Acctg 404b Finance

Prepared by: Joseph R. Mendoza CPA, MBA Financing Decision : Sources of Financing Securitization

Sources of

Marketable Assetbacked Securities Term Loans

Debt

Secured Unsecured Common Stock Preferred Stock R/E

Long term
Convertible Security Equity Finance Lease Operating Lease Bank Loan

Financing Decision

Lease

Notes Line of Credit

Commercial Paper

Pledging A/R Pledging Invty. Factoring Securitization

Short Term

Collateralized loans

Sale of A/R & Inventory

A.) Bank Finance 1.) Short term Financing a.) Bank overdraft supported by all features of a business current account; a flexible source of short term working capital finance; no fixed repayment schedule b.) Bank loans - unsecured loan from commercial banks, and is paid off from funds coming from the normal operations of the firm. the simplest and most common source of short term funds, and comes in the ff. forms: 1.) Line of credit is generally an informal agreement between the bank and the borrower as to the maximum amount of credit the bank will provide the borrower at any one time. Legal commitment of the bank to provide the credit is not created. usually, only the general purpose for which the loan is made is disclosed. usually requires the borrower to maintain a compensating balance in the bank. 2.) Transaction loans (Notes) where the specific purpose for which the loan is made is disclosed. The borrower usually signs a promissory note. c.) Receivable financing 1.) Pledging of Accounts Receivable ( A/R ) general (all) A/R are used as collateral for the loan obtained, either from a commercial bank or finance company. banks generally charge interest w/c is 2-5% higher than its prime lending rate Prime rate interest rate that a bank charges to its most creditworthy customers. - it increases as a customers credit risk increases it is called assignment of A/R when specific A/R are used as collateral for the loan 2.) Factoring A/R outright sale of A/R to a factor, which can either be a commercial bank or a finance company engaged solely in factoring of receivables. factor bears the responsibility & risk of collecting the A/R, therefore charges factors fee from the company seller of A/R and withholds part of the selling price of A/R as protection from collection risk (factors holdback)

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Acctg 404b Finance

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Prepared by: Joseph R. Mendoza CPA, MBA d.) Inventory financing loans secured by inventories. Amount of loans depend on the marketability & perishability of the inventories. In case of defaults on the loan, the bank keeps the inventory and sells it to recover the debt Kinds of Inventory Loans 1.) floating lien agreement all inventories are used as collateral for the loan. the borrower maintains full control of its inventories. 2.) chattel mortgage agreement specific inventory (identified by serial no., or otherwise ) is used as collateral for the loan. The borrower retains title to the inventory but cant sell them without the lenders consent. 3.) field warehouse financing agreement - the inventories used as collateral in the loan are physically separated from the borrowers other inventories. They are placed under the control of a third party field warehousing firm. 4.) terminal warehouse agreement same as #3 but the inventories are placed in a public warehouse, not in a third party field warehouse. Inventories are totally out of control of the borrower.

2.) Medium term financing - those with extended payment terms that exceed 180 days and can
go up to five - seven year term. a.) medium term promissory notes b.) finance and leasing options - finance to spread the cost of insurance, corporation tax or other annual payments. - repayment over five years or life of the asset. c.) bridging finance finance to fund business awaiting grant checks or drawdown of approved commercial mortgages or loan agreements.

3.) Long term financing - those that are payable over a period of 10 or more years.

a.) mortgage loan - a loan secured by real property of the borrower and is usually obtained to
finance companys large undertakings. Lending companies usually lend from 65% - 85% of the valuation of the property b.) fixed asset loan 10 year loan for fixed assets (PPE) and is payable over their useful life. c.) Specialist product (service) loan granted by the bank to fund expansion, merger or acquisition plans. medium to long term financing may also be classified in terms of interest rate as: 1.) Variable Rate (Floating Rate) Loans interest rate varies at the banks discretion and consists of a base rate plus a credit margin which varies between borrowers Characteristics: a.) flexible, that it can be repaid early without penalty a.) a redraw facility is allowed for borrowers with excess repayments that were made b.) can be converted to a fixed rate loan c.) borrowers who wish to be protected against possible increase in interest rate can choose a capped option (the interest rate will not exceed a specified ceiling for a specific period) 2.) Fixed Rate Loan - interest rate is fixed up to a certain period but may be reset for a further fixed term or the loan may continue on a variable rate basis

used to fund expansion projects and for business entities that face a shortage of capital.

