Unit 2

Financial Instruments: Debt & Equity

Table of contents

1.Financial Institutions & instruments

2.Debt or Equity?
3.Debt financing
4.Equity financing

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Financial Institutions

1
Lending “ Financial institutions
Institutions that makes loans ,,

2
Equity
“ Financial Institutions
Funds &
that buys ownership in businesses
,, Partners

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1. Lending Institutions

1. Commercial banks
2. Credit unions
3. Savings/loan associations
4. Micro-credit & cooperatives
5. Savings banks
6. Finance companies

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Lending Institutions: the commercial bank

 Commercial Bank is the more common examples of a

lending institution

 Commercial banks are banking institutions that are geared more

toward the lending of money to customers, rather than focusing
on generating or raising money.
 Such a bank accepts deposits to personal and corporate
accounts, and then uses the combined strength of the deposits to
finance loans for individuals and businesses.
 This is in contrast to an investment bank, which focuses on
generating revenue through investments

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The commercial bank

Deposits, Loans, Basic

Retail Investment Products for
individuals

Deposits and loans from

Commercial Bank Corporate corporations or large
businesses

Trading securities, sell

Investment side (bond, stocks, ...)
Banking and buy side (private
equity).

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Other Lending Institutions

 Credit unions
Owned and operated by their members, credit unions are not-for-
profit cooperative institutions that promote saving and provide
access to credit at reasonable rates (in Italy “Cooperative Bank”).
In USA, to join a credit union, you must be a member of an
approved segment of the population, such as: employees of a
specific company; members of a church, alumni association, or
other approved non-profit group
 Savings/loan associations
Type of financial institution that offers many of the same benefits of
a bank, but focuses primarily on using its deposits to provide
mortgages to its members
 Financial services company
a company which manages, invests, exchanges, or holds money
on behalf of clients. Many types of companies can be considered
financial services companies, including banks, insurance
companies, and asset management firms, among others

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2. Equity funds & partners

Equity fund & partners provide professional equity co-

invested with the entrepreneur to fund an early stage
(seed and start-up) or expansion venture

 Offsetting the high risk the investor expects a return on

the investment higher than average
 The equity investors take a percentage of ownership of
the company
 Equity investors share profits and losses of the company.
 Partners are first equity investors

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Equity funds & partners: continued

Models of Equity Financing Business stage Investors

People close to
Family, friends, fools entrepreneur
Idea

Crowdfunding Healthy People

Start up Businessman
Business Angels Retired Managers
Develop
Incubators, Accelerators Wealthy Family
Scale & growth Pension Funds
Venture & Impact Capital Private investors
Insurance Companies
Mature
Banks
Private Equity Large Companies
Consolidate

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From Fin. Institutions to Financial Instruments

Basing on the Fin. Institution, there are two main financial instruments

1
Debt
“ Borrowing money
a lender to pay back in the future
investing in your growth ,,

“ Taking capital from an outside investor

in exchange for an ownership stake Equity
2
in your business ,,

 Any entrepreneurs shall consider both debt and equity…

1. Business Model and Industry
2. Financial Need
3. Business stage

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Debt capital: definition & nature

 Debt capital is the capital that a business raises

 by taking out a loan from a lending institution

 The loan is normally repaid at some future precise date

 Interests payments is when you pay interest charges for the loan
 Capital repayments is when you repay the money you borrowed
 Interest on debt capital must be repaid in full before any dividends
are paid to any suppliers of equity (secured/privileged creditors)

PAY ATTENTION
Debt capital differs from equity or share capital because
subscribers to debt capital do not become part owners of the
business, but are merely creditors, and the suppliers of debt capital
usually receive a contractually fixed annual percentage return on their
loan

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Debt capital: the collateral

Collateral is a borrower’s pledge of specific property to a lender,

to secure repayment of a loan

 The borrower (entrepreneur) provides the lender with an asset:

a collateral

 The collateral serves as protection for a lender against a

borrower’s default (failing to pay). If a borrower does default on a
loan (due to insolvency or other event), the lender then becomes
the owner of the collateral

 Typical collateral: real estate (land or buildings), financial

instruments (ex bond), or even objects such as art, jewelry, or other
items

 The type and amount of collateral required for a given loan is often
a matter of negotiation between the lender and borrower
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Equity capital: definition & nature

Equity capital refers to the acquisition of ownership and

participation in a private (unlisted) company or startup /
buying and holding of shares of listed companies.

