Chapter 14 Understanding Financial Contracts Financial Contracts Business
Chapter 14 Understanding Financial Contracts
Financial Contracts § Business borrow funds in the financial markets primarily through two ways: § Direct Financing: § Directly from savers § Using traded securities § Indirect Financing: § Through financial intermediaries § Using non-traded securities § Financial contracts are written between lenders and borrowers 14 -2
Financial Contracts § Non-traded financial contracts § Tailor-made to fit the characteristics of the borrower § Lenders tend to hold these securities until maturity § Publicly traded financial contracts § Standardized § Suitable to meet the needs of large number of investors § Lenders may not hold these securities until maturity 14 -3
Financial Contracts Features of Financial Contracts § Describes how instruments/securities are originated § Describes restrictive covenants § Describes terms of contract 14 -4
Why Business Needs Financing Reasons for Financing § To finance permanent assets such as plant and equipment § To finance working capital § Inventory § accounts receivable § To purchase plants and equipments § To finance payroll § To finance the acquisition of another business 14 -5
Financing Small Businesses Definition of Small Business § Assets size: less than $10 million § Most of them are privately owned § Therefore, do not issue stocks § Ownership concentrated in a single family 14 -6
Financing Small Businesses Features of Small Business Financing § Profitable ones often have sufficient capital to be self-financing § Generally, do not need external financing beyond trade credit § Delayed payment offered by suppliers § Banks are most likely source of external financing 14 -7
Financing Small Businesses Features of Small Business Financing § Receives funds from banks in two forms: § Short-term loan § Line of credit (L/C) 14 -8
Financing Small Businesses Short Term Loans § Negotiated contract with short maturity § One time, needs renegotiation each time loans are extended § Typical maturity is 90 days of less 14 -9
Financing Small Businesses Line of Credit (L/C) § § Bank extends a credit for specified period of time The borrowing firm draws down funds against L/C Provides a continuous source for working capital Removes uncertainty of denials or credit rationing § Credit Rationing: A situation when banks curtails issuance of new loans 14 -10
Financing Small Business Origination Mechanism § Locate a bank that meets business’s needs § Usually through a referral (bank’s accountant) § Origination involves three steps: § Credit analysis § Negotiation of terms § Loan approval or Denial 14 -11
Origination Mechanism 14 -12
Origination Mechanism Credit Analysis § Reviewing of financial statements by a loan officer § Visiting the place of business § Assessing managerial strengths and future growth potential § Seeking additional information about the firm § Obtaining credit report on the firm § Addressing any other concerns with the borrower 14 -13
Origination Mechanism Negotiation Phase § Borrower and bank negotiate terms of the loan Loan Approval § Small loans can be approved by a loan officer § Larger loans are approved by more senior officers § Above a certain amount must get approval from loan committee 14 -14
Financing Small Businesses Unique Features § Loans have shorter maturity (rarely exceeds 5 years) § Loans are often secured (collateralized): § Pledging of assets against the loan § Owner often pledges personal assets as collateral and be personally liable for any unpaid balance § Bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to recoup the balance § During application period and after the loan is granted, a personal relationship between bank and 14 -15 borrower is developed
Financing Small Businesses Unique Features § Loan contains restrictive covenants § Covenant: § Restrictions placed by the lender on future actions and strategies of the borrowing firm § Designed to make sure that firm does not become risky § An audited financial statement is required to verify the convents are not been broken § When covenants are broken, bank may demand immediate payment of loan § Possible for the borrower to renegotiate the terms of the loan to reflect higher risk 14 -16
Financing Midsize Businesses Definition of Midsize Business § Assets between $10 million and $150 million § Owner managed or managed by someone other than the owner § 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 publicly owned that issue equity or stocks traded in the over-the-counter market 14 -17
Financing Midsize Businesses Features § For short-term debt, primarily rely on commercial banks § May rely on a local or non-local bank § May have restrictive covenants § May be required to pledge collateral § For long-term debt, commercial bank may combine a line of credit with intermediate-term loan known as Revolving Line of Credit 14 -18
Financing Midsize Businesses Long Term Debt Financing § Forms of financing: § Through non-bank institutions § Through Private Placement Market 14 -19
Long Term Debt Financing Non-Bank Institutions § Mezzanine debt funds provide loans to smaller midsize companies § Recall, these are financing that lie between straight debt and equity. Typical forms are: § Combination of both debt and equity financing § Convertible Debt § Subordinate Debt 14 -20
Long Term Debt Financing Private Placement Market § Mid-size business issues bonds over $10 million § Sold only to financial institutions and high net worth investors with sophisticated knowledge of investment § Bonds do not have to be registered with the SEC § Public disclosure of information is not required 14 -21
Private Placement Market Features § Generally not resold by original investor for at least two years § Covenants that are less restrictive than when borrowing from a bank § Terms can be renegotiated one or more times during the life span of the loan if the company wishes to embark on a new strategy 14 -22
Private Placement Market Origination § Structured and marketed by an agent, commercial banks or investment banks § Due diligence: the agent handling the private placement evaluates the firm’s management, financial condition, and business capabilities § Credit Rating: Based on due diligence, the placement issue will receive a formal credit rating which measures the perceived risk from a rating agency (such as NAIC) 14 -23
