Transcript Ch 20 - Finance and Risk - Pearson Education Canada
CHAPTER 20 Financial Decisions and Risk Management
Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Learning Objectives
Describe the responsibilities of a financial
manager.
Distinguish between short-term (operating) and
long-term (capital) expenditures.
Identify four sources of short-term financing for businesses.
Distinguish among the various sources of long-term financing and explain the risks involved in each.
Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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More Learning Objectives
Discuss some key issues in financial management for businesses Explain how risk affects business operations and identify the five steps in the
risk-management process.
Explain the distinction between insurable and
uninsurable risks
Distinguish among the different types of insurance purchased by businesses.
Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Financial Managers
Responsible for planning & overseeing the financial resources of a firm including
Cash flow management
Financial control
Financial planning Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Cash Flow Management
Managing the pattern of cash inflows (revenues) and outflows (debt payments) Investing funds service debt that are not needed to Funds must either be committed to maintaining the firm, or earning interest, not sitting idle Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Financial Control
Checking actual performance against strategic plans to ensure that desired goals are achieved
Making adjustments as required when plans change, or do not work as intended Preparing budgets to ensure that sufficient cash is on hand to meet operational & debt service needs
Actual results that vary from the budget need explanation and adjustment Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke
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Financial Planning
A plan for achieving a desired financial status in the future
Projections of revenue flows
Sources & planned uses of funds
Timing of when funds will be required Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Short-Term (Operating) Expenses
Accounts payable
unpaid bills, wages, taxes due within the year
main source of short-term debt
Accounts receivable
funds due from customers who bought on credit
estimation of cash inflow development of a policy to ensure timely payment
Inventory
goods awaiting sale for future revenue
raw materials (basic supplies, unassembled product) work-in-progress (goods being manufactured) finished goods (goods completed and awaiting sale)
Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke
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Long-Term (Capital) Expenditures
Funding fixed assets that have a long life and a lasting value
land, buildings, machinery
not normally sold or converted to cash
acquisition requires a large investment
ties up the firm’s resources for a long period of time Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Short-Term Sources of Funds
Allows firms to cover operational expenses and implement short-term plans
Trade credit
Secured and unsecured loans
Commercial paper
Factoring accounts receivable Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Trade Credit
The granting of credit by a selling firm to a buying firm
Open book credit
sellers simply ship goods on credit, expecting that payment will follow Promissory note
buyers sign a promise-to-pay agreement before merchandise is shipped Trade draft
buyers sign a statement of payment terms attached to merchandise by the seller
once signed it is called a “trade acceptance” Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke
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Secured Short-Term Loans
A short-term loan for which the borrower is required to put up collateral
If the borrower defaults, the collateral is seized inventories and accounts receivable often used as collateral
Excessive administrative burden of such loans
Interest rates are usually lower than for unsecured loans
Appeals to firms whose credit rating is not sufficient (or who are too new) to qualify for unsecured loans Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Unsecured Short-Term Loans
(1 of 3) Line of Credit
A specified amount made available to the borrower for a short-term unsecured loan
The borrower draws on funds as they are needed
Banks do not agree that the funds will always be available as needed Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Unsecured Short-Term Loans (2 of 3)
Revolving Credit Agreements
guaranteed line of credit
the firm pays the bank interest on borrowed funds, as well as a fee for extending the line of credit
banks guarantee availability of the funds
the firm does not have to borrow funds if it doesn’t need them The bank charges a “commitment fee” for keeping the line of credit open for the firm Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Unsecured Short-Term Loans
(3 of 3) Commercial Paper
a firm sells unsecured notes for less than their face value, then repurchases them in 30 to 270 days for the face value
Investors make money on the spread between the face value and purchase price
As an unsecured note, only creditworthy firms are able to sell them successfully
The cost of commercial paper to the borrowing firm is usually less than prevailing interest rates Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Sources of Long-Term Funds
Debt financing
seeking long-term funds through borrowing from external sources Equity financing
seeking long-term funds through internal financing Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Debt Financing
Long-term loans
borrowing money for 3 to 10 years at a fixed or floating rate
loans are quick to process and do not require divulging business plans or the purpose for the loan Corporate bonds
a promise by the borrower to pay the lender an amount of money on the maturity date
usually large amounts over long periods (10 to 30 years)
interest payments are received in the interim
assets may be pledged against the bond Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Equity Financing
Common stock
a firm sells ownership rights by issuing shares
investors buy the stock hoping that it will appreciate Retained earnings
financing by retaining profits in the firm and not paying dividends to shareholders Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Hybrid Financing: Preferred Stock
Preferred shares
require fixed payments as do bonds
unlike bonds, they do not have a maturity date
shareholders receive a dividend if the firm can afford it
preferred shareholders get paid first when dividends become available Preferred shareholders have no voting rights, so the control of the firm is not affected Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Comparing Debt and Equity Financing
Debt Financing
Fixed deadline Yes, regular and fixed.
