and other assets held by an investor.

Overview of Warrants

A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Some important characteristics to consider include the following:

A warrant is exercised when the holder informs the issuer of their intention to purchase the shares underlying the warrant.
A warrant’s “premium” represents how much extra you have to pay for your shares when buying them through the warrant as compared to buying them the regular way.
A warrant’s “gearing” is the way to ascertain how much more exposure you have to the underlying shares using the warrant as compared to the exposure you would have if you buy the shares through the market.
If you plan on exercising the warrant, you must do so before the expiration date. The more time remaining until expiration, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant (unless it depreciates). Therefore, the expiration date is the date on which the right to exercise ceases to exist.
Like options, there are different exercise types associated with warrants such as American style (holder can exercise anytime before expiration) or European style (holder can only exercise on expiration date).

Sometimes, the issuer will try to establish a market for the warrant and to register it with a listed exchange. In this case, the price can be obtained from a stockbroker. Often, though, warrants are privately held or not registered, which makes their prices less obvious.

Warrants Versus Other Convertibles

Warrants are very similar to call options. For instance, many warrants confer the same rights as equity options, and warrants often can be traded in secondary markets like options. However, there are several key differences between warrants and equity options:

Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public options exchange.
Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases. When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer. Unlike common stock shares outstanding, warrants do not have voting rights.
Warrants are considered over-the-counter instruments, and thus are usually only traded by financial institutions with the capacity to settle and clear these types of transactions.
A warrant’s lifetime is measured in years (as long as 15 years), while options are typically measured in months. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.
Warrants are not standardized like exchange-listed options. While each option contract is generally over 1,000 underlying ordinary shares, the number of warrants that must be exercised by the holder to buy the underlying asset depends on the conversion ratio set out in the offer documentation for the warrant issue.

Valuation

There are various methods of evaluating warrants, the most popular being the Black-Scholes evaluation model [see section on Options]. However, it is important to have some understanding of the various influences on warrant prices. The market value of a warrant can be divided into two components:

Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as in-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant’s exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time value – to be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in-the-money.

Time value: Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiration of the warrant gets closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiration. Time value is affected by time to expiration, volatility, dividends and interest rates.

Traditional warrants are issued in conjunction with a bond (known as a warrant-linked bond), and represent the right to acquire shares in the entity issuing the bond. In other words, the writer of a traditional warrant is also the issuer of the underlying instrument. Warrants are issued in this way to reduce the interest rate that must be offered in order to sell the bond issue. Valuing this type of warrant can be accomplished with the following equation:

Valuing a Warrant

Where: P is the price paid for the bond with warrants; C is the coupon payment; T is the maturity of the bond; r is the required rate of return; and F is the face value of the bond.

Uses, Advantages & Disadvantages

Warrants are often used as deal sweeteners, in order to entice hesitant investors. However, a warrant only benefits the investor if the company grows. Warrants can also be used for portfolio protection. For example, put warrants allow the owner to protect the value of the owner’s portfolio against falls in the market or in particular shares. Because of the dilutive nature of warrants, their issuance can lead to a decrease in stock value and loss of voting control. Warrants may also carry liquidity risk, due to their specialized nature.

16.4: Derivatives

16.4.1: Overview of Derivatives

A derivative is a financial instrument whose value is based on one or more underlying assets.

Learning Objective

Differentiate between different types of derivatives and their uses

Key Points

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative, the type of underlying asset, the market in which they trade, and their pay-off profile.
The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies.
Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly.
Derivatives contracts can be either over-the-counter or exchange-traded.

Key Terms

derivative: A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant, an option, etc.
margin: Collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty.
notional: Having descriptive value as opposed to a syntactic category.

Overview Of Derivatives

A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions – especially dates, resulting values of the underlying variables, and notional amounts – under which payments are to be made between the parties.

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative, the type of underlying asset, the market in which they trade, and their pay-off profile. The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies.

Derivatives are used by investors for the following:

To provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative.
To speculate and make a profit if the value of the underlying asset moves the way they expect.
To hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to the underlying position and cancels part or all of it out.
To obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives).
To create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

The use of derivatives can result in large losses because of the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly .

World Wealth Vs. World Derivatives

This graph illustrates total world wealth versus total notional value in derivatives contracts between 1998 and 2007.

Types

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market.

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is mostly unregulated with respect to disclosure of information between the parties.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. It acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Common Derivative Types

A forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time, at a price agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold. On the other hand, the forward contract is a non-standardized contract written by the parties themselves. Forwards also typically have no interim partial settlements – or “true-ups” – in margin requirements like futures, such that the parties do not exchange additional property, securing the party at gain, and the entire unrealized gain or loss builds up while the contract is open.

Swaps are derivatives in which counterparties exchange cash flows of one party’s financial instrument for those of the other party’s financial instrument. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

16.5: Managing Risk with Derivatives

16.5.1: Uses of Derivatives to Manage Exposure

Derivatives allow risk related to the price of underlying assets, such as commodities, to be transferred from one party to another.

Learning Objective

Discuss how derivatives manage exposure

Key Points

Companies that produce or depend on the purchase of commodities are exposed to price fluctuations that occur in commodities markets.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, etc. ) and sells it using a futures contract.
Although a third party, called a “clearing house,” insures a futures contract; not all derivatives are insured against counter-party risk.

Key Term

commodities: term used to describe a class of goods for which there is demand, but which is supplied without qualitative differentiation across a market.

Managing Exposure

Companies that produce or depend on the purchase of commodities are exposed to price fluctuations that occur in commodities markets. Examples of such companies include the airline industry, which is constantly exposed to the price of oil, and farming, which is not only exposed to the fluctuation in the price they can sell their goods at, but also the fluctuation in the price of animal feed, fertilizer, pesticides, and other such inputs.

Commodity Price Fluctuation

This graph shows the price of crude oil between August 2008 and January 2009. Companies depending on the price of oil for their supply can implement hedging strategies using derivatives to manage this exposure.

Derivatives allow risk related to the price of underlying assets, such as commodities, to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, etc.) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market’s current assessment of the future value of the asset.

Derivatives can serve legitimate business purposes, as well. For example, a corporation borrows a large sum of money at a specific interest rate. The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Chapter 15: Dividends

15.1: Introduction to Dividends

15.1.1: Defining Dividends

Dividends are a portion of company earnings regularly paid to shareholders, paid as some fixed amount per share price.

Learning Objective

Describe the process of issuing a dividend

Key Points

Dividends are periodical payments a corporation can choose to issue to its shareholders, with the amount of payment to each shareholder commensurate with their number of shares. They may be paid as cash, additional stock, or property.
Dividends may also be categorized as common stock or preferred dividends; preferred stock owners get their dividends paid in full first, before any common stock dividends are distributed.
Ratios using dividend value, such as dividends per share (DPS), dividend yield, and payout ratio have historically been used as indicators of a stock’s investment strength and the company’s overall performance, though their usefulness has been contested.

Key Terms

dividends per share: The amount shareholders earn per share.
dividend yield: A company’s total annual dividend payment per share, divided by its price per share.
dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).

Dividends are payments made by a corporation to its shareholder members on a regular (usually quarterly) basis–these are essentially the shareholder’s portion of a company’s profits. A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding; owning more shares results in greater dividends for the shareholder. When it is time to make dividend payments, corporations always pay preferred stock owners first, and then common stock dividends are allocated after all preferred dividends are paid in full. In the United States, dividends are usually declared quarterly by the corporation’s board of directors.

Historical dividend information for Franklin Automobile Company

Dividends are one of the privileges of stock ownership, and preferred shares get more rights to them than common shares do.

Dividends per share (DPS) refers to the dollar amount shareholders earn for each share, calculated by dividing total dividend amount by total number of shares outstanding. Dividend yield refers the ratio between dividends per share and the market price of each share, and it is expressed in terms of percentage. Payout ratio is calculated by dividing the company’s dividend by the earnings per share. A payout ratio greater than 1 means the company is paying out more in dividends for the year than it earned, while a low payout ratio indicates that the company is retaining a greater proportion of their earnings instead of paying out dividends. These ratios have historically been used as indicators of a stock’s investment strength and the company’s overall performance.

Dividends may be allocated in different forms of payment, outlined below:Cash dividends are the most common. As the name suggests, these are paid out as currency via electronic funds transfer or a printed paper check. For each share owned, a declared amount of money is distributed. Thus, if a person owns 1000 shares and the cash dividend is USD 0.90 per share, the holder of the stock will be paid USD 900.Stock dividends (also known as scrips) are payments in the form of additional stock shares of the company itself or one of its subsidiaries, as the name suggests. This may be a more palatable option for companies who would prefer to use its earnings towards growth of the company, rather than diverting them into cash dividends for shareholders. Property dividends or dividends in specie (Latin for “in kind”) are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and can take the form of securities of other companies owned by the issuer, or products and services. Companies may also offer reinvestment plans where shareholders can automatically reinvest dividends into more stock.

For public companies, there are six important dates to remember regarding dividends:

Declaration date is the day the board of directors announces its intention to pay a dividend. On this day, a liability is created and the company records that liability on its books; it now owes the money to the stockholders. The board will also announce a date of record and a payment date.
In-dividend date is the last day, which is one trading day before the ex-dividend date, where the stock is said to be cum dividend (‘with [including] dividend’). In other words, existing holders of the stock and anyone who buys it on this day will receive the dividend, whereas any holders selling the stock lose their right to the dividend. After this date the stock becomes ex-dividend.
Ex-dividend date (typically two trading days before the record date for U.S. securities) is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This is an important date for any company that has many stockholders, including those that trade on exchanges, as it makes reconciliation of who is to be paid the dividend easier. Existing holders of the stock will receive the dividend even if they now sell the stock, whereas anyone who now buys the stock will not receive the dividend. It is relatively common for a stock’s price to decrease on the ex-dividend date by an amount roughly equal to the dividend paid. This reflects the decrease in the company’s assets resulting from the declaration of the dividend. The company does not take any explicit action to adjust its stock price; in an efficient market, buyers and sellers will automatically price this in.
Book closure date is when company will ideally temporarily close its books for fresh transfers of stock.
Record date refers to the date that shareholders must be registered on record in order to receive the dividend. Shareholders who are not registered as of this date will not receive the dividend.
Payment date is the day when the dividends will actually be distributed to the shareholders of a company or credited to brokerage accounts.

15.1.2: The Nature of Dividends

Dividends are attractive to many investors because they are seen as steady streams of income from low risk investments.

Learning Objective

Analyze what dividends mean to an investor making a decision on which stock to include in her portfolio

Key Points

Dividends offer consistent returns on relatively low risk investments. While companies experiencing rapid growth are unlikely to offer dividends, established companies with stable business and less room to grow do pay dividends to shareholders.
A firm’s dividend decision may also serve as a signalling device about a firm’s future prospects. Due to information asymmetry between investors and the firm managers, investors will look to indicators like dividend decisions, which may give clues about what the firm managers forecast for the firm.
Critics of dividends contend that company profits are better used reinvested back into the company for research, development, and capital expansion.

Key Term

information asymmetry: In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.

The nature of dividends may appeal to investors because they offer consistent returns on relatively low risk investments. While companies experiencing rapid growth are unlikely to offer dividends, established companies with stable business and less room to grow do pay dividends to shareholders. Despite the low earnings growth of these stocks, shareholders get the benefit of knowing that the value of their initial investment is likely to remain stable. They can still profit off a steady stream of dividend payments.

A firm’s dividend decision may also serve as a signaling device which gives clues about a firm’s future prospects. Due to information asymmetry between investors and the firm managers, investors will look to indicators like dividend decisions. Studies have shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm are more likely to increase dividends.

Investors can use this knowledge about managers’ behavior to determine their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. Managers tend to avoid sending a negative signal to the market about the future prospects of their firm. This also tends to lead to a dividend policy of a steady, gradually increasing payment .

Stock prices shown in a ticker in Tokyo, Japan

Stock prices may be informed by a firm’s dividend decisions.

On the other hand, critics of dividends contend that company profits are best re-invested back into the company for research and development, capital expansion, and so forth. Their view is that an eagerness to return profits to shareholders may signal to investors that the management does not have ideas for the firm’s future prospects.

15.1.3: Dividend Irrelevance Theory

Under perfect market conditions, stockholders would ultimately be indifferent between returns from dividends or returns from capital gains.

Learning Objective

Discuss the implications and assumptions of the Modigliani-Miller theory

Key Points

Dividend irrelevance comes from Modigliani-Miller’s capital irrelevance model, which works under specific market conditions–no taxes, no transaction costs, and no flotation costs. Investors and firms must have identical borrowing and lending rates and the same information on the firm’s prospects.
Firms that pay more dividends offer less stock price appreciation. However, the total return from both dividends and capital gains to stockholders should be the same, so stockholders would ultimately be indifferent between the two choices.
If dividends are too small, a stockholder can simply choose to sell some portion of their stock for cash and vice versa.

Key Terms

capital gains: Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.
dividend irrelevance: Theory that a firm’s dividend policy is not relevant because stockholders are ultimately indifferent between receiving returns from dividends or capital gain.
flotation costs: Costs paid by a firm for the issuance of new stocks or bonds.

Economists Modigliani and Miller put forth a theory that only the firm’s ability to earn money and riskiness of its activity can have an impact on the value of the company; the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt, nor does it matter what the firm’s dividend policy is. Dividend irrelevance follows from this capital structure irrelevance.

Merton Miller

Merton Miller, one of the co-authors of the capital irrelevance theory which implied dividend irrelevance.

Modigliani-Miller grounded their theory on a set of assumptions:

No time lag and transaction costs exist.
Securities can be split into any parts (i.e., they are divisible).
No taxes and flotation costs.
Financial leverage does not affect the cost of capital.
Both managers and investors have access to the same information.
Firm’s cost of equity is not affected in any way by distribution of income between dividend and retained earnings.
Dividend policy has no impact on firm’s capital budget

Under these frictionless perfect capital market assumptions, dividend irrelevance follows from the Modigliani-Miller theorem. Essentially, firms that pay more dividends offer less stock price appreciation that would benefit stock owners who could choose to profit from selling the stock. However, the total return from both dividends and capital gains to stockholders should be the same. If dividends are too small, a stockholder can simply choose to sell some portion of his stock. Therefore, if there are no tax advantages or disadvantages involved with these two options, stockholders would ultimately be indifferent between returns from dividends or returns from capital gains.

Since the publication of the papers by Modigliani and Miller, numerous studies have shown that it does not make any difference to the wealth of shareholders whether a company has a high dividend yield or if a company uses its earnings to reinvest in the company and achieves higher growth. However, the importance of a firm’s dividend decision is still contested, with a number of theories arguing for dividend relevance.

15.1.4: Value of a Low Dividend

Low dividend payouts can be interpreted in a number of ways, including: as a leading indicator of future growth or a sign of instability.

Learning Objective

Discuss the advantages of a stock having a low dividend

Key Points

A relatively low payout could mean that the company is retaining more earnings toward developing the firm instead of paying stockholders, which hints at future growth. Future capital gains also have tax advantages. These are all factors in favor of investing in stocks with low dividends.
If a stock has a low dividend yield, this implies that the stock’s market price is considerably higher than the dividend payments a shareholder gets from owning the stock. This may indicate an overvalued stock or larger dividends in the future.
A history of low or falling yields may indicate that the firm’s cash situation is not stable. They cannot afford to give higher dividends because they do lack cash on hand. As a result, there is some measure of risk involved with these low dividend investments.

Key Terms

dividend yield: A company’s total annual dividend payment per share, divided by its price per share.
dividend cover: The ratio of total earnings to total dividend payments.

The value of a dividend is expressed as some percentage proportion of the number of shares held. A relatively low payout could mean that the company is retaining more earnings toward developing the firm instead of paying stockholders. Some investors would prefer this low payout because it hints at future growth. Furthermore, retained earnings lead to long-term capital gains, which have taxation advantages over high dividend payouts, according to the Taxation Preference Theory. Taxes on capital gains are deferred into the future when the stock is actually sold, as opposed to immediately like cash dividends. Furthermore, capital gains are taxed at lower rates than dividends. Therefore, taxation benefit is another point in favor of low dividend payouts .

Investor preferences for low dividend payouts

According to the clientele effect, firms offering low dividend payout will attract certain investors who are looking for a long term investment and would like to avoid taxes.

However, under dividend irrelevance theory, the actual value of a dividend is inconsequential to investors. If the dividend is too low, they can simply sell off part of their portfolio to generate more income for themselves. The conflicting theories on dividend policy complicate interpretations of low dividends in real life.

Dividend value must also be considered in relation to other measures of the firm, such as their earnings and stock price.

If a stock has a low dividend yield, this implies that the stock’s market price is considerably higher than the dividend payments a shareholder gets from owning the stock. There are a number of ways to interpret this ratio. A history of low or falling yields may indicate that the firm’s cash situation is not stable. They cannot afford to give higher dividends because they do lack cash on hand.

This instability can be seen in calculating the dividend cover, which is calculated as DC = EPS/DPS. A ratio of 2 or higher is considered safe—in the sense that the company can well afford the dividend—but anything below 1.5 is risky. If the ratio is under 1, the company is using its retained earnings from a previous year to pay this year’s dividend, which signals the risk of instability and poor performance of the firm. Signs of risk will deter investors, particularly if they are looking for cash dividends as a steady source of income.

Conversely, a low dividend yield can be considered evidence that the firm is experiencing rapid growth or that future dividends might be higher. Investors who prefer a “growth investment” strategy may prefer a stock with low to no dividend yields, as that is one of several indicators for a firm experiencing quick growth.

15.1.5: Value of a High Dividend

High dividend yields are attractive to investors who desire current income and stability since established firms often offer such stocks.

Learning Objective

Discuss the advantages of owning stock that has a high dividend

Key Points

A high-yield stock is generally considered as a stock whose dividend yield is higher than the yield of any benchmark average such as the 10 year U.S. Treasury note, although the exact classification of high yield may differ depending on the analyst.
High-yield may indicate undervaluation of the stock because the dividend is high relative to stock price or it can be a sign of a risky investment. If the high yield is due to a declining stock price, that reflects poorly on the firm’s performance and suggests that the dividend is unsustainable.
Generally speaking, firms that usually pay out high dividends are quite mature, profitable, and stable. They pay out high dividends simply because they have too much cash flow and few positive net present value investment possibilities.
The Dogs of the Dow strategy is a famous and extreme strategy using high dividend yields, where the investor buys the 10 highest dividend yielding stocks from the Dow Jones Industrial Average.

Key Term

Dogs of the Dow: An extreme investing strategy that dictates buying the 10 stocks with the highest dividend yields from the Dow Jones Industrial Average at the beginning of the year.

A high-yield stock is generally considered as a stock whose dividend yield is higher than the yield of any benchmark average such as the 10 year U.S. Treasury note. The classification of a high-yield stock is relative to the criteria of any given analyst. Some analysts may consider a 2% dividend yield to be high, while others may consider 2% to be low. There is no set standard for judging whether a dividend yield is high or low. A high dividend yield indicates undervaluation of the stock because the stock’s dividend is high relative to the stock price. High dividend yields are particularly sought after by income and value investors. High-yield stocks tend to outperform low yield and no yield stocks during bear markets because many investors consider dividend paying stocks to be less risky.

