Chapter 3 Finance Flashcards
1.1 Choosing an appropriate financing option
This will depend upon the specific circumstances of the project, the business making the decision and the general business environment. The main considerations are:
- Cost
- Current level of gearing
- The signalling effect.
- Availability
- Security is often needed for debt finance.
- Duration: match the term of finance to the term of the proposed project
- Control: equity issues may change the balance of control
- Cash flow: equity is more flexible if cash flows are uncertain.
- Covenants in existing debt agreements
- Currency
- Green finance
2.1 Bonds
When a company issues a bond, it needs to know what return (yield) is required by the lenders so it can set the appropriate issue price/coupon rate/redemption premium.
2.2 Yield on a bond
Three key things which affect the yield required on a bond:
- Base rates
- The credit worthiness of the company
- The liquidity and marketability of the bonds. The smaller the number of bonds that are issued the less liquid they are, and therefore riskier requiring a higher yield.
There are two ways of calculating the yield on a bond:
- Flat yield: this is the coupon rate divided by current market value. consequently, it ignores the impact of any redemption payment, so the flat yield is of little use in practice.
- Gross redemption yield (yield to maturity): this is more commonly used. It is calculated by finding the IRR of the current market value, gross interest payments and the redemption amount. It can be calculated using the spreadsheet function =IRR or =RATE.
2.3 The yield curve for a bond
The yield curve plots gross redemption yields of bonds of equal credit risk and different maturities. The upward slope shows that the yield on a bond is greater the longer there is to maturity. The reason for the yield curve is the liquidity preference theory. This states that investors will demand a higher return the longer they have to wait for redemption. If the bond is long dated, then the yield will rise compared to a short, dated bond.
2.4 Credit ratings – credit risk and credit spread.
The yield on a bond will be influenced by the likelihood of the company issuing the bond to default (credit risk). Typical criteria to analyse for assessing credit risk:
- Loan suitability: length of loan/term structure
- Affordability
- Security availability
- Financial stability
- Capital structure.
- Management
Credit rating companies assess this risk, and bond yields are determined accordingly. Yield on a corporate bond = risk free rate + credit spread.
The credit spread is determined by the assessed credit risk of the company.
2.5 Volatility of a bond’s value
There is an inverse relationship between interest rates and bond prices. However, the prices of some bonds are more sensitive to changes in interest rates than others (prices more volatile). The price of a bond Is more volatile if the bond has a longer time until maturity, lower coupon and lower yield.
The Macauley Duration is used to compare the volatility of two different bonds. The calculation gives a measure of the sensitivity of a bond’s price to changes in interest rates. It is the weighted length of time to the receipt of a bond’s benefits.
3.1 Overseas finance – factors affecting the financing decision.
If a company is investing overseas, it might be more suitable to take out a foreign currency loan. It can often provide a natural hedge against foreign currency risk.
Factors affecting the financing decision:
- Yield calculation: exchange rate movement needs to be considered when calculating the yield on overseas finance. The risk step is to translate all currency cash flows into sterling at the predicted exchange rates. Then apply the IRR / RATE function to the sterling cash flows.
- Tax: if interest is not deductible in the O/S country, then debt finance becomes less attractive. High local taxes increase the benefit of tax deductibility. High withholding taxes or other remittance restrictions makes equity less attractive.
- Exchange rate risk: financing an O/S investment with a loan is risky if the exchange rate is volatile. Financing a foreign investment with a local currency loan would remove this risk.
- Business risk: international diversification may reduce the volatility of the firm’s operating profits, enabling the firm to take on more borrowing.
- Guarantees: a parent company may guarantee the debts of a subsidiary enabling it to have a more highly geared capital structure than normal
5.1 Leasing
To compare the costs of finance (with a loan), we calculate the NPV of the relevant cash flows discounted at the post-tax cost of finance. Relevant cash flows for leasing:
- The lease payments (often paid at the start of the year)
- The tax relief on lease payments
The relevant cash flows for buying:
- The purchase scrap value of the asset
- The tax savings from tax-allowable depreciation
For both sets of calculations use the post-tax cost of borrowing when discounting: cost of borrowing x (1 – tax rate).
6.1 Dividend policy
Retained earnings are an important source of finance, but a process of reinvesting money back into the company can have an impact on the money being paid out as dividends. If investors are used to a stable dividend policy, which is then changed it can impact the value of the firm. This impact is assessed through a valuation model:
G = b (ROA + D / E (ROA – i( 1 – t)))
Where g is the growth rate, ROA is the return on net assets of the company, b is the retention rate, D is the book value of debt, E is the book value of equity, I is the cost of debt and t is the tax rate.
7.1 Financing reconstruction
These schemes are undertaken when companies have got into difficulties or as part of a strategy to enhance the value of the firm for its owners. Designing a reconstruction:
- Estimate the position of each party is liquidation is to go ahead, this is the minimum acceptable.
- Assess additional sources of finance.
- Design the reconstruction according to the details of the question.
- Calculate and assess the new position and also how each group has fared, compared to step 1.
- Check that the company is financially viable after the reconstruction.
Methods of reconstruction include:
- Leveraged capitalisation: a firm replaces the majority of its equity with a package of debt.
- Debt-equity swap: a portion of the debt is exchanged for a predetermined amount of equity, possibly done to reduce the gearing level.
- Equity-debt swap: shareholders given the right to exchange their shares for a predetermined amount of debt.
- Refinancing: a firm may replace current debt with a package of cheaper or more flexible debt, but the benefits may be outweighed by penalty clauses or transaction fees from paying off the original debt early
- Securitisation: process of using non-liquid assets or trade receivables as collateral for a loan
8.1 Financial distress
Legal consequences of financial distress:
- Fraudulent trading: occurs where a company has traded with intent to defraud creditors.
- Wrongful trading: occurs when directors have continued to trade when the company is no longer financially viable and should be in liquidation.
Management of companies in financial distress:
- Administration: powers of management are subjugated to the authority of the administrator, who has the same powers as those of the directors and may do anything necessary to try and save the company if possible
- Company voluntary arrangement: directors retain control and manage the company and they must put together a proposal to put to creditors as an acceptable alternative to liquidation.
9.1 Financing options for small and medium sized companies
SMEs often find it difficult to raise finance to fund their business plans as they are usually unquoted and have fewer assets to be used as security. There are numerous sources of finance, such as:
- Owner financing
- Business angels
- Venture capital
- Leasing
- Debt factoring
- Bank loans
- Government grants and loans
- Green finance
- A medium sized company can issue their share on the alternative investment market. This market has no minimum market value and has fewer rules to comply with than the stock exchange.
