Chapter Four: Financing a New Venture

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Chapter FourFinancing a New Venture
Strategic Tax Planning
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Internal Financing

• Positive cash flow from operations
• (or uninvesting selling off assets)
• In excess of distributions (if any) to owners

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External Financing

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

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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

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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.

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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.

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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.

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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
  fluctuations
• Cost is lower on debt financing because interest
  payments are tax deductible.

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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.

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External Financing

• Negotiating
• Businesses that suffer operating loss can get tax
  benefits by carrying losses back to offset
  profits.
• 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
  owners.

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External Financing

• Anticipation
• Changes in interest rates can affect the cost of
  capital
• 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

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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.

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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
  time.

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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.