Business Financing Decisions

The goal of business finance is to raise sufficient capital at the least cost for the level of risk that management is willing to live with. The risk is that a business will not be able to service the debt and be forced into bankruptcy.

Broadly speaking there are 5 main ways of funding a company’s needs:

• Receive credit from suppliers

• Obtain lease financing

• Obtain bank loans

• Issue bonds

• Issue stock

Supplier credit

This is the easiest way that companies obtain funding. Companies buy goods and services and have anywhere from seven days till 6 months to pay for them; when companies need more credit from suppliers the financial controllers will negotiate longer credit terms or larger credit lines. The payment terms can also be stretched and this can work well because the creditors do not want the customer to go into bankruptcy taking their money with them.

Lease financing

Instead of buying equipment, many companies choose to lease equipment - this is a form of franchising.Cars,computers and heavy equipment can be financed for short periods or indeed longer periods.

If it is a short period it is referred to as an operating lease and at the end of the lease the property is still useful and is returned to the finance company.

Long term leases are, in substance, ways are ways of funding a purchase rather than buying the temporary services of a piece of equipment. These are often referred to as capital leases.

For capital leases the leased assets and the financing liability are recorded on the leasing company’s books as though the company had bought the equipment outright.

Bank financing

The next level of financing involves banks. If a company has a credit line or revolver with a bank it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by assets of the firm however if a business runs into trouble it may not be able to pay the bank and go into bankruptcy

Bond Insurance

Bonds have fixed interest rate contractual payments and a principal maturity. The risk comes to the firm’s owners if they cannot be serviced. The principle bond owners can then exchange them for ownership of the company and oust the owners.

The After-Tax cost of Borrowing

Interest payments for borrowing from vendors, bankers or bondholders are tax-deductible, while dividends to shareholders are not. The after-tax cost of borrowing is the interest cost less the tax benefit.

Stock Issues

Stock issues have non-contractual, non tax deductible dividend payments. Stock represents an ownership in the business and in all of its assets. If additional shares of stock are issued to raise cash, this is done at the at the expense of the current shareholders’ ownership interest. New shareholders share their ownership interest equally on a per-share basis with the current shareholders – this is why analysts say that the new shareholders dilute the interest of existing shareholders.

Summary

In summarising, the higher the percentage of debt to total capital, the higher a company’s value, to a point. At the point where the risk of bankruptcy becomes significant, values fall. The cost of financing decreases as a company adds lower-cost shielded debt to displace the higher returns required by equity investors.

Business Investment Decisions

There are many investments that a company can make. It is a financial manager’s job to help the management team evaluate the investments, rank them and suggest choices. This process is called capital budgeting.

Some investments, however, defy financial analysis; an example of this may be seen in charitable donations, which provide intangible benefits that financial mangers alone cannot evaluate.

It may be argued that investment decisions fall into one of three basic decision categories:

Accept or reject a single investment proposal

Choose one competing investment over another

Capital rationing – with this particular category, the limited investment pool is active deciding which projects among many should be chosen.

Whilst each corporation uses its own criteria to ration its limited resources, the major tools are:

Payback period

Net present value

Payback period method – many companies believe that the best way to judge investments is to calculate the amount of time it takes to recover their investments.

Analysts can easily calculate paybacks and make simple acceptance or reduction decisions based on a necessary payback period. Those projects that come close to the mark are accepted, those falling short are rejected. For example, the managers of a small company may believe that all energy and labour saving devices should have a three-year payback and that all new machinery must have an eight-year payback. Additionally, research projects should pay back in ten years. Those requirements are based on management’s judgements, experience, and level of risk.

By accepting projects with longer paybacks, management accepts more risk. The further out an investment’s payback, the more uncertain and risky it is. Payback criteria are desirable because they are easy to use, calculate and understand; however they ignore the timing of cash flows and accordingly the time value of money. Projects with vastly different cash flows can have the same payback period.

Another disadvantage of using payback is that it ignores the cash flows received after the payback.

Net present value methods

The same method used for valuing the cash flows of bonds and stocks is also used to value projects. It is the most accurate and most correct method. The further in the future a dollar is received the greater the uncertainty that it will be received, referred to as risk, and the greater the loss of opportunity to use those funds, referred to as opportunity cost. Accordingly cash flows received in the future will be discounted more steeply depending on the riskiness of the project.

The way a business wishes to fund itself are financing decisions independent of investment decisions.

In my own experience, I have only ever used the payback method, along with my fellow business colleagues, perhaps because this has always been easier to understand and use and calculate. This served us well but caused frequent conflicts between operations, marketing and finance, for understandable reasons.

In summary, whereas most companies may continue to use the payback method due to the aforementioned reasons, it is well worth noting that another option is there and, especially for the financial side of the business, gives a very interesting option.

Advertising: Relationships vs Business Decisions

Successful businesses know the importance of building and maintaining good working relationships, whether it is with partners, employees, business or trade organizations, the government, media representatives, vendors, consumers, or the community at large. A business must carefully balance the benefits of these interpersonal relationships and should never allow these relationships to blind their judgment especially when it relates to what is in the best interest of the business's continued success and growth

Buying advertising media based on interpersonal relationships is a common mistake made by many small businesses. This strategy throws the business's strategic marketing plan into the winds of chance in exchange for the warm and fuzzy feelings that come with doing business among friends. However, when the smoke clears the business has made costly advertising expenditures with little or no results and the long term negative effects may not readily be seen. Simply, the marketing / advertising expenditures have been made, the budget may or may not be busted, and the results may be none to little measurable penetration into the business's target demographic market segment.

Is buying media from a friend in the business always bad? No, however in order to choose the most effective media channels a business must first consider the audience or customer it is trying to reach. Developing a strong sense of the target demographics' buying and shopping patterns, interests and hobbies, entertainment and media choices for example will lend itself a tremendous benefit to making informed media buying choices. Once the advertising business has developed a strong sense of what media channels may prove to be the most effective it should try each a little at a time carefully tracking the results of each. Once this is complete the business will be able to make an educated decision on where to invest its marketing dollars, prioritizing expenditures into the mediums that have proven results for the business.

It is true that strong interpersonal relationships skills and the ability to develop and maintain good working relationships with a variety of people, businesses, and other organizations are imperative in today's business environments. However, the importance of a well designed and implemented strategic marketing plan can not be understated and is paramount to the business's development and longevity never taking second seat to friendship.