Chapter 14 - Understanding financial contracts. In this chapter you will learn to differentiate among the different mechanisms of external financing of firms, explain why mechanisms of external financing depend upon firm size, understand how financial contracts may reduce the adverse selection and moral hazard problems of asymmetric information. | Chapter 14 Understanding Financial Contracts Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Differentiate among the different mechanisms of external financing of firms • Explain why mechanisms of external financing depend upon firm size • Understand how financial contracts may reduce the adverse selection and moral hazard problems of asymmetric information Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-2 Introduction • Chapter focuses on financial contracts between lenders and borrowers • Non-traded financial contracts are tailor-made to fit the characteristics of the borrower • In business financing, the differences in contracting can be great, both in terms of how financial instruments are originated and in the characteristics of the terms of contract Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-3 1 Introduction (Cont.) • Asymmetric information—problems associated with the availability of information about the borrowers who seek funding • Apply this concept to analysis to contrast the differences between consumer and business financing Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-4 How Business Obtains Financing • Businesses need funds for a variety of reasons – Finance permanent assets such as plant and equipment – Finance the acquisition of another business – Finance working capital—inventory or accounts receivable Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-5 How Business Obtains Financing (Cont.) • Financing Small Businesses – Small firms—assets less than $10 million – Vast majority are privately owned with ownership concentrated in a single family – Generally do not need external financing beyond trade credit—delayed payment offered by suppliers – Profitable firms may have sufficient capital to be selffinancing – Banks are most likely source of external financing Copyright © 2009 Pearson Addison-Wesley. All rights .
