PowerPoint Presentation by Charlie Cook, The University of West Alabama © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. A Firm’s Sources of Financing PART 3 Developing the New Venture Business Plan

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–2 Basic Types of Financing Sources of Financing Spontaneous Financing Profit Retention External Financing

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–3 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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–4 Debt or Equity Financing? Tradeoffs Between Debt and Equity Potential Profitability Voting Control Financial Risk

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–5 Exhibit 12.1 Tradeoffs between Debt and Equity

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–6 Debt or Equity Financing? (cont’d) Return on AssetsReturn on Assets  Rate of return earned on a firm’s total assets invested  Computed as operating income ÷ total assets Return on EquityReturn on Equity  Rate of return earned on the owner’s equity investment  Computed as net income ÷ owner’s equity investment

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–7 Exhibit 12.3 Sources of Financing Funds

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–8 Exhibit 12.5 Sources of Personal Capital for Small Firms 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.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–9 Bank Financing Types of Loans Line of Credit Revolving Credit Agreement Mortgages Chattel Real Estate Term Loans

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–10 Understanding a Banker’s Perspective Bankers’ ConcernsBankers’ 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 CreditThe 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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–11 Questions Lenders Ask Lender’s Questions: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?

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–12 Financial Information Required for a Bank Loan Three years of the firm’s historical statementsThree years of the firm’s historical statements  Balance sheets, income statements, and statements of cash flow The firm’s pro forma financial statementsThe firm’s pro forma financial statements  The timing and amounts of the debt repayment included as part of the forecasts Personal financial statementsPersonal financial statements  The borrower’s personal net worth (assets – debts) and estimated annual income

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–13 Negotiating a Loan: Interest Rate Prime RatePrime Rate  Interest rate charged by a commercial bank on loans to its most creditworthy customers LIBOR (London InterBank Offered Rate)LIBOR (London InterBank Offered Rate)  Interest rate charged by London banks on loans to other London banks Fixed Interest RatesFixed Interest Rates  Interest rate remains the same for the term of the loan Floating Interest RatesFloating Interest Rates  Interest rate varies with the changes in the prime rate

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–14 Negotiating a Loan: Term of the Loan Loan Maturity DateLoan Maturity Date  Maturity date matched to use of funds Repayment ScheduleRepayment Schedule  Equal monthly or annual payments  Decreasing monthly or annual payments Loan CovenantsLoan Covenants  Bank-imposed restrictions on a borrower  Financial statements  Loan use restrictions and salary limits  Equity requirements  Personal guarantees by borrower

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–15 Business Suppliers and Asset-Based Lenders Accounts Payable (Trade Credit)Accounts Payable (Trade Credit)  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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–16 Business Suppliers and Asset-Based Lenders (cont’d) Equipment Loan and LeasesEquipment 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

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–17 Business Suppliers and Asset-Based Lenders (cont’d) Asset-Based LendingAsset-Based Lending  A line of credit secured by working-capital assets  Factoring  Obtaining cash by selling accounts receivable 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.  Purchase-order financing  Lender advances the amount of the borrower’s cost of goods sold for a specific customer order.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–18 Private Equity Investors Business AngelsBusiness Angels  Private individuals who invest in others’ entrepreneurial ventures. Informal Venture CapitalInformal Venture Capital  Funds provided by wealthy private individuals (business angels) to high-risk ventures Formal Venture CapitalistsFormal Venture Capitalists  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.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–19 The Government Small Business Administration (SBA) loansSmall 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)

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–20 The Government (cont’d) State and Local Government AssistanceState and Local Government Assistance  Loan guarantees help lower down payment.  Focus on enhancing specific industries or facilitating certain community goals. Community-Based Financial InstitutionsCommunity-Based Financial Institutions  Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12–21 Where Else to Look Large CorporationsLarge Corporations  Provide financing and technical assistance to critical suppliers and technology developers Stock SalesStock 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