Generally speaking, most firms that pay out high dividends are quite mature, profitable, and stable. They pay out high dividends simply because they have too much cash flow and few positive net present value investment possibilities. But not all firms offering high dividend yields are steady, reliable investments. Perhaps the greatest risk in high-dividend securities is a falling stock price, which means that the high yield is due to decline of the firm. If a company is not earning enough profit to cover their dividend payments, the current dividend is unsustainable. In this case, a falling stock price indicates investor fears of a dividend cut. Therefore, if an investor buys these risky high-dividend stocks and the dividend is decreased because the company is suffering losses, the investor will have the problem of both less dividend income and portfolio of stocks with declining values. There may be investors, such as retirees, who prefer current income from high dividends to low dividends and growth in stock value. Theories may say this should not matter since investors could sell a portion of the low dividend paying stocks to supplement cash flow, but in the real world, markets are not frictionless. The sale of securities involves transaction costs that may outweigh any benefits of the sale. Therefore, some individuals are better off holding high dividend stock.

The Dogs of the Dow strategy is a well known and rather extreme strategy that incorporates high dividend yields. The strategy dictates that the investor compile a list of the 10 highest dividend yielding stocks from the Dow Jones Industrial Average and buying an equal position in all 10 at the beginning of each year. At the end of each year, the investor finds the 10 highest dividend yield stocks again, and reallocates their positions so as to have an equal position in all 10 Dogs of the Dow. The Dogs of the Dow made a compounded annual return of 18% from 1975 to 1999 outperforming the market by 3%. This would make 10,000 turn into 625,000 in 25 years .

High dividend gambles

Risk aversion can be applied to many different situations including investments, lotteries, and any other situations with uncertain outcomes.

Proponents of the Dogs of the Dow strategy argue that blue chip companies do not alter their dividend to reflect trading conditions. Therefore, the dividend is a measure of the average worth of the company. In contrast, the stock price fluctuates through the business cycle. This should mean that companies with a high yield, with high dividend relative to price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low yield companies. Under this model, an investor annually reinvesting in high-yield companies should out-perform the overall market. The logic behind this is that a high dividend yield suggests both that the stock is oversold and that management believes in its company’s prospects and is willing to back that up by paying out a relatively high dividend. Investors are thereby hoping to benefit from both above average stock price gains as well as a relatively high quarterly dividend. Of course, several assumptions are made in this argument. The first assumption is that the dividend price reflects the company size rather than the company business model. The second is that companies have a natural, repeating cycle in which good performances are predicted by bad ones.

15.2: Dividend Policy

15.2.1: Accounting Considerations

Accounting for dividends depends on their payment method (cash or stock).

Learning Objective

Describe the accounting considerations associated with dividends

Key Points

Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is transferred into a separate dividends payable account and this is debited on payment day.
Accounting for stock dividends is essentially a transfer from retained earnings to paid-in capital.
Unlike cash dividends, stock dividends do not come out of the firm’s income, so the firm is able to both maintain their cash and offer dividends. The firm’s net assets remain the same, as does the wealth of the investor.

Key Terms

paid-in capital: Capital contributed to a corporation by investors through purchase of stock from the corporation.
retained earnings: The portion of net income that is retained by the corporation rather than distributed to its owners as dividends.
declaration date: the day the Board of Directors announces its intention to pay a dividend

Example

Cash dividend example: Firm A’s Board of Directors declared a dividend on December 1, 2011 of $100,000 payable to shareholders of record on Feb 1, 2012 and payable on Feb 29, 2012. This $100,000 goes down as a liability on the firm’s accounting sheet.

Accounting for dividends depends on their payment method (cash or stock). On the declaration day, the firm’s Board of Directors announces the issuance of stock dividends or payment of cash dividends. Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is placed in a separate dividends payable account.

The accounting equation for this is simply:

Retained Earnings = Net Income − Dividends

Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity (shareholders’ equity). ” It is mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners/stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

On the date of payment, when dividend checks are mailed out to stockholders, the dividends payable account is debited and the firm’s cash account is credited.

Stock dividends are parsed out as additional stocks to shareholders on record. Unlike cash dividends, this does not come out of the firm’s income. The firm is able to both maintain their cash and give dividends to investors. Here, the firm’s net assets remain the same. If a firm authorizes a 15% stock dividend on Dec 1st, distributable on Feb 29, and to stockholders of record on Feb 1, the stock currently has a market value of $15 and a par value of $4. There are 150,000 shares outstanding and the firm will issue 22,500 additional shares. The value of the dividend is (150,000)(15%)(15) = $337,500.

The declaration of this dividend debits retained earnings for this value and credits the stock dividend distributable account for the number of new stock issued (150,000*.15 = 22,500) at par value. We must also consider the difference between market value and par (stated) value and record that as credit for additional paid-in-capital . On the day of issuance, the stock dividends distributable account is debited and stock is credited $90,000.

15.2.2: Investor Preferences

The significance of investors’ dividend preferences is a contested topic in finance that has serious implications for dividend policy.

Learning Objective

Identify the criteria that define a company’s dividend policy

Key Points

Elements of dividend policy include: paying a dividend vs reinvestment in company, high vs low payout, stable vs irregular dividends, and frequency of payment.
Some are of the opinion that the future gains are more risky than the current dividends, so investors prefer dividend payments over capital gains. Others contend that dividend policy is ultimately irrelevant, since investors are indifferent between selling stock and receiving dividends.
Assuming dividend relevance, coming up with a dividend policy is challenging for the firms because different investors have different views on present cash dividends and future capital gains.
Importance of the content and the stability of a dividend policy are subject to much academic debate.

Key Terms

capital gains: Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.
dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
dividend policy: A firm’s decisions on how to distribute (or not distribute) their earnings to their shareholders.

The role of investor preferences for dividends and the value of a firm are pieces of the dividend puzzle, which is the subject of much academic debate. Assuming dividend relevance, coming up with a dividend policy is challenging for the directors and financial manager of a company because different investors have different views on present cash dividends and future capital gains. Investor preferences are first split between choosing dividend payments now, or future capital gains in lieu of dividends. Further elements of the dividend policy also include:1. High versus low payout, 2. Stable versus irregular dividends, and 3. Frequency of payment. Cash dividends provide liquidity, but the bonus share will bring capital gains to the shareholders. The investor’s preference between the current cash dividend and the future capital gain has been viewed in kind.

Many people hold the opinion that the future gains are more risky than the current dividends, as the “Bird-in-the-hand Theory” suggests. This view is supported by both the Walter and Gordon models, which find that investors prefer those firms which pay regular dividends, and such dividends affect the market price of the share. Gordon’s dividend discount model states that shareholders discount the future capital gains at a higher rate than the firm’s earnings, thereby evaluating a higher value of the share. In short, when the retention rate increases, they require a higher discounting rate.

In contrast, others (see Dividend Irrelevance Theory) argue that the investors are indifferent between dividend payments and the future capital gains. Therefore, the content of a firm’s dividend policy has no real effect on the value of the firm.

Investor preferences play an uncertain role in the “dividend puzzle,” which refers to the phenomenon of companies that pay dividends being rewarded by investors with higher valuations, even though according to many economists, it should not matter to investors whether or not a firm pays dividends. There are a number of factors, such as psychology, taxes, and information asymmetries tied into this puzzle, which further complicate the matter.

Stock Market

Different kinds of investors are active in stock market.

15.2.3: Stock Dividends vs. Cash Dividends

Investors’ preference for stock or cash depends on their inclinations toward factors such as liquidity, tax situation, and flexibility.

Learning Objective

Assess whether a particular shareholder would prefer stock or cash dividends

Key Points

Cash dividends provide steady payments of cash that can be used to reinvest in a company, if the shareholder desires.
Holders of stock dividends can sell their stock for (hopefully) high capital gains in the future, or they can sell it off immediately to get cash, much like a cash dividend. This flexibility is seen by some as a benefit of stock dividend.
Cash dividends are immediately taxable as income, while stock dividends are only taxed when they are actually sold by the shareholder.
If an investor is interested in long-term capital gains, he or she will likely prefer stock dividends. If an investor needs a regular source of income, cash dividends will provide liquidity.
Firms can choose to issue stock dividends if they would like to direct their earnings toward the development of the firm but would still like to appease stockholders with some form of payment.
Established firms with little more room to grow do not have pressing needs for all their cash earnings, so they are more likely to give cash dividends.

Key Terms

cash dividend: a payment by the company to shareholders paid out in currency, usually via electronic funds transfer or a printed paper check
stock dividends: Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.
cash dividends: Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check.

If a firm decides to parcel out dividends to shareholders, they have a choice in the form of payment: cash or stock. Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check. This is the most common method of sharing corporate profits with the shareholders of a company. Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.Cash dividends provide investors with a regular stream of income. Stock dividends, unlike cash dividends, do not provide liquidity to the investors; however, they do ensure capital gains to the stockholders. Therefore, if investors are not interested in a long-term investment, they will prefer regular cash payments over payments of additional stock.

Income from Dividends

When choosing between cash or stock dividends, the trade-off is between liquidity in the short-term or income from capital gains in the long-term.

Costs of taxes can also play a role in choosing between cash or stock dividends. Cash dividends are immediately taxable under most countries’ tax codes as income, while stock dividends are not taxable until sold for capital gains (if stock was the only choice for receiving dividends). This can be seen as a huge benefit of stock dividends, particularly for investors of a high income tax bracket. A further benefit of the stock dividend is its perceived flexibility. Shareholders have the choice of either keeping their shares in hopes of high capital gains, or selling some of the new shares for cash, which is somewhat like receiving a cash dividend.

If the payment of stock dividends involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization of the shares held. It has the same effect as a stock split: the total value of the firm is not affected. If the payment involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held. As such, receiving stock dividends does not increase a shareholder’s stake in the firm; by contrast, a shareholder receiving cash dividends could use that income to reinvest in the firm and increase their stake.

For the firm, dividend policy directly relates to the capital structure of the firm, so choosing between stock dividends and cash dividends is an important consideration. A firm that is still in its stages of growth will most likely prefer to retain its earnings and put them toward firm development, instead of sending them to their shareholders. The firm could also choose to appease investors with stock dividends, which would still allow it to retain its earnings. Conversely, a firm that is already quite stable with low growth is much more likely to choose payment of dividends in cash. The needs and cash flow of the firm are necessary points of consideration in choosing a dividend policy.

15.2.4: Signaling

Dividend decisions are frequently seen by investors as revealing information about a firm’s prospects; therefore firms are cautious with these decisions.

Learning Objective

Describe what information a shareholder can obtain from a company issuing dividends

Key Points

Signaling is the idea that one agent conveys some information about itself to another party through an action. It took root in the idea of asymmetric information; in this case, managers know more than investors, so investors will find “signals” in the managers’ actions to get clues about the firm.
For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Investors will notice this and choose to sell their share of the firm.
Investors can use this knowledge about signal to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations.
Firms are aware of this signaling effect, so they will try not to send a negative signal that sends their stock price down.

Key Terms

dividend decision: A decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company’s stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.
information asymmetry: In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.
signalling: Action taken by one agent to indirectly convey information to another agent.

A dividend decision may have an information signalling effect that firms will consider in formulating their policy. This term is drawn from economics, where signaling is the idea that one agent conveys some information about itself to another party through an action.

Signaling took root in the idea of asymmetric information, which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services . An information asymmetry exists if firm managers know more about the firm and its future prospects than the investors.

A company’s dividend decision may signal what management believes is the future prospects of the firm and its stock price.

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm’s future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information in actions like the firm’s dividend policy. For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers’ behavior to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

15.2.5: Impact of Dividend Policy on Clientele

Change in a firm’s dividend policy may cause loss of old clientele and gain of new clientele, based on their different dividend preferences.

Learning Objective

Describe how the clientele effect can influence stock price

Key Points

The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change.
Current clientele might choose to sell their stock if a firm changes their dividend policy and deviates considerably from the investor’s preferences. Changes in policy can also lead to new clientele, whose preferences align with the firm’s new dividend policy.
In equilibrium, the changes in clientele sets will not lead to any change in stock price.
The real world implication of the clientele effect lies in the importance of dividend policy stability, rather than the content of the policy itself.

Key Terms

clientele effect: The theory that changes in a firm’s dividend policy will cause loss of some clientele who will choose to sell their stock, and attract new clientele who will buy stock based on dividend preferences.
clientele: The body or class of people who frequent an establishment or purchase a service, especially when considered as forming a more-or-less homogeneous group of clients in terms of values or habits.
dividend clientele: Sets of investors who are attracted to certain types of dividend policy.

Example

Suppose Firm A had been in a growth stage and did not offer dividends to its shareholders, but their policy changed to paying low cash dividends. Clientele interested in long term capital gains might be alarmed, interpreting this decision as a sign of slowing growth, which would mean less stock price appreciation in the future. This set of clientele could choose to sell the stock. On the other hand, dividend payments could appeal to investors who are interested in regular additional income from the investment, and they would buy Firm A’s stock.

The Clientele Effect

The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change. These investors are known as dividend clientele. For instance, some clientele would prefer a company that doesn’t pay dividends at all, but instead invests their retained earnings toward growing the business. Some would instead prefer the regular income from dividends over capital gains. Of those who prefer dividends over capital gains, there are further subsets of clientele; for example, investors might prefer a stock that pays a high dividend, while another subset might look for a balance between dividend payout and reinvestment in the company.

Clientele Type Example

Retirees are more likely to prefer high dividend payouts over capital gains since this provides them with cash income. Therefore, if a company discontinued paying dividends, the clientele effect may cause retiree shareholders to sell the stock in favor of other income generating investments.

Clientele may choose to sell their stock if a firm changes its dividend policy, and deviates considerably from its preferences. On the other hand, the firm may attract a new clientele group if its new dividend policy appeals to the group’s dividend preferences. These changes in demographics related to a stock’s ownership due to a change of dividend policy are examples of the “clientele effect. “

This theory is related to the dividend irrelevance theory presented by Modigliani and Miller, which states that, under particular assumption, an investor’s required return and the value of the firm are unrelated to the firm’s dividend policy. After all, clientele can just choose to sell off their holdings if they dislike a firm’s policy change, and the firm may simultaneously attract a new subset of clientele who like the policy change. Therefore, stock value is unaffected. This is true as long as the “market” for dividend policy is in equilibrium, where demand for such a policy meets the supply.

The clientele effect’s real world implication is that what matters is not the content of the dividend policy, but rather the stability of the policy. While investors can always choose to sell shares of firms with undesirable dividend policy, and buy shares of firms with attractive dividend policy, there are brokerage costs and tax considerations associated with this. As a result, an investor may stick with a stock that has a sub-optimal dividend policy because the cost of switching investments outweighs the benefit the investor would receive by investing in a stock with a better dividend policy.

Although commonly used in reference to dividend or coupon (interest) rates, the clientele effect can also be used in the context of leverage (debt levels), changes in line of business, taxes, and other management decisions.

15.3: Setting the Dividend

15.3.1: Setting the Target Payout Ratio

Companies determine what kind of investors they want to attract and the investment opportunities they face before setting the target payout ratio.

Learning Objective

Calculate a company’s target payout ratio

Key Points

The ratio is calculated by dividing Dividends Paid by Net Income for the same accounting period, or Dividend per Share by Earnings per Share.
A high dividend ratio appeals to investors who want high current income and are unconcerned with capital gains. A lower ratio appeals to investors who value growth and capital gains over income.
In general, the Dividend Payout Ratio of publicly traded companies has steadily declined, on average, since 1940.

Key Term

capital gains: Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.

Setting the Target Payout Ratio

The Target Payout Ratio, or Dividend Payout Ratio, is the fraction of net income a firm pays to its stockholders in dividends. It is calculated by dividing the dividends distributed by the net income for the same period. The part of the earnings not paid to investors in the form of a dividend is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with high Dividend Payout Ratios.

However investors seeking capital growth may prefer lower payout ratios. This is appealing to some investors because a lower dividend implies that more earnings are being reinvested in the company, which should cause the stock price to rise. Some investors, such as young people saving for retirement, may prefer higher returns later than smaller cash distributions now.

Dividend Ratio and Investment Strategy

The Target Payout Ratio depends on what investors the management of a company are trying to attract, and what current investors’ expectations are. It also depends on the growth goals of the company. If a company is trying to grow very fast, it may prefer to reinvest its income in expanding operations.

A more established firm with an established market probably does not need to expand its operations, and would prefer to use its earning to compensate its investors. High growth firms in early life generally have low or zero payout ratios. As they mature, they tend to return more of the earnings back to investors.

Historical Perspective

The payout rate has gradually declined from 90% of operating earnings in the 1940s to about 30% in recent years. For smaller growth companies, the average payout ratio can be as low as 10%

15.3.2: Residual Dividend Model

The Residual Dividend Model first uses earnings to finance new projects, then distributes the remainder as dividends.

Learning Objective

Apply the Residual Dividend Model to making decisions about dividends

Key Points

The Residual Dividend Model implies the Irrelevance of Dividends Theory, which claims that investors are indifferent between returns in the form of dividends or capital gains.
Residual Dividends result in a passively-calculated dividend, which changes every year.
Since the Residual Dividend Model assumes dividends and capital gains are two forms of the same value, it will not affect the market value.

Key Terms

dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
ex-dividend date: the first date upon which the buyer of a stock is not permitted to receive the next payment from the company to shareholders

Definition

The Residual Dividend Model is a method a company uses to determine the dividend it will pay to its shareholders.

Companies which use retained earnings to finance new projects use this method. The company first determines which new projects it wants to finance, dedicates funds to those projects, and then distributes any leftover profits to its shareholders as dividends.

This model can lead to unpredictable and inconsistent dividend returns for the investor. However, the company’s goal is to generate further profits from the projects it funds, which benefits the shareholders overall.

Irrelevance of Dividends

The Residual Dividend Model is an outgrowth of The Modigliani and Miller Theory that posits that dividends are irrelevant to investors. This school of thought believes that investors do not state any preference between current dividends and capital gains. It goes on to say that dividend policy does not determine market value of a stock. Accordingly, the shareholders are indifferent to the two ways by which their investment grows:

receiving a dividend
share price increasing due to retained earnings

What investors want are high returns – either in the form of dividends or in the form of re-investment of retained earnings by the firm .

Writing a check.

Companies usually issue investors a check for their dividend.

Dividend or Capital Gain Trade-Off

The Residual Model dividend policy is a passive one and, in theory, does not influence market price because the same wealth is created for the investor regardless of the dividend. The firm paying out dividends is obviously generating income for an investor; however, even if the firm diverts some earnings for investment opportunities, the income of the investors will rise later, assuming that those investments are profitable. The dividend, therefore, fluctuates every year because of different investment opportunities and earning levels.

15.3.3: Methods of Paying Dividends

Dividends, which are distributed based on how many shares each person owns, can be paid using cash, stock, or other company property.

Learning Objective

Classify the different types of dividends based on method of payment

Key Points

The most common method of payment for dividends is cash. This can be either electronic transfer or check to the shareholder, and is taxed when it is received.
The dividend can also be paid as new shares of stock. This can either involve newly issued shares or old shares.
The most rare method is to distribute property or other assets as the dividend.

Key Terms

interim: A transitional or temporary period between other events.
proportion: A quantity of something that is part of the whole amount or number.

Proportional Payment

A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding.

Cash

Cash dividends are those paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is 50 cents per share, the holder of the stock will be paid 50 dollars. Dividends paid are not classified as an expense, but rather a deduction of retained earnings. Dividends paid does not show up on a Income Statement but does appear on the Balance Sheet.

Real S&P Prices, Earnings, and Dividends 1871-2006

A graph visualizing S&P’s prices, earnings, and dividends over a 130-year period. Earnings and dividends have risen steadily over time; price spiked substantially around 2000 and is only slightly lower now.

