o Decrease in funds to be lent and an increase
F A R F I NAL S R EV IEWE R
Short-term Source of Funds
Trade Credit
- Business to business agreement
- customer can purchase goods without paying
cash up front, and paying the supplier at a later
scheduled date.
Importance
 helpful tool for growing businesses
 arrangement effectively puts less pressure on
cashflow
 helpful in reducing and managing the capital
requirements of a business.
Types
 Open Account
 Trade Acceptance
 Promissory Notes
Direct Costs of Trade Credit
 Early Payment Discount
 Late Payment Penalties
Commercial Bank
- financial institution that accepts deposits,
offers checking account services, makes various
loans, and offers basic financial products like
certificates of deposit (CDs) and savings
accounts to individuals and small businesses.
Commercial Banks Loans
Short-term business credit requiring the borrower
to sign a promissory note to acknowledge the
amount of debt, maturity and interest. Appears on
the balance sheet as notes payable
Compensating Balances
 Fee charged by the bank for services rendered
or an average minimum account balance.
 interests’ rates are lower, the compensating
balances rises
Maturity Provision (Term Loan)
 Credit is extended for one to seven years.
 Loan is usually repaid in monthly or quarterly
installment.
 Only superior credit applicants qualify
 Interest rate fluctuates with market conditions
Credit Crunch Phenomenon
 Federal Reserve tightens the growth in the
money supply to combat inflation Effect:
in interest rates
o Increase in demand for funds to carry
inflation- laden inventory and receivables
o Massive withdrawals of savings deposits at
banking and thrift institutions, fueled by
the search for higher returns
 Credit conditions can change dramatically and
suddenly due to
o Unexpected defaults
o Economic recessions
o Changes in monetary policy
o Other economic setbacks
Intercorporate Deposit
- unsecured short-term loans from corporation/s
to another
- company/ies with excess funds would lend to
another company in need of money
- Because it’s an uncollateralized loan, the lender
will demand a higher interest rate
Range
 from one day to one year
 most frequent term is 90 days
Characteristics
 brief length of time (three or six months)
 company-based relationship
 straightforward procurement procedure
 not fixed interest rate
 not governed by any legislation.
Types
 Call deposit which the lender withdraws the
money after giving a one-day notice however, a
lender must wait at least three days.
 Three-month deposit offers funds for three
months to cover short-term liquidity shortages
 Six-month Deposit the lending company lends
money to another company for six months
Commercial Paper
- unsecured, short-term debt instrument issued
by corporations
- used to the finance short-term liabilities such
as payroll, accounts payable, and inventories.
- Maturities range from one to 270 days, with an
average of around 30 days
Involved Parties
 a bank (the drawer)
 a payer (the drawee or issuer)
 a payee (the lender)
Types According to Uniform Commercial
Code (UCC)
 Draft, written agreement between three
parties. The bank instructs the commercial
paper issuer to pay the lender a specific amount
of money at a specific time.
 Check paid on demand by a bank rather than
by a certain time.
 Note an individual is promised to pay another
individual or bank a particular amount.
 Certificates of Deposit, bank receipt, or
certificate, that asserts that the bank has
received a sum of money deposited by an
investor. It agrees to pay back this money plus
interest at a specific time in the future
Public Deposit
- any money received by a company through the
deposits or loans collected from the public
- source of financing for medium-term and long-
term requirements of a company.
- to finance the working capital requirements of
the firm.
- do not require complicated legal formalities
Rate
 8-9% for one year
 9-10% for two years
 10-11% for three years
According to the Companies Amendment
Rules 1987
 maximum maturity period is 3 years.
 minimum maturity period is 6 months
 maximum maturity period for Non-banking
Financial Companies is 5 years
 cannot go past 25% of free reserves and share
capitals
 companies need to publish information
regarding their position and financial
performance
Pledging Account Receivables
- pledge their receivables in return for financing
options such as loans
- accounts receivables are submitted as collateral
to the lender against a pre-decided loan
How does it work?
 lender looks at the aging schedule and only
accepts those receivables that are not overdue
 lender then determines what amount of the
company’s receivables they will accept
 percentage usually around 75% or 85%.
