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ALLAMA IQBAL OPEN UNIVERSITY

Department of Business Administration Course. Level Course Code Topic Assigned Name of Tutor Name of Student Roll No Semester CORPORATE FINANCE MBA 5542 VARIOUS FORMS OF DEBT FINANCING

AVAILABLE IN PAKISTAN FOR CORPORATIONS SIR WAQAR MUHAMMAD FARHAN SABIR

AH522537 AUTUMN 2011

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ACKNOWLEDGMENTS

My first and foremost humble and gratitude to ALLAH the almighty for giving me the valor to remain dedicated to make this report. Apart from it I take the opportunity to acknowledge the real efforts of: First, we would like to thank SIR WAQAR, for his valuable support and encouragement which he has offered. His words of wisdom will always be remembered, and we are convinced that the knowledge CORPORATE FINANCE that he has imparted would go a long way and helping us all through our professional career.

Table of Contents

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Contents

Page No

Title page Acknowledgement Abstract

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Table of Contents Introduction to the issue Short-Term Debt Financing

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Long-Term Debt Financing

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Conclusion Recommendations

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Types of debt financing available in Pakistan for corporations

Debt financing is a strategy that involves borrowing money from a lender or investor with the understanding that the full amount will be repaid in the future, usually with interest. In contrast, equity financing which investor receives partial ownership in the company in exchange for their fund not have to be repaid. In most cases, debt financing does not include any provision for ownership of the company (although some types of debt are

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convertible to stock). Instead, small businesses that employ debt financing accept a direct obligation to repay the funds within a certain period of time. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providing the money. For example, a lender might charge a startup company a higher interest rate than it would a company that had shown a profit for several years. Since lenders are paid off before owners in the event of business liquidation, debt financing entails less risk than equity financing and thus usually commands a lower return.

So in simple. A method of financing in which a company receives a loan and gives its promise to repay the loan
Debt financing includes both secured and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt. Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone. Here are some types of security you can offer a lender:

Guarantors sign an agreement stating they'll guarantee the payment of the loan. Endorsers are the same as guarantors except for being required, in some cases, to post some sort of collateral.

Co-makers are in effect principals, who are responsible for payment of the loan. Accounts receivable allow the bank to advance 65 to 80 percent of the receivables' value just as soon as the goods are shipped.

Equipment provides 60 to 65 percent of its value as collateral for a loan. Securities allow publicly held companies to offer stocks and bonds as collateral for repaying a loan.

Real estate, either commercial or private, can be counted on for up to 90 percent of its assessed value.

Savings accounts or certificate of deposit can also be used to secure a loan.

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Chattel mortgage applies when equipment is used as collateral--the lender makes a loan based on something less than the equipment's present value and holds a mortgage on it until the loans repaid.

Insurance policies can be considered collateral for up to 95 percent of the policy's cash value.

Warehouse inventory typically secures up to only 50 percent of the loan. Display merchandise such as furniture, cars and home electronic equipment can be used to secure loans through a method known as "floor planning."

Lease payments can be assigned to the lender, if the lender you're approaching for a loan holds the mortgage on property you're trying to lease.

In addition to secured or unsecured loans, most debt will be subject to a repayment period. There are three types of repayment terms: 1. Short-term loans are typically paid back within six to 18 months. 2. Long-term loans are paid back from the cash flow of the business in five years or less.

Advantages to Debt Financing

Maintain ownership: When you borrow from the bank or another lender, you are obligated to make the agreed-upon payments on time. But that is the end of your obligation to the lender. You can choose to run your business however you choose without outside interference.

Tax deductions: This is a huge attraction for debt financing. In most cases, the principal

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and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It helps to think of the government as a partner in your business, with a 30 percent ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation, then its beneficial to your business.

Lower interest rate: Furthermore, you should analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10 percent for your loan, and the government taxes you at 30 percent, then there is an advantage to taking a loan you can deduct. Take 10 percent and multiply it by (1-tax rate), in this case its: 10 percent times (1-30 percent), which equals 7 percent. After your tax deductions, youll be paying the equivalent of a 7 percent interest rate.