In liquidation, creditors come first.
No Bond interest is tax deductible.
Yes, many constraints.
Considerations
When must it be paid?
Will it make claims on income?
Will it have claims on assets?
Will it affect management control?
How are taxes affected?
Will it affect management flexibility?
Equity Financing
No limit.
Only residual claim.
In liquidation, shareholders must wait until creditors are paid and preferred equity precedes common equity.
May cause challenge for corporation control.
Dividends are not tax deductible.
No, few constraints.
Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke
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The Risk-Return Relationship
High Lower quality common stocks Corporate bonds with low credit ratings
Aggressive
Size of financial returns to attract
High quality, common stocks
Moderate
investors
Conservative
Medium quality, preferred stocks High quality, stable common stocks High grade corporate bonds, commercial paper Short-term Treasury Bills and bank GIC's (risk free) Low Low (No risk) High (Big risk)
Uncertainty about financial returns on investments Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Financial Management for Small Business
Small business owners must strive to get credit, manage it well, build their credit rating, and manage cash flow in order to
obtain financing at start-up and beyond
arrange lines of credit
organize trade credit Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Venture Capital
External equity funding provided in return for part ownership in the borrowing firm
Venture capital firms actively seek investment opportunities
Favour firms with rapid growth potential Failure rates in new ventures are high, particularly those with rapid growth; therefore, investors demand high returns for their money Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke
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Risk Management
Conserving a firm’s financial power or assets by minimizing the financial effect of accidental losses
Risk : uncertainty about future events Speculative risk : the chance for gain or loss Pure risk : only the chance of loss
Chance of a warehouse fire Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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The Risk-Management Process
1. Identify risks Speculative Risk Pure Risk Risk Avoidance 2. Measure impact on firm.
3. Evaluate Alternatives Risk Control Risk Retention 4. Implement Program Risk Transfer 5. Monitor Results Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Risk Management Alternatives
Risk avoidance
refusing to participate in risky ventures Risk control
techniques to prevent losses, or minimize their impact Risk retention
covering a firm’s unavoidable losses with its own funds Risk transfer
transferring risk to another firm, or individual, often by contract
for a
premium
, an
insurance company policy
to pay for losses, less the issues an
deductible insurance
Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Insurance
Insurance companies return policyholders to their financial position before the loss Insurable risk criteria include:
Predictability
Casualty
Unconnectedness
Verifiability Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Liability Insurance
Insurance that covers losses resulting from damage to people or property when the insured party is judged liable
Employers are required to provide workers ’ compensation coverage for workers who are permanently, or temporarily, disabled by job related accidents or disease Approximately $10 to $15 of every $100 paid in premiums goes to cover losses due to fraud Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Property Insurance
Covers losses resulting from physical damage to real estate or personal property
Fire and allied lines: damage to property by fire, lightning, theft Marine: transportation insurance covering the act of transportation (water, land, or air) and the good being transported Others: title, business interruption, credit, co-insurance Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Life Insurance
Pays benefits to the survivors of the policyholder Beneficiary
person to whom the benefits of a life insurance policy are paid Most companies buy group life insurance Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke Copyright © 2008 Pearson Education Canada
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Special Forms of Business Insurance
Key Person Insurance
insurance taken out by a firm on important staff members
covers losses due to their death, or other departure Business Continuation Agreements
agreement whereby owners make plans to buy the ownership interest of a deceased associate from his/her heirs Copyright © 2008 Pearson Education Canada Business, Sixth Canadian Edition, by Griffin, Ebert, and Starke