Stock

Stock or scrip dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation, such as its subsidiary corporation. They are usually issued in proportion to shares owned. For example, for every 100 shares of stock owned, a 5% stock dividend will yield 5 extra shares. If the payment involves the issue of new shares, it is similar to a stock split: it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held.

Property

Property dividends or dividends in specie (Latin for “in kind”) are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer. However, they can take other forms, such as products and services.

Interim Dividends

Interim dividends are dividend payments made before a company’s annual general meeting and final financial statements. This declared dividend usually accompanies the company’s interim financial statements.

Other

Other dividends can be used in structured finance. Financial assets with a known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for “spinning off” a company from its parent is to distribute shares in the new company to the old company’s shareholders. The new shares can then be traded independently.

15.4: Cash Dividend Alternatives

15.4.1: Stock Splits

A stock split increases the number of shares outstanding without changing the market value of the firm.

Learning Objective

Describe a stock split

Key Points

A stock split is executed by offering several new shares in exchange for old ones. This may be a 3-for-1 split, for example: each share could be traded in for three new ones.
A stock split does not change the market capitalization of the firm, it merely changes the number of shares outstanding. Therefore the price per share decreases as the number of shares outstanding increases.
Each shareholder retains his or her same ownership stake because the number of share s/he holds changes in proportion to the change in the total number of shares outstanding.

Key Term

market capitalization: The total market value of the equity in a publicly traded entity.

A stock split or stock divide increases the number of shares in a public company. Suppose a company has 1,000 shares outstanding. The company may want to increase this number to 2,000 shares without issuing new shares. They would split their stock 2-for-1. That means that every shareholder trades in one old share and gets two new shares in return.

The ownership stake for each shareholder remains constant because the number of shares held changes in proportion to the number of shares outstanding. They own the same percentage of the outstanding shares, though the nominal number of shares increases.

The price of the shares, however, changes. Since the market value of the company remains the same, the price of the new shares adjusts to reflect the new number of outstanding shares. For example, a company that has 100,000 shares outstanding that trade at $6 has a market capitalization of $600,000. After a 3-for-1 stock split the market capitalization of the company remains unchanged at $600,000, but there are not 300,000 shares trading at $2.

Lowering the price per share is attractive to some companies. Berkshire Hathaway Class A shares have never been split, so the price has followed the company’s growth over time . Since the price of a Class A share was over $121,000 on May 2, 2012, smaller investors may have chosen not to invest in Berkshire Hathaway Class A shares because of cash-flow or liquidity concerns. There are, however, Class B shares that trade at a lower value.

Berkshire Hathaway

Berkshire Hathaway has famously never had a stock split, and has never paid a dividend. As a result its Class A shares traded at $121,775.00 as of May 2, 2012, making them the highest-priced shares on the New York Stock Exchange.

15.4.2: Stock Dividends

Stock dividends are when a company gives each shareholder additional stock in lieu of a cash dividend.

Learning Objective

Create a journal entry to record a stock dividend and a stock split

Key Points

Stock dividends are no different than stock splits in practice. They simply increase the number of shares outstanding, but not the market capitalization or the total value of the shareholders’ assets.
Stock dividends may be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).
Cash dividends are taxed while stock dividends are not.
The journal entry to record the stock dividend is a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

Key Terms

stock split: To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.
stock dividend: a payment to a shareholder paid out in the form of additional stock shares of the issuing corporation, or another corporation (such as its subsidiary corporation)

In lieu of cash, a company may choose to pay its dividend in the form of stock. Instead of each shareholder receiving, say $2 for each share, they may receive an additional share. A stock dividend (also known as a scrip dividend) can be the economic equivalent of a stock split.

When a stock dividend is paid, no shareholder actually increases the values of his or her assets. The total number of shares outstanding increases in proportion to the change in the number of shares held by each shareholder. If a 5% stock dividend is paid, the total number of shares outstanding increases by 5%, and each shareholder will receive 5 additional shares for each 100 held. As a result, each shareholder has the same ownership stake as before the stock dividend.

In addition, the value of the shares held does not change for each shareholder. As the number of shares outstanding increases, the price per share drops because the market capitalization does not change. Therefore, each shareholder will hold more shares, but each has a lower price so the total value of the shares remains unchanged.

The stock dividend is not, however, exactly the same as a stock split. A stock split is paid by switching out old shares for a greater number of new shares. The company is essentially converting to a new set of shares and asking each shareholder to trade in the old ones.

A stock dividend could be paid from shares not-outstanding. These are the company’s own shares that it holds: they are not circulating in the market, but were issued just the same. The company may have gotten these shares from share repurchases, or simply from them not being sold when issued.

Stock dividends may also be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).

The company would record the stock dividend as a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

An advantage of paying stock dividends instead of cash dividends to the shareholder is due to tax considerations. Cash dividends are taxed, while stock dividends are not . Of course, stock dividends don’t actually change the asset value of the shareholders so, in effect, nothing of substance has occurred.

Supreme Court Seal

The Eisner vs. Macomber case was a US Supreme Court Case that helped determine the differences in taxation of cash and stock dividends.

15.4.3: Reverse Splits

Reverse splits are when a company reduces the number of shares outstanding by offering a number of new shares for each old one.

Learning Objective

Define a reverse split

Key Points

In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.
A reverse split boosts the share price, so there is a stigma attached. Some investors have rules against trading shares below a certain value, so a company in financial trouble may issue a reverse split to keep their share price above that threshold.
A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment.

Key Terms

outstanding shares: Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.
outstanding stock: all the stock of a corporation or financial asset that have been authorized, issued and purchased by investors and are held by them

By owning a share, the shareholder owns a percentage of the company whose share s/he owns. A share, however, does entitle the shareholder to a specific percentage ownership; the amount of the company that the shareholder owns is dependent of the number of shares owned and the number of shares outstanding. If Jim owns 10 shares of Oracle, and there are 1,000 shares outstanding, Jim effectively owns 1% of Oracle. If the number of shares outstanding were to double to 2,000, Jim’s 10 shares would now correspond to a 0.5% ownership stake. In order for Jim’s ownership stake to remain constant, the number of shares he holds must change in proportion to change in outstanding shares: he must own 20 shares if there are 2,000 shares outstanding.

That is the premise behind a reverse stock split. In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.

The reduction in the number of issued shares is accompanied by a proportional increase in the share price. A company with a market capitalization of $1,000,000 from 1,000,000 shares trading at $1 chooses to reduce the number of outstanding shares to 500,000 through a reverse split. This leads to a corresponding rise in the stock price to $2.

There is a stigma attached to doing a reverse stock split, so it is not initiated without very good reason and may take a shareholder or board meeting for consent. Many institutional investors and mutual funds, for example, have rules against purchasing a stock whose price is below some minimum. In an extreme case, a company whose share price has dropped so low that it is in danger of being delisted from its stock exchange, might use a reverse stock split to increase its share price. For these reasons, a reverse stock split is often an indication that a company is in financial trouble.

A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment. If the number of shareholders drops, the company may be placed into a different regulatory categories and may be governed by different laws .

SEC

The Securities and Exchange Commission is the department that sets the different regulations regarding stock trading and splitting.

15.4.4: Repurchasing Shares

A share repurchase is when a company buys its own stock from public shareholders, thus reducing the number of shares outstanding.

Learning Objective

Describe the different ways a company may repurchase its stock

Key Points

Since the market capitalization is unchanged and the number of shares outstanding drops, a share repurchase will lead to a corresponding increase in stock price.
The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase.
There are a number of methods for repurchasing shares, the most popular of which is open-market: the company buys back shares at the market dictated price if the price is favorable.

Key Term

Repurchase: To buy back a company’s own shares. The issuing company pays public shareholder for their shares.

An alternative to cash dividends is share repurchases. In a share repurchase, the issuing company purchases its own publicly traded shares, thus reducing the number of shares outstanding. The company then can either retire the shares, or hold them as treasury stock (non-circulating, but available for re-issuance).

When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase. Repurchasing shares when a company’s share price is undervalued benefits non-selling shareholders and extracts value from shareholders who sell.

Repurchasing shares will lead to a corresponding increase in price of the shares still outstanding. The market capitalization of the company is unchanged, meaning that a reduction in the number of shares outstanding must be accompanied by an increase in stock price.

There are six primary repurchasing methods:

Open Market: The firm buys its stock on the open market from shareholders when the price is favorable. This method is used for almost 75% of all repurchases.
Selective Buy-Backs: The firm makes repurchase offers privately to some shareholders.
Repurchase Put Rights: Put rights are the right of the seller to purchase at a certain price, set ahead of time. If the company has put rights on its shares, it may use them to repurchase shares at that price.
Fixed Price Tender Offer: The firm announces a number of shares it is looking for and a fixed price they are willing to pay. Shareholders decide whether or not to sell their shares to the company.
Dutch Auction Self-Tender Repurchase: The company announces a range of prices at which they are willing to repurchase. Shareholder voluntarily state the price at which they individually are willing to sell. The company then constructs the supply-curve, and then announces the purchase price. The company repurchases shares from all shareholders who stated a price at or below that repurchase price .
Employee Share Scheme Buy-Back: The company repurchases shares held by or for employees or salaried directors of the company.

15.4.5: Benefits of Repurchasing Shares

Share repurchases are beneficial when the stock is undervalued, management needs to meet a financial metric, or there is a takeover threat.

Learning Objective

Discuss the benefits of a company repurchasing its shares

Key Points

If management feels the company is undervalued, they will repurchase the stock, and then resell it once the price of the shares increases to reflect the accurate value of the firm.
A member of management may have to meet earnings per share (EPS) metrics which can be increased by increasing earnings or lowering the number of outstanding shares. Share repurchases decrease the number of outstanding shares, and thus increase EPS.
To prevent a firm from acquiring enough of a company’s stock to take it over, the takeover target may buy back shares, often at a price above market value.

Key Terms

Earnings Per Share: EPS. (Net Income – Dividends on Preferred Stock) / Outstanding Shares
hostile takeover: An attempted takeover of a company that is strongly resisted by the target company’s management.

A company may seek to repurchase some of its outstanding shares for a number of reasons. The company may feel that the shares are undervalued, an executive’s compensation may be tied to earnings per share targets, or it may need to prevent a hostile takeover.

For shareholders, the primary benefit is that those who do not sell their shares now have a higher percent ownership of the company’s shares and a higher price per share. Those who do choose to sell have done so at a price they are willing to sell at – unless there was a ‘put’ clause, in which case they had to sell because of the structure of the share, something they would have already known when they bought the shares.

Undervaluation

Repurchasing shares may also be a signal that the manager feels that the company’s shares are undervalued. In this event, it will choose to repurchase shares, and then resell them in the open market once the price increases to accurately reflect the value of the company.

Executive Compensation

In some instances, executive compensation may be tied to meeting certain earnings per share (EPS) metrics. If management needs to boost the EPS of the company to meet the metric, s/he has two choices: raise earnings or reduce the number of shares. If earnings cannot be increased, there are a number of ways to artificially boost earnings (called earnings management), but s/he can also reduce the number of shares by repurchasing shares . Strictly speaking, this is a benefit to the management and executives, not the company or the shareholders. -Thwart.

Marc Benioff

CEOs, like Marc Benioff of Salesforce.com, may have to meet certain financial targets in order to earn his or her bonus. If one of these targets is EPS, they may have an incentive to try to increase EPS artificially.

Hostile Takeovers

A company can take over another firm if it holds enough of the other takeover target’s shares (the buyer of the shares is called the bidder, and the company it is trying to buy is called the takeover target). The bidder is buying the takeover target’s shares in an attempt to purchase enough to own it. Assuming the firm does not want to be taken over this way, the takeover attempt is called hostile. In order to prevent this from happening, the takeover target needs to prevent the bidder from purchasing enough of the shares. To do this, the takeover target will repurchase its own shares from the unfriendly bidder, usually at a price well above market value. Furthermore, it can prevent future takeover attempts. Companies with a lot of cash on their balance sheets are more attractive takeover targets because the cash can be used to pay down the debt incurred to carry out the acquisition. Share repurchases are one way of lowering the amount of cash on the balance sheet.

15.4.6: Drawbacks of Repurchasing Shares

Share repurchases often give an advantage to insiders and can be used to manipulate financial metrics.

Learning Objective

Discuss the drawbacks of a share repurchase

Key Points

Insiders are more likely to know if a firm is undervalued, and are therefore more likely to know whether they should sell their shares in an open-market repurchase.
Financial ratios that use the number of shares outstanding change when shares are repurchased. Executives and management whose compensation is tied to these metrics have an incentive to manipulate them through share repurchases.
Share repurchases are often not completed. It is tough to value the effect of a share repurchase announcement because it is unknown whether it will occur in full.

Key Terms

Earnings Per Share: The amount of earnings per each outstanding share of a company’s stock.
insider: A person who has special knowledge about the inner workings of a group, organization, or institution.

There are a number of drawbacks to share repurchases. Both shareholders and the companies that are repurchasing the shares can be negatively affected.

Shares may be repurchased if the management of the company feels that the company’s stock is undervalued in the market. It repurchases the shares with the intention of selling them once the market price of the shares increase to accurately reflect their true value. Not every shareholder, however, has a fair shot at knowing whether the repurchase price is fair. The repurchasing of the shares benefits the non-selling shareholders and extracts value from shareholders who sell. This gives insiders an advantage because they are more likely to know whether they should sell their shares to the company .

Martha Stewart

Martha Stewart was convicted of insider trading, which is not the same as insiders choosing whether to sell their shares in a share repurchase. Insiders are still at an advantage because they will know not to sell during the share repurchase.

Furthermore, share repurchases can be used to manipulate financial metrics. All financial ratios that include the number of shares outstanding (notably earnings per share, or EPS) will be affected by share repurchases. Since compensation may be tied to reaching a high enough EPS number, there is an incentive for executives and management to try to boost EPS by repurchasing shares. Inaccurate EPS numbers are not good for investors because they imply a degree of financial health that may not exist.

From the investor’s standpoint, one drawback of share repurchases is that it’s hard to judge how it will affect the valuation of the company. Companies often announce repurchases and then fail to complete them, but repurchase completion rates increased after companies were forced to retroactively disclose their repurchase activity. It is difficult for shareholders, especially relatively uninformed ones, to judge how the announcement will affect the value of their holdings if there is no guarantee that the full announced repurchase will occur.

15.4.7: Dividend Reinvestments

Dividend reinvestment plans (DRIPs) automatically reinvest cash dividends in the stock.

Learning Objective

Describe a dividend reinvestment plan

Key Points

DRIPs help shareholders reinvest their dividends in the underlying stock without having to wait for enough money to buy a whole number of shares. It also may allow them to avoid some brokerage fees.
DRIPs help stabilize stock prices by inherently encouraging long-term investment instead of active-management, which may cause volatility.
DRIPs are generally associated with programs offered by the company. However, brokerage firms may offer similar reinvestment programs called “synthetic DRIPs”.

Key Term

reinvest: To invest cash again, instead of holding it as cash.

In some instances, a company may offer its shareholders an alternative option to receiving cash dividends. The shareholder chooses to not receive dividends directly as cash; instead, the shareholder’s dividends are directly reinvested in the underlying equity. This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).

The purpose of the DRIP is to allow the shareholder to immediately reinvest his or her dividends in the company. Should the shareholder choose to do this on his or her own, s/he would have to wait until enough cash accumulates to buy a whole number of shares and s/he would also incur brokerage fees .

Charles Schwab

Brokerage firms like Charles Schwab earn money by charging a brokerage fee for executing transactions. Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.

Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder. Some DRIPs are free of charge for participants, while others do charge fees and/or proportional commissions.

DRIPs have become popular means of investment for a wide variety of investors as DRIPs enable them to take advantage of dollar-cost averaging with income in the form of corporate dividends that the company is paying out. Not only is the investor guaranteed the return of whatever the dividend yield is, but s/he may also earn whatever the stock appreciates to during his or her time of ownership. However, s/he is also subject to whatever the stock may decline to, as well.

There is an advantage to the the company managing the DRIP, too. DRIPS inherently encourage long-term investment in the shares, which helps to mitigate some of the volatility associated with active-trading. DRIPs help to stabilize the stock price.

The name “DRIP” is generally associated with programs run by the dividend-paying company. However, some brokerage firms also offer similar plans where shareholders can choose to have their cash dividends reinvested in stocks for little or no cost. This is called a synthetic DRIP.

Chapter 14: Obtaining Capital: Methods of Long-Term Financing

14.1: Types of Financing

14.1.1: Financing Life Cycle of the Firm

Firms progress through four stages of a developmental life cycle, each with their own funding needs.

Learning Objective

Identify which type of finance is appropriate for a business based on its stage of development

Key Points

In the first stage, a new company’s external financing needs (EFN) are high, since it needs money to develop its idea but lacks retained earnings. They are usually financed through debt, but may find investors who are willing to take on risk if projected growth is high.
In the growth stage, a firm’s initial EFN is high relative to its current value; it needs significant funds for growth. It can be financed through venture capital or issuing equity.
Growth eventually slows and the firm enters the mature stage. These firms can be financed by equity or debt. If they have no new projects, EFN is relatively low.
The firm may go into decline as their product becomes obsolete or a competitor outperforms them. In this case, they have very low external financing needs.

Key Terms

venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.
external financing needs: Additional funds needed from sources outside the firm, in order to support firm operations.
debt: Money that the borrowing entity owes or is required to pay to a lender.

Most businesses pass through a series of well defined stages based on their level of development. Churchill and Lewis (1983) identified that all businesses vary greatly in size and potentiality for growth. However, they all experience common problems that arise at similar stages of their development.

From these observations came the four stage life cycle of the firm. Methods of obtaining financial capital may be more or less suitable for a firm, depending on the current stage of its life cycle .

Firm Life Cycle

Firms progress through stages of development, indicated by their changing profits over time.

Introduction

In the first stage, a new company begins with the seed of an idea. Its external financing needs (EFN) are high, since it needs money to develop but lacks retained earnings. These young firms are frequently financed through debt, acquiring loans from banks and acquaintances. They may also acquire seed money, a form of securities offering in which an investor (usually friends, family, or angel investors) purchases part of a business. The source of the financing may depend on the perceived riskiness and growth of the business.

Growth

After the firm is able to acquire external funding and develop its product/service, it enters the growth phase. Once a company has a successful strategy, it attempts to offer its products or services to potential customers–expanding first to other states and regions and then often internationally and globally. Successful companies can turn in increasing earnings year after year, evidenced by the increasingly steep slope in the diagram. Firms may face an increase in competitors. In the growth stage, a firm’s initial EFN is high relative to its current value; it needs significant funds for growth. If it fits the specifications for venture capital (high growth potential, innovative product) a VC firm may agree to finance the firm. It may also raise capital through equity financing. As it progresses through the growth stage, earnings begin to increase less rapidly. At some point, the company may decide to go public, offering its stock to the general public on a security exchange as a means of equity financing.

Maturity

Eventually, all possible customers have the product or service. They may still buy parts or replace their product with newer models, etc, but growth slows. This is the mature stage of a company’s development. If the firm has no new projects in the works, their EFN is quite low and internal funding is high. In fact, the firm may have so much in retained earnings that they cannot put all of it to productive use. They can choose to finance operations by issuing bonds and equity.

Decline

When the firm has reached the final stage, sales can stagnate or decline due to replacement by a better product or competitor. EFN declines further. They may choose to retire debt or repurchase stock, as significant external financing is no longer necessary.

