CHAPTER 19 Mastering Financial Management 19.1 A WORD FROM THE AUTHORS In this chapter, we define financial management as all the activities concerned with (1) obtaining money and (2) using it effectively. The chapter is organized around this two-part definition. We begin with brief explanations of the need for financing (both short- and long-term) and the need to manage spending in accordance with established priorities. We develop the concept of sound financial management further in a discussion of organizational objectives, budgeting, and sources of funds, with illustrations from a small retail store. We devote the remainder of the chapter to an examination of various methods of obtaining funds. We discuss the types of unsecured short-term financing, including trade credit, promissory notes, unsecured bank loans, and commercial paper. Then we discuss loans secured by inventory, loans secured by receivables, and accounts receivable sold to a factor. Next, we compare short-term financing methods with regard to cost. The methods used to obtain long-term financing are categorized under equity financing and debt financing including selling common stock and/or preferred stock, retained earnings, venture capital, private placements, loans, and corporate bonds. Finally, we compare long-term financing methods with regard to cost. 19.2 TRANSITION GUIDE New in Chapter 19: Mastering Financial Management • The first two learning objectives have been revised in Chapter 19. • A new Inside Business feature, “How J. M. Smucker Manages Its Money,” has been included. • The chapter begins with a new section, “Why Financial Management?,” which explains why financial management is so important in today’s economy. • The Ford Motor Company is used as an example of how aggressive financial management can make a difference between success and bankruptcy in the section “Why Financial Management?” • Figure 19.1 (Figure 19.2 in the eleventh edition), “Business Bankruptcies in the United States,” has been updated. • The section, “Financial Reform After the Economic Crisis,” has been updated and now includes coverage of the Dodd–Frank Wall Street Reform and Consumer Protection Act. • The “Careers in Finance” section now follows the section “Financial Reform After the Economic Crisis.” • “The Need for Financing” is now the second section in Chapter 19. • A new Personal Apps asks students to determine their short- and long-term financing needs. • The section, “Establishing Organizational Goals and Objectives,” now reviews the meaning and timing for both goals and objectives. • In the “Establishing Organizational Goals and Objectives” section, an example about McDonald’s annual advertising budget ($635 million) illustrates that a firm’s goals and objectives can be very expensive. • A new example describing how Berkshire Hathaway constructed a capital budget to determine the best way to pay for its acquisition of Lubrizol Corporation has been included in the section “Budgeting for Financial Needs.” • Figure 19.4 (in the eleventh edition), “Sales Budget for Stars and Stripes Clothing,” has been deleted. • Figure 19.4, “Cash Budget for Stars and Stripes Clothing,” was Figure 19.5 in the eleventh edition. • A new example describing how Pfizer sold its Capsugel manufacturing unit to KKR (Kohlberg Kravis Roberts) in order to increase its cash balance has been included in the section “Identifying Sources of Funds.” • In the “Monitoring and Evaluating Financial Performance” section, a new example about Borders illustrates what can happen when a firm doesn’t monitor and manage its finances. • Discount Tire Stores has been provided as an example in the section “Trade Credit.” • Figure 19.5 now has information on the prime rate from 1990 to January 2012. • In the section “Unsecured Bank Loans,” the information about a line of credit and revolving credit agreement has been deleted. • Information in the “Commercial Paper” section has been expanded. • New information about how GE Capital and CIT Group are becoming more involved in factoring has been included in the section “Factoring Accounts Receivable.” • Groupon, LinkedIn, and Facebook are used as examples in the section “Initial Public Offering and the Primary Market.” • The all-time largest IPOs for U.S. companies are included in Figure 19.6. • Information about how Sunoco used an IPO to spin off its Sun Coke Energy division has been provided in the section “Initial Public Offering and the Primary Market.” • The Going for Success feature, “What Makes a Good IPO,” has been deleted. • A new Social Media feature, “Talk to Chuck,” describes Charles Schwab Corporation’s efforts to use social media to communicate to its clients. • In the “Preferred Stock” section, the material on par value has been deleted. • The amount of retained earnings for GE has been updated in the section “Retained Earnings.” • The material in the section, “Venture Capital and Private Placements,” has been expanded. • The Sustaining the Planet feature, “Green Energy Loans,” has been deleted. • A new Personal Apps feature recommends that students consider themselves as the CFO of their life. • A new Figure 19.7 illustrates the principle that a corporation pays less interest if its bonds are considered high quality than if its bonds are more speculative. • The old Figure 19.7, “Pepsico Corporate Bonds,” has been deleted. • The Spotlight feature describing average yields on corporate bonds has been deleted. • An interest calculation has been included in the “Corporate Bonds” section. • A new Return to Inside Business about J. M. Smucker has been added. • Case 19.2, “Darden Restaurants Serves Up Long-Term Growth,” has been revised. • The Building Skills for Career Success section contains a new Social Media Exercise. • The Exploring the Internet feature in Building Skills for Career Success has been deleted. 