Chapter 15

4. Implement the Risk-Management Program

- depend on both the technique chosen and the activity being managed e.g. - risk avoidance for certain activities can be implemented by purchasing those activities from outside providers, such as hiring delivery services instead of operating delivery vehicles. - Risk control might be implemented by training employees and designing new work methods and equipment for on-the-job safety

examples of secured short-term loans

- inventory as collateral - accounts receivable as collateral - factoring accounts receivable

Trade credit can take several forms:

- open-book credit - promissory notes - trade draft and trade acceptances

common stock values are expressed in three ways:

- par value - book value - market value

the factors management takes into account when deciding between debt and equity financing:

- when must it be repaid? - will it make claims on income? - will it have claims on assets? - will it affect management control? - how are taxes affected? - will it affect management flexibility?

The risk-management process usually involves five steps:

1. identify risks and potential losses 2. Measure the Frequency and Severity of Losses and their Impact 3. Evaluate Alternatives and Choose Techniques that Will Best Handle Losses 4. Implement the Risk-Management Program 5. Monitor Results

Factoring Accounts Receivable

A firm can also raise funds by factoring (i.e., selling) its accounts receivable The purchaser of the receivables (called a factor) might, for example, buy $50 000 worth of receivables for 80 percent of that sum ($40 000) The factor then tries to collect on the receivables and profits to the extent that the money it eventually collects exceeds the amount it paid for the receivables. Usually the factor ends up with a profit of 2 to 4 percent, depending on the quality of the receivables, the cost of collecting them, and interest rates. Factoring essentially means outsourcing the collection process.

lines of credit

A standing agreement with a bank to lend a firm a maximum amount of funds on request the firm knows the maximum amount it will be allowed to borrow if the bank has sufficient funds The bank does not guarantee that the funds will be available when requested

5. monitor results

Because risk management is an ongoing activity, follow-up is always essential. - managers must continually monitor a company's risks, reevaluate the methods used for handling them, and revise them as necessary.

secured bonds

Bonds issued by borrowers who pledge assets as collateral in the event of non-payment. borrowers can reduce the risk of their bonds by pledging assets to bondholders in the event of default If the corporation does not pay interest when it is due, the firm's assets can be sold and the proceeds used to pay the bondholders

disadvantages of long-term loans

- Large borrowers may have trouble finding lenders to supply enough funds. - Long-term borrowers may also have restrictions placed on them as conditions of the loan. They may have to pledge long-term assets as collateral. And they may have to agree not to take on any more debt until the borrowed funds are repaid.

issuing common stock

By selling shares of common stock, the company obtains the funds it needs to buy land, buildings, and equipment Individuals and companies buy a firm's stock, hoping that it will increase in value (a capital gain) and/or will provide dividend income can be expensive because paying dividends is more expensive than paying bond interest. interest paid to bondholders is tax-deductible, but dividends paid to stockholders are not. Even though equity financing is expensive, financial managers cannot rely totally on debt capital, because long-term loans and bonds carry fixed interest rates and represent a promise to pay regardless of the profitability of the firm. If the firm defaults on its obligations, it may lose its assets and even go into bankruptcy.

sinking-fund provisions

Callable bonds are often retired by the use of sinking-fund provisions issuing company is required to put a certain amount of money into a special bank account annually At end of a certain number of years, the money (including interest) will be sufficient to redeem the bonds Failure to meet the sinking-fund provision places the issue in default Such bonds are generally regarded as safer investments than many other bonds.

default

If a company fails to make a bond payment, it is in default

1. Identify Risks and Potential Losses

Managers analyze a firm's risks to identify potential losses e.g. firm with fleet of delivery trucks => one truck will be expected to involve in an accident, accident may cause injury oneself or other drivers, physical damage to truck and other trucks, damage to any goods carried in the truck

hybrid financing: preferred stock

Preferred stock is a hybrid because it has some of the features of corporate bonds and some features of common stock payments on preferred stock are for fixed amounts referred stock never matures can be held indefinitely, like common stock dividends are paid, preferred stockholders receive them first in preference to dividends on common stock usually issued with a stated par value Some preferred stock is callable, meaning that the issuing firm can require the preferred stockholders to surrender their shares in exchange for a cash payment The amount of this cash payment, known as the call price, is specified in the agreement between the preferred stockholders and the firm.

equity financing

Raising money to meet long-term expenditures by issuing stock or retaining the firm's earnings

capital structure

Relative mix of a firm's debt and equity financing.

