3.2.2 external sources of finance

Question 1

What are the ways in which a business can finance its operations?

Answer 1

A business can finance its operations in two ways

• Debt Financing
• Equity Financing

Question 2

What is debt financing?

Answer 2

Debt finance involves borrowing from sources outside the business such as banks, finance companies or government. These borrowings must be repaid-with interest. Examples include overdrafts, loans and mortgages.

Question 3

What is equity financing?

Answer 3

Equity finance involves using the owner’s fund from within the business or selling shares (equity) to new owners who are outside the business to help raise capital. Examples include retained profits and owners equity.

Question 4

Businesses usually use a combination of ……….. and ………. to finance their tactical and operational plans to achieve their financial and business objectives

Answer 4

Businesses usually use a combination of debt and equity to finance their tactical and operational plans to achieve their financial and business objectives

Question 5

What can short term borrowing include?

Answer 5

Short-term borrowing (overdraft, commercial bills)- funds repaid within one year

Question 6

What can long-term borrowing include?

Answer 6

Long term borrowing (mortgage, debentures, unsecured notes, leasing)- funds repaid over long periods, usually three to twenty years

Question 7

What are other sources of financing (excluding short term and long term)?

Answer 7

other sources of debt include- factoring, venture capital and grants.

Question 8

What are two forms of short-term borrowing?

Answer 8

A business will borrow short-term funds to finance temporary periods of lower cash inflows or higher cash inflows. The two main examples are overdrafts and commercial bills.

Question 9

What are overdrafts?

Answer 9

Overdrafts are an arrangement between the business and its bank that allows the business to overdraft its accounts by an agreed amount. Interest is charged on the number of funds that are overdrawn. The overdraft can be either secured or unsecured against the assets of the business. Although overdrafts are a short term loan, businesses may run overdrafts on a continuing basis. overdrafts provide flexibility and assist with the cash flows and liquidity of a business.

Question 10

What are commercial bills?

Answer 10

Commercial bills are non-bank bills of exchange that are issued by companies or merchant or investment banks. The bill itself is the indicator of the borrower’s debt and the commitment of the borrower to repay this short-term debt at the due date. The title commercial bills indicates that the bills are not issued by banks.

Question 11

Are commercial bills liquid?

Answer 11

Commercial bills are highly liquid and can be converted into cash easily by selling them at a discount (selling the bill for less than the amount written on the bill) to the banking system. They also guarantee payment.

Question 12

What is factoring?

Answer 12

Factoring is the selling of a company’s accounts receivable (money that is owed to the business) to a finance company for immediate cash.

Question 13

What does factoring provide a business with?

Answer 13

Factoring provides the business with quick access to cash from credit sales, assisting the working capital and liquidity of the business.

Question 14

What is a result of factoring?

Answer 14

A result of factoring the business does not have to wait for its usual accounts receivable turnover rate, which may be thirty or sixty days for payment of credit sales.

Question 15

What are long term borrowing funds mainly used for?

Answer 15

Long-term funds are mainly used to purchase assets. These arrangements include mortgages, debentures, unsecured notes and leasing.

Question 16

What are mortgages?

Answer 16

Mortgages are loans with a fixed schedule of payments and an asset provided as security.

Question 17

In a mortgage what types of assets are provided as security?

Answer 17

The assets provided as security include property for longer-term mortgages and equipment such as machinery for shorter-term mortgages

Question 18

Why is security necessary for a loan?

Answer 18

Security against the loan is necessary in case the borrower cannot meet their payments (defaults). If that happens, the bank can take the asset offered as security and sell it in an attempt to recover the loan value.

Question 19

What are debentures?

Answer 19

Debentures are fixed interest securities issued by a company that will pay a fixed interest rate on the money loaded to the company for a set time period. They are similar to a bank’s fixed-term deposits except they are issued by large businesses to raise capital.

Question 20

Why do investors purchase debentures?

Answer 20

Investors purchase debentures for a regular income from their interest. Returns on debentures are usually higher than other cash investment rates because of the longer term of the investment (between 12 months and 10 years)

Question 21

Where can debentures be traded?

Answer 21

Debentures can be traded on the secondary market

Question 22

What happens to debentures in the event of the business closing they are invested in?

Answer 22

Debenture holders are creditors of the business and, in the event of the business closing down, these creditors will be given preferred claim to recover their investment capital.

Question 23

What are unsecured notes?

Answer 23

Unsecured notes are loans made by finance companies, referred to as the issuer. The loan is not secured by any assets of the issuing business. The loans on unsecured notes tent to be for periods of three months to three years and are usually at a fixed interest rate. The interest that applies is usually higher than a debenture through unsecured notes lack the security of a debenture.

Question 24

What form financing is leasing?

Answer 24

Leasing is another form of external medium to long term fiancee that allows a business to use an asset in return for payments over a set time period.

Question 25

What are the two main types of leases?

Answer 25

A financial lease and an operational lease

Question 26

What is a financial lease?

Answer 26

A financial lease is for a set time and payments cover interest and the eventual purchase of the asset. It is similar to a loan.

Question 27

What is an operational lease?

Answer 27

An operational lease is similar to a financial lease except that the business does not gain ownership of the asset at the end of the lease. Many businesses that require motor vehicles and office equipment such as computer will lease them.

Question 28

What are some advantages of an operational lease?

