Chapter 4 Sources of finance Flashcards
1.1 Introduction to finance
Sources of finance for companies include stock markets, banks, bond markets, leasing, debt factoring, crowdfunding, peer-to-peer lending and government and European union grants. However capital finance can be divided into three main types:
- Equity or ordinary shares: features include dividends, full voting rights (control of company) and paid last in a winding up of the company but are entitled to all profits remaining after debt and preference shares are repaid. Equity shareholders are true owners of the company, they suffer most risk and highest return
- Preference shares: features include a fixed percentage dividend, cumulative dividend, limited right to vote at a general meeting and it is repaid before equity in a winding up of the company. They are not strictly equity, often treated as debt by companies assessing their gearing levels. Although the dividends are not tax deductible and not guaranteed and therefore have higher risk.
- Debt (loan stock or debentures): features include interest (tax deductible) must be paid irrespective of profit levels, no voting rights and is repaid first in a winding up of the company. Debt holders suffer least risk and therefore lowest return
2.2 Sources of finance
Internally generated funds: these are the profits earned by the company. Advantages are they are readily available, low cost, immediate and no change of control. The disadvantages are cash may not be available and may have an impact on the firm’s dividend policy.
Rights issues: issue of new shares for cash to existing shareholders in proportion to existing shareholdings. Usually discounted to current market price, the shareholder can take up the rights or sell them. The advantages are issue costs are lower than for a new issue, no change in control and pricing is easier than for a new issue, as no wealth is being shared with new investors. Disadvantages include shareholders being unable or unwilling to invest.
New issues: new issue of shares to investors. Advantage is finance is generally found. Disadvantages are they can have high issue costs, will reduce control of the existing shareholders and pricing is difficult (to high of a price will cause issue to fail, but too low a price and existing shareholders suffer).
Underwriting: service where for a fixed fee, an institution agrees to purchase shares not sold by the company. This provides insurance against the risk that the issue will fail.
Venture capital: provision of risk bearing capital, usually in the form of a participation in equity, to companies with high growth potential. Venture capitalists seek a high return, which is often realised through a stock market listing, and accept the high risk. They usually expect 20-49.9% of the company, often demand a position on the board, the investor provides advice and is able to influence management and much of the return is in the form of capital gains after 3-5 years. Failure to hit targets by venture capitalist leads to shares being transferred to their ownership at no additional cost. This is called an equity ratchet.
Crowdfunding: company will create a project on a crowdfunding platform and request a specific sum of investment. Investors can provide the funds in smaller amounts in exchange for either goods or services or equity. Advantages include it being a quick process, provides business awareness to attract new customers and it can be useful for start-up companies that do not have a trading history. Costs include a fee to the crowdfunding site, legal/advisory costs and admin cost of dealing with investor requests for more information.
Initial coin offering raises finance from investors, has two differences to an initial public offering. An investor receives a token, that might be for a share or an entitlement to use a product or service and payment is made in cryptocurrency. The issuer raises money by issuing a white paper. This details the venture concept and the details of the tokens that will be exchanged for cryptocurrency. This is essentially the cryptocurrency version of crowdfunding.
Two main ways shares are issued include:
- Offer for sale: company gives shares to issuing house and the shares then sold to investing public
- Direct offer or offer for subscription: company sells shares to investing public
3.1 Calculations for share issues
There are three calculations involving share issues:
- The theoretical ex-issue price: (market value of shares already in issue) + (proceeds from new share issue) + (project NPV) / number of shares in issue after the new/right issues
- The theoretical value of a right: the ex-rights price (shown above) – exercise price of the right
- Impact on wealth of shareholders looks at wealth before and after issue
The calculations assume the investor has perfect information concerning the project NPV and there are no other short-term impacts on the share price
4.1 Sources of debt
Term loans: loan from a single lender (normally bank), which has to be repaid, with interest at fixed periods including a fixed final repayment date. The advantages include arrangement fees are small compared with issue costs of loan stocks, may have either fixed or floating rates of interest and interest payments attract tax relief. The disadvantage are generally secured on company assets (either fixed or floating charges) and so may not be available if a company doesn’t have a strong balance sheet.
Loan stock (or debentures): method of borrowing small amounts from many different lenders. The company issues a loan stock certificate in return for an amount of cash. Each loan stock certificate specifies the:
- Nominal value of the loan: always £100, although the bond can be issued at a premium or discount
- Coupon rate: interest rate paid, always a percentage of the £100 nominal value
- Interest payment dates
- For redeemable debentures, the redemption value and date
The advantages are that it may be unsecured, the certificate can be sold, flexibility as they can be irredeemable or redeemable and they can be offered with either conversion rights or warrants. The disadvantages are high issue costs, often have higher interest rates than a term loan.
