Chapter 7 - Business Finance Flashcards
What are the two ways a business is financed by
Equity and Debt
What is the key difference between the levels of risk between Equity and Debt
- Debt Holders have lower risks and lower returns
- Equity Holders - Face higher risks and higher returns in the form of profits distributed as dividends
What is liquidity?
Being able to pay debts as they fall due
Profitability
Minimising the holding of cash - an idle asset
What are the costs of holding cash
Lost interest on deposits or other investments
What are the influences on the level of cash balances
- Transaction motive
- Precautionary motive
- Investment motive
- Finance motive
What is transaction motive
Meet current day to day financial obligations
What is a precautionary motive
Cushion against unplanned expenditure
What is a investment motive
Take advantage of opportunities
What is a finance motive
Cover major transactions
What are the costs of running out of cash (treasury)
- Loss of settlement discounts
- Loss of supplier goodwill
- Poor industrial relations if wages are not paid
- Winding up of business, liquidation
Why does a business require financing for short term operational needs?
Paying for goods, services and wages as they full due
Why does a business require financing for longer term operational needs?
Purchase of non-current asset for ongoing use in the business and finance growth which involves in the medium term: increasing inventory and receivable levels
What is the classic rule for short term financing
Need to be financed by short term funds -> Working capital (balance of inventories, payables, receivables, cash) and overdrafts.
What is the classic rule for long term financing
Assets should be financed by long term funds, debt and equity.
What are the advantage of short term financing
> Relatively cheap - Shorter period of risk exposure for lenders. [Trade payables are interest free. Unsecured overdrafts are expensive]
> Flexible - Bank overdraft, only when needed
What are the disadvantages of short term financing?
> Renewal Risk - Overdraft may be recalled on demand at the lenders discretion
> Interest rate risk - Short term interest rates can fluctuate.
What are the advantages and disadvantages of long term financing?
> More expensive due to higher risk of uncertainty.
Equity finance will expect high returns due to risk of business failures
Debt finance (money lent from banks) will be expensive for long-term loans
What is aggressive financing
Business use more short term finance over debt and equity; offers greater profitability as it is cheaper but greater risk
What is defensive financing?
Risk averse and will use a portion of long term finance for its short term needs. Carries less risk but more expensive
What is average financing?
Middle of both aggressive and defensive for a medium between the risk and reward in financing approach
What is a financial intermediary?
E.g. Bank
> Bring together investors/lenders with borrowers/users of funds
> Mirror real world by providing relatively risk-free lending environment and easily accessible funds
What is a role of the financial intermediary
> Risk diversification
Aggregation
Maturity transformation
Making a market
Advice
[Financial intermediary] What is risk diversification?
one lender not lending all money to one borrower
[Financial intermediary]
What is aggregation
Pooling lots of deposits together to get better returns
[Financial intermediary]
What is maturity transformation?
Loans and deposits mature at different times
[Financial intermediary]
What is making a market?
Putting lenders and borrowers “in touch”
[Financial intermediary]
What is advice?
Advice on the best rates for example
What are the three types of banks?
- Retail banks
- Commercial and investment banks
- Bank of England
What is a retail bank?
Banks which deal with day to day transmissions e.g. clearing banks like barclays natwest and lloyds
What is a commercial and investment bank?
Offer tailored advice to large commercial clients usually in raising considerable sums e.g. merchant banks like LCF Rothschild.
What is the bank of england?
Acts as a banker to bank by lending money to the banking sector through its financial operations
What is the role of the bank of england?
- Carry out monetary policy
- Ensuring financial stability
What is the monetary policy of the bank of england?
> Lends money to the banking sector at the base rate which is set by the monetary policy committee
> Banks then lend and borrow money amongst themselves at rates such as the sterling overnight index average which affects the rates offered to customers
How does Bank of England enable financial stability?
- BoE Financial Policy Committee (FPC) is responsible for taking action to remove systematic risks in the UK financial system
- The Prudential Regulation Authority (PRA) is part of the bank of england and is responsible for prudent regulation and supervision of banks, building societies, credit unions, insurers and major investment firms
What is the Financial Conduct Authority? (FCA)
FCA firms are not supervised by the PRA but regulated by the FCA which is independent and responsible for
- Promoting effective competition
- Ensuring that relevant markets function well
What are the 8 cash transmission mechanisms?
FEDS PCBG
- Faster Payments Scheme
- Electronic Fund Transfers (EFT)
- Bank Automated Clearing Systems (BACS)
- Clearing house Automated Payments Systems (CHAPS)
- Societies for worldwide interbank financial telecommunication (SWIFT)
- Payments gateways
- Digital Commerce Platforms
- General Clearing
What is the Faster Payment Schemes?
