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Raising Money to Grow a Business Lesson 1 Taking Loans and Issuing Bonds
How Companies Expand Aim: • What are the pros and cons of borrowing the money you need to grow your business? Do Now: • From your experience hearing about loans people take to buy homes and cars, identify the essential elements of every loan.
How Companies Expand • Do Now answers: • The dollar amount borrowed. • The annual interest rate applied to the borrowed money. • The amount of time, usually in years or months, the borrower has to pay it back.
Frizzle, Inc. • Ice cream and restaurant. • Opening new Frizzle’s around the world for the past five years. • One of the most popular ice cream restaurants in the United States and Europe. • 20% market share. • 25,000 employees in multiple locations in the United States and Europe. • Headquartered in New York, NY. • Looking to expand to China or Russia. • Needs $500 million in order to expand. • Financial statements indicate a healthy, profitable company.
Frizzle, Inc. Frizzle, Inc. has 2 choices to borrow money Frizzle, Inc. Issue Bonds Borrow money from a bank
Borrowing from a Bank Company can take a loan from a bank in order to get the capital (ie: cash to use for a long while) it needs • Similar to an individual borrowing money • Must be paid back in a certain time by a specified date with interest
Borrowing from a Bank Advantages Disadvantages May be more expensive and have to pay a higher rate of interest (than the other form of borrowing, a bond) Potential prepayment penalty Could decrease cash flow if repayment starts right away • May be able to secure loan quickly • Owners don’t give up control • Less restrictions on what the money can be used for
Borrowing with Bonds • What is a bond? • A document (ie: security) that represents an amount of money (usually $1,000), which is clearly printed on the bond (ie: Principal) • For each $1,000 an investor wants to lend to a governent or business, it receives one bond • Lender/Bondholder – We say the investor “buys” the bond because he or she pays (the Principal $ amount) for it. • Issuer – The company or government that borrows the money. It has this name because it issues the bonds!
Bonds The issuer is repaying the lender’s/bondholder’s original investment(Principal) when the term of the bond is due. This date, also printed on the bond, is called the Maturity Date)
Bonds In the days before computers, the bond was issued with coupons. Every six months, one would be torn off and turned in to receive interest. The coupons went away, but we continue to call the interest rate the coupon rate, and the payment itself the coupon payment. The issuer pays interest to the bondholder during the term of the bond. The coupon payments end when the bond reaches maturity.
Bonds • Principal (aka “Face Value”):The original investment is repaid when the bond matures. • Maturity Date:Predetermined date in the future when the bond matures and the lender/bondholder receives the principal investment. • Coupon Rate (%):The interest that the lender/bondholder receives. • Coupon Payment ($):A dollar amount that is paid to the lender/bondholder regularly until the bond matures (payment is based on the Coupon Rate and Principal)
Bonds Principal + Coupon Payment • Cash Flows of a Bond Coupon Payment Coupon Payment Coupon Payment Coupon Payment Maturity 0 1 2 3 4 5 Year
Bonds Credit riskis the chance that a bond issuer will fail to repay the principal and interest on the specified date Coupon Payment Coupon Payment Coupon Payment Coupon Payment 0 1 2 3 4 5 Year
Rating Process For Bonds • To assess a company’s risk of failing, bond investors turn to the following three credit ratings agencies: • Ratings are based on whether or not the issuer will be able to make their principal and interest payments, to the bond holder, on time A “AAA” high grade bond offers more security but a lower yield than a “C” bond A “C” bond is more risky but has a higher yield
Maturity Date • Bonds • Coupon Rate • Face Value (Prin.) • Coupon Payment
Issuing a Bond(vs. Borrowing From a Bank) Advantages Disadvantages Company may have difficulty issuing bonds if they are experiencing financial difficulties within their company Company may not be large enough to issue bonds • Company can borrow at a lower interest rate than they would have to pay the bank • Company will be able to raise a large sum of money from the large community of bond investors
Lesson Summary • What are the two choices corporations have if they want to borrow money? • What are the relative pros and cons of each? • What are the major elements of a bond? • Identify the three big bond ratings agencies • What are the highest and lowest available ratings? • What are the pros and cons of borrowing the money you need to grow your business?
Web Challenge #1 Q: The Federal Reserve has tried to keep down the interest rate at which people and corporations can borrow money. Will this cause there to be more or less money borrowed? • A: It will encourage more borrowing because low rates means less interest costs. • Challenge: Find corporations that have issued bonds because it’s just cheap to borrow and they want to lock in a low rate. Hint: Look for the explanation that the money will be used for “general corporate purposes”.
Web Challenge #2 • Challenge: Not any company can walk into a bank and get a loan. Research the characteristics a business must have to qualify for a bank loan. Prepare a checklist of five to 10 requirements. Indicate the most challenging one, explaining why. (Hint: the evaluation by the bank is formally called “underwriting”.)
Web Challenge #3 Q: The Small Business Administration is a government department that was created to help small businesses, including providing loans to them. • Challenge 3a: Visit sba.gov. Identify three ways that it can help a small business. • Challenge 3b: Prepare one argument for and one against having the government loan money to businesses. After all, who loses if the business fails and can’t repay the loan?