ZeePedia Add to Favourites   |   Contact us


Financial Management

<<< Previous SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING: Next >>>
 
img
Financial Management ­ MGT201
VU
Lesson 41
SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following
topics:
·  Financing (Short Term and Long Term Financing)
·  Lease Financing
In this lecture we shall continue our discussion of working capital financing and will discuss financing,
short and long term financing and lease financing.
Working Capital Financing:
·  Financial Managers spend More than 50% of their time on Working Capital Financing. This has
been observed in many companies. In other words, arrangement for funds to meet day-to-day
expenses like inventory, raw material supplies and miscellaneous expenses has great significance.
·  Sources of Financing
­  Permanent Financing:
Permanent Financing comes in two forms:
·  Long-term Loans / Bonds ­ Duration of this source is More Than 1 Year. It has
Low Risk for Firm but has High Cost
·  Common Equity / Stock - "Perpetual." By definition. Less Risk for Firm but
Highest Cost.
Recall here concepts of cost of debt and cost of equity we studied in capital structure to
decide which source of financing is better for firm and why?.
­  Temporary Financing:
Temporary financing also has two forms:
·  Short-term Loan (An example of working capital financing) ­ Duration of this
source is Less Than 1 Year i.e. 3 months, 6 months, 9 months, etc. Easier to obtain
than Long-term Loan as for long term loans many requirements like financial
statements and guarantees need to be fulfilled. Less costly than Long-term Loan
due to lower interest rate generally. But this interest costs is variable / uncertain as
you have to renew it each time and you are not sure whether you will get the same
lower interest rate as before. So More risky. Needs to be rolled over frequently so it
is less liquid.
·  Spontaneous Financing - Current Liabilities like Trade Credit and Accrued Taxes
(payable) and Wages payable form its base. Arise "Spontaneously" from day-to-day
operations. It is in the form of money you have to pay but have not paid yet to your
suppliers. It is free loan or credit on which you do not have to pay any interest. As
you do not know the amount of money you will have and when, there is Highest
Uncertainty / Risk. It has Least Cost (can be free!). But you cannot depend on it for
day-to-day expenses as this all is just your rough idea. You are not sure.
·
Tradeoff between Liquidity (Risk) & Profitability (Return)
­  High Current Assets means High Liquidity but Low Profitability. This is due to more
money tied in current assets that have low profitability.
­  Low Current Assets means High Profitability but High Risk. This is due to money tied
in fixed assets may not be available for payments as they come due.
­  High Long-term Debt means Low Risk of illiquidity but High Cost of Debt in form of
interest.
­  High Current Liabilities (or short-term Spontaneous Financing like Trade Debt) means
Low Cost but High Risk of illiquidity.
169
img
Financial Management ­ MGT201
VU
Graphical View of Financing
Maturity Matching Principle
Match the Maturity of Financing to Usage of Asset
Spontaneous
Value (Rupees)
TEMPORARY CURRENT ASSETS ­
Current
Usage Less than 1 Year
Liabilities &
Short Term
Financing
Short Term
Financing
& Long
Term
"PERMANENT" CURRENT ASSETS
Financing
­ Usage More than 1 Year
Long Term
Debt &
FIXED ASSETS ­
Equity
Usage More than 1 Year
Time (Months)
If a firm uses long term financing it has higher cost of financing comparatively due to high
interest cost of long term loans. Despite of this high cost you have low risk here due to surety of access
to money for a longer period. Current liabilities as a source of financing are not reliable as you have no
surety whether you will have same amount of money available next month for financing or less amount
of money or how much money. Also, if firm keeps continue this practice and do not pay its accounts
payable will raise so much after a period that it may go bankrupt.
How Much Liquidity to Keep?
·  Keep enough Liquidity to meet maturing short term obligations (i.e. Accounts Payable, Interest,
etc) on time. How much firm should keep of short term loans and how much of long term
loans? The decision is made keeping in view the following principles:
·
Hedging Principle (or Principle of Self-Liquidating Debt or MATURITY MATCHING)
­  Match Cash-flow characteristics of Asset being purchased with the maturity of the
Source of Financing used to buy the asset.
·
Example: Shoe Shop Owner can use Current Liability to finance seasonal expansion in
inventory during Eid Time. If he uses Long-term financing, then excess / surplus / IDLE
LIQUIDITY GIVING LOW / NO YIELD BUT COSTING INTEREST SO LOWER PROFITS.
Eid does not come each month. Shop owner needs extra money / inventory only for one month.
He should take short term loan. If he decides to take long term loan he will have to pay for extra
interest cost unnecessarily.
·
Another way of describing the hedging principle is Permanent Asset Investments should be
financed by Permanent Financing. Buy Temporary Assets through Temporary Financing.