Same day clearing for amounts < 250k, for some customers of some banks, using phone or internet instruction
What is the Electronic Fund Transfer (ETF)
Computer based system used to transfer money electronically
What are bank automated clearing systems (BACS)
A type of EFT that deals with salaries, and direct debits. Same day clearing in the UK GBP
What is the society for worldwide interbank financial telecommunication (SWIFT)
Similar to CHAPS used for international transfers
What is a payment gateway?
System for payment authorisation when using credit cards online
What is the digital commerce platform?
E.g. Paypal
Payments made using just e-mail address
What is General clearing in terms of Cash transmission mechanisms?
Mainly Cheques -ve = short delay to clear the funds
What is the relationship between a Bank and a customer called?
A fiduciary relationship
What does it mean by a bank has a fiduciary relationship
They are expected to act in good faith in relationship with their customer
What are the four types of contractual arrangements between the bank and the customer
> Mortgator/ Mortgagee - bank has right to asset if customer defaults on loan
> Principle/agent - Bank acts as an agent for the customer e.g. paying a third party sum
> Bailor/Bailee - Safeguard property e.g. title deeds as collateral on mortgage
> Receivable/payable - Contractually owe each other dependent on whether overdrawn or in credit
What are the two types of financial markets?
Money Market
Captial Market
What is a money market?
Term that covers many markets buying and selling different forms of money or marketable securities
The money market provides short term <1 year borrowing and investing to companies, banks and the public sector
What is the capital market?
> National and intentionally market in which a business may obtain the finance it needs for its short-term and long-term plans
> The capital market deal in longer term borrowing and investing mainly through the stock exchange.
> UK London Stock Exchange and Alternative Market AIM
What are marketable securities?
Short term highly liquid investments that are readily convertible into cash
What are the types of marketable securities? (6)
- Treasury Bills
- Deposits
- Certificates of deposits (CDs)
- Gilts
- Bonds
- Commercial papers
What are treasury bills?
- Issued by bank of England on behalf of the government
- Minimum investment is £500,000, last up to a maximum of 12 months, very secure but low returns
What are deposits?
Usually placed in accounts with banks for periods from overnight to five years. Yields usually higher than treasury bills
What are Certificates or deposits (CDs)
Issued for deposits of £50,000 or more for a fixed term. They can be traded in the CD market
What are gilts?
Offer a range of maturities and rates based on money market rates
What are bonds
Debentures and loan stock of companies quoted on the stock exchange
What are commercial papers
IOUs issued by large companies which can be held to maturity or sold to third parties beforehand
How can a business access finance? (6)
- National stock markets
- Banking System
- Bond Markets
- Leasing
- Debt factoring
- International markets
How can the National Stock market help a business access finance
In the UK this includes LSE and Alternative Investment Market:
- Primary Markets > Via new share issues
- Secondary markets > Shares that are already in issue
How can the Banking system help a business access finance
- Retail market - for small businesses/ individuals
- Wholesale market (for large companies)
How can Leasing help a business access finance
Important source of business finance
How can debt factoring help a business access finance?
Used by small businesses to help finance their working capital requirements
How can the international markets help a business access finance
Typically available to larger companies, allow finance to be raised in different currencies in large amounts
What are the three types of market instruments?
- Equity
- Preference shares
- Loan stocks and debenture
What is equity in relation to capital market instruments
Ordinary shares in the business
Equity shareholders are the owners of the business and exercise ultimate control
What is preference shares in relation to capital market instruments
Entitled to dividends before ordinary shareholders, therefore they carry less risk
Usually receive a fixed percentage dividend
What are Loan Stocks and debentures in relation to capital market instruments
Typically receive a fixed rate of interest.
Usually secured on specific assets such that lenders are protected in liquidation
What are the three main ways a business can raise equity finance?
- Retained earnings
- Rights issue of shares
- New issue of sharesW
What are retained earnings and why are they important?
Internally generated funds that are easy and important
> Profits can be paid out in the form of dividends or reinvested in the business
Shareholders expect a return on the funds re-invested in the business (i.e. an increase in their wealth)
> Profits which are re-invested in the business may lead to business growth and a resulting increase in share pric
What are rights issue of shares?
Issue of new shares to existing shareholders in proportion to their holdings
> Legally rights issue must be made before new issues to public (unless share holders agree otherwise)
> Existing shareholders have rights of first refusal (pre-emption rights) on new shares
> Rights can also be waived by selling to others
What are factors to be considered when making a rights issue?
> Issue cost - Estimation of 4% on 2m raised but many costs are fixed so percentage falls as the sum raised increases
> Shareholder’s reactions - may react badly if forced to either give up rights or sell them.
