Chapter 15 - Sources of Finance Flashcards
Why do firms need finance?
to provide working capital
to invest in non-current assets
What is the criterial for choosing a source of finance?
- cost
- duration
- term structure of interest rates
- Gearing
- accessibility
What is risk?
the variability of potential returns
Investment risk arises because of what?
returns are variable and uncertain
An increase in the risk taken on by an investor generally requires what?
an increase in returns provided by the investment
shareholders provide what to the business?
provide equity funding to the business
lenders provide what to a business?
provide debt finance
Lenders lend money in return for what?
interest receipts and capital repayment
Is debt or equity more protected when lending to companies in risk industries?
debt providers will be more protected than equity providers. This provides therefore take on less risk on their investment than shareholders
What is one principle of raising finance in regards to the duration?
duration of the funding should match the duration of the need for it
What are the some negatives and positives of bank overdrafts?
- flexible and only used when needed
- bank can call them in at any time, making them risky to use in the long-term
- interest rates high
- if used intermittently only when needed can be cheaper than arranging a loan
What are bank loans?
- can be arranged quickly and put in place for a number of years
- may not always be available and company may need to provide security
IN the short term a company can aim to?
- collect their receipts in faster
- delay payments to suppliers
- have a more efficient inventory system in place
Who are equity shareholders?
Ordinary shareholders - the owners of the business and exercise ultimate control through their voting rights
What is equity finance?
the investment in a company by the ordinary shareholder, represented by the issued ordinary share capital plus reserves
What are preference shares?
their characteristics bear more resemblance to debt finance and so far for the purposes of such calculations as gearing they are considered part of debt than equity
How can we raise finance?
- internally generated funds
- rights issues
- new external share issues
what are internally generated funds?
retained earnings not already paid out as dividends or used for prior investment. Quick and cheap source of finance if available
what are rights issues?
the issue of new shares to existing shareholders in proportion to their existing shareholdings at a discount to the current market value
What are new external share issues?
placings, offers for sale etc
what would happen to the share price after a rights issue?
expected to fall
What is the formula for the theoretical ex-rights price (TERP)?
(Market value of shares already in issue + proceeds from new share issue) / no. of shares in issue after the rights issue
What is another reason for the affect in TERP value?
if funds raised from the rights issue are being used to undertake a positive NPV project, the value of that NPV with be theoretically added to the value of the company and therefore would increase the TERP
What is the value of a right calculation?
TERP - issue (subscription) price
What is the value of a right per existing share price?
(TERP-issue price) / no. of shares needed to obtain a right
What are the different shareholder options in regards to a rights issue?
- take up the rights by buying the specified proportion of shares at the price offered
- renounce the rights and sell them in the market
- renounce part of the rights and take up the remainder
- do nothing
What are the characteristics of new external share issues?
- expensive and may fail if investors cannot be found to purchase enough shares to raise the required total cash
What is underwriting?
when company chooses to have the issue insured
Some companies do what to raise enough cash for new external share issues?
may require business to become quoted - stringent criteria to adhere to
What is a bond/ loan note?
a written acknowledgment of a debt by a company, normally containing provisions as to payment of interest and the terms of repayment of the principal
What are features of long term finance?
- traded on the stock market
- usually denominated in blocks of $100 nominal value
- interest (coupon) paid as percentage of nominal value
- secured or unsecured
- may be redeemable or irredeemable
What are the advantages for an investor for long-term debt?
low risk, low return
What are the advantages for a company for long-term debt?
cheap, predictable, doesn’t dilute control
What are the dis-advantages for an investor for long-term debt?
No voting rights (no control) - debt investors do not have equity shares they cannot influence the direction of the company
What are the dis-advantages for a company for long-term debt?
inflexible, increase risk at high levels of gearing, must be repaid
What are examples of other types of loan notes?
Deep discount loan notes
Zero coupon loan notes
Hybrid loan notes - convertibles
Hybrid loan notes - with warrants
What are deep discount loan notes?
issued at a discount to nominal value and redeemable at nominal value and above
What are zero coupon loan notes?
like deep discount but zero interest is paid whilst in issue. Investors entire return is in the form of a capital gain from the difference between the issue and redemption prices
What are hybrid loan notes - convertibles?
these give the loan note holder the right to convert (if they choose at the time) the debt into other securities, normally ordinary shares, at a future date
What are hybrid loan notes - with warrants?
these give the loan note holder the right to subscribe at a fixed future date for a certain number of ordinary shares at a predetermined price
Long term lease arrangements would be used when?
as debt finance for assets that have a useful life over the mdeium to long-term period
What are characteristics of leasing?
- The lease generally covers the whole useful life of the asset.
- The lessor does not usually deal directly in this type of asset.
- The risks and rewards of ownership are generally passed to the lessee.
- The lease agreement cannot be cancelled.
What are venture capital investors?
take up shares in small, fast growing companies that have significant growth potential
What do venture capital investors provide?
the funds to help the business grow, and often take an active role in advising the company too
Venture capitalists usually aim to do what?
grow the company to the point at which it can be floated on the stock market. This allows them to sell their shares, all being well at a huge profit on their original stake
SMEs tend to be unquoted and can have difficulty raising finance due to what?
- small number of owners with limited capital available between them
- lack of business history or proven track record
- lower level of public scrutiny over accounts and records
- lack of internal controls and governance over owner-manager decisions
- lack of tangible assets to use as security for lending.
What is the funding gap?
the gap between the finance that SMEs could product
What are the different options for an SME to raise finance from different sources?
- seed capital
- high street bank
- government grant
- business angel
- venture capitalist
What is the maturity gap?
SME find easier to obtain long-term finance compared to small to medium term.
Islamic finance operates in accordance to what principles of sharia law?
- sharing of profits and losses
- no interest (riba) allowed
- restricted to islamically acceptable transactions, i.e., no investment in alcohol, gambling etc
What is Murabaha?
Trade credit, similar to equity finance.
What is Ijara?
Lease finance. The investor owns the asset and makes it available for use by the borrower in return for rental/purchase payments
What is Sukuk?
similar to debt finance. Instead of owning a bond, the investor owns a share of an asset that the sukuk is linked to
What is Mudaraba?
Provision of finance (by the rab ul mal) and management of the venture (by the mudarib) are separate.
What is musharaka?
The investor and investee contribute capital to a joint venture. Both may be involved in management of the venture.
