B3. Impact of financing on investment decisions and adjusted present values Flashcards
Short term debt.
Consists mainly of overdrafts and short-term loans.
• Overdrafts – can be arranged relatively quickly and offer degree of flexibility with regards to amount borrowed. Interest is only paid when account overdrawn. Penalties if overdrawn beyond authorized limit.
• Overdrafts – most appropriate for day-to-day trading and cash flow financing requirements.
• Short-term loans – more formal than overdrafts, with fixed amounts for a specified period of time. The company knows how much and when to pay back and does not need to worry about withdrawal or reduction of overdraft facility. Interest is paid for the duration of the loan.
Long term finance.
More appropriate for major investments. Tends to be more expensive and less flexible than short-term finance.
Long-term debt comes in various forms including bank loans, and bonds whose price will wary according to the product and prevailing market conditions. Long-term debt tends to be most appropriate for long-term investments. One of the main advantages of long-term debt is that interest is tax deductible, making it cheaper than equity finance.
• Bonds A tradeable security with a nominal value $100 or $1000, normally maturing in 7-30 years and paying fixed interest; protected by covenants (e.g. restrictions on dividend policy). Normally redeemable at their nominal value. Bond holders are lenders of debt finance and will be paid a fixed return known as the coupon. Bonds are usually secured on non-current assets thus reducing risk to the lender. Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to the issuing company
• Slower and more expensive to organise than a loan and less flexibility than a bank loan in the event of default (banks generally more flexible as want to maintain relationship). Often cheaper interest costs compared to a loan (because it is liquid investment as can be sold by investor).
Equity finance.
Raising new equity finance through sale of ordinary shares to investors, either as a new issue or as rights issue. The issue of equity is at the bottom of the pecking order because of the cost of issue and being more expensive in terms of required returns. The high risk means that equity shareholders expect the highest returns of long-term providers of finance. As with long-term debt, equity finance will be used for long-term investments.
Stock market listing adv and disadv
A listing on stock market makes it easier to obtain equity. Advantages:
• Higher public profile and improved marketability of shares
• Higher investor confidence (audited accounts, regular briefings, NEDs)
• Access to wider pool of equity finance
• Allows owners to realise some of their investment
• Allows use of share issues for incentive schemes and takeovers
Disadvantages
• Significantly greater public regulation, accountability and scrutiny.
• A wider circle of investors with more exacting requirements will hold shares.
• Additional costs involved in making share issues, including brokerage commissions and underwriting fees.
The possible methods of obtaining a stock exchange listing are:
- Initial public offer
* A placing.
Initial public offer
Initial public offer–is an invitation to apply for shares in a company based upon information contained in a prospectus. It is a means of selling the shares of a company to the public at large for the first time. Subsequent issues are likely to be placings or rights issues.
o They are offered to public, either at a fixed price or via a tender process where investors ‘bid’ for shares.
o They are often issued by smaller, younger companies looking to expand, or large private companies wanting to become public.
o For the individual investor it is tough to predict share prices on the initial day of trading as there’s little past data about the company often, so it’s a risky purchase.
o These are underwritten & advertised. This means they are expensive - so good for large issues
A placing.
This way of raising equity finance involves allocating large amounts of ordinary shares with small number of institutional investors. The bank advising the company selects institutional investors to whom the shares are ‘placed’ or sold. If the general public wish to acquire shares, they must buy them from the institutions.
o A placing may be used for smaller issues of shares (up to $15 million in value).
o This is cheapest and quickest way.
Rights Issues.
The rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings. This right of pre-emption: enables them to retain their existing share of voting rights and can be waived with the agreement of shareholders.
• Effect on EPS. Obviously, this will fall as there are now more shares in issue than before, and the company has not received full MV for them. To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue.
• Effect on shareholders wealth. There is no effect on shareholders wealth after a rights issue. This is because, although the share price has fallen, they have proportionately more shares. Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up the right
Debt v Equity – things to consider.
- Gearing and financial risk. Equity finance will decrease gearing and financial risk, while debt finance will increase them
- Target capital structure. The aim is to minimise weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress)
- Availability of security. Debt will usually need to be secured on assets by either: a fixed charge (on specific assets) or a floating charge (on a specified class of assets).
- Economic expectations. If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead.
- Control issues. A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.
- Less or more risk? The providers of debt finance face less risk than the providers of equity finance because there is more certainty over the level of their return. As a result debt providers will require a lower level of return on their investment than equity providers.