Drawbacks to Debt Financing Repayment: As mentioned above, your sole obligation to the lender is to make your payments. Unfortunately even if your business fails, you will still have to make these payments. And if you are forced into bankruptcy, your lenders will have claim to repayment before any equity investors. High rates: Even after calculating the discounted interest rate from your tax deductions, as explained above, you may still be faced with a high interest rate. Interest rates will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history Impacts your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as levering up, but each loan will be noted on your credit rating. And the more you borrow, the higher the risk to the lender, and the higher interest rate youll pay. Cash and collateral: Even if you plan to use the loan to invest in an important asset, youll need to make sure your business will be generating sufficient cash flows by the time loan repayment starts. Also youll likely be asked to put up collateral on the loan in case you default on your payments.

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Short-Term Debt Financing

What is it?
Short Term Debt Financing applies to money needed for the day-to-day operations of the business, such as purchasing inventory, supplies, or paying the wages of employees. Short term financing is referred to as an operating loan or short term loan because scheduled repayment takes place in less than one year. Short term refers to the time for which a loan is required and the period over which its repayment is expected to take place. Short Term Loans usually take the form of operating term loans (less than one year) and revolving lines of credit. These finance the day-to-day operations of the business, including wages of employees and purchases of inventory and supplies. Supplies are used up quickly and inventory is sold resulting in stock-turns. Also bridge financing (interim loans with a short, fixed term) can be used to finance accounts receivable contracts, which are relatively risk-free, but delayed for one to three months. Short term operations money may be secured against first, any

unencumbered physical assets of the business; second, additional funds from shareholders or personal guarantees from principals. On occasion, inventories can be used as temporary security for operations loans. Bridge financing is normally secured by assignment of all the receivables and personal guarantees. On the balance sheet the accounts receivable, inventory and supplies stocks show up in the current assets section, while the counterpart loan information is displayed in the current liabilities section.

Working Capital Loan It is the most popular short-term financing option. It is meant to meet the working needs like the purchase of raw material, payment of wages and other administrative expenses, financing inventories, managing internal cash-flows, supporting supply chains, funding production and marketing operations. Most banks provide these against collaterals. Companies who borrow from banks are subjected to the discipline of maintenance of proper accounts and regular repayments

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of loans. They are subjected to periodical monitoring through a reporting structure of financial and other statements and also through analysis of cash flows routed through the banks.

Overdraft Overdraft is an instant extension of credit from a lending institution. When a company has an overdraft arrangement with a bank, it can draw down or transmit cash from its account beyond the available balance. It is also revolving in nature; does not have a fixed repayment period. The amount of credit will depend on the overdraft limit negotiated with the bank. (The advantage of an overdraft arrangement is that the company does not have to ensure that sufficient cash is always available for operating activities such as stock turnover or payment to creditors in the short term). Letter of Credit Letter of Credit is a letter from a bank guaranteeing a buyer's payment to a seller, that a seller will receive the amount within the credit period. The advantage of having such an arrangement with a bank is that it enables a company to negotiate better credit terms (E.g. longer credit period) with suppliers. Bill of Exchange Bill of exchange is a document that binds one party to pay a fixed sum of money to another party at a specified future date. It is often used in international trade. An exporter can grant credit to an importer for goods shipped, by drawing a bill of exchange to the same amount and credit period.

Commercial Banks and Credit Unions The Commercial Banks and Credit Unions are normally prepared to offer financing based on accounts receivable bridging and/or inventory purchases. Revolving or operating lines of credit (and overdraft schemes) are offered by the major commercial banks and some credit unions.

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Approaching Mortgage Lenders: There are many short term mortgage loan financiers to be found in the private sector. Many of these private mortgage financiers advertise their services aggressively, especially where those offerings relate to mortgage extensions on property in strong real estate markets.

