Chapter 8 Business finance

Question 1

1.1 The banking system

Answer 1

Banks are a financial intermediary; they bring together investors with borrowers and provide a relatively risk-free lending environment and accessible funds. The roles of an intermediary include risk diversification (different lenders and borrowers), aggregation (pooling deposits for better returns), maturity transformation (loans and deposits mature at different times), making a market and advice.

Question 2

1.2 Relationship between the bank and customer

Answer 2

Banks have a fiduciary relationship meaning they are expected to act in good faith with customers. There are four contractual arrangements between the bank and the customer.
- Mortgagor/mortgagee: bank has right to assets of customer if they default on a loan
- Principal/ agent: bank acts as agent for the customer (paying third party sums promised on a customer cheque)
- Bailor/bailee: safeguard property (title deeds are collateral on a mortgage)
- Receivable/payable: contractually owe each other depend on whether overdrawn or in credit

Question 3

1.3 Types of bank

Answer 3

Primary banks (deal with day-to-day money transmission), secondary banks (offer tailored advice to large commercial clients usually in raising considerable sums) and the bank of England (acts as a banker to the banks by lending money to the banking sector).

Question 4

1.4 Roles of the bank of England

Answer 4

The bank of England has to carrying out monetary policy and ensuring financial stability.
- Monetary policy: they lend money to the banking sector at the base rate set by the Monetary Policy committee. Banks then lend and borrow money among themselves at rates such as the London Intern Bank Offered Rate (LIBOR), which in turn affects the rates offered to customers when combined with other determining factors
- Financial stability: The Bank of England’s financial policy committee is responsible for taking action to remove systemic risks in the UK financial system. The Prudential Regulation Authority is responsible for prudential regulation and supervision of banks, building societies, credit unions, insurers, and investment firms
- Financial conduct authority: financial service firms which are not supervised by the PRA are regulated by the FCA which is an independent body responsible for the following promoting effective competition and ensuring that relevant markets function well

Question 5

1.5 Fintech

Answer 5

Financial technologies disrupting the traditional banking sector includes challenger banks and banking apps. This includes crowd funding, peer to peer lending, online currency conversion and digital wallets.

Question 6

1.6 Cash transmission mechanisms

Answer 6

• General clearing: mainly cheques, costly and takes up to 4 days to clear
• Electronic fund transfers: any computer based system used to transfer money electronically
• Bank automated clearing system deals with salaries, standing orders and direct debits. Same day clearing
• Clearing house automated payments system covers items more than £10,00, provides same day clearing in UK in GBP
• Society for worldwide interbank financial telecommunication: CHAPS for international transfers
• Faster payments scheme: same day clearing for less than £250k, using phone or internet instruction
• Payment gateways: system for payment authorisation when using credit cards online
• Digital commerce platforms: such as PayPal, payments made using e-mail address. Low cost.

Question 7

2.1 Financial markets

Answer 7

There are two main types of financial markets to consider: money markets (vast array of markets with different forms of money or marketable securities. Provide short term (less one year) borrowing and investing to companies, banks, and public sector) and capital market (business obtaining finance for both short term and long term plans. Deals with longer term borrowing, mainly via stock exchange).

Question 8

2.2 The money markets

Answer 8

Marketable securities are short term liquid investments ready to convert to cash. The types of money market financial instruments include:
- Treasury bills: issued by bank of England on behalf of government. Minimum investment of £500k, last up to a maximum of 12 months. Secure but low returns
- Deposits: placed in accounts with banks for periods from overnight to five years.
- Certificates of deposit: issued for deposits of £50k or more for a fixed term. 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 stock exchange
- Commercial papers: IOUs issued by large companies can be held to maturity or sold to third parties

Question 9

2.3 The capital market

Answer 9

These are the ways in which businesses can raise finance
- National stock markets includes the London stock exchange and the alternative investment market. They act as primary markets (new share issues) and as secondary markets (shares already in issue)
- The banking system: split between the retail market (individuals and small businesses) and the wholescale market for large companies
- Bond markets
- Leasing
- Debt factoring: used by small businesses to finance their working capital requirements
- International markets: allows finance to be raised in different currencies

Question 10

2.4 Key capital market instruments

Answer 10

Three types of capital market instruments include: equity (shares in business), preference shares (entitled to dividends and usually receive fixed percentage dividend) and loan stocks and debentures (received fixed rate of interest, secured on specific assets so lenders are protected in liquidation).

Question 11

3.1 Business finance, risk v return

Answer 11

Business are financed by equity and debt. The difference is the level of risk. Debt holders face lower risk but lower returns, they receive interest before dividends are paid, secure debt with fixed and floating charges and they are paid in preference to equity holders on liquidation. Equity holders have higher risk but higher returns in the form of dividends.

