Chapter 7 - Business Finance

Question 1

What are the two main ways a business is financed?

Answer 1

By equity (from its owners in return for dividends) and/or by debt (from lenders in return for interest). e.g. bank loans, higher purchase for assets), loan stocks, debentures

Question 2

What distinguishes the different forms of equity and debt financing?

Answer 2

Their different levels of risk.

Question 3

What are the characteristics of debt holders? 4

Answer 3

Debt holders face lower risk but lower returns.
They receive interest before equity holders receive dividends, debt is often secured by fixed or floating charges, and in the event of company failure,
debt holders rank higher than equity holders to receive their capital back.
However, they receive a lower rate of return on their capital.

Question 4

What are the characteristics of equity holders?

Answer 4

Equity holders face higher risk but can enjoy higher returns.
They suffer the downside of any loss but any profits after (interest and tax) go to the equity holders, not the debt holders.

Question 5

Define risk-return trade-off

Answer 5

The risk/return trade-off is the relationship between the amount of risk taken and the potential return on an investment. In simple terms, it implies that investors expect higher returns for taking on more risk. If an investment is riskier, investors would expect a higher return as compensation. Therefore, in structuring its finances, a company must have regard to the risk-return trade-off desired by potential investors.

Question 6

What must a company consider when structuring its finances?

Answer 6

A company must have regard to the risk-return trade-off desired by potential investors.

Question 7

What are examples of immediate financial needs for a business?

Answer 7

Immediate financial needs include paying wages and payables.

Question 8

What are the long-term financial needs of a business?

Answer 8

Long-term (defensive) financial needs include funding increases in inventory and receivables as the business grows, as well as funding non-current assets.

Question 9

How is financing current assets typically structured?

Answer 9

Businesses commonly use long-term (defensive) finance for non-current assets and permanent current assets, and short-term (aggressive) finance for fluctuating current assets.

Question 10

What options do firms have when structuring their finances for current assets?

Answer 10

Firms can choose more long-term (defensive) or short-term (aggressive) finance structures.

Question 11

Why is short-term finance usually cheaper than long-term finance?

Answer 11

Short-term finance is cheaper because lenders take on lower risks over the short-term.

Question 12

When can short-term interest rates be higher than long-term rates?

Answer 12

Short-term interest rates can be higher if rates are expected to fall over the period. This is occassionally not the standard

Question 13

What is an advantage of the flexibility of short-term finance?

Answer 13

The flexibility of short-term finance may reduce overall costs, as long-term finance is less easy to repay early.

Question 14

What is a risk associated with short-term finance such as payables?

Answer 14

Making payments late to suppliers can cause potential damage despite the low cost of short-term finance.

Question 15

What risks are associated with borrowing short-term finance? 2

Answer 15

The risks include renewal risk and interest rate risk.

Question 16

Renewal risk

Answer 16

The risk that the loan is recalled in at the end of the term and is not refinanced. Renewal risk is the probability that a customer will not renew their contract or subscription with your business. It can have a significant impact on your revenue, retention, and growth. Therefore, it is essential to identify and mitigate renewal risk as early and effectively as possible.

Question 17

Interest rate risk

Answer 17

The risk that between borrowing terms that interest rate changes.

Question 18

What factors influence the decision between short-term and long-term finance?

Answer 18

The decision depends on the risk appetite and the perceived risk/return trade-off of the business.

Question 19

What is the financial position of aggressive companies?

Answer 19

Aggressive companies have more short-term credit than equity, offering higher profits but at greater risk.

Question 20

What is the financial position of average companies?

Answer 20

Average companies match maturities to have less risk than aggressive companies but also lower returns.

Question 21

What is the financial position of defensive companies?

Answer 21

Defensive companies prioritize liquidity over profitability, using little short-term credit to finance fluctuating current assets, resulting in low risk and low returns.

Question 22

Saying Revenue is ….. Profit is …….. Cash is ……..

Answer 22

Revenue is vanity, Profit is sanity and Cash is reality

Question 23

What is the cost of holding cash for a business?

Answer 23

The cost of holding cash is the opportunity cost of what else could be done with the money.

Question 24

What are the costs of running out of cash for a business?

Answer 24

Costs include loss of settlement discounts, loss of supplier goodwill, delayed wage payments leading to poor industrial relations, and payables petitioning to wind up the business.

Question 25

What are the motives that influence the level of cash balances in a business? 4

Answer 25

The motives include transactions motive - meet day to day obligations finance motive - pay big bills e.g. tax precautionary motive - e.g. rainy day investment motive/speculative motive - make cash work in the business

Question 26

If we have surplus cash what can we do? 5

Answer 26

Offer customer discounts Start a price war Payment to shareholders (dividends) Settle debts Make acquisitions

Question 27

What should a business do if it identifies a short-term surplus of cash?