Factoring Receivable
- financial transaction in which a company sells
its accounts receivable to a financing company
that specializes in buying receivables at a
discount
- also known as invoice factoring or accounts
receivable financing
How does it work?
 factoring companies typically pay most of the
value of the invoice in advance, the amounts
vary depending on the industry, but can be as
much or more than 90%.
 customer pays the factoring company the full
value of the invoice
 factoring company pays you whatever remains
between the amount you were advanced and
the full invoice amount minus fees.
Types
 Recourse Factoring factor can demand money
back from the company that transferred
receivables if it cannot collect from customers
 Non-recourse Factoring factor takes on all the
risk of uncollectible receivables, company that
transferred receivables has no liability for
uncollectible receivables
Inventory Financing
- Short-term loan or a revolving line of credit
that is acquired by a company so it can
purchase products to sell at a later date
- Products serve as collateral for loan
Importance
 useful for companies that must pay their
suppliers for stock that will be warehoused
before being sold to customers
 a way to smooth out the financial effects of
seasonal fluctuations in cash flows
 help a company achieve higher sales volumes
by allowing it to acquire extra inventory for use
on demand
Types
 Short-term loan
- may avail of a from a bank to purchase the
inventory
- tedious process as the company will have to
go through the whole process of loan
sanctioning
 Line of credit
- provides businesses with revolving credit
- gives regular access to credit as long as they
make regular monthly payments to satisfy
the terms and conditions of the contract
 IDK  Free access to all available information
 There is risk-free asset and there is no
Modern Portfolio Theory restriction on borrowing and lending at the
- developed by Harry Markowitz risk-free rate
- published under the title "Portfolio Selection"  There are no taxes and transaction costs
in 1952 Journal of Finance.
- practical method for selecting investments in Capital Structure Issues
order to maximize their overall returns - amount of debt and/or equity employed by a
within an acceptable level of risk. firm to fund its operations and finance its
assets
Two Components:
 Systematic Risk
- largely unpredictable and generally known as
being difficult to avoid
- affects the overall market, not just a
particular stock or industry.
 Unsystematic Risk.
- not shared with wider market or industry
- often specific to an individual company.
Efficient Frontier
- set of optimal portfolios that offer highest
expected return for a defined level of risk or the
lowest risk for a given level of expected return.
Beta
- degree to which different portfolios are affected -
by these systematic risks as compared to the debt-to-equity or debt-to-capital ratio.
effect on the market as a whole Optimal Capital Structure
- the systematic risks of various securities differ - proportion of debt and equity that result in the
due their relationships with the market lowest total cost of capital or weighted average
- Beta factor describes the movement in a stock's cost of capital (WACC) for the firm
or a portfolio's returns in relation to that of the
market returns. Dynamics of Debt and Equity
Debt Equity
Capital Asset pricing model Risk Low risk High risk
- developed in mid-1960's by economists Jack L. First claim on Only receive
Treynor, William Sharpe, John Lintner and Jan assets in the residual value
Mossin. event bankruptcy after debt
- describes the relationship between the expected investors are
return and risk of investing in a security repaid
- used throughout finance for pricing risky Return Low return High return
securities and generating expected returns for Interest and Dividend and
assets Capital back Capital growth
- if expected return does not meet or beat the
required return, then the investment should not Ownership No ownership Ownership rights
be undertaken rights – voting rights
- uses the principles of Modern Portfolio Theory Payments Fixed repayment No mandatory
to determine if a security is fairly valued schedule fixed payments
- help investors understand the relationship Interest No interest
between expected risk and reward payments payments
Assumptions of CAPM: Operational restrictions on maximum
 All investors are averse to risk Flexibility operational operational
 Maximizing the utility of terminal wealth flexibility flexibility
 Choice on the basis of risk and return
 Similar expectations of risk and return
 Identical time horizon

Method of Recapitalization
1. Issue debt and repurchase equity
2. Issue debt and pay a large dividend to equity
investors
3. Issue equity and repay debt
Merges and Acquisitions
- the capital structure of the combined entities
can often undergo a major change
Leveraged Buyouts (LBO)
- firm will take on significant leverage to finance
the acquisition.
- common practice for private equity firms
seeking to invest the smallest possible amount
equity and finance the balance with borrowed
funds.
Assessing Long-term Debt, Equity and
Capital structure
- firm-mobilizes funds which, depending upon
their maturity period
Why Capital Structure Changes Over Time
1. Deliberated Management Actions
- firm is not currently at its target
- may deliberated raise new money in a
manner that moves the actual structure
towards the target.
