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  1. 1. Chapter 14 Understanding Financial Contracts
  2. 2. Introduction <ul><li>Chapter focuses on financial contracts between lenders and borrowers </li></ul><ul><li>Non-traded financial contracts are tailor-made to fit the characteristics of the borrower </li></ul><ul><li>In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract </li></ul>
  3. 3. Asymmetric Information <ul><li>Problems associated with the availability of information about the borrowers who seek funding. </li></ul>
  4. 4. How Business Obtains Financing <ul><li>Businesses need funds for a variety of reasons </li></ul><ul><ul><li>Finance permanent assets such as plant and equipment </li></ul></ul><ul><ul><li>Finance the acquisition of another business </li></ul></ul><ul><ul><li>Finance working capital —inventory or accounts receivable </li></ul></ul>
  5. 5. Financing Small Businesses <ul><li>Small firms—assets less than $10 million </li></ul><ul><li>Vast majority are privately owned with ownership concentrated in a single family </li></ul><ul><li>Generally do not need external financing beyond trade credit—delayed payment offered by suppliers </li></ul><ul><li>Profitable firms may have sufficient capital to be self-financing </li></ul><ul><li>Banks are most likely source of external financing </li></ul>
  6. 6. Banks Provide Funds <ul><li>Short-term loan—negotiated contract with short maturity </li></ul><ul><li>Line of Credit </li></ul><ul><ul><li>Bank extends a credit for specified period of time </li></ul></ul><ul><ul><li>The borrowing firm can draw down funds against L/C </li></ul></ul><ul><ul><li>Credit Rationing —insures borrower has access to funds even if bank would prefer to curtail new loans </li></ul></ul><ul><li>When financing capital assets the maturity of the loan is typically less than life span of the asset </li></ul>
  7. 7. Bank Loan Origination <ul><li>Locate a bank that meets your needs, usually through a referral </li></ul><ul><li>The bank’s loan officer conducts a complete credit analysis </li></ul><ul><ul><li>Review borrower’s financial statements </li></ul></ul><ul><ul><li>Visit the place of business </li></ul></ul><ul><ul><li>Assesses the managerial strengths/weaknesses of borrower </li></ul></ul><ul><ul><li>Provides an opportunity to develop a one-on-one relationship </li></ul></ul>
  8. 8. Bank Loan Origination
  9. 9. Bank Loan Origination <ul><li>Obtain additional information about the firm </li></ul><ul><li>Obtain credit report on the firm and borrower </li></ul><ul><li>Address any concerns with the borrower </li></ul><ul><li>Loan is approved by the bank </li></ul><ul><ul><li>Small loan approved by a loan officer </li></ul></ul><ul><ul><li>Larger loans are approved by more senior officers </li></ul></ul><ul><ul><li>Above a certain amount must get approval from loan committee </li></ul></ul><ul><ul><li>Borrower and bank negotiate terms of the loan </li></ul></ul><ul><ul><li>Maturity of small business loans rarely exceeds 5 years </li></ul></ul>
  10. 10. Features of a Small Business Loan <ul><li>During application period and after the loan is granted, develop a relationship between bank and borrower </li></ul><ul><li>Loans are often collateralized </li></ul><ul><ul><li>Pledging of assets against the loan </li></ul></ul><ul><ul><li>Secured lender —bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to satisfy the loan </li></ul></ul><ul><ul><li>Unsecured lender —have right to proceeds from sale of assets after secured lenders have been paid </li></ul></ul><ul><ul><li>Owner may pledge personal assets as collateral </li></ul></ul>
  11. 11. Features of a Small Business Loan <ul><li>Loan can be guaranteed by the owner </li></ul><ul><ul><li>Borrower is personally liable for any unpaid balance </li></ul></ul><ul><ul><li>Lender may require a personal financial statement of the borrower </li></ul></ul><ul><ul><li>With very small firms, often loan is strictly dependent on creditworthiness of the individual not the small business </li></ul></ul>
  12. 12. Restrictive Covenants <ul><li>Loan may contain restrictive covenants </li></ul><ul><ul><li>Covenant —promises that the company makes to the bank regarding their future actions and strategies </li></ul></ul><ul><ul><li>The bank may require an audited financial statement to verify the convents have not been broken </li></ul></ul><ul><ul><li>More restrictive covenants are linked to actions indicating the company has become riskier </li></ul></ul>
  13. 13. Financing Midsize Businesses <ul><li>Assets between $10 million and $150 million </li></ul><ul><li>Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market </li></ul><ul><li>Some are likely to be publicly owned—issue equity traded in the over-the-counter market </li></ul><ul><li>Can either be owner managed or managed by someone other than the owner </li></ul>
  14. 14. Financing Midsize Businesses <ul><li>For short-term debt, principally rely on commercial banks </li></ul><ul><ul><li>Depending on size of debt and bank, can use either local or non-local banks </li></ul></ul><ul><ul><li>Typically have covenants placed on the loan and may pledge collateral </li></ul></ul><ul><li>Revolving Line of Credit --access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan </li></ul>
  15. 15. Financing Midsize Businesses <ul><li>Long-term debt financing is often provided by non-bank institutions </li></ul><ul><ul><li>Mezzanine debt funds provide loans to smaller midsize companies </li></ul></ul><ul><ul><li>Private Placement Market (Figure 14.2) </li></ul></ul><ul><ul><ul><li>Generally a bond issue in excess of $10 million </li></ul></ul></ul><ul><ul><ul><li>Bonds do not have to be registered with the SEC </li></ul></ul></ul><ul><ul><ul><li>Avoids public disclosure of information </li></ul></ul></ul><ul><ul><ul><li>Sold only to financial institutions and high net worth investors </li></ul></ul></ul>
  16. 16. Private Placement Origination
  17. 17. Financing Large Businesses <ul><li>Firms with assets in excess of $150 million </li></ul><ul><li>Becomes cost effective to enter the public bond market </li></ul><ul><li>These bond issues are liquid assets that are traded in the secondary market </li></ul><ul><li>Therefore, can be issued at a lower yield than a nontraded instrument </li></ul>
  18. 18. Financing Large Businesses <ul><li>Large businesses can afford the high distribution and underwriting costs of a public issue </li></ul><ul><ul><li>Additional costs to sell to a wider range of investors </li></ul></ul><ul><ul><li>Substantial costs associated with registering the bond with the SEC </li></ul></ul><ul><li>Securities Underwriting (Figure 14.3) </li></ul><ul><ul><li>Issuer selects an underwriter , generally an investment bank, to assist in issuing and marketing the bond </li></ul></ul><ul><ul><li>Underwriters actively market their services to companies large enough to issue in the public market </li></ul></ul>
  19. 19. Securities Underwriting
  20. 20. Shelf Registration <ul><li>Permits the issuer of a public bond to register a dollar capacity with the SEC </li></ul><ul><li>Draw down on this capacity at any time </li></ul><ul><li>This avoids additional registration requirements </li></ul><ul><li>Permits issuers to respond instantaneously to changing market conditions </li></ul>
  21. 21. Financing Large Businesses <ul><li>Large companies with good credit ratings tend to rely on the commercial paper market for short-term financing </li></ul><ul><li>Some very large businesses also issue medium-term notes , which are like commercial paper, except maturities range from one year to five years </li></ul><ul><li>Also issue equities , through underwriters, which is another form of external long-term financing </li></ul>
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