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Financing Capital Assets

Financing Capital Assets. Relationships between parties Risks and mitigations Sample credit transactions Financial markets & debt instruments. Dan Goldzband , CMA Financial Management BUSA 40439 UCSD Extension. Part 1: Relationships between parties.

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Financing Capital Assets

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  1. Financing Capital Assets Relationships between parties Risks and mitigations Sample credit transactions Financial markets & debt instruments Dan Goldzband, CMA Financial Management BUSA 40439 UCSD Extension

  2. Part 1:Relationships between parties Note: All primary parties are shaded throughout this presentation.

  3. Capital asset sale: cash flows between parties • Lender/source of funds: • Short-term (whse line) to finance inventory • Long-term financing of sale contracts Seller (manufacturer or dealer) Buyer (sale) Sale proceeds from finance company (not buyer) to seller Payments from buyer to finance company Cash flows indicated by solid arrows Capital asset transfer indicated by dashed arrow Captive finance company or independent leasing/finance company

  4. Relationships between parties:commercial real estate loan Capital sources (depositors) Lender (bank, finance company, etc) Borrowing entity Principle (general partner, etc.) Collateral Agreements/contracts indicated by solid arrows Security interest indicated by dashed arrows Contractors and service providers Tenants

  5. Part 2:Risks and mitigations

  6. Borrower risk and mitigation Lender (bank, finance company, etc) Borrowing entity Risk Mitigation Credit evaluation Credit reports Tax return copy from IRS Late payment Late fee Payment default Foreclosure Technical default Default interest rate

  7. Collateral risk and mitigation(pre-loan/underwriting phase) Lender (bank, finance company, etc) Collateral Risk Mitigation Title Title insurance Physical condition Inspection, reserve loan funds for repairs Environmental contamination Phase 1 review Adequacy of value Appraisal Violation of building code Certificate of occupancy Violation of zoning, land use Zoning confirmation Absence of utilities service Utilities’ confirmations of service

  8. Collateral risk and mitigation(post-funding) Lender (bank, finance company, etc) Collateral Risk Mitigation Insurance coverage Notification of coverage lapse by carrier Force-placed insurance Loss due to property tax default Annual check of property tax status Failure to pay insurance, taxes Additional advances from loan Loss from fire, accident, etc. Insurance proceeds payable to lender Secondary financing Balance due upon any further encumbrance

  9. Tenant risk and mitigation Lender (bank, finance company, etc) Collateral Tenants Risk Mitigation Vacancy upon foreclosure Subordination, non-disburbance and attornment agreements Adequate tenant improvement funds Reserve loan funds for this purpose New tenant’s effect on value Lender’s review of proposed new leases

  10. Contractor & service provider risk and mitigation Lender (bank, finance company, etc) Collateral Contractors and service providers Risk Mitigation Mechanics’ liens Lien releases from contractors, separate bond to offset any lien Service provider liability Proof of liability insurance Incomplete / inadequate work Holdback of portion of each progress payment by contractor/service provider until satisfactory completion Insurance carrier financially weak Minimum carrier standards (AB Best ratings, etc.)

  11. Separate loan guaranty: mitigation of previous risks Lender (bank, finance company, etc) Principle (general partner, etc.) Loan guaranty Guarantee invoked in event of failure or inadequacy of: Borrower’s ability to pay Collateral value (after foreclosure) Other means to repay loan. Risk Mitigation Inadequacy of previous remedies Loan guaranty by principle or independent party Note: effectiveness depends upon state law. CA law holds guarantees by related parties to be invalid.

  12. Interest rate risk Capital sources (depositors) Lender (bank, finance company, etc) Borrowing entity Interest on deposits or other capital sources at Y% Loan payments at X% Risk Mitigation Disintermediation (X% < Y%) Loan sale to fixed-income investor Short-to-medium loan term to minimize exposure

  13. Part 3:Sample credit transactions Transaction 1: Production and trade financing, followed by repayment and take-out financing

  14. Short-term financing: L/C trade credit Seller’s bank Letter of credit Buyer’s bank Short-term production loan L/C agreement Equipment Seller/mfgr Buyer • Buyer & Seller conclude a sale contract, but have no credit relationship between them. • Buyer and Seller each have a banking relationship with credit facility. • The two banks are correspondent banks, with a credit relationship between them • Buyer’s Bank issues letter of credit to Seller’s Bank. • Seller’s Bank makes production loan to Seller on basis of L/C (source of repayment). • Seller ships goods, consigned to Buyer’s Bank per L/C instructions. • Seller present’s shipping docs to Seller’s Bank, receives Banker’s Acceptance & 90-day draft. • Seller discounts draft to Seller’s Bank for proceeds. • Seller’s Bank presents draft to Buyer’s Bank for ultimate payment.