Venture capital.
Venture capital is risk capital which is generally provided in return for an equity stake in the business. It is most suited to private companies with high growth potential. Venture capitalists seek a high return (at least 20%), although their principal return is achieved through an exit strategy (sale of shares on IPO). As well as providing funding for start-up businesses, venture capital is an important source of finance for management buy-outs.
Business angels.
These are wealthy individuals who invest in start-up and growth businesses in return for an equity stake. The investment can involve both time and money depending on the investor. These individuals are prepared to take high risks in the hope of high returns. As a result, business angel finance can be expensive for the business. Investments in the region of 25k, so useful to fill the gap between venture capital and debt finance, particularly for start-up businesses. One of the main advantages is that they often follow up their initial investment with later rounds of financing as the business grows. New businesses benefit from their expertise in the difficult early stages of trying to establish themselves.
Leasing.
This is a useful source of finance for the following reasons:
• Protection against obsolescence. Since it can be cancelled at short notice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business. This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms and servicing cover
• Less commitment than a loan. There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided. Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.
• Cheaper than a loan. By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition that borrowing.
• Off balance sheet finance. Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet.
Private equity.
Consists of equity securities in companies that are not publicly traded on a stock exchange. In Europe, private equity represents the entire spectrum of the investment sector that includes venture capital and management buyouts and buy-ins. Private equity funds tend to invest in more mature companies with the aim of eliminating inefficiencies and driving growth. Private equity funds might require a 20 – 30% shareholding or/and rights to appoint directors.
Asset securitisation.
Asset securitisation involves the aggregation of assets into a pool then issuing new securities backed by these assets and their cash flows. The securities are then sold to investors who share the risk and reward from these assets. Securitisation is similar to ‘spinning off’ part of a business, whereby the holding company ‘sells’ its right to future profits in that part of the business for immediate cash. The new investors receive a premium (usually in the form of interest) for investing in the success or failure of the segment.
The main reason for securitising a cash flow is that it allows companies with a credit rating of (for example) BB but with AAA-rated cash flows to possibly borrow at AAA rates. This will lead to greatly reduced interest payments as the difference between BB rates and AAA rates can be hundreds of basis points.
Most securitisation pools consist of tranches. Higher tranches carry less risk of default (and therefore lower returns) whereas junior tranches offer higher returns but greater risk.
Drawbacks. Securitisation is expensive due to management costs, legal fees and continuing administration fees.
Initial Coin Offerings.
ICOs are a type of crowdfunding or crowd investing tool conducted entirely on the blockchain. ICO is a new way for organizations to raise capital. Like IPO, an ICO raises finance from investors. However, there are two key differences:
• Instead of receiving shares, an investor receives a new type of coin or token (investment, asset or utility)
• Payment is made in a cryptocurrency such as bitcoin or ether.
The future value of the tokens depends on success of the venture. Entrepreneurs present a whitepaper of the business model and the technical specifications of a project before the ICO. They lay out a timeline for the project and set a target budget where they describe the future funds spending (marketing, R&D, etc.) as well as coin distribution (how many coins are they going to keep for themselves, token supply, etc.).
ICO regulatory status, adv and disadv
Regulatory status. Banned in some countries. In general regulators are less concerned with ICOs that do not offer investors the reasonable expectation of the profit (ICO that offer utility tokens as outside definition of security). ICOs that in some way offer future income streams are likely to be judged to be securities (equity tokens) and are likely to have to fulfil the related regulatory criteria for an issue of securities.
Advantages of an ICO. Increase in IC) activity, due to:
• Its speed and ease of use as source of finance for new ideas compared to traditional methods.
• Investor interest, often based on speculative expectation of rapid, high returns.
Disadvantages of ICO.
• To investor.
o Fraud risk. ICOs launched by start-ups with vague organizational details.
o Valuation risk. Valuation of tokens is highly speculative.
• To the issuer
o Risk of money laundering. The anonymity of transactions makes ICO’s a target for organized crime funds.
o Risk of regulation
o Value of cryptocurrency (bitcoin value falling by 50%
The Islamic economic model
The Islamic economic model has developed over time based on the rulings of Sharia on commercial and financial transactions. The Islamic finance framework seen today is based on the principles developed within this model. The main principles of Islamic finance are that:
• Wealth must be generated from legitimate trade and asset-based investment. (The use of money for the purposes of making money is expressly forbidden.)