Answer 27

It should aim to invest the surplus cash to earn a return.

Question 28

How should a business handle surplus funds in the longer term?

Answer 28

The use of funds will differ significantly in the long term compared to the short term, often involving more strategic investments.

Question 29

What is financial intermediation?

Answer 29

Financial intermediation is the process where banks take deposits from customers and use that money to lend to other customers.

Question 30

What are the benefits of financial intermediation? 4

Answer 30

Benefits include: combining small amounts to provide larger loan packages, transferring short-term savings into long-term loans, allowing companies to approach banks directly for loans, and reducing risk by not tying up an individual's savings with one borrower.

Question 31

How does financial intermediation reduce risk?

Answer 31

Risk is reduced as an individual's savings are not tied up with one individual borrower directly.

Question 32

Why is financial intermediation useful for companies seeking loans?

Answer 32

Companies can approach banks directly rather than finding individuals to lend to them.

Question 33

What are primary banks and what services do they provide?

Answer 33

Primary banks operate cheque accounts, deal with cheque clearing, and provide internet banking services. They are also known as commercial, retail, or clearing banks.

Question 34

What are secondary banks and how do they differ from primary banks?

Answer 34

Secondary banks are a wide range of merchant banks that do not take part in the clearing system. Range large corporate finance.

Question 35

What are the two main roles of the Bank of England in the UK?

Answer 35

The Bank of England carries out monetary policy and ensures financial stability.

Question 36

What is the role of the Monetary Policy Committee (MPC) of the Bank of England?

Answer 36

The MPC sets the base rate to meet the inflation target set by the Chancellor of the Exchequer and serves as a banker to other banks.

Question 37

What is the role of the Financial Policy Committee (FPC) of the Bank of England?

Answer 37

The FPC ensures financial stability by removing systemic risks in the UK financial system, such as reducing banks' reliance on wholesale money markets.

Question 38

Financial Services Authority

Answer 38

They 1. Regulates banks themselves and 2. financial conduct authority which looks at financial markets

Question 39

What determines the interval between when amounts are paid into a bank and when they can be drawn upon?

Answer 39

The interval depends on the clearing mechanism used.

Question 40

What are some examples of clearing mechanisms?

Answer 40

Examples include general clearing, Electronic Funds Transfer (EFT) using EFTPOS, Banks Automated Clearing System (BACS), Clearing House Automated Payment System (CHAPS), Society for Worldwide Interbank Financial Telecommunication (SWIFT), payment gateways, and digital commerce platforms.

Question 41

What is general clearing?

Answer 41

Mainly checks - clears within 3 days

Question 42

Electronic Funds Transfer (EFT) using EFTPOS

Answer 42

Electronic Funds Transfer (EFT) using EFTPOS (POS = Point of sale) VISA Mastercard, Amex

Question 43

Banks Automated Clearing System (BACS)

Answer 43

3 day turnaround. 1968, Pay people in bulk e.g. salaries, batch payments, drect debits

Question 44

Clearing House Automated Payment System (CHAPS)

Answer 44

Same day system. 1984

Question 45

Society for Worldwide Interbank Financial Telecommunication (SWIFT)

Answer 45

International same day system

Question 46

Payment gateways, and digital commerce platforms.

Answer 46

Internet trade e.g. world pay. To take payment via their websites

Question 47

What are the four types of bank/customer contractual relationships?

Answer 47

The four types are Debtor/creditor e.g. saver is the CR of the bank Bailor/bailee - bank must take reasonable care of your deposits Principal/agent - issue instructions to bank to do things Mortgagor/mortgagee relationship - security on assets

Question 48

What is the fiduciary relationship between a bank and a customer?

Answer 48

A fiduciary relationship means the bank, as the party with more relative power, is expected to act in good faith in its relationship with the customer.

Question 49

What are the duties of a bank as part of its fiduciary relationship with a customer? 5

Answer 49

The duties include: - Honouring a customer's cheques if correctly made out and sufficient funds are available. - Crediting cash/cheques paid into the customer's account. - Complying with customer instructions given by direct debit or standing order. - Respecting the confidentiality of the customer's affairs. - Providing reasonable notice before closing a customer's account.

Question 50

Types of money markets for national stock exchange 2

Answer 50

The money markets are a vast array of markets that buy and sell different forms of money or marketable securities. They allow financial institutions to manage short-term fluctuations in their assets and liabilities.

Question 51

What are marketable securities?

Answer 51

Marketable securities are short-term, highly liquid investments that are readily convertible into cash.

Question 52

What are the main types of financial instruments traded in the money markets? 6

Answer 52

The main types are: - Treasury bills - worth 500k in UK. Issued by treasury. Deemed to be the most secure form of investment - Deposits - fixed term investments ffered by banks - Certificates of deposit (CDs) - Gilts (longer-term government debt) - long term gov debts last between 5 to 50 years bearing amount of interest - Bonds - Loans of quoted companies, tradeable, rates at issue can fluctuate as interest rate changes - Commercial paper - IOUs for companies, they are tradeable

Question 53

What is the capital market?

