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FM > 4. FM - Sources of Finance > Flashcards

4. FM - Sources of Finance Flashcards

1
Q

What are the sources of finance for companies?

A 
Stock markets
Banks
Bond markets
Leasing 
Factors
Grants

But generally split into 3 main groups

  • Equity/ordinary shares
  • Preference shares
  • Debt (loan stock or debentures)
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2
Q

Describe equity/ordinary shares

A

Features include

  • Dividends are related to profits and will generally grow over time
  • Full voting rights, therefore control of the company
  • Paid last in winding up of the company, but are entitled to all profits remaining after debt and preference shares are repaid

These are therefore the true owners of the company
- They duffer the most risk and therefore equity attracts the highest return

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3
Q

Describe preference shares

A
  • Fixed percentage dividend (paid in priority to ordinary dividends)
  • Dividend usually cumulative
  • Limited right to vote at the general meeting
  • Repaid before equity in a winding up of the company
  • Not strictly equity and are often treated as debt by companies assessing their gearing levels, although unlike interest, the dividends are NOT tax deductible and NOT guaranteed and therefore higher risk
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4
Q

Describe debt (loan stock or debentures)

A
  • Interest (tax deductible), which must be paid irrespective of the level of profits.
  • If interest can’t be paid, the debt holders can force the company into bankruptcy
  • There are no voting rights
  • Repaid first in a winding up of the company
  • Debt holders suffer the least risk and therefore debt attracts the lowest return
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5
Q

Why are profits earned by a company a crucial source of finance?

A
  • Readily available
  • Has low cost
  • Immediate
  • No charge in control
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6
Q

What are the advantages and disadvantages of using profits as a source of finance

A

Advantages

  • Readily available
  • Has low cost
  • Immediate
  • No charge in control

Disadvanatges

  • Cash may not be readily available
  • May have an impact on the firms dividend policy
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7
Q

What is a rights issue?

A

The issue of new shares for cash to existing SH in proportion to their existing shareholdings

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8
Q

Why are rights issues often attractive?

A

As they are usually priced at a discount to the current market price
This therefore
- Increases the attractiveness of the offer
- Provides protection against a fall in the share price

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9
Q

What are the 2 options for a shareholder regarding a rights issue?

A

They can either
0 Take up the rights
0 Sell the rights

Theoretically they could let the rights lapse without selling them, but this would lead to a loss in value. In practice, the issuing company will sell the rights on the SH;s behalf so the SH doesn’t lose out (only on the admin fee)

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10
Q

What are the advantages of the rights issue?

A
  • Issue costs are lower than for a new issue
  • No change in control (unless SH don’t exercise their rights)
  • Prices is much easier than for a new issue - as no wealth is being shared with the new investors
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11
Q

What are the disadvantages of rights issues?

A
  • SH may be unable/unwilling to invest (especially a problem for unlisted companies whose shareholders will find difficulty in just selling the rights
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12
Q

What are new issue?

A

The issue of shares to new investors

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13
Q

What are the advantages of new issues?

A

The financing is generally to be found somewhere

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14
Q

What are the disadvantages of new issues?

A
  • Depending on the method used - can have very high issue costs
  • Will reduce the control of the existing shareholders (needs approval - i.e. waiving pre-emption rights)
  • Pricing is difficult. Too high a price and the issue will fail, too low a price and the existing SH will suffer.
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15
Q

What is a common type of new issue?

A

A public offer, where shares are advertised for sale e.g. in the FT to anyone who chooses to invest

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16
Q

What are the 2 main ways in which shares are issued?

A
  • Offer for sale

- Direct offer or offer for subscription

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17
Q

How does an offer for sale work as an issue of new shares?

A

Company A plc issues shares to an issuing house who then issues shares to the investing public

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18
Q

How does a direct or offer for subscription work as an issue of new shares?

A

Company A plc sells directly to the public

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19
Q

What is the difference between offer for sale work and a direct offer for subscription for new share issue?

A

Offer for sale = goes through an issuing house

Offer for sale = direct to the public

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20
Q

What is underwriting?

A

A service whereby, for a fixed fee, a financing institution (or several) agree to purchase any shares not sold by the company

Thus, underwriting provides insurance against the risk that the issue will fail

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21
Q

What are the 3 calculations that may be required for share issues

A
  • Theoretical ex-issue price
  • Theoretical value of a right
  • Impact on the wealth of SH
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22
Q

What is the theoretical ex-issue price?

A

The share price afeter a share issue (for a new issue)

Also known as theoretical ex-rights price if it is a rights issue

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23
Q

What is the difference between a theoretical ex-issue price and a theoretical ex-rights price?

A

Theoretical ex-issue price = share price after a share issue (for new issue)

Theoretical ex-rights price = share price after a share issue for a rights issue

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24
Q

How do you calculate the ex-issue or ex-rights price?

A

[(MV of shares already in issue) + (proceeds from new share issue) + (Project NPV)] / number of shares in issue after new/rights issue

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25
Q

What is the theoretical value of a right?

