Ch 20 - Finance and Risk - Pearson Education Canada

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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