Financing Growth

Chapter 6Financing GrowthCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedChapter OverviewCapitalTypesCostsDebt TerminologyLoansTypesSourcesCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedChapter OverviewEquityTypesSourcesHotel Financing in the 1970s and 1980sNew Hotel Financing VehiclesCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedCapital DefinedMoney, or the equivalent of money, that is loaned to, or invested in, a businessCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of CapitalDebtFixed obligation or liability of the business that must be paid back, with interest, over a specified period of time.EquityOwnership in the business that does not require immediate repayment, but requires a return on the capital invested.Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedCost of CapitalCost of DebtInterest expense the borrower pays the lenderCost of EquityPortion of cash flow the sponsor of a deal allocates to the investorCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWeighted Average Cost of Capital or WACCAmount of interest expense and cash flow allotted to equity investors divided by the amount of capitalTakes into consideration:Capital mixTax effectInterest portion of debt service treated as an expense for tax purposes in the USCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWACC CalculationWACC = wd kd (1-T) + we ke Weight of debt = wd Cost of debt = kd (1-T) Tax rate of business = T Tax effect = (1-T) Weighted cost of debt = wd kd (1-T) Weight of equity = we Cost of equity = ke Weighted cost of equity = we ke Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedWACC Calculation ExampleWeight of debt = 0.4Cost of debt = 10% (1-0.2)Tax rate of business = 0.2Tax effect = 0.8 Weighted cost of debt = (0.4)(10%)(0.8)Weight of equity = 0.6Cost of equity = 20% Weighted cost of equity = (0.6)(20%) WACC = (0.4)(10%)(0.8) + (0.6)(20%) = 3.2% + 12% = 15.2%Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedFinancial LeverageIncreasing debt to lower the cost of capitalCost of debt is almost always less than the cost of equityEquity investors have a greater riskBusinesses should maximize the amount of debt they borrowCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLeverage ExampleIf you require $100,000 of capital and you project annual cash flow of $10,000:What would your ROI be if you raise 100% of the capital as equity? $10,000 cash flow / $100,000 of equity = ROI of 10%2. What would your ROI be if you raised 50% of the capital as equity, 50% of the capital as debt, and your annual debt service payment was 5% of your loan? $10,000 gross cash flow - $2,500 debt service = $7,500 net cash flow $7,500 net cash flow / $50,000 of equity = ROI of 15%Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedAdvantages of DebtCost of debt is lower than the cost of equityTax effectMore sourcesEasier to obtainDoes not dilute ownershipCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTax Effect ComparisonTax Savings with Interest Payments Financed with 100% equity Financed with 100% debt Revenues $600,000 $600,000 All costs 300,000 300,000 Interest 0 100,000 Earnings before tax 300,000 200,000 Tax (30%) 90,000 60,000 Net Income $210,000 $140,000 Tax savings $90,000 - $60,000 = $30,000Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedAdvantages of EquityLess demanding than creditorsDo not require a set payment timelineEquity distributions can be delayedOwners cannot close down a businessPartners can add experience, knowledge, and expertiseCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan TermsPrincipalAmount of money borrowedTermNumber of months or years given to repay the loanInterestAmount paid to the lender for lending the fundsPrincipal RepaymentPortion of debt service that reduces the amount of money owed to the lenderCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan TermsAmortization RateNumber of years debt service calculation is based uponCollateralAsset offered to lender as loan insurancePersonal GuaranteeSignatory agrees to use personal funds to make debt service paymentsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedLoan TermsPre-payment PenaltyBorrower pays the total amount of interest had the loan not been paid off earlyBullet LoanShort-term loan with a long-term amortization rateBalloon PaymentPayment due at the end of the loan termCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansBusiness LoanUsed to start a company or to expand itBased on:Merits of the borrowerMerits of the business planFinancial strength of the borrowerCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansConstruction Loan1 to 2 year termInterest onlyUsed to build, expand, acquire, or renovateAsset being constructed is provided as collateral60% of total project costCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansPermanent LoanTypically a 10 year termMini-perm LoanHybrid of the permanent loan5 year termNon-recourse LoanLender cannot seek payment from borrower’s personal assetsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansMezzanine LoanFills the gap between the total project cost, first mortgage, and equity capital investedInterest rate is higher than a permanent loanTerm runs concurrently with permanent or mini-perm loanCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansConvertible LoanHybrid of debt and equityCan be converted to equitySmall Business Administration Loan or SBA 7(a)Maximum amount is $2 millionBelow-market interest rateCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansCDC (504) or Federal 504Loan program for small businessesUsed to purchase fixed assetsBorrower required to provide 10% of project costInterest rate is below marketBorrower must haveNet worth under $7 millionAverage annual earnings for two years under $3 millionCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of LoansLeasingForm of debt financingRequires fixed or variable monthly lease paymentsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedSources and Types of LoansSources/LoansBusinessConstructionMini-PermPermanentMezzanineConvertibleSBA 7 (a)CDC (504)Local BanksXXXNational BanksXXSmall Business Investment CompaniesXBusiness and Industrial Development OrganizationsXXInsurance CompaniesXXXPension FundsXXXPrivate Credit CompaniesXXXXIndividualsXXXVenture CapitalistsXCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of EquityCash EquityLandBuilding LeasesPopular for restaurantsExisting BuildingsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTypes of EquityGovernment SubsidiesTax abatementTraining grantInfrastructureHighway exitNew curbSidewalkCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedSources of EquityIndividualsInsurance CompaniesVenture Capital FundsState and Local GovernmentsOwners of AssetsConstruction and Management CompaniesInvestment BanksCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedHotel Financing in the1970s and 1980sBoom time for hotel real estate developersLoans based on percentage of value, not costDevelopers secured debt financing in excess of the project’s costTax shelters were createdCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedHotel Financing in the1970s and 1980sSavings & Loan industry was able to:Make commercial real estate loansResidential loansOwn commercial real estateGovernment offered:Investment tax credits to developersAccelerated depreciation to developersCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedTax Reform Act of 1986Eliminated tax sheltersProhibited savings & loans from owning real estateReal estate projects went bankruptLenders began foreclosing on loansBegan a monumental financial crisis in the U.S.Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedResolution Trust Corporationor RTCCreated by the federal government to bail out loan industryTasks of the RTCAssume ownership of failed savings and loansSell loansSell foreclosed assetsRecoup cash for US citizens lost in the savings and loansRTC sold most of the loans and foreclosed assets for a small percentage of their actual valueCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedNew Hotel Financing VehiclesReal Estate Investment Conduit or REMICMade mortgage loansSold mortgages as commercial mortgage baked securities (CMBS)Enabled lenders to purchase a small percentage of several loansCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedNew Hotel Financing VehiclesReal Estate Investment Trust (REIT)Tax exempt corporation that owns real estateThree different categoriesEquity REITInvests in and owns propertiesMortgage REITInvests in mortgages and mortgage related securitiesHybrid REITCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedNew Hotel Financing VehiclesTimeshareRights to a room are sold on a weekly basisCondominium HotelsEach room is sold as an investmentMixed-use DevelopmentFocuses on offering a range of productsMay include a hotel, restaurant, retail space, etc.Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved