Financing the Corporate Venture

How to finance?• Prior to WWI, companies were owned and operated by the

founders.• Funds for various expenditures (replacement of worn-out

equipment, modest plant expansions) from the company earnings.

• After WWII, internal funds not sufficient to meet company needs.– Mergers– Acquisitions– Joint ventures– Alliances

• External sources the only option for large-scale projects.

Business Plans• A business plan must be developed before any

funds are sought for a new product or venture.• Business Plans minimally consist of the following

information along with a projected timetable:– Perceived goals and objectives of the company– Market data

• Projected share of the market• Market Prices• Market Growth• Market the company serves• Competition, both domestic and global• Project and/or product life

Business Plans– Capital requirements

• Fixed capital investment• Working capital• Other capital requirements

– Operating expenses• Manufacturing expenses• Sales expenses• General overhead expenses

– Profitability• Profit after taxes• Cash flow• Payout period• Rate of return• Returns on equity and assets• Economic value added

Business Plans

– Projected risk• Effect of changes in revenue• Effect of changes in direct and indirect expenses• Effect of cost of capital• Effect of potential changes in market competition

– Project life:• Estimated life cycle of the product or venture

• The business plan is then submitted to the sources of capital funding, e.g., investment banks, insurance companies.

Sources of Funds• The funding available for corporate ventures may be obtained from

internal or external sources.• Internal financing is “owned” capital – could be loaned or invested

in other ventures to receive a given return.• Internal funds may be retained earnings or reserves.• Retained earnings of a company are the difference between the

after-tax earnings and the dividends paid to stockholders.• Usually not all after-tax earnings are distributed as dividends.• The part retained by company is used for R&D expenditures or for

capital projects.• Reserves are to provide for depreciation, depletion and

obsolescence.• Inflation cuts severely into reserves.

Sources of Funds

• Three sources of external financing:– Debt– Preferred stock– Common stock

• A new venture with modest capital requirements could be funded by common stock.

• In contrast, a well-established business area may be financed by debt.

Debt• Debt may be classified as:

– Current debt: maturing up to 1 year– Intermediate debt: maturing between 1 and 10 years– Long-term debt: maturing beyond 10 years

• Current debt: Suppose a company wants to take a loan it will pay off in 90-120 days.– It can obtain a commercial loan from a bank.– It can borrow from the open market using a negotiable note

called commercial paper.– Open-market paper or banker’s acceptance: The company could

sign a 90-day draft on its own bank paid to the order of the vendor; the company will pay a commission to its own bank to accept in writing the draft.

Debt

• Intermediate debt:– This form of debt is retired in 1-10 years– Three types:

• Deferred payment contract: borrower signs a note that specifies a series of payments to be made over a period of time.

• Revolving credit: the lender agrees to loan a company an amount of money for a specified time period. A commission or fee is paid on the unused portion of the total credit.

• Term loans: divided into installments that are due at specified maturity dates. Monthly, quarterly, semiannual or annual payments.

Debt• Long-term debt:– Bonds are special kinds of promissory notes.– Four types of bonds in the market:

• Mortgage bonds – backed by specific pledged assets that may be claimed particularly if the company goes out of business.

• Debenture bonds – only a general claim on the assets of a company. Not secured by specific assets but by the future earning power of the company.

• Income bonds –interest is paid not on loan taken but on earnings in that period; used to recapitalize after bankruptcy and the company has uncertain earning power.

• Convertible bonds – hybrids that can be converted to stock. Bonds are safe investments in periods of low inflation or deflation. Stocks reflect the inflationary trend and retain purchasing power.

Stockholders’ Equity• This is the total equity interest that stockholders have

in a corporation.• Two broad classes:– Preferred stock

• These stockholders receive their dividends before common stockholders.

• These stockholders recover funds before common stockholders in case of company liquidation.

• Have no vote in company affairs.– Common stock

• Common stockholders are at greatest risk because they are the last to receive dividends for use of their money.

• Have a voice in company affairs at the company annual meetings.

Debt versus Equity Financing• The question is a complex one and depends on other issues:

– State of the economy– Company’s cost of capital, i.e. cost of borrowing from all sources.– Current level of indebtedness

• If a company has a large proportion of its debt in bonds, it may not be able to cover the interest on bonds.

• A high debt/equity ratio is a weakness.• Many capital-intensive industries like chemicals, petroleum, steel

etc have ratios of 2 or 3 to 1.• They may have to liquidate some of their assets to survive.• On the other hand, if ratio is 1 to 1, chance of a takeover.• A company must have a debt/equity ratio similar to successful

companies in the same line of business.

In Conclusion• The largest holders of corporate securities are

“institutional” investors.• These include– Insurance companies– Educational organizations– Philanthropic organizations– Religious organizations– Pension funds

• They may purchase securities in a “private” placement or in the open market as initial public offerings (IPO).