Financing Investments

Welcome to this article on financing investments!

In the context of an investment project, the business unit must be certain that the possible credit application will be accepted by its bank. This must be done before the study of economic profitability.

The company must also carry out a financing study to determine the least expensive means of financing for it.

In any case, the business unit must distinguish the internal source of financing from the external means of financing.

Here is what you will learn in this course on how to finance an investment in the Operational Management subject of the BTS MCO Operational Commercial Management:

• Self-financing as a means of financing
• Contributions to the current account of partners
• The capital increase
• Leasing
• The bank loan
• Investment financing and NTFs
• The profitability of an investment
• Conclusion

 

Internal financing

Self-financing

Self-financing, which is a method of internal financing, corresponds to the use of funds available in the business unit's treasury.

This means of financing is funded by the profits made by the company which are redistributed in the form of dividends and also to supplement the CAF.

Self-financing does not cost the company anything but is by default limited to the amount held in its Bank account.

The amount of dividends paid to shareholders has a direct impact on self-financing.

The higher the dividend amount, the lower the company's self-financing capacity. Of course, the reverse is also true.

The amount of dividends is voted on at the ordinary general meeting (OGM).

 

Contributions to the current account of partners

Within the business unit, partners can participate in internal financing in the form of cash advances called current account contributions.

The company and the partners negotiate the terms of this advance of funds, in particular the repayment period and the interest rate...

This means of internal financing is rather used by small companies which do not have enough weight to negotiate with banks.

 

External financing

The capital increase

This means of financing is the issue of securities on the market so that companies and/or individuals can acquire them. Thus, they become shareholders and obtain rights (voting rights, dividend rights, etc.).

The funds thus obtained increase the “Capital” item of the liabilities of the balance sheet of the issuing company.

There are other types of capital increase such as:

• Incorporation of reserves
• Contribution in kind
• Converting bonds into capital
• Merge with another company
• Cash contribution

 

Leasing

Leasing is a fixed-term rental contract for an asset, with the option of becoming the owner at the end of the contract. During the term of the contract, the company pays rent (deductible expenses) and does not own the asset.

The main advantage of this means of financing is that leasing does not change the major financial balances. There is therefore no impact on cash flow.

The user company does not own the property and it therefore does not appear in the balance sheet of the business unit.

The rents paid by the company are deductible expenses which:

• reduce the result of the exercise
• reduce the amount of tax
• reduce the amount of CAF

When signing the contract, the company must pay a security depositDuring the term of the contract, the amount of rent may vary: remain constant or be decreasing.

At the end of the contract, the security deposit is returned to the company. On that same date, the company has the choice between the following different options:

1. she can decide to renew the contract
2. she may decide to return the property to the leasing company and not renew the contract
3. she can decide to acquire the property after deduction of the rents already paid.

This method of financing is advantageous because in the event of equipment failure, maintenance is carried out by the leasing company.

The bank loan

Here is another external means of financing that companies use very regularly: bank loans.

When the company purchases an asset using this method of financing, it becomes owner of said property. Consequently, it appears in its balance sheet and is depreciated like any other immobilization owned by the business unit.

Here are the different impacts of a bank loan:

1. the amount of the loan appears in the liabilities of the balance sheet in account 164 – Loans from credit institutions
2. to interest charges (i.e. interest) reduces the amount of the accounting result
3. interest reduces the amount of tax
4. depreciation which are calculated charges reduce the amount of the company's financial year result
5. depreciation has no impact on CAF
6. Interest charges appear in the Financial expenses du operating account of the business unit

For this means of financing, financial institutions check the financial statements of the business unit and also study the debt capacity of the company.

 

What are the characteristics of a bank loan?

The amount of the loan

Le price amount granted by the bank is generally limited to 80% of the cost of the investment.

Bank loan generates the return of capital (i.e. the amount borrowed) but also the payment of interest charges.

 

The amount of interest

The interests are calculated based on the Repayment period of the loan and of the interest rate. This can be fixed or variable.

 

The amortization table

All the figures are summarized in a loan amortization table.

It includes the periods, the amount of capital remaining to be repaid, the annuity and of course the amount of interest.

Here is an example of loan amortization table :

 

The proportional rate

Sometimes the loan is repaid quarterly or monthly. In this type of case, it is necessary to calculate a proportional rate at the annual rate.

To do this, you must therefore know by heart the different periods of the calendar year:

• one year is 12 months
• a quarter corresponds to 3 months
• one semester corresponds to 6 months
• there are 2 semesters in the year
• there are 4 quarters in the year
• 12 months ago in a year

The classic annual interest rate is therefore modified by taking into account the number of periods.

Here is an example of a proportional rate calculation.

For an annual rate of 4%, a loan of 5 years, with quarterly repayment, we will have:

Annual rate = 4%
Number of periods = 5 years x 4 quarters or 20 periods
Proportional rate = 4% / 4 quarters or 1%

 

Methods of repaying a loan (3 examples)

Repayment by constant amortization

Loan: €10
Duration: 5 years
Annual rate: 6%
Repayment: constant depreciation

 

I give you all the explanations of the table:

(1): this is the amount remaining to be repaid at the start of the period. It is decreasing because it is reduced each period due to the repayment of the capital.