  15. Paying off short-term financing, replacing with medium-term loan Funds per L/C (disbursed 90 days later) Seller’s bank Buyer’s bank Buyer’s Bank receives security interest in equipment (lien on collateral). Equipment loan replaces L/C , finances equipment. L/C funds repay production loan. Seller/mfgr Buyer • Seller has been paid via discounted draft. • Seller’s Bank is repaid for production loan via L/C funds. • Buyer obtains equipment after signing equipment loan, which replaces L/C agreement. • Buyer’s Bank is repaid for funds disbursed under L/C by equipment loan principle payments. Equipment

  16. Part 3:Sample credit transactions Transaction 2: Commercial construction loan, followed by repayment and take-out financing

  17. Commercial construction loan: Construction phase Loan guaranty (separate from loan) Principle (general partner, etc.) Borrowing entity (property owner/developer) Lender (commercial bank) Service providers: Architect, engineers, etc. Collateral (land and improvements) General contractor Risk mitigations: • Lender receives security interest in collateral (dotted line). • All service providers (contractor, architect, etc.) contract with developer but assign their contracts to lender (dotted lines). • Separate loan guaranty from principle or independent party. • Lender disburses funds (progress payments) directly to contractor and subcontractor, in exchange for lien releases, less any holdbacks. Subcontractors

  18. Commercial construction loan: leasing / stabilization phase Borrowing entity (property owner/developer) Lender (commercial bank) Lease SNDA Risk mitigations: Tenants Loan guaranty continues (but is not shown). Lender reviews proposed leases and prospective tenant credit (to determine effect on collateral value). SNDA: Subordination, non-disturbance and attornment agreement (between tenant and lender). Provides for subordination of lease to lender’s security in collateral, and, in event of foreclosure, guarantees non-disturbance of tenant and preservation of lease by lender and attornment by tenant to lender (as new landlord).

  19. Commercial construction loan: takeout / permanent financing Borrowing entity (property owner/developer) Permanent lender (life insurance company, pension fund), pays off construction loan with “permanent mortgage” Lease (unchanged) SNDA (with new lender) Tenants Risk mitigations: Separate guarantee may or may not be required (varies by lender). Lender reviews proposed leases and prospective tenant credit (to determine effect on collateral value), in addition to all other underwriting of borrower and guarantor. SNDA: Subordination, non-disturbance and attornment agreement (between tenant and lender). Provides for subordination of lease to lender’s security in collateral, and, in event of foreclosure, guarantees non-disturbance of tenant and preservation of lease by lender and attornment by tenant to lender (as new landlord).

  20. Part 4:Financial markets and debt instruments

  21. Financial Markets & Debt Instruments Overview: Financial market structure and organization. Financial markets divided into two sectors: • Equity markets (trade & set prices for equity securities) • Debt markets (trade & set prices for debt securities) SubmarketSecurities traded Money markets Original duration <= 1 year Capital markets Original duration > 1 year

  22. Money markets • Used to trade short-term securities (<= 1 year) • Purpose of short-term financing: to meet transactional, production, seasonal or operating cycle needs. Types of financing include: Short-term loans A/R financing INV flooring lines Letters of credit Revolving credit lines • Examples of securities created and traded: Commercial paper Short-term negotiable CD’s Bankers’ acceptances

  23. Money markets • Sources of financing: Commercial banks Factors, commercial credit companies, asset-based lenders Money market funds

  24. Debt markets Organization: two ways to organize/divide: • By issuer: government & corporate • By term: medium-term (1-5 years) and long-term (>5 years) debt instruments

  25. Debt markets--issuers • Government debt : • Federal (US treasury securities & others backed by “full faith & credit of US goverment”) • State, municipality and other govt agency debt (incl. special districts and US debt not fully guaranteed) • Corporate debt: • Debentures (unsecured corporate bonds) • Secured corporate debt instruments (often issued by special purpose entities)

  26. Medium-term financing • Purpose: to meet project or medium-term asset financing needs. • Types of financing: Auto and truck loans Equipment purchases and leases Other medium-term consumer loans Construction loans Interim / mezzanine financing • Sources of financing: Commercial banks Captive finance companies Commercial finance companies • Securities created: generally 3-5 year asset-backed securities

  27. Long-term (permanent) financing • Purpose: to provide long-term (“permanent”) financing of major capital assets (including corporate acquisitions) and meet general financing needs of large public corporations and governments. • Types of financing: Home mortgages and equity lines Commercial real estate mortgages (incl. “take-out” loans) Major (non-real estate) fixed asset loans (large equipment, aircraft, etc.) Infrastructure construction financing

  28. Long-term financing • Sources of financing: Commercial banks (as brokers and arrangers) Mortgage companies Investment banks Life insurance companies Pension funds • Securities created: Long-term , fixed-rate instruments: Unsecured bonds Bonds secured by specific assets or pools of assets

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