Chapter 15 - Sources Of Finance

Question 1

Various sources of finance

Answer 1

1. Cost
   - The higher the cost of funding, the lower the firm’s profit.
   - Debt finance tends to be cheaper than equity
   - Interest on debt finance is normally corporation tax deductible but returns on equity are not.
2. Duration
   - Normally, long term finance is more expensive than short term finance.
   - Long term finance does however carry the advantage of security whereas short term finance can often be withdrawn at short notice.
3. Term structure of interest rates
   - The relationship between interest rates charges for loans of differing maturities.
   - While short term funds are usually cheaper than long term funds, this situation is sometimes reversed and interest rates should be carefully checked.
4. Gearing
   - The ratio of debt to equity finance.
   - High gearing involves the use of cheap debt finance but it brings the risk of having to meet regular payments of interest and principal on the loans. If this is not met, the company could end up in liquidation.
5. Accessibility
   - Not all companies have access to all sources of finance. Small companies traditionally have problems in raising equity and long term debt finance.
   - A quoted company is one whose shares are dealt in on a recognised market. This makes it easier to attract new investors to buy new shares issued by the company because these investors know that they can always sell their shares if they wish to realise their investment.
   - Investment in shares of unquoted companies represents the acquisition of a highly illiquid investment. It is much more difficult to raise finance by new share issues.

Question 2

Types of share capital

Answer 2

1. Equity shareholders are the owners of the business and exercise ultimate control through their voting rights.
2. Equity finance is the investment in a company by the ordinary shareholders, represented by the issued ordinary share capital plus reserves.

Question 3

Ordinary Shares

Answer 3

1. Security or voting rights: Voting rights in general meetings. Rank after all creditors and preference shares in rights to assets on liquidation.
2. Income: Dividends payable at the discretion of the directors out of undistributed profits remaining after senior claims have been met.
3. Amount of capital: The right to all surplus funds after prior claims have been met.

Question 4

Cumulative preference shares

Answer 4

1. Security of voting rights: Limited right to vote at a general meeting (When dividend is in arrears or when it is proposed to change the legal rights of the shares). Rank after all creditors but usually before ordinary shareholders in liquidation.
2. Income: A fixed amount per year at the discretion of the directors. Arrears accumulate and must be paid before a dividend on ordinary shares may be paid. Dividend is not corporation tax deductible.
3. Amount of capital: A fixed amount per share.

Question 5

Non-cumulative preference shares

Answer 5

1. Security or voting rights: Typically acquire some voting rights if the dividend has not been paid for three years. Rank as cumulative in liquidation.
2. Income: A fixed amount per year as above. Arrears do not accumulate.
3. Amount of capital: A fixed amount per share.

Question 6

Raising equity

Answer 6

1. Internally generated funds
   - Earnings retained in the business (undistributed profits attributable to ordinary shareholders).
   - Can represent the single most important source of finance for both short and long term purposes.
   - Retained earnings are also a continual source of new funds provided that the company is profitable and profits are not all paid out as dividends.
   - Cheap, quick to raise, requiring no transaction costs, professional assistance or time delay.
2. Rights issue
   - An offer to existing shareholders to subscribe for new shares at a discount to the current market value in proportion to their existing holdings.
   - The rights of pre-emption: Enables them to retain their existing share of voting rights and can be waived with the agreement of shareholders.
   - Shareholders not wishing to take up their rights can sell them on the stock market.
3. TERP

Ex-rights price = (Market value of shares already in issue + Proceeds from new share issue)/ Number of shares in issue after the rights issues (ex rights)

Question 7

Value of a right

Answer 7

Value of a right = Theoretical ex rights price - Issue (subscription) price

Question 8

New share issues

Answer 8

1. Unquoted
   - Company requirement: Finance without an immediate stock market quotation.
   - Method of issue: Private negotiation or placing. Enterprise Investment Scheme (EIS)
   - Type of investor: Individual merchant banks, finance corporations.
2. Unquoted or quoted
   - Company requirement: Finance with an immediate quotation. Finance with a new issue.
   - Method of issue: Stock exchange or small market placing. Public offer (fixed price or offer for sale by tender).
   - Type of investor: The investing public, pension funds, insurance companies and other institutions.
3. Quoted or unquoted
   - Company requirement: Limited finance without offering shares to non-shareholders.
   - Method of issue: Rights issue.
   - Type of investor: Holders of existing shares.