Answer 53

The capital market is the national and international market where a business can obtain finance for its short-term and long-term plans.

Question 54

What are the different ways businesses can access finance in the capital market? 6

Answer 54

1. National stock exchange (Primary markets for new finance and Secondary markets for securities already issued). 2. The banking system (retail and wholesale markets). 3. Bond markets (for large organizations to raise substantial amounts). - form of debt finance 4. Leasing (important for various entities). 5. Debt factoring (used by smaller businesses for working capital). Through the sale of their recievables ledger. 6. International markets (larger companies finance in different currencies).

Question 55

Types of money markets for national stock exchange 2

Answer 55

For companies in the UK this includes the Main Market and the AIM (alternative investment market) of the London Stock Exchange.  Primary markets – source of new finance e.g. new share issue  Secondary markets – for securities that are already in issue

Question 56

What is the difference between primary and secondary markets in the national stock exchange?

Answer 56

Primary markets are the source of new finance (e.g., new share issues), while secondary markets deal with securities that are already in issue.

Question 57

What is equity in the context of business finance?

Answer 57

Equity represents ordinary shares in the business, making shareholders the owners who exercise ultimate control through voting rights. Right to dividends and right to share of assest on winding up (if anything is left)

Question 58

What are preference shares and how do they differ from ordinary shares?

Answer 58

Preference shares are part of the risk-bearing ownership but carry less risk than ordinary shares. They entitle holders to dividends before ordinary shareholders, typically at a fixed maximum rate, making them similar to debt.

Question 59

What are loan stocks and debentures?

Answer 59

Loan stocks and debentures are fixed interest rate borrowings with a set repayment date. They are often secured on specific or general assets, providing lenders protection above unsecured creditors in liquidation.

Question 60

What are retained earnings in the context of equity finance? 2

Answer 60

Retained earnings are the profits earned by a business that can either be 1. paid out to owners as dividends or 2. reinvested in the business. They are the most important source of equity in the real world.

Question 61

What is a rights issue of shares?

Answer 61

A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings. Shareholders in private and public companies have pre-emption rights to maintain their percentage holdings, but they can waive these rights by selling them to others.

Question 62

What factors should be considered when making a rights issue? 4

Answer 62

Factors include issue costs - administration % per £Million shareholder reactions - dilution control and whether the company is unlisted.

Question 63

What are the two main avenues for issuing new equity?

Answer 63

1. Placings: Fresh shares are offered to institutional investors (e.g. pension and insurance companies) first, then sold to the public on the secondary market. 2. Public offers: Shares are sold directly to the public through either offers for sale (via an issuing house e.g. investment bank which then sells shares to the public) or direct offers (no intermediary) sold direct to public.

Question 64

Define what offers for sales mean in public offers

Answer 64

1. Placings: Fresh shares are offered to institutional investors (e.g. pension and insurance companies) first, then sold to the public on the secondary market.

Question 65

Define what offers for sales mean in direct offers

Answer 65

2. Public offers: Shares are sold directly to the public through either offers for sale (via an issuing house e.g. investment bank which then sells shares to the public) or direct offers (no intermediary) sold direct to public.

Question 66

What are preference shares 1 and their benefits 2 and drawbacks 1?

Answer 66

Preference shares usually carry no voting rights and no right to share in excess profits. Fixed rate dividend. Benefits: Avoid creating extra debt, don't dilute current shareholders' holdings. Drawbacks: Fixed-rate dividends must be paid and are not optional. Can be cummulative prefercne shares where they can be paid year after, for two years worth of dividends

Question 67

What advantages and drawbacks to a company with regards to gaining a full listing?

Answer 67

Listing is the process of a private company making its shares available for trading to the public on a recognised stock exchange. Public to private company. Shareholders sell their shares at market rate (pay day). Company may raise finance in the process through the issue of new shares. Advantages  Gives access to a large source of finance  Improves the marketability of shares, which should increase the value of the company  Improves the standing of the company, as it will be under more scrutiny once listed, so raising more finance may then be easier Disadvantages/problems  Cost: costs run into hundreds of thousands of pounds even for modest issues  Dilution of control (at least 25% of the company has to be in public hands)  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 £50m (often referred to as market sentiment)  Possibility of being taken over  Extra costs of control and reporting systems to meet the increased demands on the company. A listing agreement commits directors to certain levels of compliance, of reporting to shareholders and of corporate governance

Question 68

What is an overdraft?

Answer 68

An overdraft is a short-term loan of variable amount up to a limit from a bank, typically repayable on demand. Interest is charged on a day-to-day basis at a variable rate.

