Chapter 14. Understanding Financial Contracts. Learning Objectives. Introduction

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1 Chapter 14 Understanding Financial Contracts Learning Objectives Differentiate among the different mechanisms of external financing of firms Explain why mechanisms of external financing depend upon firm size Understand how financial contracts may reduce the adverse selection and moral hazard problems of asymmetric information 14-2 Introduction Chapter focuses on financial contracts between lenders and borrowers Non-traded financial contracts are tailor-made to fit the characteristics of the borrower In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract

2 Introduction Asymmetric information problems associated with the availability of information about the borrowers who seek funding Apply this concept to analysis to contrast the differences between consumer and business financing 14-4 Businesses need funds for a variety of reasons Finance permanent assets such as plant and equipment Finance the acquisition of another business Finance working capital inventory or accounts receivable 14-5 Financing Small Businesses Small firms assets less than $10 million Vast majority are privately owned with ownership concentrated in a single family Generally do not need external financing beyond trade credit delayed payment offered by suppliers Profitable firms may have sufficient capital to be selffinancing Banks are most likely source of external financing

3 Financing Small Businesses Provide funds via a short-term loan or line of credit (L/C) for either working capital or purchase of plant and equipment Short-term loan negotiated contract with short maturity Line of Credit Bank extends a credit for specified period of time The borrowing firm can draw down funds against L/C Credit Rationing insures borrower has access to funds even if bank would prefer to curtail new loans When financing capital assets the maturity of the loan is typically less than life span of the asset 14-7 Financing Small Businesses Bank Loan Origination (Figure 14.1) Locate a bank that meets your needs, usually through a referral The bank s loan officer conducts a complete credit analysis Review borrower s financial statements Visit the place of business Assesses the managerial strengths/weaknesses of borrower Provides an opportunity to develop a one-on-one relationship 14-8 FIGURE 14.1 Bank loan origination

4 Financing Small Businesses Bank Loan Origination (Figure 14.1) Obtain additional information about the firm Obtain credit report on the firm and borrower Address any concerns with the borrower Loan is approved by the bank Small loan approved by a loan officer Larger loans are approved by more senior officers Above a certain amount must get approval from loan committee Borrower and bank negotiate terms of the loan Financing Small Businesses Unique features of a small business loan During application period and after the loan is granted, develop a relationship between bank and borrower Banks offer a wide menu of options to borrower Loans are often collateralized Pledging of assets against the loan Secured lender bank has the right to petition the bankruptcy court to sell the asset pledged as collateral to satisfy the loan Financing Small Businesses Unique features of a small business loan Loans are often collateralized Unsecured lender have right to proceeds from sale of assets after secured lenders have been paid Owner may pledge personal assets as collateral Loan can be guaranteed by the owner Borrower is personally liable for any unpaid balance Lender may require a personal financial statement of the borrower

5 Financing Small Businesses Unique features of a small business loan Loan may contain restrictive covenants Covenant promises that the company makes to the bank regarding their future actions and strategies The bank may require an audited financial statement to verify the convents have not been broken More restrictive covenants are linked to actions indicating the company has become riskier Financing Small Businesses Unique features of a small business loan Loan may contain restrictive covenants If violated, bank may demand immediate payment of loan Possible for the borrower to renegotiate the terms of the loan to reflect higher risk Maturity of small business loans rarely exceeds 5 years With very small firms, often loan is strictly dependent on creditworthiness of the individual not the small business Financing Midsize Businesses Assets between $10 million and $150 million Large enough to no longer be bank-dependent for external debt financing, but not large enough to issue traded debt in the public bond market Some are likely to be publicly owned issue equity traded in the over-the-counter market Can either be owner managed or managed by someone other than the owner

6 Financing Midsize Businesses For short-term debt, principally rely on commercial banks Depending on size of debt and bank, can use either local or non-local banks Typically have covenants placed on the loan and may pledge collateral Revolving Line of Credit--access to longer-term debt financing through their commercial bank that combines an L/C with intermediate-term loan Financing Midsize Businesses Long-term debt financing is often provided by nonbank institutions Mezzanine debt funds provide loans to smaller midsize companies Private Placement Market (Figure 14.2) Generally a bond issue in excess of $10 million Bonds do not have to be registered with the SEC Avoids public disclosure of information Sold only to financial institutions and high net worth investors Financing Midsize Businesses Private Placement Market Generally not resold by original investor for at least two years Have covenants that are generally less restrictive than when borrowing from a bank Terms will be renegotiated one or more times during the life span of the loan if the company wishes to embark on a new strategy

7 Financing Midsize Businesses Private Placement Origination (Figure 14.2) Issued through agents, commercial banks or investment banks who structure the contract and market the issue Due diligence the agent handling the private placement evaluates the firm s management, financial condition, and business capabilities Based on due diligence, the placement issue will receive a formal credit rating which measures the perceived risk FIGURE 14.2 Private placement origination Financing Midsize Businesses Private Placement Origination (Figure 14.2) The terms of the contract are negotiated to be attractive to investors interest rate, maturity, covenants, and any special features Offering memorandum/term sheet containing information of the firm and the offering are sent to prospective investors Once the issue is placed, the investors do their own due diligence which verifies the original information

8 Financing Large Businesses Firms with assets in excess of $150 million Becomes cost effective to enter the public bond market These bond issues are liquid assets that are traded in the secondary market Therefore, can be issued at a lower yield than a nontraded instrument Financing Large Businesses Large businesses can afford the high distribution and underwriting costs of a public issue Additional costs to sell to a wider range of investors Substantial costs associated with registering the bond with the SEC Securities Underwriting (Figure 14.3) Issuer selects an underwriter, generally an investment bank, to assist in issuing and marketing the bond Underwriters actively market their services to companies large enough to issue in the public market FIGURE 14.3 Securities underwriting

