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DEBT SOURCES OF

FINANCE

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What is debt financing?


n Debt borrowing money from an outside source with

the promise to return the principal, in addition to an agreed-upon level of interest. n Debt is also referred to as leverage in finance. n In contrast equity financing does not have to be repaid. n The interest rate reflects the level of risk that the lender undertakes by providing the money. Debt financing entails less risk than equity financing, thus it is usually cheaper.

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Debt financing - pros


n Maintained ownership allows the founders to retain

n n n

ownership and control of the company (in contrast to equity financing) Greater degree of financial freedom provides business with a greater degree of financial freedom than equity financing as debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business Easy to administer lacks the complex reporting requirements accompanying some forms of equity financing Tax deductions interest payments can be deducted from business income taxes (lower interest rate) Less expensive tends to be less expensive over the long term than equity financing

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Debt finanicng - cons


n Repayment shortages in CF may make regular payments n n n n

difficult (incl. penalties, taking possession of collateral etc.) High rates interest rates vary with macroeconomic conditions, the borrowers history with banks, business credit rating, personal credit history Impacts borrowers credit rating debt increases leverage, failure to make payments adversely affects business credit rating and its ability to obtain further financing Cash and collateral necessary to make sure the business will be generating sufficient CF, it is asked to put up collateral on the loan Availability limited to established businesses it can be difficult for unproven businesses to obtain loans, the amount of money SMEs may be able to obtain via debt financing is likely to be limited, so they may need to use other sources of financing as well

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Bank loan factors influencing interest rates


n Factors influencing the price of the loan: - Macroeconomic factors: the level of inflation; the volume of M2

money supply and higher monetary aggregates and politics of money supply regulation; velocity of money circulation; level of GDP and its growth rate; level of investments and rate of savings; discount rate of the National Bank
-

Microeconomic factors: creditors costs of obtaining funds; level of risk of the financed project; period of a loan (maturity); relation between short-term loan sources and long-term sources; amount of a loan; backing of a loan; individual rate of profit (project, business, industry); NPV of investment project

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The loan process


Documents necessary to submit: loan application, business plan, financial statements, documents of legal capacity (trading certificate, extract of companies register), - other documents may be required. n After submitting the loan application and the accompanying documents the employee of the bank loan department prepares the loan proposal, particularly evaluates creditworthiness of the client containing evaluation of personal and objective creditworthiness
n -

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Collateral
n C. an item that is pledged to guarantee

repayment of a loan; comes into play when a business needs to make a secured loan n The nature of collateral acceptable depends on the type of a loan, structure, tenor, amount, etc.

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Types of collateral
n Real estate land, buildings are used (especially for

n -

medium to long-term loans and revolving loans of significant size) Principles of this agreement: banks accept real estate as a whole (not parts), it is necessary to limit the possibility to sell real estate, insurance benefits for events of damage have to be pledged for account of the bank, banks usually require the present market value of pledged real estate to exceed the amount of the loan by 20 -30 %

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Types of collateral (continued)


n Tangible assets called lombard n Lombard loan usually means only loans secured by short-

term securities n This type of collateral risky banks usually require their value to be twice the loan amount at least n Intangible assets very rarely used as collateral, only in the case of short-term loans of large companies (technology, knowhow, trademarks, software, accounts receivable) n Guarantor (the third party) an aval, may enter the loan relation between the bank and the client, may be a specialized bank (SZRB in Slovakia) or another guarantor (legal or physical entity) - if the client does not repay the loan, the guarantor has to take on his obligations

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Long-term and medium-term debt sources of finance


n financial loans, n supplier loans, n bonds (alternative sources
following chapter), characterized in the

n special debt forms (alternative sources -

leasing, franchising, forfeiting following chapter).

characterized in the

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Short-term debt sources of finance


n trade credit, n permanent and semi-permanent accruals, n bank loans (overdrafts, short-term specific

loans, lombard loans, paper loans, specific credit services), n advance payments, n factoring (alternative source - characterized in following chapter), n commercial papers (alternative source characterized in following chapter).