19.3 QUICK REFERENCE GUIDE Instructor Resource Location Transition Guide IM, pp. 737–738 Learning Objectives Textbook, p. 550; IM, p. 740 Brief Chapter Outline IM, pp. 740–741 Comprehensive Lecture Outline IM, pp. 741–755 At Issue: Should executive pay at companies that have accepted bailout money be capped by the government? IM, p. 743 Going for Success Investor Relations in the Social Media Era Textbook, p. 565 Social Media Talk to Chuck Textbook, p. 566 Entrepreneurial Success Looking for Venture Capital from Corporations Textbook, p. 567 Inside Business How J. M. Smucker Manages Its Money Textbook, p. 551 Return to Inside Business Textbook, p. 572 Questions and Suggested Answers, IM, p. 756 Marginal Key Terms List Textbook, p. 574 Review Questions Textbook, p. 574 Questions and Suggested Answers, IM, pp. 756–758 Discussion Questions Textbook, p. 575 Questions and Suggested Answers, IM, pp. 759–760 Video Case 19.1 (Financial Planning Equals Profits for Nederlander Concerts) and Questions Textbook, p. 575 Questions and Suggested Answers, IM, pp. 760–761 Case 19.2 (Darden Restaurants Serve Up Long-Term Growth) and Questions Textbook, p. 576 Questions and Suggested Answers, IM, p. 761 Building Skills for Career Success Textbook, pp. 577–578 Suggested Answers, IM, pp. 761–764 IM Quiz I & Quiz II IM, pp. 765–767 Answers, IM, p. 767 Classroom Exercises IM, pp. 768–769 19.4 LEARNING OBJECTIVES After studying this chapter, students should be able to: 1. Understand why financial management is important in today’s uncertain economy. 2. Identify a firm’s short- and long-term financial needs. 3. Summarize the process of planning for financial management. 4. Describe the advantages and disadvantages of different methods of short-term debt financing. 5. Evaluate the advantages and disadvantages of equity financing. 6. Evaluate the advantages and disadvantages of long-term debt financing. 19.5 BRIEF CHAPTER OUTLINE I. Why Financial Management? A. The Need for Financial Management B. Financial Reform After the Economic Crisis C. Careers in Finance II. The Need for Financing A. Short-Term Financing B. Long-Term Financing C. The Risk–Return Ratio III. Planning—The Basis of Sound Financial Management A. Developing the Financial Plan 1. Establishing Organizational Goals and Objectives 2. Budgeting for Financial Needs 3. Identifying Sources of Funds B. Monitoring and Evaluating Financial Performance IV. Sources of Short-Term Debt Financing A. Sources of Unsecured Short-Term Financing 1. Trade Credit 2. Promissory Notes Issued to Suppliers 3. Unsecured Bank Loans 4. Commercial Paper B. Sources of Secured Short-Term Financing 1. Loans Secured by Inventory 2. Loans Secured by Receivables C. Factoring Accounts Receivable D. Cost Comparisons V. Sources of Equity Financing A. Selling Stock 1. Initial Public Offering and the Primary Market 2. The Secondary Market 3. Common Stock 4. Preferred Stock B. Retained Earnings C. Venture Capital and Private Placements VI. Sources of Long-Term Debt Financing A. Long-Term Loans 1. Term-Loan Agreements 2. The Basics of Getting a Loan B. Corporate Bonds 1. Types of Bonds 2. Repayment Provisions for Corporate Bonds C. Cost Comparisons 19.6 COMPREHENSIVE LECTURE OUTLINE The ability to borrow money (debt capital) or obtain money from the owners of a business (equity capital) is necessary for the efficient operation of a business firm and our economic system. I. WHY FINANCIAL MANAGEMENT? During the recent economic crisis, many financial managers and business owners found it was increasingly difficult to use many of the traditional sources of short- and long-term financing described later in this chapter. In some cases, banks stopped making loans even to companies that had always been able to borrow money. Furthermore, the number of corporations selling stock for the first time to the general public decreased because investors were afraid to invest in new companies. There was an increase in the number of businesses that filed for bankruptcy during the crisis (see Figure 19.1). But there were many more business firms that were able to weather the economic storm and keep operating because of their ability to manage their finances. A. The Need for Financial Management. Financial management consists of all the activities concerned with obtaining money and using it effectively. To some extent, financial management can be viewed as a two-sided problem: 1. On one side, the uses of funds often dictate the type or types of financing needed by a business. 2. On the other side, the activities a business can undertake are determined by the types of financing available. Financial managers must ensure that funds are available when needed, that they are obtained at the lowest possible cost, and that they are used as efficiently as possible. It must also ensure that: • Financing priorities are established in line with organizational goals and objectives. • Spending is planned and controlled. • Sufficient financing is available when it is needed, both now and in the future. • A firm’s credit customers pay their bills on time, and the number of past due accounts is reduced. • Bills are paid promptly to protect the firm’s credit rating and its ability to borrow money. • The funds required for paying the firm’s taxes are available when needed to meet tax deadlines. • Excess cash is invested in