14.1.2: Venture Capital

Venture capital is an equity investment in a new company.

Learning Objective

Differentiate between the different stages of funding

Key Points

Young companies with high growth potential turn to venture capitalists for funding because they cannot issue debt or raise capital in public markets.
Venture capitalists assume high risk by investing in small, unproven companies, rationalizing that successful investments will have so much growth that their returns will far exceed any failed investments.
By agreeing to fund a start-up company, the VC firm gets the potentials of high future returns, significant control over company decisions, and a portion of the company’s ownership.
Because a VC firm’s returns are contingent on the company’s performance, it is in their interest to take an active role in company decision-making.
A company receiving venture capital goes through several rounds of funding, roughly corresponding to stages of company development.

Key Terms

IPO: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public for the first time. Through this process, a private company transforms into a public company.
venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.

What is Venture Capital

Venture capital (abbreviated as VC) is an attractive funding option for young companies with high growth potential, most often in high technology industries. These new companies are unable to raise funds in more conventional ways like bank loans. Investors assume high risk of loss in exchange for high potential of future growth, significant control over company decisions, and a portion of the company’s ownership.

How to Obtain Venture Capital

Obtaining venture capital is different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. In contrast, the venture capitalist’s return is dependent on the growth and profitability of the business. Return is earned when the venture capitalist sells its shareholdings. This happens when the business goes public, issues shares to the general public through an Initial Public Offering (IPO), or is acquired by a third party company.

It is also in the venture capitalist’s interest to nurture the companies in which they invest. This increases the likelihood of reaching an IPO stage when valuations give high returns. Therefore, in addition to the initial financial funding, VC firms provide time, expertise and valuable business connections. As these investments are illiquid and require 3-7 years to reap full benefit, venture capitalists carry out due diligence, conducting very detailed investigations into the firms prior to investment. This process includes examining the firm’s financial records and all aspects of its operations. Most venture capitalists will also require significant detail about a company’s business plan. Venture investors may obtain special privileges that are not granted to holders of common stock, including:

Anti-dilution protection
Guaranteed seats on the company’s board.
Positive and negative covenants that the company must abide by
Registration right, defined as the special rights to demand registration of their stock on public exchanges, and to participate in an IPO
Representations and warranties.These are statements in which the company gives certain assurances to the VC firm as to the operations and financial condition of the company
Liquidation preferences – in any liquidation event, the VC investors get their money back, often with interest before common stock is paid any funds from liquidation.

Initially, VC firms establish a fund which pools money raised from individuals, companies and other interested parties. This pooled investment vehicle is then used for investment in start-up enterprises.

Structure of a Venture Capital Firm

The venture capital firm pools capital from investors and allocates it to venture efforts deemed worthy of investment.

Stages of Funding

Through informal and formal business networks, VC firms and entrepreneurs will meet to discuss the business plan and investment possibilities.There are different rounds of financing corresponding to different stages of a company’s development:

Seed money round: The entrepreneur must convince the venture capitalist to fund their business vision. The VC firm is looking for a number of qualities including a solid business plan, an effective management team, high growth potential, and high target minimum returns. The VC firm will investigate into the technical and economic feasibility of the venture’s idea. If it is not directly feasible, but the investor sees potential, the investor will choose to invest some seed money for further investigation.
Start-up: VC firms provide capital to early stage firms that need funding for marketing and product development. Organization of the company is formed, with finalization of the management team and establishment of an individual from the VC firm on the company’s board. The prototype product/idea is developed and tested. Market research for the idea is conducted, and the VC firm also monitors product feasibility and capability of the management. If at this stage the VC firm is not satisfied with the progress from market research, the VC firm may stop their funding and the venture will have to search for other sources of funding.
Second-Round: Early-stage companies that are selling product but not yet turning a profit receive working capital.
Expansion/Mezzanine financing: As the name suggests, VC firms provide expansion money for a newly profitable company.
Bridge financing/exit of venture capitalist : Finally, the company is expected to either “go public” or be bought by a third-party company. The VC firm then exits by selling off its shareholdings of the company. The investor’s risk of losing the investment decreases as the company advances from one round to the next of this process.

14.1.3: Long-Term Debt

Long-term debt is a means of financing that allows firms access to capital without diluting equity; capital & interest is paid off over time.

Learning Objective

Discuss how long-term debt is used by companies

Key Points

Debt financing takes the form of loans that must be repaid by the borrower over a specified period of time, usually with interest.
Generally, debt financing is most appropriate for firms who are in the start-up phase or have progressed to the maturity phase. For young companies, debt financing usually takes the form of bank loans, while mature companies may issue bonds.
When investors buy a corporate bond or the bank loans to a small business, they must have faith that the company will have the means to repay them. Riskier investments will require compensation for the lender in the form of higher interest rates.
Bonds may be an attractive alternative to getting bank loans or issuing stock because it can have less restrictive loan terms and better interest rates than loans, and it doesn’t dilute equity or ownership as stock does. It also has considerable corporate tax advantages.
Costs of debt financing include: bankruptcy costs (in the event of inability to cover payments to lenders) and increased uncertainty about future financing needs.

Key Terms

bond: A documentary obligation to pay a sum or to perform a contract; a debenture.
debt: Money that the borrowing entity owes or is required to pay to a lender.

Overview

In the most basic terms, debt financing takes the form of short-term or long-term loans that must be repaid over a specified period of time, usually with interest. Money is borrowed, and usually the borrower (debtor) gives the lender (creditor) a promissory note that obligates the debtor to pay back a certain defined amount at a particular and defined time in the future .

Bank loans as a means of financing

A promissory note dating to 1926 from the Imperial Bank of India, Rangoon, Burma for 20,000 Rupees, plus interest.

With debt financing, the creditor’s return is fixed as the agreed upon interest rate for the debt, which varies depending on the perceived riskiness of the debtor. Debt financing usually takes the form of bank loans or bonds.

Bonds

Bonds are a debt security under which the issuer owes the holders a debt. Depending on the terms of the bond, the bond issuer is obliged to pay the bondholders interest and/or to repay the principal (also known as nominal, par or face amount). Most corporate bonds are fixed-rate bonds, meaning that the interest rate stays the same until maturity. Some use floating rates to determine the exact interest rate paid to bond holders. The interest rate paid on these varies depending on some index, such as LIBOR. Other corporate bonds, called zero-coupons, make no regular interest payments at all, but investors still receive returns because these bonds are originally sold at a discount, and then are redeemed at par value upon maturity.

Interest Rate

The interest that the firm will pay ultimately comes down to one factor: at what rate will investors believe the bonds are a good investment? Riskier investments will require compensation for the lender in the form of higher interest rates. Indicators for riskiness can include individual credit histories (for a bank loan) or bond rating by a credit rating company (for corporate bonds). The difference in yield reflects the higher probability of default and liquidity and risk premium.

Capital Structure Theory

The actual effect of the firm’s capital structure on firm value is a contested topic in financial theory (see Miller Modigliani Theorem). From a tax perspective, debt financing may have some advantages over equity financing for both investors and the firm. Under a majority of taxation systems around the world, firms are subject to corporate tax and individuals to income tax, leading to double taxation of dividends, if the firm is financed through issuing stock.

For example, a firm that earns 100 dollars in profits in the U.S. would have to pay around 30 dollars in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say 20 on the 70 dollars of dividends. The 100 dollars of profits turned into 50 dollars of investor income.

If, instead the firm finances with debt, then, assuming the firm owes 100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say 30 dollars. This implies for 100 dollars of profits before taxes, investors got 70 dollars. The firm also benefits considerably, as interest payments can be deducted from the firm’s taxable income while dividends and share repurchases cannot be deducted.

It is also postulated that debt makes management more disciplined, forcing them to work harder to ensure that they will make enough to cover their interest payments. These benefits are applicable to both bonds and bank loans. However, costs of debt can outweigh these benefits, depending on the firm. In the event of inability to repay debts, firms go into bankruptcy which is a costly process in itself. Furthermore, the more debt a firm takes on, the more uncertainty it will have about future financing needs: if a firm is already taking on a considerable amount of debt today, where will it get financing for its operations in the future?

14.1.4: Common and Preferred Stock

Firms may raise capital by receiving funds from investors in exchange for equity stakes in the form of common and preferred stock.

Learning Objective

Differentiate the different types of preferred stock

Key Points

Firms using equity financing gain financial capital from investors, in exchange for ownership stakes in the firm in the form of common and preferred stocks.
The main advantage of equity financing is the lack of an obligation to pay back all investors in the event of poor company performance, while the main disadvantage is diminished control and business autonomy.
In the event of liquidation and dividend payments, preferred stock has priority claims to assets. Common stockholders must wait until all preferred stockholders have been paid in full.
In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid.
Common stockholders often have voting rights, exercising some measure of control over company board elections and corporate policy, while preferred stockholders usually lack these rights.
Preferred stock is divided into a number of sub-categories including: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock.

Key Terms

Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock. It also has priority to common stock in liquidation.
Common stock: Shares of an ownership interest in the equity of a corporation or other entity with limited liability. Holders of this type of stock are entitled to dividends. Importantly, the financial rights for holders of this type of stock are junior to preferred stock and liabilities.

Example

If a company’s stock currently sells for 40 a share, expects to pay a dividend of 2 next year, is subject to flotation costs of 10%, and expects to maintain a growth rate of 10%, the cost of newly issued common stock = 2/[40(1-.10)] + .1 = 14.5%

Introduction: Equity Financing

Equity financing occurs when ownership stakes in a particular firm are exchanged for financial capital from investors. These investors may be all types of people, from friends and family of the business, to wealthy, “angel” investors, to venture capitalists. The main advantage of equity financing is that the business is not obligated to repay anything, since the individual investors are assuming a certain amount of risk in return for the possibility of making money in the future. However, because equity financing involves trading funds for ownership in the company, these new investors do gain some decision-making power in the company, and the managers lose some autonomy.

Common Stock and Preferred Stock

Typically, firms obtain their long-term sources of equity financing by issuing common and preferred stock. Holders of common stock (also be known as a “voting share” or an “ordinary share”) often have voting rights on corporate policy and have a say in electing the firm’s Board of Directors. They also receive dividend payments if the firm offers them. That being said, in the event of liquidation, preferred stock is considered more senior than common stock, in terms of rights awarded to particular investors. If one investor has preferred stock, while another holds common stock, that first individual has more rights to their share of assets, in the event of a liquidation. After bondholders, creditors (including employees), and preferred stock holders are paid their full share, common stock investors receive any funds that still remain. Thus, it is clear that common stock investors have the riskiest investment, often receiving nothing in the event of a bankruptcy.

Preferred stock is considered to be a form of equity security. It has properties of both an equity and a debt instrument, making it a “hybrid instrument”. Preferred stock generally has preference in receiving dividend payments and always has preference in asset claims during liquidation. That being said, holders of this type of stock usually do not have voting rights, while common stock holders do. Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount (for example, Pacific Gas & Electric 6% Series A Preferred). Sometimes, dividends on preferred shares may be negotiated as floating. This means that they may change according to a benchmark interest-rate index (such as LIBOR).

Types of Preferred Stock

In general, there are four different types of preferred stock: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock. With cumulative preferred stock, If the dividend is not paid, it will accumulate for future payment. With non-cumulative preferred stock, dividends will not accumulate if they are unpaid. In other words, holders of this type of stock cannot make claims to forgone, past dividends. Convertible preferred stock are preferred issues which holders can exchange for a predetermined number of the company’s common-stock shares. This exchange may occur at any time the investor chooses, regardless of the market price of the common stock. It is a one-way deal, and an individual cannot convert the common stock back to preferred stock, if they have already exchanged their preferred stock with the company. The final type, participating preferred stock, are preferred issues that offer holders a set, specified dividend. These also offer investors the the opportunity to receive extra dividends if the company achieves predetermined financial goals. In the event of liquidation, holders of this last type of preferred stock are entitled to receive back the total amount they invested in the company, as well as the accumulated unpaid dividends, before any common stock holders are paid.

Participating Preferred vs. Non-Participating Preferred

This graph shows an example of a liquidation event, illustrating how assets will be divided up between common, participating preferred, and non-participating preferred stock holders. All preferred stockholders are paid first, before common stock holders. Participating preferred stockholders can “double dip”, and are entitled to both their money back, as well as the leftovers for common stock, proportionate to the amount of common stock for which their preferred stock can be converted into.

There are capital costs associated with equity financing, including accounting and legal costs, as well as underwriting and filing fees. For new issues of stocks, there are flotation costs that must be taken into consideration before choosing equity as a method of long-term financing. These can be established with the following formulas. Cost of preferred stock = Next dividend to be paid/[Current market value(1-flotation costs)]Cost of newly issued common stock = Next dividend to be paid/Current market value(1-flotation cost) + projected growth rate.

14.2: Venture Capital

14.2.1: Defining Venture Capital

Early-stage business ventures gain funding and guidance from venture capitalists in exchange for an equity stake in the firm.

Learning Objective

Describe how the venture capital process works

Key Points

Venture capital is the financial capital provided to early-stage high-potential start-ups unable to acquire the necessary funding through conventional means.
For venture capitalists, the high risk of investing is offset by the potential of high returns.
Venture capitalists typically spread out their fund over a number of investments so that returns from successful investments will outweigh the losses from failed ventures.
Venture capitalists take an active role in a company’s performance; guidance, expertise, and industry connections can be just as valuable as financial capital.

Key Terms

Initial public offering: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public.
venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.

Venture capital is a method of financing a business start-up in exchange for an equity stake in the firm. The risk of investment loss and the potential for future payout are both very high. As a shareholder, the venture capitalist’s return is dependent on the growth and profitability of the business. Return is earned when the business is sold to another owner or it “goes public” with an initial public offering (IPO). The venture capitalist can then “exit” by selling his shareholdings in the company.

Venture capital funds revolutionary social networking services

Facebook is one example of a entrepreneurial idea that benefited from venture capital financing. The Menlo Park-based firm has seen immense success since their launch in 2004. Unfortunately for Facebook’s venture capitalist investors (Accel Partners, Greylock Partners and Meritech Capital), the IPO has not performed as well as expected.

Due to their risky nature, most venture capital investments are done with pooled investment vehicles. Investors combine their financial contributions into one fund, which is then used to invest in a number of companies. This way, investors are diversifying their portfolio and spreading out risk. Venture capitalists are gambling that returns from successful investments will outweigh investments lost in failed ventures. Venture capitalists are selective in their investments. Innovative technology, growth potential and a well-developed business model are among the qualities they look for. Growth potential is the most important quality, given the high risk a VC firm assumes by investing. The priority for VC firms is high financial return and a successful exit within three to seven years.Venture funding is most suitable for businesses having large up-front capital requirements that cannot be financed by debt or other alternatives. These characteristics usually best fit companies in high-tech industries, which explains the venture capital boom of the late 1990s. The technology firms of Silicon Valley and Menlo Park were primarily funded by venture capital. These industries saw a surge in public interest that eventually generated large returns for VC firms.

A VC firm’s contributions often extend beyond financial funding. To increase the likelihood of high returns, it is in the venture capitalists’ interests to nurture their investments. Any guidance and expertise venture capitalists offer to start-up firms can be instrumental to success.

14.2.2: Advantages and Disadvantages of VC Financing

While VC financing provides the benefit of significant resources, costs include loss of ownership and autonomy.

Learning Objective

Discuss the advantages and disadvantages of using venture capital

Key Points

With VC financing, companies can acquire large sums of capital that would not be possible through bank loans or other conventional methods.
Venture capitalists provide expertise and industry connections that can be extremely valuable.
Accounting and legal costs make securing a VC deal a difficult process. If a deal is secured, VC investors will be highly involved in deciding on the company’s strategic direction.

Key Term

venture capital: Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are considerable.

Weighing advantages and disadvantages

Pursuing venture capital financing may not be appropriate for most start-up companies. It is important to weigh the benefits of receiving abundant resources against the costs of losing autonomy and ownership.

Advantages: The primary advantage of venture capital financing is an ability for company expansion that would not be possible through bank loans or other methods. This is essential for start-ups with limited operating histories and high upfront costs. In addition, repayment of VC investors isn’t necessarily an obligation like it would be for a bank loan. Rather, investors are shouldering the investment risk because they believe in the company’s future success.

In addition to financial capital, venture capitalists provide valuable expertise, advice and industry connections. A stipulation of many VC deals includes appointing a venture capitalist as a member of the company’s board. This way, the VC firm has intimate involvement in the direction of the company.

Venture capital is also associated with job creation (accounting for 2% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography.

Disadvantages: Securing a VC deal can be a difficult process due to accounting and legal costs a firm must shoulder. The start-up company must also give up some ownership stake to the VC company investing in it. This results in a partial loss of autonomy that finds venture capitalists involved in decision-making processes. VC deals also come with stipulations and restrictions in composition of the start-up’s management team, employee salary and other factors. Furthermore, with the VC firm literally invested in the company’s success, all business operations will be under constant scrutiny. The loss of control varies depending on the terms of the VC deal.

14.2.3: IPOs

Initial public offerings are a primary and potentially lucrative means of exit from investment for venture capitalists.

Learning Objective

Describe the benefits and disadvantages of an IPO

Key Points

An initial public offering is the first time a company’s stock is sold to the general public on a securities exchange, transforming the company from private to public. Though unpredictable and potentially costly, IPOs give benefits like increased access to financial markets and more capital.
Venture capitalists gain both financial returns and professional reputation from successful IPOs.
For venture-backed companies, their VC investors often expect the company to go public within a certain time frame so that they can sell or distribute their holdings of the company and exit the investment.
Venture capitalists protect their ability to sell shares by contracting for registration rights prior to agreeing on funding the company. Demand rights allow the investors to initiate an IPO, while piggyback rights allow investors to sell when the company initiates an IPO.
If the IPO market is weak, this threatens the venture capitalists’ chances of a successful exit. The VC investors may instead select a different method of exit, or they can wait and hope for the market to improve.

Key Terms

Registration rights: A contractual agreement specifying conditions for registering shares of stock with the SEC prior to selling them on a security exchange.
Initial public offering: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public.

Example

For a recent example of a weak IPO market, we can look to online companies like Facebook and Zynga. Facebook’s IPO launch in May 2012 was highly anticipated but ended up under-performing, losing 47% of its original offering price as of August 2012. The online game developer Zynga’s IPO similarly fell flat despite high expectations. Falling values can put pressure on the VC investors to sell before they can lose any more of their returns.

An initial public offering (IPO), also known as a stock market launch, is the first time a private company’s shares are sold to the general public on a securities exchange. Allowing the general public to take up equity stakes in the company transforms it from being privately traded to publicly traded. If the company was venture-backed, the VC firms often gain their returns from IPO yields. Usually, the VC exits investments within a short time (1-3 years, normally) after the IPO is concluded either by distributing the shares to VC fund investors or selling them off on the market. Going public can also have benefits for the company, including:

Apple Computers IPO Prospectus

The Initial Public Offering (IPO) Prospectus for Apple Computer Inc. in December 1980. A total of 5 million shares were offered to the public for $22 each. The total outstanding shares after the offering were 54,215,332. The company’s officers, directors and major shareholders held 32 million shares and the rest were held by the company for stock options plans and other needs. Apple’s valuation after the IPO was over $1 billion. (54 million shares at $22. )

Increasing exposure, prestige, and public image
Enlarging and diversifying equity base
Enabling cheaper access to capital, which is particularly important for high growth companies
Allowing owners of the company to cash in on their efforts in a very lucrative way (if the IPO is successful).
Attracting and retaining better management and employees through liquid equity participation

IPOs are not without cost to the company. Disadvantages to completing an initial public offering, include:

Legal, accounting and marketing costs associated with the process
Requirement to disclose financial and business information
Meaningful time, effort and attention required of senior management
Risk that required funding will not be raised
Public dissemination of information which may be useful to competitors, suppliers and customers.

