BusFi: Time Value of Money

• Debt financing can be in the form of borrowing from banks or other lending institutions or the issuance of debt securities like commercial papers and bonds.
• Debt financing can be in the form of advances.
• Debt financing creates a contractual obligation for the borrower to pay interest and principal.
• Benefits of Debt Financing:

  • Interest expense is tax-deductible: interest expense provides tax shield.
  • Allows a company to grow without diluting interest of the controlling shareholders or proprietor, in the case of a single proprietorship
  • Creditors generally do not intervene in the decisions of management
• Benefits of debt financing can be realized if the level of debt incurred by a company is manageable
• Equity financing refers to the issuance of new shares of stocks and retained earnings plowed back into the operations of a company.
• Equity financing provides a company financial flexibility.
• Retained earnings plowed back into the operations of a company is also called an internally generated fund.
• Disadvantages of Equity Financing

  • Cash dividends are not tax-deductible: cash dividends do not provide any tax shield
  • Offering the new shares to other investors may dilute the ownership stake, in terms of percentage, of the existing shareholders
  • It is the most expensive source of financing
• Short-term funds are normally used to finance the day-to-day operations of a company
• Short-term funds is used for working capital requirements, such as accounts receivable and inventories
• Short-term funds is also used to pay the salaries of employees, utility expenses, business and income taxes, and security services
• Short-term funds can also be used for bridge financing
• Sources of short-term financing include banks and nonbank financial institutions
• Nonbank financial institutions include lending investors and credit cooperatives
• Sources of Short-term Funds:

  • Suppliers' credit
  • Advances from owners or shareholders
  • Advances from customers
  • Credit cooperatives
  • Bank loans
  • Commercial papers
  • Lending companies
  • Informal lending sources such as "5-6"
• Suppliers of raw materials and merchandise are the best sources of short-term working capital
• Banks can provide both short-term and long-term loans
• Commercial papers are short-term debt securities issued to the public, normally with tenors of one year
• Informal lending sources such as "5-6" is a very expensive source of financing and should be avoided
• Long-term funds are used for long-term investments, or sometimes called capital investments
• Sources of Long-term Funds

  • Equity
  • Internally generated funds
  • Bank loans
  • Lending Companies
  • Bond Market
• Bank loans have lower interest rate while nonbank loans have higher
• Banks loans normally require collateral while nonbank loans may or may not be required
• Reasons for the inability of SMEs to take advantage of available financing

  1. Limited track record
  2. Limited acceptable collateral
  3. Inadequate financial statements
  4. Lack of business plans
• Reasons for rejecting the loan applications

  1. Poor credit history
  2. Insufficient collateral
  3. Inadequate financial statements
  4. Insufficient sales, income, and cash flows
  5. Unstable business type
  6. Poor business plans
• Duties of the borrower to creditors

  1. Pay the creditors based on the payment schedule agreed upon
  2. Provide the collaterals as agreed upon in the loan negotiation with proper documentation, if necessary and if applicable
  3. Comply with the provisions of loan covenant such as maintaining certain liquidity and stability or leverage ratios
  4. Notify the creditor if a company is acquiring another company or a company is now the subject of acquisition
  5. Do not default on the loans as much as possible
• One of the most fundamental concepts in finance is the Time Value of Money
• Time Value of Money states that "A peso today is worth more than a peso tomorrow"
• Future Value (FV) is the amount to which an investment will grow after earning interest.
• Present Value (PV) is the amount you have to invest today if you want to have a certain amount of cash flow in the future.
• An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan's principal amount and the interest accrued
• Common amortized loans include auto loans, home loans, and personal loans from a bank for small projects or debt consolidation
• The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the interest amount owed decreases as payments are made.
• Any payment in excess of the interest amount reduces the principal, which in turn, reduces the balance on which the interest is calculated
• Interest and principal have an inverse relationship within the payments over the life of the amortized loan.
• An amortized loan payment first pays off the relevant interest expense for the period, after which the remainder of the payment is put toward reducing the principal amount
• The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the interest amount owed decreases as payments are made
• A loan amortization schedule is a complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of its term
• Each periodic payment is the same amount in total for each period