financing an investment

1. FINANCIAL MANAGEMENT
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2. Lecture 4 - overview
Types of Financial Decisions: Investment and Financing.
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3. Financing and Investment
There are two fundamental types of financial decisions that
the finance team needs to make in a business:
Investment
Financing
The two decisions boil down to how to spend money and
how to borrow money.
The overall goal of financial decisions is to maximize
shareholder value, so every decision must be put in that
context.
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4. The Financing Decision
When a company needs to raise money, it can invite
investors to put up cash in exchange for a share of future
profits, or it can promise to pay back the investors’ cash
plus a fixed rate of interest.
In the first case, the investors receive shares of stock and
become shareholders, part owners of the corporation. The
investors in this case are referred to as equity investors, who
contribute equity financing.
In the second case, the investors are lenders, that is, debt
investors, who one day must be repaid.
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5. Financing Decision
 The choice between debt and equity financing is often
called the capital structure decision. Here “capital” refers
to the firm’s sources of long-term financing. A firm that is
seeking to raise long-term financing is said to be “raising
capital.”
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6. Investment
 An investment decision revolves around spending
capital on assets that will yield the
highest return for the company over a desired
time period.
 In other words, the decision is about what to buy so
that the company will gain the most value.
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7. Investment
To do so, the company needs to find a balance between its
short-term and long-term goals. In the very short-term, a
company needs money to pay its bills, but keeping all of its
cash means that it isn't investing in things that will help it
grow in the future.
On the other end of the spectrum is a purely long-term view.
A company that invests all of its money will maximize its
long-term growth prospects, but if it doesn't hold enough
cash, it can't pay its bills and will go out of business soon.
Companies thus need to find the right mix between long-
term and short-term investment.
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8. Financing
 There are two ways to finance an investment:
 Using a company's own money (Profits, Personal
savings
 By raising money from external funders.
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9. Financing
 There are two ways to raise money from external funders:
 By taking on debt .
Taking on debt is the same as taking on a loan. The loan
has to be paid back with interest, which is the cost of
borrowing.
 Selling equity
Selling equity (shares) is basically selling part of your
company. When a company goes public, for example, they
decide to sell their company to the public instead of
to private investors. Going public entails
selling stocks which represent owning a small part of the
company. The company is selling itself to the public in
return for money.
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10. Equity vs Debt Capital
 Equity capital:
represents the
personal investment
of the owner (s) of a
company.
 Debt capital: the
financing that a
business owner has
borrowed and must
repay with interest
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11. Debt Financing: Loans from commercial
banks
 Short-term loans
Commercial loans
Lines of credit
 Intermediate and
long-term loans
Installment loan
Term loan
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12. Advantages of Debt Financing
 The bank or financial institution has no say in the
way a company is managed and has no
ownership rights.
 The business relationship ends once the debt is
paid.
 If you get a low rate interest loan, the debt is
easily going to be repaid in installments over a
period of time
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13. Disadvantages of Debt Financing
 You have to repay the loan, plus interest. Failure to
do so exposes your property and assets to
repossession by the bank.
 Debt financing is also borrowing against future
earnings. This means that instead of using all future
profits to grow the business or to pay owners, you
have to allocate a portion to debt payments.
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14. Equity Financing: Public Stock
Sale
Advantages
 Ability to raise large amounts of capital
 Equity financing does not have to be repaid.
 You share the risks and liabilities of company ownership
with the new investors.
 Since you don't have to make debt payments, you can use
the cash flow generated to further grow the company or to
diversify into other areas.
 Maintaining a low debt-to-equity ratio also puts you in a
better position to get a loan in the future when needed.
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15. Equity Financing: Public Stock
Sale
Disadvantages
 Dilution of ownership, Loss of control, Loss of privacy,
Accountability to shareholders
You give up partial ownership and, in turn, some level of
decision-making authority over your business
 Reporting to SEC (Stock Exchange)
 You have to share a portion of your earnings with the equity
investor.
 Over time, distribution of profits to other owners may exceed
what you would have repaid on a loan.
