Financial Planning

 Outline:
 Long-Term Financing

 Raising equity capital (Chapter 23)

 Debt financing (Chapter 24)

 Short-Term Financing

 Working capital Management (Chapter 26)

 Short-Term Financial Planning (Chapter 27)

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 How companies can raise capital

 Financing comes basically from two sources:

 Internal

 Retained earnings

 Usually insufficient to satisfy firm’s needs.

 External

 Private Public

 Debt Equity Hybrid

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 Sources of external capital

Capital
Markets

Debt Equity

Supplier Ordinary Preference

Bank Loans Bonds Leases Informal Warrants Informal
Credit Shares Shares

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Alternative Issue Methods

Private
General Cash
Placement or
Offer
Placing

Rights Issue Public

Issues

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The Environment for Raising Capital

The Legal
The Financial System
Environment

Ownership Structure

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 Pros and cons of private capital

• Private sources of capital have several advantages:

 Terms can be customized.
 Easier to renegotiate.
 No costly registration with the securities regulator.
 No need to reveal confidential information.

• Privately placed debt can also have disadvantages:

 Limited investor base
 Less liquid.

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 Venture Capital
 Start-ups often require venture capital to finance growth. Venture
capital provides entrepreneurs with financing to grow their firms.
 Steps to obtaining venture funding:
 Prepare a business plan.

 Receive first-stage financing.

 Receive subsequent staged financing.

 Types of Venture Investors

 Angel Investors: Investors who finance companies in their earliest

stages of growth
 Corporate Venturers: Corporations that offer venture assistance to

finance young, promising companies.

 Private Equity: Investors who offer funds to finance firms that do

not trade on stock exchanges.

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 Types of Offerings

Seasoned
Initial Public
Equity Offerings
Offerings (IPOs)
(SEOs)

Primary Secondary
Offerings Offerings

 When a firm requires more capital than private investors can provide,
it can choose to go public through an Initial Public Offering (IPO).
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 Benefits of going public (IPO)

 Raise additional capital (for further expansion like new

investments, acquisitions; repay debt).
 Allow the owners to sell their stakes (diversification - risk
sharing benefits).
 Increase liquidity benefits to shareholders/managers.
 Escape control/monitoring of banks.
 Enhance company’s image, visibility, status and prestige.
 Provide incentive compensation scheme for managers /
employees.

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 Costs of going public (IPO)

 Issuance costs: investment bank fees; legal, accounting

and administrative expenses; indirect expenses like the
management time spent.
 Obligation to disclose new information (information
revealed to competitors).
 Ongoing costs of periodic disclosures.
 Loss of potential funds by issuing shares at an offer price
set below the true value (Underpricing).
 Underwriters can purchase additional shares at the offer
price (Green Shoe Option).
 Pressure for good performance from outsiders.
 Agency costs of managerial discretion.
 Danger of loss of control.
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Investment Banking and the Underwriting
Process

Origination Distribution

Risk-Bearing Certification

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Types of Underwriting Arrangements

Firm Negotiated vs
Commitment Competitive

Best Effort Auction

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The Underwriting Agreement

Underwriting Overallotment
Spread Option

Green Shoe
Fees
Option

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 The cost of equity issues

Spread or
Other Direct Indirect
Underwriting
Expenses Expenses
Discount

Abnormal
Underpricing Green Shoe
Returns
(IPOs; Fig 23.4) Option
(SEOs)

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Financial intermediaries

Banks Banks Insurance

(Commercial) (Investment) Companies

Pension Charitable
Mutual Funds
Funds Foundations

Venture
Hedge Funds
Capital

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Debt financing

 Debt can be:

Short-term / Long-term
Private / Public
Negotiable / Non-negotiable
 Major forms of debt

Bank loans (Lines of credit / Loan commitment)

Bonds
Commercial paper
Supplier credit
Lease (Operating lease / Financial lease)
 Basic features of debt

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 Bond (debt) features

Amount of
Date of Issue Maturity Face Value
Issue

Coupon
Annual
Offer Price Payment Security
Coupon
Dates

Sinking Fund Call Provision Call Price Credit Rating

Covenants /
Options
Indentures
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 Different types of bond

Floating Rate Zero-coupon or

Straight-coupon
or Bullet Bond
Pure Discount Income Bond
Bond Bond

Islamic Bond Convertible Deferred-

Put Bond
or Sukuk Bond coupon Bond

Perpetuity Annuity
Bond Bond

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Types of bond options

Callability Convertibility

Exchangeability Putability

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 Bond covenants

Asset Covenant: Governs the firm’s

acquisition, use and disposition of assets.
Covenants are Dividend Covenant: restricts the payment
restrictions imposed of dividends.
on the issuer
Financing Covenant: Description of the
amount of additional debt the firm can issue
and the claims to assets that this additional
debt might have in the event of default.

