Finance 110631-1165

CORPORATE FINANCE-METHODS OF FINANCING ENTERPRISES

Finance 110631-1165

Lecture outline

The notion and goal of corporate finance Sources of financing companies Sources of capital in companies

Finance 110631-1165

Corporate finance-definition

An area of finance focused on monetary flows in enterprises, on the ways of financing the companies’ activity and methods of financial analysis

Finance 110631-1165

Financial decisions

Short term eg. settling current liabilitiesLong term egg. fundraising, investments

Finance 110631-1165

The goal of corporate finance

The goal depends on the legal form and activity profile of the company

Maximizing the company’s profit Ensuring the company’s liquidity Maximizing the company’s value

Finance 110631-1165

Liquidity vs. solvency

Liquidity- the ability to settle current payments within the specified contract deadlines (short term)

Solvency- the ability to meet long term financial liabilities

The company’s value

Several ways of company valuation eg. asset based, income based, market based

The problem- which method reflects best the company’s value?

The most popular- discounted cash flow

Finance 110631-1165

Finance 110631-1165

Financing the company’s activity

The company’s activity requires several types of resources

Monetary resources Current assetsFixed assets

Finance 110631-1165

Financing the company’s activity

In the process of corporate financing there is

constant transformation of monetary resources into assets and vice versa

E.g. the purchase of production infrastructure or the sell of manufactured goods

Finance 110631-1165

Sources of financing

Internal sources e.g. the company’s profits, sell of assets

External sources- fundraising e.g. issuing bonds, issuing equity securities, bank loans

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Sources of capital (1)

Sources of capital ≠ sources of financingNot every source of financing is a source of

capital!Monetary resources become capital only if they

are invested!

Finance 110631-1165

Sources of capital (2)

Own capital also called equity- contributed by the owner or entrepreneur

Borrowed capital- contributed by an external institution or person

Finance 110631-1165

Own capital (equity)

Own capital does not have to be returned in contrast to borrowed capital

Therefore it is a safe source of financingIt constitutes a guarantee for the creditorsIt enables the supervision of the

shareholders/owners over the management

Finance 110631-1165

Finance 110631-1165

Own capital-examples

Income derived from equity securities (shares)

issuance –this is an external source of own capital

Income derived from the companies profit division –this is an internal source of own capital

Finance 110631-1165

Borrowed capital- examples

Short term and long term loans

Income derived from the issuance of long term and short term debt securities eg. bonds

Capital provision process

Investors provide capital to the company and receive a rate of return (interest payments)

The company invests the capital during its activity and receives a rate of profitability

Providing capital enables the company to invest and not to achieve a monetary surplus therefore this process is different from just providing finance!

Finance 110631-1165

The financial decisions of the company

Decisions concerning the sources of financing and the sources of capital

Decisions concerning investmentsDecisions concerning revenue division

(payment of dividends)

Finance 110631-1165

Finance 110631-1165

The financing strategy (1)

External or internal financingThe choice of capital sourcesThe choice of instruments to raise capital

Finance 110631-1165

The financing strategy (2)

The financing strategy depends on the specific financing need

E.g. Fixed assets should be financed by long term capital

The choice of capital source

Own or borrowedLong term or short termDomestic or international sourcesProvided by financial markets or financial

institutionsBalance sheet or off-balance sheet capital

Finance 110631-1165

Finance 110631-1165

Capital structure

The choice of capital sources influences the capital structure vital importance

For some types of companies there are regulatory requirements concerning capital structure

Finance 110631-1165

Own or borrowed capital?The most important decision is whether the

company requires own or borrowed capitalThis choice influences the division of future

profitsThe profit can constitute a future internal source

of own capitalIf the company has to pay dividends- it will need

external sources of capital

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Long term or short term capital?

The share of long and short term capital depends on the structure of the assets of the company

Current assetsFixed assets

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Assets Fixed assets Current assets

Liabilities Equity Borrowed capital

(interest payments) Other liabilities (no

interest payments)

Finance 110631-1165

Long term or short term capital?

The capital requirement period should be synchronized with the period of the requirement of the assets which are financed by this capital

Fixed capital ≥ Fixed assetsShort term liabilities≤ current assetsThis should ensure liquidity

Finance 110631-1165

Why do companies raise capital abroad?

More investors compared to the domestic market

Higher market liquidityLower capital cost (lower interest payments,

favorable regulations)Diversification of capital sourcesCompany’s image

Finance 110631-1165

What risk do firms face when raising capital abroad?

Exchange rate risk the need of insuranceCurrency mismatch- assets and liabilities held in different currencies High start up costs on foreign financial markets

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Is it profitable to raise capital on financial markets ?

Broader access to capital Higher liquidity of issued

securities Objective valuation of the

company Increasing credibility of

the company

High entry costs Disclosure

requirements Hostile takeover

possibility

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Balance-sheet or off balance sheet capital?

Off-balance sheet capital- a tool of risk management

Off-balance sheet capital is a reserve for unforeseen circumstances e.g. in the case of indemnity payments

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Off- balance sheet capital-examples

Conditional financing- funds are provided if specified conditions are met e.g. a natural disaster takes place

Contingent capitalCatastrophe bonds

The meaning of capital provision

Capital provision determines the scope of economic activity

Potential measure-domestic credit to private sector

Financial resources provided to the private sector: loans, purchases of nonequity securities, trade credits

Finance 110631-1165

Source:World Bank

Finance 110631-1165

Literature

R.W.Melicher, E.A.Norton, Introduction to Finance. Markets, Investments and Financial Management, John Wiley&Sons,2007