certificates of deposit (CDs), government securities, or conservative, marketable securities. Teaching Tip: Use the combination homework and class activity “Financial Management” here. The homework part should be assigned during the class prior to the session in which the class activity takes place. The activity itself should take approximately 20 minutes. B. Financial Reform After the Economic Crisis. In the wake of the crisis that affected both business firms and individuals, a cry for more regulations and reforms became a high priority. To meet this need, President Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010. Although the U.S. Senate and House of Representatives debate additional regulations, the goals are to hold Wall Street firms accountable for their actions, end taxpayer bailouts, tighten regulations for major financial firms, and increase government oversight. There has also been debate about limiting the amount of executive pay and bonuses, limiting the size of the largest financial firms, and curbing speculative investment techniques that were used by banks before the crisis. C. Careers in Finance. The Bureau of Labor Statistics projects there will be an 8 percent increase in the number of jobs in the financial sector of the economy between now and 2018. There are many different types of positions in finance. 1. A chief financial officer (CFO) is a high-level corporate executive who manages a firm’s finances and reports directly to the company’s CEO or president. 2. Although some executives in finance make $300,000 a year or more, many entry-level and lower-level positions that pay quite a bit less are available. a) Banks, insurance companies, and investment firms have a need for workers who can manage and analyze financial data, as well as businesses involved in manufacturing, services, and marketing. Colleges and universities, not-for-profit organizations, and government entities at all levels also need finance workers. 3. People in finance must have certain traits and skills. One of the most important priorities is honesty. Managers and employees in the finance area must also: a) Have a strong background in accounting or mathematics. b) Know how to use a computer to analyze data. c) Be an expert at both written and oral communication. 4. Depending on qualifications, work experience, and education, starting salaries generally begin at $25,000 to $35,000 a year, but it is not uncommon for college graduates to earn higher salaries. II. The Need for Financing. Money is needed both to start a business and to keep it going. The original investment of the owners, along with money they may have borrowed, should be enough to open the doors. After that, sales revenues should be used to pay the firm’s expenses and provide a profit. However, income and expenses may vary from month to month or from year to year. Temporary financing may be needed when expenses are high or sales are low. Situations such as the opportunity to purchase a new facility or expand an existing plant may require more money than is currently available within a firm. A. Short-Term Financing. Short-term financing is money that will be used for one year or less. As illustrated in Table 19.l, there are many short-term financing needs, but three deserve special attention. 1. Certain business practices may affect a firm’s cash flow and create a need for short-term financing. Cash flow is the movement of money into and out of an organization. a) The goal is to have sufficient money coming into the firm in any period to cover the firm’s expenses during that period. b) This goal is not always achieved. For example, a firm that offers credit to its customers may need short-term financing to pay its bills until its customers have paid theirs. 2. A second major need for short-term financing is speculative production. Speculative production refers to the time lag between the actual production of goods and when the goods are sold. (See Figure 19.2.) When manufacturing begins, a firm negotiates short-term financing to buy materials and supplies, to pay wages and rent, and to cover inventory costs until its products are sold to wholesalers and retailers. Once the firm’s finished products are shipped and payment is received, sales revenues are used to repay the short-term financing. 3. A third need for short-term financing is to increase inventory. Firms must build up their inventories before peak selling periods. Teaching Tip: The month between Thanksgiving and the Christmas/Hanukkah holiday is often a peak selling period for many retailers. Ask students to identify some businesses that must increase inventory at this time (e.g., perfumes, sweaters, etc.). B. Long-Term Financing. Long-term financing is money that will be used for longer than one year. 1. Long-term financing is needed to start a business. 2. It is also needed for business mergers and acquisitions, new product development, long-term marketing activities, replacement of equipment that has become obsolete, and expansion of facilities. C. The Risk–Return Ratio. According to the financial experts, business firms will find it more difficult to raise capital for two reasons: 1. First, financial reform and increased regulations will lengthen the process required to obtain financing. 2. Second, both lenders and investors are more cautious about who receives financing. 3. As a result, financial managers must develop a strong financial plan that describes how the money will be used and how it will be repaid. 