FIN 370 Week 3 Financial Markets and Institutions Example

Where a Growing Machine Shop Can Raise $6 Million: Comparing a Bank Term Loan, an SBA-Guaranteed Loan, a Private Placement of Notes and Outside Equity Through the Lens of Financial Markets

[Student Name]

University of Phoenix

FIN/370: Finance for Business

Week 3 Assignment

[Instructor Name]

[Date]

The machine shop, its lenders and all figures are composites written for a model paper; concepts and research findings come from the sources listed.

A composite machine shop in the Midwest turns out machined components for hydraulic pump and packaging machinery builders. Its two owners have grown sales to $22 million, but the building is full and a major customer wants to double orders. A second facility, with equipment, will cost $6 million. The owners have received four offers of money, each from a different corner of the financial system. Every financing offer is a price quoted by someone who has money for someone who needs it, and understanding who that someone is explains the price. This paper places the options in the financial system and compares them.

How Markets and Institutions Move Money

Financial markets bring together savers with surplus funds and borrowers who need them. Money markets trade short-term instruments, such as Treasury bills and commercial paper, maturing within a year; capital markets trade longer-term debt and equity. In primary markets, companies issue new securities and receive the proceeds; in secondary markets, investors trade existing securities, which gives them liquidity and helps set prices for new issues (Brigham & Houston, 2022).

Financial institutions stand between savers and borrowers. Commercial banks take deposits and make loans, evaluating borrowers and monitoring them. Investment banks help companies issue securities. Insurance companies and pension funds invest long-term money, often in bonds and private placements. Private equity funds pool investors' money to buy stakes in private companies. Each institution has different information about borrowers, different funding costs and different appetites for risk.

The Four Offers

First, the shop's bank of fifteen years offered a $6 million term loan at 7.9%, with a ten-year amortization, a covenant on debt to earnings and the owners' personal guarantees.

Why the Rates Differ

A quoted rate can be broken into components: the real risk-free rate, a premium for expected inflation, a default risk premium, a liquidity premium and a maturity premium. With ten-year Treasury yields near 4.3%, the government pays only for real return and inflation. The shop's bank adds about 3.6 points for default risk, the illiquidity of a private loan and its term. The SBA guarantee lowers the lender's default risk, which is why that loan is cheaper. The insurance company's notes are priced higher because they are interest only for five years, extending the lender's exposure, and because the placement is small and costly to arrange.

The Federal Reserve influences all of these rates through its target for short-term interest rates, as money and banking texts describe (Mishkin, 2022), which shapes banks' funding costs and expectations of future rates. When the Fed raised rates in 2022 and 2023, the shop's variable-rate line of credit rose with it.

Equity Has a Cost Too

The private equity offer carries no interest, but it gives up 35% of the company's future value and some control. If the shop's value grows as the owners expect, from about $17 million today to $30 million in five years, the fund's stake would be worth about $10.5 million, an implied annual return of more than 11% on its $6 million, higher than any of the debt options. Equity also brings a partner who expects an exit, usually a sale, within five to seven years.

Comparing the Options

The bank loan is familiar and moderately priced but requires personal guarantees and a covenant that would limit further borrowing. The SBA-guaranteed loan is the cheapest and allows a lower down payment, but it involves more paperwork and still requires guarantees. The private placement avoids amortization for five years, easing cash flow during the ramp-up, but costs more and is a less natural fit for a company this size. Equity avoids repayment risk but is the most expensive if the expansion succeeds and changes the owners' control.

Timing and Market Conditions

The timing of the financing also matters. With short-term rates elevated and the yield curve relatively flat, a fixed-rate loan locks in today's cost for ten years, which protects the shop if rates rise further but costs more if they fall. The SBA program allows a fixed rate on the real estate portion, which the owners prefer given their thin margin for error during the ramp-up. They also asked the bank about a rate lock between approval and closing, since construction will take eight months.

Recommendation

The owners should use the SBA-guaranteed loan for the building and major equipment, about $5 million, and fund the rest with a smaller term loan from the same bank or internally generated cash over the ramp-up year. This keeps the cost lowest and ownership intact. If the customer's orders are uncertain, the owners could negotiate a smaller equity investment later, when the new facility's results would support a higher valuation.

What the Lenders Will Want to See

Whichever option the owners choose, the lenders will ask for the same evidence: three years of reviewed or audited financial statements, a projection of cash flows for the new facility with and without the new customer orders, the customer's purchase commitments and the owners' personal financial statements for the guarantees. Preparing that package now shortens the approval process and signals that the owners understand how lenders price risk. The bank also asked the shop to move its deposit accounts to the bank, which is common in relationship lending and gives the bank a view of the shop's cash flows.

Why the Relationship Mattered

In the survey data Petersen and Rajan (1994) studied, longer relationships with a lender went with easier access to credit for small firms. The shop's fifteen-year relationship explains why its bank offered two competitive options quickly and why the owners' personal guarantees, while required, were negotiated to cap at half the loan amount.

Conclusion

Each funding option came from a different part of the financial system, and its price reflected that institution's information, costs and risk. For a company too small for public markets, a bank relationship and a government guarantee provide the cheapest capital, while private placements and private equity offer flexibility at a higher cost.

References

Brigham, E. F., & Houston, J. F. (2022). Fundamentals of financial management (16th ed.). Cengage.

Mishkin, F. S. (2022). The economics of money, banking, and financial markets (13th ed.). Pearson.

Petersen, M. A., & Rajan, R. G. (1994). The benefits of lending relationships: Evidence from small business data. The Journal of Finance, 49(1), 3-37. https://doi.org/10.1111/j.1540-6261.1994.tb04418.x