Personal Guarantees
The principal makes an agreement that if the limited company is unable to repay the loan, he/she will do so personally. If this guarantee is on top of other security, attempt to negotiate a limited guarantee to cover only the shortfall in the security. Recover the personal guarantee as soon as the business has paid off its obligation or can carry the debt on its own security. A personal guarantee places all those things you and your family hold dear at risk. Interim Loans Interim loans are a type of bridge financing intended to "bridge the gap" between the time a specific receivable is received in cash and the time the company's parables become due. The assignment of the receivables is the primary security for the loan. This is quite common where a government agency purchase has been made. The lender knows the customer will pay, but also that the cash may take some time to collect. When a government financial assistance program makes an award, reimbursable only after the moneys have been spent or the project is in place, bridge financing is an appropriate format.

Revolving Lines of Credit A line of credit is a long term commitment by a commercial lender to honor the day to day cherubs of a business up to a maximum figure agreed to in consultation with the business. The lender retains a number of signed drafts (notes held for discount) from the business on hand to

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use as required to place funds as needed into the account. The business was made responsible for depositing all sales revenues on a regular basis into the account to "buy down" the outstanding loan balance whenever there were the funds available to do so. This up and down, fluctuating nature of the loan amount (account balance) is why it has come to be called a "revolving line of credit." There is no scheduled repayment of principal because there is no set principal amount of the loan. Trade credit Suppliers can often provide an easily available way to supplement conventional borrowing. Startup businesses may benefit from shopping for prospective suppliers as soon as the entrepreneur has a business location picked out Inter-corporate deposits
This is a short-term help provided by one corporate with surplus funds to another in need of funds. The major disadvantage to lenders is that the money is locked in for the certain period of time.

Who qualifies for it? Basically, there are no formal qualifying criteria for obtaining short term debt financing. In general, companies need to have owner's capital and a strong business case to support the viability of the business. Suppliers offer short term credit on purchases to enhance their competitiveness; banks offer short term loans and overdrafts to earn interest as well as to build on client relationships. Hence, as long as the company is relatively transparent in its financials and operations, and is not 'blacklisted' on the credit bureau, or has a bad reputation in the industry for defaulting on debts, short term debt financing is possible. What are the advantages and disadvantages? Short term debt financing provides the business with liquidity to conduct its day-to-day operations and to maintain working capital needs. However, they do present some disadvantages to the business as well. These are detailed below.

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Advantages Short term debt financing is a source of 'quick' liquidity for the business, in particular SMEs, who do not have large pool of reserve funds for emergency uses. Small enterprises are more prone to short term shocks from their operating environment such as a large debtor declaring bankrupt, or an abruptly ceased partnership with a major supplier. Hence, short term debt financing provides almost immediate funds to tide over such difficult situations that could otherwise impact the going concern of SMEs. Short term debt financing is usually easier to negotiate (compared to long term debts and equity financing), as the financier faces relatively lower credit risk. Due to the ease of negotiation, short term debt financing can be used to free up funds in the business for good investment opportunities that would otherwise have been foregone. Most short term debt financing instruments can be obtained without having to pledge a considerable amount of collateral, as long as the borrowing company has relatively stable operations and turnover rate (i.e. moderate business risk). The cost of servicing short-term credit is less taxing on the company. Short-term loans usually offer lower interest charges, and most suppliers do not charge interest at all until the credit allowance period is breached. Disadvantages Short term debt financing has to be monitored closely to avoid bad relationships with suppliers and bankers, or a bad reputation in the industry for not paying debts on time. Short-term debts only meet working capital or immediate business needs. They are not useful for servicing any long term plans with larger capital requirements, higher risk, and longer payback horizons.

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The following are some of the risks that come with short term debt financing. Over-reliance on certain lines of short-term credit, especially from suppliers, may cause the company to take on more business risk in offering aggressive credit terms to customers. In the event that the suppliers change their credit terms, the company will be put in a position of payable-receivable mismatch (i.e. paying faster than collections). Changing its own credit terms may mean loss of customers and market share. Badly maintained credit lines (late payments etc) may result in the company being 'blacklisted' by credit bureaus or industry players, making it more difficult or expensive to obtain financing in future.