Question 12

3.2 Treasury (cash) management

Answer 12

The treasury trade of with liquidity (able to pay debts as they fall due) and profitability (minimising the holding of cash, an idle asset). The costs of holding cash include lost interest on deposits or other investments. The influences of cash balances include:
- Transaction motive: meet current day financial obligations
- Precautionary motive: cushion against planned expenditure
- Investment motive: take advantage of opportunities
- Finance motive: cover major transactions
The costs of running out of cash include loss of settlement discounts, loss of supplier goodwill, poor industrial relations if wages not paid and winding up of the business.

Question 13

3.3 Short term and long term finance

Answer 13

Businesses must finance day to day operations and longer term aspirations. The classic rule for financing is short term needs to be financed by short term funds, this is working capital (inventories, payables, receivables, and cash) and overdrafts. Long term assets should be financed by debt and equity.
Short term financing is cheap and flexible. But it has a renewal risk and interest rate risk, with fluctuating interest rates. Long term finance is more expensive due to higher risk but has lower operational risk.

Question 14

3.4 Balancing short term and long term finance

Answer 14

Three broad approaches are categories as:
- Aggressive: business use short term finance over debt and equity
- Defensive: business use a portion of long term finance for short term needs
- Average: business strikes a balance between the risk and reward in its financing approach

Question 15

4.1 Sources of equity finance

Answer 15

There are three main ways of raising equity finance. Retained earnings, rights issue of shares and a new issue of shares. A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings, legally a rights issue must be made before a new issue to the public and shareholders have rights of first refusal (pre-emption rights) on the shares, the rights can be waived by selling them to others. The factors to consider when making a rights issue are issue costs (estimated 4% on £2m raised, but many costs are fixed), shareholder reactions, control (unless large numbers of existing shareholders sell the rights to new shareholders there is little impact) and unlisted companies often find rights issues difficult, as shareholders may not have funds to take up the rights but are not able to sell them.
An issue of new shares is usually done if the company is listed on a stock market or listing for the first time. This is expensive and time consuming.

Question 16

4.2 New issues of shares

Answer 16

New issues of shares take the form of placings or public offers. Placings is the most common when the company first comes to market. The shares are sold to an issuing house who places shares with its clients. The investor base in a placing is made of institutional investors, contacted by the issuing house. This lowers transaction costs but only offers to a narrow pool of institutional investors.
Public offers occur in two ways. An offer for sale is when shares hold to an issuing house who offers shares to the public. The director offer or offer for subscription is when the company sells shares directly to the public. The issue in both methods is likely to be underwritten and there is no restriction on the amount of capital raised by public offer.

Question 17

4.3 Pricing for new issues

Answer 17

Pricing of new share issues can be managed by underwriting the issue or using an offer for sale by tender. Underwriting involves an institution agreeing to purchase any securities not subscribed for by the public in exchange for a fixed free (usually 1-2% of the total finance raised). The cost is still payable even if underwriter does not have to invest. The offer for sale by tender means the public is invited to tender (offer) for shares at the price it is willing to way. A minimum price is set by the issuing company and tenders must be at or above the minimum. Procedure is to receive all tenders and the shares are issued at once price. Investors who tendered at higher prices pay less than the amount tendered. This ensures shares do not need to be underwritten as the tender process should ensure all shares are sold.

Question 18

4.4 Preference shares

Answer 18

They have no voting rights and no right to share excess profits. The company can raise new capital and avoid additional debt or dilute the ordinary shareholder’s influence. The drawback is the share offers a fixed rate of dividend each year and they tend to be cumulative, so all arrears have to be paid before equity dividends can be paid.

Question 19

4.5 Going public

Answer 19

The advantages is access to a large source of finance, it improves the marketability of shares and raises the profile of the company. But it can be expensive, dilute control (at least 25% of the company has to be in public hands), needs to have traded for three years, greater scrutiny, listing might not be successful unless the business is worth at least £50m, possibility of being taken over and extra costs of control and reporting systems to meet the demands on the company due to listing rules.
The process involves the company goes to a sponsor (usually an investment bank) who assesses whether it is appropriate, and they can price and underwrite the issue, accountants are involved in long form reporting, corporate brokers advises on market conditions and likely demand. Solicitors deal with the legal aspects; the registrars record the ownership of shares, and the shares are public.

