Chapter 9 - Sources Of Long-term Finance Flashcards
What are the advantages and disadvantages of raising long-term finance through equity shares?
• Advantages:
- Paid residual funds in the event of liquidation, after all other lenders and creditors
- Equity shares of a quoted company can be easily traded in the stock market
• Disadvantages:
- Issue of further shares will dilute existing shareholders which will affect their control and future dividends
What are the 4 ways of raising equity shares?
1) New shares – public issue: offered to the general public by inviting them to apply for shares at a fixed price or by tender. Increases marketability of shares. Time consuming and incurs costs. High level of regulation and public scrutiny. Threat of takeovers
2) New shares – placing: selling shares direct to third party investors.
3) Rights issue: offers existing SH rights to buy new shares in proportion to existing holdings. Retain voting rights. Option to sell rights on the stock market
4) Bonus share/scrip issue: additional free shares given to current holders based on their existing number of shares
What are the advantages and disadvantages of raising finance through retained earnings?
• Advantages:
o Cheapest source of capital and no issue costs as they are internal. Price savings on expenses such as marketing, publicity, printing and other administrative costs
o Cash is immediately available
o No obligation to pay interest
o Management have flexibility to decide how money can be used
o Part of reserves. Increases goodwill
o Can be saved for a year of poor performance to issue dividends
o Investors like sufficient capital reserves therefore share price may increase
• Disadvantages:
o May not be sufficient for financing – may need more cash
o Investment requirements may not match the availability/timing of funds and could miss opportunities
o If no suitable investments available, SH money is being tied up in the company
o Excessive savings may be misused against the interest of SHs and can starve company of cash
What are the 4 types of preference shares?
1) Cumulative / non-cumulative: Cumulative = accrues fixed dividends if not paid in one year. Non-cumulative, rights to dividends are lost in that year
2) Redeemable and irredeemable – redeemable can be purchased back by the company subject to terms of issue. Irredeemable cannot.
3) Participating and non-participating - participating are entitled to a fixed rate of dividend and to a share in surplus profits which remain after dividends are paid to equity shareholders. Non-participating are only entitled to the fixed rate
4) Convertible and non-convertible – convertible enjoys the right to convert preference to equity at a future date. Non-convertible cannot.
What are the advantages and disadvantages of preference shares?
• Advantages:
o Dividends are only payable if there are sufficient profits available
o No loss of control as no voting rights
o Rights to dividends are lost if not paid (unless cumulative)
o Shares are not secured on company’s assets
• Disadvantages:
o Dividends are not tax allowable.
o Preference pays a higher rate of interest than debt because of extra risk to shareholders
o On liquidation, preference ranks before ordinary.
What are the 4 types of bonds and debentures?
1) Secured & unsecured – can be secured against collateral and gives debenture holders first charge on the assets. Fixed charge = restricted from selling asset. Floating charge = free to dispose of asset in ordinary course of business. Unsecured are backed by reputation and trust of issuer.
2) Redeemable and irredeemable – redeemable debentures are issued for a limit period of time. Irredeemable debentures are perpetual and are rare. Redeemable are usually repaid at normal value but may be issued as repayable at a premium on nominal. Repayable at a fixed date
3) Convertible and non-convertible – option to convert to equity at a time and in a ratio decided by the Co when issued.
What are the advantages and disadvantages of bonds and debentures?
• Advantages:
o Repayable on a fixed date and pay a fixed rate of interest. Interest paid is usually less than dividend paid to SH as they are less risky
o Advantageous to issuer as they have a repayment date in the future
o Interest paid is tax allowable, reducing the net cost to the company
o No restrictions contained in company law regarding terms of issue
o No right to vote or have a voice in management and therefore no dilution of control
• Disadvantages:
o Creditors of a company and therefore have first charge on secured assets upon liquidation
o Debenture holders receive interest payments regardless of profit or loss. Interest payments are due prior to paying out dividends to SH.
o Risk for an investor is less than in shares but still a risk of default.
What are bonds with fixed interest (coupon)?
