Copyright © 2006 Pearson Education Canada Inc Chapter 16 Financial Decisions and Risk Management

Copyright © 2006 Pearson Education Canada Inc Learning Objectives Describe the responsibilities of a financial manager Distinguish between short-term (operating) and long-term (capital) expenditures Identify four sources of short-term financing for businesses Distinguish among the various sources of long-term financing and explain the risks involved in each

Copyright © 2006 Pearson Education Canada Inc Learning Objectives Discuss some key issues in financial management for businesses Explain how risk affects business operations and identify the five steps in the risk-management process

Copyright © 2006 Pearson Education Canada Inc Financial Managers Responsible for planning & overseeing the financial resources of a firm including Finance Cash flow management Financial control Financial planning

Copyright © 2006 Pearson Education Canada Inc Cash Flow Management Managing the pattern in which cash inflows (revenues) and outflows (debt payments) Investing funds that are not needed to service debt Funds must either be committed to maintaining the firm, or earning interest, not sitting idle

Copyright © 2006 Pearson Education Canada Inc Financial Control Checking actual performance against strategic plans to ensure that desired goals are achieved Making adjustments as required when plans change, or do not work as intended Preparing budgets to ensure that sufficient cash is on hand to meet operational & debt service needs Actual results that vary from the budget need explanation and adjustment

Copyright © 2006 Pearson Education Canada Inc Financial Planning A plan for achieving a desired financial status in the future Projections of revenue flows Sources & planned uses of funds Timing of when funds will be required

Copyright © 2006 Pearson Education Canada Inc Short-Term (Operating) Expenditures Accounts payable Main source of short-term debt Accounts receivable Estimation of cash inflow Development of a policy to ensure timely payment Inventory: goods awaiting sale for future revenue Raw materials (unassembled product) Work-in-progress (goods being manufactured) Finished goods (goods completed and awaiting sale)

Copyright © 2006 Pearson Education Canada Inc Long-Term (Capital) Expenditures Funding assets, such as buildings, that have a long life and a lasting value Not normally sold or converted to cash Acquisition requires a large investment Ties up the firm’s resources for a long period of time

Copyright © 2006 Pearson Education Canada Inc Sources of Short-Term Funds Allows firms to cover operational expenses and implement short-term plans Trade credit Secured and unsecured loans Commercial paper Factoring accounts receivable

Copyright © 2006 Pearson Education Canada Inc Trade Credit Open book credit Sellers simply ship goods on credit, expecting that payment will follow Promissory note Buyers sign a promise-to-pay agreement before merchandise is shipped Trade draft Buyers sign a statement of payment terms attached to merchandise by the seller Once signed it is called a “trade acceptance”

Copyright © 2006 Pearson Education Canada Inc Secured Short-Term Loans A short-term loan for which the borrower is required to put up collateral If the borrower defaults, the collateral is seized Interest rates are usually lower than for unsecured loans Appeal to firms whose credit rating is not sufficient (or who are too new) to qualify for unsecured loans

Copyright © 2006 Pearson Education Canada Inc Unsecured Short-Term Loans Line of Credit A specified amount made available to the borrower for a short-term unsecured loan The borrower draws on funds as they are needed Banks may not have sufficient funds available as needed

Copyright © 2006 Pearson Education Canada Inc Unsecured Short-Term Loans Revolving Credit Agreements guaranteed line of credit the firm pays the bank interest on borrowed funds, as well as a fee for extending the line of credit banks guarantee availability of the funds the firm does not have to borrow funds if it doesn’t need them The bank charges a “commitment fee” for keeping the line of credit open for the firm

Copyright © 2006 Pearson Education Canada Inc Unsecured Short-Term Loans Commercial Paper a firm sells unsecured notes for less than their face value, then repurchases them in 30 to 270 days for the face value Investors make money on the spread between the face value and purchase price As an unsecured note, only creditworthy firms are able to sell them successfully The cost of commercial paper to the borrowing firm is usually less than prevailing interest rates

Copyright © 2006 Pearson Education Canada Inc Sources of Long-Term Funds Debt financing seeking long-term funds through borrowing from external sources Equity financing seeking long-term funds through internal financing

Copyright © 2006 Pearson Education Canada Inc Debt Financing Long-term loans Borrowing money for 3 to 10 years at a fixed or floating rate Loans are quick to process and do not require divulging business plans or the purpose for the loan Corporate bonds A promise by the borrower to pay the lender an amount of money on the maturity date Interest payments are received in the interim Assets may be pledged against the bond

Copyright © 2006 Pearson Education Canada Inc Equity Financing Common stock A firm sells ownership rights by issuing shares Investors buy the stock hoping that it will appreciate Retained earnings Financing by retaining money in the firm and not paying dividends to shareholders

Copyright © 2006 Pearson Education Canada Inc Hybrid Financing: Preferred Stock Preferred shares Require fixed payments as do bonds Unlike bonds, they do not have a maturity date Shareholders receive a dividend if the firm can afford it Preferred shareholders get paid first when dividends become available Preferred shareholders have no voting rights, so the control of the firm is not affected

Copyright © 2006 Pearson Education Canada Inc Comparing Debt and Equity Financing Debt FinancingConsiderationsEquity Financing Fixed deadline When must it be paid? No limit. Yes, regular and fixed. Will it make claims on income? Only residual claim. In liquidation, creditors come first. Will it have claims on assets? In liquidation, shareholders must wait until creditors are paid and preferred equity precedes common equity. NoWill it affect management control? May cause challenge for corporation control. Bond interest is tax deductible. How are taxes affected? Dividends are not tax deductible. Yes, many constraints. Will it affect management flexibility? No, few constraints.

Copyright © 2006 Pearson Education Canada Inc The Risk-Return Relationship

Copyright © 2006 Pearson Education Canada Inc Financial Management for Small Business Small business owners must strive to get credit, manage it well, build their credit rating, and manage cash flow in order to obtain financing at start-up and beyond arrange lines of credit organize trade credit

Copyright © 2006 Pearson Education Canada Inc Venture Capital External equity funding provided in return for part ownership in the borrowing firm Venture capital firms actively seek investment opportunities Favour firms with rapid growth potential Failure rates in new ventures are high, particularly those with rapid growth; therefore, investors demand high returns for their money

Copyright © 2006 Pearson Education Canada Inc Risk Management Conserving a firm’s financial power or assets by minimizing the financial effect of accidental losses Risk: uncertainty about future events Speculative risk: the chance for gain or loss Pure risk: only the chance of loss or Chance of a warehouse fire

Copyright © 2006 Pearson Education Canada Inc The Risk-Management Process

Copyright © 2006 Pearson Education Canada Inc Risk Avoidance and Control Risk avoidance Stopping participation in or refusing to participate in ventures that carry any risk Firm with delivery trucks could avoid any risk of physical damage or bodily injury by closing down its delivery service Pharmaceutical maker may withdraw a new drug for fear of liability suits

Copyright © 2006 Pearson Education Canada Inc Risk Avoidance and Control Risk control Techniques to prevent, minimize, or reduce losses or the consequences of losses Delivery firm use of loss-prevention techniques such as defensive-driving techniques, mapping out safe routes, and maintaining trucks

Copyright © 2006 Pearson Education Canada Inc Risk Avoidance and Control Risk retention Covering a firm’s unavoidable losses with its own risk Delivery firm with high rates of vandalism on its trucks may find it cheaper to pay for repairs out of pocket rather than submit claims to its insurance company

Copyright © 2006 Pearson Education Canada Inc Risk Avoidance and Control Risk transfer Transfer of risk to another firm, namely an insurance company or individual, often by contract In transferring risk to an insurance company, a firm pays a premium In return an insurance company issues an insurance policy to pay a specified amount in the event of certain losses