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2

Financing the Corporate Venture

Prior to World War I, most companies were small in comparison to companies


today. They were often owned and operated by the founders [1]. The capital
expenditures were for replacement of obsolete or worn-out equipment, or perhaps
for modest plant expansions. The funds for these expenditures were, for the most
part, obtained from company earnings.
Between World War I and II, industrial growth took place with plant
acquisitions or mergers with other firms. Since these were often major
expenditures, internal funds were not sufficient to meet company needs.
Established companies, like Du Pont and Eastman, that in the past had relied on
internally generated funds were forced to examine their policy in order to replace
equipment and grow. External funding sources had to be obtained and the sources
were 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 for
ventures had to be sought. In very recent times, with the mergers, acquisitions,
joint ventures, and alliances, and interest in megadollar projects, external sources
were the only option for large-scale projects. Cash generated from internal
sources 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, vigorous
company. Two of the most important areas of management responsibilities are

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8 Chapter 2

capital budgeting and planning. Committees within the firm are formed to plan
for the future and prepare capital budgets.
A business plan must be developed before any funds are sought for a new
product or venture. The capital budgeting function may be divided into several
categories depending upon the time frame involved [1,2].
. Strategic planning involves setting the goals, objectives, and broad business
plans for a 5- to 10-year time period in the future.
. Tactical planning involves the detailing of the strategic planning for say 2 – 5
years in the future.
. Capital budgeting involves a request, analysis, and approval of expenditures
for the coming year.
Business plans minimally consist of the following information along with a
projected timetable:
. Perceived goals and objectives of the company
. Market data
Projected share of the market
Market prices
Market growth
Markets the company serves
Competition, both domestic and global
Project and/or product life
. Capital requirements
Fixed capital investment
Working capital
Other capital requirements
. Operating expenses
Manufacturing expenses
Sales expenses
General overhead expenses
. Profitability
Profit after taxes
Cash Flow
Payout period
Rate of return
Returns on equity and assets
Economic value added
. Projected risk
Effect of changes in revenue
Effect of changes in direct and indirect expenses
Effect of cost of capital
Effect of potential changes in market competition

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Financing the Corporate Venture 9

. Project life
Estimated 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 or
external sources.

2.2.1 Internal Sources


The capital from internal sources is from retained earnings or from an allowance
known as reserves. Internal financing is “owned” capital, and it is argued that it
could be loaned or invested in other ventures to receive a given return. In
determining the cost of owned capital, interest to be paid on this capital is equal to
the present return on all the company’s capital [1 –3].

2.2.1.1 Retained Earnings


Retained earnings of a company are the difference between the after-tax earnings
and the dividends paid to stockholders. If a firm plans no growth, then
theoretically all the after-tax earnings could be distributed as dividends to the
stockholders. Management would not do this. The company retains a certain part
of the profits, and a part is paid to the stockholders as dividends. That part
retained may be used for research and development expenditures or for capital
projects [1].

2.2.1.2 Reserves
Earlier in this section, reserves were mentioned as a possible source for internally
generated funds. The reserves are to provide for depreciation, depletion, and
obsolescence. Deprecation reserves seldom cover the replacement costs of
equipment because improved technology results in more expensive, sophisticated
equipment. Also, inflation severely cuts into reserves. Therefore, with the
necessity 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 financing: debt, preferred stock, and common
stock. These sources vary widely with respect to the cost and the risk the company
assumes with each of these financing sources. The cheapest form of capital is

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10 Chapter 2

the least risky. A general rule is the riskier the project, the safer should be the type
of financing the capital used. A new venture with modest capital requirements
could be funded by common stock. In contrast, a well-established business area
may be financed by debt.

2.2.2.1 Debt
For discussion purposes, debt may be classified arbitrarily as follows:
Current debt—maturing up to 1 year
Intermediate debt—maturing between 1 and 10 years
Long-term debt—maturing beyond 10 years

2.2.2.1.1 Current Debt. Let’s consider this case: A company has the
opportunity of purchasing a raw material at a low price, but the company
doesn’t have ready cash. The company wants to pay off the debt in 90 –120 days.
There are three options available. First, it could be obtained from a bank by
means of a commercial loan [1].
As an alternate, if the company has a good line of credit, it could borrow the
money in the open market. It would draw a note to the order of the bearer of the
note 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 banker’s
acceptance. If a raw material is to be purchased from a single source, the
company could sign a 90-day draft on its own bank paid to the order of the
vendor. The company will pay a commission to its own bank to accept in writing
the draft and the company has an unconditional obligation to pay the full amount
on the maturity date. Many chemical companies use this form of the 90-day note
to the financial institution.
2.2.2.1.2 Intermediate Debt. This form of debt is retired in 1 –10 years. This
is usually the smallest form of debt based on the total debt. There are three types
of intermediate debt, namely, deferred-payment contract, revolving credit, and
term loans.
In the deferred-payment contract, the borrower signs a note that specifies a
series 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 typical
lenders.
Revolving credit is an agreement in which the lender agrees to loan a
company an amount of money for a specified time period. A commission or fee is
paid on the unused portion of the total credit. Banks usually are the lenders.

