PowerPoint Presentation by Charlie Cook The University of West Alabama Longenecker Moore Petty Palich © 2008 Cengage Learning. All rights reserved. CHAPTER 11 A Firm’s Sources of Financing Developing the New Venture Business Plan Part 3

© 2008 Cengage Learning. All rights reserved.11–2 Looking AHEAD 1.Describe how the nature of a firm affects its financing sources. 2.Evaluate the choice between debt financing and equity financing. 3.Identify the typical sources of financing used at the outset of a new venture. 4.Discuss the basic process for acquiring and structuring a bank loan. 5.Explain how business relationships can be used to finance a small firm. After you have read this chapter, you should be able to:

© 2008 Cengage Learning. All rights reserved.11–3 Looking AHEAD (cont’d) 6.Describe the two types of private equity investors that offer financing to small firms. 7.Distinguish among the different government loan programs available to small companies. 8.Explain when large companies and public stock offerings can be sources of financing. After you have read this chapter, you should be able to:

© 2008 Cengage Learning. All rights reserved.11–4 The Nature of a Firm and Its Financing Sources Firm’s economic potential Owner preferences for debt or equity Company size and maturity Factors That Determine Financing Types of assets

© 2008 Cengage Learning. All rights reserved.11–5 Debt or Equity Financing? Tradeoffs Between Debt and Equity Potential Profitability Voting Control Financial Risk

© 2008 Cengage Learning. All rights reserved.11–6 Tradeoffs Between Debt and Equity 11-1

© 2008 Cengage Learning. All rights reserved.11–7 Debt or Equity Financing? (cont’d) Return on Assets  Rate of return earned on a firm’s total assets invested, computed as operating income ÷ total assets Return on Equity  Rate of return earned on the owner’s equity investment, computed as net income ÷ owner’s equity investment

© 2008 Cengage Learning. All rights reserved.11–8 Debt Versus Equity at the Levine Company 11-2

© 2008 Cengage Learning. All rights reserved.11–9 Sources of Funds 11-3

© 2008 Cengage Learning. All rights reserved.11–10 Startup Financing for Inc. 500 Companies in Source: Mike Hofman, “The Big Picture,” Inc., Vol. 25, No. 12 (October 2003), p. 87. Copyright 2003 by Mansuelo Ventures LLC. Reproduced with permission of Mansuelo Ventures LLC in the format Textbook via Copyright Clearance Center.

© 2008 Cengage Learning. All rights reserved.11–11 Debt or Equity Financing? Sources Close to Home Personal Savings Credit Cards Family and Friends

© 2008 Cengage Learning. All rights reserved.11–12 Sources of Personal Capital for Small Firms 11-5 Source: Republished with permission of Dow Jones Inc. from Staff, “Entrepreneurship Monitor 2002,” Wall Street Journal, August 26, 2003, p. B8; permission conveyed through Copyright Clearance Center, Inc.

© 2008 Cengage Learning. All rights reserved.11–13 Bank Financing Types of Loans Line of Credit Revolving Credit Agreement Mortgages Chattel Real Estate Term Loans

© 2008 Cengage Learning. All rights reserved.11–14 Understanding a Banker’s Perspective Bankers’ Concerns  How much the bank will earn on the loan?  What is the likelihood that the lender will be able to repay the loan? The Five C’s of Credit  Character of the borrower  Capacity of the borrower to repay the loan  Capital invested in the venture by the borrower  Conditions of the industry and economy  Collateral available to secure the loan

© 2008 Cengage Learning. All rights reserved.11–15 Questions Lenders Ask Lender’s Questions 1. Do the purpose and amount of the loan make sense, both for the bank and for the borrower? 2. Does the borrower have strong character and reasonable ability? 3. Does the loan have a certain primary source of repayment? 4. Does the loan have a certain secondary source of repayment? 5. Can the loan be priced profitably to the customer and to the bank, and are this loan and the relationship good for both the customer and the bank? 6. Can the loan be properly structured and documented?

© 2008 Cengage Learning. All rights reserved.11–16 The Banker’s Concerns How much money is needed? What is the venture going to do with the money? When and how will the money be paid back? When will the money be needed?