> Control - Unless large number of existing shareholders sell their rights to new shareholders there is little impact on control
> Unlisted companies - often find rights issue difficult to use, as shareholders may not have sufficient funds to take up their rights but are not able to sell
What are new issue of shares?
Issue of new shares when the company is listed on the stock market or listing for the first time
> Expensive
Time consuming
How are new issue of shares issued?
Placing
Public Offer
What is placings in relation to new issue of shares
- Share sold to an issuing house (investment bank)
- Issuing house places shares with its clients i.e. selling the shares
Investors are made up of institutional investors
What are the benefits and disadvantages of Placings?
Lower transaction costs (e.g. admin, advertisement) than public offers
Disadvantage: Can only offer to small pool of institutional investors which reduces efficiency of the market shares
What are the two ways a public offer can take place?
- Offer for sale
- Direct offer or Offer for subscription
What is an offer for sale?
- Shares sold to an issuing house (investment bank)
- Issuing house offers shares to general public
What is a direct offer or offer for subscription
Shares direct to general public
What happens if the pricing of shares is too high?
Issue fails
What happens if the pricing of shares is too low?
Too many shares are issued
How can the pricing of new shares be managed?
- Underwriting the issue
- Using an offer for sale by tender
What does it mean by underwriting?
Involves an institution or group of institutions agreeing to purchase any securities not sold to public in exchange of a fixed fee (1-2% of total finance raised)
Disadvantage - Cost is still payable even if underwriter does not have to invest
How can pricing of new share issues be managed by using an offer for sale by tender?
Investing public is invited to tender (offer) shares at the price that is is willing to pay.
A minimum price is set by the issuing company and tenders must be above the minimum
What is the procedure for an offer for sale by tender?
> Receive all tenders
The shares are issued at one price. Investors who tendered at higher prices pay less than the amount tendered
What are preference shares?
Preference shares have no voting rights and no rights to share in excess profits
What are the advantages and disadvantages of preference shares?
Advantage: Attractive if looking to raise new capital without additional debt or dilute the ordinary shareholders’ influence.
Disadvantage: Preference shares offer a fixed rate of dividend each year. Most preference shares are cumulative so all arrears have to be paid before equity dividends can be paid before equity dividends can be paid.
What does it mean by going public?
Successful large company may decide to go public or ‘float’ on the official list of the Stock Exchange
What are the advantages of going public?
> Access to larger source of finance
Improves marketability of shares -> Increase the value of the company
Raises the profile of the company
What are the disadvantages of going public?
- Cost - can be expensive
- Dilution of control (at least 25% of shares must be public)
- Need to have traded for three years
- Having to answer to other investors - often professional institutional investors
- Greater scrutiny of the affairs of the company and the actions of the directors
- Listing might not be successful unless the business is worth at least 50mil
- Possibility of being taken over
- Extra costs of control and reporting systems to meet the increased demands on the company due to listing rules
Who is involved with the process of a business going public.
- Company Sells Shares to Raise Capital
- A sponsor: Usually an investment bank, stock broker or accountant
> Assesses whether flotation is appropriate
> Helps draft prospectus
> Co-ordinates all advisors
> Prices and underwrites the issues - Corporate Broker (can be the same as sponsor)
> Advises on market conditions and likely demand
> Generates interest with investors
> Help with issue method and pricing
> May organise sub-underwriting - Solicitors
> Deal with legal aspects - Registrars
> Record ownership of shares - Investing public
- Accountant
> Involved in long-form report (financial controls, track, record, financing and forecasting)
What are the sources of debt finance?
- Overdraft
- Debt Factoring
- Term loans
- Loan Stock
- Leasing
What is an overdraft?
Short-term loan from the bank and repayable on demand.
Used by business to meet short-term cash deficits
What are the advantages of having an overdraft?
> Flexibility - Can be used and repaid as desired
Cost - Overall interest cost can be lower as interest is only paid when overdrawn
What are the disadvantages of having an overdraft?
> Risk - As it is repayable on demand it is not suitable as a long-term source of capital, since banks can and do demand immediate repayment
> Cost - If permanently overdrawn, the overall interest cost is higher as the interest rates are generally higher
> Control - The bank may require security on assets of the business
What is debt factoring?
- When the business receives loan finance and insurance (known as non-recourse factoring), so that in the event a customer does not pay the business does not have to repay the loan
- Service typically offered by a debt factor include
> Financing the credit taken by customers
> Insuring receivables
> Managing the running of the receivables lodgers
What are term loans?
Term loan is usually a bank loan where the repayment date is set at the time of borrowing. They are not repayable on demand unless the borrower defaults on repayments
> Interest rates can be fixed or variable
Relatively small arrangement fees payable on loans
Term Loans are usually secured against assets
Repayment schedules are flexible interest “holidays” of up to two years can be negotiated to allow new ventures to become established before loan repayment are made.
