18-1

Financial Management

Chapter 18

Chapter 18 ObjectivesAfter studying this chapter, you will be able to:

• Identify three fundamental concepts that affect financial decisions and identify the primary responsibilities of a financial manager.

• Describe the budgeting process, three major budgeting challenges, and the four major types of budgets.

• Compare the advantages and disadvantages of debt and equity financing and explain the two major considerations in choosing from financing alternatives.

18-2

Chapter 18 Objectives Cont.

• Identify the major categories of short-term debt financing.

• Identify the major categories of long-term financing.

• Describe the two options for equity financing and explain how companies prepare an initial public offering.

18-3

The Role of Financial Management

18-4

Financial Management: Planning for a firm’s money needs and managing the allocation and spending of funds.

•Balancing short-term and long-term demands

•Risk / return trade-off

•Balancing leverage and flexibility

Financial Management: Three Fundamental Concepts

1-5

Developing a Financial PlanFinancial Plan: A document that outlines the funds needed for a certain period of time, along with the sources and intended uses of those funds.

The financial plan takes its input from three information sources:

•Strategic plan

•Company’s financial statements

•External financial environment

1-6

Finding and Allocating Funds

1-7

Managing Accounts Receivable and Accounts Payable

1-8

Accounts Receivable:Amounts that are currently owed to a firm.

Accounts Payable:Amounts that a firm currently owes to other parties.

Monitoring the Working Capital Accounts

1-9

The Budgeting Process

• Budget: A planning and control tool that reflects expected revenues, operating expenses, and cash receipts and outlays.

• Top down: Top executives specify amount of money for each functional area.

• Bottom up: Individual supervisors add up amounts needed based on number of employees and expenses.

• Financial Control: The process of analyzing and adjusting the basic financial plan to correct for deviations from forecasted events.

18-10

Budgeting Challenges

18-11

The Budgeting Process

Hedging:Protecting against cost increases with contracts that allow a company to buy supplies in the future at designated prices.

Zero-Based Budgeting:A budgeting approach in which each year starts from zero and must justify every item in the budget, rather than simply adjusting the previous year’s budget amounts.

18-12

Types of Budgets

18-13

Types of Budgets

Start-up budget (launch budget) identifies all the money it will need to launch the business.

Operating budget (master budget) identifies all sources of revenue and coordinates the spending of those funds throughout the coming year.

Capital budget outlines expenditures for real estate, new facilities, major equipment, and other capital investments (Money paid to acquire something of permanent value in a business).

Project budget identifies the costs needed to accomplish a particular project.

1-14

Financing Alternatives

18-15

Debt versus Equity Financing

Debt financing; Arranging funding by borrowing money.

Equity financing; Arranging funding by selling ownership shares in the company, publicly or privately.

When choosing between debt and equity financing, companies consider a variety of issues; •prevailing interest rates •maturity•the claim on income •the claim on assets•desire for ownership control

1-16

Financing AlternativesShort-term financing is any financing that will be repaid within one year

Long-term financing is any financing that will be repaid in a period longer than one year.

A company’s cost of capital is the average rate of interest it must pay on its debt and equity financing.

The prime interest rate (often called simply the prime) is the lowest interest rate offered on short-term bank loans to preferred borrowers.

1-17

Financing Alternatives

Leverage:The technique of increasing the rate of return on an investment by financing it with borrowed funds.

Capital Structure :A firm’s mix of debt and equity financing.

1-18

Short-Term Financing Options

• Credit cards

• Trade credit

• Secured loans

• Unsecured loans

• Commercial paper

• Factoring and Accounts Receivables Auctions

18-19

Short-Term Financing Options

Credit cards are one of the most expensive forms of financing, but they are sometimes the only form available to business owners.

Trade credit, often called open-account purchasing, occurs when suppliers provide goods and services to their customers without requiring immediate payment.

1-20

Short-Term Financing Options

Secured loans are those backed by something of value, known as collateral, that may be seized by the lender in the event that the borrower fails to repay the loan.

Unsecured loans are ones that require no collateral. Instead, the lender relies on the general credit record and the earning power of the borrower.

1-21

Short-Term Financing Options

Compensating Balance:The portion of an unsecured loan that is kept on deposit at a lending institution to protect the lender and increase the lender’s return.

Line of Credit :An arrangement in which a financial institution makes money available for use at any time after the loan has been approved.

1-22

Short-Term Financing OptionsWhen businesses need a sizable amount of money for a short period of time, they can issue commercial paper—short-term promissory notes, or contractual agreements, to repay a borrowed amount by a specified time with a specified interest rate.

Businesses with slow-paying trade credit customers and tight cash flow have the option of selling their accounts receivable, a method known as factoring; where a company sells its accounts receivable to an intermediary that collects from the customer.

1-23

Sources of Long-Term Debt Financing

18-24

Sources of Long-Term Debt Financing

18-25

Long-Term Financing Options

Long-term loans, sometimes called term loans, can have maturities between 1 and 25 years or so, depending on the lender and the purpose of the loan.

The Five C’s

1-26

Long-Term Financing Options

Lease: An agreement to use an asset in exchange for regular payment; similar to renting.

Rather than borrowing money to purchase an asset, a firm may enter into a lease, under which the owner of an asset (the lessor) allows another party (the lessee) to use it in exchange for regular payments.

1-27

Long-Term Financing OptionsWhen a company needs to borrow a large sum of money, it may not be able to get the entire amount from a single source. Under such circumstances, it may try to borrow from many individual investors by issuing bonds—certificates that obligate the company to repay a certain sum, plus interest, to the bondholder on a specific date.

•Secured bonds

•Debentures

•Convertible bonds

•Sinking fund1-28

Corporate BondsSecured Bonds: Bonds backed by specific assets that will be given to bondholders if the borrowed amount is not repaid.

Debentures: Corporate bonds backed only by the reputation of the issuer.

Convertible Bonds: Corporate bonds that can be exchanged at the owner’s discretion into common stock of the issuing company

Sinking fund: When a corporation issues a bond payable by asinking fund, it must set aside a certain sum of money each year to pay the dept.

1-29

Equity Financing

• Venture capital

• Going public

Private Equity: Ownership assets that aren’t publicly

traded; includes venture capital.

18-30

Public Stock Offerings

1-31

Public Stock Offerings

1-32

Underwriter: A specialized type of bank that buys the shares from the company preparing an IPO and sells them to investors.

Prospectus: An SEC-required document that discloses required information about the company, its finances, and its plans for using the money it hopes to raise.