risk-return relationship

Shows the amount of risk and the likely rate of return on various financial instruments. recognized by financial planners, who try to gain access to the greatest funding at the lowest possible cost High-grade corporate bonds rate low in terms of risk, but they also provide low returns. Junk bonds, on the other hand, rate high in terms of risk (because the company might default), but they also provide high returns to attract investors

raw-materials inventory

The basic supplies a firm buys to use in its production process e.g. huge rolls of denim

finance

The business function involving decisions about a firm's long-term investments and obtaining the funds to pay for those investments.

callable bonds

The issuer of callable bonds may call them in and pay them off before the maturity date at a price stipulated in the indenture Usually issuer cannot call the bond for a certain period of time after issue, often within the first five years issuer must still pay a call price to call in the bond The call price usually gives a premium to the bondholder The premium is merely the difference between the face value and call price.

3. Evaluate Alternatives and Choose Techniques that Will Best Handle Losses

They generally have four choices: - avoidance - control - retention - transfer

Long-term expenditures differ from short-term outlays in the following ways, all of which influence the ways that long-term outlays are funded:

Unlike inventories and other short-term assets, they are not normally sold or converted to cash. Their acquisition requires a very large investment. They represent a binding commitment of company funds that continues long into the future.

When constructing a financial plan, several questions must be answered:

What funds are needed to meet immediate plans? When will the firm need more funds? Where can the firm get the funds to meet both its short- and its long-term needs?

Inventory as Collateral

When a loan is made with inventory as a collateral asset, the lender lends the borrower some portion of the stated value of the inventory. Inventory is more attractive as collateral when it can be readily converted into cash. e.g. Boxes full of expensive, partially completed lenses for eyeglasses are of little value on the open market, but a thousand crates of canned tomatoes might well be convertible into cash.

Accounts Receivable as Collateral

When accounts receivable are used as collateral, the process is called pledging accounts receivable In the event of non-payment, the lender may seize the receivables (funds owed the borrower by its customers). If these assets are not enough to cover the loan, the borrower must make up the difference This option is especially important to service companies such as accounting firms and law offices Because they do not maintain inventories, accounts receivable are their main source of collateral. Typically, lenders that will accept accounts receivable as collateral are financial institutions with credit departments capable of evaluating the quality of the receivables.

promissory notes

When sellers want more reassurance, they may insist that buyers sign legally binding promissory notes before merchandise is shipped The agreement states when and how much money will be paid to the seller

Risk Transfer

When the potential for large risks cannot be avoided or controlled They transfer the risk to another firm—namely, an insurance company => a firm pays a premium. => the insurance company issues an insurance policy—a formal agreement to pay the policyholder a specified amount in the event of certain losses. the insured party must also pay a deductible—an agreed-upon amount of the loss that the insured must absorb prior to reimbursement.

corporate bond

a contract—a promise by the issuing company or organization to pay the bondholder a certain amount of money (the principal) on a specified date, plus interest in return for use of the investor's money

stockbroker recommendations

a recommendation to buy a stock may increase demand and cause its price to increase, while a recommendation to sell may decrease demand and cause the price to fall

market value

a stock's real value - current price of a share in the stock market For successful companies, the market value is usually greater than its book value when market price falls to near book value, some investors buy the stock on the principle that it is underpriced and will increase in value in the future

To handle short-term (operating) expenditures, financial managers must pay attention to:

accounts payable accounts receivable inventories

advantages of long-term loans

arranged quickly - the duration of the loan is easily matched to the borrower's needs, and if the firm's needs change, the loan usually contains clauses making it possible to change the terms

Secured Short-Term Loans

bank loans are a vital source of short-term funding. Such loans almost always involve a promissory note in which the borrower promises to repay the loan plus interest banks also require the borrower to put up collateral—to give the bank the right to seize certain assets if payments are not made Inventories, accounts receivable, and other assets (e.g., stocks and bonds) may serve as collateral for a secured loan. Secured loans allow borrowers to get funds when they might not qualify for unsecured credit. Moreover, they generally carry lower interest rates than unsecured loans.

book value

book value of common stock represents stockholders' equity (the sum of a company's common stock par value, retained earnings, and additional paid-in capital) divided by the number of shares

risk avoidance

by declining to enter or by ceasing to participate in a risky activity. e.g. the firm with the delivery trucks could avoid any risk of physical damage or bodily injury by closing down its delivery service. Similarly, a pharmaceutical maker may withdraw a new drug for fear of liability lawsuits.

