B. Sources of long-term funds Flashcards
what are some sources of external finance?
- the capital markets: new share issues, rights issues or bonds
- bank borrowings
- venture capital funds: high risk
- government and similar sources
what is the main issue with venture capital funds?
providers tend to demand significant equity participation in a company and will also want to influence the policy of the company
what is the criteria for selecting sources of finance?
- cost of the different sources of finance
- duration: how long is finance required?
- lending restrictions
- gearing level
- liquidity implications
- the currency of the cash flows associated with the new project
- impact of different financing options on the financial statements, tax position and financial stakeholders of the entity
- availability of finance
what are the liquidity implications of financing?
ability of the business to service the new debt, allocating sufficient cash resources to meet interest and capital repayment obligations
why is debt finance cheaper than equity?
cost of interest is allowable expense for tax purposes, so cost of debt is interest cost less the tax relief on the interest
lower risk taken with debt finance
how does the duration of debt finance compare to equity finance?
debt: fixed term, can be short or long
equity capital:long term ‘permanent’ capital
how should a company decide the duration of financing?
matching concept
long term assets financed by long term funds
short term assets such as inventories and receivables should be financed by a mixture of short-term and long-term funds
what is a debt covenant?
clauses written into existing debt agreements which protect the lender’s interest by requiring the borrower to satisfy certain criteria
what is debt finance?
loan of funds to a business without conferring ownership rights
what are the key features of debt finance?
- interest is paid out of pre-tax profits as an expense of the business
- paying interest reduces the taxable profits of the business and hence the tax payable
- debt finance carries a risk of default if interest and principal payments are not met
- to reduce the risk to the lender, security and/or covenants are used
how does currency affect debt financing?
cash flows of new project should be denominated in a foreign currency, the entity may decide to raise finance denominated in the same foreign currency, to reduce the risk of exchange rate movements by matching the receipts from the project with the servicing costs of the finance
how do different financing options affect the financial statements?
investors use ratio analysis which they calculate from financial statement e.g. ROE or gearing and interest cover
how do different financing options affect the tax position?
debt finance gives rise to interest payments which are tax deductible, so impacting the tax position of the business
how do different financing options affect the financial stakeholders?
closely monitor the business’ performance
management must clearly explain the rationale for any new financing method which impacts the financial statements or the tax position
what is a share?
a fixed identifiable unit of capital in an entity which normally has a fixed nominal value, which may be quite different from its market value
shareholders receive returns in the form of dividends and also capital growth in the share price
what are ordinary shares?
dividend paid at directors’ discretion
owners of the company, attend meetings and have voting rights
paid last to other finance providers on winding up
what are preference shares?
pays fixed dividend
get paid before ordinary but after other debtors
why are preference shares considered to behave in the same way as debt finance?
paid fixed portion annually, similar to interest paid
how are preference shares different to debt finance?
dividends are paid out of post-tax profits unlike debt finance where interest is paid out of pre-tax profits
preference share dividends can be skipped but debt finance interest can’t be
what are the 4 types of preference shares?
cumulative preference shares
non-cumulative preference shares
participating preference shares
convertible preference shares
what are cumulative and non cumulative shares?
cumulative:must be paid including skipped shared
non-cumulative:skipped dividends do not have to be paid
what are participating shares?
give the holder fixed dividends plus extra earnings based on certain conditions
what are convertible preference shares?
can be exchanged for a specified number of ordinary shares on some given future date
what is the primary function of the stock market?
enable companies to raise new finance
- access to large pool of potential investors
- in UK, must be plc before accessing stock market