Issuance of bonds of a certain face/par value (usually £100) for a fixed amount of time promising to pay interest annually or semi-annually.
E.g. 10-year bond with coupon rate of 10% and par value of £100. Co will pay interest of £10pa for 10 years and will pay £100 at end of 10 years to buy the bond back.
What are deep discount and zero-coupon bonds?
- Issued at a large discount in comparison to their face value but redeemable at par on maturity.
- Investors will receive a “bonus” on maturity.
- As they don’t pay interest (or low interest) investors will save on tax payments.
What are Eurobonds?
- Bond issued for international investors
- Usually issued in a currency other than home currency. Most common = Eurodollar or Euroyen
- Issuers can choose the country of issuance based on the regulatory market, interest rates and activity of the market.
What are share warrants (options)?
- Rights given to lenders allowing them to buy new shares at a future date at a fixed, given price.
- Usually attached to a bond or preference share.
What is a finance lease?
- Non-cancellable and long-term financing agreement whereby lessor buys the asset and provides it for use to the lessee for an agreed rent and period of time. Consists of interest expenses and principal value.
- Lessor will expect to recover the whole (or most) of its cost of buying the asset during the rental lease period. The Lessee will use the asset for the majority of its useful life.
- After expiry of the initial lease term, the asset is leased for a further period at a token rent and the lessee is offered the option to purchase the asset at nominal value
- Repair and maintenance during the period is the Lessee’s responsibility
- Appears as both the asset and liability in Lessee’s FS.
- Non-cancellable long-term finance. Required to pay even if entity is no longer using the asset.
- Can get costly due to incidental costs (e.g. running costs)
What is an operating lease?
- Represents off-balance sheet short-term financing of an asset. Lessee agrees to rent from the lessor
- Lessee rents the asset for a small period of its useful economic life and all risks and rewards are attributed to the lessor
- If the asset is no longer required, lessee can terminate the lease
- Lessor has responsibility of maintenance and repair.
- Lessees need to recognise assets and liabilities for all leases with a term of more than 12 months unless the underlying asset has a low value. If it is a short-term lease and low value asset, it is treated as a rental expense.
- Beneficial where there is not sufficient cash to purchase the asset upfront
- Payments on operating leases are a tax-deductible business expense.
What are the advantages and disadvantages of finance and operating leases?
Advantages:
- Lower upfront costs, spreads payments
- Payments on operating leases are tax-deductable
- Lessees can take advantage of capital allowances on financial leases where passed on by the Lessor.
- Often cheaper compared to other sources of finance.
- Lessee on operating leases gets maintenance and technical support for the asset.
- Lessee pays a fixed number of rental payments each year even if cost of asset goes up.
- At expiry of primary period, Lessee given option of leasing asset at a token rent or given option to buy at residual value.
Disadvantages:
- Non-cancellable long-term finance
- Can get costly due to incidental costs. Lessee must pay rental costs plus admin and running costs.
- Legal ownership of asset held by Lessor. Lessee has option to buy at end of finance lease.
- Lessee of operating lease is not able to show asset on BS. Finance lease, it appears as both the asset and liability in Lessee FS.
What are the advantages / disadvantages of sale and leasebacks?
- Owner sells an asset to another party whilst maintaining the legal rights to use (the lease-back) the asset from the buyer
- Main advantage = company can raise more money than from a normal mortgage arrangement.
• Disadvantages:
o Fewer assets remain to support future borrowing and market may view the company negatively if it has to sell its property
o If market rent keeps increasingly rapidly, the lessee has to pay an exorbitant rent over time.
o Lessee loses the opportunity to profit from capital gains.
What are the advantages / disadvantages of hire purchase?
Advantages:
- often a fixed term and deposit to suit budget and usually documented by signed contract
- allows companies to buy assets that they may not have been able to normally
- fixed rate of interest and monthly payments making financial planning easier. Potential to amend to suit
- Assets treated as outright purchase, hence the tax deduction provided through capital allowance. Interest payment usually an allowable tax deduction
Disadvantages:
- as it is a fixed contract, the asset may be repo’d by the lender if buyer defaults on payments
- total cost of asset higher than if bought outright due to interest and admin costs
- may tempt companies to get excess assets not economically viable to them
- hirer can return asset however, will lose out on all foregoing payments made as well as asset.
