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Chapter 7: Business Finance Flashcards

1
Q

Businesses are finances by a combination of what?

A

Equity (supplied by owners who want a dividend in return)

Debt (supplied by lenders who want interest in return)

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2
Q

What is the level of risk for debt holders?

A

Debt holders face a lower risk to equity holders but a lower return

  • they receive interest before dividends are paid
  • they often secure the debt with fixed/floating charges and
  • if the company fails, they are paid in preference to equity holders
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3
Q

What is the level of risk to equity holders?

A

Equity holders face higher risk than debt holders but enjoy higher returns in the form of profits distributed as dividends.

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4
Q

What are the two components of a treasury trade-off?

A

Liquidity - being able to pay debts as they fall due.

Profitability - minimising the holding of cash - an idle asset

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5
Q

What are the costs of holding cash?

A

Lost interest on deposits or other investments

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6
Q

What are the four influences on the level of cash balances?

A

Transaction motive - to meet current day to day financial obligation

Precautionary motive - to cushion against unplanned expenditure

Investment motive - to take advantage of opportunities

Finance motive - to cover major transactions

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7
Q

What are the costs of running out of cash?

A

Loss of settlement discounts
Loss of supplier goodwill
Poor industrial relations if wages are not paid
Winding up of business, liquidation

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8
Q

What is short term finance for?

A

The shorter term operational needs of a business including paying for good, services and wages as they fall due

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9
Q

What is long term finance for?

A

Longer term needs to include the purchase of non-current assets for ongoing use in the business and financing growth, which involves in the medium term: increasing inventory and receivable levels

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10
Q

What is the classic rule for financing?

A

Short term needs to be financed by short term funds. This is basically working capital (inventories, payables, receivables and cash) and overdrafts.

Long term assets should be financed by long term funds, essentially debt and equity.

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11
Q

What are the advantages of short term financing?

A

Relatively cheap - shorter period of risk exposure for lenders. Trade payables are interest free. Although unsecured overdrafts are expensive

Flexible - a blank overdraft, for example, is only used when needed

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12
Q

What are the disadvantages of short term financing?

A

Renewal risk - an overdraft may be recalled on demand at the lender’s’ discretion

Interest rate risk - short term interest rates can fluctuate

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13
Q

What is the advantage and disadvantage of long term finance?

A

Long term finance is more expensive due to higher levels of risk and uncertainty. However, it is more predictable and assured, presenting lower operational risk

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14
Q

What is an aggressive finance approach?

A

An aggressive position sees a business use more short term finance, over debt and equity; it offers greater profitability as it is cheaper, but higher risk

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15
Q

What is a defensive finance approach?

A

A defensive business is risk averse and will use a portion of long term finance for its short term needs. This carries less risk but is an expensive option

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16
Q

What is an average finance approach?

A

The average position sits in the middle looking to strike a reasonable balance between the risk and rewards in its financing approach

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17
Q

What are financial intermediaries?

A

Bring together investors/lenders with borrowers/users of funds

They mirror the ‘real world’ by providing a relatively risk-free lending environment and easily accessible funds for borrowing

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18
Q

What are the roles of the financial intermediary?

A

Risk diversification - one lender not lending all money to one borrower

Aggregation - pooling lots of deposits together to get better returns

Maturity transformation - loans and deposits mature at different times

Making a market - putting lenders and borrowers ‘in touch’

Advice - on best rates available

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19
Q

What are the three different types of UK banks?

A

Retail banks
Commercial and investment banks
Bank of England

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20
Q

What are retail banks?

A

Those banks which deal with day-to-day money transmission

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21
Q

What are commercial and investment banks?

A

Offer tailored advice to large commercial clients usually in raising considerable sums

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22
Q

What is the Bank of England?

A

Acst as a banker to the banks by lending money to the banking sector through its financial market operations

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23
Q

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

A

Carrying out monetary policy

Ensuring financial stability

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24
Q

What is monetary policy?

A

The BoE lends money to the banking sector at the base rate which is set by the Monetary Policy Committee

Banks then lend and borrow money among themselves at rates such as the SONIA which then in turn affects the rates offered to customers when combined with determining factors