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Long-term debt sources of finance

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Financial loans term loans


n based on a contract requiring the borrower to

make periodic payments of interest and principal to the lender n the commonest form loan financing the development needs (also called investment loan), also can be used to finance operating needs beyond one year n resources to repay it generated by the financed project, therefore creditors assess potential profitability of projects

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Financial loans term loans (continued)


n The creditors generally: - require backing by first-class personal or property

guarantee, - limit the amount of the loan (debtor shares in financing the project at least 30 to 50%), - try to agree as short maturity as possible (according to the character and limits of the financed project), - analyse in detail financial and overall economic situation of the applicant incl. expected income, longterm projections of financial situation.

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Financial loans term loans (continued)


Characteristics: - 1 10 or 15 years maturity, - repaid regularly by regular instalment payments using several types of term-loan amortization schedules, - they are secured by different types of collateral, - the interest rate fixed or floating; the longer maturity, the more often the floating rate is used, - financing large projects the bank consortia to diversify risks.

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Financial loans mortgage loans


n Mortgage a form of loan that is normally secured on freehold n n n n n n n

property; maturity 15 30 years, provides a business with an opportunity to purchase, build, reconstruct and maintain real estate; provided by specialized banks (mortgage banks) or commercial banks having the license to provide them; in Slovakia 9 banks: SOB, Dexia Banka, Istrobanka, OTP Banka Slovensko, Slovensk sporitea, Tatrabanka, UniCreditBank, Volksbank, VB in case of not fulfilling obligations the bank can sell pledged real estate funds through mortgage bonds limits percentage of the value of mortgage collateral to which banks may grant mortgage loans (up to 60% market value of pledged real estate) borrower pays interest and periodically repays principal SR particularly house building

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Revolving credit line


n intermediate source (2-3 years); short-term

loan is repaid by another short-term loan revolving n determined maximum amount that can be borrowed over a period, may be collateralized n rather risky (liquidity), expensive

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Export loans; supplier loans


n Export loan special form of advance

payment to exporter granted by banks


n Supplier loan medium- to long-term loans

granted by suppliers of equity, interest included in price

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Short-term debt sources of finance

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Trade credit
n typical short-term loan associated with agreed

n n n n

delayed payments for goods/services; spontaneous generated by day-to-day operation; not financial loan (form of goods/services paid for later) readily available to most businesses, payment terms may differ between suppliers the oldest loan form, simplifies sales interest included in price, when promptly paid discount (2/10 net 30) secured: open account up to agreed limit; written debenture; bill of exchange

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Trade credit (continued)


n Advantages: - convenient / informal / cheap, - available to companies of any size.

Factors determining terms of trade credit: - tradition within industry, - bargaining position of the two parties.

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Permanent and semi-permanent accruals


n Accrual an expense that has been incurred

but has not yet been paid (1) accrued wages and salaries, (2) accrued taxes n Represent spontaneous financial source

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Bank overdrafts
n Enable to take more money out of a bank

account that it contains, granted by banks on overdraft account, combine current and loan accounts; credit, zero or debit balance n Debit balance should not be below agreed loan limit

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Bank overdrafts pros and cons


n Advantages: - flexibility up to agreed limit - interest paid for really drawn moned for real

period of loan n Disadvantages: - banks right to withdraw facility at short notice, - issue of security, - more expensive than special loans

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Short-term special loans; lombard loan


Short-term special loans n granted by banks for special agreed purposes n finance short-term operational needs (seasonal stocks, seasonal costs, temporary shortage of funds etc.) n usually repaid with one payment including principal and interest Lombard loan n granted against the pledged securities (or accepted bills of exchange, accounts receivable, stocks, bullions); used to bridge personal or business financial shortfalls; lombard loan equates to percentage of pledged assets market value

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Advance payments
n currently used in some industries (ship

building, manufacturing of large equipment, house building etc.) n the part (or the whole) of contractually due sum paid in advance by buyers to suppliers n limited use in highly competitive industries

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