9 Financing Large Businesses Securities Underwriting (Figure 14.3) Underwriter does due diligence on the issuer and then issues the following items Registration Statement conforms to specific disclosure requirements Offering (preliminary) prospectus contains all relevant factual information about the firm and its financing Financing Large Businesses Securities Underwriting (Figure 14.3) Registration statement is blessed by the underwriter, the accountants, and issuing firm s attorneys The registration statement is approved by the SEC and can now be distributed Role of underwriter in the distribution Underwriting syndicate is formed by the managing underwriter to share responsibility for distribution the issue and the underwriting risk Financing Large Businesses Securities Underwriting (Figure 14.3) Role of underwriter in the distribution Underwriting risk occurs when the underwriters make a firm commitment to sell the bonds at an agreed price (implied interest rate) If bonds sell below this price, underwriter takes a loss Underwriting Spread hope to sell bonds at a higher offering price, above the commitment price It is difficult to incorporate highly restrictive covenants in publicly traded bonds

10 Financing Large Businesses Shelf Registration Permits the issuer of a public bond to register a dollar capacity with the SEC Draw down on this capacity at any time This avoids additional registration requirements Permits issuers to respond instantaneously to changing market conditions Financing Large Businesses Large companies with good credit ratings tend to rely on the commercial paper market for shortterm financing Some very large businesses also issue medium-term notes, which are like commercial paper, except maturities range from one year to five years Also issue equities, through underwriters, which is another form of external long-term financing Contracting Figure 14.4 summarizes method and nature of financial contracting according to firm size. The concept of transactions costs helps explain why firms of different size rely on different financial contracts to raise funds However, to fully understand the differences must rely on the concept of asymmetric information buyers and sellers are not equally informed about the quality of the product

11 FIGURE 14.4 Credit market comparison Contracting Asymmetric Information and Financial Contracting Adverse Selection Caused by asymmetric information before a transaction is consummated Bank loan officer cannot easily tell the difference between high and low quality borrowers Part of the loan officer s job is to use credit analysis to uncover relevant information Asymmetry of information is particularly acute for small firms since there is little publicly available information Contracting Asymmetric Information and Financial Contracting Adverse Selection As a result, loans are often structured such that borrowers can signal their true quality based on the types of loans they will accept Is owner willing to pledge personal outside assets as collateral or offer a personal guarantee? If owner is not willing, this would signal that they are uncertain of the future

12 Contracting Asymmetric Information and Financial Contracting Moral Hazard Occurs after the loan is made Loan contract may give the firm the incentive to pursue actions that take advantage of the lender If the firm does very well, the owner does not pay more to the issuer of the bank loan If the firm does poorly, the owner s liability is limited to the terms of the loan Contracting Asymmetric Information and Financial Contracting Moral Hazard Therefore, owners disproportionately share in the upside of increased risk, while lenders disproportionately share in the downside Contracting Contracting and Firm Continuum There are things firms can do to convince potential lenders that they will not engage in risky tactics Large firms Relatively easy to observe any risk shifting is easily detected Labor contracts are often public knowledge Supplier relationships are often well known Marketing success or failure is well documented Motivated to not switch to high risk activities the firm s desire to maintain their reputation

13 Contracting Contracting and Firm Continuum Large firms Therefore, public markets for stocks and bonds will generally reflect true riskiness of investment strategies, with prices and yields determined accordingly Contracting Contracting and Firm Continuum Small firms External reputations are difficult to establish Most activities are beyond the public s scrutiny Therefore, need proxies to demonstrate they are low risk and committed to not shifting their risk profiles Outside collateral or personal guarantees place more of the owner s wealth at risk Inside collateral, bank files a lien against collateral Loan covenants prevent risk shifting by explicitly constraining borrower behavior Contracting Contracting and Firm Continuum Small firms Small firms cannot enter into long-term debt contracts since there is too much flexibility given the incentives to shift risk Therefore, bank loans to small business are typically made on a short-term basis

14 Contracting Contracting and Firm Continuum Midsize Companies Their information problems lie between small and large size companies More visible publicly than small, but more informationally impaired than large companies Still need a financial intermediary at the origination stage to address adverse selection problems and design a tailor-made contract May have access to long-term debt in the private placement market Contracting Firm Continuum (Figure 14.5) Describes the relationship between information and market access in terms of a firm continuum The larger the firm, greater and more accurate information becomes available As a firm matures there is more access to long-term financial contracts, first in the private placement market progressing into publicly traded stocks and bonds FIGURE 14.5 Firm continuum

15 Contracting Firm Continuum (Figure 14.5) Growth also enables the firm to obtain different types of short-term credit A firm may revert back to a form of financial contract typically associated with a smaller firm, but this is consistent with the concept of firm continuum and the firm will do what is in their best interest Contracting Consumer Lending, Financial Contracting and Securitization Asymmetric information also exists in consumer lending Some consumers are high-risk borrowers, some are low-risk Adverse selection exists since it might be difficult to determine the riskiness of a potential borrowers Moral hazard is also present since consumers may borrow for one purpose and switch to a riskier activity Contracting Consumer Lending, Financial Contracting and Securitization Consumer lenders use some of the same techniques as business lenders to solve these problems Banks may use subtle pricing schemes to sort out low-risk borrowers from high-risk ones and permit loan packages to be tailored for both groups

16 Contracting Consumer Lending, Financial Contracting and Securitization Asymmetric information is probably less in consumer lending than business lending Easier to access consumer risk since personal financial information is much less complex Relatively fewer types of consumer loans so evaluating consumer risk is easier than business loans Collateral virtually eliminates the asymmetry problem Easier to securitize consumer loans pooling a group of loans into a trust and then selling securities issued against the trust

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