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Financing the Corporate Venture 11

This form of credit is often used to purchase raw materials on a spot basis and for
variable or recurring demands for funds for a specified time period. It is not
intended to be a long-term loan. The duration of these agreements are of the order
of 1 – 5 years [1].
Term loans are divided into installments that are due at specified maturity
dates that may be as long as 10 years. There are a variety of arrangements that
can be made, such as monthly, quarterly, semiannual, or annual payments.
These obligations may be paid off prior to maturity, both with and without
penalties, depending on how the agreement is drawn. Large commercial banks
and insurance companies are typical lenders [1,2].
2.2.2.1.3 Long-Term Debt. Bonds or long-term notes are examples of this
type debt. They are special kinds of promissory notes and are negotiable
certificates that are issued at par values of $1000. They are securities promising to
pay a certain amount of interest every 6 months for a number of years until the
bond 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 specific pledged assets that may be
claimed if the terms of the indebtness are not met and particularly if the
company issuing the bonds goes out of business. Utilities and railroads often
use this type of debt.
Debenture bonds are only a general claim on the assets of a company. This
type of bond is usually preferred by companies because it is not secured by specific
assets but by the future earning power of the company and allows the company to
buy and sell manufacturing facilities without being tied to specific assets.
Income bonds are different from other forms of long-term debt in that a
company is obligated to pay no more of the interest charges that have
accrued in a certain period than were actually earned in that period. These
types of bonds find use when a company has, to recapitalize after bankruptcy
and the company has uncertain earning power.
Convertible bonds are hybrids. In periods of inflation, an investor may
become wary of putting funds in bonds that merely repay the principal in
dollars that have deteriorated in purchasing power. To tempt the investor back
into bonds, corporations resort to convertible bonds. If inflation sends stocks
upward, one can convert the bonds to stocks and protect the rea purchasing
power of the principal. In periods of low inflation or deflation, bonds are safe
investments but in periods of inflation, stocks reflect the inflationary trend so
that purchasing power may be retained.

2.2.2.2 Stockholders’ Equity


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

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12 Chapter 2

several classes or types of each of these shares issued by a corporation and they
have different attributes.
2.2.2.2.1 Preferred Stock. The word “preferred” means that these
stockholders receive their dividends before common stockholders. In the event
of company liquidation, preferred stockholders will recover funds from the
company assets before common stockholders. Preferred stockholders generally
have no vote in company affairs. Most preferred shares are issued by the
company at a par value of $100 at a stated dividend rate, say 7%. This means that
each shareholder is entitled to a $7 dividend when dividends are paid to
stockholders. Most preferred stock offered today is cumulative, which means that
if in any year no dividends are paid, the dividends accumulate in favor of the
preferred 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. This
stock, 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 because
they are the last to receive dividends for the use of their money. When the
company grows and flourishes and the earnings are high, they receive the greatest
benefits in the form of dividends. An added feature is that the common
stockholder has a voice in company affairs at the company annual meetings
[1,2,4].
Venture capital firms fund start-up companies in return for common stock
that someday might be offered as an initial public offering (IPO) that may be
worth a lot of money. In some cases the venture capitalists seek positions in the
start-up company. Normally, a venture capital firm doesn’t put money in a firm
and watch from afar to see what happens to the young firm. These firms are likely
to stay active in the firm until the IPO is offered [5].

2.3 DEBT VERSUS EQUITY FINANCING


Various options for obtaining funds to finance capital projects were presented in
Section 2.2. Top-level management is confronted with how a venture will be
funded, considering the costs and risks involved. The capital requirements may
vary from millions to billions of dollars.
The final decision is a complex one and significant questions must be
addressed. For example, what is the state of the economy? Is it growing, static, or
declining? What is the company’s cost of capital, i.e., the cost of borrowing from
all sources? What is the current level of indebtedness? Should the company incur

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Financing the Corporate Venture 13

more long-term indebtedness or should it seek venture capital through the


issuance of stock? The answers to these questions are not simple [1].
A company must consider its position with respect to leverage. Does the
company have a large proportion of its debt in bonds or preferred stock? If so, the
common stock is said to be highly leveraged. If earnings decline by say 10%, this
could wipe out dividends to the common stockholders. The company might also
not be able to cover interest on bonds without using accumulated retained
earnings. There is a great danger when companies have a high debt/equity ratio
illustrating 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 to
survive. On the other hand, if the ratio is of the order of 1 to 1, this strategy
increases the chance of a takeover and does affect the stock price.
The strategies for financing a venture depend on a number of factors, some
of which may have a synergistic effect and have to be evaluated from the
standpoint of what is best for the company. A company must attempt to maintain
a 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. These
include insurance companies; educational, philanthropic, religious organizations;
and pension funds. These organizations may purchase securities as all or part of a
new stock issue in what is called “private” placement or in contrast may purchase
securities on the open market as initial public offerings (IPO).
There are many excellent texts on the subject of corporate finance as well as
courses in business schools on this topic. In this chapter, the focus was to present
general types of financing a venture available to corporations.

REFERENCES
1. JR Couper, WH Rader. Applied Finance and Economic Analysis for Scientists and
Engineers. 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.

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