Business Finance Flashcards
Overdraft
Good because you can dip in and out when you need.
Bad - because if you sit in it permanently the rates tend to be higher. High risk as the bank can remove OD whenever they want.
An overdraft is an overdrawn balance on a current account and is the most common form of bank funding. This is due to their flexibility and ease of operation; a facility letter is all that is required to initiate this facility. In the UK overdrafts are strictly repayable on demand. Interest which is variable and calculated daily tends to be at a higher rate than other short-term sources of finance.
Short term loan
A short-term loan is where a fixed amount of funds are borrowed for a fixed period (of less than one year) of time at the end of which the full amount has to be repaid. Interest is charged on the total amount borrowed either at a fixed or variable rate.
Trade credit
Trade credit refers to the provision of credit by trade suppliers. This is an important source of financing for current assets. Trade credit is often described as a ‘free’ source of finance as interest is not charged, however delayed payment could result in the loss of a settlement discount, interest being charged on the overdue amount (Late Payment of Commercial Debts (Interest) Act 1998) or the loss of future credit.
Lease finance
Short-term lease finance is in the form of an operating lease where finance is provided specifically to access the use of a particular asset e.g. a photocopier. The legal ownership of the asset remains with the lessor, however the lessee has physical use of the asset and makes (normally monthly) payments
for doing so. This is consequently very similar to renting an asset and due to the security provided by the asset, operating leases are often available to organisations that may find it difficult to obtain other sources of finance because of their poor credit rating.
Equity finance
Equity finance normally takes the form of ordinary shares and these denote ownership of the business. This is the primary risk capital as if the business fails, it is the last to be paid, conversely however if the business is a success it will receive the greatest benefit in the form of increasing dividends and share prices.
Preference shares also exist, but these tend not to denote ownership and receive a fixed return in the form of a set dividend. As the Preference dividend is paid before the Ordinary dividend, Preference shares are also sometimes referred to as prior charge capital.
Issuing equity finance will reduce the level of gearing and assuming the business expansion results in increased profits, interest coverage would also improve and financial risk would fall.
Debt finance
Debt finance takes the form of a long term loan which is normally secured on some of the organisations assets and receives regular interest payments. Thus compared to equity finance, debt finance is relatively low risk and so receives a commensurately low return. Debt is also referred to as debentures, bonds, loan stock and loan notes. Debt may be irredeemable (the capital is never repaid), redeemable (the capital is repaid at a pre-agreed date) or convertible (the debt may be converted into a pre agreed number of shares at the option of the debt holder)
Lease finance (long term)
Long-term lease finance is in the form of a finance lease where a lessee selects an asset which the lessor purchases and then leases to the lessee. Substantially all of the risks and rewards of ownership are transferred to lessee. Thus this is very similar to debt finance however the finance is provided for a specific (long term) asset.
Venture capital
Venture capital refers to higher risk finance provided by venture capitalist companies. This will normally take the form of an investment in ordinary shares and unsecured debt in an unlisted company for a period of around five years at the end of which time the venture capitalist will look for an exit route either by listing or selling the company. In this way they can realise their investment. The venture capitalist will normally insist on Board representation.
Identify and discuss methods of raising equity finance
Rights Issue
Private placing
Public offers
Stock exchange listing
Rights Issue
A rights issue is where a company offers further shares, at a fixed price which is normally below the current market price, to existing shareholders in proportion to their existing holding.
This will reduce the level of gearing (as for any issuance of ordinary shares).
It is possible to calculate what the share price will theoretically be immediately after the rights
issue using a weighted average approach; this is known as the theoretical ex rights price (TERP).
The TERP is calculated before taking into account what use the proceeds will be put to.
Theoretical ex rights price (TERP)
(Total share value before+proceeds from issuance - issue costs). / (Total shares before + New shares issued)
The value of a right =
TERP - rights issue price
Private placing
A placing is where the shares are sold privately to clients of an issuing house at a fixed issue price. This is a relatively simple and cheap method of raising equity finance.
This will however dilute the ownership and control of existing shareholders but will not require security (unlike most debt) and will also reduce the level of gearing.