Question 9

Debt finance

Answer 9

1. Loan notes from the viewpoint of the investor.
   Debt is viewed as low risk because:
   - It often has a definite maturity and the holder has priority in interest payments and on liquidation.
   - Income is fixed so the holder receives the same interest whatever the earnings of the company.

Debt holders do not usually have voting rights. Only if interest is not paid will holders take control of the company.

2. Loan note from the viewpoint of the company.
   - Debt is cheap because it is less risky than equity for an investor.
   - Debt interest is an allowable expense for tax.
   - Cost is limited to the stipulated interest payment.
   - There is no dilution of control when debt is issued.

Disadvantages of debt

• Interest must be paid whatever the earnings of the company. If interest is not paid, the trustees for the loan note holders can call in the receiver.
• Shareholders may be concerned that a geared company cannot pay all its interest and still pay a dividend and will raise the rate of return that they require from the company to compensate for this increase in risk.
• With fixed maturity dates, provision must be made for the repayment of debt.
• Long term debt, with its commitment to fixed interest payments may prove a burden especially if the general level of interest rates fall.

3. Different types of bonds.
   Deep discount bonds:
   - Loan notes issued at a price that is a large discount to the nominal value of the notes, and which will be redeemable at par (or above par) when they eventually mature.
   - The low initial price paid by the investor is balanced against a lower rate of return on the bond.

Zero coupon bonds:
- Bonds that are issued at a discount to their redemption value but no interest is paid to them.

Question 10

Venture capital

Answer 10

1. Venture capital is the provision of risk bearing capital usually in the form of a participation in equity to companies with high growth potential.
2. Venture capitalists provide start up and late stage growth finance for smaller firms.
3. Venture capitalists will assess an investment prospect on the basis of its
   - Financial outlook
   - Management credibility
   - Depth of market research
   - Technical abilities
   - Degree of influence offered - controlling stake or board seat?
   - Exit route

Question 11

Islamic finance

Answer 11

1. The basic principles covered by Islamic finance include:
   - Sharing of profits and losses.
   - No interest (riba) is allowed.
   - Finance is restricted to Islamically accepted transactions, i.e. No investment in alcohol or gambling.
2. Instead of interest being charged, returns are earned by channeling funds into an underlying investment activity which will earn profit. The investor is rewarded by a share in that profit after a management fee is deducted by the bank.

Question 12

Islamic sources of finance

Answer 12

1. Murabaha
   - A form of trade credit or loan.
   - The bank will take actual constructive or physical ownership of the asset.
   - The asset is then sold onto the borrower or buyer for a profit but they are allowed to panthers bank over a set number of instalments.
2. Ijara
   - The equivalent of lease finance defined as when the use of the underlying asset or service is transferred for consideration.
   - The bank makes available to the customer the use of assets or equipment for a fixed period and price.
   - The use of the leased asset must be specified in the contract.
   - The lessor (bank) is responsible for the major maintenance of the underlying asset (ownership costs).
   - The lessee is held for maintaining the asset in good shape.
3. Sukuk
   - A company can issue tradeable financial instruments to borrow money.
   - Key features are:
   A. They don’t give voting rights in the company.
   B. Give right to profits before distribution of profits to shareholders.
   C. May include securities and guarantees over assets.
   D. Include interest based elements.

• Islamic bonds are linked to an underlying asset such that a sukukholder is a partial owner in the underlying assets and profit is linked to the performance of the underlying asset.

4. Mudaraba
   - Where one partner gives money to another for investing in a commercial enterprise. The investment comes from the first partner and the management and work is the responsibility of the other.
   - The Mudaraba is a contract with one party providing 100% of the capital and the other providing its specialist knowledge to invest the capital and manage the investment project.
   - Profits generated are shared between the parties according to a pre agreed ratio and only the lender of the money has to take losses. Similar to equity finance.
5. Musharaka
   - A relationship between two or more parties who contribute capital to a business and divide the net profit/ loss pro rata.
   - All providers of capital are entitled to participate in management but are not required to do so.
   - Profit is distributed among the partners in pre agreed ratios while the loss is borne by each partner strictly in proportion to their respective capital contributions.