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Chapter 10

MGTA02H3 Chapter Notes - Chapter 10: High-Yield Debt

Management (MGT)
Course Code
Chris Bovaird

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Chapter 10 Financial Decisions Notes
The Role of the Financial Manager
x financial managers Æ those managers responsible for planning and overseeing the financial resources of a firm
x finance (corporate finance) Æ the business function involving decisions about a firm’s long-term investments and obtaining the
funds to pay for those investments
x finance typically involves four responsibilities: (1) determining a firm’s long-term investments; (2) obtaining funds to pay for
those investments; (3) conducting the firm’s everyday financial status; (4) helping to manage the risks that the firm takes
Objectives of the Financial Manager
x financial managers collect funds, pay debts, establish trade credit, obtain loans, control cash balances, and plan for future
financial needs; but a financial manager’s overall objective is to increase a firm’s value and thus stockholders’ wealth
x financial managers make decisions for improving that status and therefore must ensure that a company that it earns a profit
x in sole proprietorships and partnerships, profits translate directly into increases in owners’ wealth
x in corporations, profits translate into an increase in the value of common stock
Responsibilities of the Financial Manager
x the various responsibilities of the financial manager in increasing a firm’s wealth fall into three general categories: cash flow
management, financial control, and financial planning
Cash Flow Management
x to increase a firm’s value, 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
x at the same time, there may be funds that are not needed immediately, which must be invested to earn more money for a firm
x cash flow management Æ managing pattern in which cash flows in the form of revenues and out in the form of debt payments
x by locating idle cash and putting it to work, firms gain additional income, and can avoid having to borrow from outside sources
x the savings on interest payments can be substantial
Financial Control
x because things never go as planned, managers must be prepared to make adjustments for actual financial changes that occur
x financial control Æ process of checking actual performance against plans to ensure that the desired financial status is achieved
x budgets are often the backbone of financial control
x the cash flows, debts, and assets not only of the whole firm but also of each department are compared at regular intervals against
budgeted amounts and discrepancies indicate the need for financial adjustments so that resources are used to the best advantage
Financial Planning
x financial plan Æ a description of how a business will reach some financial position it seeks for the future; includes projections
for sources and uses of funds
x a financial plan describes a firm’s strategies for reaching some future financial position
Why Do Businesses Need Funds?
x every company needs money to survive
x failure to make a contractually obligated payment can lead to bankruptcy and the dissolution of the firm
x however, the successful financial manager must distinguish between two different kinds of financial outlays: short-term
(operating) expenditures and long-term (capital) expenditures
Short-Term (Operating) Expenditures
x a firm incurs short-term expenditures regularly in its everyday business activities
x to handle these expenditures, financial managers must pay attention to AP, AR, and to inventories
Accounts Payable
x accounts payable are unpaid bills owed to suppliers plus wages and taxes due within the upcoming year
x for most companies, this is the largest single category of short-term debt
x to plan for funding flows, managers want to know in advance the amounts of new AP as well as when they must be repaid
x for information about such obligations and needs—say, the quantity of supplies required by a certain department in an upcoming
period—financial managers must rely on other managers
Accounts Receivable
x accounts receivable consist of funds due from customers who have bought on credit
x a sound financial plan requires financial managers to project accurately both how much credit is advanced to buyers and when
they will make payments on their accounts
x because AR represent an investment in products for which a firm has not yet received payment, they temporarily tie up its funds
x clearly, the seller wants to receive payments as quickly as possible
x credit policy Æ rules governing a firm’s extension of credit to customers
x this policy sets standards as to which buyers are eligible for what type of credit
x typically, credit is extended to customers who have the ability to pay and who honour their obligations
x between the time a firm buys raw materials and the time it sells finished products, it ties up funds in inventory
x inventory Æ materials and goods currently held by the company that will be sold within the year
x failure to manage inventory can have grave financial consequences
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x too little inventory of any kind can cost a firm sales; too much inventory means tied-up funds that cannot be used elsewhere