4. When developing a financial plan for a business, a financial manager must also consider the risk–return ratio when making decisions that affect the firm’s finances. The risk–return ratio is based on the principle that a high-risk decision should generate higher financial returns for a business, while more conservative decisions (with less risk) often generate lesser returns. Although financial managers want higher returns, they must strive for a balance between risk and return. III. PLANNING—THE BASIS OF SOUND FINANCIAL MANAGEMENT. A financial plan is a plan for obtaining and using the money needed to implement an organization’s goals. A. Developing the Financial Plan. Figure 19.3 shows the three steps involved in financial planning. 1. Establishing Organizational Goals and Objectives. A goal is an end result that an organization expects to achieve over a one- to ten-year period. Objectives are specific statements detailing what the organization intends to accomplish within a certain period of time. a) If goals and objectives are not specific and measurable, they cannot be translated into dollar costs, and financial planning cannot proceed. 2. Budgeting for Financial Needs. A budget is a financial statement that projects income and/or expenditures over a specified future period. a) Usually, the budgeting process begins with the construction of departmental budgets for sales and various types of expenses. b) Financial managers can combine each department’s budget for sales and expenses into a company-wide cash budget. (1) A cash budget estimates cash receipts and cash expenditures over a specified period. c) Figure 19.4 shows a typical cash budget for a retailer. d) Most firms use one of two approaches to budgeting. (1) In the traditional approach, each new budget is based on the dollar amounts contained in the budget for the preceding year. These amounts are modified to reflect any revised goals and managers are required to justify only new expenditures. The problem with this approach is that it leaves room for padding budget items to protect the (sometimes selfish) interests of the manager or his or her department. (2) Zero-based budgeting is a budgeting approach in which every expense in every budget must be justified. Teaching Tip: Ask students how much time they think it would take them each week if they had to justify each purchase they made. e) To develop a plan for long-term financing needs, managers often construct a capital budget that estimates a firm’s expenditures for major assets, including new product development, expansion of facilities, replacement of obsolete equipment, and mergers and acquisitions. 3. Identifying Sources of Funds. The four primary sources of funds, listed in Figure 19.3, are sales revenue, equity capital, debt capital, and proceeds from the sale of assets. a) Future sales revenue generally provides the greatest part of a firm’s financing. b) A second type of funding is equity capital. For a sole proprietorship or partnership, equity capital is provided by the owner or owners of the business. For a corporation, equity capital is money obtained from the sale of shares of ownership in the business. Equity capital is used almost exclusively for long-term financing. c) A third type of funding is debt capital, which is borrowed money. Debt capital may be borrowed for either short- or long-term use. d) A fourth type of funding is the proceeds from the sale of assets. Selling assets is a drastic step but it may be a reasonable last resort when sales revenues are declining and equity capital or debt capital cannot be found. Assets may be sold when they are no longer needed or don’t “fit” with the company’s core business. B. Monitoring and Evaluating Financial Performance. It is important to ensure that financial plans are being implemented and to catch potential problems before they become major ones. 1. Interim budgets (weekly, monthly, or quarterly) may be prepared for comparison purposes. 2. These comparisons point up areas that require additional or revised planning—or at least those areas calling for more careful investigation. IV. SOURCES OF SHORT-TERM DEBT FINANCING. Typically, short-term debt financing is money that will be repaid in one year or less. During the economic crisis, many business firms found that it was much more difficult to borrow money for short periods of time to purchase inventory, buy supplies, pay salaries, and meet everyday expenses. Today, the amount of available short-term financing has increased. The decision to borrow money does not necessarily mean that a firm is in financial trouble. On the contrary, astute financial management often means regular, responsible borrowing of many different kinds to meet different needs. A. Sources of Unsecured Short-Term Financing. Short-term financing is usually easier to obtain than long-term debt financing for three reasons. 1. For the lender, the shorter repayment period means less risk of nonpayment. 2. The dollar amounts of short-term loans are usually smaller than those of long-term loans. 3. A close working relationship normally exists between the short-term borrower and the lender. Most lenders do not require collateral for short-term financing. When they do, it is usually because they are concerned about the size of a particular loan, the borrowing firm’s poor credit rating, or the general prospects of repayment. Unsecured financing is financing that is not backed by collateral. A company seeking unsecured short-term financing has several options. 