Prior to agreeing to provide capital, venture capitalists contract for privileges including “registration rights”, which ensure their ability to sell shares into the public capital markets, thereby safeguarding their future returns. Prior to selling shares on the stock exchange, companies must register these shares with the Securities and Exchange Commission. The registration rights agreement between the company and the venture capitalists requires the company to register the offering of shares by venture capitalists under certain conditions.

These conditions may be in the form of “demand rights” or “piggyback rights”.

Demand rights require the company itself to prepare, file and maintain a registration statement on behalf of the investors’ shares, so that investors can actually initiate a public offering and sell their shares.
Piggyback rights require that the VC investors’ shareholdings are included in a company-initiated registration, so that the investors can sell their shares when the company initiates a public offering. The number of each type of demand or piggyback rights, the percentage of investors necessary to exercise these rights, allocation of expenses of registration, the minimum size of the offering, the scope of indemnification and the selection of underwriters and brokers are all areas of potential negotiation in the registration rights agreement.

14.3: Leasing

14.3.1: Capital Leases vs. Operating Leases

Capital leases and operating leases are two types of leases with different criteria.

Learning Objective

Distinguish between a capital and an operating lease

Key Points

The finance company is the legal owner of the asset during duration of the lease. However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.
An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc. ) being leased.
Unlike a Financial Lease or Finance lease, at the end of the operating lease the title to the asset does not pass to the lessee, but remains with the lessor.

Key Term

present value: Present value, also known as present discounted value, is the value on a given date of a payment or series of payments made at other times.

Capital lease

A capital lease (or finance lease) is a type of lease. It is a commercial arrangement where:

the lessee (customer or borrower) will select an asset (equipment, vehicle, software);
the lessor (finance company) will purchase that asset;
the lessee will have use of that asset during the lease;
the lessee will pay a series of rentals or installments for the use of that asset;
the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee;
the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price);

The finance company is the legal owner of the asset during duration of the lease. However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.

Under US accounting standards, a finance (capital) lease is a lease which meets at least one of the following criteria:

ownership of the asset is transferred to the lessee at the end of the lease term;
the lease contains a bargain purchase option to buy the equipment at less than fair market value;
the lease term equals or exceeds 75% of the asset’s estimated useful life;
the present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.

Operating lease

An operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased. An operating lease is commonly used to acquire equipment on a relatively short-term basis. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease.

The lessor leases the equipment to the lessee which pays periodically a rent. Operating lease is the smartest way for the outsourcing of industrial equipment. It allows the company not to use its equity in a investment that produces no direct added value, but to dedicate it to its core business and valuation.

Unlike a Financial Lease or Finance lease, at the end of the operating lease the title to the asset does not pass to the lessee, but remains with the lessor. Accordingly, at the end of an operating lease, the lessee has several possibilities:

Lease

Leasing is a good way to lower the costs of a company.

Pursuit of the lease
Return of the equipment
Renewal of equipment
Restoration of equipment
Purchase of equipment at their market value

14.3.2: Impact of Leasing on the Income Statement

Leasing assets, both as lessee or lessor, has significant impacts on various financial statements.

Learning Objective

Identify the income statement implications of leasing an asset, both as lessor and lessee

Key Points

Leasing is an alternative approach to buying an asset required for operation or selling an unused asset.
The lessee, or the individual renting the asset, benefits from leasing through incurring lower costs (albeit consistently over time). The lessor benefits by procuring a return on a previous under-utilized investment.
Capital leases usually transfer ownership of the leased item to the lessee at the end of the contract, while operating leases generally just represent utilization of the asset (and not eventual ownership).
Capital leases and operating leases have different accounting implications for both the lessee and the lessor. Capital leases, due to the transfer of an asset, have a greater impact on the balance sheet.

Key Terms

capital lease: A capital lease is usually quite long, perhaps even the entire duration of the life of the asset being leased. A capital lease has balance sheet implications, as the asset itself may be transferred at the end of the contract.
operating lease: An operating lease is usually short compared to the life of the asset being leased, and does not result in a change of ownership at the end of the lease.

Leasing is an alternative approach to buying or selling a given asset or real estate location. The lessee will pay the lessor for the rights to utilize a given asset (i.e. the lessor is the owner of the asset, the lessee is renting it over a fixed time frame). For each respective organization, leasing will have significant impacts on financial statements during the accounting process. Understanding the accounting implications for each organization (lessee and lessor) is useful for accurate reporting on both the income statement and the balance sheet.

Capital and Operating Leases

In accounting, leases can be considered either operating leases or capital leases (also called financial leases). An operating lease is not reported as an asset or a liability (i.e. not represented on the balance sheet) and is expensed via the income statement as payments are incurred. A capital lease, on the other hand, is recorded as both asset and liability calculated as the present value of the cumulative rental payments (but never more than the overall fair market value of the underlying asset).

Capital Lease Criteria

When determining whether a lease is capital or operating, the following criteria are useful considerations:

The lessee gains ownership of the asset at the conclusion of the lease
The lessee is offered a bargain purchase contract at the end of the lease. This means the lessee can purchase the lease from the lessor at a price below the fair market price
The life of the lease is equal to or greater than 75% of the economic life of the asset
The present value of the minimum lease payments (MLP) is equal to or greater than 90% of the fair market value of leased property

If any one of these criteria are accurate in a given leasing contract, the lease is considered a capital lease and thus will impact the assets and liabilities of the balance sheet. Otherwise, it is seen as an expense and filed as an operating lease on the income statement.

Lessee Accounting

The lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable when on an operating lease. From an income statement perspective, the expense incurred is equivalent to the cumulative rent being paid over the reporting period.

With a capital lease, the lessee does not record rent as an expense. However, due to the classification of the leased asset, there are interest and depreciation alterations to be made via the income sheet when applicable. Over time, the depreciation and interest will equate to the value of the underlying rent payments.

From the lessee’s perspective, there are some situations where accountants must be aware of altercations to the asset and/or existing contract with the lessor:

Improvements: If improvements are made, they should be capitalized and depreciated over the lease life. If the lessor gives the lessee a cash allowance for improvements, this is treated as a reduction of rent and amortized over the lease term.
Percentage Rent: Some contracts have a percentage kick-back to the lessor in instances where sales reach a certain volume (common in retail leases). For example, the lessor decides that if the shop sells over $100,000, any sales past that point are subject to a 10% kick back to the owner of the property.

Lessor Accounting

For an operating lease – the ownership of the asset is maintained by the lessor and must be represented on the balance sheet as an asset. Rent revenue is credited with a corresponding debit to cash/cash receivables.

For a capital lease – the lessor debits the receivable account for the present value of the rents and credits any owned assets. Cash is debited upon payment while the receivable is credited, and unearned (interest) income is credited as well.

14.3.3: Advantages of Leasing

The main advantage of leasing lies in a business’ ability to attain assets without outlaying essential cash.

Learning Objective

Describe how a company can benefit from leasing its equipment

Key Points

Leasing is a process by which a firm can obtain the use of a certain fixed asset for which it must pay a series of contractual, periodic, tax deductible payments.
Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses.
Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.

Key Term

capital-intensive: Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor.

Leasing Overview

Leasing is a process by which a firm obtains the use of a certain fixed asset for which it must pay a series of contractual, periodic, tax deductible payments.

In these arrangements there is a lessee and a lessor. The lessee is the receiver of the services or the assets under the lease contract while the lessor is the owner of the assets.

Advantages of Leasing

For businesses, leasing property may have significant financial benefits, which are outlined below:

Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than by purchasing property.
Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses rather than assets, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.
In some cases, a lease may be the only practical option; for example, a small business may wish to open a location in a large office building within tight location parameters.
Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.

14.4: The Role of Investment Banks in Financing

14.4.1: Underwriter

Investment bank underwriters help securities issuers lessen their risk in exchange for a premium.

Learning Objective

Explain the role of underwriters

Key Points

Security issuers want to mitigate the risk of having an unsuccessful issue.
Underwriters will buy the securities from the issuer and then sell it on the market. The underwriter aims to buy the securities below market price, and then sell them for a profit.
Underwriters deal with both companies and government. The issuer could issue stocks, bonds, or any other type of security.

Key Terms

issuer: The firm or government selling the security.
security: proof of ownership of stocks, bonds, or other investment instruments.W

Underwriting refers to the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products (equity capital, insurance, mortgage, or credit). Underwriters exist in a number of different industries, and are primarily responsible for evaluating the risk of potential clients.

In investment banking, underwriters are best known for the role that they play in initial public offerings (IPOs). IPOs are when a company decides to sell equity on the stock market for the first time . They sell their own stock on the market and in the process, raise money through selling equity. However, investment banks are involved in the underwriting of all types of securities, not just stock.

NYSE

Firms may issue an IPO on an exchange such as the New York Stock Exchange (NYSE). They sell their stock in exchange for cash.

The company needs to set a price for its stock; they want to set it high enough to raise as much money as possible but low enough that they will be able to sell their stock. Thus, there is a risk to the company in the offering of securities. For all types of securities, whether offered by companies or the government, there is a risk that the issuer may not be able to have a successful securities offering.

That is where the job of the security underwriter comes in. The underwriter offers to take on some of the risk of the offering in exchange for a premium. In essence, the underwriter buys the securities from the issuer and then turns around to sell the securities on the market. This means that the issuer gets cash up front. The issuer knows that it is probably not getting the full market value of the securities, but that’s okay because it no longer has the risk of having to find enough buyers to purchase the securities at a desirable price. The underwriting investment bank likes the deal because if it can sell the securities on the market at a higher price than it purchased them, it can make a profit.

There are sometimes multiple investment banks involved in the underwriting of a security. The details of the process may vary from deal to deal, but the fundamental job of the underwriter(s) is to take some of the issuer’s risk in exchange for a premium.

14.4.2: Market Maker

Market makers provide liquidity to securities markets by submitting both bids and asks on a security.

Learning Objective

Explain the role of market makers

Key Points

Without sufficient liquidity, markets would become more inefficient because there may not be a buyer/seller to transact with, even at what should be the market price.
Market-designated market makers provide liquidity by submitting both bids and asks on certain securities. This helps ensure transactions can occur at the market price.
By submitting bids below ask prices, the market maker can make money.
The difference between the highest bid and the lowest ask price is called the bid-ask spread.

Key Terms

liquidity: Availability of cash over short term: ability to service short-term debt.
bid-ask spread: the difference between the prices quoted for an immediate sale and an immediate purchase
bid: The submitted price at which the trader is willing to buy.
ask: The submitted price at which the trader is willing to sell.
bid price: the amount offered by a buyer

The price of a stock is determined through a simple process of matching buyers and sellers. All those who want to sell the stock say the price at which they’re willing to sell a certain number of shares (the ask price). All those who want to buy say the maximum price they’re willing to pay for a certain number of shares (the bid). The difference between the highest bid and the lowest ask price is called the bid-ask spread . If the one person’s bid equals another’s ask price, they have found a price at which they’re both willing to do business, and the transaction occurs. The mutually agreeable price is then inputted as the stock price.

New York Spot Prices

The highest price someone is willing to pay (bid) for gold is $742.30 and the lowest someone is willing to accept (ask) is $743.30. There is a bid-ask spread of $1.10.

In major stock exchanges (such as the New York Stock Exchange) there are enough people who want to buy or sell at any given time that it’s generally easy to find someone to transact with if you’re making a bid/ask near the last price. This is called liquidity.

But what happens if there is no liquidity? Since there aren’t very many people looking to trade the stock, the highest bid may be significantly lower than the lowest ask price, so no transactions occur. A lack of liquidity is really bad for investors. If they don’t think they can buy/sell the stock when they need to, they will choose to just not deal with it.

That’s where a special type of trader comes in. They are the market makers. Market makers are a company or individual that quotes both an ask price and a bid. This helps to provide liquidity to the market, making the market more efficient. For this reason, many exchanges (such as the New York Stock Exchange and American Stock Exchange) have designated market makers for certain securities.

The financial reason why market makers do this is because the ask price that they submit will always be slightly higher than their bid. It is the bid-ask spread that provides the money-making opportunity. A bid-ask spread of even a cent can mean a huge profit when trading thousands of shares.

14.4.3: The Role of an Advisor

The advisory group of an investment bank is primarily concerned with facilitating the mergers and acquisitions of businesses.

Learning Objective

Define how investment banks act as advisors

Key Points

Mergers and acquisitions (M&A) require an investment bank to bring the buyer and seller together and to help negotiate the deal.
The advisor is hired by the client company to find a buyer/seller. The advisor pitches the deal to potential buyers/sellers using a pitch book, which contains all relevant financial information.
The advisor also helps facilitate the deal which is incredible context because it must account for everything from financial projections to assets to brand names.

Key Term

M&A: Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.

Advisory Role

Investment banks also play the role of advisor to companies. They are not consultants, but are more like facilitators. The advisory group in an investment bank is often termed M&A.

M&A stands for “mergers and acquisitions”, which refers to the the buying, selling, dividing and combining of different firms. For example, if a company wants to sell of an unprofitable division, they will hire an investment bank to find a company that would want to buy it. Investment banks play a large role in facilitating M&A deals. The advisory group is charged with the task of helping buyers find sellers and vice versa, and then facilitating the deal.

Once the advisory group is hired by a company looking to sell itself to another, it will put together something called a pitch book. The pitch book contains all the relevant financial information about the company looking to get acquired. The investment bank then takes the pitch book to companies that it thinks might be interested in acquiring their client.

If the pitch is successful, the bank arranges the deal for the client. In order for the acquisition to take place, the two boards and leadership must be agree on the terms. This is often a very complex process because of the intricacies of the financial, functional, and organizational structures of both companies. There must be a plan for transferring everything from technology to debt to employees to titles, and the transaction must occur at a favorable price . If the negotiations are successful, the investment bank’s client will be acquired.

Pricewaterhouse Cooper

Pricewaterhouse Cooper got it’s name after the 1998 merger of Price Waterhouse and Coopers & Lybrand.

14.4.4: Agency

In its agency role, an investment bank is tasked with matching companies with investors.

Learning Objective

Define the different sources of capital financing

Key Points

Many small and private companies cannot access traditional financial markets for capital, so they need to either take on debt or find other sources of financing. Investment banks help them find those other sources of capital.
Common sources of financing are equity financing, mezzanine financing, and specialist financing (e.g., government loans).
The investment banks match their clients to investors and then charge a fee for the service.

Key Term

private: A company that is not publicly traded.

Investment banks are not confined solely to working with and making money on large, publicly traded companies. They also can be hired by private firms. A private firm might hire an investment bank for help with a merger or acquisition or for issuing an IPO (initial public offering of shares). A private firm might also hire an investment bank as a placement agent.

Suppose a firm does not want to be acquired and cannot (or does not want to get) good loans from banks. They still need to raise capital, but can’t access public markets, such as the stock market; they have to find different ways to raise capital. They hire a placement agent to act as an intermediary between them and investors. This allows them not only to connect with investors, but also allows them to focus on management, instead of finding investors.

Capital financing for private companies can come from a number of sources. Three of the main capital sources are:

Equity financing: Private firms can sell some or all of their equity to investors. This is akin to selling off a portion of the ownership of the company. It may seem undesirable to sell a portion of the company’s ownership, but many firms (especially start-ups and growth companies) need to do so for immediate capital to fund future growth .
Mezzanine capital: A subordinated debt or preferred equity instrument that represents a claim on a company’s assets, which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.
Specialist financing: This could include things such as government loans or special grants that the company qualifies for.

Placement agents are most often compensated through fee arrangements based on the amount of money raised and supported by the fund or company they are representing.

14.5: Distributing Stock

14.5.1: Defining Spread

The spread is the difference between the prices for immediate purchase and sale of a stock, which is one measure of market liquidity.

Learning Objective

Describe the importance of spread in a stock transaction

Key Points

The party that initiates the trade is the liquidity demander who pays the spread. The counterparty is the liquidity supplier who earns the spread.
Liquidity suppliers use limit orders. A limit order is when the buyer waits until the stock reaches a designated price.
The spread is one component of transaction cost, which along with brokerage fees, reflects the cost of making an instantaneous trade.

Key Terms

liquidity: Availability of cash over short term: ability to service short-term debt.
tender offer: an invitation to shareholders of a corporation to exchange their shares in return for a monetary buy-out

Concept

The bid–offer spread for securities is the difference between the prices quoted for an immediate sale (offer) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and size of the transaction cost. If the spread is 0 then the security is a frictionless asset.

Signals from dividend policy may give clues about stocks.

The spread measures the cost of executing an instant trade.

Liquidity

The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders.

Limit Order

A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the stock’s market price reaches the limit price. While limit orders do not guarantee execution, they help ensure that an investor does not pay more than a pre-determined price for a stock.

Example

If the current bid price for the EUR/USD currency pair is 1.5760 and the current offer price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices (3 pips) is the spread.

For a round trip (a purchase and sale together), the liquidity demander pays the spread and the liquidity supplier earns the spread. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.

Transaction Costs

The bid–offer spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the transaction cost—brokerage fees and bid-offer spreads. Under competitive conditions, the bid-offer spread measures the cost of making transactions without delay.

14.5.2: Pricing a Security

The price of a security is the market determination of the value of the underlying asset.

Learning Objective

Differentiate the different methods of pricing a security

Key Points

Several methods are used to determine the value of a company including Present Value, Comparable Company Analysis, and Net Asset Value. The goal of each of these methods is to determine the worth of a potential investment in the company.
Financial analysis of this sort determines what investors are willing to pay for a given security because it is what they think the security is worth.
If most investors think a stock is worth a lot, or will be in the future, they buy it and this demand drives price up. The opposite occurs if investors are not confident about the stock. Therefore, stock price reflects investor expectations.

Key Term

security: proof of ownership of stocks, bonds, or other investment instruments.W

Concept

The price of a security reflects the value of the asset underlying it. Therefore, the market price for a security indicates the consensus value placed on its asset by all the buyers and sellers in the market. It is the result of the valuation of the asset .

Price

Price fluctuates depending on how the market values the security.

Valuation

In finance, valuation is the process of estimating what something is worth. There are different valuation methods. The choice of which method to use depends in part on what kind of security one is valuing. For instance, some financial instruments such as options are valued using mathematical models which take several variables into account. The price of stocks, on the other hand, depends on the value of the company. There are several methods used to value the company itself.

Present Value

This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present. This concept of discounting future money is commonly known as the time value of money. The time value of money says that if you have an asset that matures in one year and pays $1 at that time, it is worth less than $1 today. This is because if you have a dollar today, you can do all kinds of things with it: invest it, use it to buy something you want, or pay back a debt. On the other hand, if you have to wait a year to get your dollar, you miss out on all these opportunities. Those missed opportunities are called the opportunity cost. Therefore, money you get in the future needs to be reduced to approximate the opportunity cost. The size of the discount is based on the opportunity cost of capital and it is expressed as a percentage. This percentage is the discount rate.

For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Then one makes a calculation to compute the present value of the future cash flows.

Comparable Company Analysis

This method determines the value of a firm by observing the prices of similar companies that sold in the market. Those sales could be shares of stock or sales of entire firms. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book value ratios. Next, one or more price multiples are used to value the firm. For example, the average price-to-earnings multiple of the guideline companies is applied to the subject firm’s earnings to estimate its value.

