Chapter 9 - Sources of finance

Question 1

What is the pecking order for sources of finance?

Answer 1

1. Retained earnings
2. Debt
3. Equity

Question 2

What is the ranking of debt/equity from least riskiest to riskiest?

Answer 2

1. Secured debt
2. Unsecured debt
3. Preference shares
4. Ordinary shares

Question 3

What are the short-term sources of finance?

Answer 3

• Overdraft
• Short-term loan
• Trade credit
• Short-term lease

Question 4

What are the long-term sources of finance?

Answer 4

• Bank loan
• Loan notes
• Long-term lease
• Equity finance - ordinary shareholders
• Preference shares
• Venture capital

Question 5

What are the methods of raising equity finance?

Answer 5

• Internal finance - could have been paid as a dividend
• Rights issue
• Placing
• Public offer

Question 6

What is ‘placing’?

Answer 6

Offering equity to institutional investors - this is cheap and quick

Question 7

What is a rights issue?

Answer 7

A discount share price offered to existing shareholders pro-rata

Question 8

What happens to the share price after a rights issue?

Answer 8

It increases as the company has more to invest in positive NPV investments thus shareholder wealth is maximised

Question 9

What is riba?

Answer 9

Payment of interest - it is forbidden under islamic finance

Question 10

What is Murabaha?

Answer 10

Trade credit

• Deferred payment sale
• Price of goods, mark-up, delivery and payment dates agreed

Question 11

What is Musharaka?

Answer 11

Partnership with active investor (venture capital)

• Each party known as musharik
• All partners bring share of capital and expertise
• Any profits shared between partners according to ratios in contract, losses are distributed to partners in proportion of capital contribution

Question 12

What is Mudaraba?

Answer 12

Equity

• The rab al mal contributes capital, and the mudarib contributes skill and expertise
• One solely provides capital and the other runs day-to-day.
• Profits shared according to contract and losses shared according to capital contribution

Question 13

What is Ijara?

Answer 13

Leasing

• One party allows other to use their asset against payment of rental fee
• Lessor incurs risk of ownership - responsible for maintenance and insurance

Question 14

What is Sukuk?

Answer 14

Bonds

• Underlying tangible asset that the sukuk holder shares in risk and rewards of ownership
• Ownership of underlying asset transferred to holder of sukuk with ownership benefits and risks.

Question 15

What does it mean if a bond is trading at a conversion discount?

Answer 15

It is quoted at a lower value than the shares it can be converted into so is more likely to be converted

Question 16

What needs to be taken into consideration when undertaking a rights issue?

Answer 16

• Share price - enough to attract investment but not so low EPS is diluted
• Relative cost - it is cheaper as simpler admin
• Ownership - voting rights unaffected if shareholders take up offer
• Gearing - may reduce gearing as higher equity

Question 17

What are the advantages of a scrip dividend?

Answer 17

• Preserve cash position

- Share issue decreases gearing and increases borrowing capacity

Question 18

What are the disadvantages of a scrip dividend?

Answer 18

• Total cash paid in dividend increases

- Negative signal in market - cash flow issues