4.) Lease option - a lease is a rental agreement for the use of a product or property. A long-term,
noncancellable lease has all the characteristics of a debt obligation. a.) Capital lease (financing lease) - leases that substantially transfer all the benefits and risks of ownership from the owner. a lease is capitalized whenever any of the following conditions exists. 1.) Ownership of the property is transferred to the lessee by the end of the lease term. 2.) The lease contains a bargain purchase price (sure to be purchased) at end of lease. 3.) The lease term is > 75 % of the estimated life of the leased property. 4.) The PV of minimum lease payments > 90% of the fair value of the leased property at the beginning of the lease. capitalized amount is presented in the statement of financial position and is amortized and written off over the life of the lease. capital lease liability is written off through amortization with an "implied" interest expense on the remaining balance.

b.) Operating lease essentially a mere rental agreement it is usually short-term, often cancelable at the option of the lessee (at little or no cost,
provided that the lessee gives the agreed notice (if any) of cancellation to the lessor)

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Acctg 404b Finance

Prepared by: Joseph R. Mendoza CPA, MBA and the lessor frequently provides the needed maintenance. Presented in the statement of operations

Sources of

c.) Sales and Lease-back Agreement where the owner of the asset sells the asset to a
financial institution for an amount usually equal to its current market value and immediately leases it back from the institution. Advantages of leasing 1.) Takes care of lack of sufficient funds or the credit capability issues to purchase assets 2.) Provisions of lease may be substantially less restrictive 3.) May not require a down payment 4.) Lessors expertise may reduce negative effects of obsolescence 5.) Creditor claims on certain leases are restricted in bankruptcy & reorganization procedures. 6.) Tax benefits 7.) Infusion of capital through a sale-leaseback. B.) Government Sources Government subsidies economic benefits (like tax allowance or duty rebate) or financial aid (like cash grant or soft loan) provided by the government to: 1.) Support a desirable activity such as exports 2.) Keep prices of staples low 3.) Maintain the income of the producers of critical or strategic products 4.) Maintain employment levels or induce investment to reduce unemployment The basic characteristic of all subsidies is to reduce the market price of an item (subvention). Ex: subsidies to encourage sale of exports, subsidies on some foods to lower cost of living, subsidies to encourage the expansion of farm production and achieve self reliance in food production 1.) Government Grants bounty, contribution, gift or subsidy (in cash or in kind) bestowed by the government for specific purpose to a specific eligible recipient. It is usually conditional upon certain qualifications as to the use, maintenance of specified standards or a proportional contribution by the grantee or other grantors. The government provides finance to companies in cash grants and other forms of direct assistance to help develop the national economy, especially in high technology industries and in areas of high unemployment. National and regional grants usually focus on particular purpose or theme like: a.) Investment to support growth through capital investment and job creation, especially in economically depressed areas Innovation to support research and development activities c.) Energy and the Environment to support those businesses that invests in improving energy efficiency and environmental improvements. d.) Training to assist the development of skills and capabilities of management staff. Other grants are available depending on the location and type of the business e.) Exports to support businesses manufacturing products for exports f.) Logistics and freight to promote alternatives to road haulage g.) Industry specific grants to support individual industries that need promotion like rural diversification, crafts, tourism and agriculture Some local grants are intended to help new businesses and boost employment 2.) Tax incentives intended to improve economic conditions in disadvantaged regions, to promote certain types of business industries and to increase employment rates Ex: a sports apparel manufacturer might get government subsidy and tax benefits after building a plant in a disadvantaged zone, hiring local workers, paying social security taxes and partnering with regional businesses. 3.) Tax Holiday a temporary reduction or elimination of tax, usually granted as incentives for business investment. the Omnibus Investments Code grants tax holidays of 4-6 years, followed by a 5% tax thereafter, to registered enterprises that will conduct business within a special economic zone. The exemption from national taxes covers all internal revenue taxes, including VAT. (E.O. no. 226). In addition, they are granted tax credits for purchases of Philippine made capital equipment and raw materials. Examples of Special Economic Zones a.) Philippine Economic Zone Authority (PEZA) given a tax holiday of 3-8 years. It is subject to 5% tax on gross income (sales costs) in lieu of all local and national taxes.

b.)