Question 20

5.1 Sources of debt finance - overdraft

Answer 20

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. Used to meet short-term cash deficits, but some companies have a permanent overdraft for long-term sources of finance. This is flexible and overall interest cost is low. But as it is payable on demand it is not suitable as a long-term source of capital, of permanently in overdrawn the interest costs are higher and the bank may require security on assets of the business.

Question 21

5.2 Debt factoring

Answer 21

When the business receives loan finance and insurance (non-recourse factoring), so in the event of a customer not paying, the business does not have to repay the loan. The services offered by a debt factor include financing the credit taken by customers, ensuring receivables, and managing the running of the receivables ledger.

Question 22

5.3 Term Loans

Answer 22

A term loan (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. Interest rates can be fixed or variable, small arrangement fees are usually payable on term loans, term loans are usually secured against assets. Repayment schedules are flexible, interest holidays of up to two years can be negotiated.

Question 23

5.4 Loan stock

Answer 23

Loan stock is debt capital (called bonds or debentures) in the form of securities issued by companies, the government, or local authorities. They have coupon (interest) rate, which is the coupon rate x the nominal value of the stock, this can be a fixed rate or variable. The redemption value is when the loan can be repaid at par or at a premium or discount to the par value. If repaid at a premium, investors find the stock more attractive and are happier to accept a lower or zero coupon rate. The redemption date is normally medium to long-term, some bonds are undated (perpetual or irredeemable), on undated bonds you must sell the loan stock to get capital back. With UK bonds issued on the stock exchange, the bond holders name is recorded on a register, some bonds are bearer bonds, and the holder will receive the payments due.

Question 24

5.5 Leasing

Answer 24

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. An operating lease is any other lease. Finance leases are long-term, operating are short term. On a finance lease ownership passes to the lessee at the end of the term, this does not appear with operating leases. For operating leases, the lessor is responsible for repairs and maintenance. Finance lease agreements cannot be cancelled, or charges occur, an operating lease can sometimes be cancelled at short notice. A finance lease covers the majority of an asset’s useful life, an operating lease is less than the useful life.

Question 25

6.1 Financing a growing business

Answer 25

Business angels are experienced, wealthy individuals investing in start-ups. They tend the invest at an earlier stage than formal venture capitalists. Crowdfunding is a means of funding a new business or project. The individuals contribute money as loans, equity, or donations, they can pre-buy a product that has not been launched, peer-to-peer lending and equity-based investment are the largest sectors of crowdfunding and are regulated by the FCA, other forms are largely unregulated.

Question 26

6.3 Venture capitalists

Answer 26

Venture capital is the provision of risk-bearing capital, usually in form in equity to companies with high growth potential., and they often request a presence on the board. If tends to be a medium term source of finance, the investor is able to influence management, the return is mostly in the form of capital gains after three to five years. The VC’s exist route can be by a trade sale, floatation or a buy-back of shares on re-financing.

Question 27

6.4 Alternative investment market

Answer 27

The AIM has less regulations than the full stock exchange and is available to companies with a value of at least £1m.

Question 28

7.1 Financing reports – trading risk

Answer 28

Trading risks exist for companies who export goods. Physical risk (goods stolen or lost), trade risk (customer refuses to accept goods on delivery), credit risk (default by customer), liquidity risk (inability to finance the credit given to customers). Such risks can be reduced by banks, insurance companies, credit reference agencies and government agencies, such as UK’s Export guarantee department.

Question 29

7.2 Bills of exchange

Answer 29

A document by the exporter and sent to the overseas buyer’s bank. The bank accepts the obligation to pay the bill and therefore payment is guaranteed. The seller can sell or discount the bill to a third party for cash.

Question 30

7.3 Letters of credit

Answer 30

Provide a method of payment in international trade which is risk free. The arrangement between the exporter, the buyer and banks must take place before the export sale takes place. The exporter receives immediate payment, less the discount from the bank and the buyer is able to get a period of credit before having to pay for the imports. This is slow to arrange and admin heavy.

Question 31

7.4 Export credit insurance

Answer 31

This is insurance against the risk of non-payment by foreign customers for export debts. Private companies provide credit insurance for short-term export credit business and the UK government’s export credits guarantee department provides long-term guarantees to banks on behalf of exporters.

Question 32

8.1 Green finance

Answer 32

Is any source of finance used specifically to finance projects or activities that lead to environmental benefits. They include green bonds, loans, grants, and venture capital funds specialising in green projects.
Greens bonds are a type of bond instrument where the proceeds are exclusively applied to eligible green projects aligned with the four core components of the GBP, which are:
- Proceeds must be used for projects with clear environmental benefits
- Must be a defined process for project evaluation and selection
- Proceeds kept in separate account (or tracked by issuer)
- Use of proceeds should be reported