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Chapter Four: Financing a New Venture


Internal Financing ... Debt financing gives the company a leverage by allowing equity investment to ... External Financing. Negotiating ... – PowerPoint PPT presentation

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Title: Chapter Four: Financing a New Venture

Chapter FourFinancing a New Venture
Strategic Tax Planning
Internal Financing
  • Positive cash flow from operations
  • (or uninvesting selling off assets)
  • In excess of distributions (if any) to owners

External Financing
  • Debt Financing
  • Short term Borrowing
  • Long term Debt
  • Equity Financing
  • Common Stock (shares)
  • Other Ownership interests

Internal Financing
  • Not practical until after the early stage of
    financing when there is a steady stream of
    positive cash flow.
  • Two Major Advantages
  • Control over Cash Flow
  • Control over Management

Internal Financing
  • Value-Added is higher because neither enhanced
    cash flow nor the increase value of the firm are
    shared with anyone but the original owners.

Internal Financing
  • Affected by anticipated tax law changes.
  • If taxes are expected to increase, sufficient
    earnings must be retained to cover taxes not paid
    when transactions occur.
  • Affected by market conditions.

External Financing
  • Strategy
  • Managers search for optimal capital structure in
    the long run.
  • Enhance shareholder value.
  • Value-Adding
  • Debt financing gives the company a leverage by
    allowing equity investment to control more assets
    which adds value when increased cash flows from
    debt-financed expansion exceed the cash that is
    diverted to debt service.

External Financing
  • Value-Adding (cont)
  • Risk affecting financing choices
  • Operating Risk result from cycles in an economy
    which can affect the firms ability to pay
    interest and principle.
  • Financial Risk result from interest rate
  • Cost is lower on debt financing because interest
    payments are tax deductible.

External Financing
  • Adjusting Value-Adding for Risk
  • Debt has higher risk than equity because of
    required periodic payments.
  • Income tax can mitigate risk for investor and
    lowered risk can be passed on to the firm with
    lower interest rates.

External Financing
  • Negotiating
  • Businesses that suffer operating loss can get tax
    benefits by carrying losses back to offset
  • Losses are less important to new enterprise
    because no immediate benefit because company only
    has losses.
  • LLCs and S corporation can pass losses to equity

External Financing
  • Anticipation
  • Changes in interest rates can affect the cost of
  • If firm can anticipate rate reduction, it could
    issue stock prior to the tax decrease.
  • Three important aspects of timing
  • Anticipated situation
  • Tax status of party transacted
  • Decision of the relative expected tax status

External Financing
  • Anticipation
  • Effect of Clienteles
  • Tax-Free investors may prefer distributions such
    as dividends to delay cash flows.
  • If the firm knows the clientele will be tax
    exempt, it can issue debt or equity based on its
    own needs, disregarding investor tax status.

External Financing
  • Anticipation
  • In the United States, interest income must be
    recognized periodically through amortization of
    the original issue discount.
  • The firm can increase its present value of stock
    by paying out dividends for a certain length of

External Financing
  • Transactions Cost Effects on Value Adding
  • Firm should anticipate future capital needs in
    order to minimize issuances.
  • Transforming
  • Firms can enable themselves or their investors to
    transform ordinary income into capital gain by
    issuing stock or securities which are convertible
    to equity.