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Bond credit ratings

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 Managing Working Capital

 Until now, our main focus was on long-term financial

decisions. Now, we pay attention to short-term financing:
 It involves cash inflows and outflows within a year.

 Working capital management refers to decisions relating to:

 target levels of current assets, and

 financing of current assets.

 Three types of decisions:

 Credit management

 Inventory management

 Cash management

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 Elements of Working Capital

 Current assets: these are either in the form of cash or

can be converted into cash very quickly
 Cash and Marketable securities
 Accounts receivables (Trade debtors)
 Inventories
 Current liabilities: these are expected to come due
within the year
 Notes payable / Short-term loans / Bank overdrafts
 Accounts payables (Trade creditors)
 Current payments of long-term debt
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 Financial ratios related to working
capital (1)

 Liquidity ratios: a firm’s ability to meet short-

term obligations

Current assets
Current ratio 
Current liabilities
Quick assets
Quick ratio 
Current liabilitie s
Current assets - Inventorie s

Current liabilitie s
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 Financial ratios related to working
capital (2)

 Activity ratios: how effectively a firm’s assets

are managed?

Total operating revenues (Sales)

Receivables turnover 
Average Receivables

Cost of goods sold

Inventory turnover 
Inventory

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 Credit management

 Firms usually sell goods and services on credit.

 Selling on credit results in extra costs being
incurred by the firm:
 Credit administration costs

 Bad debts

 Opportunity costs of cash

 However, these costs of selling on credit must be

weighed against all benefits of higher sales.

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 Credit policy

 The components of credit policy are:

 Terms of sale (Which conditions?)

 Credit analysis (Which customers?)

 Collection policy (How to collect quickly?)

 Terms of sale includes conditions like the length of credit

period and the amount of cash discount
 Five Cs (Character, Capacity, Collateral, Capital and
Conditions) used to evaluate credit risk
 The length of credit period is determined by:
 Probability that customer will not pay,

 Size of the account,

 Extent to which goods are perishable,

 …..
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 Inventory management

 Inventory includes raw materials, work-in-process, and

finished goods.
 The goal is to provide the required amount of inventories in
order to sustain business operation at the lowest possible
cost.
 Typically, these costs are two types:
 Carrying (or Holding) costs, and

 Shortage costs.

 What would be the optimal (the amount that minimizes total

costs) inventory level?

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 Inventory carrying and shortage costs

Shortage
Annual costs
costs Total costs
(€)

Carrying or
Holding costs

0 CA*
Amount of inventory

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 Cash management

 Finance manager wants to minimize the amount of

cash the firm must hold for conducting its normal
business activities.
 At the same time, the firm should have sufficient
cash to meet any unexpected requirement.
 Primary reasons for holding cash:
 Transactions motive
 Precautionary motive
 Compensating balances
 The cost of holding cash is the opportunity cost of
lost interest.
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 Determining the target cash balance

 How much cash should be held by a firm?

 It involves a trade-off between the opportunity

costs of holding too much cash and the trading

costs of holding too little.
 How to help control the cash balance?
 Use upper and lower control limits

 How to determine the optimal cash balance?

 Use the trade-off between opportunity costs and

trading costs
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 Determining target cash balance

$ Minimum Total costs of holding cash.

point
Costs of carrying cash
(Opportunity costs)

Costs of not
carrying cash
(Trading costs)

Optimal Size of cash balance ($)

cash
balance
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 Cash management techniques

 Cash flow synchronization

 Accelerating collections
 Controlling disbursements
 Investing idle cash
 Getting available funds to where they are needed

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 Short-Term Financial Planning

 A company needs to forecast its cash flows to know

whether it will have surplus or deficit in each period, and
then determine whether it is temporary or permanent.
 Firms typically require short-term planning for three
reasons:
 Is there a seasonal pattern?
 Is there a negative cash flow shock?
 Is there a sudden cash flow surplus?
 Adopt a policy that minimizes transaction costs: follow
Matching Principle – short-term needs should be financed
with short-term debt and long-term cash requirements
should be financed with long-term sources of funds.
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 Cash Budget

 A cash budget is a primary tool of short-run financial

planning and control. It allows the finance manager to
identify short-term financial needs (and opportunities).
 The idea is simple:
 Record the estimates of cash receipts and cash

disbursements; and then

 Forecast periods of cash surpluses and cash deficits

 When there is a cash surplus, decide on the best use of

funds; when there is a cash deficit, take adequate actions
(bank loans, commercial papers).

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