x in extreme cases, a company may have to sell excess inventory at low profits simply to raise cash
x there are three basic types of inventories: raw materials, work-in-process, and finished goods
x raw materials inventory Æ that portion of a firm’s inventory consisting of basic supplies used to manufacture products for sale
x work-in-process inventory Æ that portion of a firm’s inventory consisting of goods partway though the production process
x finished goods inventory Æ that portion of a firm’s inventory consisting of completed goods ready for sale
Working Capital
x working capital is difference between current assets and current liabilities; it is liquid asset out of which current debts can be paid
x a company calculates its working capital by adding up the following: inventories (that is, raw materials, work-in-process, and
finished goods on hand) and accounts receivable (minus accounts payable)
x large companies typically devote 20 cents of every sales dollar to working capital
x there are 2 very important benefits of reducing these sums: (1) every dollar that is not tied up in working capital becomes a dollar
of more useful cash flow; and (2) reduction of working capital raises earnings permanently
x the second advantage results from the fact that money costs money (in interest payments and the like)
x reducing working capital, therefore, means saving money
Long-Term (Capital) Expenditures
x companies need funds to cover long-term expenditures for fixed assets
x fixed assets are items that have a lasting use or value, such as land, buildings, and machinery
x long-term expenditures are usually more carefully planned than short-term outlays because they pose special problems
x they differ fro short-term outlays in the following ways, all of which influence the ways that long-term outlays are funded:
o unlike inventories and other short-term assets, they are not normally sold or converted into cash
o their acquisition requires a very large investment
o they represent a binding commitment of company funds that continues long into the future
Sources of Short-Term Funds
x firms can call on many sources for the funds they need to finance day-to-day operations and to implement short-term plans
x these sources include trade credit, secured and unsecured loans, and factoring accounts receivable
Trade Credit
x accounts payable are 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
x trade credit Æ the granting of credit by a selling firm to a buying firm
x trade credit can take several forms:
o open-book credit Æ form of trade credit in which sellers ship merchandise on faith that payment will be forthcoming
o promissory note Æ form of trade credit in which buyers sign promise-to-pay agreements before merchandise is shipped
o trade draft Æ form of trade credit in which buyers sign statements of payment terms attached to merchandise by sellers
x trade acceptance Æ trade draft that has been signed by the buyer
Secured Short-Term Loans
x secured loan Æ a short-term loan in which the borrower is required to put up collateral
x collateral Æ any asset that a lender has the right to seize if a borrower does not repay a loan
x inventories, accounts receivable, and other assets may serve as collateral for a secured loan
x secured loans allow borrowers to get funds when they might not qualify for unsecured credit
x moreover, they generally carry lower interest rates than unsecured loans
x most short-term business borrowing is secured by inventories and accounts receivable
Inventory Loans
x when a loan is made with inventory as collateral, the lender loans the borrower some portion of the stated value of the inventory
x inventory is more attractive as collateral when it provided the lender with real security for the loan amount: if the inventory can
be readily converted into cash, it is relatively more valuable as collateral
Accounts Receivable as Collateral
x pledging accounts receivable Æ using accounts receivable as collateral for a loan
x in the event of non-payment, the lender may seize the receivables—that is, funds owed the borrower by its customers
x this option is important to service companies because they do not maintain inventories, AR are their main source of collateral
x typically, lenders who will accept accounts receivable as collateral are financial institutions with credit departments capable of
evaluating the quality of the receivables
Factoring Accounts Receivable
x a firm can raise funds rapidly by factoring: selling the firm’s accounts receivable
x in this process, the purchaser of the receivables, usually a financial institution, is known as the factor
x factor pays some percentage of the full amount of receivables due to the selling firm and the seller gets this money immediately
x the factor profits to the extent that the money it eventually collects exceeds the amount it paid
x this profit depends on the quality of the receivables the cost of collecting them, and interest rates
Unsecured Short-Term Loans
x unsecured loan Æ a short-term loan in which the borrower is not required to put up collateral
x in many cases, however, 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
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