Private Placement Origination. 14 -24
Private Placement Market Origination § Contract Construction The terms of the contract including interest rate, maturity, covenants, and any special features are negotiated to make it attractive to investors § Offering memorandum and Term sheet containing information of the issuing firm and the contract terms are sent to prospective investors § Once the issue is placed, the investors do their own due diligence which verifies the information in the issue 14 -25
Financing Large Businesses Features § Large firms are the ones with assets in excess of $150 million § Cost effective to enter the public bond market § Public bonds are liquid. Issuer receives a Liquidity premium § However, public bond issues can be costly § Issues more than 100 m § Gain from liquidity premium can more than offset the cost of public bond issuance 14 -26
Financing Large Businesses Cost of Issuing Public Bond § Distribution cost: costs to sell to a wider range of investors § Registration cost: costs associated with registering the bond with the SEC § Underwriting cost: costs of issuing and marketing a public issue 14 -27
Securities Underwriting Process: § Issuer selects an underwriter, generally an investment bank or a commercial bank to assist in issuing and marketing the bond § Underwriters also market their services to companies large enough to issue in the public market § Underwriter does due diligence on the issuer and comes up with two items: § Registration Statement § Offering (preliminary) prospectus 14 -28
Securities Underwriting. 14 -29
Securities Underwriting Registration Statement § Must conform disclosure requirements § Certified by underwriter, accountants, and issuing firm’s attorneys § The registration statement must be approved by the SEC before distribution Offering (preliminary) prospectus § Must contain relevant factual information about the firm and its financing history 14 -30
Role of Underwriter § Underwriting syndicate § Formed by the managing underwriter to share responsibility of § Distribution the issue § underwriting risk § Underwriter provides a firm commitment to sell the issue at a commitment price § Involves extensive market research § Ability to attract institutional investors 14 -31
Role of Underwriter § Underwriting Spread § The difference between the offering price and the commitment price § Serves as the profit to underwriters § Underwriting risk § occurs when the underwriters make a firm commitment to sell the bonds at an agreed price (implied interest rate) § If bonds sell below this price, underwriter takes a loss 14 -32
Financing Large Businesses Shelf Registration § Permits the issuer of a public bond to register a dollar capacity with the SEC § This avoids lengthy registration time § Permits issuers to respond instantaneously to changing market conditions § Draw down on this capacity by calling for competitive bids from investment bankers § Whenever underwriting syndicate is formed after the winning the bid, it is called a bought deal 14 -33
Financing Large Businesses Summary § For short-term financing, Large companies with good credit ratings tend to rely on commercial paper market § Very large businesses may be able to issue medium-term notes: § Commercial paper § For long-term financing, they issue public bond or equities through underwriters § Equity issues are much less frequent than bond § Equity issuance requires larger syndicate and enable higher profits to investment bankers.
Economics of Financial Contracting § Why do firms of different size rely on different financial contracts to raise funds § Transactions costs § Asymmetric information 14 -35
Asymmetric Information Adverse Selection § Caused by asymmetric information before a transaction is consummated § Bank loan officer cannot easily tell the difference between high and low quality borrowers § Part of the loan officer’s job is to use credit analysis to uncover relevant information § Asymmetry of information is particularly acute for small firms since there is little publicly available information 14 -36
Asymmetric Information Moral Hazard § Occurs after the loan is made § Loan contract may provide the firm an incentive to pursue actions that take advantage of the lender § If the firm does very well, the owner does not pay more to the issuer of the bank loan § If the firm does poorly, the owner’s liability is limited to the terms of the loan § Therefore, owners disproportionately share in the upside of increased risk, while lenders disproportionately share in the downside 14 -37
Economics of Financial Contracting § Large firms § § § Relatively easy to observe Labor contracts are often public knowledge Supplier relationships are often well known Marketing success or failure is well documented Cares about its reputation and therefore, motivated to not switch to high risk activities 14 -38
Economics of Financial Contracting § Large firms § Public markets for stocks and bonds will generally reflect true riskiness of investment. § Prices and yields for large firms will be determined accordingly 14 -39
§Economics of Financial Contracting § Small firms § External reputations are difficult to establish § Most activities are beyond the public’s scrutiny § Need proxies to demonstrate they are low risk and committed to not shifting their risk profiles § Outside collateral or personal guarantees plays an important role § Inside collateral, bank files a lien against collateral § Loan covenants prevent risk shifting by explicitly constraining borrower behavior 14 -40
§Economics of Financial Contracting § Small firms § Cannot enter into long-term debt contracts § Small business are made on a short-term basis 14 -41
Economics of Financial Contracting § Midsize Companies § Their information problems lie between small and large size companies § More visible publicly than small, but more informationally opaque than large companies § Still need a financial intermediary at the origination stage to address adverse selection problems and design a tailor-made contract § May have access to long-term debt in the private placement market 14 -42
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