Business Finance Flashcards
What are businesses financed with?
- Equity
- Debt
Equity (companies) definition
Money given by owners who want a dividend in return
Ordinary shares in the business
Influences on the level of cash balances
- Transaction motive
- Precautionary motive
- Investment motive
- Finance motive
Transaction motive
Meeting day to day financial obligations
Finance motive
To cover major transactions
Disadvantage of short term financing
- Renewal risk
- Interest rate risk
Renewal risk
E.g. overdraft may be recalled on demand at lender’s discretion
Interest rate risk
Short term interest rates can fluctuate
Long term finance risk
Lower operational risk, more expensive
Long term finance examples
- Equity
- Debt finance
Equity finance
Shareholders
Expect high returns due to risk of business failure
Debt finance
Money lent from banks
More expensive for long term loans due to greater risk exposure
Aggressive approach to financing
More short term finance over debt and equity
More profitable
Cheaper
Riskier
Defensive approach to finance
Portion of long term finance for short term needs
Less risk
More expensive
Average finance position
Reasonable balance
What is a bank a type of?
Financial intermediary
What do financial intermediaries do?
Bring together investors/lenders with borrowers/users of funds
Mirror real world by providing relatively risk free lending environment and easily accessible funds for borrowing
Roles of the financial intermediary
- Risk diversification
- Aggregation
- Maturity transformation
- Making a market
- Advice
Risk diversification e.g.
1 lender not lending all money to 1 borrower
Aggregation
Pooling deposits to get better returns
Maturity transformation
Loans and deposits mature at different times
Making a market
Putting lenders and borrowers in touch
Market Advice e.g.
Best rates available
Three types of UK bank
- Retail
- Commercial + investment
- Bank of England
Retail banks
Day to day money transmission
E.g. NatWest, Barclays, Lloyds
Commercial and investment banks
Offer tailored advice to large commercial clients usually in raising considerable finds
E.g. merchant banks e.g. LCF Rothschild
Bank of England 2 activities
Acts as a banker to the banks
Lending money through its financial market operations
2 roles of the bank of Engländ
- Carrying out monetary policy
- Ensuring financial stability
BOE Monetary policy process
- Lends money to banks at base rate
- Banks lend/borrow internally at other rates
- Partly affects rates offered to customers
Example of an inter-bank rate
SONIA
SONIA
Sterling overnight index average
BOE: Financial stability sectors
- Financial policy committee (FPC)
- Prudential regulation authority (PRA)
FPC responsible for
Removing systemic risks in UK financial system as a whole
PRA responsible for
Prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms
Who are financial service firms not supervised by the PRA supervised by?
The FCA
FCA
- INDEPENDENT body (Not BOE)
- Promotes effective COMPETITION
- Ensures relevant markets FUNCTION well
8 Cash transmission mechanisms
- Faster payments scheme
- Electronic find transfers (EFT)
- Bank automated clearing system (BACS)
- Clearing house automated payments system (CHAPS)
- Society for worldwide interbank financial telecommunication (SWIFT)
- Payment gateways
- Digital commerce platforms
- General clearing
Faster payments scheme
Same day clearing of amounts up to £250k
For some customers of some banks
Using phone or internet
EFT
Any computer-based system that transfers money electronically
E.g. EFTPOS in shops
BACS
A type of EFT that deals with salaries and direct debits.
Same day clearing
CHAPS
A bank to bank system that provides same day clearing in the uk in GBP
SWIFT
Similar to CHAPS but for international transfers
Payment gateways
A system for payment authorisation when using credit cards online
Digital commerce platforms
E.g. PayPal
Payments made using just email address
Very cheap
General clearing
Mainly cheques
Short delay to clear funds
Relationship between bank and customer
Fiduciary duty
4 contractual arrangements between bank and customer
- Mortgagor/mortgagee
- Principal/agent
- Bailor/bailee
- Receivable/payable
Mortgagor/mortgagee relationship
Bank has right to assets if customer defaults on loan
Principal/agent relationship
Bank acts as agent for customer
E.g. paying 3P sums owed on customer cheque
Bailor/bailee relationship
To safeguard property
E.g. Title deeds collateral on mortgage
Receivable/payable relationship
Contractually owe each other depending on if withdrawn or in credit
Types of financial market
- Money markets
- Capital markets
Money market
Buying and selling different forms of money and marketable securities
Short term borrowing and investment to companies, banks and public sector (less than one year)
Capital market
The national + international market where a business can obtain money for short and long term plans
Longer term borrowing and investing, usually via a stock exchange
UK stock exchanges
- London stock exchange
- Alternative investment market (AIM)
Marketable securities
Short term highly liquid investments readily convertible into cash
Money market financial instruments
- Treasury bills
- Deposits
- Certificates of deposit (CD)
- Gilts
- Bonds
- Commercial papers
Treasury bills
Issued by the BOE on behalf of the government
Minimum investment is £500k
Last up to 12m
Very secure but low returns
Deposits
Placed in bank accounts
Overnight - 5y
Typically higher yield than treasury bills
Certificates of deposit
Offered for deposits of more than 50k for a fixed term
Can be traded in the CD market
Gilts
Offer range of maturities and rates based on money market rates
Bonds
Debentures and loan stock of companies quoted on the stock exchange
Commercial papers
IOUs issued by large companies which can be held to maturity or sold to 3Ps beforehand
Ways businesses can access finance
- National stock markets
- The banking system
- Bond markets
- Leasing
- Debt factoring
- International markets
Two ways national stock markets can act
- Primary markets
- Secondary markets
Primary markets
I.e. source of new finance via share issues
Secondary markets
For securities such as shares that are already in issue
The banking system can be split between
- Retail market (for individuals/small businesses)
- Wholesale market (for large companies)
Bond markets usually for
Very large organisations to raise very large sums
International markets
Allow finance to be raised in different currencies
Usually very large amounts
Usually for larger companies
What does raising new long-term finance invariably involve?