• Investment should also have a social and an ethical benefit to wider society beyond pure return.
• Risk and reward should be shared between the investor and the user of the funds.
• All harmful activities (haram) should be avoided.
• Making money with money is deemed immoral and hence interest (riba) is forbidden.
Commercial reasons for the use of Islamic finance.
- Availability of finance. The impact of the credit crash on Islamic nations has been less than in many other parts of the world. The Gulf countries own approx. 45% of the world’s oil and gas reserves.
- Islamic finance may also appeal due to it more prudent investment and risk philosophy. Conventional banks aim to profit by taking money deposits in return for the payment of interest (or riba) and then lending money out in return for the payment of a higher level of interest. Islamic finance does not permit the charging of interest and invests under arrangements which share profits and losses of the enterprises.
Two key screening tests for islamic finance
To tap into the Islamic equity markets, a company must be sharia compliant. To achieve this, there are two key screening tests:
• Does the company engage in business practices that are contrary to Islamic law (e.g. alcohol, gambling, tobacco, money lending etc)
• Does the company pass key financial tests, eg a low debt-equity ratio (less than 33%).
Products based on equity participation.
To establish social justice Islam requires that investors and entrepreneurs share risk and reward; there are two main products offered by Islamic banks that facilitate it.
• Mudaraba (getting finance).
• Musharaka (partnership).
• Sukuk (debt finance).
Products based on equity participation.
Mudaraba
Mudaraba (getting finance). Mudaraba transaction is a partnership transaction in which only one of the partners contributes capital, and the other contributes skill and expertise. Profits are shared according to pre-agreed contract – there are no dividends paid. Losses are solely attributable to the provider of capital, eg bank. The entrepreneur take sole responsibility for running the business, because they have the expertise in doing so – if losses are made the entrepreneur loses their time an effort. Mudaraba contracts can either be restricted (to a particular project) or unrestricted (funds can be used for any project).
Products based on equity participation.
Musharaka
Musharaka (partnership). Musharaka transactions are typically suitable for investments in business ventures or specific business projects and need to consist of at least two parties. Profits are shared according to pre-agreed contract – there are no dividends paid. Both the organization/investment manager and finance provider participate in managing and running the join venture. Profits are normally shared in proportion that takes into account the capital contribution and the expertise being contributed by the bank and entrepreneur/joint venture partners. Losses are shared in proportion to the % capital being contributed by each party. Under diminishing musharaka agreement the mudarib pays increasingly greater amounts to increase their ownership over time, so that eventually the mudarib owns the whole venture or asset.
Products based on equity participation.
Sukuk
Sukuk (debt finance). Although these are often referred to as Islamic bonds, the sukuk holders share risks and rewards, so this arrangement is more like equity. The sukuk holder shares in the risk and rewards of ownership of a specific asset, project or join venture. Sukuk requires the creation of a special purpose vehicle (SPV) which acquires the assets. This adds to the costs of the bond-issuing process, but they are often registered in tax-efficient jurisdictions. The prospectus for a sukuk must clearly disclose its purpose, its risk and the Islamic contract on which it is based (mudaraba, musharaka, ijara). Basically, the company sells the certificate to the investor, who then rents it back to the company for a predetermined rental fee. The company promises to buy back the bonds at a future date at par value.
Products based on investment financing.
Products based on investment financing. Debt finance is also possible but, even here, no interest can be charged; the products ensure both parties involved share risk (late fees=charity), and no money is actually loaned (purchase on behalf of client). • Murabaha (trade credit). • Ijara (lease finance). • Salam (derivative). • Istisna.
Products based on investment financing.
Murabaha
Murabaha (trade credit). Murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the purchase of goods for immediate delivery in deferred payment terms. The financial institution purchases the asset and sells it to the business or individual. There is a pre-agreed mark-up to be paid, in recognition of the convenience of paying later, for an asset that is transferred immediately. No interest is charged.
Products based on investment financing.
Ijara
Ijara (lease finance). Ijara is the equivalent of lease finance; where on party allows another party to use their asset against the payment of a rental fee. The financial institution purchases the asset for the business to use, with lease payments, period and payment terms being agreed at the start of the contract. The financial institution is still the owner of the asset and incurs the risk of ownership. This means that the financial institution will be responsible for major maintenance and insurance, which is different from a conventional finance lease.