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Acctg 404b Finance

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Prepared by: Joseph R. Mendoza CPA, MBA b.) Subic Bay Metropolitan Authority (SBMA) or Subic Bay Freeport Zone and Clark Development Corporation (Clark Freeport Zone) subject to 5% tax on gross income. Other tax incentives under E.O. no. 266 include, but not limited to the following: a.) Tax credit on domestic capital equipment b.) exemption from contractors tax c.) simplification of customs procedures d.) exemption on breeding stocks and genetic materials e.) tax credit on domestic breeding stocks and genetic materials f.) tax credit for taxes and duties on raw materials g.) exemption from taxes and duties on imported spare parts h.) exemption from wharfage dues and export taxes 4.) Tax credits credits against taxes and or duties equal to those actually paid or would have been paid to which a tax credit certificate shall be issued

C.) Microcredit - the extension of very small loans (microloans) to those in poverty designed to spur
entrepreneurship. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. Microcredit is a part of microfinance, which is the provision of a wider range of financial services to the very poor. In her proclamation no. 719, former President Arroyo mentioned microfinance as the cornerstone strategy of the governments fight against poverty. The governments microfinance program targeted 1 million women as beneficiaries. To date, there are already 2 million beneficiaries of microfinancing from government financial institutions alone with P24 billion released for small loans. Some Institutions Providing Microcredit Programs Baba's Foundation, Inc. (Davao, City Philippines) established 5 farmers cooperative and under its technical guidance, the coops have developed well, providing farmers with new technologies, collective marketing of their produce and greater solidarity. Kaunlaran s Kabuhayan, Unlad Kabayan, Kabalikat Para sa Maunlad na Buhay, Inc. Tulay sa Pag-unlad Development Corporation Program Beneficiaries Development Small and Medium Enterprises Credit (SMEC) Program Collateral Free Loans to MSMEs through the Credit Surety Fund Program National Livelihood Support Fund Microfinance program of DSWD DBP, Land Bank of the Philippines, SSS New Rural Bank of Victorias, Inc. Quedan and Rural Credit Guarantee and Finance Corporation CARD Mutually Reinforcing Institution Center for Community Transformation Negros Women for Tomorrow Foundation Philippine Export-Import Credit Agency Cebu Micro-Enterprise Development Foundation, Inc. Taytay sa Kasuwagan, Inc.

D.)

Trade Credit a credit extended by a firms suppliers. It is equivalent to a short-term loan made by the seller to the purchaser, of an equal amount to the purchase price. It is often the largest source of short-term credit, especially for small firms. Approximately 40 percent of shortterm financing is in the form of accounts payable or trade credit. It is spontaneous, easy to get, but cost can be high. It grows as the business expands and contracts when business declines. Advantages of Trade Credit 1.) It is flexible - the amount of credit reflects the value of business done with a supplier 2.) It is low cost - trade creditors dont charge interest on the amount outstanding unless payment is delayed well beyond the settlement date 3.) It matches the purchase of goods and services Components of Trade Credit (TC) : 1.) Free TC- received during the discount period. 2.) Costly TC- taken in excess of free trade credit, whose cost is equal to the discount period lost.

E.) Venture Capital and Financial Sources For Small Enterprises 1.) Personal Savings funds come from the owner himself. Outside investors and lenders expect 2.) Family and Friends potential source of low or no interest loans. However, since all business Page 4
the entrepreneur to put some of his capital into the business before investing theirs.