A

If an existing SH doesn’t want to take up his right to buy new shares, this right can be sold
This value is = Ex-rights price - the exercise price

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26
Q

How do you show the impact of wealth on SH after a rights issue/ new share issue?

A

Look at the wealth before and after the issue

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27
Q

What are the different sources of debt?

A
  • Term loans
  • Loan stocks (bonds or debentures)
  • Convertible loan stock
  • Loan stock with warrants
  • Loan documentation
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28
Q

What are term loans?

A

A term loan is a loan from a single lender (usually a bank) which has to be repaid with interest at fixed periods, including a fixed final repayment date

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29
Q

What are the advantages of term loans?

A
  • Arrangement fee is small compared with issue costs of loan stock
  • May have either fixed or floating rates of interest
  • Interest payments attract tax relief
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30
Q

What are the disadvantages of term loans?

A
  • They are generally secured on the company assets (either fixed or floating charge) and so may not be available if the company doesn’t have a strong balance sheet
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31
Q

What are loan stocks/ bonds or debentures?

A

Method of borrowing small amounts from many different lenders
Company issues a loan stock certificate for an amount of cash

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32
Q

Describe loan stock certificates

A
  • Nominal value of the loan - always £100 (although the bond may be issued at either a premium on or discounted below nominal value)
  • Coupon rate (the interest rate paid) is always given as a percentage of the £100 nominal value
  • Interest payment dates (generally 6 monthly)
  • For redeemable debentures - the redemption value and date
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33
Q

What are the advantages of loan stock?

A
  • May be unsecured
  • Loan stock certificate can be sold on by the original investor just like a share certificate. Interest (and redemption amount) is paid to whoever owns the certificate at the time. This provides flexible exit route for investor while still guaranteeing that the comp has funds for a fixed period. Many debentures are listed to facilitate the exist
  • Flexibility: debentures can be either irredeemable or redeemable. Issue prices and redemption values can be at either premium or discount
  • Debentures can be offered with either conversion rights or warrants (share options attached)
34
Q

What are the disadvantages of loan stock?

A
  • High issue costs

- Often have higher interest rates than a term loan (due to lower quality of assets provided as security)

35
Q

What is convertible loan stock?

A

Loan stock that may be converted, at several times during its life, into predetermined amounts of the company’s equity, at the discretion of the bond holder.
Conversion rate may be stated in terms of a conversion ratio or conversion price

36
Q

What can conversion rights be stated in terms of for a convertible loan stock?

A
  • Conversion ratio

- Conversion price

37
Q

What are the advantages of convertible loan stock?

A

Lower interest rates

Potential to avoid redemption cash flow problems

38
Q

What are loan stocks with warrants?

A

Entitle the holder to subscribe for ordinary shares in the company at a predetermined price at set future dates

Often used as a sweetener to encourage investment in debt issues

39
Q

What are loan stocks with warrants used for?

A

Often used as a sweetener to encourage investment in debt issues

40
Q

What is loan documentation?

A

Often to ensure that debt holders will have a low risk investment, they often ask for adequate loan documentation to be in place

41
Q

What does loan documentation often include?

A
  • Representations on the legality and affordability of the loan
  • Guarantees: such as a parent company guaranteeing the loan of a subsidiary
  • Covenants: such as restrictions on taking out further debt finance or key ratios to be maintained
42
Q

What kind of firms tend to use international money markets?

A

Larger firms

i.e. they borrow in foreign currency

43
Q

How do international money markets work?

A

Just as with sterling, the borrowing can take the form of term loans or a bond issue
Just in a different currency

44
Q

What are the advantages of an international money market?

A
  • Interest rates tend to be cheaper (spread between borrowing and lending narrows) because there is less regulation
  • Access to a wider market of investors
  • Where investment in a f reign country is required, borrowing in the same currency tends to protect against exchange rate movements
45
Q

What are the disadvantages of international money markets?

A
  • Unless you are borrowing substantial sums, issue costs can be high. So only large companies tend to use international markets
  • When the time comes for the loan to be repaid, exchange rates might have moved adversely.
46
Q

What does the terminology start with for any foreign currency borrowings?

A
  • Tends to begin with ‘euro’ regardless of what the currency is
47
Q

What is the name for a foreign currency loan?

What would a foreign currency loan in dollars be called?

A
  • Eurocurrency loan

E.g. dollar = eurodollar loan

48
Q

What is a bond issued in a foreign currency called?

A

Eurobond

49
Q

What is a Eurobond?

A

A bond issued in a foreign currency

50
Q

What is a Eurocurrency loan?

A

A foreign currency loan

51
Q

What is a eurodollar loan?

A

A loan in dollars (just always have euro on front for some reason)

52
Q

What is a Eurocredit?

A

A line of foreign currency credit from an international bank

53
Q

What is a Euronote?

A

A loan note (short term bond) in another currency

54
Q

What is a euro-equity issue?

A

Share issues issued in a foreign country

55
Q

What does EMH stand for?

A

Efficient market hypothesis

56
Q

What is Efficient Market hypothesis?

