Raising Money to Grow a Business

Lesson 1 Taking Loans and Issuing Bonds

How Companies Expand

Aim: What are the pros and cons of borrowing the

money you need to grow your business?

Do Now: From your experience hearing about loans

people take to buy homes and cars, identify the essential elements of every loan.

How Companies Expand Do Now answers:

1. The dollar amount borrowed.

2. The annual interest rate applied to the borrowed money.

3. The amount of time, usually in years or months, the borrower has to pay it back.

Ice cream and restaurant. Opening new Frizzle’s around the world for the past five

years. One of the most popular ice cream restaurants in the

United States and Europe. 20% market share. 25,000 employees in multiple locations in the United States

and Europe. Headquartered in New York, NY. Looking to expand to China or Russia. Needs $500 million in order to expand. Financial statements indicate a healthy, profitable company.

Frizzle, Inc.

Borrow money from a bank

Issue Bonds

Frizzle, Inc.

Frizzle, Inc.Frizzle, Inc. has 2 choices to borrow money

Similar to an individual borrowing money

Must be paid back in a certain time by a specified date with interest

Borrowing from a BankCompany can take a loan from a

bank in order to get the capital (ie: cash to use for a long while) it needs

Advantages May be able to secure loan

quickly Owners don’t give up

control Less restrictions on what

the money can be used for

Disadvantages May be more expensive and

have to pay a higher rate of interest (than the other form of borrowing, a bond)

Potential prepayment penalty Could decrease cash flow if

repayment starts right away

Borrowing from a Bank

What is a bond? A document (ie: security) that

represents an amount of money (usually $1,000), which is clearly printed on the bond (ie: Principal)

For each $1,000 an investor wants to lend to a governent or business, it receives one bond

Borrowing with Bonds

Lender/Bondholder – We say the investor “buys” the bond because he or she pays (the Principal $ amount) for it.

Issuer – The company or government that borrows the money. It has this name because it issues the bonds!

Bonds

Lender Lends Money

Issuer

Lends Money

The issuer is repaying the lender’s/bondholder’s original investment (Principal) when the term of the bond is due. This date, also printed on the

bond, is called the Maturity Date)

Bonds

The issuer pays interest to the bondholder during the term of the bond. The coupon payments end

when the bond reaches maturity.

In the days before computers, the bond was issued with coupons. Every six months, one would be torn off and turned in to receive interest. The coupons went away, but we continue to call the interest rate the coupon rate, and the payment itself the coupon payment.

Bonds Principal (aka “Face Value”): The original investment is

repaid when the bond matures.

Maturity Date: Predetermined date in the future when the bond matures and the lender/bondholder receives the principal investment.

Coupon Rate (%): The interest that the lender/bondholder receives.

Coupon Payment ($): A dollar amount that is paid to the lender/bondholder regularly until the bond matures (payment is based on the Coupon Rate and Principal)

Principal+ CouponPayment

Bonds Cash Flows of a Bond

0 1 2 3 4 5

CouponPayment

CouponPayment

CouponPayment

CouponPayment

Year

Maturity

Bonds

0 1 2 3 4 5

CouponPayment

CouponPayment

CouponPayment

CouponPayment

Year

Credit risk is the chance that a bond issuer will fail to repay the principal and interest on the specified date

To assess a company’s risk of failing, bond investors turn to the following three credit ratings agencies:

Rating Process For Bonds

A “AAA” high grade bond offers more security but a lower yield than a “C” bond

A “C” bond is more riskybut has a higher yield

Ratings are based on whether or not the issuer will be able to make their principal and interest payments, to the bond holder, on time

CREDIT RATINGS*MOODY’S STANDARD & POOR’S FITCH

INVESTMENT GRADE

STRONGEST Aaa AAA AAA

Aa AA AA

A A A

Baa BBB BBB

NON-INVESTMENT GRADE

WEAKEST

Ba BB BB

B B B

Caa CCC CCC

Ca CC CC

C C C

C D D

*These credit ratings are reflective of obligations with long-term maturities.

Bonds

Maturity Date

Coupon Rate

Face Value (Prin.)

Coupon Payment

Advantages Company can borrow at a

lower interest rate than they would have to pay the bank

Company will be able to raise a large sum of money from the large community of bond investors

Disadvantages Company may have

difficulty issuing bonds if they are experiencing financial difficulties within their company

Company may not be large enough to issue bonds

Issuing a Bond(vs. Borrowing From a Bank)

Lesson Summary1. What are the two choices corporations have if

they want to borrow money?

2. What are the relative pros and cons of each?

3. What are the major elements of a bond?

4. Identify the three big bond ratings agencies

5. What are the highest and lowest available ratings?

6. What are the pros and cons of borrowing the money you need to grow your business?

Web Challenge #1Q: The Federal Reserve has tried to keep down the interest rate at which people and corporations can borrow money. Will this cause there to be more or less money borrowed?

• A: It will encourage more borrowing because low rates means less interest costs.

• Challenge: Find corporations that have issued bonds because it’s just cheap to borrow and they want to lock in a low rate. Hint: Look for the explanation that the money will be used for “general corporate purposes”.

Web Challenge #2• Challenge: Not any company can walk

into a bank and get a loan. Research the characteristics a business must have to qualify for a bank loan. Prepare a checklist of five to 10 requirements. Indicate the most challenging one, explaining why. (Hint: the evaluation by the bank is formally called “underwriting”.)

Web Challenge #3Q: The Small Business Administration is a government department that was created to help small businesses, including providing loans to them.

• Challenge 3a: Visit sba.gov. Identify three ways that it can help a small business.

• Challenge 3b: Prepare one argument for and one against having the government loan money to businesses. After all, who loses if the business fails and can’t repay the loan?