Public offers
A public offer is where shares are offered directly to the public either at a fixed price or by tender.
Fixed price offer: This is where shares are offered directly to the public at a fixed price. The issuance may be underwritten (by an investment bank) in order to reduce the risk to the company of less than full subscription.
Offer for sale by tender: This is where shares are offered to the public, but no fixed price is set. Instead, potential investors bid for shares with a striking price set based on demand. These issuances are often via an issuing house (investment bank) which will also underwrite the issuance and are rarer than fixed price offers.
Stock exchange listing
A stock exchange listing is where a company has its shares listed on a recognised stock exchange by fulfilling certain criteria:
In the UK in order to obtain a listing on the main market a company must have at least a three year trading history, be worth at least £700,000 and at least 25% of the shares must be in the hands of the public.
Such shares have a secondary market i.e. they can be traded between individual shareholders, and this makes it considerably easier to issue further shares. It is common for companies to simultaneously obtain a listing and issue more shares – this is called an initial public offer (IPO)
Matching
Course Notes 75 A fundamental principle of financing is that the type/source of funds used should match the use of
those funds. Matching can cover the following variables:
Duration – long term funds (e.g. mortgage) used to fund long term acquisitions (e.g. house purchase) and shorter term funds (e.g. three-year loan) used to finance shorter term items (e.g. car). A short term shortfall in day to day spending could be financed with an overdraft.
Currency – An investment in a foreign asset could be funded with a foreign source (e.g. currency loan, Eurobond issue, equity issue in foreign currency), which will reduce exposure to foreign exchange rate movements (covered in Chapter 7).
Pattern of cash flows – try to mirror the pattern of receipts from projects with the pattern of payments made on the finance. High risk projects where the potential returns are high but by no means certain, may be more suited to being financed with equity where returns are not obligatory. Projects with regular steady income may be able to support the use of debt finance.
Cost
Cost covers many areas and is an important factor when looking into raising finance. It is sensible to split this into issue costs and on-going servicing costs.
Issue costs will include the following:
Arrangement fees
Underwriting fees
Prospectus printing costs
Advisers’ fees (e.g. merchant bankers, accountants, lawyers)
In general it is much cheaper to issue debt than shares in terms of the above issue costs.
The on-going servicing costs will include dividends with equity and interest payments with debt. Generally, required returns on equity will be higher than those on debt due to equity being the highest risk form of finance from the provider’s point of view (see later in this chapter). Other on-going cost factors to consider include:
Tax (interest is tax deductible for the company whereas dividends are not). This makes debt finance attractive.
Reporting/Information provision required. If raising debt finance the banks/investors may well require regular information (e.g. monthly detailed accounts).
Capital providers
Any existing or potential future capital provider’s positions need to be assessed in terms of areas such as:
Impact on gearing? (debt covenants, future borrowing capacity etc.)
Impact on control? (new share issue will dilute control unless it’s a fully subscribed rights issue)
Impact on EPS?
How much is needed?
As well as these factors you need to look at the current state of the market (is it a good time to be issuing shares? What about the “credit crunch”?) and the type of company; is it private or listed.
Trade credit (Murabaha)
A Murabaha transaction involves a bank buying an asset and then selling on to a business for a marked-up price (agreed when purchase is made). The business will then pay the amount due in instalments.
The overall idea here is that goods can be bought and then sold at a higher price to make a profit. These goods are then paid for with the mark-up element being paid for out of the profits.
Lease finance (Ijara)
An Ijara transaction is the Islamic equivalent of a lease and works in exactly the same way as conventional leases except if it is a finance lease the lessor remains responsible for major maintenance and insurance costs. The use of the asset will be specified in the contract.
The reason such leases are allowed is because the payments being made by lessee, are rental payments not interest payments i.e. the asset is being rented from its owner.
Debt finance (Sukuk)
A Sukuk transaction is where a business asset with a life of three to five years is bought and paid for by a third party or parties. The business then uses this asset to earn profits which it then shares with the third party or parties (i.e. there is no interest).
If the asset makes a loss, this is also shared with the third party or parties.