A

In an efficient market, new info is rapidly and rationally incorporated into share prices

57
Q

What are the benefits of having an efficient stock market? (EMH)

A
  • Ensure investor confidence

- Reflect performance and prospects in the share price

58
Q

What are the 3 forms of efficiency in EMH? What do they depend on?

A

Weak
Semi strong
Strong
Depend on where the new information comes from

59
Q

Where does info come from for weak form EMH?

A

Past share price movements
i.e. when a new event happens/ is made public, the share price doesn’t react instantly- can take time for new info to be reflected fairly

60
Q

Where does info come from for semi strong form EMH?

A

All public information
including past share price movements
i.e. share price incorporates all info that has been made public about a company

61
Q

Where does info come from for strong form EMH?

A 
All information (both public and private)
i.e. Share price at at all times incorporates all information that exists about a company
62
Q

What is the impact of strong form EMH on the share price?

A

The moment a new event takes place, the share price instantly moves to incorporate the impact of the event
Means it would be impossible to beat the market consistently, even with insider trading

63
Q

Is strong form EMH correct?

A

No, share prices don’t react instantly to all new events, especially those not made in public (it is often possible for people with inside info to use this to beat the market- ILLEGAL)
Stock Exchange encourages quick release of info to prevent insider trading opportunities

64
Q

How is insider trading prevented?

A

Stock Exchange encourages quick release of info to prevent insider trading opportunities

65
Q

What is the impact of semi strong EMH on the share prices?

A

The moment new events are made public, the share price instantly moves to incorporate the impact of the event

It would be possible to beat the market consistently by insider trading
But impossible to consistently beat the market simply by analysing new info about a company

66
Q

Is the market semi-strong EMH?

A

More or less, yes.
Commonly trade stocks tend to be fairly semi-strong efficient for most important new pieces of info
In practice, often takes 5-10 mins of new info being released (as long as the markets are open) to
- Rise in response to good news
- Fall in response to bad news

67
Q

What is the impact if the market is weak form efficient?

A
  • It would be possible to consistently beat the market by insider trading or by analysing new info if acting quickly
    But impossible to beat it consistently if you were charting past share prices only (chartism)
  • Share prices would follow a random walk with no pattern or trends
68
Q

What is chartism?

A

When you chart past share price movements

69
Q

Is the market weak form efficient?

A

Most people would say yes, market is at least weakly efficient
In practice, research shows that only 0.1% of a share price change in 1 day can be predicted from knowledge of the change on the previous day

70
Q

Summarise how efficient the market is

A
  • Shares are fairly priced
  • Managers can improve SH wealth by investing in +ve NPV projects and communicating this to the market
  • Most investors (incl prof fund managers) can’t consistently beat the market without inside info
71
Q

What are some of the key behavioural factors that cause an inefficiency in the market?

A
  • Oveconfidence and miscalculation of probability
  • Conservatism and cognitive dissonance
  • Availability bias and narrow framing
  • Representativeness and extrapolative expectation
72
Q

When would you use behvaioural finance in an exam?

A

To question the validity of the efficiency market model

73
Q

What is overconfidence and miscalculation of probability?

A
  • Inv overestimate their abilities of accuracy in their forecasts
  • Shown inv tend to overestimate the likelihood of unusual events and underestimate the likelihood of common ones
74
Q

What is conservatism and cognitive dissonance?

A
  • Inv tend to be naturally conservative and resistant to changing their minds
  • Often continue with a long held belief even in the face of significance significant evidence to the contrary
75
Q

What is availability bias and narrow framing?

A
  • Investors pay attention to one particular fact more than they should simply because it is prominent in their minds
  • Leads to over reliance on one factor or observation, rather than a broad view
76
Q

What is representativeness and extrapolative expectation?

A

Investors tend to assume that history will repeat itself.

Have tendency to buy shares if their price has risen and sell then after their prices have fallen

77
Q

What types of activity does the ICAEW code of ethics specifically cover relating to corporate finance?

A
  • General corporate finance advice
  • Advising in a merger or takeover
  • Underwriting or placing securities for a client
  • Acting as a sponsor or adviser under the Listing rules (AIM rules)
78
Q

What ethics questions might you be asked?

A

To discuss the ethical issues of a particular situation

79
Q

What are the fundamental ethical principles?

A
  • Integrity
  • Objectivity
  • Professional competence and due care
  • Confidentiality
  • Professional behaviour
80
Q

What are the threats to objectivity?

A 
Self interest
Self review
Advocacy
Familiarity
Intimidation
81
Q

When must you consider the threats to objectivity?

A

When deciding whether to take on an assignment and during the performance of the assignment

82
Q

Give some examples of specific issues related to the giving of corporate finance advice relating to ethics

A
  • Underwriting/ marketing shares (An acc shouldn’t underwrite/promote the issue of shares for a client if they are also the auditor - advocacy threat)
  • Statutory/legislative requirements (acc must be aware of and comply with requirement governaing corporate fin assignments e.g. City Code on Takeovers and Mergers

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