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16. Financing and investment decisions
 Financing and investment decisions (both long- and
short-term) are of course interconnected. The amount
of investment determines the amount of financing
that has to be raised, and the investors who
contribute financing today expect a return on that
investment in the future. Thus, the investments that
the firm makes today have to generate future returns
for payout to investors.
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17. Financing and investment decisions
 Money flows from investors to the firm and back to
investors again. The flow starts when cash is raised from
investors. The cash is used to pay for the investment
projects needed for the firm’s operations. Later, if the firm
does well, the operations generate enough cash inflow to
more than repay the initial investment. Finally, the cash is
either reinvested or returned to the investors who
furnished the money in the first place).
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18. Financing and investment decisions
 The firm finances its investments by issuing financial
assets to investors. A share of stock is a financial asset,
which has value as a claim on the firm’s real assets and the
income that those assets will produce. A bank loan is a
financial asset also. It gives the bank the right to get its
money back plus interest. If the firm’s operations can’t
generate enough income to pay what the bank is owed, the
bank can force the firm into bankruptcy and stake a claim
on its real assets.
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19. How do you know which is right
for you?
 How soon do you need financing?
 If you need cash as soon as possible, then debt
financing is the way to go. You can get business
loans incredibly fast -- in a matter of
hours even, if you apply to the right lenders.
Meanwhile, equity financing involves finding
the right investors, pitching your business,
drawing up the legal documents and more.
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20. How do you know which is right
for you?
 How much capital do you need?
 If you don’t need a lot, or you’re only looking
for a small amount, then debt financing is the
better choice. Equity financing rarely comes in
small amounts,
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21. How do you know which is right
for you?
 Are you looking for more than just money?
 If so, equity is probably for you. Debt financing is
transactional. You borrow, then you pay back what
you owe. Equity will give you access to an
investor’s knowledge, contacts and expertise. You
get to establish a relationship that could have a
hugely positive effect on your business -- as long as
you’ve partnered with the right people.
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22. How do you know which is right
for you?
 Do you mind sharing your business?
 If you don’t want to lose control over how your
business operates, then equity financing isn’t the
way to go.
 How big do you want to get in the future?
 Investors often look for companies with the
potential to grow into national brands or global
businesses. If that’s your goal, then equity can help
you get there.
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23. Can we use both financing methods
in an investment?
 Yes, an investment can be funded to some extent by
borrowing a loan (Debt Financing) and to some extent
by issuing shares (Equity Financing).
 In this case, the capital cost components must be added
where the contribution of each capital source is
weighted by the proportion of total funding it
provides. This is known as:
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WACC = (Proportion of total funding that is equity funding ) x (Cost of equity)
+ [(Proportion of total funding that is debt funding) x (Cost of Debt)
x (1 – Corporate tax rate)]

24. Weighted Average Cost of Capital
(WACC)
 A firm's cost of capital from various sources
usually differs somewhat between the different sources of
capital. Cost of capital may differ, that is, for funds
raised with bank loans,, or equity financing. As a result,
Weighted average cost of capital (WACC) represents the
appropriate cost of capital for the firm as a whole. WACC
is simply the arithmetic average (mean) capital cost,
where the contribution of each capital source is weighted
by the proportion of total funding it provides.
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25. Question 1
 ABC Ltd is looking for ways to gain public confidence
back again. The company is planning to pay dividends
of $30M in total to its shareholders and invest in new
assets worth $60M. The company’s net cash from
operations equals $50M and they plan on borrowing
$20M this year. Can they do it? What options can the
company consider?
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26. Answer to Q1
 No, they cannot do it.
Capital Held = $50M + $20M = $70M
Investment & Dividends= $60M + $30M =$90M
Capital < Investment by $20M
The options they have:
 Raise more capital thus more debt
 Invest less in new assets
 Pay less dividends to shareholders
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27. Question 2- Equity Financing
Jack invests $500,000 in a startup technology company acquiring
10,000 of the firm’s 200,000 total shares outstanding.
After a year, the technology company grows and needs additional
capital. The firm’s management decides to raise the funds by issuing
new stocks and giving a percentage of ownership to more investors in
exchange for cash.
Jack agrees to invest $300,000 at a share price of $60. How many
shares Jack will acquire?
Before the stock issuance, Jack controlled 5% of the company (10,000
shares of the firm’s 200,000 total shares outstanding).
