Topic 5.

Sources and Methods of Investment Financing

5.1. Characteristics and classification of investment financing sources 5.2. Internal sources of investment financing 5.3. External sources for investment financing. 5.4. Methods of investment financing

Key words:

Equity Debt Own sources Self financing Inside / Outside Capital to Finance Direct / Indirect Financing

Introduction
The investment decision is a key point for a manager. One side of the coin is where to invest money. And the second one is how to finance project(s). Both, investment and financing sources are important in a decisionmaking process.

Financing investment is a significant step in the investment process

Financing investment is following the investment decision, materialized through the establishment of: financing sources, the proportion of funding from own sources and loans, the combination of sources that minimizes the total cost of funding and maximizes shareholders wealth.

Financing decisions
A finance manager must identify when, where and how the funds can be acquired to the firms investment needs. In sourcing of finance, he should keep in view the cost of respective sources of funds, the advantages and disadvantages of various sources of finance, impact of taxation etc.

Subjects of financing decision

The decision of financing depends on the enterprise because its goal is to obtain the capital and the efficient utilization of the funds. But at the same time the financing decision is influenced by banks, shareholders (their willingness to give up dividends to finance projects in the enterprise) etc.

The main factors in taking the decision of financing are:

profitability, if it is higher than the interest rate, then it is opportunely to call the loans, in this case will increase profits and return on equity; solvency, the decision by financial indebtedness has a positive influence on the solvency, but in case of loss it diminishes quickly; liquidity, financing through indebtedness has positive effect on liquidity, but it have to take into consideration the fact that the borrowed resources are offered on a limited time period.

Classification of main sources of financing investments

1. From the point of view of effort to obtain them, sources of funding can be grouped into two categories: financing through firms own sources (self financing by net income, depreciation, transfer of assets etc.). financing by long-term arrangements (bank loans, leasing, loans from specialized financial institutions, growth of capital by incorporating reserves to capital through debt conversion).

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2. From the point of view of their structure (or funds belonging) exist: Internal / inside financing External / outside financing 3. From the point of view of their origin, there are:

public sources, private sources, foreign sources.


4. On territorial approach are distinguished: Domestic financing Abroad capital. 5. Depending on time committed, there is: Short term financing Medium / long term financing

Individual task

Study the structure of investment according to financing sources in the Republic of Moldova in the last three years (www.statistica.md)

5.2. Internal sources of investment financing

Internal funding is based on resources generated in the economy of the economic agent. Internal financing can be done through several sources: investors and his partners savings; depreciation of fixed assets; reserves formed after distribution of profits, money from assets assigning , retained earnings etc.

The most obvious sources of cash for own financing are:

Personal savings, securities, real estate, inheritances, mortgage extensions (on a personal residence), and other personal assets. Friends and relatives may provide additional sources of funds. Personal investment in the business by you, your family, and your friends demonstrates a faith in, and a commitment to, your business. This is important to other potential investors and lenders.

In most cases, the small business owner must assume the largest share of the risk- this means making the largest investment in the business. In fact, banks and other lending institutions have established guidelines for the amount of investment that is required before they will lend money to a business. This is sometimes called the debt-to-equity ratio, and it varies depending on the type and nature of your business.

As internal sources also can be

included:
Accumulated depreciation of fixed assets during the period the realization of investments. Depreciation serves as a way of gradual recovery in the value of fixed assets input, by providing resources necessary funding replacement of fixed assets used, as well as upgrading their. Assets assigning is a occasional source of internal financing that occurs especially when enterprise renews their fixed assets by selling the old.. The revenues of sale machines removed from service feeding development fund from which investment are financed. The feed value of the transfer of assets is subject to taxation

Reserves which are formed from profit which remains to the company, this means the net profit left after the payment of dividends to shareholders. There are more types: reserves stipulated by the legislation, reserves provided by statute, other reserves. Net profit which follows to be reinvested (retained earnings). For investment is usually distributed only a part of net profit as it can be distributed for other destinations: shareholders dividends, bonuses for employees, etc. Other sources

Financing only from internal sources has some advantages and disadvantages.

Advantages are: represents a sure way of covering the financial needs of the enterprise, maintain financial independence and autonomy because dont create additional obligations (interests, warranties), gives a greater degree of independence and control over the actions of the enterprise because the company does not require someone to be justified, funds invested do not need to be reimbursed.

Disadvantages are:

the limited financial resources, lack of possibilities for extending the investment activity in a favorable conjuncture of investment market, the restriction of entrepreneurs ability to develop business, the possibility of losing some opportunities for investment due to insufficient financial resources at the right time, the entrepreneur will have to accept an increased level of personal risk

5.3. External sources for investment financing.

External financing is an alternative for investors when capacity of self financing is below the investment programs. The two main ways of financing a business, equity financing and debt financing, will be discussed.