Net Asset Value

The third common method of estimating the value of a company looks to the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value. Normally, the discounted cash flows of a well-performing company exceed this floor value. However, some companies are “worth more dead than alive,” such as weakly performing companies that own many tangible assets. This method can also be used to value heterogeneous portfolios of investments, as well as non-profit companies for which discounted cash flow analysis is not relevant.

Financial Analysis

Financial professionals make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on

price-to-book
price-to-earnings
price-to-cash-flow
present value calculations

All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing stock or bond prices, and may result in buying or selling by market participants.

Price and Valuation

Investors use valuation methods to estimate what a company is worth, but the price of a stock on the market usually does not rest at the book-value of the company. Typically there will be people who are either optimistic about the company–because they anticipate that it will be worth more in the future than it is in the present–or pessimistic–because they think it will do worse in the future. Optimists will buy more of the stock and drive the price up, while pessimists will sell and drive it down. Therefore, a stock’s market price also takes into account expectations for the future performance of the company.

14.5.3: Shelf Registration

Shelf registration is a type of public offering in which the issuer is allowed to offer several types of securities in a single prospectus.

Learning Objective

Describe the self registration process

Key Points

A company can file a shelf registration statement with a prospectus that offers different classes of securities. It can then sell all, none, or some of the classes at any time.
Regulators generally grant shelf registration to companies that are reliable. They also require a statement of material changes in business since the prospectus was filed before each security is actually sold.
Shelf registration can be used by a company as a strategy to quickly sell securities for funds when market conditions become favorable.

Key Term

prospectus: A document that describes a proposed endeavor (venture, undertaking) such as a literary work (which one proposes to write).

Definition

Shelf registration or shelf offering is a type of public offering where certain issuers are allowed to offer and sell securities to the public without a separate prospectus for each act of offering. Instead, there is a single prospectus for multiple, undefined future offerings. The prospectus (often as part of a registration statement) may be used to offer securities for up to several years after its publication .

Shelf Registration

Some of the securities in the prospectus can be “shelved,” and sold later.

Application

A company can file a shelf registration statement with, for instance, a prospectus for 100,000,000 shares, $1,000,000,000 face value of bonds, $500,000,000 dollar face value of convertible bonds, $50,000,000 Series A warrants, and $50,000,000 Series B warrants. These five different classes or series of securities are offered in a single document. The company may offer to sell all of them, none of them, or any part of some class. It can sell 30,000,000 shares at one time and another 50,000,000 a year later. In that case, it will then have 20,000,000 unissued shares covered by the shelf prospectus.

Material Changes in Business

Before each offering and sale is actually made, the company must file a relatively short statement regarding material changes in its business and finances since the shelf prospectus was filed.

Regulation

Shelf registration is usually available to companies deemed reliable by the securities regulation authority in the relevant country. Shelf offerings, due to their purposefully time-constrained nature, are examined far less rigorously by those authorities, compared to standard public offerings.

Strategy

Shelf registration is a registration of a new issue which can be prepared up to two years in advance, so that the issue can be offered quickly as soon as funds are needed or market conditions are favorable. By using shelf registration, the firm can fulfill all registration-related procedures beforehand and go to market quickly when conditions become more favorable.

Firms often use universal shelf filings and choose between debt and equity offerings based on the prevailing relative market conditions.

14.6: Comparing Public and Private Financing

14.6.1: Advantages of Public Financing

The main advantage in seeking public financing is that it offers a larger pool of funding for the company than private financing alone.

Learning Objective

Discuss why a company may want to go public

Key Points

The magnitude of funding available from public financing is its chief advantage.
An initial public offering is when a private company converts to a public company by selling shares of its stock publicly.
A company can sell further shares of stock in secondary offerings.
A company can also sell debt, in the form of bonds, in public exchanges.

Key Term

security: proof of ownership of stocks, bonds, or other investment instruments.W

Public Company Definition

A publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating over the counter markets. .

Public Financing

Public financing offers immediate access to large amounts of funding.

Main Advantage of Public Financing

Usually, security of a publicly traded company is owned by many investors while the shares of a privately held company are owned by relatively few shareholders. Therefore, publicly traded companies are able to raise funds and capital through the sale (in the primary or secondary market) of their securities, whether debt or equity, to a wide range of buyers. This is the reason publicly traded corporations are important; prior to their existence, it was very difficult to obtain large amounts of capital for private enterprises. The magnitude of funding available from public financing is its chief advantage.

Advantages from Initial Public Offering

New companies, which are typically small, tend to be privately held. After a number of years, if a company has grown significantly and is profitable or has promising prospects, there is often an initial public offering, which converts the privately held company into a publicly traded company.

Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, to monetize the investments of early private investors, and to become publicly traded enterprises.

When a company lists its securities on a public exchange, the money paid by the investing public for the newly issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a portion of their holdings (secondary offering) as part of the larger IPO. An IPO, therefore, allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital. A company selling common shares is never required to repay the capital to its public investors.

An IPO accords several benefits to the previously private company:

Enlarging and diversifying equity base
Enabling cheaper access to capital
Increasing exposure, prestige, and public image
Attracting and retaining better management and employees through liquid equity participation
Facilitating acquisitions (potentially in return for shares of stock)
Creating multiple financing opportunities, such as equity, convertible debt, and cheaper bank loans

Advantages from Follow-On Offering

Once a company is listed, it is able to issue additional common shares in a number of different ways, one of which is the follow-on offering. This method provides capital for various corporate purposes through the issuance of equity without incurring any debt. This ability to quickly raise potentially large amounts of capital from the marketplace is a key reason many companies seek to go public.

14.6.2: Advantages of Private Financing

Private financing can enhance a firm’s capital structure, save on costs, and improve managerial incentive alignment.

Learning Objective

Describe why a company may want to go private

Key Points

One advantage of private financing is that private investors may infuse the company with more capital than was available to it from public financing.
Private financing also saves on administrative costs of being a publicly traded company.
Private financing can improve incentives for management, and increase investor involvement.

Key Terms

incentive: Something that motivates, rouses, or encourages.
Stock: The capital raised by a company through the issue of shares. The total of shares held by an individual shareholder.
investor: A person who invests money in order to make a profit.

Definition

In countries with public trading markets, a privately held business is generally taken to mean one whose ownership shares or interests are not publicly traded. Often, privately held companies are owned by the company founders or their families and heirs or by a small group of investors. Sometimes employees also hold shares of private companies. Most small businesses are privately held.

Private financing

Private financing can offer advantages over public.

Going Private

Though most companies start out privately held, there are situations in which a publicly traded company becomes privately acquired. This means that a small group of investors purchases all outstanding shares of the company. The company is then privately financed. This transition it known as “going private. “

Advantages

There are several advantages to private financing:

Increased capital: Sometimes going private results in a significant injection of capital, because the investors are willing to buy the company’s stock at a higher price than it is trading on the market. They are willing to pay more in order to privately control the firm.
Administrative costs: It is possible for the company to save administrative costs. Being a publicly traded company entails administrative costs, such as annual reports, registration with regulating bodies, and communicating with shareholders. A privately financed company does not have these costs.
Managerial incentives: In many instances it is the management which takes over and privately controls the company. In this case, they have a more immediate incentive to improve the company’s performance, because they are investors as well.
Investor involvement: A publicly traded company’s shareholders are a large, anonymous, and mostly uninformed group. They do not typically know the business, much less the daily operations, of the company and are not in a good position to be productively involved with it. Private investors, on the other hand, can offer expert knowledge, and direct oversight of the company in a way that can benefit performance.

1903 stock certificate of the Baltimore and Ohio Railroad

Normally stocks are traded publicly, except in the instance of private stocks, which are only offered and traded by internal stakeholders such as founders, employees, etc.

14.6.3: Types of Private Financing Deals: Going Private and Leveraged Buyouts

LBOs use debt to secure an acquisition and the acquired assets service the debt.

Learning Objective

Define a leveraged buyout

Key Points

The acquiring party borrows money in addition to using its own funds to meet the purchase price of the target. LBOs can also occur to public companies, such as in public to private (PtP) transactions.
The term typically applies to a deal in which a financial sponsor acquires a company. In this instance, the sponsor uses debt to increase its return on equity.
LBOs are appealing to the acquiring company because debt typically carries a lower cost of capital than equity, which means that by employing more debt, the acquiring party magnifies returns.

Key Terms

insolvency: The condition of being insolvent; the state or condition of a person who is insolvent; the condition of one who is unable to pay his debts as they fall due, or in the usual course of trade and business; as, a merchant’s insolvency.
overleveraged: Subject to excessive leverage
leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

Definition of Leveraged Buyout

A leveraged buyout (LBO) is an acquisition (usually of a company, but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt, and in which the cash flows or assets of the target are used to secure and repay the debt . As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with the increasing debt. The debt thus effectively serves as a lever to increase returns, which explains the origin of the term leveraged buyout (LBO).

Financing deal

An LBO is a type of financing deal.

Forms of LBOs

LBOs are a very common occurrence in today’s Mergers and Aquisitions environment. The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are part-funded by bank debt, and thus also effectively representing an LBO. LBOs can have many different forms, such as Management Buyout (MBO), Management Buy-in (MBI), and secondary buyout and tertiary buyout, among others. They can occur in growth situations, restructuring situations, and insolvencies just like in companies with stable performance. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction, Public to Private).

Common Cause of LBOs

As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were “overleveraged”, meaning that they did not generate sufficient cash flows to service their debt. In turn, this then led to insolvency or to debt-to-equity swaps, in which the equity owners lose control over the business and the debt providers assume the equity.

Characteristics

LBOs have become attractive, as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending. The amount of debt banks which are willing to provide and support an LBO varies greatly and depends on the quality of the asset to be acquired–stability of cash flows, history, growth prospects, and hard assets; the amount of equity supplied by the financial sponsor; and the history and experience of the financial sponsor.

Debt Ratio

For companies with very stable and secured cash flows, debt volumes of up to 100% of the purchase price have been provided. In situations of “normal” companies with normal business risks, debt of 40–60% of the purchase price are normal figures. The debt ratios that are possible also vary significantly between the regions and industries of the target. Depending on the size and purchase price of the acquisition, the debt is provided in different tranches:

Senior debt: This debt is secured with the assets of the target company and has the lowest interest margin
Junior debt: This debt usually has no securities and bears a higher interest margin

Chapter 13: Capital Structure

13.1: Introducing Capital Structure

13.1.1: Capital Structure Overview and Theory

Capital Structure is the way a company finances its assets through a combination of equity and liabilities.

Learning Objective

Describe how a company’s capital structure can influence its value and investment decisions

Key Points

In theory, capital structure does not alter the value of a firm, so there is an incentive to use more debt and deduct interest expense to achieve tax savings.
In reality, there is financial risk in taking on too much debt, so each company must find a balanced structure.
Trade-Off Theory and Pecking Order Theory are two different explanations for differences among observed capital structures.

Key Terms

equity: Ownership, especially in terms of net monetary value, of a business.
structure: A cohesive whole built up of distinct parts.

Capital Structure Overview

Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is the composition or ‘structure’ of its liabilities. For example, a firm that sells 20 billion dollars in equity and 80 billion dollars in debt is said to be 20% equity-financed and 80% debt-financed. The firm’s ratio of debt to total financing, 80% in this example, is referred to as the firm’s leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed by the firm which comes from outside of the business, such as by taking a short term loan.

Capital Structure.

Capital Structure shows how a company’s assets are built out of debt and equity.

Modigliani and Miller created a theory of Capital Structure in a perfect market. There are several qualifications for a “perfect market”:

no transaction or bankruptcy cost
perfect information
firms and individuals can borrow at the same interest rate
no taxes
investment decisions are not affected by financing decisions

Modigliani and Miller made two findings under these conditions:

The value of a company is independent of its capital structure
The cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk

This means, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.

If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.

Capital Structure Theory

Trade-off theory allows bankruptcy cost to exist. It states that there is an advantage to financing with debt (the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in Debt/Equity ratios between industries, but it doesn’t explain differences within the same industry.

Pecking Order Theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to issuing shares of equity) according to least resistance, preferring to raise equity for financing as a last resort. Internal financing is used first. When that is depleted, debt is issued. When it is no longer sensible to issue any more debt, equity is issued.

This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, while debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

The Pecking Order Theory is popularized by Myers (1984), when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.

13.2: Capital Structure Considerations

13.2.1: Optimal Capital Structure Considerations

The optimal capital structure is the mix of debt and equity that maximizes a firm’s return on capital, thereby maximizing its value.

Learning Objective

Explain the influence of a company’s cost of capital on its capital structure and therefore its value

Key Points

Capital structure categorizes the way a company has its assets financed.
Miller and Modigliani developed a theory which through its assumptions and models, determined that in perfect markets a firm’s capital structure should not affect its value.
In the real world, there are costs and variables that create different returns on capital and, therefore, give rise to the possibility of an optimal capital structure for a firm.
The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.
The weighted average cost of capital multiplies the cost of each security (debt or equity) by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.

Key Terms

capital structure: Capital structure is the way a corporation finances its assets, through a combination of debt, equity, and hybrid securities.
leverage: Debt taken on by a firm in order to finance assets.
cost of capital: the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

Capital structure is the way a corporation finances its assets, through a combination of debt, equity, and hybrid securities. In short, capital structure can be termed a summary of a firm’s liabilities by categorization of asset sources. In a simple example, if a company’s assets come from a $20 million equity issuance and lending that amounts to $80 million, the capital structure can be said to be 20% equity and 80% debt. While equity results from the selling of ownership shares, debt is termed “leverage. ” Therefore, a term that has issued no debt or bonds is said to not be leveraged. This is a simplistic view, because in reality a firm’s capital structure can be highly complex and include many different sources.

Capital Structure

Captial structure is the assignment of the sources of company assets into equity or debt securities.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure (though it is generally viewed as a purely theoretical result, since it disregards many important factors in the capital structure decision). The theorem states that in a perfect market, how a firm is financed is irrelevant to its value. However, as with many theories, it is difficult to use this abstract theory as a basis to evaluate conditions in the real world, where markets are imperfect and capital structure will indeed affect the value of the firm. Actual market considerations when dealing with capital structure include bankruptcy costs, agency costs, taxes, and information asymmetry.

Cost of Capital Considerations

One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. A company’s securities typically include both debt and equity; therefore, one must calculate both the cost of debt and the cost of equity to determine a company’s cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.

Because of tax advantages on debt issuance, such as the ability to deduct interest payments from taxable income, issuing debt will typically be cheaper than issuing new equity. At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is due to the fact that adding debt increases the default risk and, thus, the interest rate that the company must pay in order to borrow money. This increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock). Management must identify the “optimal mix” of financing, which is the capital structure where the cost of capital is minimized so that the firm’s value can be maximized.

13.2.2: Tax Considerations

Taxation implications which change when using equity or debt for financing play a major role in deciding how the firm will finance assets.

Learning Objective

Explain how taxes can influence a company capital structure

Key Points

Tax considerations have a major effect on the way a company determines its capital structure and deals with its costs of capital.
Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.
In general, since dividend payments are not tax deductible but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in usage of debt to finance capital, relative to usage of equity issuance.
There are different kinds of debt that can be used, and they may have different deductibility and tax implications. This will affect the types of debt used in financing, even if corporate taxes do not change the total amount of debt used.

Key Terms

Interest: The price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a fraction of the amount or value of what was borrowed.
dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
optimal capital structure: the amount of debt and equity that maximizes the value of the firm

Tax considerations have a major effect on the way a company determines its capital structure and deals with its costs of capital .

Taxes

A company’s decision makers must take taxes into consideration when determining a firm’s capital structure.

Miller and Modigliani assume that in a perfect market, firms will borrow at the same interest rate as individuals, there are no taxes, and that investment decisions are not changed by financing decisions. This leads to a conclusion that capital structure should not affect value.

When the theory is extended to include taxes and risky debt, things change. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure then, would be to have virtually no equity at all.

However, we see that in real world markets capital structure does affect firm value. Therefore, we see that imperfections exist; often a firm’s optimal structure does not involve having one hundred percent leveraging and no equity whatsoever. There is much debate over how changing corporate tax rates would affect debt usage in capital structure. In general, since dividend payments are not tax deductible, but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in usage of debt to finance capital, relative to usage of equity issuance. However, since many things fall into tax applicability, including firm location and size, this is a generality at best.

There are also different kinds of debt that can be used, and they may have different deductibility and tax implications. That is why, while many believe that taxes don’t really affect the amount of debt used, they actually do. In the end, different tax considerations and implications will affect the costs of debt and equity, and how they are used, relative to each other, in financing the capital of a company.

13.2.3: Cost of Capital Considerations

Cost of capital is important in deciding how a company will structure its capital so to receive the highest possible return on investment.

Learning Objective

Describe the influence of a company’s cost of capital on its capital structure and investment decisions

Key Points

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project’s projected cash flows.
The weighted average cost of capital multiplies the cost of each security (debt or equity) by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.

Key Terms

cost of preferred stock: the additional premium paid to have an equity security with certain additional features not present in common stock
capital rationing: restrictions on how or how much a company can invest
cost of capital: The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.

The expected return on an asset is compared to the cost of capital to invest in the asset.

Cost of capital is an important way of determining whether or not a firm is a worthwhile investment.

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. A company’s securities typically include both debt and equity, so one must therefore calculate both the cost of debt and the cost of equity to determine a company’s cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.

If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.

Because of tax advantages on debt issuance, such as the ability to deduct interest payments from taxable income, it will be cheaper to issue debt rather than new equity. At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock). Management must identify the “optimal mix” of financing–the capital structure where the cost of capital is minimized so that the firm’s value can be maximized.

13.2.4: The Marginal Cost of Capital

The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.

Learning Objective

Describe how the cost of capital influences a company’s capital budget

Key Points

The marginal cost of capital is calculated as being the cost of the last dollar of capital raised.
When raising extra capital, firms will try to stick to desired capital structure, but once sources are depleted they will have to issue more equity. Since this tends to be higher than other sources of financing, we see an increase in marginal cost of capital as capital levels increase.
Since an investment in capital is logically only a good decision if the return on the capital is greater than its cost, and a negative return is generally undesirable, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into raising more capital.

Key Terms

capital gains yield: compound rate of return of increases in a stock’s price
marginal tax rate: the percent paid out to the government of the last dollar (or applicable currency) earned
Marginal Cost of Capital: The cost of the last dollar of capital raised or the minimum acceptable rate of return or hurdle rate.

The marginal cost of capital is calculated as being the cost of the last dollar of capital raised. Generally we see that as more capital is raised, the marginal cost of capital rises . This happens due to the fact that marginal cost of capital generally is the weighted average of the cost of raising the last dollar of capital. Usually, we see that in raising extra capital, firms will try to stick to desired capital structure. Usually once sources are depleted they will have to issue more equity. Since the cost of issuing extra equity seems to be higher than other costs of financing, we see an increase in marginal cost of capital as the amounts of capital raised grow higher.

Cost of Money

The Marginal Cost of Capital is the cost of the last dollar of capital raised. It is an important consideration the firm must take into account when making corporate decisions.

The marginal cost of capital can also be discussed as the minimum acceptable rate of return or hurdle rate. The investment in capital is logically only a good decision if the return on the capital is greater than its cost. Also, a negative return is generally undesirable. As a result, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into raising more capital. If it is determined that the dollars invested in raising this extra capital could be allocated toward a greater or safer return if used differently, according to the firm, then they will be directed elsewhere. For this we must look into marginal returns of capital, which can be described as the gains or returns to be had by raising that last dollar of capital.