After the equity financing, Jack will control what % of the
company?
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28. Answer to Q2
 Jack agrees to invest $300,000 at a share price of $60. How many
shares Jack will acquire?
 $300000/$60 = 5000 shares
 After the equity financing, Jack will control what % of the
company?
 Before the stock issuance, Jack controlled 5% of the company
(10,000 shares of the firm’s 200,000 total shares outstanding).
 After the issuance, Jack holds a total of 15,000 shares
(10000shares + 5000 new ones) out of 200 000 shares.
 Therefore, he controls 7.5% of the company (15000 shares /
200000 total shares)
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29. Question 3
Assume newly formed Corporation ABC needs to raise $1
million in capital so it can buy office buildings and the equipment
needed to conduct its business. The company issues and sells
6,000 shares at $100 each to raise the first $600,000. Because
shareholders expect a return of 6% on their investment, the cost
of equity is 6%.
Corporation ABC then borrows a loan of $400,000 in from the
bank at a 5% interest rate so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity +
$400,000 debt) = $1 million and its corporate tax rate is 35%.
Now we have all the ingredients to calculate Corporation ABC's
weighted average cost of capital (WACC).
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30. Answer to Q3
WACC = [(Proportion of total funding that is equity funding ) x (Cost of equity)] +
[(Proportion of total funding that is debt funding) x (Cost of Debt) x (1 – Corporate
tax rate)]
Proportion (%) of equity funding: $600 000/ $1 000 000 = 60%
Proportion (%) of debt funding: $400 000/ $1 000 000 = 40%
Cost of Equity: 6%
Cost of Debt: 5%
Corporate Tax Rate: 35%
WACC= (60% x 6%) + [(40% x 5%) x (1 – 35%)]
= 0.036 + [0.02 x 0.65]
= 0.049 or 4.9%
Corporation ABC's weighted average cost of capital is 4.9%.
This means for every $1 Corporation ABC raises from external funders, it must
pay them almost $0.05 in return.
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31. Question 4
 Steven approached a bank for financing for his business
venture, the development of a wireless golf buggy. On 1
July 2014, he borrowed $200 000 at an annual interest
rate of 12%. The loan is repayable over 5 years in
annual instalments of $55,480, principal and interest
due on 30 June each year. The first payment is due on
30 June 2015. His wireless golf buggy entity’s year end
will be 30 June. Prepare a loan schedule for the 5 Years
2014- 2019. Round all calculations to the nearest dollar
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32. Answer to Q4
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33. Question 5
 Francis approached a bank for financing for his business
venture, the development of a wireless golf buggy. On 1
July 2015, he borrowed $100 000 at an annual interest rate
of 10%. The loan is repayable over 5 years in annual
instalments of $26,380, principal and interest due on 30
June each year. The first payment is due on 30 June 2016.
His wireless golf buggy entity’s year end will be 30 June.
Prepare a loan schedule for the 5 Years 2015- 2020.
Round all calculations to the nearest dollar
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34. Answer to Q5
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35. Question 6
Assume newly formed Corporation XYZ needs to raise $1 million
in capital so it can buy office buildings and the equipment needed
to conduct its business. The company raises 40% of the capital
from issuing shares and expect it would be able to pay 6% to
shareholders as their return.
Corporation XYZ then borrows 60% of the capital from the bank at
a 12% interest rate.
Corporation XYZ's corporate tax rate is 30 %.
Now we have all the ingredients to calculate Corporation XYZ's
weighted average cost of capital (WACC).
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36. Answer to Q6
 Proportion (%) of equity funding: 40 %
 Proportion (%) of debt funding: 60%
 Cost of Equity: 6%
 Cost of Debt: 12%
 Corporate Tax Rate: 30%
 WACC= (40% x 6%) + [(60% x 12%) x (1 – 30%)]
= 0.024 + [0.0504]
= 0.074 or 7.4 %
 Corporation XYZ's weighted average cost of capital is 7.4 %.
 This means for every $1 Corporation XYZ raises from external
funders, it must pay them almost $0.074 in return.
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37. END OF SESSION 
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38. Next week …
 Business Valuation
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