Products based on investment financing.
Salam
Salam (derivative). A commodity is sold for future delivery; cash is received from the financial institution in advance (at a discount) and delivery arrangements are determined immediately.
Products based on investment financing.
Istisna.
Istisna. For funding large, long-term construction projects. The financial institution funds a project; the client pays and initial deposit, followed by instalments during the course of construction. At completion, ownership of the property passes to the clie
Advantages of Islamic finance.
Islamic finance operates on the underlying principle that there should be a link between the economic activity that creates value and the financing of that economic activity.
• Following principle of Islamic finance allows access to a source of worldwide funds. Access to Islamic finance is not restricted to Muslim communities, which may make it appealing to companies that are focused on investing ethically.
• Speculation is not allowed, reducing the risk of losses
• Excessive profits not allowed, only reasonable mark-ups
• Banks cannot use excessive leverage and are therefore less likely to collapse
• The rules encourage all parties to take a longer-term view and focus on creating a successful outcome for the venture, which should contribute to a more stable financial environment
• The emphasis on mutual interest and co-operation, with a partnership based on profit creation through ethical and fair activity benefiting the community as a whole.
Disadvantages of Islamic Finance.
Islamic finance does not remove all commercial risk.
• There is no international consensus on Sharia interpretations, e.g. some Murabaha are based on prevailing interest rates rather than economic or profit conditions.
• Documentation is often tailor-made for the transaction, so high transaction/issue costs
• Trading in Sukuk products has been limited, especially since the financial crisis
• With no interest - it is hard to claim some Islamic instruments as debt - therefore losing the tax benefit and increasing the WACC
• Some Islamic products may not be compatible with international financial regulation.
• Restrictions are placed on a company’s business operations and financial structure
• Approval of new products can take time.
• Islamic banks cannot minimise their risks as hedging is prohibited
Financing decision.
The primary objective of profit-making company is normally assumed to be to maximise shareholder wealth. Investments will increase shareholder wealth if they cover the cost of capital and leave a surplus for the shareholders. The cost of capital represents the return required by the investors (such as equity holders, preference holders or banks). The lower the overall cost of capital the greater the wealth that is created. The cost of capital is made up of the cost of debt + cost of equity. In order to be able to minimise the overall cost of finance, it is important initially to be able to estimate the costs of each finance type. The cost of the different forms of capital will reflect their risk. Debt is lower risk than equity because debt ranks before equity in the event of a company becoming insolvent, and because interest has to be paid. Therefore, debt will be cheaper than equity and the more security attached to the debt the cheaper it should be.
Creditor hierarchy.
When a company cannot pay its debts and goes into liquidation, it must pay its creditors in the following order: • Creditors with a fixed charge • Creditors with a floating charge • Unsecured creditors • Preference shareholders • Ordinary shareholders
Marginal vs average cost of capital
Marginal Cost of Capital. If a company gets a specific loan or equity to finance a specific project then this loan/equity cost is the MARGINAL cost of capital.
Average Cost of Capital. If a company is continuously raising funds for many projects then the combined cost of all of these is the AVERAGE cost of capital.
Cost of equity.
The dividend valuation model
capital asset pricing model.
DVM or CAPM. CAPM is generally preferred out of the 2 methods as more precise and explains what it calculates.
The dividend valuation model and assumptions
DVM states that the current share price is determined by the future dividends, discounted at the investor’s required rate of return.
DVM uses the following assumptions:
• Future income stream is the dividends paid out by the company (or market value of shares is directly related to expected future dividends on the shares).
• Dividends will be paid in perpetuity
• Dividends will be constant or growing at a fixed rate
DVM (assuming constant dividends)
P_0=D/r_e
Where
D = constant dividend from year 1 to infinity
P0 = share price now (year 0)
re = shareholder’s required return, expressed as decimal (cost of equity)
DVM (assuming dividend growth at a fixed rate).
P_0=(d_0×(1+g))/(r_e-g)
Where
Pₒ= the ex-div market value of the share
dₒ=latest dividend
re = the investor’s required rate of return (i.e. Kₑ)
g = expected annual growth rate of dividends.
This can be rearranged for cost of equity as follows:
k_e=(d_0×(1+g))/P_o +g
Where
Pₒ= the market value determined by the investor
dₒ=current dividend
g = expected annual growth rate of dividends.
