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2

Financing the Corporate Venture

Prior to World War I, most companies were small in comparison to companiestoday. They were often owned and operated by the founders [1]. The capitalexpenditures were for replacement of obsolete or worn-out equipment, or perhapsfor modest plant expansions. The funds for these expenditures were, for the mostpart, obtained from company earnings.

Between World War I and II, industrial growth took place with plantacquisitions or mergers with other rms. Since these were often majorexpenditures, internal funds were not sufcient to meet company needs.Established companies, like Du Pont and Eastman, that in the past had relied oninternally generated funds were forced to examine their policy in order to replaceequipment and grow. External funding sources had to be obtained and the sourceswere banks, insurance companies, and investment banking houses.

In the period after World War II, growth was one of the management goals.For companies to maintain a regular dividend policy, external funding forventures had to be sought. In very recent times, with the mergers, acquisitions, joint ventures, and alliances, and interest in megadollar projects, external sourceswere the only option for large-scale projects. Cash generated from internalsources alone could not begin to fund the capital-intensive projects.

2.1 BUSINESS PLANS

The planning function is essential for the growth of a successful, vigorouscompany. Two of the most important areas of management responsibilities are

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capital budgeting and planning. Committees within the rm are formed to planfor the future and prepare capital budgets.

A business plan must be developed before any funds are sought for a newproduct or venture. The capital budgeting function may be divided into severalcategories depending upon the time frame involved [1,2].

. Strategic planning involves setting the goals, objectives, and broad businessplans for a 5- to 10-year time period in the future.

. Tactical planning involves the detailing of the strategic planning for say 25years in the future.

. Capital budgeting involves a request, analysis, and approval of expendituresfor the coming year.

Business plans minimally consist of the following information along with aprojected timetable:. Perceived goals and objectives of the company. Market data

Projected share of the marketMarket pricesMarket growthMarkets the company serves

Competition, both domestic and globalProject and/or product life. Capital requirements

Fixed capital investmentWorking capitalOther capital requirements

. Operating expensesManufacturing expenses

Sales expensesGeneral overhead expenses. Protability

Prot after taxesCash FlowPayout periodRate of returnReturns on equity and assets

Economic value added. Projected risk

Effect of changes in revenueEffect of changes in direct and indirect expensesEffect of cost of capitalEffect of potential changes in market competition

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. Project lifeEstimated life cycle of the product or venture

The business plan is then submitted to the source of capital funding, e.g.,

investment banks, insurance companies.

2.2 SOURCES OF FUNDS

The funding available for corporate ventures may be obtained from internal orexternal sources.

2.2.1 Internal Sources

The capital from internal sources is from retained earnings or from an allowanceknown as reserves . Internal nancing is owned capital, and it is argued that itcould be loaned or invested in other ventures to receive a given return. Indetermining the cost of owned capital, interest to be paid on this capital is equal tothe present return on all the companys capital [13].

2.2.1.1 Retained Earnings

Retained earnings of a company are the difference between the after-tax earningsand the dividends paid to stockholders. If a rm plans no growth, thentheoretically all the after-tax earnings could be distributed as dividends to thestockholders. Management would not do this. The company retains a certain partof the prots, and a part is paid to the stockholders as dividends. That partretained may be used for research and development expenditures or for capitalprojects [1].

2.2.1.2 Reserves

Earlier in this section, reserves were mentioned as a possible source for internallygenerated funds. The reserves are to provide for depreciation, depletion, andobsolescence. Deprecation reserves seldom cover the replacement costs of equipment because improved technology results in more expensive, sophisticatedequipment. Also, ination severely cuts into reserves. Therefore, with thenecessity of providing for dividends to stockholders and to purchase equipment,it is essential to seek external funding [1].

2.2.2 External Sources

There are three sources of external nancing: debt, preferred stock, and commonstock . These sources vary widely with respect to the cost and the risk the companyassumes with each of these nancing sources. The cheapest form of capital is

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the least risky. A general rule is the riskier the project, the safer should be the typeof nancing the capital used. A new venture with modest capital requirementscould be funded by common stock. In contrast, a well-established business areamay be nanced by debt.