Answer 28

The advantages of operational leases are that the cost is lower than the purchase of the equipment, these are tax concessions, the business does not have to maintain the leased assets and the equipment can continually be updated.

Question 29

What’s is a disadvantage of an operational lease?

Answer 29

The only disadvantage is that the business does not own the equipment at the end of the lease

Question 30

How are operational leases similar to rental agreements?

Answer 30

Operational leases are quite similar to rental agreements and usually contain provisions stating that the arrangement cannot be cancelled without a large penalty, the lessee is not expected to purchase the asset and the lessor is usually responsible for servicing and maintenance.

Question 31

What is equity?

Answer 31

The funsd invested into the business by the owner= owners of the business

Question 32

What does finance through equity involve?

Answer 32

Raising finance through equity involves fewer risks than debt financing but has the disadvantage of increasing the numbers of owners, thus diluting the original owners share of the business.

Question 33

How can equity be raised?

Answer 33

Equity can be raised through:

• Ordinary shares (New shares, rights issues, placements, share purchase plans)
• Private Equity

Question 34

What are ordinary shares?

Answer 34

Ordinary shares are the usual way than an investor can buy part ownership of a public company

Question 35

What is a person that owns ordinary shares entitled to?

Answer 35

A person or business that owns ordinary shares in a company is entitled to vote at general meetings of the company’s shareholders and may be entitled to receive dividends from the distributed profits of the company.

Question 36

What are new issues of ordinary shares?

Answer 36

New issues of ordinary shares are the usual way that a company would raise additional funds for expansion. New issues of shares are offered to existing shareholders and outside investors

Question 37

What does it mean for shares to be underwritten (guaranteed)?

Answer 37

The value of the new issues of shares is often underwritten (guaranteed) by merchant banks and stockbrokers. This means that the underwriters offer the shares to potential investors and guarantee to take up any shares that are leftover in the new issue.

Question 38

What are rights issues? (Shares)

Answer 38

Rights issues involve the offer of additional shares to the existing shareholders of a company.

Question 39

How is owner proportion maintained with Rights issues?

Answer 39

The number of shares offered is in proportion to the holdings of ordinary shares of each shareholder. In this way, if a shareholder takes up the rights issues the proportion of ownership in the company will be maintained. If new shares were issued directly to the stock market it would dilute the ownership of current shareholders.

Question 40

Are shareholder obligated to buy rights issues?

Answer 40

Shareholders are not obligated to take up rights when they are offered. If they do take them up they can trade these to buyers on secondary markets.

Question 41

What are placements?

Answer 41

A placement is the issuing of shares directly to an investor, usually an institution, rather than making a public offering which would then be underwritten by merchant banks and/ or stockbrokers.

Question 42

What do share placements allow a company?

Answer 42

Share placements allow a company to raise up to 15% of its existing capitalisation without seeking the approval of existing shareholders and without issuing a prospectus.

Question 43

What is a prospectus?

Answer 43

A prospectus is a document which sets out details of the investments offered and other terms and can be expensive.

Question 44

What is money raised from placements often used for?

Answer 44

Money raised from placements is often used to take over another business or to expand the existing company.

Question 45

Why has the Australian securities and investments commission (ASIC) agreed to rules that no prospectus is needed to be issued for placements?

Answer 45

The ASIC has agreed to rules that no prospectus needs to be issued because the investors in a placement are institutions which have the capacity to analyse the markets and information relevant to the placement and to make up their minds quickly.

Question 46

What do share purchase plans allow a business to do?

Answer 46

Share purchase plans allow companies to issue a maximum of $5000 in new shares to each existing shareholder without having to issue a prospectus

Question 47

What is the main benefit of share purchase plans?

Answer 47

The main benefit for the issuing company is that it gets to raise capital cheaply and quickly.

Question 48

What does private equity refer to?

Answer 48

Private equity refers to securities that are held in companies that are not listed and not publicly traded on the Australian Securities exchange

Question 49

What strategies can be used to raise private equity?

Answer 49

• Leveraged buyouts (LBO)
• Venture capital
• Growth Capital

Question 50

What is a leveraged buyout?

Answer 50

With an LBO a private equity company buys majority control of an existing business. The private company’s management undertakes to buy a business using borrowed funds. The business making the takeover might not have the necessary funds but is convinced that the acquisition of the target business is a good investment.

Question 51

What is venture capital?

Answer 51

Venture capital is financial support provided to risky business projects with potentially high returns. This source of funding may be arranged as a loan to be repaid but more often is a type of private equity funding where the venture capitalist becomes a shareholder of the business.

Question 52

What may venture capital be used to provide?

Answer 52

Ventrue capital may be used to provide:

• Start-up funds for a new business
• ‘Seed capital’ for a new but potentially viable innovation
• development capital for the expansion of a business

Question 53

What is growth capital?

Answer 53

Growth capital differs from venture capital because growth capital is usually sought by mature businesses that are looking to expand or transform their operations.

Question 54

What types of businesses seek growth capital?

Answer 54

The types of businesses that seek this source of equity funds are able to make profits but do not generate enough cash to fund expansions and other investments. The way the funding transaction takes place is that the company seeking the funds actually sells part of the business to private investors. Unlike lenders, these investors will have no rights to interest but as part-owners, they are entitled to a share of profits.