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Questions
What sources has your company raised capital from in order to finance projects? Why were these sources used? In what form was the finance provided (loans, grants, other )? Were any possible sources considered but not used?
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Investing decision: is the project acceptable? (i.e. does it have a positive NPV, at the relevant discount rate?) Financing decision: what is the best (usually, the cheapest) way to fund it?
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Why are these securities not all relevant to small and medium-sized companies?
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Commercial Banks
Banks are businesses that offer a variety of options to other organisations to finance their investments. The most frequent options are:
1. Loans to finance the purchase of fixed assets (land and/or equipment) 2. Lines of credit (debt provided by the bank without conditions on how the borrower must use those funds)
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Development Corporations
Development corporations/banks are established to contribute to the economic development of a particular community or region Projects which comply with their criteria can apply for loans Question: what development corporations/banks are you aware of?
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Leasing has become a major source of financing that is provided by some equipment vendors and subsidiary finance companies (lease-providers). With financial leases (or capital leases): Title to the equipment is held by the firm which operates it (the lease-holder) The lease-provider retains a first security interest in the equipment The lease-holder faces the risks and receives the rewards of ownership
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But:
Present owners may not have spare capital available Bringing in new shareholders may dilute the shareholdings of present shareholders
Share issues
Public issues of stock:
For larger companies Requires a stock market listing Substantial administrative costs Not usually suitable for single projects
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Any other restrictions put on the company (e.g. a maximum ratio of debt to equity, to limit risk)
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Question
If your company were to apply to a bank for a loan to finance a project:
What information is the bank likely to require from you? Is there any further information that you could provide to support your application?
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= NET PROFIT
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Typical information to evidence a companys credit-worthiness (2) For sole traders and partnerships: personal financial statements and/or tax returns of the owner(s)
Bank and credit references; payment histories on other loans or leases
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Explain that the company is also applying for a matching grant, e.g. from a government programme
Potential growth of the company due to increased cash flows from the investment The firms fiscal stability and ability to repay the loan
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Summary
Gather information on the past lending practices of each potential funding source (to gain insight into their motivations)
Consider the motivation of the funding source when preparing an application Anticipate the information needs for the sources of capital
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Investment projects
Investment projects and company value Discussion of experiences with investment projects Typical project types & goals
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Project financing
Project financing sources
Discussion of course participant experiences with project financing
Types of investment and financing decisions Different types of funding sources
Cost/Benefit Analysis
When benefits and costs are measured on the same scale, such as dollars, the benefits should exceed the costs for a given course of action.
Cost/Benefit Analysis
When benefits can not be measured readily in dollars, costbenefit analysis generally requires the comparison of two or more alternatives.
Cost/Benefit Analysis
When the alternatives are estimated to provide the same benefit (such as the same level of national defense), the alternative with the lowest cost should be selected.
Cost/Benefit Analysis
Benefit Measurement Methods
The process of identifying the financial (economic) benefits is called
Capital Budgeting.
It is the decision-making process by which some organizations evaluate and select projects.
Cost/Benefit Analysis
Benefit Measurement Methods
Sophisticated capital budgeting techniques take into consideration depreciation schedules, tax information, inflation and other economic considerations.
Cost/Benefit Analysis
Benefit Measurement Methods Since we are discussing only the principles of capital budgeting we will restrict our discussion to:
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Benefit/Cost Ratio Payback Period Discounted Cash Flow Net Present Value Internal Rate of Return (IRR)
Cost/Benefit Analysis
Benefit Measurement Methods
Benefit/Cost Ratio
Simply put it is the financial value of the benefit divided by the financial cost.
$Benefit $Cost
Cost/Benefit Analysis
Benefit Measurement Methods
Benefit/Cost Ratio
Project Benefit = $ 7,000
Project Cost =
$ 5,000
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Payback Period
Payback period is the length of time, usually expressed in years or fractions there of, needed for a firm to recover its initial investment on a project.
Cost/Benefit Analysis
Benefit Measurement Methods
Payback Period
Initial Project Expense = $5,000
Payback Year 1 Year 2 Year 3 Year 4 $1,000 $2,000 $2,000 $2,000 ($4,000) ($2,000) $0 $2,000
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
These two approaches have a common problem. They do not take into consideration the
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Future Value
FV = PV (1+interest rate)
raised to the (number of years) power.
Cost/Benefit Analysis
Benefit Measurement Methods
Future Value
Lets say we have $1,000 invested at 6% for three years. FV = $1,000 (1+.06) to the third power. FV = $1,000 * (1.1910) FV = $1,191
Cost/Benefit Analysis
Benefit Measurement Methods
3%
1.0300
1.0609 1.0927
6%
1.0600
1.1236 1.1910
10%
1.1000
1.2100 1.3310
1
2 3
4
5
1.0824
1.1040
1.1255
1.1592
1.2624
1.3382
1.4641
1.6105
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value
The result of discounting one or more amounts to be received or paid in the future by a discount rate.
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value
For example:
$100 invested at 6% will amount to $106 at the end of one year (this is a future value).
Therefore:
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value
The present value of $106 due at the end of one year at 6% is $100.
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value
Lets say we have $1,000 being sent to us 3years from now and the inflation rate is at 3%. PV = $1,000 * 1/((1+.03) to the third power). PV = $1,000 * (.9151) FV = $915.10
Cost/Benefit Analysis
Benefit Measurement Methods
3%
.9708
.9425 .9151
6%
.9433
.8899 .8396
10%
.9090
.8264 .7513
1
2 3
4
5
.9238
.9057
.8884
.8626
.7921
.7472
.6830
.6209
Cost/Benefit Analysis
Benefit Measurement Methods
Present Value Analysis Any method of evaluating alternatives with the time value of money incorporated to more effectively determine the long term financial effects on investment dollars. (It is the recognition that any amount due in the future is worth less than that same amount if it were due today.)
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods Discounted Cash Flow
Initial Project Expense = $5,000
(Payback) Discounted
Future
Present
Value
Value
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods Net Present Value
Discounted Cash Flow at 6%. Year 1 $1,000 $ 943 Year 2 $2,000 $1,780 Year 3 $2,000 $1,697 Year 4 $2,000 $1,584 Total $6,004 accrued benefit Less Investment - 5,000 Net Present Value $1,004
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
IF we invested $5,000 in a project, and we got a $6,004 discounted return on the investment, WHAT interest rate would we have had to have received on an investment of $5,000 to get that $6,004?
Cost/Benefit Analysis
Benefit Measurement Methods Internal Rate of Return (IRR)
3%
1.0300 1.0609
6%
1.0600 1.1236
10%
1.1000 1.2100
1.0612
1.0927
1.1910
1.3310
4
5
1.0824
1.1040
1.1255
1.1592
1.2624
1.3382
1.4641
1.6105
Cost/Benefit Analysis
Benefit Measurement Methods
Cost/Benefit Analysis
Benefit Measurement Methods
Hurdle Rate
The minimum acceptable
return on investment.
Cost/Benefit Analysis
Benefit Measurement Methods
Hurdle Rates
High Tech Companies tend to very high hurdle rates.
Less competitive organizations tend to have much lower hurdle rates.
Cost/Benefit Analysis
Benefit Measurement Methods
Benefit/Cost Ratio
Payback Period Discounted Cash Flow
Net Present Value
Payback
= time needed for net cash inflows to equal the initial investment
simple to calculate and understand reflects risk of project life being shorter than
expected
ignores all cash flows after payback point simple version completely ignores time value of
money
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