2.2.2.1 Debt

For discussion purposes, debt may be classied arbitrarily as follows:

Current debtmaturing up to 1 yearIntermediate debtmaturing between 1 and 10 yearsLong-term debtmaturing beyond 10 years

2.2.2.1.1 Current Debt. Lets consider this case: A company has theopportunity of purchasing a raw material at a low price, but the companydoesnt have ready cash. The company wants to pay off the debt in 90120 days.There are three options available. First, it could be obtained from a bank bymeans of a commercial loan [1].

As an alternate, if the company has a good line of credit, it could borrow themoney in the open market. It would draw a note to the order of the bearer of thenote and have it discounted by a dealer in this type of note or by the purchaser of

the note. This type of borrowing is a negotiable note known as commercial paper .A third method is through what is known as open-market paper or bankers

acceptance . If a raw material is to be purchased from a single source, thecompany could sign a 90-day draft on its own bank paid to the order of thevendor. The company will pay a commission to its own bank to accept in writingthe draft and the company has an unconditional obligation to pay the full amounton the maturity date. Many chemical companies use this form of the 90-day noteto the nancial institution.

2.2.2.1.2 Intermediate Debt. This form of debt is retired in 110 years. Thisis usually the smallest form of debt based on the total debt. There are three typesof intermediate debt, namely, deferred-payment contract , revolving credit , andterm loans .

In the deferred-payment contract, the borrower signs a note that species aseries of payments are to be made on a time schedule over a period of time,perhaps 5 or 10 years. This type of debt may be used for the purchase of

equipment, the title of which rests with the note holder until the debt is retired.Institutional investors, banks, and insurance companies are examples of typicallenders.

Revolving credit is an agreement in which the lender agrees to loan acompany an amount of money for a specied time period. A commission or fee ispaid on the unused portion of the total credit. Banks usually are the lenders.

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This form of credit is often used to purchase raw materials on a spot basis and forvariable or recurring demands for funds for a specied time period. It is notintended to be a long-term loan. The duration of these agreements are of the orderof 15 years [1].

Term loans are divided into installments that are due at specied maturitydates that may be as long as 10 years. There are a variety of arrangements thatcan be made, such as monthly, quarterly, semiannual, or annual payments.These obligations may be paid off prior to maturity, both with and withoutpenalties, depending on how the agreement is drawn. Large commercial banksand insurance companies are typical lenders [1,2].

2.2.2.1.3 Long-Term Debt. Bonds or long-term notes are examples of thistype debt. They are special kinds of promissory notes and are negotiable

certicates that are issued at par values of $1000. They are securities promising topay a certain amount of interest every 6 months for a number of years until thebond matures. There are four types of bonds in the market, namely, mortgage,debenture, income , and convertible bonds [1,2,4].

Mortgage bonds are backed by specic pledged assets that may beclaimed if the terms of the indebtness are not met and particularly if thecompany issuing the bonds goes out of business. Utilities and railroads oftenuse this type of debt.

Debenture bonds are only a general claim on the assets of a company. Thistype of bond is usually preferred by companies because it is not secured by specicassets but by the future earning power of the company and allows the company tobuy and sell manufacturing facilities without being tied to specic assets.

Income bonds are different from other forms of long-term debt in that acompany is obligated to pay no more of the interest charges that haveaccrued in a certain period than were actually earned in that period. Thesetypes of bonds nd use when a company has, to recapitalize after bankruptcy

and the company has uncertain earning power.Convertible bonds are hybrids. In periods of ination, an investor may

become wary of putting funds in bonds that merely repay the principal indollars that have deteriorated in purchasing power. To tempt the investor back into bonds, corporations resort to convertible bonds. If ination sends stocksupward, one can convert the bonds to stocks and protect the rea purchasingpower of the principal. In periods of low ination or deation, bonds are safeinvestments but in periods of ination, stocks reect the inationary trend sothat purchasing power may be retained.

2.2.2.2 Stockholders Equity

This is the total equity interest that stockholders have in a corporation. There aretwo broad classes of equity: preferred stock and common stock . There may be

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several classes or types of each of these shares issued by a corporation and theyhave different attributes.

2.2.2.2.1 Preferred Stock. The word preferred means that thesestockholders receive their dividends before common stockholders. In the event

of company liquidation, preferred stockholders will recover funds from thecompany assets before common stockholders. Preferred stockholders generallyhave no vote in company affairs. Most preferred shares are issued by thecompany at a par value of $100 at a stated dividend rate, say 7%. This means thateach shareholder is entitled to a $7 dividend when dividends are paid tostockholders. Most preferred stock offered today is cumulative , which means thatif in any year no dividends are paid, the dividends accumulate in favor of thepreferred stockholders. The cumulative dividends must be paid before any

common stockholders receive dividends [1,4].There is also a convertible preferred stock offered by companies. Thisstock, like a convertible bond, carries for a stated period of time the privilege of converting preferred stock to common stock. Usually, convertible preferred stock pays a lower dividend than preferred stock [4].

2.2.2.2.2 Common Stock. The holders of common stock are the source of venture capital for a corporation. As such, they are at the greatest risk becausethey are the last to receive dividends for the use of their money. When thecompany grows and ourishes and the earnings are high, they receive the greatestbenets in the form of dividends. An added feature is that the commonstockholder has a voice in company affairs at the company annual meetings[1,2,4].

Venture capital rms fund start-up companies in return for common stock that someday might be offered as an initial public offering (IPO) that may beworth a lot of money. In some cases the venture capitalists seek positions in thestart-up company. Normally, a venture capital rm doesnt put money in a rmand watch from afar to see what happens to the young rm. These rms are likelyto stay active in the rm until the IPO is offered [5].

2.3 DEBT VERSUS EQUITY FINANCING

Various options for obtaining funds to nance capital projects were presented inSection 2.2. Top-level management is confronted with how a venture will be

funded, considering the costs and risks involved. The capital requirements mayvary from millions to billions of dollars.The nal decision is a complex one and signicant questions must be

addressed. For example, what is the state of the economy? Is it growing, static, ordeclining? What is the companys cost of capital, i.e., the cost of borrowing fromall sources? What is the current level of indebtedness? Should the company incur

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more long-term indebtedness or should it seek venture capital through theissuance of stock? The answers to these questions are not simple [1].

A company must consider its position with respect to leverage. Does thecompany have a large proportion of its debt in bonds or preferred stock? If so, thecommon stock is said to be highly leveraged. If earnings decline by say 10%, thiscould wipe out dividends to the common stockholders. The company might alsonot be able to cover interest on bonds without using accumulated retainedearnings. There is a great danger when companies have a high debt/equity ratioillustrating a weakness of companies with an unusually high ratio. Many capital-intensive industries like chemicals, petroleum, steel, etc. have ratios of 2 or 3 to 1.The danger is that they may be confronted with liquidating some of their assets tosurvive. On the other hand, if the ratio is of the order of 1 to 1, this strategyincreases the chance of a takeover and does affect the stock price.

The strategies for nancing a venture depend on a number of factors, someof which may have a synergistic effect and have to be evaluated from thestandpoint of what is best for the company. A company must attempt to maintaina debt/equity ratio similar to successful companies in the same line of business.

2.4 CONCLUDING REMARKS

The largest holders of corporate securities are institutional investors. Theseinclude insurance companies; educational, philanthropic, religious organizations;and pension funds. These organizations may purchase securities as all or part of anew stock issue in what is called private placement or in contrast may purchasesecurities on the open market as initial public offerings (IPO).

There are many excellent texts on the subject of corporate nance as well ascourses in business schools on this topic. In this chapter, the focus was to presentgeneral types of nancing a venture available to corporations.

REFERENCES

1. JR Couper, WH Rader. Applied Finance and Economic Analysis for Scientists andEngineers. New York: Van Nostrand Reinhold, 1986.

2. CB Nickerson. Accounting Handbook for Non-Accountants. 2nd ed. Boston: CBI,1979.

3. EA Helfert. Techniques of Financial Analysis. Homewood, IL: Irwin, 1987.

4. PA Samuelson. Economics. 3rd ed. New York: McGraw-Hill, 1976.5. CHEMTECH, p. 50, April 1997.