(2): This is the interest that is calculated on the basis of the remaining capital. It is regressive because the amount of the remaining capital is also decreasing. To find the amount, we multiply the amount remaining due by the interest rate.

(3): In this example, we are talking about repayment by constant amortization, so the amount borrowed is simply divided by the number of periods. €10 / 000 years = €5 per year.

(4): The annuity is the sum of the interest amount and the amount of capital repaid. For period N, we have 600 + 2 or €000.

(5): This is the capital remaining due after repaying the capital portion. For N we therefore have 10 – 000 = €2. This amount is carried over to the next line in the column “Capital remaining due at start of period”.

 

Repayment by constant annuities

Loan: €10
Duration: 5 years
Annual rate: 6%
Repayment: constant annuities

First, you must calculate the amount of the constant annuity by applying the following formula:

 

Loan amount: Amount borrowed from the credit institution

Interest rate: Based on banking conditions

The element "n" corresponds to the number of periods.

Applying the formula to our example we obtain:

 

 

And therefore: a = €2

Once you have found the amount of the constant annuity, you can establish the loan amortization table as follows:

 

I give you all the explanations of the table:

The amount of the constant annuity must be copied over the entire repayment period in the “Annuity” column.

Column (2): this is the amount remaining to be repaid at the beginning of the period. It is decreasing because it is reduced each period due to the repayment of the capital.

Column (3): This is the interest that is calculated on the basis of the remaining capital. It is regressive because the amount of the remaining capital is also regressive. To find the amount, we multiply the amount remaining due by the interest rate.

Column (4): The repayment amount is the difference between the constant annuity and the interest amount.

Column (5): This is the capital remaining due after repaying the capital portion. For N we therefore have 10 – 000 = €1. This amount is carried over to the next line in the column “Capital remaining due at the start of the period”.

 

Reimbursement ultimately

This method of financing is very special since it allows the entire amount borrowed to be repaid in one go at the end of the period.

Interest remains due from the start of the first period.

Here is a numerical example for this type of loan.

Loan: €10
Duration: 5 years
Annual rate: 6%
Refund: refund ultimately

 

I give you all the explanations of the table:

(1): the amount of capital remaining due does not change because there is no repayment of capital.

(2): This is the interest that is calculated on the basis of the outstanding capital. Since the latter does not change, the amount of interest does not change either. 10 x 000 = €0,06 for each period.

(3): The repayment amount is zero. This is precisely the principle of this loan: no repayment during the loan period. The only repayment is at the end of the period.

(4): The annuity is equal to the sum of the interest and the amortization (i.e. the repayment). 600 + 0 = €600.

(4): This is the capital remaining due after repaying the capital portion. For each period, the amount is equal to the amount borrowed except for the last period.

 

Investment Financing and NTFs

The principle is to integrate the type of financing into the net cash flow (NCF) table.

You must therefore add, depending on the case:

• rent in case of financing by leasing
• the amount of interest in the case of loan financing

Here is an example of a CAF table after financing.

Element	Year 1	Year 2	Year 3	Year 4	Year 5
Turnover excluding tax
- Operating costs
- Rent
- Depreciation
= Operating result
- Interest charges
= Profit before tax
- Tax
= Result after tax
+ Depreciation
= Operating CAF

 

As for the FNT table, you have to include the loan repayments in the uses. In addition, you must also add the amount borrowed in the resources in period 0 (zero).

Here is an example of a FNT table taking into account investment financing.

Element	Year 0	Year 1	Year 2	Year 3	Year 4
JOBS
Investments
+ Variation of BFR
Repayment of the loan
= Total Jobs
FREE
Loan
Operating CAF
Residual value
+ Recovery of BFR
= Total Resources
Net Cash Flow (NCF)

 

The profitability of an investment

The economic profitability of an investment

Here is a definition of the economic profitability of the site Central Charts :

La profitability Economic is an indicator to measure the performance of a company in creating value. To do this, it compares the after-tax income from the operation of the company (operating result) to the means implemented to generate its income (equity + debt). Economic profitability does not take into account the financial structure of the company, i.e. where its financing comes from (equity or debt).

Here is the formula for economic profitability:

Economic profitability = Economic result / Capital invested

 

 

Le economic result concerns a result generated by the company such as operating profit for example.

The notion of invested capital corresponds for example to the net fixed assets which made it possible to generate this economic result. It can also be financial debts.

 

The financial profitability of an investment

Financial profitability measures the company's ability to make the financial resources provided by its partners profitable.

The formula for financial profitability is as follows:

Financial profitability = Net accounting result / Equity

 

Conclusion

As you can see, there are many means of financing, both internal and external, each with their advantages and disadvantages.

The business unit will have to find the right balance between, on the one hand, the least expensive type of financing, and on the other hand, with significant economic and financial profitability.

If you want to apply what you have just read, I strongly invite you to consult my article on corrected management exercises entitled Loan table – Annuity – Quarterly: 13 Corrected exercises.

There you have it, now you know how to choose a financing method. You no longer have any excuses for not reaching your goal: Get an excellent grade in the Operational Management test!