With regard to maturity dates, there are three types of bonds:

callable serial convertible

convertible bonds

can be converted into the common stock of the issuing company

rumours

claims that a company has made a big gold strike

risk management

conserving the firm's earning power and assets by reducing the threat of losses due to uncontrollable events

three sources of long-term financing for businesses:

debt financing equity financing hybrid financing

financial plan

describes a firm's strategies for reaching some future financial position

finance involves four responsibilities

determining a firm's long-term investments obtaining funds to pay for those investments conducting the firm's everyday financial activities managing the risks that the firm takes

speculative risk

e.g. financial investments, which involve the possibility of gain or loss e.g. designing and distributing a new product is a speculative risk. The product may fail or succeed

par value

face value of a share of stock is set by the issuing company's board of directors

cash-flow management

financial managers must ensure that it always has enough funds on hand to purchase the materials and human resources that it needs to produce goods and services Managing the pattern in which cash flows into the firm in the form of revenues and out of the firm in the form of debt payments. Funds that are not needed immediately must be invested to earn more money

risk retention

firm is thus said to "assume" or "retain" the financial consequences of the loss e.g. the firm with the fleet of trucks may find that each vehicle suffers vandalism totalling $300 per year. Depending on its coverage, the company may find it cheaper to pay for repairs out of pocket rather than to submit claims to its insurance company.

Long-Term (Capital) Expenditures

fixed assets like land, buildings, and machinery Long-term expenditures are more carefully planned than short-term outlays because they pose special problems

major advantage of preferred stock

flexibility - secures funds for the firm without relinquishing control, since preferred stockholders have no voting rights - does not require repayment of principal or the payment of dividends in lean times.

accounts receivable

funds due from customers who have bought on credit represent an investment in products for which a firm has not yet received payment, they temporarily tie up its funds A sound financial plan requires financial managers to project accurately both how much credit is advanced to buyers and when they will make payments

Work-in-process inventory

goods partway through the production process e.g. Cut-out but not-yet-sewn jeans

budgets

important in financial control provide the "measuring stick" against which performance is evaluated cash flows, debts, and assets, not only of the whole company, but also of each department, are compared at regular intervals against budgeted amounts. Discrepancies indicate the need for financial adjustments so that resources are used to the best advantage.

finished-goods inventory

items that are ready for sale e.g. completed blue jeans ready for shipment to Levi's dealers

three common types of unsecured loans:

lines of credit revolving credit agreements commercial paper

two primary sources of debt financing:

long-term loans sale of bonds

debt financing

major component of most firms' long-term financial planning most appealing to companies that have predictable profits and cash-flow patterns

bonds

major source of long-term debt financing for most large corporations Bonds are attractive when companies need large amounts of funds for long periods of time; in many cases, bonds may not be redeemed for 30 years bonds involve expensive administrative and selling costs, and they may also require high interest payments if the issuing company has a poor credit rating

2. Measure the Frequency and Severity of Losses and their Impact

managers must consider both past history and current activities. How often can the firm expect the loss to occur? What is the likely size of the loss in dollars? For example, our firm with the fleet of delivery trucks may have had two accidents per year in the past. If it adds more trucks to its fleet, it may reasonably expect the number of accidents to increase.

inventories

materials and goods that it will sell within the year Too little inventory of any kind can cost a firm sales, while too much inventory means tied-up funds that cannot be used elsewhere

open-book credit

most common form essentially a "gentlemen's agreement." Buyers receive merchandise along with invoices stating credit terms Sellers ship products on faith that payment will be forthcoming.

choosing between debt and equity financing

most conservative strategy is to use all-equity financing and no debt, because a company has no formal obligations for financial payouts riskiest strategy would be to use all debt financing - indebtedness increases the risk that a firm will be unable to meet its obligations and will go bankrupt Financial managers try to find a mix somewhere between these two extremes that will maximize stockholders' wealth

market capitalization

multiplying the number of a company's outstanding shares times the market value of each share

price of a share of stock can be influenced by both:

objective factors (company profits) subjective factors (rumours, investor relations, stockbroker recommendations)

financial managers

plan and control the acquisition and dispersal of the company's financial assets to increase a firm's value: collect funds, pay debts, establish trade credit, obtain loans, control cash balances, and plan for future financial needs must ensure that a company's revenues exceed its costs—in other words, that it earns a profit

investor relations

publicizing the positive aspects of a company's financial condition to financial analysts and financial institutions

registered bonds

register the names of holders with the company, which then mails out cheques to the bondholders.