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25
What is financial stability?
The BoE's Financial Policy Committee (FPC) is responsible for taking action to remove systematic risks in the UK financial system as a whole. The PRA is also part of the BoE and is responsible for prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms
26
What is the Financial Conduct Authority?
Financial service firms which are not supervised by the PRA are regulated by the FCA which is an independent body that is also responsible for the following: - Promoting effective competition - Ensuring that relevant markets function well
27
What are the 8 cash transmission mechanisms?
Faster Payment Scheme - same day <= 250k Electronic Fund Transfers- computer based system Bank Automated Clearing System - type of EFT that deals with salaries, direct debits, same day clearing Clearing House Automated Payments System - bank to bank same day clearing in UK in GBP Society for Worldwide Interbank Financial Telecommunication - similar to CHAPS but for international transfers Payment Gateways - system for payment authorisation when using credit cards online Digital Commerce Platforms - payments made just using email, low cost General Clearing - mainly cheques - short delay to clear funds
28
What are the four contractual arrangements between the bank and the customer?
Mortgagor/mortgagee - bank has right to assets of customer if customer defaults on loan Principal/agent - bank acts as agent for the customer Bailor/bailee - safeguard property Receivable/payable - contractually owe each other dependent on whether overdrawn or in credit
29
What are the two main types of financial market?
Money markets Capital market
30
What is a money market?
Covers a vast array of markets buying and selling different forms of money or marketable securities The money markets provide short term borrowing and investing to companies, banks and the public sector
31
What is a capital market?
This is the national and international market, businesses obtain the finance it needs for its short term and long term plans The capital market deal in longer term borrowing and investing mainly via the stock exchange
32
What are marketable securities?
Marketable securities are short term high liquid investments that are readily convertible into cash
33
What are the 6 different types of money market financial instruments?
Treasury bills - issued by BoE on behalf of the government. Minimum investment is £500k, maximum of 12 months, very secure but low returns Deposits - placed in accounts with banks for periods from overnight to five years, Yields usually higher than treasury bills Certificates of deposit - issued for deposits of £50k or more for a fixed term. They can be traded in the CD market Gilts - offer a range of maturities and rates based on money market rates Bonds - debentures and loan stock of companies quoted on the stock exchange Commercial papers - IOUs issued by large companies which can be held to maturity or sold to third parties beforehand
34
What are the 6 different ways in which businesses can access finance?
National stock markets - primary and secondary markets The banking system - retail and wholesale market Bond markets - very large organisations to raise large amounts of money Leasing Debt factoring - small businesses to help finance their working capital requirements International markets - larger companies, finance can be raised in different currencies, typically very large amounts
35
What are the three main ways of raising equity finance?
Retained Earnings Right issue of shares New issue of shares
36
What are the three main types of capital market instruments available for a business to use as finance?
Equity - Ordinary shares in the business Preference shares - entitled to dividend before ordinary shareholders, usually fixed percentage dividend Loan stocks and debentures - typically receive a fixed rate of interest, usually secured on specific assets such that lenders are protected in liquidation
37
Retained earnings as a way of raising equity finance
Very easy and important source of finance Profits can either 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 Profits which are reinvested in the business may lead to business growth and resulting increase in share price.
38
What is a rights issue of shares?
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings
39
What are the four factors to consider when making a rights issue?
Issue costs - estimated at around 4% on £2mil raised but, may of the costs are fixed, so the percentage falls as the sum raised increases. Shareholder's reactions - shareholders may react badly as they are forced either to take up their rights or sell them. They may sell their shares, driving down the market price Control - unless large numbers of existing shareholders sell their right to new shareholders there should be little impact in terms of control Unlisted companies - often find rights issues difficult to use, as shareholders many not have sufficient funds to take up their rights but are not able to sell them
40
What are the disadvantages of a new issue of shares?
Expensive Time Consuming
41
New issues of shares may take the form of what?
Placings Public offers
42
What are placings?
Placings are the most common method of issuing shares when a company first comes onto the market X plx sells shares to an issuing house (investment bank). The issuing house sell the shares to the investing institutions
43
What is the benefit of placings?
Lower transaction costs (advertising and admin) than public offers
44
What is the drawback of placings?
By only offering to a narrow pool of institutional investors which reduces the efficiency of the market in the shares
45
What are public offers?
Offer for sale: X plc sells shares to an issuing house who then offers the shares for sale to the general public Direct offer or offer for subscription: X plc sells shares direct to the general public
46
What needs to be considered when pricing new issues?
If priced too high, then the issue fails If priced too low, then too many shares are issued Pricing of new share issues can be managed by: - underwriting the issue - using an offer for sale by tender
47
What is underwriting?
Underwriting involves an institution or group of institutions agreeing to purchase any securities not subscribed for by the public in exchange for a fixed fee (usually 1-2% of the total finance raised)
48
What is an offer for sale by tender?
The investing public is invited to tender for shares at the price it is willing to pay. A minimum price is set by issuing company and tenders must be at or above the minimum
49
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
50
What are preference shares?
They have no voting right and no right to share in excess profits
