Finance CORPORATE FINANCE- METHODS OF FINANCING ENTERPRISES

Finance Lecture outline  The notion and goal of corporate finance  Sources of financing companies  Sources of capital in companies

Finance Corporate finance-definition  An area of finance focused on monetary flows in enterprises, on the ways of financing the companies’ activity and methods of financial analysis

Finance Financial decisions  Short term eg. settling current liabilities  Long term egg. fundraising, investments

Finance The goal of corporate finance  The goal depends on the legal form and activity profile of the company  Maximizing the company’s profit  Ensuring the company’s liquidity  Maximizing the company’s value

Finance Liquidity vs. solvency  Liquidity- the ability to settle current payments within the specified contract deadlines (short term)  Solvency- the ability to meet long term financial liabilities

The company’s value  Several ways of company valuation eg. asset based, income based, market based  The problem- which method reflects best the company’s value?  The most popular- discounted cash flow Finance

Financing the company’s activity  The company’s activity requires several types of resources  Monetary resources  Current assets  Fixed assets

Finance Financing the company’s activity  In the process of corporate financing there is constant transformation of monetary resources into assets and vice versa  E.g. the purchase of production infrastructure or the sell of manufactured goods

Finance Sources of financing  Internal sources e.g. the company’s profits, sell of assets  External sources- fundraising e.g. issuing bonds, issuing equity securities, bank loans

Finance Sources of capital (1)  Sources of capital ≠ sources of financing  Not every source of financing is a source of capital!  Monetary resources become capital only if they are invested!

Finance Sources of capital (2)  Own capital also called equity- contributed by the owner or entrepreneur  Borrowed capital- contributed by an external institution or person

Finance Own capital (equity)  Own capital does not have to be returned in contrast to borrowed capital  Therefore it is a safe source of financing  It constitutes a guarantee for the creditors  It enables the supervision of the shareholders/owners over the management

Finance Own capital-examples  Income derived from equity securities (shares) issuance –this is an external source of own capital  Income derived from the companies profit division –this is an internal source of own capital

Finance Borrowed capital- examples  Short term and long term loans  Income derived from the issuance of long term and short term debt securities eg. bonds

Capital provision process  Investors provide capital to the company and receive a rate of return (interest payments)  The company invests the capital during its activity and receives a rate of profitability  Providing capital enables the company to invest and not to achieve a monetary surplus therefore this process is different from just providing finance! Finance

The financial decisions of the company  Decisions concerning the sources of financing and the sources of capital  Decisions concerning investments  Decisions concerning revenue division (payment of dividends) Finance

The financing strategy (1)  External or internal financing  The choice of capital sources  The choice of instruments to raise capital

Finance The financing strategy (2)  The financing strategy depends on the specific financing need  E.g. Fixed assets should be financed by long term capital

The choice of capital source  Own or borrowed  Long term or short term  Domestic or international sources  Provided by financial markets or financial institutions  Balance sheet or off-balance sheet capital Finance

Capital structure  The choice of capital sources influences the capital structure  vital importance  For some types of companies there are regulatory requirements concerning capital structure

Finance Own or borrowed capital?  The most important decision is whether the company requires own or borrowed capital  This choice influences the division of future profits  The profit can constitute a future internal source of own capital  If the company has to pay dividends- it will need external sources of capital

Finance Long term or short term capital?  The share of long and short term capital depends on the structure of the assets of the company  Current assets  Fixed assets

Finance Assets  Fixed assets  Current assets Liabilities  Equity  Borrowed capital (interest payments)  Other liabilities (no interest payments)

Finance Long term or short term capital?  The capital requirement period should be synchronized with the period of the requirement of the assets which are financed by this capital  Fixed capital ≥ Fixed assets  Short term liabilities≤ current assets  This should ensure liquidity

Finance Why do companies raise capital abroad?  More investors compared to the domestic market  Higher market liquidity  Lower capital cost (lower interest payments, favorable regulations)  Diversification of capital sources  Company’s image

Finance What risk do firms face when raising capital abroad?  Exchange rate risk  the need of insurance  Currency mismatch- assets and liabilities held in different currencies  High start up costs on foreign financial markets

Finance Is it profitable to raise capital on financial markets ?  Broader access to capital  Higher liquidity of issued securities  Objective valuation of the company  Increasing credibility of the company  High entry costs  Disclosure requirements  Hostile takeover possibility

Finance Balance-sheet or off balance sheet capital?  Off-balance sheet capital- a tool of risk management  Off-balance sheet capital is a reserve for unforeseen circumstances e.g. in the case of indemnity payments

Finance Off- balance sheet capital- examples  Conditional financing- funds are provided if specified conditions are met e.g. a natural disaster takes place  Contingent capital  Catastrophe bonds

The meaning of capital provision  Capital provision determines the scope of economic activity  Potential measure-domestic credit to private sector  Financial resources provided to the private sector: loans, purchases of nonequity securities, trade credits Finance

Source:World Bank

Finance Literature R.W.Melicher, E.A.Norton, Introduction to Finance. Markets, Investments and Financial Management, John Wiley&Sons,2007