© 2008 Cengage Learning. All rights reserved.11–17 Financial Information Required for a Bank Loan Three years of the firm’s historical statements  Balance sheets, income statements, and statements of cash flow The firm’s pro forma financial statements  The timing and amounts of the debt repayment included as part of the forecasts Personal financial statements  The borrower’s personal net worth (assets – debts) and estimated annual income

© 2008 Cengage Learning. All rights reserved.11–18 Negotiating a Loan: Interest Rate Prime Rate  Interest rate charged by a commercial bank on loans to its most creditworthy customers LIBOR (London InterBank Offered Rate)  Interest rate charged by London banks on loans to other London banks Fixed Interest Rates  Interest rate remains the same for the term of the loan Floating Interest Rates  Interest rate varies with the changes in the prime rate

© 2008 Cengage Learning. All rights reserved.11–19 Negotiating a Loan: Term of the Loan Loan Maturity Date  Maturity date matched to use of funds Repayment Schedule  Equal monthly or annual payments  Decreasing monthly or annual payments Loan Covenants  Bank-imposed restrictions on a borrower to encourage timely repayment  Financial statements  Loan use restrictions and salary limits  Equity requirements  Personal guarantees by borrower

© 2008 Cengage Learning. All rights reserved.11–20 Business Suppliers and Asset-Based Lenders Trade Credit (Accounts Payable)  Supplier-provided financing of inventory to a company, which sets up an account payable for the amount.  Short-duration financing (30 days)  Amount of credit available depends on type of firm and supplier’s willingness to extend credit

© 2008 Cengage Learning. All rights reserved.11–21 Business Suppliers and Asset-Based Lenders (cont’d) Equipment Loan and Leases  Installment loan (mortgage on equipment) from the seller of machinery purchased by a business.  Equipment leased from a supplier:  Frees up cash for other purposes  Leaves lines of credit open  Provides a hedge against obsolescence

© 2008 Cengage Learning. All rights reserved.11–22 Business Suppliers and Asset-Based Lenders (cont’d) Asset-Based Loan  A line of credit secured by working-capital assets Factoring  Obtaining cash by selling accounts receivable to another firm.  Accounts sold to factor at discount to invoice value.  Factor can refuse questionable accounts.  Factor charges fees for servicing accounts and for amount advanced to firm prior to collection.

© 2008 Cengage Learning. All rights reserved.11–23 Private Equity Investors Informal Venture Capital  Funds provided by wealthy private individuals (business angels) to high-risk ventures Formal Venture Capitalists  Individuals who form limited partnerships for the purpose of raising venture capital from large institutional investors  The firm’s expected profits in future years  The venture capitalist’s required rate of return.

© 2008 Cengage Learning. All rights reserved.11–24 The Government Small Business Administration (SBA) loans  The 7 (a) Guaranty Loan Program  SBA guarantees repayment of loan to lender  The Certified Development Company (CDC) 504 Loan Program  The 7(m) Microloan Program  Small Business Investment Companies (SBICs)  Small Business Innovative Research (SBIR)

© 2008 Cengage Learning. All rights reserved.11–25 The Government (cont’d) State and Local Government Assistance  Loan guarantees help lower down payment.  Focus on enhancing specific industries or facilitating certain community goals. Community-Based Financial Institutions  Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development.

© 2008 Cengage Learning. All rights reserved.11–26 Where Else to Look Large Corporations  Financing and technical assistance to critical suppliers and technology developers Stock Sales  Private placement  The sale of a firm’s capital stock to selected individuals  Initial public offering (IPO)  The issuance of stock that is to be traded in public financial markets  Places firm under SEC securities regulations

© 2008 Cengage Learning. All rights reserved.11–27 Key TERMS return on assets return on equity line of credit revolving credit agreement term loan chattel mortgage real estate mortgage prime rate LIBOR (London InterBank Offered Rate) balloon payment loan covenants limited liability accounts payable (trade credit) equipment loan asset-based loan factoring business angels informal venture capital formal venture capitalists 7(a) Loan Guaranty Program Certified Development Company (CDC) 504 Loan Program 7(m) Microloan Program small business investment companies (SBICs) Small Business Innovative Research (SBIR) Program community-based financial institution private placement initial public offering (IPO)