13.2.5: Trade-Off Consideration

Trade-off considerations are important because they take into account the cost and benefits of raising capital through debt or equity.

Learning Objective

Describe the balancing act between debt and equity for a company as described by the “trade-off” theory

Key Points

An important purpose of the trade off theory is to explain the fact that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt.
The marginal benefit of further increases in debt declines as debt increases while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
One would think that firms would use much more debt than they do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in credit markets—especially when a firm tries to take on too much debt.

Key Terms

trade-off: Refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
trade credit: a form of debt offered from one business to another with which it transacts

Trade-Off Consideration

The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. It is often set up as a competitor theory to the pecking order theory of capital structure. An important purpose of the theory is to explain the fact that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt—the tax benefits of debt, and there is a cost of financing with debt—the cost of financial distress including bankruptcy.

Structural Considerations

Trade-off considerations are important factors in deciding appropriate capital structure for a firm since they weigh the cost and benefits of extra capital through debt vs. equity.

The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases. Of course, using equity is initially more expensive than debt because it is ineligible for the same tax savings, but becomes more favorable in comparison to higher levels of debt because it does not carry the same financial risk. Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

Another trade-off consideration to take into account is that the while interest payments can be written off, dividends on equity that the firm issues usually cannot. Combine that with the fact that issuing new equity is often seen as a negative signal by market investors, which can decrease value and returns.

As more capital is raised and marginal costs increase, the firm must find a fine balance in whether it uses debt or equity after internal financing when raising new capital. Therefore, one would think that firms would use much more debt than they do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in credit markets—especially when a firm tries to take on too much debt. Therefore, trade off considerations change from firm to firm as they impact capital structure.

13.2.6: Signaling Consideration

Signaling is the conveyance of nonpublic information through public action, and is often used as a technique in capital structure decisions.

Learning Objective

Explain how a company’s attempts at signaling can affect its capital structure

Key Points

Signaling becomes important in a state of asymmetric information.
Signaling can affect the way investors view a firm, and corporate actions that are made public can indirectly alter the value investors assign to a firm.
In general, issuing new equity can be seen as a bad signal for the health of a firm and can decrease current share value.
While the issuance of equity does have benefits, in the sense that investors can take part in potential earnings growth, a company will usually choose new debt over new equity in order to avoid the possibility of sending a negative signal.

Key Terms

asymmetric information: State of being regarding decisions on transactions where one party has more or better information than the other.
Signaling: The idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal).

In economics and finance, signaling is the idea that a party may indirectly convey information about itself, which may not be public, through actions to other parties. Signaling becomes important in a state of asymmetric information (a deviation from perfect information), which says that in some economic transactions inequalities in access to information upset the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party. That party would then interpret the signal and adjust its purchasing behavior accordingly — usually by offering a higher or lower price than if the signal had not been received. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value. A basic example of signaling is that of a student to a potential employer. The degree the student obtained signals to the employer that the student is competent and has a good work ethic — factors that are vital in the decision to hire.

Signaling

Education credentials, such as diplomas, can send a positive signal to potential employers regarding a workers talents and motivation.

In terms of capital structure, management should, and typically does, have more information than an investor, which implies asymmetric information. Therefore, investors generally view all capital structure decisions as some sort of signal. For example, let us think of a company that is issuing new equity. If a company issues new equity, this generally dilutes share value. Since the goal of the firm is generally to maximize shareholder value, this can be a viewed as a signal that the company is facing liquidity issues or its prospects are dim. Conversely, a company with strong solvency and good prospects would generally be able to obtain funds through debt, which would generally take on lower costs of capital than issuing new equity. If a company fails to have debt extended to it, or the company’s credit rating is downgraded, that is also a bad signal to investors. While the issuance of equity does have benefits, in the sense that investors can take part in potential earnings growth, a company will usually choose new debt over new equity in order to avoid the possibility of sending a negative signal.

13.2.7: Constraint on Managers

Managers will have their actions influenced by their firm’s capital structure and the resources that it allows them to use.

Learning Objective

Explain how capital structure can minimize a company’s agency problem

Key Points

Debt-heavy capital structures put constraints on managers by limiting the amount of free cash they have available to them.
Managers may often act in their own best interests instead of those of the firm’s investors. This is known as an agency dilemma.
We see that the firms that have debt-heavy capital structures limit free cash to managers and, therefore, have managers with goals that tend to be more aligned with those of the shareholder.

Key Term

Agency Dilemma: Takes into account the difficulties in motivating one party (the “agent”), to act on behalf of another (the “principal”).

Managers who make decisions about the firm’s corporate behavior will have their actions influenced by capital structure and the resources that it allows them to use.

Managerial finance is the branch of the industry that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique. However, this process can be tainted by the fact that managers may often act in their own best interests instead of those of investors of the firm. This is known as an agency dilemma.

Adopting the right kind of capital structure can help combat this kind of problem, however. When the capital structure draws heavily on debt, then this leaves less money to be distributed to managers in the form of compensation, as well as free cash to be used on behalf of the business. Managers have to be more careful with the resources they are given to use with the purpose of running the firm successfully, since they have to produce enough income to pay back this debt by a certain date, with interest. When managers work with equity heave capital structure they have a little more leeway, and while shareholders may be upset or suffer because of fluctuations in the value of the firm, managers may find ways to make sure their compensation can have some immunity from the market value of the firm.

Therefore, firms that have debt-heavy capital structures have managers with goals that tend to be more aligned with those of the shareholder. The limitation of free cash that managers have provides incentive for them to make decisions for the company that will grow the firm in value and increase the cash they have available to them to pay back debt, pay back into the firm, and compensate themselves.

13.2.8: Pecking Order

In corporate finance pecking ordering consideration takes into account the increase in the cost of financing with asymmetric information.

Learning Objective

Explain the benefits and shortcomings of using the “pecking order” theory to evaluate a company’s value

Key Points

When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively.
Outside investors tend to think managers issue new equity because they feel the firm is overvalued and wish to take advantage, so equity is a less desired way of raising new capital. This then gives the outside investors an incentive to lower the value of the new equity.
The form of debt a firm chooses can act as a signal of its need for external finance. This sort of signalling can affect how outside investors view the firm as a potential investment.

Key Term

Pecking Order: Theory that states that the cost of financing increases with asymmetric information. When it comes to methods of raising capital, companies prefer financing that comes from internal funds, debt, and issuing new equity, respectively. Raising equity can be considered a last resort.

Pecking Order Consideration

The pecking order of investors or credit holders in a company plays a part in the way a company decides to structure it’s capital. Pecking order theory basically states that the cost of financing increases with asymmetric information. Financing comes from internal funds, debt, and new equity. When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively. Raising equity, in this sense, can be viewed as a last resort.

The pecking order theory was popularized by Stewart C. Myers when he argues that equity is a less preferred means to raise capital because managers issue new equity (who are assumed to know better about true conditions of the firm than investors). Investors believe that managers overvalue the firms and are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. This sort of signalling can affect how outside investors view the firm as a potential investment, and once again must be considered by the people in charge of the firm when making capital structure decisions.

Tests of the pecking order theory have not been able to show that it is of first-order importance in determining a firm’s capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama, French, Myers, and Shyam-Sunder find that some features of the data are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem.

13.2.9: Window of Opportunity

In corporate finance, a “window of opportunity” is the time when an asset or product which is unattainable will become available.

Learning Objective

Identify a window of opportunity

Key Points

Windows of opportunity must be taken into consideration by a corporation in order to purchase capital to achieve maximum return.
From the seller’s perspective, the unique time a party will be able to sell a certain product at its highest price point in order to get a maximum return on capital purchased and used.
The people in charge of a firm must take windows of opportunity into account in order to keep costs low and returns high, in order to make the firm look like the best investment possible for creditors of all types.

Key Term

Window of opportunity: The idea of a time when an asset or product. which is unattainable, will become available. It can be extended to a time when a certain product will be attainable at a certain price, or from an opposite perspective, the unique time a party will be able to sell a certain product at its highest price point in order to get a maximum return on investment.

In corporate finance, a “window of opportunity” basically is the idea of a time when an asset or product that is unattainable will become available. It can be extended to a time when a certain product will be attainable at a certain price or from an opposite perspective, the unique time a party will be able to sell a certain product at its highest price point in order to get a maximum return on investment.

For example, when a firm issues an IPO, which allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital. A company selling common shares is never required to repay the capital to its public investors. Those investors must endure the unpredictable nature of the open market to price and trade their shares. However, for a company with massive growth potential, the IPO may be the lowest price that the stock is available for public purchase. Therefore, the IPO presents a window of opportunity to the potential investor to get in on the new equity while it is still affordable and a greater return on investment is attainable. From the firm side, the opportunity to purchase a new plant or real estate at a cheap cost or lower lending rates also presents an opportunity to attain a greater investment on assets used in production. Management of a firm must take this into account in order to keep costs low and returns high, in order to make the firm look like the best possible investment for creditors of all types.

Twitter at the New York Stock Exchange

A Twitter banner hanging over the New York Stock Exchange on the day of its IPO.

13.2.10: Bankruptcy Considerations

Bankruptcy occurs when an entity cannot repay the debts owed to creditors and must take action to regain solvency or liquidate.

Learning Objective

Describe how the risk of a corporate bankruptcy can influence a company’s cost of capital

Key Points

Generally, a debtor declares bankruptcy to obtain relief from debt. This is accomplished either through a discharge of the debt or through a restructuring of the debt.
In the U.S. firms that go bankrupt generally file for Chapter 7 or 11. Chapter 7 involves basic liquidation for businesses. It is also known as straight bankruptcy. Chapter 11 involves rehabilitation or reorganization while allowing the firm to continue functioning.
When liquidation occurs one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little to no capital left over for common shareholders.

Key Terms

Chapter 11: In bankruptcy involves rehabilitation or reorganization and is known as corporate bankruptcy. It is a form of corporate financial reorganization which typically allows companies to continue to function while they follow debt repayment plans.
Chapter 7: In bankruptcy involves basic liquidation for businesses. Also known as straight bankruptcy, it is the simplest and quickest form of bankruptcy available.
bankruptcy: Legal status of an insolvent person or an organisation, that is, one who cannot repay the debts they owe to creditors.

Bankruptcy is a legal status of an insolvent person or an organization, that is, one who cannot repay the debts they owe to creditors . In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor. Generally, a debtor declares bankruptcy to obtain relief from debt. This is accomplished either through a discharge of the debt or through a restructuring of the debt. Usually, when a debtor files a voluntary petition, his or her bankruptcy case commences.

Chapter 9 Bankruptcy

Jefferson County, Alabama underwent Chapter 9 bankruptcy in 2009.

In the U.S. firms that go bankrupt normally file for Chapter 7 or 11. Chapter 7 involves basic liquidation for businesses. It is also known as straight bankruptcy. Chapter 7 is the simplest and quickest form of bankruptcy available. Chapter 11 involves rehabilitation or reorganization and is known as corporate bankruptcy. It is a form of corporate financial reorganization that typically allows companies to continue to function while they follow debt repayment plans. When liquidation occurs one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little or no capital left over for common shareholders.

When gaining the financing for capital, firms must take the possibility of bankruptcy into consideration. This is especially important when looking into financing capital through debt. If potential creditors sense that bankruptcy could be likely firms will have a harder time acquiring financing and even if they do, it will probably come at a high interest rate that significantly increases the cost of debt. These firms will have to rely heavily on equity, which once again can be seen as a negative signal about the firm’s current state. It can put a downward pressure on equity values. This places a high cost on raising capital, with potential for low returns. Therefore, it is best that the firm take into consideration any possibilities of bankruptcy and work to minimize them when designing capital structure.

13.3: Understanding the Bankruptcy Process

13.3.1: What Happens in Bankruptcy

Bankruptcy allows debtors to either reorganize and restructure debts or liquidate assets to be used to pay off creditors.

Learning Objective

Differentiate between the different types of bankruptcy

Key Points

The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts.
In voluntary bankruptcy cases, debtors petition the bankruptcy court. In involuntary bankruptcy cases, creditors file the petition.
The automatic stay provision generally prohibits the commencement, enforcement, or appeal of actions and judgments against a debtor for the collection of a claim that arose prior to the filing of the bankruptcy petition.
Under Chapter 7, a trustee collects the non-exempt property of the debtor, sells it, and distributes the proceeds to the creditors.
Chapters 9, 11, 12, and 13 allow the debtor to keep some or all of his or her property and use future earnings to pay off creditors.

Key Terms

financial distress: a term used to indicate a condition when promises to creditors are broken or honored with difficulty.
insolvent: Unable to pay one’s bills as they fall due.

What Happens in Bankruptcy

Individuals or entities undergoing financial distress may be forced to consider bankruptcy. Bankruptcy is the legal status of an insolvent person or organization, that is, one who cannot repay the debts they owe to creditors. The principal focus of insolvency legislation and business debt restructuring practices is not on the elimination of insolvent entities but on remodeling the financial and organizational structure of debtors experiencing financial distress, so as to permit the rehabilitation and continuation of their business. The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts.

Features of Bankruptcy in the United States

Bankruptcy cases are either voluntary or involuntary. In voluntary bankruptcy cases, which account for the overwhelming majority filed, debtors petition the bankruptcy court. In involuntary bankruptcy cases, creditors file the petition. Commencement of a bankruptcy case creates an estate. The estate consists of all property interests of the debtor at the time of case commencement, subject to certain exclusions and exemptions.

The United States District Courts have jurisdiction over bankruptcy matters; however, each district court may “refer” bankruptcy matters to the Bankruptcy Court. Most district courts have a standing “reference” order to that effect, so that all bankruptcy cases are handled by the Bankruptcy Court. The US Attorney General appoints trustees for each of the 21 geographical regions in the US. These trustees maintain and supervise a panel of private trustees for Chapter 7 bankruptcy cases. Furthermore, a US trustee may be heard on any issue in any bankruptcy case, except for filing a Chapter 11 plan of reorganization.

Automatic Stay

The Bankruptcy Code imposes an automatic stay at the moment a bankruptcy petition is filed. The automatic stay generally prohibits the commencement, enforcement, or appeal of actions and judgments against a debtor for the collection of a claim that arose prior to the filing of the bankruptcy petition. In other words, as soon as a petition is filed, a debtor is entitled to all the provisions of the Bankruptcy Code. The automatic stay also prohibits collection actions and proceedings directed toward property of the bankruptcy estate itself.

A secured creditor may be allowed to take the applicable collateral if the creditor first obtains permission from the court. The court must either grant permission or provide adequate protection to the secured creditor that the value of their collateral will not decrease during the stay.

Chapters of the Bankruptcy Code

Entities seeking relief under the Bankruptcy Code may file a petition for relief under a number of different chapters of the Code, depending on the circumstances. A case is typically referred to by the chapter under which the petition is filed.

Chapter 7: Liquidation

Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Under Chapter 7, a trustee collects the non-exempt property of the debtor, sells it, and distributes the proceeds to the creditors. Because each state allows for debtors to keep essential property, most Chapter 7 cases are “no asset” cases – meaning that there are not sufficient non-exempt assets to fund a distribution to creditors.

Chapter 9: Reorganization for Municipalities

A Chapter 9 bankruptcy is available only to municipalities, and is a form of reorganization, not liquidation. Because municipalities are entities of state governments, the power of Congress to adjust debts through bankruptcy is limited. Municipalities’ ability to re-write collective bargaining agreements is much greater than in a corporate Chapter 11 bankruptcy, and can trump state labor protections, allowing cities to renegotiate unsustainable pension or other benefits packages negotiated in flush times.

Chapter 9 Bankruptcy

Jefferson County, Alabama underwent Chapter 9 bankruptcy in 2009.

Chapters 11, 12 & 13: Reorganization

Bankruptcy under Chapter 11, 12, or 13 requires more complex reorganization, and involves allowing the debtor to keep some or all of his or her property and to use future earnings to pay off creditors. Individuals usually file Chapter 7 or Chapter 13. Chapter 12 is similar to Chapter 13, but it provides extra benefits to “family farmers” and “family fisherman” in certain situations. Chapter 12 generally has more generous terms for debtors than a comparable Chapter 13 case would have available.

Chapter 11 is commonly the form of re-organizational bankruptcy frequently entered into by businesses. Debtors may “emerge” from a Chapter 11 bankruptcy within a few months or several years, depending on the size and complexity of the bankruptcy. The Bankruptcy Code accomplishes this objective through the use of a bankruptcy plan. With some exceptions, the plan may be proposed by any party in interest. Interested creditors then vote for a plan.

13.3.2: Financial Management Before and During Bankruptcy

To avoid the negative impacts of bankruptcy, individuals and companies in financial distress can implement certain financial management techniques.

Learning Objective

Devise a management plan when a company is in financial distress

Key Points

Bankruptcy has the disadvantage of making it more difficult for an individual to borrow in the future, and companies that are reorganized and not dissolved face the risk of higher costs of capital for future operations.
Before entering into bankruptcy, a company or individual can reduce debt obligations and take actions to increase income and profitability.
During the period of reorganization, a company must reduce debt and increase profits in order to emerge from bankruptcy without losing control of operations.

Key Term

garnishment: A judgment that a third party should pay money owed to a debtor directly to a creditor.

Management before and during Bankruptcy

Financial Management before and during Bankruptcy is an effective method for companies and individuals to remedy financial distress and insolvency. However, it has the disadvantage of making it more difficult for an individual to borrow in the future and companies that are reorganized and not dissolved face the risk of higher costs of capital for future operations after emerging from bankruptcy. To avoid the negative impacts of bankruptcy, individuals and companies in financial distress have a number of bankruptcy alternatives.

Management before Bankruptcy

Financial distress typically arises when a high amount of fixed or unavoidable costs exists relative to the amount of cash flow or income. In terms of an individual, the most obvious solution is to reduce monthly spending to allow extra cash flow to service debt. For a company, there are many options of avoiding financial distress, including:

decrease the amount of financial and operating leverage,
dispose of investments or operations not producing a profit,
stagger or extending obligatory payments on debt,
lower earnings distributions, such as dividends,
diversify operations,
reduce costs where possible,
avoid risky investments,
improve efficiency.

If the situation is too dire for such measures and a debtor does not expect to have steady income or property, it may be appropriate to utilize the take no action approach. In other words, the debtor should do nothing since a company with no assets or income cannot undergo garnishment by a creditor. In such cases, however, a creditor could attempt to seize.

Altman Z-Score

A company may reference the Altman Z-score formula in order to determine the likelihood that it will be forced into bankruptcy. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. Specifically, the formula references:

ratios of working capital to total assets,
retained earnings to total assets,
EBIT to total assets,
market value of equity to book value of liabilities,
sales to total assets .

Management during Bankruptcy

For the option of financial management during bankruptcy to exist, a form of bankruptcy allowing reorganization, such as chapter 11, must be used. Chapter 11 requires that all interested parties agree on a plan. Once confirmed, the plan becomes binding and identifies the treatment of debts and operations of the business for the duration of the plan. Under this plan, a debtor may be able to acquire financing and loans on favorable terms by giving new lenders first priority on the business’ earnings. The court may also permit debtors to reject and cancel contracts previously agreed to, if this would be financially favorable to the company and its creditors. If the company’s debts exceed its assets, the bankruptcy can result in the company’s owners being left with nothing. In such a case, the company’s creditors may be awarded with ownership of the newly reorganized company. During the period of reorganization, a company must utilize financial management, consisting of the options listed above, in order to emerge from bankruptcy without losing control of operations.