51
What are the benefits of preference shares?
Attractive if looking to raise new capital but want to avoid additional debt or dilute the ordinary shareholders' influence
52
What are the drawbacks of preference shares?
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. Expensive to issue and finance
53
What are the advantages of going public?
Access to large source of finance Improves the marketability of shares, increasing the value of the company Raises the profile of the company
54
What are the disadvantages of going public?
Cost can be very expensive Dilution of control (at least 25% of the company has to be in public hands) Need to have traded for 3 years Having to answer to other investors Greater scrutiny of the affairs of the company and actions of the directors Listing may not be successful unless the business is worth at least £50m Possibility of being taken over Extra costs of control and reporting systems to meet the increased demands on the company due to listing rules
55
What is an overdraft?
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
56
What are the advantages of an overdraft?
Flexibility - can be used and repaid as desired Cost - overall interest cost can be lower as interest is only paid when overdrawn
57
What are the disadvantages of 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 in overdrawn, the overall interest cost is higher as the interest rate is generally higher Control - the bank may require security on assets of the business
58
What is debt factoring?
Debt factoring is when the business receives loan finance and insurance, known as non-recourse factoring, so that, in the event that a customer does not pay, the business does not have to repay the loan
59
What are the services typically offered by a debt factor?
Financing the credit taken by customers Insuring receivables Managing the running of the receivables ledger
60
What is a term loan?
A term loan, usually a bank loan, is where the repayment date is set at the time of borrowing. They are not repayable on demand, unless the borrower defaults on repayment
61
What are the characteristics of term loans/
Interest rates can be fixed or variable Relatively small arrangement fees are usually payable on term loans Term loans are usually secured against assets Repayment schedules are flexible
62
What is loan stock?
Loan stock is debt capital (called bonds or debentures) in the form of securities issued by companies, the government and local authorities
63
What are the key considerations of loan stock?
Coupon rate Redemption value Redemption date Recipient
64
What is a finance lease?
A finance lease is a lease that transfers substantially all the risks and rewards of ownership of an asset from the lessor to the lessee
65
What is an operating lease?
An operating lease is any other lease that is not a finance lease
66
What are the features of a finance lease?
Long term debt finance One lease exists from the majority of the assets useful life Either ownership passess to the lessee at the end of the term or any secondary lease period is at a very low rent The lessee takes on the risks and rewards of ownership The lease agreement cannot be cancelled or early cancellation charges mean the lessee effectively has a liability for all payments
67
What are the features of an operating lease?
Short term rental of an asset The lease period is less than the assets useful life Ownership remains with the lessor The lessor is normally responsible for repairs and maintenance The lease can sometimes be cancelled at short notice
68
What are business angels?
Business angels are experiences, wealthy individuals investing in startups, early stage or expanding businesses. Business angels tend to invest at a much earlier stage than most formal venture capitalists.
69
What is crowdfunding?
Crowdfunding is a means of funding a new business or new project for an existing business by raising a specific sum of money from individuals, usually via the internet
70
What are venture capitalists?
Venture capital is the provision of risk-bearing capital, usually in the form of equity, to companies with high growth potential The investment in high risk so VCs expect high returns. they often request a presence on the board
71
What are the characteristics of venture capitalists?
It tends to be a medium term source of finance The investor provides advice and is able to influence management Much of the return is in the form of capital gains after three to five years
72
What is a VC's exit route?
A trade sale - the VC's shares, or the whole company is sold to another company Flotation Buy-back of shares on re-financing
73
What is the Alternative Investment Market?
The AIM has less stringent regulations than the full Stock Exchange and is available to companies with a value of at least £1m.
74
What are the 4 types of trading risk?
Physical risk - goods being lost or stolen in transit Trade risk - the customer refusing to accept goods on delivery, or the cancellation of the order in transit Credit risk - default by the customer Liquidity risk - the inability to finance the credit given to customers
75
What is a bills of exchange?
A document drawn up by the exporter 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 sell or discount the bill to a third party for cash now
76
What are letters of credit?
Letters of credit provide a method of payment in international trade which is risk free. The arrangement between the exporter, the buyer and participating banks must take place before the export sale takes place. The exporter receives immediate payment of the amount due, less the discount form the bank. The buyer is able to get a period of credit before having to pay for the imports
77
What are the disadvantages of letters of credit?
Slow to arrange Administratively cumbersome
78
What is export credit insurance?
Export credit insurance is insurance against the risk of non-payment by foreign customers for export debts
79
What is green finance?
Green finance is any source of finance that is used specifically to finance projects or activities that lead to environmental benefits
80
What are examples of green finance?
Green binds, green loans, grants and venture capital funds that specialise in investing in green projects
81
What are green bonds?
Green bonds are any type of bond instrument where the proceeds will be exclusively applied to eligible green projects and which are aligned with the four core components of the GBP
82
What are the green bond principles?
Proceeds must only be used for projects 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
83
What is the Green Finance Institute?
Established in 2019 as a response to recommendations made by the industry-led Green Finance Taskforce

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