1. Trade Credit. Manufacturers and wholesalers often provide financial aid to retailers by allowing them 30 to 60 days (or more) in which to pay for merchandise. Trade credit is a type of short-term financing extended by a seller who does not require immediate payment after delivery of merchandise. a) It is the most popular form of short-term financing; 70 to 90 percent of all transactions between businesses involve some trade credit. b) The seller may offer a cash discount to encourage prompt payment. c) The terms of a cash discount are specified on the invoice. A common cash discount is 2/10, n/30 which means that the customer may take a 2 percent discount if it pays the invoice within ten days of the invoice date. If payment is made between 11 and 30 days after the date of the invoice, the customer must pay the entire amount. 2. Promissory Notes Issued to Suppliers. A promissory note is a written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date. Although repayment periods may extend to one year, most short-term promissory notes are repaid in 60 to 180 days. a) A promissory note offers two important advantages to the firm extending the credit: (1) A promissory note is a legally binding and enforceable document. (2) A promissory note is a negotiable instrument. This means that the firm extending credit may be able to discount or sell the note to its own bank. If the note is discounted, the dollar amount received by the company extending credit is slightly less than the maturity value because the bank charges a fee for the service. The supplier recoups most of its money immediately, and the bank collects the maturity value when the note matures. 3. Unsecured Bank Loans. Banks and other financial institutions offer unsecured short-term loans to businesses at interest rates that vary with each borrower’s credit rating. a) The prime interest rate is the lowest rate charged by a bank for a short-term loan. Figure 19.5 traces the fluctuations in the average prime rate charged by U.S. banks from 1990 to January 2012. (1) The lowest rate is generally reserved for large corporations with excellent credit ratings. (2) Organizations with good to high credit ratings may pay the prime rate plus “2” percent; firms with questionable credit ratings may have to pay the prime rate plus 4 percent. (3) If the banker feels loan repayment may be a problem, the borrower’s loan application may be rejected. b) When a business obtains a short-term bank loan, interest rates and repayment terms may be negotiated. (1) As a condition of the loan, a bank may require that a compensating balance be kept on deposit at the bank. Compensating balances are typically 10 to 20 percent of the borrowed funds. (2) The bank may also require that every commercial borrower clean up (pay off completely) its short-term loans at least once each year and not use it again for a period of 30 to 60 days. 4. Commercial Paper. Commercial paper is a short-term promissory note issued by a large corporation. The maturity date for commercial paper is normally 270 days or less. a) Commercial paper is secured only by the reputation of the issuing firm; no collateral is involved. b) The interest rate a corporation pays when it sells commercial paper is tied to its credit rating and its ability to repay the commercial paper. In most cases, corporations selling commercial paper pay interest rates slightly below the interest rates charged by banks for short-term loans. c) Although it is possible to purchase commercial paper in smaller denominations, larger amounts ($100,000 or more) are common. (1) Money obtained by selling commercial paper is most often used to purchase inventory, finance a firm’s accounts receivable, pay salary and other necessary expenses, and solve cash-flow problems. B. Sources of Secured Short-Term Financing. If a business cannot obtain enough capital through unsecured financing, it must put up collateral to obtain additional short-term financing. Almost any asset can serve as collateral, but inventories and accounts receive-able are the assets most commonly pledged for short-term financing. 1. Loans Secured by Inventory. Finished goods, raw materials, and work-in-process inventories may be pledged as collateral for short-term loans. Lenders prefer the much more salable finished goods. a) A lender may insist that inventory used as collateral be stored in a public warehouse. (1) The receipt issued by the warehouse is retained by the lender, and without this receipt, the public warehouse will not release the merchandise. (2) The lender releases the warehouse receipt—and the merchandise—to the borrower when the borrowed money is repaid. (3) In addition to paying the interest on the loan, the borrower must pay for storage in the public warehouse. b) This type of loan is more expensive than an unsecured short-term loan. 2. Loans Secured by Receivables. Accounts receivable are amounts owed to a firm by its customers. A firm can pledge its accounts receivable as collateral to obtain short-term financing, and a lender may advance 70 to 80 percent of the dollar amount of the receivables. a) A lender first conducts a thorough investigation to determine the quality of the receivables—the credit standing of the firm’s customers, coupled with their ability to repay their credit obligations when due. b) When the borrowing firm collects from a customer whose account has been pledged as collateral, it must turn the money over to the lender as partial repayment of the loan. c) An alternative approach is to notify the borrower’s credit customers to make their payments directly to the lender. C. Factoring Accounts Receivable. Accounts receivable can be sold to a factoring company, or factor. A factor is a firm that specializes in buying other firms’ accounts receivable. The