chapter 14 understanding financial contracts. financial contracts business borrow funds from the...

Chapter 14

Understanding Financial Contracts

Financial Contracts

Business borrow funds from the financial markets primarily through two ways:

Direct Financing Directly from savers Issuing traded securities

Indirect Financing Through financial intermediaries Issuing non-traded securities

Financial contracts are written between lenders and borrowers

Financial Contracts

Non-traded financial contracts Tailor-made to fit the characteristics of the borrower

Lenders tend to hold these securities until maturity

Financial Contracts

Publicly traded financial contracts Standardized Suitable to meet the needs of large number of investors

Lenders may not hold these securities until maturity

In this case, they will only receive holing period returns

Financial Contracts

Features of Financial Contracts Describes how instruments/securities are originated

Describes terms of contract Maturity Interest rates

Describes restrictive covenants

Why Business Needs Financing

Common Reasons for Financing To finance permanent assets such as plant and equipment

To finance working capital Inventory accounts receivable

To finance payroll To finance the acquisition of another business

Financing Small Businesses

Definition of Small Business Assets size: less than $10 million

Most of them are privately owned Therefore, do not issue stocks Ownership concentrated in a single family


Features of Small Business Financing Profitable ones often have sufficient capital to be self-financing

Generally, do not need external financing beyond trade credit Delayed payment offered by suppliers

Banks are most likely source of external financing


Features of Small Business Financing Receives funds from banks in two forms: Negotiated Short-term loan Line of credit (L/C)


Short Term Loans Negotiated contract with short maturity

One time, needs renegotiation each time loans are extended

Typical maturity is 90 days of less


Line of Credit (L/C) Bank extends a credit for specified period of time

The borrowing firm draws down funds against L/C

Provides a continuous source for working capital

Removes uncertainty of denials or credit rationing Credit Rationing: A situation when banks curtails issuance of new loans often in response information asymmetry

Financing Small Business

Origination Mechanism Locate a bank that meets business’s needs

Usually through a referral (bank’s accountant)

Origination involves three steps: Credit analysis Negotiation of terms Loan approval or Denial

Origination Mechanism


Credit Analysis Reviewing of financial statements by a loan officer

Visiting the place of business Assessing managerial strengths Future growth potential and cash flow projection

Seeking additional information about the firm

Obtaining credit report on the firm Addressing any other concerns with the borrower


Negotiation Phase Borrower and bank negotiate terms of the loan

Loan Approval Small loans can be approved by a loan officer

Larger loans are approved by more senior officers

Above a certain amount must get approval from loan committee


Unique Features Loans have shorter maturity (rarely exceeds 5 years)

Loans are often secured (collateralized): Pledging of assets against the loan Owner often pledges personal assets as collateral and be personally liable for any unpaid balance

Bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to recoup the balance

During application period and after the loan is granted, a personal relationship between bank and borrower is developed


Unique Features Loan contains restrictive covenants

Covenant: Restrictions placed by the lender on future actions and strategies of the borrowing firm

Designed to make sure that firm does not become risky

An audited financial statement is required to verify the convents are not been broken

When covenants are broken, bank may demand immediate payment of loan

Possible for the borrower to renegotiate the terms of the loan to reflect higher risk

Financing Midsize Businesses

Definition of Midsize Business Assets between $10 million and $150 million

Owner managed or managed by someone other than the owner

Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market

Some are publicly owned that issue equity or stocks traded in the over-the-counter market


Features For short-term debt, primarily rely on commercial banks

May rely on a local or non-local bank May have restrictive covenants May be required to pledge collateral For long-term debt, commercial bank may combine a line of credit with intermediate-term loan known as Revolving Line of Credit


Long Term Debt Financing Forms of financing:

Through non-bank institutionsThrough Private Placement Market

Long Term Debt Financing

Non-Bank Institutions Mezzanine debt funds provide loans to smaller midsize companies

Recall, these are financing that lie between straight debt and equity. Typical forms are: Combination of both debt and equity financing

Convertible Debt Subordinate Debt

Long Term Debt Financing

Private Placement Market Mid-size business issues bonds over $10 million

Sold only to financial institutions and high net worth investors with sophisticated knowledge of investment

Bonds do not have to be registered with the SEC

Public disclosure of information is not required

Private Placement Market

Features Generally not resold by original investor for at least two years

Covenants that are less restrictive than when borrowing from a bank

Terms can be renegotiated one or more times during the life span of the loan if the company wishes to embark on a new strategy


Origination Structured and marketed by an agent, commercial banks or investment banks

Due diligence: the agent handling the private placement evaluates the firm’s management, financial condition, and business capabilities

Credit Rating: Based on due diligence, the placement issue will receive a formal credit rating which measures the perceived risk from a rating agency (such as NAIC)

Private Placement Origination.