 At the start of a business, owners put some funding into the

business to finance operations
 The investors will get dividends and capital gains, as the value
of the stock rises
 Typically equity holders receive voting rights, meaning that they
can vote on candidates for the board of directors as well as other
specific rights

PAY ATTENTION
• Owners are the FIRST EQUITY INVESTORS
• Investors share FULL RISK with funders (profit and loss)

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Table of contents

1.Financial Institutions & instruments

2.Debt or Equity?
3.Debt financing
4.Equity financing

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15
Debt VS Equity financing

Debt financing tends to be cheaper than equity: interests

on debt are tax deductible AND lenders’ expected
returns are less than investors

DEBT EQUITY

 Influence on management None Voting rights

 Repayment Debt has maturity date No due date

No liability to
 Yearly Obligations Payment on interests pay dividends
 Tax benefits Interests are Dividends are not
tax deductible tax deductible

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Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio (D/E) is a financial ratio indicating

the relative proportion of shareholders’ equity and financial
debt used to finance company’s assets (fixed and working
capital)

TO
T
LIA AL
B IL
ITI
Financial Debt E S
D/E =
Shareholders’ Equity

 Closely related to leveraging, the ratio is also known as Risk,

Gearing or Leverage
 The two components are often taken from the firm’s reclassified
balance sheet

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Debt-to-Equity Ratio (D/E): continued

 In a general sense, the ratio is simply debt divided by equity.

However, what is classified as debt can differ depending on
the interpretation used

 Thus, the ratio can take on a number of forms including:

 Debt / Equity

 Long-term Debt / Equity

 Total Liabilities / Equity

 In finance, debt is usually considered as Net Financial

Position

“Debt vs. Equity Analysis: How to Advise Companies on Financing”

https://www.youtube.com/watch?v=MrupJdMrpaE
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Significance of D/E ratio

The company has

High D/E
an high debt exposure

The ownership has

Low D/E a lower managerial control
and decision power

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An example: African Cotton Ltd

African Fashion company based in Kampala (Uganda)

Cotton Ltd manufacturing trousers and t-shirts

1) Products:
 T-shirt
 Trousers
2) Geographic area:
1. East Africa
2. Europe EA EU

3) Type of Customers:
3. Direct operating store (DOS)
4. Retail
5. Online (E-commerce)
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African Cotton Ltd: Reclassified Balance Sheet

Reclassified Balance Sheet (FY 2015) African

Cotton Ltd

Values in USD Dollars 2015

Long Term Debt 190.000
Short Term Debt / Cash 110.000
NET FINANCIAL POSITION 300.000

Share Capital 600.000

Retained Earnings 80.000
Profit or Loss of the period 320.000
EQUITY 1.000.000

TOTAL FINANCING SOURCES   1.300.000

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African Cotton Ltd: D/E ratio

African
Cotton Ltd

What does it means?

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Table of contents

1.Financial Institutions & instruments

2.Debt or Equity?
3.Debt financing
4.Equity financing

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Debt financing: a summary

You can use debt capital from lending institution to finance both:

NET WORKING CAPITAL ASSETS

Short & Medium term Medium & long term

Bank overdraft Mortgage loans

Instalments Leasing

Ordinary credit lines Factoring

Export credit Securitization

SACCOs & table-crunching Bonds

… …

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Financing working capital with debt

Working capital financing is also called short-term debt

financing

 It usually applies to money needed for the day-to-day

operations of your business, such as purchasing inventory,
supplies, or paying the wages of employees
 Working capital financing can also be referred to as an
operating loan with repayment in less than one year
 Main instruments:
 Company savings
 Ordinary credit lines
 Bank Overdraft
 Instalments
 Micro-credit & table-banking
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Short-term financing: instruments

INSTRUMENTS

 Company savings: money that a company save every year from

the operations or other events
 Ordinary credit lines: s line of credit is a maximum amount of
funding that an individual or organization may borrow from a bank
 Bank Overdraft: make payments out of the current account and
exceed the available balance. They are either provided over a fixed
period of time or as a rolling facility with no end date
 Instalments: a payment made as part of a series of payments on
the same good, service, or obligation
 Micro-credit & table-banking: members hold monthly meeting,
where they put together money and savings. Each meeting they
distribute loans to be reimbursed with interests

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Focus: overdraft & table banking

Overdraft:
 An individual or organization may

withdrawal more money from an account

than is available. In return, the bank may
collect a fee.