2. Market Actions
- Changes in the market value of debt/equity
capital
- could result in a large change in its measures
capital structure
Traditional approach
- firm can lower its weighted average cost of
capital and increase its market value by
judicious use of financial leverage.
Modigliani and Miller (Perfect World)
Approach
- firm’s value is determined by its real assets, not
by the securities it issues
- capital structures are irrelevant and all capital
equally desirable.
Contemporary Approach
- an optimal capital structures are at least an
optimal range of structures of every firm.
 Corporate Income Taxes
 Financial Distress and Related Costs
Trade-off Theory of Leverage
- firms trade off the tax benefits of debt financing
against problems caused by potential
bankruptcy.
Business risk
- risk to the firm of being unable to cover
operating cost
- single most important determinant of capital
structure and it represents the amount of risk
that is inherent of the firm’s operations even it
uses no debt financing.
Factors that affect business risk
1. Variability of demand for the firm’s product
2. Competition
3. Variability of sales price
4. Product obsolescence
5. Variability of production costs
6. Foreign risk exposure
7. Legal exposure and regulatory risk
8. Degree of operating leverage
Financial Risk
- risk to the firm of being unable to cover
required financial obligation
- additional risk on the ordinary equity
shareholders as a result of decision to finance
the debt
- uncertainty inherent in projections of future
operating income.
Capital structure policy
- maximizes the value of the firm
- maximizes the cost of capital
- choice between risk and expected returns
associated with the firm’s financing mix.
EBIT- EPS Analysis
- used analytical technique
- used to evaluate various capital structures in
order to select the one that maximizes a firm’s
earnings per share
- measures the impact of financing alternatives
on EPS at different levels of EBIT.
Sources of Long-term Financing
Long-term financing
- any means to provide financial resources
- terms exceeding one year
- ideal for businesses that need large amounts of
cash for massive marketing campaigns,
extensive product development, international
expansion, and other huge costs of operation
- provides greater flexibility and resources
- spread out their debt maturities
Sources
 commercial loans
 bank loan
 leasing agreement
 stock offerings Cost of Capital
 debt offerings - rate of return that a firm must earn on the
 government programs. projects in which it invests to maintain its
market value and attract funds.
Long-term Investment decisions
- acts as major link between the firm’s long-term
- investments made in various financial investment decisions and the wealth of the
instruments that the investors plan to hold owners
- longer period, a year or more - rate of return required by the market suppliers
- opt for such investment options for huge profits of capital to attract their fund to the firm
awaiting the end of those investments for long
term. Four basic sources of long-term funds for
the business firm:
Types 1. Long term debt
 Stocks represent ownership in a company 2. Preferred Stock
 Bonds represent loan from an investor 3. Common Stock
 Mutual Funds managed portfolios hold many 4. Retained Earnings
securities
 Exchange Traded Funds securities that Capital Budgeting
combine some attributes of stock and mutual - process of identifying, evaluating, planning, and
funds financing capital investment projects of an
 Real Estate investment on residential property, organization
commercial property, and land
Project Classification
Long-term investing strategies 1. Replacement: Maintenance of Business
1. Buy & Hold 2. Replacement: Cost Reduction
- involves buying investments and holding them for 3. Expansion of Existing Products or Market
a long period of time, regardless of short-term 4. Safety and Environmental Projects
market fluctuations 5. Other Projects (Office Buildings, Parking lots,
2. Passive Investing Executive Aircraft)
- long-term strategy for building wealth by buying
securities that mirror stock market indexes and
holding them long term. Factors Affecting Long Term Decisions
3. Active Investing 1. Estimated Cash Flows
- investing in funds whose portfolio managers select 2. Cost of Capital
investments based on an independent assessment 3. Acceptance Criteria
of their worth
- trying to choose the most attractive investments. -
- goal to “beat the market,” or outperform certain
standard benchmarks.
4. Growth Investing
- stock-buying strategy that looks for companies
that are expected to grow at an above-average rate
compared to their industry or the broader market
- tend to favor smaller, younger companies poised
to expand and increase profitability potential in the
future
5. Value Investing
- involves picking stocks that appear to be trading
for less than their intrinsic or book value.
6. Dividend Investing
- buying stocks of companies that make regular
cash payouts to shareholders as a reward for
owning their stock.
7. Dollar Cost Averaging
- practice of investing a fixed dollar amount on a
regular basis, regardless of the share price.