­  Permanent Asset Investments: Fixed or Movable or EVEN CURRENT assets (i.e.
Inventory) that a firm plans to hold for > 1 Year. The economic life of such assets can
be more or less.
­  Temporary Assets: Current Assets that will be liquidated within 1 year. These are a
subset of current assets. Foe example, inventory in use for less than 1 year.
·
Example: Use Long Term Loan to buy a long term asset. Studio owner should Do NOT use
short-term loan (< 1 Year) to buy a sophisticated professional Sony Digital Camera costing
Rs.1.5 million which is expected to have an Economic Life of over 5 years and has a Payback
Period of 2 Years. Use Long Term Loan with Maturity over 2 Years so that there is sufficient
time to repay interest from cash flows of asset (i.e. Camera).
170
img
Financial Management ­ MGT201
VU
Working Capital Financing Policies:
Total Assets = Fixed assets + Permanent Current assets + Temporary Current assets.
­  Total assets steadily grow with life of healthy company.
­  Temporary Current fluctuates with time. Extra spontaneous inventory can be financed
by short-term debt financing or loan
This will help us to understand which kind of policy should firm adopt according to the kind of
assets a firm have.
·
3 Policies of Working Capital Financing (Based on Hedging Principle of Maturity
Matching)
­  Aggressive
·  Maximum Short-term financing at low cost (but risk of non-renewal)
·  Use short-term financing for Temporary Current Assets and even partly to buy
Permanent Current Inventory
­  Conservative
·  Maximum Long-term financing. Safe but higher interest costs.
·  Use long-term financing for Fixed Assets, entire Permanent Assets, and even
part of Temporary Current Assets
­  Moderate
·  Balance of Long and Short-term Financing. Based on Maturity Matching
Principle.
·  Long Term permanent Financing for Fixed assets like land, building,
warehouse, machinery and Permanent Current Assets only.
·  Spontaneous financing or short term financing is used for short term portion of
current assets
Long-term Debt Financing:
·  What Affects Financing Decisions (Factors influencing the choice of long term finance by
managers)
­  Capital Structure: match Actual Capital Structure to Optimum. "Sticky", non-smooth,
never-ending process. It is not one day work.
­  Maturity Matching (Hedging Principle): match maturity of debt to asset usage time
­  Interest Rates: get long-term financing if long-term interest rates are low
­  Financial Health & Credit-worthiness: get long-term financing while firm is still
healthy
·  Short-term Debt
­  Bank Loans: Maturity period < 1 Year. Collateral (security) required i.e. Property,
inventory, or a/c receivables.
­  Commercial Paper: unsecured promissory note issued by large, strong firm
·  Long-term Debt Financing (Maturity Longer than 1 Year)
The following are the forms of this loan:
­  Bank "Term Loans": > 1 Year
­  Bonds: Debentures vs. Mortgage vs. Floating Rate
­  Syndicated Loan: for large loans, one lead bank heading team of other banks. Due to
large amount of loan one bank alone cannot take the whole risk and liability.
­  Project Financing: for large international infrastructural projects i.e. Electric power
plants, dams, development of highways. Group of firms invest equity capital in a New
Project. Bank gives loan to New Project. In return, bank is repaid from cash flows of
the New Project. In fact, Bank gets the cash inflows first and then decides what to do
with them! No other collateral or security is provided. So individual assets of each of
individual firms is free. So bank protects itself by keeping control of all the cash flows.
­  Securitization: convert private debt contract into publicly traded financial instrument. A
large loan can be divided into smaller parts that are traded in the money markets.
171
img
Financial Management ­ MGT201
VU
Lease Financing
·  Leasing of Fixed Assets (Financing of Capital Expenditure in Fixed Assets)
­  Leasing Company (Lessor) buys and owns the asset and leases it to the Lessee
(Borrower) who can use, operate, and control the asset. Lessee pays Lease Rental to
Lessor in return. Lifespan of lease can vary from few days to years.
­  Like Collateralized Loan (where the leased asset is the collateral). Lease Contract is
just as serious as a loan agreement. Failure to pay lease rental is just like failure to pay
interest. Can bankrupt the Lessee (Borrower). Lessor (Lender or Leasing Company) can
seize the leased asset and, if the claim is larger, also demand up to 1 year lease rental.
­  Ownership vs. Control
­  Between 10-30% of fixed assets owned by Large Companies are leased i.e. Warehouses,
offices, equipment, machinery, computers, cars, furniture, airplanes!
·  General Advantages from Lessee's (Borrower / user) Point of View
It guides towards when lease financing should be used:
­  Less risky than investing large amount of money in fixed assets in a new businesses that
suffer from Cyclicality i.e. Airplanes.
­  More suitable for hi-tech assets that become Obsolete quickly like software houses
­  When product demand is uncertain and hence equipment life is uncertain.
­  Lender has to share portion of operational risk and maintenance costs e.g. IBM
172
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios