Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. CHAPTER 20 Financial Decisions and Risk Management

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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 entailed by each type.

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc More 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. Explain the difference between insurable and uninsurable risks Distinguish among the different types of business insurance.

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Financial Managers Responsible for planning & overseeing the financial resources of a firm including Cash flow management Financial control Financial planning

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Cash Flow Management Managing the pattern of 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Managing Short-Term (Operating) Expenses 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)

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Managing Long-Term 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 unique characteristics = financing challenges

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Short-Term Sources of Funds Allows firms to cover operational expenses and implement short-term plans Trade credit Secured and unsecured loans Commercial paper Factoring accounts receivable

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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”

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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 Excessive administrative burden of such loans 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Unsecured Short-Term Loans (1 of 3) 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 do not agree that the funds will always be available as needed

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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 (2 of 3)

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Unsecured Short-Term Loans (3 of 3) 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 $

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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.

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc The Risk-Return Relationship

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 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

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc The Risk-Management Process

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Risk Avoidance and Control Risk avoidance refusing to participate in risky ventures Risk control techniques to prevent losses, or minimize their impact Risk retention covering a firm’s unavoidable losses with its own risk Risk transfer transferring risk to another firm, or individual, often by contract

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Insurance Insurance companies return policyholders to their financial position before the loss Insurable risk criteria include: Predictability Casualty Unconnectedness Verifiability

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Liability Insurance Insurance that covers losses resulting from damage to people or property when the insured party is judged liable Employers are required to provide workers’ compensation coverage for workers who are permanently, or temporarily, disabled by job- related accidents or disease Approximately $10 to $15 of every $100 paid in premiums goes to cover losses due to fraud

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Property Insurance Covers losses resulting from physical damage to real estate or personal property Fire and allied lines: damage to property by fire, lightning, theft Marine: transportation insurance covering the act of transportation (water, land, or air) and the good being transported Others: title, business interruption, credit, co- insurance

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Life Insurance Pays benefits to the survivors of the policyholder Beneficiary person to whom the benefits of a life insurance policy are paid Includes whole life, term, endowments, universal, variable

Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc Business Life Insurance Policies Group life insurance for a group of people life insurance through an employee-based plan Key insurance insurance taken out by a firm on important staff members covers losses due to their death, or other departure