Convertible loan stock is a loan stock that can be converted into predetermined amounts of the company’s equity, at the discretion of the bond holder. Conversion rights may be stated in terms of a conversion ratio and conversion price. The advantages for the company include lower interest rates and potential to avoid redemption cash flow problems.
Loan stock with warrants entitle the holder to subscribe for ordinary shares in the company at a predetermined price at set future dates. The warrants are often used as a sweetener to encourage investment in debt issues.
Loan documentation: this can include representations on the legality and affordability of the loan, guarantees such as a parent company guaranteeing the loan of a subsidiary and covenants such as restrictions on taking out further debt finance or key ratios to be maintained.
Peer to peer lending connects established businesses looking to borrow with investors who want to lend. This allows a wide range of lenders to lend small parts of individual loans. Advantages to traditional bank lending include loans with lower interest rates, usually quicker to arrange and it can be more accessible especially for companies with low credit ratings.
5.1 International money markets
Larger firms can access the international financial markets. The advantages are interest rates tend to be cheaper because there is less regulation, access to a wider market of investors and where investment in a foreign country is required, borrowing in the same currency tends to protect against exchange rate movements. The disadvantages are unless you are borrowing substantial sums, issue costs can be high and when the loan needs to be repaid, exchange rates might have moved adversely.
A foreign currency loan is called a eurocurrency loan. If it was a loan in dollars, it would be called a Eurodollar loan. A bond issues in any foreign currency is called a Eurobond. A line of foreign currency credit from an international bank is known as eurocredit. A loan note in another currency is called a Euronote.
6.1 Green finance
Financing of investments or companies that provide environmental benefits. Companies which do not consider sustainability may face increasing costs of finance, restrictions in availability of finance and even a potential damage to their reputation. The UK government’s green financing strategy aims to integrate environmental factors into mainstream decision making, so that it is an organisation-wide approach. Methods of financing green include:
- Green loans: loans provided to finance green projects. They can be government backed and provide better terms than a traditional loan. All projects should provide clear environmental benefits, which should be quantified, measured and reported by the borrower
- Sustainability linked loans: have an in-build pricing mechanism. This allows the loan to be cheaper if the borrower achieves certain sustainable related targets.
- Green bonds: type of fixed interest bond to raise money for climate and environmental projects. These are secured, have the same credit rating as a company’s other debt and may come with tax incentives
- Green funds: stock markets provide an index of firms that satisfy social and environmental criteria. This helps investors target investments in companies with higher standards of behaviour
7.1 Capital market efficiency
In an efficient market, new information is rapidly incorporated into share prices. An efficient stock market is needed to ensure investor confidence and reflect performance and prospects in the share price. There are three forms of efficiency based on different theories about where this new information comes from:
- Weak: past share price movements
- Semi strong: all public information
- Strong: all information
7.2 Strong form efficiency
Share price at all times incorporates all information that exists about a company. The share price instantly moves upon an event; therefore, it is impossible to beat the market even by insider trading. However, share prices do not instantly react to new events and it is possible to insider trade. The stock exchange encourages quick release of new information to prevent insider trading opportunities.
7.3 Semi strong form efficiency
The share price incorporates all information made public about a company, the moment the event is made public, the share price moves to incorporate the event. It is possible to beat the market consistently by insider trading and by analysing new public information about the company. The market tends to be this and in general share prices react to events within 5-10 mins of any public information.
7.4 Weak form efficiency
When a n event happens the share price doesn’t react instantly. However, all information about price movements are at all times incorporated into the share price. If the market was weak, it would be possible to consistently beat the market by insider trading or analysing new public information, it would be impossible to beat the market consistently simply by charting past share price movements (known as Chartism) and share prices would follow a random walk with no trends.
7.5 Behavioural finance
Behavioural factors can cause inefficiency in a market. This has been used to question the validity of the efficient market model.
- Overconfidence and miscalculation of probability: investors overestimate their abilities and the accuracy of their forecasts. It has also been shown that they tend to overestimate the likelihood of unusual events and underestimate the likelihood of common ones
- Conservatism and cognitive dissonance: investors tend to be conservative and resistant to changing their minds. They continue with a long-held belief even in the face of significant evidence to the contrary.
- Availability bias and narrow framing: investors pay attention to one particular factor more than they should simply because it is prominent in their minds. This leads to overreliance on one factor or observation rather than a broad view
- Representativeness and extrapolative expectation: investors have a tendency to assume that history will repeat itself. They also have a tendency to buy shares if their prices have risen and sell them after their prices have fallen.