13.3.3: Striking Agreements to Avoid Bankruptcy

Most creditors are willing to negotiate a settlement to receive a portion of their money and not risk losing everything in a bankruptcy.

Learning Objective

Differentiate between debt restructuring and debt consolidation

Key Points

Negotiation is a viable alternative if the debtor has sufficient income, or has assets that can be liquidated so the proceeds can be applied against the debt.
Debt restructuring is a process that allows a company or individual in financial distress to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and continue its operations.
Debt consolidation typically involves borrowing from one lender at a low rate of interest in order to repay a number of higher interest rate obligations.

Key Term

delinquent: Late or failing to pay a debt or other financial obligation, like a mortgage or loan.

Striking Agreements To Avoid Bankruptcy

In general, creditors understand that bankruptcy is an option for debtors with excessive debt. Therefore, most creditors are willing to negotiate a settlement so that they receive a portion of their money, instead of risking losing everything in a bankruptcy. Negotiation is a viable alternative if the debtor has sufficient income, or has assets that can be liquidated so the proceeds can be applied against the debt. Negotiation may also buy the debtor some time to rebuild finances.

Debt Restructuring

Debt restructuring is a process that allows a company or individual in financial distress to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and continue its operations. Out-of court restructurings, also known as workouts, are becoming increasingly common. A debt restructuring is usually less expensive than bankruptcy. The main cost associated with debt restructuring is the time and effort required to negotiate with creditors. Debt restructurings typically involve a reduction of debt and an extension of payment terms. A debtor and creditor could also agree to a debt-for-equity swap, wherein a company’s creditors generally agree to cancel some or all of the debt in exchange for equity in the company. These deals typically occur with large companies in financial distress, and often result in these companies being taken over by their principal creditors.

Debt Consolidation

Debt consolidation typically involves borrowing from one lender at a low rate of interest in order to repay a number of higher interest rate obligations. By consolidating debts, the debtor replaces payments to many different creditors with a payment to one creditor. This simplifies the debtor’s obligations and can result in faster debt repayment. This is a common course of action for individuals owing large sums on multiple credit cards .

Too Much Credit

Debt consolidation is one option for individuals owing large sums on multiple credit cards.

13.4: Thinking About Operating Leverage

13.4.1: Defining Operating Leverage

Operating leverage is a measure of how revenue growth translates into growth in operating income.

Learning Objective

Identify ways to increase or decrease a company’s operating leverage

Key Points

As operating leverage increases, more sales are needed to cover the increased fixed costs.
High levels of fixed costs increase business risk, which is the inherent uncertainty in the operation of the business.
Operating leverage also increases forecasting risk. Therefore, even a small error made in forecasting sales can be magnified into a major error in forecasting cash flows.
Measures used to interpret operating leverage include the ratio of fixed costs to total costs, the ratio of fixed costs to variable costs, and Degree of Operating Leverage (DOL).

Key Terms

fixed cost: business expenses that are not dependent on the level of goods or services produced by the business
variable cost: a cost that changes with the change in volume of activity experienced by an organization

Defining Operating Leverage

Operating leverage can be defined, simply, as the degree to which a firm incurs a combination of fixed and variable costs. Specifically, it is the use of fixed costs over variable costs in production. For example, replacing production workers (variable cost) with robots (fixed cost) . Operating leverage is also a measure of how revenue growth translates into growth in operating income.

Example of Operating Leverage

Factory automation with industrial robots for metal die casting.

Recall that variable costs are those that change alongside the volume activity of a business, and fixed costs are those that remain constant regardless of volume. Utilizing operating leverage will allow variable costs to be reduced in favor of fixed costs; therefore, profits will increase more for a given increase in sales. This is, of course, after the breakeven point has been reached. In other words, because variable costs are reduced, each sale will contribute a higher profit margin to the company.

Fixed and Variable Costs

Fixed costs and variable costs, together, comprise total costs.

As operating leverage increases, more sales are needed to cover the increased fixed costs. Therefore, companies with low output would not benefit from increased operating leverage. Moreover, high levels of fixed costs increase business risk, which is the inherent uncertainty in the operation of the business. Manufacturing companies tend to invest heavily in fixed assets. Therefore, operating leverage is used much more than financial leverage for these types of firms. Operating leverage also increases forecasting risk. Therefore, even a small error made in forecasting sales can be magnified into a major error in forecasting cash flows.

Interpreting Operating Leverage

Various measures can be used to interpret operating leverage. These include the ratio of fixed costs to total costs, the ratio of fixed costs to variable costs, and the Degree of Operating Leverage (DOL). All of these measures depend on sales. The ratios of fixed cost to total costs and fixed costs to variable costs tell us that if the unit variable cost is constant, then as sales increase, operating leverage decreases. The DOL tells us, as a percentage, that for a given level of sales and profit, a company with higher fixed costs has a higher contribution margin – the marginal profit per unit sold. Therefore, its operating income increases more rapidly with sales than a company with lower fixed costs (and correspondingly lower contribution margin).

13.4.2: Break-Even Analysis

Break-even analysis tells a company how much it needs to sell in order to pay for an investment.

Learning Objective

Employ a break even analysis in the context of a company’s production process

Key Points

Break-even analysis gives a company an idea about what level of operating leverage will be ideal to generate greater profits.
To find the amount of units required to be sold in order to break even, we simply divide the total fixed costs by the unit contribution margin.
Unit contribution margin can be thought of as the fraction of sales, or amount of each unit sold, that contributes to the offset of fixed costs.
Break-even analysis helps to provide a dynamic view of the relationships between sales, costs and profits.

Key Terms

variable cost: a cost that changes with the change in volume of activity experienced by an organization
fixed cost: business expenses that are not dependent on the level of goods or services produced by the business

Example

A company sells each unit of its product for $20. The variable cost per unit is $5, and the total fixed costs are $1,000. 67 units must be sold in order to break even.

Break-Even Analysis and Operating Leverage

Recall that operating leverage describes the relationship between fixed and variable costs. Having high operating leverage (having a larger proportion of fixed costs compared to variable costs) can lead to much higher profits for a company. However, increasing operating leverage can also cause substantial losses and puts more pressure on a business. The key to understanding the appropriate amount of operating leverage lies in analysis of the break-even point.

Break-Even Definition

Break-even analysis tells a company how much it needs to sell in order to pay for an investment– or at what point expenses and revenue are equal.

To find the amount of units required to be sold in order to break even, we simply divide the total fixed costs by the unit contribution margin.

Unit Contribution Margin

Contribution margin (C) is the unit net revenue (P = price) minus unit variable cost (V = variable cost).

Unit contribution margin can be thought of as the fraction of sales, or amount of each unit sold, that contributes to the offset of fixed costs. It is simply the unit net revenue minus the unit variable cost. When sales have exceeded the break-even point, a larger contribution margin will mean greater increases in profits for a company. By inserting different prices into the break-even formula, you will obtain a number of break-even points– one for each possible price charged.

Multiple Break-Even Prices

R1, R2 and R3 = revenues at different chosen prices. TC = total cost curve. FC = fixed cost curve.

In the above graph, points A, B, and C are the break-even points. The break-even quantity at each selling price can be read off the horizontal axis and the break-even price can be read off the vertical axis.

Break-Even Application

Break-even analysis helps to provide a dynamic view of the relationships between sales, costs and profits. By providing a better understanding of the amount of success an investment or project must attain, break-even analysis gives companies a benchmark to compare to and an idea about what level of operating leverage will be ideal to generate greater profits.

Breakeven Example

FC = 1,000. P = 20. VC = 5.

13.4.3: Leverage Models

The relationship between fixed and variable costs, when calculated alongside sales volume, enables modeling of operational leverage.

Learning Objective

Calculate operating leverage using simple cost equations

Key Points

High fixed costs as a percentage of overall cost has a big impact on the variation that volume can create when it comes to operating margins and leverage.
The ratio between fixed costs and variable costs has a high impact on the overall risk incurred by a business operation.
Over time (assuming no new fixed asset investments are required), fixed costs become a smaller percentage of cost per unit while variable costs remain consistent. Increases in volume will therefore result in overall increases in margin.

Key Term

leverage: The ability to utilize something to gain more of something else.

Why Leverage Matters

Before learning each calculation, it’s useful to frame the issue of leverage first. Operating leverage is largely predicated on fixed costs. When fixed costs are high (and variable costs are low), there is quite a bit of risk if the volume of production is low. However, strong increases in revenues will eventually result in substantially higher increase in profitability (as the relative impact of variable costs is lower, and the fixed cost is being divided by higher quantity). The equations below will demonstrate this concept in practice and clarify the concept. What’s important to keep in mind is the importance of fixed costs compared to variable costs, and the impact this can have on financial leverage.

Leverage Models

Most of the calculations and models for leverage are relatively intuitive when looking at examples.

Let’s say you own a business selling coffee. Each cup of coffee you sell costs you about $0.10. You’re want to beat out the competition on price, so you sell your coffees pretty low at $1.00/coffee. As you can see, your variable cost is only 10% of the overall revenue. The rest of those costs (plus the profit left over) fall into the fixed costs category. After being in business for one year, you have spent a total of $100,000 acquiring the fixed assets you need (a small location, coffee machines, grinders, chairs, tables, and other random necessities).

If you sell one cup of coffee, you’ve spent $100,000.10 and made $1.00. Not so profitable at this point, as you can see. Your fixed costs compared to your total costs is pretty much 100%. To find our where you’ll break even, simply subtract the variable cost from the sale price and divide that by the fixed costs (i.e. how many $0.90 profits are required to cover the full $100,000 you owe in fixed costs). Around your 111,111 cup of coffee, you’ll find yourself just about even. After this point, pretty much every cup of coffee you sell if 90% profit and 10% cost. Not bad, right? But it’ll take a lot of leverage to get there, and therefore there is always the risk you’ll go out of business before you make it to your 111,111th cup of coffee.

So, the model for leverage in this case is fixed costs/total costs (or fixed costs/fixed costs + variable costs):

The Degree of Operating Leverage

Calculating the overall degree of operating leverage is an important strategic consideration to make as often as possible. The cleanest way to few this is as the overall change in operating income compared to the overall change in sales:

It is also useful to frame this as the operating margin, which compares the overall revenue to the overall operating income. This is more of a snapshot of the current situation, while the DOL above is more in tune with relative changes over time.

At the core of degree of operating leverage is the same concept discussed in the example above. The overall amount gained per new unit sold changes based on the ratio between fixed and variable costs, and this change is what is being modeled what talking about leverage.

Variable Costs and Contribution

After filtering out the fixed costs, increases in volume will increase both the overall variable expense and the overall contribution.

13.4.4: Benefits and Risks of Operating Leverage

The use of operating leverage can multiply profits when a given break-even point is reached, but it can intensify losses when it is not.

Learning Objective

Identify the types of companies that would benefit from higher operating leverage

Key Points

The use of leverage necessarily creates a degree of risk. Thus, the use of leverage will always necessitate a tradeoff between risk and return.
Once a certain break-even point is reached, sales contribute to profits in a much higher capacity than they would if more of the costs were variable.
The uncertainty of achieving a certain level of sales, and thus breaking even, can be referred to as business risk.

Key Term

break-even point: The point where total costs equal total revenue and the organization neither makes a profit nor suffers a loss.

Leverage, in general, can defined as any technique that is used to multiply gains and losses. By this definition the use of leverage creates risk, and thus will always necessitate a tradeoff between risk and return. As in any situation of this sort, added risk can produce benefits for a firm, but it can also lead to detrimental consequences.

When considering the benefits of operating leverage, it is appropriate to consider the contribution margin, or the excess of sales over variable costs. When variable costs are lower, the contribution of sales to profits will be greater. In other words, a company with higher operating leverage has the potential to generate much larger profits than a company with lower operating leverage. For example, the variable costs for a software company, such as packaging and the cost of various media devices (like CDs), are very low compared to its fixed costs, such as research and development. Therefore, once a certain break-even point is reached, the contribution that sales make to profits is much higher than it would be if a greater portion of the costs were variable.

Problems can arise if a company has very high fixed costs, and if a company has difficulty selling enough units to break even on a particular investment. This is referred to as “business risk,” since it arises from the inherent risk of doing business. In other words, the uncertainty of generating a necessary amount of sales is a dilemma all businesses face. Just as the use of operating leverage can lead to greater profits, if a company is able to reach a given, break-even point, so too can the use of leverage drastically multiply losses if that point is not reached.

Possible Business Risks

This chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect the amount of operating leverage a company should utilize.

13.5: Thinking About Financial Leverage

13.5.1: Defining Financial Leverage

Financial leverage is a tactic to multiply gains and losses, calculated by a debt-to-equity ratio.

Learning Objective

Calculate financial leverage, and recognize the core relationship between risk and return

Key Points

Leverage is a financial tactic to multiply gains and losses, accomplished through borrowing capital on existing assets.
Through achieving leverage, organizations can grow exponentially faster due to access to far more resources than their assets would generally allow.
From a financial point of view, financial leverage is calculated as total debt/shareholder equity.
When assessing financial leverage, it’s important to recognize the implications on the cost of capital. This is to say, all borrowed money comes with interest, and the weighted average cost of capital (WACC) is a critical in understanding the risk.
The Lehman Brothers were leverage over 30 times when the financial collapse of 2007-2009 occurred. This degree of risk in unsustainable and highly dangerous not only to the organization, but to the economy at large.

Key Term

leverage: The overall debt divided by shareholder equity. This borrowing allows for the multiplication of gains and losses.

Why Organizations Leverage Finances

At its simplest, leverage is a tactic geared at multiplying gains and losses. Leveraging existing assets to get exponentially more return can be a risk intensive process, and represents a significant aspect of financial strategy and capital structure. Achieving leverage can enable significant competitive advantages despite the risk, however, as it can accelerate the speed of revenue acquisition exponentially.

The standard way to accomplish leverage is through borrowing, via debt and equity, to invest at a much higher scale than one’s current assets would allow. In order to borrow substantial amounts of capital, firms must pursue a variety of financial sourcing and be able to back up their debts with valuable assets (collateral). Even with a great deal of collateral, borrowing big means risking big. Interest rates ensure that the strategic discussions around expanding leverage take into account the risk and return trade offs.

Measuring Leverage

In finance, the best definitions come in equation format. The standard definition of financial leverage is as follows:

In short, the ratio between debt and equity is a strong sign of leverage. As you may already know, equity is ownership of the organization and pays out fairly significant dividends. Debt is often lower cost access to capital, as debt is paid out before equity in the event of a bankruptcy (thus debt is intrinsically lower risk for the investor).

Leverage and Capital Costs

The debt to equity ratio plays a role in the working average cost of capital (WACC) as well, as the overall interest on financing represents the break-even point that must be obtained to achieve profitability in a given venture. WACC is essentially the overall average interest an organization owes on the capital it has borrowed for leverage.

Let’s say equity represents 60% of borrowed capital and debt is 40%. This results in a financial leverage calculation of 40/60, or 0.6667. The organization owes 10% on all equity and 5% on all debt. That means that the weighted average cost of capital is (.4)(5) + (.6)(10) – or 8%. For every $10,000 borrowed, this organization will owe $800 in interest. Profit must be higher than 8% on the project to offset the cost of interest and justify this leverage.

Leverage and the 2007-2009 Recession

A word of caution: Leverage is exponentially more risky the more it is utilized. A useful way to view leverage is the overall existing assets of an organization compared to the amount of money they owe. For example, say you own a company with an overall net worth of $1 million. If you were to be leveraged at a total of 1.5 times (i.e. financed at $1.5 million), this would put you at some risk. Arguably a reasonable amount.

Before Lehman Brothers went bankrupt, they were leveraged at over 30 times ($691 billion in financial leverage compared to $22 billion in assets). A mistake of this scale (on both the lenders and the Lehman Brothers) threatened to topple the global economy itself. It’s important to keep responsibility, accountability, and risk in mind when considering leverage options.

Financial Leverage Firm Value Implications

This graph illustrates a theoretical firm value maximizing curve when it comes to a debt-to-equity ratio. All this means is that each organization has the ideal balance between debt and equity, and finding the ‘sweet spot’ is a useful strategic aspect of financial leverage decisions.

13.5.2: Impacts of Financial Leverage

The use of financial leverage can positively – or negatively – impact a company’s return on equity as a consequence of the increased level of risk.

Learning Objective

Describe how leverage can impact a business

Key Points

If value is added from financial leveraging then the associated risk will not have a negative effect.
At an ideal level of financial leverage, a company’s return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.
If earnings before interest and taxes are greater than the cost of financial leverage than the increased risk of leverage will be worthwhile.

Key Terms

solvency: The state of having enough funds or liquid assets to pay all of one’s debts; the state of being solvent.
liquidity: Availability of cash over short term: ability to service short-term debt.

Impacts of Financial Leverage

Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company’s perspective, the use of financial leverage can positively – or sometimes negatively – impact its return on equity as a consequence of the increased level of risk.

Impact on Return on Equity

Return on equity is the rate of return on the shareholders’ equity of a company’s common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on equity shows how well a company uses investment funds to generate earnings growth. It can be calculated using the following equation:

Return On Equity

The equation used to calculate return on equity.

At an ideal level of financial leverage, a company’s return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns. However, if a company is financially over-leveraged a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. If the risk of the investment outweighs the expected return, the value of a company’s equity could decrease as stockholders believe it to be too risky.

Leverage, Risk, and Misconceptions

The most obvious risk of leverage is that it multiplies losses. Due to financial leverage’s effect on solvency, a company that borrows too much money might face bankruptcy during a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. There is a popular prejudice against leverage rooted in the observation of people who borrow a lot of money for personal consumption – for example, heavy use of credit cards. However, in finance the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. Instead of spending money it doesn’t have, a company actually creates value. On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.

There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause.

When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.

13.5.3: Combining Operating Leverage and Financial Leverage

To calculate total leverage, we multiply Degree of Operating Leverage by Degree of Financial Leverage.

Learning Objective

Calculate a company’s total leverage

Key Points

Total leverage measures the sensitivity of earnings to changes in the level of a company’s sales.
If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales to determine total leverage.
Companies usually choose one form of leverage over the other when analyzing potential investments. A company utilizing both forms of leverage undertakes a very high level of risk.

Key Term

Earnings Per Share: The amount of earnings per each outstanding share of a company’s stock.

Combining Operating and Financial Leverage

Operating and financial leverage can be combined into an overall measure called “total leverage. ” Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales. In other words, total leverage measures the sensitivity of earnings to changes in the level of a company’s sales.

Methods For Finding Total Leverage

Total leverage can be determined by a couple of different methods. If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales. Earnings can be measured in terms of EBIT, earnings before interest and taxes, or EPS, earnings per share. While EBIT can be determined by referencing a company’s income statement, we can determine earnings per share by dividing the company’s net income by it’s average price of common shares.

Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.

Total Leverage Equation 1

Total leverage = DOL x DOF

Total Leverage Equation 2

Total leverage = DOL x DOF

Therefore:

Total Leverage Equation 3

TL = Total Leverage. P = Unit Revenue. V = Unit Variable Cost. X = Units Sold. FC = Fixed Costs. I = Interest Expense.

Fully derived, we see that to multiply Degree of Operating Leverage and Degree of Financial Leverage, we subtract fixed costs and interest expense from the total contribution margin (revenue minus variable cost times the number of units sold), and divide total contribution margin by this result. Companies usually choose one form of leverage over the other when analyzing potential investments. One that utilizes both forms of leverage undertakes a very high level of risk.