Issuing securities in the form of shares (equity) or bonds (debts)
Key capital market instruments
- Equity
- Preference shares
- Loan stocks and debentures
Equity
Ordinary shares in the business
Sources of money for equity finance
- Retained earnings
- Rights issue of shares
- New issue of shares
Retained earnings
Internally generated funds
Easy
Profits can be paid out (dividends) or reinvested in the business
What may reinvested retained earnings lead to?
Business growth so share price increase
Law regarding rights issue
Must be made before new issue to the public, unless shareholders agree otherwise
Factors to consider when making rights issues
- Issue costs
- Shareholders’ reactions
- Control
- Unlisted companies
Rights issue costs
About 4% on £2m raised
But mainly fixed costs
Rights issue shareholders’ reactions
May be unfavourable as forced to either buy more or sell them
May sell shares driving down market price
Rights issue control issues
Unless many existing shareholders sell their rights to new shareholders there is little control impact
Rights issue unlisted companies issues
Unlisted companies find them difficult because shareholders may not have funds but can’t sell them
New issue of shares usually only done when?
Company listed on stock exchange or listing for the first time
Expensive
Time consuming
Two forms of a new share issue
- Placings
- Public offerings
Placings progress
- Shares sold to an issuing house
- Issuing house places (sells) the shares with its clients (institutional investors)
Most common way for C coming into the market
Placings benefit
Lower transaction costs than public offers
E.g. advertising, admin
Placings drawback
Reduces efficiency if the market in the shares because only offered to small pool of institutional investors
Public offers 2 methods
- Offer for sale
- Direct offer/offer for subscription
Public offer: Offer for sale process
- Shares sold to ISSUING HOUSE (investment bank)
- Issuing house offers shares to general public
The most common public offer method
Public offer: Direct offer/Offer for subscription process
Shares sold directly to public
What is the issue of public offer methods likely to be?
Underwritten
How much capital can be raised by public offer?
Unrestricted
New issues priced too high?
Issue fails
New issues prices too low?
Too many shares issued
2 ways pricing of new shares can be managed
- Underwriting
- Using an offer for sale by tender
Underwriting an issue
An Institution/group of institutions agreeing to purchase any securities not subscribed for by the public in exchange for a fixed fee.
(Usually 1-2% of the total finance raised)
Underwriting disadvantage
The cost is still payable even if the underwriter doesn’t have to invest
Offer for sale by tender definition
Investing public invited to tender (offer) for shares at the price it’s willing to pay.
Minimum set by issuer
Offer for sale by tender process
- Receive all tenders
- Shares issued at one price
Investors who tendered at higher prices pay less than the amount tendered
Does an offer for sale by tender normally need to be underwritten?
No because the tender process should ensure that all shares are sold
Going public/floating definition
Go onto the official list of the stock exchange
Advantages to going public
- Large source of finance
- Improved marketability of shares
So the value of the company - Raises profile of company
Disadvantages to going public
- Cost
- Dilution of control
At least 25% of company must be in public hands - Need to have traded for 3 years
- Have to answer to other investors
Often professional institutional investors - Greater scrutiny of company and director actions
- Listing may not be successful if business worth less than £50m
- Possibility of being taken over
- Extra costs of control and reporting systems to follow listing rules
Going public: Company’s actions
Sells shares to raise capital
Going public: Sponsor’s actions
(Usually an investment bank (or stockbroker, accountant…))
- Assesses whether floatation is appropriate
- Helps draft prospectus
- Coordinates all other advisors
- Prices and underwrites the issue
Going public: Corporate broker’s actions
(Can be same organisation as sponsor)
- Advises on market conditions and likely demand
- Generates investor interest
- Helps with issue method and pricing
- May organise sub-underwriting
Going public: accountant’s actions
Involved in long-form report
(E.g. financial controls, track record, financing, forecasting…)
Going public: Registrar’s actions
Record ownership of shares
Going public: Advisors necessary
- Sponsor
- Corporate broker
- Accountant
- Solicitor
- Registrar
Sources of debt finance
- Debt factoring
- Overdraft
- Term loans
- Loan stock
- Leasing
How is overdraft interest charged?
