Phil PIC #4

Every business needs financing…: What do CFOs actually do?

Finance is the economics of time and risk.

Once a business has defined its purpose, scope, and objectives, it should develop a strategy to achieve its goals.There is a relationship between growth and financial requirements and every business needs debt or equity financing, even when at first glance it might appear that funding is unnecessary : The higher a firm’s sales growth rate, the greater its need for additional financing.

Similarly, the larger s firm’s dividend payout ratio, the greater its need for additional funds.

In analyzing capital structure decisions, it is important to distinguish between internal and external sources of funds.

Internal financing arises from the operations of the firm.

It includes sources such as retained earnings, accrued wages, or accounts payable.

External financing occurs whenever the corporation’s mangers must raise funds from outside lenders or investors.

The literature on debt finance from the financial markets and equity capital is vast; here is a small but useful selection of key names that bear directly on the topics covered in this article:

Seed, venture, start-up, adventure, risk and injection capital are various names for the cash needed to get a business off the ground.

Working capital is money used to pay for inventory, salaries, and other production and operating costs.

Fixed capital is money locked up in fixed assets such as buildings and equipment.

Growth capital is cash targeted specifically to fund expansion.

A firm’s long-term financing decisions are influenced by its target capital structure, the maturity of its assets, its current and forecasted financial condition, the suitability of its assets for use as collateral, and current and forecasted interest rate levels.

The following is not exhaustive, but it identifies the major sources of finance used by CFOs.

Sources of short-term financing

  • Short-term credit is defined as any liability originally scheduled for payment within one year.
  • The four major sources of short-term credit are: Accruals, accounts payable or trade credit, bank overdrafts or loans from commercial banks and finance companies, and commercial paper.

Sources of Long-term financing

The four major sources of long-term financing are :

  1. Equity financing (Common stock, Stock options, and Preferred stock). The defining feature of equity financing is that equity is a claim to the residual that is left over after all debts have been paid.
  2. Long-term debt ( Term loan, Bond, Mortgage bond, First mortgage bond, Junior mortgage, Debenture, Subordinated debenture, Convertible bond, Bond with warrants, Income bond, Indexed bond, Development bond, Zero coupon bonds, Fixed rate and floating rate debt ).
    Corporate Long-term debt is a contractual obligation on the part of the corporation to make promised future payments in return for the long-term resources provide to it.
    Long-term financing in its broadest sense include long-term loans and long-term debt securities, such as bonds and mortgages, as well as other long-term promises of future payment by the corporation.
    Term loans and bonds are long-term debt contracts under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender.
    When it comes to bonds, the return required on each type of bond is determined by the bond’s riskiness.
    Bonds are assigned ratings which reflect the probability of their going into default: the higher a bond’s rating, the lower its interest rate.
  3. Lease financing (Operating lease, Financial lease or Capital lease, Sale and Leaseback, and Combination lease).
    Leasing is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax deductible payments.
    Operating leases generally provide for both financing and maintenance.
    Financial leases do not provide for maintenance service. They are not cancellable and are fully amortized.
    A sale and leaseback is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset, making fixed periodic payments for its use.
  4. Options, Warrants, Convertibles, and Futures.
    An option is an instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date.
    A warrant is a long-term call option issued along with a bond. Warrants are generally detachable from the bond, and they trade separately in the markets.
    When warrants are exercised, the firm receives additional equity capital, and the original bonds remain outstanding.
    A stock purchase warrant is an instrument that gives its holder the right to purchase a certain number of shares of common stock at a specified price over a certain period of time.
    A convertible bond is a bond that can be changed into a specified number of common stock.
    A convertible preferred stock is a preferred stock that can be changed into a specified number of common stock.
    When a security is converted, debt or preferred stock is replaced with common stock, and no money changes hand.
    Financial futures permit firms to create hedge positions to protect themselves against the damage which can be inflicted by fluctuating interest rates, stock prices, and exchange rates.

Conclusion

The weighted average cost of capital (WACC), reflects the expected average future cost of funds over the long run.

It is determined by combining the costs of specific types of capital after weighting each cost using historical book or market value weights or target book or market value weights.

The cost of capital is an extremely important financial concept.

It acts as a major link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the market place.

Stated another way, the problem that we seek to understand here is this: Is there a value-maximizing capital structure?

Aristote wrote “Those who wish to succeed must ask the right preliminary questions”.

In our case, the preliminary questions are:

Does debt policy matter?

How much should a firm borrow?

What is the company’s cost of capital?

Good decision-making comes from knowing the limitations of the input variables to the decision.

We will address the capital structure puzzle in stages within some upcoming articles!

So, stay connected!