factor buys the accounts receivable for less than their face value, but it collects the full dollar amount when each account is due. The factor’s profit is the difference between the face value of the accounts receivable and the amount the factor has paid for them. The amount of profit the factor receives is based on the risk the factor assumes. Risk in this case is the probability that the accounts receivable will not be repaid when they mature. Even though the firm selling its accounts receivable gets less than face value, it receives needed cash immediately and it has shifted the task of collecting and the risk of nonpayment to the factor, which now owns the accounts receivable. Generally, customers whose accounts receivables have been factored are given instructions to make their payments directly to the factor. D. Cost Comparisons. Table 19.2 compares the various types of short-term financing. V. SOURCES OF EQUITY FINANCING. Sources of long-term financing vary with the size and type of business. A sole proprietorship or partnership acquires equity capital (sometimes referred to as owners’ equity) when the owner or owners invest money in the business. For corporations, equity-financing options include the sale of stock and the use of profits not distributed to owners. All three types of businesses can also obtain venture capital. A. Selling Stock. Some equity capital is used to start every business—sole proprietorship, partnership, or corporation. In the case of corporations, equity capital is provided by stockholders who buy shares in the company. 1. Initial Public Offering and the Primary Market. An initial public offering (IPO) occurs when a corporation sells common stock to the general public for the first time. a) Established companies that plan to raise capital by selling subsidiaries to the public can also use IPOs. Moneys from the IPO will be used to increase the parent company’s cash balance and provide funding for growth opportunities and expansion. (1) In addition to using an IPO to increase the cash balance for the parent company, corporations often sell shares in a subsidiary when shares can be sold at a profit or when the subsidiary no longer fits with its current business plan. (2) Some corporations will sell a subsidiary that is growing more slowly than the rest of the company’s operating divisions. b) When a corporation uses an IPO to raise capital, the stock is sold in the primary market. The primary market is a market in which an investor purchases financial securities directly from the user of the securities. c) An investment banking firm is an organization that assists corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities. d) Although a corporation can have only one IPO, it can sell additional stock after the IPO assuming that there is a market for the company’s stock. e) Even though the cost of selling stock (often referred to as flotation costs) is high, the ongoing costs associated with this type of equity financing are low for two reasons. (1) The corporation doesn’t have to repay money obtained from the sale of stock. (2) The corporation is under no legal obligation to pay dividends to stockholders. A dividend is a distribution of earnings to the stockholders of a corporation. For any reason (for example, if a company has a bad year), the board of directors can vote to omit dividend payments. Earnings are then retained for use in funding business operations. 2. The Secondary Market. Although a share of corporate stock is only sold one time in the primary market, the stock can be sold again and again in the secondary market. The secondary market is a market for existing financial securities that are traded between investors. Although a corporation does not receive money each time its stock is bought or sold in the secondary market, the ability to obtain cash by selling stock investments is one reason why investors purchase corporate stock. Without the secondary market, investors would not purchase stock in the primary market because there would be no way to sell shares to other investors. Usually, secondary-market transactions are completed through a securities exchange or over-the-counter (OTC) market. a) A securities exchange is a marketplace where member brokers meet to buy and sell securities. Generally, securities issued by larger corporations are traded at the New York Stock Exchange (NYSE) (now owned by the NYSE Euronext holding company) or at regional exchanges located in different parts of the country. Securities of very large corporations may be traded at more than one of these exchanges. Securities of firms may also be listed on foreign securities changes. b) Stocks issued by several thousand companies are traded in the OTC market. The over-the-counter (OTC) market is a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange. Most OTC securities today are traded through an electronic exchange called the Nasdaq (National Association of Securities Dealers Automated Quotations). (1) The Nasdaq is now one of the largest securities markets in the world and is known for its forward-looking, innovative growth companies, including Microsoft, Cisco Systems, and Dell Computer. c) There are two types of stock: common and preferred. Each has advantages and disadvantages as a means of long-term financing. 