Question 69

Can you think of advantages 2 and drawbacks 3 of using an overdraft as a longer-term funding solution?

Answer 69

Advantages of an overdraft * Flexibility: an overdraft can be used and repaid as desired, giving the borrower * Cost: overall interest cost can be lower than a term loan, as interest is only paid when overdrawn Disadvantages of an overdraft * Risk: as it is repayable on demand it is not strictly suitable as a long-term source of capital, since banks can – and do – demand immediate repayment * Cost: if the account is permanently in overdraft, the overall interest cost is higher than with a term loan as the interest rate is generally higher * Control: the bank may require security on assets of the business

Question 70

What is debt factoring?

Answer 70

Debt factoring is when a business receives loan finance and insurance (non-recourse factoring) such that, if a customer does not pay, the business does not have to repay the loan. Loan made against recievables ledger. Good as instant cash. Bad as can be aggressive in credit collection which can upset customer

Question 71

What is a term loan?

Answer 71

A term loan is a loan with a repayment date set at the time of borrowing, typically from a bank. It is not repayable on demand unless the borrower defaults on repayment.

Question 72

What is loan stock?

Answer 72

Loan stock refers to debt capital in the form of securities issued by companies, governments, or local authorities. They are also known as bonds or debentures.

Question 73

What is leasing, and what are its types? 2

Answer 73

Leasing is a source of finance commonly used for vehicles, office, and production equipment. Types include: - Finance lease: Transfers risks and rewards of ownership from lessor to lessee. - Operating lease: Any lease other than a finance lease.

Question 74

What are other forms of debt finance? 3

Answer 74

Other forms include 1. money market borrowing - can borrow money from the market 2. securitisation (asset-backed borrowing) - long term secure loan set against a particular asset 3. public sector grants and loans - usually cash for gov usually have strings attached e.g. making sure a certain no of people are employed as a result of taking the grant

Question 75

What are the likely characteristics of small but growing businesses that create financing problems? 3

Answer 75

Management A lack of knowledge about the possible sources of finance available, and a potential lack of financial acumen, may compound the inherent problems facing a small business. Inability to present a financial argument. History Businesses in their early stages of development are small. Such businesses lack any convincing trading history upon which potential investors can rely, making them unattractive investments. Credit score Size A small business will lack assets to offer as security. It will also have less diversity of products and markets to spread risk, and the small scale of business will not generate reliable cash flows, all of which preclude investment finance

Question 76

What are the sources of finance mentioned? 4

Answer 76

The sources of finance include 1. Business Angels - experienced people with money seeking an investment 2. Venture Capitalists - high risk, high return investors. Often provide a lot of capital 3. Alternative Investment Market (AIM) - floatation of a private business into a plc. Can issue primary market and issue new share capital and raise finance that way 4. Crowdfunding - raise finance from the public, uses an intermediary (e.g. crowd funding website), can take form of loans, donations, pre-purchase. May be incentives for people to take this up.

Question 77

What are the types of trading risks in exporting? 4

Answer 77

Types of trading risks include: - Physical risk: Loss or theft of goods in transit, or loss of accompanying documents. - Credit risk: Possibility of customer payment default. - Trade risk: Customer refusal to accept goods or order cancellation in transit. - Liquidity risk: Inability to finance the credit given to customers.

Question 78

Define trade risk in relation to exporting

Answer 78

Trade risk: Customer refusal to accept goods or order cancellation in transit.

Question 79

Define liquidity risk in relation to exporting

Answer 79

liquidity risk: Inability to finance the credit given to customers.

Question 80

How can trading risks in exporting be reduced? 4

Answer 80

Trading risks can be reduced using banks, insurance companies, credit reference agencies, and government agencies such as the UK's Export Credits Guarantee Department (ECGD).

Question 81

What are methods to reduce credit risk in foreign trade? 3

Answer 81

Methods include: - Bills of exchange - promise to pay, its contractualised. Can be sold at a discount to recieve funds and security is given by buyers bank. 3 partes involved: buyer, seller, buyers bank - Letters of credit - supplier deals with customers bank not customer themselves - Export credit insurance

Question 82

What is green finance?

Answer 82

Green finance comprises sources of finance used to fund projects that benefit the environment, such as specialised green bonds, green loans, grants, and venture capital funds.

Question 83

What are green bonds?

Answer 83

Green bonds are bond instruments where proceeds are exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects. They align with the Green Bond Principles set by ICMA.

Question 84

What are the Green Bond Principles? 4

Answer 84

The Green Bond Principles are voluntary guidelines by ICMA, including: - Use of proceeds: For projects with clear environmental benefits. - Process for project evaluation and selection: Defined process to determine project eligibility. - Management of proceeds: Proceeds tracked or kept in separate accounts. - Reporting: Information on the use of proceeds must be made available.