Long-Term Debt Financing

What is it?
In contrast to short-term borrowings, long-term debt is used to finance business investments that have longer payback periods. For example, the purchases of machinery, which may help the company, produce goods over a 5-year period. There are 2 main types of long term debt financing options.

Term Loan
Basically, term loan is a loan with a repayment period of more than one year. It is usually taken by companies with longer investment or payback horizons, such as building of a new factory or purchase of new production equipment. A bank term loan is usually repaid via periodic installments. Mortgage is basically a long-term loan, secured by collateral of some specified real estate property. The loan is normally amortized and the borrower is obligated to make a periodic installment to repay the loan. Failing which, the lender can enforce its rights to possess the mortgaged property.

Leasing
Leasing, in general, allows a company use of an asset without having to pay the full amount upfront. A leasing agreement is drawn up with the lessee agreeing to pay periodic rental payments in exchange for the use of a capital asset. It is in effect a rental agreement, apart from a clause, which allows the lessee to own, or to buy over the machine at a reduced rate, at the end of the lease agreement.

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Syndicated loans
Syndicated loans are large capital loans raised by big corporations from a group of banks. These are aimed at acquiring domestic or international companies. In this case, one bank acts as a lead bank.

Project Finance Large and long-term infrastructure projects require huge amounts amount of funding both in the form of debt and equity. In project financing, lenders (banks) rely on the assets created for the project as security and the cash-flow generated by the project as source of funds for repaying their dues. These projects include building of roads, dams; ports etc are sensitive to regulatory and political policies and tariffs. Debentures This is a long-term debt instrument issued by a company with the acknowledgement that it would repay the money at a certain rate of interest to the buyer. These are not shares, thus the buyer can stake no claim in the share of the company. Who qualifies for it? Long term debt financing is usually more risky to the financier as it involves longer payback periods and thus higher credit risks. Hence, long-term debt financiers would usually require the borrowing company to pledge some form of asset as collateral. Such assets can range from inventories to factories and properties. The amount of funds that the company is able to obtain through long term debt financing would depend greatly on the value of assets, which the company is able and willing to pledge. Generally, long term debt financiers will also look at the credit worthiness of the borrowing company, in terms of its long term business prospects, cash flows, profitability, capital structure (debt-equity ratio) and other qualitative factors such as the transparency of operations, credibility and integrity of management etc. Long-term debt financiers such as financial institutions would usually require a set of up-to-date audited financial statements to perform their credit evaluation. Table below shows some of the quantitative factors that are commonly used by long-term debt financiers to evaluate borrowers. Advantages

Long term debt financing is usually less prone to short term shocks as it is secured by

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formally established contractual terms. Hence, they are relatively more stable than shortterm debt.

Long term debt financing is directly linked to the growth of the company's operating capacity (purchase of capital assets such as machinery).

Long-term debt financing options such as leases offer a certain degree of flexibility, compared to having to purchase the asset (E.g. machinery).

Disadvantages Long term debt is often costly to service (interest charges are higher). Long term debt financiers usually demand a great amount of information from the company to perform its credit evaluation. Long-term debt financing contracts normally contain a lot of restrictive clauses and covenants, including the scope of business operations that the company is allowed to engage in, capital and management structure limitations, etc. What are the risks? Considering the often large amounts of funds involved, long term debt financing is a relatively risky source of financing.

Breach of debt covenants may result in the company going into financial distress. For example, certain clauses state that if a certain covenant is breached, the entire loan amount has to be repaid in full immediately, or the mortgaged asset confiscated.

Secured creditors may take actions against the company if it is not able to meet payments. If the interest charge is based on a floating rate, interest rates may move adversely against the company, causing huge unplanned and un-hedged increases in interest expenses and cash outflows.

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