Origination Contract Construction The terms of the contract including interest rate, maturity, covenants, and any special features are negotiated to make it attractive to investors

Offering memorandum and Term sheet containing information of the issuing firm and the contract terms are sent to prospective investors

Once the issue is placed, the investors do their own due diligence which verifies the information in the issue

Financing Large BusinessesFeatures Large firms are the ones with assets in excess of $150 million

Cost effective to enter the public bond market Public bonds are liquid. Issuer receives a Liquidity Premium (offer a lower interest rate)

However, public bond issues can be costly For Issues more than 100m, gain from liquidity premium can more than offset the cost of public bond issuance

Financing Large Businesses

Cost of Issuing Public Bond Distribution cost: costs to sell to a wider range of investors

Registration cost: costs associated with registering the bond with the SEC

Underwriting cost: costs of issuing and marketing a public issue

Securities Underwriting

Underwriting Process: Issuer selects an underwriter, generally an investment bank or a commercial bank to assist in issuing and marketing the bond

Underwriters also market their services to companies large enough to issue in the public market

Underwriter does due diligence on the issuer and comes up with two items: Registration Statement Offering (preliminary) prospectus

Securities Underwriting.

Securities Underwriting

Registration Statement Must conform disclosure requirements Certified by underwriter, accountants, and issuing firm’s attorneys

The registration statement must be approved by the SEC before distribution

Offering (preliminary) prospectus Must contain relevant factual information about the firm and its financing history

Role of Underwriter

Underwriting syndicate Formed by the managing underwriter to share responsibility of Distribution the issue Underwriting risk

Underwriter provides a firm commitment to sell the issue at a commitment price

Involves extensive market research Ability to attract institutional investors

Role of Underwriter

Underwriting Spread The difference between the offering price and the commitment price

Serves as the profit to underwriters Underwriting risk Occurs when the underwriters make a firm commitment to sell the bonds at an agreed price (implied interest rate)

If bonds sell below this price, underwriter takes a loss


Shelf Registration Permits the issuer of a public bond to register a dollar capacity with the SEC

This avoids lengthy registration time Permits issuers to respond instantaneously to changing market conditions

Draw down on this capacity by calling for competitive bids from investment bankers

Whenever underwriting syndicate is formed after the winning the bid, it is called a bought deal


Summary For short-term financing, Large companies with good credit ratings tend to rely on commercial paper market

Very large businesses may be able to issue medium-term notes.

For long-term financing, they issue public bond or equities through underwriters

Equity issues are much less frequent than bond

Equity issuance requires larger syndicate and enable higher profits to investment bankers.

Economics of Financial Contracting

Why do firms of different size rely on different financial contracts to raise funds Transactions costs Asymmetric information

Asymmetric Information

Adverse Selection Caused by asymmetric information before a transaction is consummated

Bank loan officer cannot easily tell the difference between high and low quality borrowers

Part of the loan officer’s job is to use credit analysis to uncover relevant information

Asymmetry of information is particularly acute for small firms since there is little publicly available information

Asymmetric Information

Moral Hazard Occurs after the loan is made Loan contract may provide the firm an incentive to pursue actions that take advantage of the lender If the firm does very well, the owner does not pay more to the issuer of the bank loan

If the firm does poorly, the owner’s liability is limited to the terms of the loan

Therefore, owners disproportionately share in the upside of increased risk, while lenders disproportionately share in the downside


Large firms Relatively easy to observe Labor contracts are often public knowledge

Supplier relationships are often well known

Marketing success or failure is well documented

Cares about its reputation and therefore, motivated to not switch to high risk activities


Large firms Public markets for stocks and bonds will generally reflect true riskiness of investment.

Prices and yields for large firms will be determined accordingly


Small firms External reputations are difficult to establish

Most activities are beyond the public’s scrutiny

Need proxies to demonstrate they are low risk and committed to not shifting their risk profiles


Small firms Some common proxies include:

Outside collateral or personal guarantees plays an important role

Inside collateral, bank files a lien against collateral

Loan covenants prevent risk shifting by explicitly constraining borrower behavior


Small firms Cannot enter into long-term debt contracts

Small business are made on a short-term basis


Midsize Companies Their information problems lie between small and large size companies

More visible publicly than small, but more informationally opaque than large companies

Still need a financial intermediary at the origination stage to address adverse selection problems and design a tailor-made contract

May have access to long-term debt in the private placement market

chapter 14 understanding financial contracts. financial contracts business borrow funds from the...

Documents