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Chapter 14. Understanding Financial Contracts. Introduction . Chapter focuses on financial contracts between lenders and borrowers Non-traded financial contracts are tailor-made to fit the characteristics of the borrower

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Chapter 14

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chapter 14

Chapter 14

Understanding Financial Contracts

  • Chapter focuses on financial contracts between lenders and borrowers
  • Non-traded financial contracts are tailor-made to fit the characteristics of the borrower
  • In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract
asymmetric information
Asymmetric Information
  • Problems associated with the availability of information about the borrowers who seek funding.
how business obtains financing
How Business Obtains Financing
  • Businesses need funds for a variety of reasons
    • Finance permanent assets such as plant and equipment
    • Finance the acquisition of another business
    • Finance working capital—inventory or accounts receivable
financing small businesses
Financing Small Businesses
  • Small firms—assets less than $10 million
  • Vast majority are privately owned with ownership concentrated in a single family
  • Generally do not need external financing beyond trade credit—delayed payment offered by suppliers
  • Profitable firms may have sufficient capital to be self-financing
  • Banks are most likely source of external financing
banks provide funds
Banks Provide Funds
  • Short-term loan—negotiated contract with short maturity
  • Line of Credit
    • Bank extends a credit for specified period of time
    • The borrowing firm can draw down funds against L/C
    • Credit Rationing—insures borrower has access to funds even if bank would prefer to curtail new loans
  • When financing capital assets the maturity of the loan is typically less than life span of the asset
bank loan origination
Bank Loan Origination
  • Locate a bank that meets your needs, usually through a referral
  • The bank’s loan officer conducts a complete credit analysis
    • Review borrower’s financial statements
    • Visit the place of business
    • Assesses the managerial strengths/weaknesses of borrower
    • Provides an opportunity to develop a one-on-one relationship
bank loan origination9
Bank Loan Origination
  • Obtain additional information about the firm
  • Obtain credit report on the firm and borrower
  • Address any concerns with the borrower
  • Loan is approved by the bank
    • Small loan approved by a loan officer
    • Larger loans are approved by more senior officers
    • Above a certain amount must get approval from loan committee
    • Borrower and bank negotiate terms of the loan
    • Maturity of small business loans rarely exceeds 5 years
features of a small business loan
Features of a Small Business Loan
  • During application period and after the loan is granted, develop a relationship between bank and borrower
  • Loans are often collateralized
    • Pledging of assets against the loan
    • Secured lender—bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to satisfy the loan
    • Unsecured lender—have right to proceeds from sale of assets after secured lenders have been paid
    • Owner may pledge personal assets as collateral
features of a small business loan11
Features of a Small Business Loan
  • Loan can be guaranteed by the owner
    • Borrower is personally liable for any unpaid balance
    • Lender may require a personal financial statement of the borrower
    • With very small firms, often loan is strictly dependent on creditworthiness of the individual not the small business
restrictive covenants
Restrictive Covenants
  • Loan may contain restrictive covenants
    • Covenant—promises that the company makes to the bank regarding their future actions and strategies
    • The bank may require an audited financial statement to verify the convents have not been broken
    • More restrictive covenants are linked to actions indicating the company has become riskier
financing midsize businesses
Financing Midsize Businesses
  • Assets between $10 million and $150 million
  • Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market
  • Some are likely to be publicly owned—issue equity traded in the over-the-counter market
  • Can either be owner managed or managed by someone other than the owner
financing midsize businesses14
Financing Midsize Businesses
  • For short-term debt, principally rely on commercial banks
    • Depending on size of debt and bank, can use either local or non-local banks
    • Typically have covenants placed on the loan and may pledge collateral
  • Revolving Line of Credit--access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan
financing midsize businesses15
Financing Midsize Businesses
  • Long-term debt financing is often provided by non-bank institutions
    • Mezzanine debt funds provide loans to smaller midsize companies
    • Private Placement Market (Figure 14.2)
      • Generally a bond issue in excess of $10 million
      • Bonds do not have to be registered with the SEC
      • Avoids public disclosure of information
      • Sold only to financial institutions and high net worth investors
financing large businesses
Financing Large Businesses
  • Firms with assets in excess of $150 million
  • Becomes cost effective to enter the public bond market
  • These bond issues are liquid assets that are traded in the secondary market
  • Therefore, can be issued at a lower yield than a nontraded instrument
financing large businesses18
Financing Large Businesses
  • Large businesses can afford the high distribution and underwriting costs of a public issue
    • Additional costs to sell to a wider range of investors
    • Substantial costs associated with registering the bond with the SEC
  • Securities Underwriting (Figure 14.3)
    • Issuer selects an underwriter, generally an investment bank, to assist in issuing and marketing the bond
    • Underwriters actively market their services to companies large enough to issue in the public market
shelf registration
Shelf Registration
  • Permits the issuer of a public bond to register a dollar capacity with the SEC
  • Draw down on this capacity at any time
  • This avoids additional registration requirements
  • Permits issuers to respond instantaneously to changing market conditions
financing large businesses21
Financing Large Businesses
  • Large companies with good credit ratings tend to rely on the commercial paper market for short-term financing
  • Some very large businesses also issue medium-term notes, which are like commercial paper, except maturities range from one year to five years
  • Also issue equities, through underwriters, which is another form of external long-term financing