Equity financing

Equity capital is the amount of money that you and/or your partners put into the business or raise from other investors. Equity is not debt. While investors share in the profits (or losses) of the business, their investment is not a loan. Remember that to attract investors (shareholders) or partners, you must be able to demonstrate both the profitability and the reasonable risk of your business venture.

Sources of Equity Financing are:

1. shareholder capital subscription, Subscribing shareholder equity is a form through which small savings of individuals and legal entities are transformed into investments. Issuing shares becomes one of the most important leverage of external funding and can be achieved either through the issue of new shares (simple or preferred). You must be able to demonstrate the viability and profitability of your business venture to attract potential shareholders.

As a Sources of Equity Financing serves:

2. capital increases is a way of financing through own equity, with the objective of developing economic activity and increase of profitability. When a firm takes such a decision it must first decide whether to try to raise the capital from the firms existing stockholders or whether to seek new investors. Private companies usually raise additional equity capital by increasing the nominal value of the existent stocks or selling new shares to existing common stockholders. This generally satisfies these stockholders because they continue to exercise complete control over the firm. Nevertheless, when your business becomes sufficiently large and prosperous, a public share offering can be an attractive method of obtaining financing.

Raising the capital of an enterprise

may be the result of several types of financial transactions and namely: capital increase in cash, capital increase as a result of merger and acquisition transactions, capital increase through debt conversion, capital increase by incorporation of reserves.

Venture capital (VC)

is financial capital provided to early-stage, high-potential, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc. The typical venture capital investment occurs after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event, such as an IPO or trade sale of the company. In addition to angel investing and other seed funding options, venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value). Venture capital is also associated with job creation (accounting for 21% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography. Every year there are nearly 2 million business created in the USA, and only 600-800 get venture capital funding. According to the National Venture Capital Association 11% of private sector jobs come from venture backed companies and venture backed revenue accounts for 21% of US GDP.

Equity partners and investors

An angel investor or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund.Although typically reflecting the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc

Debt Financing

With your equity capital in place, you are now in a position to approach lenders for a business loan. Debt capital is the money your business borrows. It must be fully repaid with interest, over a specific time period. While lenders do not share in business profits as investors do, they must be repaid with interest whether the business is showing a profit or not.

Potential lenders include the following:

Banks and Trust Companies Credit Unions Commercial Finance Companies International Financial Institutions Public sector bodies Private Investors etc.

Ways of lending for medium or long term

Among these the most used are: -call on public savings - debenture loans, -call on specialized financial institutions -bank loans, leasing,

The benefits of a business term loan are the following:

The loan agreement is based on the borrower's ability to repay the loan out of earnings As long as the borrower meets the terms of the loan agreement, no payments other than the regular installments will be required before the due date of the loan A long-term working relationship is established between lender and borrower

Debenture loans

Recourse to public savings is an alternative to attract financial resources necessary to assure economic growth and observance of obligations assumed payment. Access to debenture loans can be supported by strong companies individually or grouped through association of several economic agents with the condition that each one of them guarantees the loans or through several institutions or collective investment using attracted sources in the form of loans to enterprises with financing needs. The essential advantage of debenture loans is that remuneration it is deducted from taxable profit, making it more accessible. Debenture loans grouped are recommended when large enterprises have reduced financing needs and do not want to consume their capital from the public trust.

The benefits of a business term loan are the following:

The loan agreement is based on the borrower's ability to repay the loan out of earnings As long as the borrower meets the terms of the loan agreement, no payments other than the regular installments will be required before the due date of the loan A long-term working relationship is established between lender and borrower

Sources from International Financial Institutions

The most significant sources of financing investment projects in Moldova are the external loans and grants granted by international financial institutions (IFI). Among the IFI, the biggest lenders that have been investing in Moldova are: the World Bank (WB), the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB), the International Fund for Agricultural Development (IFAD), the Council of Europe Development Bank (CEB) and he German Bank Kreditanstalt fur Wiederaufbau (KfW).

Methods of investment financing

Depending on used mechanisms are: Self financing Financing trough the mechanisms of capital market Financing trough the mechanisms of credit market Mixed Financing Other methods

Depending on the access to sources are:

Direct financing methods Indirect financing methods

How the decision of self financing can be influenced?

The weight of this resource depends on company policy to distribute dividends and on what share of earnings to be invested. Managers option for self financing is influenced by: various legal restrictions and financial market restrictions and taxation.

..

Thus, relative to the legal constraints are countries where the legislative framework require enterprises a minimum self financing and banks providing credit to only those companies that have own equity in a certain amount. Opportunities for access to funds from the financial market are limited for unlisted companies in stock market which are forced to call to self financing or to some sources attracted. Regarding taxation observes that a big taxation increase the self financing because capitalization of profit reduces taxes owed to the state while fiscal policies that increase the deductible base with expenditures of depreciation, reimbursement of credits or interest payment will diminish the interest for self financing.