chapter 14 understanding financial contracts. 14-2 financial contracts financial contracts are...
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Chapter 14
Understanding Financial Contracts
14-2
Financial Contracts
Financial contracts are written between lenders and borrowers
Non-traded financial contracts are tailor-made to fit the characteristics of the borrower
Publicly traded financial contracts are more standard and suitable to meet the needs of large number of inverstors
14-3
Financial Contracts
Contracting matters because: Determines how instruments/securities
are originated Determines restrictive covenants Determines terms of contract
14-4
Why Business Needs Financing
Businesses need funds for a variety of reasons
Finance permanent assets such as plant and equipment
Finance the acquisition of another business
Finance working capital—inventory or accounts receivable
Payroll
14-5
How Business Obtains Financing
Financing Small Businesses Small firms—assets less than $10 million Vast majority are privately owned with ownership
concentrated in a single family Profitable firms may 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
14-6
Financing Small Businesses
Characteristics: Provide funds via a short-term loan or line of
credit (L/C) for either working capital or purchase of plant and equipment Short-term loan—negotiated contract with short
maturity Line of Credit
Bank extends a credit for specified period of time The borrowing firm can draw down funds against L/C Credit Rationing—insures borrower has access to funds
even if bank would prefer to curtail new loans When financing capital assets the maturity of the loan
is typically less than life span of the asset
14-7
Financing Small Business
Origination Mechanism Locate a bank that meets your needs,
usually through a referral (bank’s accountant)
The bank’s loan officer conducts a complete credit analysis. Which involves: Review borrower’s financial statements Visit the place of business Assesses the managerial
strengths/weaknesses of borrower Provides an opportunity to develop a one-on-
one relationship
14-8
Origination Mechanism
14-9
Financing Small Business
Origination Mechanism Credit Analysis
Obtain additional information about the firm Obtain credit report on the firm and borrower Address any concerns with the borrower
Loan Approval Small loan approved by a loan officer Larger loans are approved by more senior officers Above a certain amount must get approval from
loan committee Borrower and bank negotiate terms of
the loan
14-10
Financing Small Businesses
Unique features of a small business loan
During application period and after the loan is granted, a personal relationship between bank and borrower is developed
Banks offer a wide menu of options to borrower Loans have shorted maturity (rarely exceeds 5
years) Loans are often collateralized, which means
Pledging of assets against the loan Owner may pledge personal assets as collateral Secured lender—bank has the right to petition the
bankruptcy court to sell the asset pledged as collateral to satisfy the loan
14-11
Financing Small Businesses
Unique features of a small business loan
Loan can be guaranteed by the owner Borrower is personally liable for any unpaid balance Lender may require a personal financial statement of the
borrower
Loan may contain restrictive covenants Covenant—promises that the company makes to the
bank regarding their future actions and strategies The bank may require an audited financial statement to
verify the convents have not been broken More restrictive covenants are linked to actions indicating
the company has become riskier If violated, bank may demand immediate payment of loan Possible for the borrower to renegotiate the terms of the
loan to reflect higher risk
14-12
Financing Midsize BusinessesCharacteristics:
Assets between $10 million and $150 million 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 likely to be publicly owned—issue equity traded in the over-the-counter market
Can either be owner managed or managed by someone other than the owner
14-13
Financing Midsize Businesses
Characteristics For short-term debt, principally rely on
commercial banks Depending on size of debt and bank, can use
either local or non-local banks Typically have covenants placed on the loan and
may pledge collateral For long-term debt, commercial bank may
combines an line of credit with intermediate-term loan known as Revolving Line of Credit
14-14
Financing Midsize BusinessesLong Term Debt Financing
Through non-bank institutions Mezzanine debt funds provide loans to smaller
midsize companies Through Private Placement Market
Generally a bond issue in excess of $10 million Bonds do not have to be registered with the
SEC Avoids public disclosure of information Sold only to financial institutions and high net
worth investors with sophisticated knowledge of investment
14-15
Private Placement Market
Characteristics: Generally not resold by original investor for at
least two years Have covenants that are generally less
restrictive than when borrowing from a bank Terms will be renegotiated one or more times
during the life span of the loan if the company wishes to embark on a new strategy
14-16
Private Placement Market
Origination Issued through agents, commercial banks or
investment banks who structure the contract and market the issue
Due diligence: the agent handling the private placement evaluates the firm’s management, financial condition, and business capabilities
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)
14-17
Private placement origination.