What is a loan stock?
Debt capital (called bonds or debentures) in the form of securities issued by companies, the government and local authorities
[Loan Stock] What is a coupon (interest) rate
Annual interest is the coupon rate x the nominal value of the stock
Can be fixed rate or variable rate
[Loan Stock] What is the redemption value
> A £100,000 loan can be repaid at par (£100,000) or with a premium e.g. £105,000 or discount e.g. £95,000
> If repaid at premium, investors will find the stock more attractive and will be happier to accept a lower or zero coupon rate –> eases company’s cash flow.
[Loan Stock] Redemption date
- Loan stocks are normally medium to long-term
- Some bonds are undated (perpetual or irredeemable)
- On undated bonds, must sell the loan stock to get capital back.
[Loan Stock] What is a recipient
- UK domestic bonds issued on the stock exchange, the bond holder’s name is recorded on a register
- Some bonds e.g. eurobonds are “bearer” bonds. The holder of the bond will receive the payments due.
What is a finance leasing?
A finance lease is a lease that transfers substantially all the risk and rewards of ownership of an asset from the lessor (the finance company or bank) to the lessee (the business)
What are the five differences between Finance lease and operating leases?
- Finance: Long term
Operating: Short term - Finance: One lease for majority of assets life
Operating: Period > than assets useful life - Finance: Ownership passes to lessee or secondary lease period at very low rent
Operating: Ownership remains with the lessor - Finance: Lessee takes on risks and rewards of ownership
Operating: Lessor responsible for repairs and maintenance - Finance: Lease cannot be cancelled or early cancellation charges mean the lessee effectively has liability for all payments
Operating: Lease can sometimes be cancelled
What are business angels?
Experienced, wealthy individuals investing in start-ups, early stage or expanding businesses
What are crowdfunds
Funding a new business or a new project for an existing business by raising a specific sum of money from individuals
> Individuals contribute money as loans, equity or donations
Or they can pre-buy a product or service that has not yet been launched
Peer-to-peer lending and equity-based investment are the largest sectors of crowdfunding and are regulated by the FCA
Other forms of crowdfunding are still largely unregulated
What are venture capitalists?
Risk-bearer capital, usually in the form of in equity to companies with high growth potential
What are the properties of Venture Capitalists?
High risk but high returns (20-40%).
> It tends to be a medium source of finance
Investor provides advice and can influence management
Much of the returns is in the form of capital gains after 3-5 years
What are the exit routes of a venture capitalists?
Trade sale - The VC’s shares, or whole company is sold to another company
- Flotation
- Buy-back of shares on re-financing
What is the Alternative investment market?
Less stringent regulations than the full stock exchange and available to companies with values of at least 1m
What are the types of trading risks?
- Physical risks - goods being lost or stolen in transit
- Trade risk - the customer refusing to accept goods on receipt or cancellation of order in transit
- Credit risks - default by the customer
- Liquidity - inability to finance the credit given to customers
These risks can be reduced by banks, insurance companies, credit reference agencies, government agencies such as UK export credits guarantee department (ECGD)
What is the bill of exchange?
Document drawn up by the exporter (seller) and sent to the overseas buyer’s bank.
The bank accepts the obligation to pay the bill by signing it and therefore payment is guaranteed. The seller can discount the bill to a third party for cash
What are letters of credit?
Letters of credit provides a method of payments in international trade which is risk free
Arrangement between exporter and the buyer, the buyer and participating banks must take place before export sale does
The exporter receives immediate payment of the amount due, less discount from bank
Buyer is able to get period of credit before having to pay for the imports
What are the disadvantages of a letter of credit?
> Slow to arrange
Administratively hard
What are export credit insurance?
Insurance against the risk of non-payment by foreign customers for export debts
Some private companies provide credit insurance for short-term export credit business, and the UK government’s Export Credit Guarantee Department (ECGD) provides long-term guarantees to banks on behalf of exporters
What is green finance?
Source of finance that is used specifically to finance project or activities that lead to envrionmental bonds
What is an example of green finance?
Green bonds, green loans, grants and ventures capital funds that specialise in green projects
What are green bonds?
Any type of bond investment where the proceeds will be exclusively applied to eligible green projects which aligned with the four core components of GBP
What are the principles of green bonds
> Proceeds must only be used for principle with clear environmental benefits
Must be a defined process for project evaluation and selection
Proceeds must be kept in a separate account (or tracked by issuer)
Use of proceeds should be reported
What is a green finance institute? (GFI)
Industry-led green finance taskforce