3. Common Stock. A share of common stock represents the most basic form of corporate ownership. In return for the financing provided by selling common stock, management must make certain concessions to stockholders that may restrict or change corporate policies. a) Every corporation must hold an annual meeting, at which the holders of common stock may vote for the board of directors and approve or disapprove major corporate actions. Among such actions are the following: (1) Amendments to the corporate charter or by-laws (2) Sale of certain assets (3) Mergers and acquisitions (4) New issues of preferred stock or bonds (5) Changes in the amount of common stock issued b) Few investors will buy common stock unless they believe their investment will increase in value. 4. Preferred Stock. The owners of preferred stock must receive their dividends before holders of common stock receive theirs. Preferred stockholders know the dollar amount of their dividend because it is stated on the stock certificate. a) Preferred stockholders have first claim (after creditors) on assets if the corporation is dissolved or declares bankruptcy. b) The board of directors must approve dividends on preferred stock, and this type of financing does not represent a debt that must be legally repaid. c) In return for preferential treatment, preferred stockholders generally give up the right to vote at the annual meeting. d) Although a corporation usually issues one type of common stock, it may issue many types of preferred stock with varying dividends or dividend rates. B. Retained Earnings. Most large corporations distribute only a portion of their after-tax earnings to shareholders. The portion of a corporation’s profits that is not distributed to stockholders is called retained earnings. Because retained earnings are undistributed profits, they are considered a form of equity financing. 1. The amount of retained earnings in any year is determined by corporate management and approved by the board of directors. 2. Most small and growing corporations pay no cash dividend—or a very small dividend—to their shareholders. Earnings are reinvested in the business for research and development, expansion, or the funding of major projects. Reinvestment tends to increase the value of the firm’s stock while it provides essentially cost-free financing for the business. 3. More mature corporations may distribute 40 to 60 percent of their after-tax profits as dividends. Utility companies and other corporations with very stable earnings often pay out as much as 80 to 90 percent of what they earn. 4. For a large corporation, retained earnings can amount to a hefty bit of financing. C. Venture Capital and Private Placements. To establish a new business or expand an existing one, an entrepreneur may try to obtain venture capital. Venture capital is money invested in small (and sometimes struggling) firms that have the potential to become very successful. 1. Most venture capital firms do not invest in the typical small business but in firms that have the potential to become extremely profitable. 2. Generally, a venture capital firm consists of a pool of investors, a partnership established by a wealthy family, or a joint venture formed by corporations with money to invest. In return for financing, these investors generally receive an equity or ownership position in the business and share in its profits. 3. Venture capital firms vary in size and scope of interest. Some offer financing for start-up businesses, while others finance only established businesses. 4. Another method of raising capital is through a private placement—when stocks and other corporate securities are sold directly to insurance companies, pension funds, or large institutional investors. a) Private placements often have fewer government regulations and lower costs compared with selling stocks and other corporate securities. b) Typically, terms between the buyer and seller are negotiated in a private placement. VI. SOURCES OF LONG-TERM DEBT FINANCING. Businesses borrow money on a short-term basis for many valid reasons. There are equally valid reasons for long-term borrowing. Successful businesses often use the financial leverage created by borrowing money to improve their financial performance. Financial leverage is the use of borrowed funds to increase the return on owners’ equity. The principle of financial leverage works as long as a firm’s earnings are larger than the interest charged for the borrowed money. Table 19.3 illustrates how financial leverage can increase a firm’s return on owners’ equity. The most obvious danger when using financial leverage is that the firm’s earnings may be lower than expected. If this situation occurs, the fixed interest charge actually works to reduce or eliminate the return on owners’ equity. Additionally, borrowed money eventually must be repaid. For a small business, long-term debt financing is generally limited to loans. Large corporations have the additional option of issuing corporate bonds. A. Long-Term Loans. Many businesses finance their long-range activities with loans from commercial banks, insurance companies, pension funds, and other financial institutions. (See Table 19.1.) 1. Term-Loan Agreements. When the loan repayment period is longer than one year, the borrower must sign a term-loan agreement. A term-loan agreement is a promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual installments. a) Long-term business loans are normally repaid in three to seven years. b) The interest rate and other specific terms are often based on such factors as the reasons for borrowing, the borrowing firm’s credit rating, and the value of collateral. c) Although long-term loans may occasionally be unsecured, the lender usually requires some type of collateral. d) Lenders may also require that borrowers maintain a minimum amount of working capital. 