363LecNote-Part1

363LecNote-Part1 - 1 Introductory Concepts Equity Financing...

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1 Introductory Concepts Equity Financing vs Debt Financing Financial Markets Financial Instruments Interest Rates 1.1 Equity Financing vs Debt Financing Setup Your are planning to shoot a f lm and sell it both domestically and internationally. You need to raise $5 million to shoot the f lm. Although you have a good script and talent in f lm-making, you have no money to invest in this project. You have two choices. Borrow money. Debt f nancing (taking bank loans, issuing bonds). Ask somebody to invest in the project. Equity f nancing (issuing stocks/shares). Suppose you form the f lm-shooting project legally as a corporation . Important Debt is senior to Equity. That is, debts have to be repaid before (especially in liquidation of the corporation). Failure to make promised payments to debt hold- ers may trigger bankruptcy . Equity holders are “ residuals claimants ”andshare the ownership of the corporation. Example The f lm-making project requires $5 million in- vestment, all of which are used as expenses (in- cluding the compensation for the f lm director). You f nd a bank which lends $2 million to the cor- poration. Ignore interest rate and other borrowing costs for now. f nd an wealthy woman (a venture capitalist) who invests the remaining $3 million in your f lm making project. Ignore taxes, depreciation, etc.
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Question Who owns the project? The wealthy woman (shareholder) owns the cor- poration. She delegates you to run the project. Separation of Ownership and Control. Case A The f lm is successful. It makes $10 MM in rev- enue. Film distribution cost is $1 MM. All in cash. Pro f t-Loss (ignoring depreciation, taxes, etc.) Revenue $10 MM Expenses Production $5 MM Distribution $1 MM Pro f ts $4 MM Balance Sheet Cash $9 MM Bank Debt $2 MM Equity $7 MM The corporation repays $2 MM to the bank. The value of the project becomes 7 MM. The wealthy woman will be pleased to know that her $3 MM investment increases to $7 MM. Case B Suppose that the f lm is miserable. It makes only $2 MM in revenue ($8 MM less than the f rst example). Pro f t-Loss (ignoring depreciation, taxes, etc.) Revenue $2 MM Expenses Production $5 MM Distribution $1 MM Pro f ts $4 MM
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B/S Cash $1 MM Bank Debt $2 MM Equity $1 MM The project cannot make promised payments to the bank. The bank takes all $1 MM, be- cause the bank is senior to the shareholder. The owner (wealthy woman) receives zero, be- cause shareholders are residual claimants .How - ever, she has no other obligation to the bank, because shareholders have limited liability . The manager is an agent chosen by the owner (shareholder). The manager’s job is to make the owner wealthier. However, the owner (and also the lender) should beware of the agency problem .
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This note was uploaded on 11/05/2011 for the course FINA 363 taught by Professor Masoudie during the Spring '10 term at South Carolina.

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363LecNote-Part1 - 1 Introductory Concepts Equity Financing...

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