retained earnings

represent profits not paid out in dividends Using retained earnings means that the firm will not have to borrow money and pay interest on loans or bonds

Bearer (or coupon) bonds

require bondholders to clip coupons from certificates and send them to the issuer to receive payment. Coupons can be redeemed by anyone, regardless of ownership

revolving credit agreements

similar to bank credit cards for consumers a lender agrees to make some amount of funds available on demand to a firm for continuing short-term loans The lending institution guarantees that funds will be available when sought by the borrower. In return, the bank charges a commitment fee—a charge for holding open a line of credit for a customer even if the customer does not borrow any funds. The commitment fee is often expressed as a percentage of the loan amount, usually 0.5 to 1 percent of the committed amount.

Businesses constantly face two basic types of risk:

speculative risk pure risk

bond indenture

spells out the terms of the bond, including the interest rate that will be paid, the maturity date of the bond, and which of the firm's assets, if any, are pledged as collateral

unsecured short-term loan

the borrower does not have to put up collateral In many cases, the bank requires the borrower to maintain a compensating balance—the borrower must keep a portion of the loan amount on deposit with the bank in a non-interest-bearing account.

bond's default risk

the chance that one or more promised payments will be deferred or missed altogether Bonds differ from one another in terms of their level of risk. To help bond investors make assessments, several services rate the quality of bonds from different issuers

serial bonds

the firm retires portions of the bond issue in a series of different preset dates. e.g. a company with a $100 million issue maturing in 20 years may retire $5 million each year.

trade credit

the granting of credit by one firm to another, is effectively a short-term loan

financial control

the process of checking actual performance against plans to ensure that the desired financial outcome occurs For example, planned revenues based on forecasts usually turn out to be higher or lower than actual revenues. Why? Simply because sales are unpredictable. Control involves monitoring revenue inflows and making appropriate financial adjustments.

credit policy

the rules governing a firm's extension of credit to customers Predicting payment schedules is a function of credit policy policy sets standards as to which buyers are eligible for what type of credit. Typically, credit is extended to customers who have the ability to pay and who honour their obligations. Credit is denied to firms with poor payment histories. sets specific payment terms

risk control

the use of loss-prevention techniques to minimize the frequency of losses. e.g. A delivery service, for instance, can prevent losses by training its drivers in defensive-driving techniques, mapping out safe routes, and conscientiously maintaining its trucks.

responsibilities of financial managers

three general categories: cash-flow management financial control financial planning.

financial manager's overall objective

to increase a firm's value and stockholders' wealth

three sources of short-term financing for businesses

trade credit secured short-term loans unsecured short-term loans

trade draft / trade acceptances

trade draft is attached to merchandise shipment by the seller and states the promised date and amount of payment due To take possession of the merchandise, the buyer must sign the draft Once signed by the buyer, the document becomes a trade acceptance Trade drafts and trade acceptances are useful forms of credit in international transactions.

short-term (operating) expenditures

typically less than one year regularly in its everyday business activities

risk

uncertainty about future events - is a factor in every manager's job because nearly every managerial action raises the possibility for either positive or negative outcomes

accounts payable

unpaid bills owed to suppliers plus wages and taxes due within a year. For most companies, this is the largest single category of short-term debt financial managers want to know in advance the amounts of new accounts payable, as well as when they must be repaid not merely an expenditure They are also a source of funds to the company, which has the use of both the product purchased and the price of the product until the time it pays its bill

debentures

unsecured bonds No specific property is pledged as security for these bonds. Holders of unsecured bonds generally have claims against property not otherwise pledged in the company's other bonds debentures have inferior claims on the corporation's assets. Financially strong corporations often use debentures.

Long-Term Loans

usually matched with long-term assets Interest rates for the loan are negotiated between the borrower and lender. Although some bank loans have fixed rates, others have floating rates tied to the prime rate that they charge their most creditworthy customers

pure risk

which involve only the possibility of loss or no loss e.g. chance of a warehouse fire

Commercial Paper

which is backed solely by the issuing firm's promise to pay, is an option for only the largest and most creditworthy firms Corporations issue commercial paper with a face value. Companies that buy commercial paper pay less than that value. At the end of a specified period (usually 30 to 90 days, but legally up to 270 days), the issuing company buys back the paper—at the face value