On a day to day basis at a variable rate
Overdraft disadvantage
Control
Bank may require security on assets of the business
Debt factoring
Receiving loan financing and insurance (aka non-recourse factoring) so that the business doesn’t have to repay the loan if the customer doesn’t pay
3 services typically offered by a debt factor
- Financing customer credit
- Insuring receivables
- Managing running of receivables ledger
Term loans
Repayment date set at time of borrowing
Often bank loans
Term loans interest rates can be either
Fixed or variable
Term loans arrangement fees are
Low
How are term loans usually made safer for lender?
Secured against assets
Term loan repayment schedules are
Flexible
Interest holidays of you to 2y can be negotiated to allow new ventures to become established before repayments are made
Loan stock
Debt capital (aka bonds or debentures)
Securities issued by companies, gov and local authorities
Key loan stock considerations:
- Coupon (interest) rate
- Redemption value
- Redemption date
- Recipient
Loan stock coupon rate
Annual interest = coupon rate x stock NV
Can be fixed or variable
The 3 ways loan stock redemption value can be repaid…
At par
At a premium (with more)
At a discount (with less)
Investors’ opinions of loan stock with redemption value at a premium
More attractive, so happier to accept a low or zero coupon rate
Which eases the C’s cash flow
Loan stock redemption date
- Normally medium to long term
- Some bonds are undated (aka perpetual/irredeemable)
How to get capital back on undated bonds
Must sell the loan stock
Loan stock: Recipient
- With UK domestic bonds issued on the stock exchange, the bond holder’s name is recorded on a register (like with shares)
- Some bonds e.g. Eurobonds are ‘bearer’ bonds - the holder of the bond will receive payments due
What is a finance lease
A lease that transfers substantially all the risks and rewards of ownership of an asset from the lessor to the lessee
Normal finance lessor
A finance company or bank
Normal finance lessee
The business
Types of lease
- Finance lease
- Operating lease
Operating lease definition
Any other lease to a finance lease
Finance lease duration
Long term
A purchase of the asset by the lesee
Financed by a loan from the lessor
Operating lease duration
Short term rental (of an asset)
Finance lease period
For the majority of the asset’s useful life
Operating lease period
Less than the asset’s useful life
Finance lease passing of ownership
Either to lessee at end of term
Or any secondary lease period is at a very low rent
Operating lease passing of ownership
Remains with the lessor
Finance lease responsibility
Lessee takes on risks and rewards of ownership
E.g. risk of downtime
Operating lease responsibility
Lessor usually responsible for repairs + maintenance
Finance lease possibility of cancellation of lease agreement
Cannot be cancelled
Or early cancellation charges mean the lessee effectively has liability for all payments
Operating lease possibility of cancellation
Can sometimes be cancelled at short notice
Ways of financing a growing business
- Business angels
- Crowdfunding
Ways crowd-funders contribute money
- Loans
- Equity
- Donations
Two largest sectors of crowdfunding
- Equity-based investment
- Peer-to-Peer lending
Both regulated by FCA
The rest largely unregulated
Venture capital definition
Provision of risk-bearing capital
Usually in form of equity
To companies with high growth potential
Venture capital duration
Medium term
Much of VC gains if in the form of
Capital gains
After 3-5y
VC key issue
The VC’s exit route
Three key VC exit routes
- Trade sale
- Floatation
- Buy-back of shares on refinancing
Trade sale
VC’s shares, or whole company, sold to another company
AIM 2 key points
- Less stringent regulations
- Available for companies valued over £1m
Financing exports: Trading risks
{CaPTL}
- Capital
- Physical risk
- Trade risk
- Liquidity ris
Financing exports: physical risk
Goods lost or stolen in transit
Financing exports: trade risk
Customer refusing to accept goods on delivery (due to substandard/inappropriate goods)
Calculation of order in transit
Financing exports: credit risk
Default by customer
Financing exports: liquidity risk
Inability to finance credit given to customers
People who can help reduce trading risks
- Banks
- Insurance companies
- Credit reference agencies
- Government agencies (e.g. UK’s export credits guarantee dept. (ECGD))
Financing exports: Bills of exchange
Document drawn up by exporter (seller) sent to overseas buyer’s bank
Guarantees payment because bank accepts obligation to pay bill by signing it
Seller can sell (‘discount’) bill to 3P for cash now
Financing exports: Letters of credit
- Arrangement between exporter, buyer and participating banks takes place before export sale takes place
- Buyer has period of credit for paying for imports
- Risk free method of international trade
Letters of credit disadvantages
- Slow to arrange
- Cumbersome admin
Financing exports: Export credit insurance
Insurance against the risk of non-payment by foreign customers for export debts
Who provides export credit insurance?
- Some private companies provide insurance for short-term export credit businesses
- The UK gov Export Credits Guarantee Dept (ECGD) provides long term guarantees to banks on behalf of exporters
Green finance definition
Financing things with environmental benefits
Green finance includes
- Green bonds
- Green loans
- Green grants
- Green VC funds
Green bonds
Proceeds exclusively applied to eligible Green projects and which are aligned with the core components of the Green bond principles
Green bond principles
- Proceeds must only be used for projects with clear environmental benefits
- Must be a defined process for project evaluation and selection
- Proceeds must be kept in separate account (or tracks by issuer)
- Use of proceeds reported