2. The Basics of Getting a Loan. Preparation is the key when applying for a long-term business loan. a) To begin, you should get to know potential lenders before requesting debt financing. The logical place is where your business does its banking. b) Before applying for a loan, you may also want to check your firm’s credit rating with a national credit bureau such as D&B (formerly known as Dun & Bradstreet). c) Typically, business owners will be asked to fill out a loan application, and the lender will also want to see your current business plan that explains what your business is, how much funding you require to accomplish your goals, and how the loan will be repaid. d) Most lenders insist that you submit current financial statements that have been prepared by an independent certified public accountant. e) Compile a list of references that includes your suppliers, other lenders, or the professionals with whom you are associated. You may also be asked to discuss your loan request with a loan officer. f) If your loan request is not approved, determine why it was rejected and what you could do to improve your chances of getting a loan the next time you apply. Teaching Tip: Consider using the “To Lease or to Buy—That Is the Question” exercise here. A handout for this 10- to 15-minute exercise is provided. B. Corporate Bonds. In additions to loans, large corporations may choose to issue bonds in denominations of $1,000 to $50,000. One of the reasons why corporations sell bonds is so that they can borrow a lot of money from a lot of different bondholders and raise larger amounts of money than could be borrowed from one lender. A corporate bond is a corporation’s written pledge that it will repay a specified amount of money with interest. Interest rates for corporate bonds vary with the financial health of the company issuing the bond. Specific factors that increase or decrease the interest rate that a corporation must pay when it issues bonds include: • The corporation’s ability to pay interest each year until maturity • The corporation’s ability to repay the bond at maturity The maturity date is the date on which the corporation is to repay the borrowed money. Today, most corporate bonds are registered bonds. A registered bond is a bond registered in the owner’s name by the issuing company. Many corporations do not issue actual bonds; instead, the bonds are recorded electronically. Until a bond’s maturity, a corporation pays interest to the bond owner at the stated rate. 1. Types of Bonds. Corporate bonds are generally classified as debentures, mortgage bonds, or convertible bonds. Most corporate bonds are debenture bonds. a) A debenture bond is a bond backed only by the reputation of the issuing corporation. b) A mortgage bond is a corporate bond secured by various assets of the issuing firm. Typical corporate assets that are used as collateral for a mortgage bond include real estate, machinery, and equipment that are not pledged as collateral for other debt obligations. c) A convertible bond can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. A corporation can gain in three ways by issuing convertible bonds. (1) First, convertibles usually carry a lower interest rate than nonconvertible bonds. (2) Second, the conversion feature attracts investors who are interested in the speculative gain that conversion to common stock may provide. (3) Third, if the bondholder converts to common stock, the corporation no longer has to redeem the bond at maturity. 2. Repayment Provisions for Corporate Bonds a) Maturity dates for bonds generally range from 10 to 30 years after the date of issue. Some bonds are callable before the maturity date; that is, a corporation can buy back or redeem them. (1) Corporations usually pay the bond owner a call premium. (2) The amount of the call premium is specified, along with other provisions, in the bond indenture. The bond indenture is a legal document that details all the conditions relating to a bond issue. b) Before deciding if bonds are the best way to obtain corporate financing, managers must determine if the company can afford to pay the interest on the bonds. c) Corporate bonds must be redeemed at face value at maturity. If the corporation defaults on either of these payments, owners of bonds could force it into bankruptcy. d) A corporation may use one of three methods to ensure that it has sufficient funds available to redeem a bond issue. (1) It can issue the bonds as serial bonds—bonds of a single issue that mature on different dates. (2) It can establish a sinking fund—a sum of money to which deposits are made each year for the purpose of redeeming a bond issue. (3) It can pay off an old bond issue by selling new bonds. e) A corporation that issues bonds must also appoint a trustee—an individual or independent firm that acts as the bond owners’ representative. C. Cost Comparisons. Table 19.4 compares the different types of long-term equity and debt financing. 1. Selling common stock to generate funds is generally a popular option for most financial managers. Once the stock is sold and upfront costs are paid, the ongoing costs of using stock to finance a business are low. 2. The type of long-term financing that generally has the highest ongoing costs is a long-term loan (debt). 3. To a great extent, firms are financed through the investments of individuals—money deposited in banks or used to purchase stocks, mutual funds, and bonds. Instructor Manual for Business William M. Pride, Robert J. Hughes, Jack R. Kapoor 9781133595854, 9780538478083, 9781285095158, 9781285555485, 9781133936671, 9781305037083
Download
Close
Close