Acctg 404b Finance

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Prepared by: Joseph R. Mendoza CPA, MBA ventures involve risk, it would be appropriate to make a written loan agreement, specifying all necessary terms of the loan. 3.) Banks provides two basic types of small loans based on the credit history of the borrower. a.) business loans extended solely for pursuing business purposes. It is usually secured with company or personal assets to gauge whether the borrower thinks it is worth taking the risk. have more strict requirements than consumer loans. Ex: during financial crisis, the bank may demand full payment of the loan, w/c is unlikely to happen with a consumer loan. b.) consumer loans - extended to borrower for personal or business consumption. It requires less paperwork and approval process is faster than business loans. 4.) Government Guaranteed Loans (Small Business Administration SBA) guarantees and or provides loans to borrowers for the purpose of building or starting a business, not for paying creditors or investors, investing in real estate or other restricted purposes. In the Philippines, this is called as credit guarantee programs/schemes. The Philippine Export-Import Credit Agency guarantees both small and large loans, although it is supposed to be export focused. Recently, the BSP has been sponsoring small credit surety funds in cooperation with selected local government units and some finance-oriented cooperatives. 5.) Offices of Economic Development - state and local entities that provide financing and information on finding other sources of capital. 6.) Finance Companies provides a higher risk but higher interest rate commercial loans. They are the best outsourced when: a.) the business is highly growing and continually needs high amount of loans b.)the borrowers credit history is spotty c.) the borrower has a high debt ratio but with a strong cash flow. 7.) Venture Capitalists and Business Angels - invests in growth businesses in return for an ownership stake in the company and a degree of involvement and control. However, the borrower company must understand their differences in certain respects, in order to maximize chances of success and minimize time and resources invested in raising capital. Differences Angel Investors Venture Capitalists 1.) Source of Funds acting alone or in groups, are Corporate entities that pool their usually wealthy individuals, often money from a range of with a successful entrepreneurial institutional and individual record, who invest their own investors money 2.) Deal Size Individual: $25,000 - $100,000 $500,000-$10,000,000 or above, Group: $1,000,000 or more may provide second round provide the seed capital needed financing after angel investor to develop a venture to the stage where it is possible to seek formal outside finance from venture capitalists, banks and other financial institutions Earlier stage businesses Different stages of business devt. 3.) Development Stage Concentrate on high-growth Allocate funds to a range of 4.) Industry and sectors, often associated with ventures, frequently tied with Geographic Focus technology or innovation their areas of expertise 5.) Ease of Obtaining Relatively easy to identify Highly rigorous process firm Funds through local resources, must first meet all the investment networking, internet researches, criteria like: and references from existing a.) Extraordinary growth potential contacts b.) Management talent and experience c.) Proprietary products or services Have higher return expectations 6.) Cost & restrictions Lesser cost and restrictions and more defined criteria than angel investors

8.) grants almost impossible to come for a business start-up but can be available for the
development of a product or service that will benefit the public or will generate a product or service the government needs.

Negotiating Term Loans : A Process and A Strategy

term loan - A loan from a bank for a specific amount that has a specified repayment schedule and a

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Prepared by: Joseph R. Mendoza CPA, MBA floating interest rate. It is the most common form of intermediate-term financing arranged by commercial banks, maturing in 1-15 years and can be structured in a wide diversity of ways. provides working capital needed to acquire inventory and PPEs generating cash flow. may be secured or unsecured, and carry interest rate based on the lender's cost of funds, interbank overnight loans or the bank prime rate. paid thru future earnings & cash flows of business, according to a fixed amortization schedule. Borrowers Objective: to get the largest loan at the best rate. requires a solid strategy in the entire negotiation process. The borrower must be aware of other financial institutions and market players and the terms of loan they offer. borrower can benefit by doing research into the banks current market and objectives in commercial finance. borrower must deal with the issues and objections that will be raised by the bank, in a manner that keeps the loan proposal positive in nature. Borrower must know the conditions of the industry where he/it belongs, anticipate what risks the bank will perceive in their industry and be prepared to tackle those risks by properly preparing information as to what the business has done in the past and what it intends to do in the future to deal with those risks and achieve its full potential. Example: Since the bank focuses on cash flow and looks at historical cash flow to reflect future cash flow, the borrower must discuss well how and where cash flows will be generated, specially if revenues and profits are not stable in the past years. Since the bank will also be concerned with the borrowers financial condition, it will scrutinize the balance sheet. So the weaknesses in the balance sheet need to be tabled and discussed. He must review and understand the financial ratios that will most likely be scrutinized such as liquidity, solvency, operating, and fixed asset coverage ratios. In summary, all banks and other finance firms have very similar and basic analysis models around term loans - they involve industry and financial statement analysis, focusing as much on the past and future as the present. The borrower has to understand these metrics used by banker in order to limit the loan restrictions and get the loan amount needed. Items Negotiated in a Loan 1.) Interest how is the rate calculated? Will it be variable or fixed? 2.) Payment terms how much is the periodic payment? When is the final principal due? Is there a right to extend the due date of the loan? 3.) Fees are there ongoing fees or charges during the life of the loan? 4.) Use of loan proceeds are the loan proceeds restricted for certain uses? 5.) Representation and Warranties of the Borrower accuracy of the borrowers F/S, payment of all taxes and filling of all tax returns. Loan modifications changes on the loan agreement that makes it easier for the borrower to make payments. It is offered by a bank when it is more beneficial than a legal suit to a borrower.

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