14-18
Private Placement Market
Origination The terms of the contract are negotiated to be
attractive to investors—interest rate, maturity, covenants, and any special features
Offering memorandum and Term sheet containing information of the 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 original information
14-19
Financing Large Businesses
Characteristics Firms with assets in excess of $150 million Becomes cost effective to enter the
public bond market These bond issues are liquid assets that
are traded in the secondary market Therefore, can be issued at a lower yield
than a non-traded instrument
14-20
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
14-21
Securities Underwriting
Underwriting Process: Issuer selects an underwriter, generally an
investment bank, to assist in issuing and marketing the bond
Underwriters actively market their services to companies large enough to issue in the public market
Underwriter does due diligence on the issuer and then issues the following items
Registration Statement Offering (preliminary) prospectus
14-22
Securities underwriting.
14-23
Securities Underwriting
Registration Statement conforms to specific disclosure requirements blessed by the underwriter, the accountants,
and issuing firm’s attorneys The registration statement is approved by the
SEC and can now be distributed It is difficult to incorporate highly restrictive
covenants in publicly traded bonds
Offering (preliminary) prospectus Contains all relevant factual information about
the firm and its financing
14-24
Role of Underwriter
Underwriting syndicate is formed by the managing underwriter to share responsibility for distribution the issue and the underwriting risk
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
Underwriting Spread—hope to sell bonds at a higher offering price, above the commitment price
14-25
Financing Large Businesses
Shelf Registration Permits the issuer of a public bond to register
a dollar capacity with the SEC Draw down on this capacity at any time This avoids additional registration
requirements Permits issuers to respond instantaneously to
changing market conditions
14-26
Financing Large Businesses
Summary Large companies with good credit ratings
tend to rely on the commercial paper market for short-term financing
Some very large businesses also issue medium-term notes, which are like commercial paper, except maturities range from one year to five years
Also issue equities, through underwriters, which is another form of external long-term financing
14-27
Credit market comparison
14-28
Economics of Financial Contracting
transactions costs helps explain why firms of different size rely on different financial contracts to raise funds
However, to fully understand the differences must rely on the concept of asymmetric information—buyers and sellers are not equally informed about the quality of the product
14-29
Asymmetric Information and Financial ContractingAdverse 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
14-30
Asymmetric Information and Financial Contracting
Moral Hazard Occurs after the loan is made Loan contract may give the firm the
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
14-31
Economics of Financial ContractingSmall 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: This puts owner’s
wealth at risk Inside collateral: This allows bank files a lien against
collateral Loan covenants: This prevent risk shifting by explicitly
constraining borrower behavior No long-term debt contracts:
There is too much flexibility in small business operation incentives to shift risk is very high
14-32
Economics of Financial ContractingLarge firms Relatively easy to observe and any risk shifting is
easily detected for following reasons: Labor contracts are often public knowledge Supplier relationships are often well known Marketing success or failure is well documented No incentive to switch to high risk activities: the firm’s
desire to maintain their reputation Therefore, public markets for stocks and bonds will
generally reflect true riskiness of investment strategies.
This riskiness in turn determines prices and yields of the stocks and bonds issued by large firms
14-33
Economics of Financial ContractingMidsize Companies
Their information problems lie between small and large size companies
More visible publicly than small, Less transparent than large companies
At the origination stage, financial intermediary Needs to address adverse selection problems Design a tailor-made contract
May have access to long-term debt in the private placement market
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