See: CBA Bank in Kenya

https://www.cio.co.ke/featured/cba-to-offer-customers-loans-an
d-overdrafts-via-loop-platform/

Table-banking:
 Some individuals (eg. In the neighborhood)

put the money together, and provide them

circularly to someone that need to invest
them, and bring back with interests.
See: Table-banking in Kenya
https://www.theguardian.com/global-development/2014/nov/14
/table-banking-kenya-women-poverty

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Medium/Long-term debt financing

Debt capital can be used to finance investments in assets and

sustain the company growth.
To do so, there are medium & long-term financial
instruments.
INSTRUMENTS

 Mortgage loans
 Leasing
 Factoring
 Securitization
 Bonds
 Mezzanine (Junior Debt) – between Debt and Equity

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Focus: mortgages loans

Mortgages are loans, where the borrower is obliged to pay back

with a predetermined set of payments

 Mortgages are often used by individuals and businesses to make

large real estate purchases without paying the entire value of the
purchase up front
 In a mortgage loan transaction, the real estate/asset serves as
collateral. Should the buyer fail to pay the loan under the mortgage
loan agreement, the ownership of the real estate is transferred to the
bank
 With every regular monthly payment, the borrower is repaying some
of the loan and some interest
 Over a period of many years, the borrower owns the property

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Focus: leasing & factoring

Leasing

 Leasing is a process by which a firm can obtain the use of

a certain fixed assets for which it must pay a series of
contractual, periodic, tax deductible payments.
 A lease is a contract which defines the relationship
between an owner, the lessor, and a renter, the lessee

Factoring

 Factoring is a financial transaction in which a business

sells its accounts receivable (i.e. invoices) to a third party
(called a factor) at a discount.
 In “advance" factoring, the business owner sells his
receivables in the form of invoice to the factor, who makes an
advance of 70-85% of the purchase price of the receivable
amount
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Mezzanine capital

Mezzanine Debt is an hybrid of DEBT & EQUITY financing.

Typically used in expansion of existing companies. (Ref. Unit 5)

 Mezzanine debt capital refers o layer of financing between

company senior debt (loans) and equity
 Mezzanine carries a higher interest rate than the senior
debt that companies would obtain through their banks
(reflecting greater risk than senior debt), but is substantially
less expensive than equity in terms of overall cost of
capital
 Mezzanine typically comes in the form of 'subordinated debt'
or 'preferred equity' with a fixed-rate coupon or dividend,
and may have some participation rights in the common
equity of a business, but is materially less dilutive than
common equity
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Bank loan calculation

 Initial amount of loan

 Terms (months or years) & Interest rate (%)
 You need to pay by month or year:
 The interest +
 The principal
 Interests are calculated on the Loan Balance

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Table of contents

1.Financial Institutions & instruments

2.Debt or Equity?
3.Debt financing
4.Equity financing

33
Equity financing: overview
Unit 4 Unit 5
Profit

Further Stages

Expansion Growth
Third Stage
– improvement – growth quickly
Early of production – strength competition
Second Stage
Financing – improvement – restructuring business
distribution
Start-up – Products & Services–
First Stage new markets
Design &
Financing development – strengthen the position
– market outlets within the market
Validate Seed – start-up
– sales success – facilitating the Stock
Financing – products
Exchange listing
Grant market launch
– idea
– Design – prototype
– Validate – market analysis
– Prepare
Business SHORT TERM LOANS LONG TERM LOANS
Model
VENTURE
INCUBATOR IPO
PHILANTH VENTURE CAPITAL FINANCING VC & PRIVATE EQUITY
ROPY
& ACCEL. *

Loss * Initial Public Offer

Small Big

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 n d n o w …
A
sines s !
y our bu
ba ck t o
Let’s go

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