What is the securitisation of assets and how are they used in practice?
- Pooling together illiquid assets and repackaging them into an interest-bearing security that can be traded to raise more finance
- Common practice for financial institutions to reduce their risk on illiquid assets (such as mortgages and credit cards) by selling or removing them from its BS
- The packages are made and their related cash flows are sold to investors as securities which may be described as bonds, pass-through securities or collateralised debt obligations (CDO). Also have mortgage-backed securities (MBS) and asset-backed securities (ABS). Investors are repaid from the principal and interest cash flows collected from the underlying debt
- A SPV is created and the pooled assets are transferred to this entity for legal and tax reasons. The SPV then issues interest-bearing securities such as MBS which are used to raise more finance.
- Securitisation offers investors a diversification of risks from a pool of assets. SPVs usually also have excellent credit ratings.
- Investors benefit from a payment structure closely monitored by an independent trustee and yields that are higher than those of similar debt instruments.
- Provides flexibility to tailor the instrument to meet the investor’s risk appetite. Has also been misuse of SPVs in the past to mask crucial financial information from investors such as Enron – hiding assets and debts and 2007 financial banking crisis.
What are the advantages / disadvantages of the securitisation of assets?
• Advantages:
o Raises large amounts of funding
o SPVs are separate from originating business and allow off-balance sheet treatment of assets
o Interest rates are lower than on corporate bonds
• Disadvantages:
o Can be complicated and expensive
o May restrict the ability of the business to raise money in the future
o Transactions may not always lead to off-balance sheet treatment
o Business may incur substantial costs to close the SPV and reclaim underlying assets
What are private finance initiatives (PFIs)?
- PFI introduced in the UK as a means of obtaining private finance for public sector projects (such as social housing, schools, hospitals etc). now falls under the public-Private Partnership (PPP) initiative which provides private sector funding for public projects
- Private firms are contracted to complete, manage and handle the upfront costs of public projects and typically the contract is repaid by the government over a 30-year period
- Places risks of buying and maintaining asset with the private sector whilst allowing the public sector to procure high-quality and cost-effective public services whilst avoiding the need to raise taxes in the short term
- Ultimate risk lies with the public sector
- Controversial due to wasteful spending built into public sector procurement agreements. Many projects are flawed and overcharged (e.g. M25 widening £1bn more than forecast)
What are the advantages / disadvantages of private finance initiatives (PFIs)?
Advantages:
- Public sector doesn’t have to fund large capital outflows at the start of the project. Allows public sector to procure high-quality, cost-effective public services whilst avoiding financing at high borrowing rates and taxes.
- public obtains valuable operational and management expertise and overall cost efficiencies from the private sector (and vice versa)
- private sector takes on risks of financing, constructing, managing project. Higher value for money expectation than public financing.
- extra investment can kickstart more projects, bringing economic and social benefits.
- PFI projects are nearly all fixed price contracts in which the private sector is not paid until the asset has been delivered. PFI firms eventually pay tax, making the overall costs cheaper for the government.
- All PFI projects go through a bidding process, encouraging competition for design and quality of delivery.
Disadvantages:
- The biggest disadvantage is the high annual cost charged to the public sector for the project. The costs have been significantly larger than the annual cost of comparable projects. Many projects have run over budget.
- Since the asset ownership is transferred to the private sector, it may lead to a loss of control and accountability from the public sector.
- ultimate risk of inflexibility and poor value for money with a project lies with the public sector. Many stories of flawed projects and wasteful spending.
- repair or maintenance costs could also be higher.
- admin cost spending on advisers and lawyers and the costs of the bidding process could cost millions.
What are the advantages / disadvantages of government grants and assistance?
Advantages:
- cheap form of financial assistance.
- Interest rates on government loans are much lower than market rates.
- Unlike loans, most government grants don’t have to be repaid.
- Information about grants is easily accessible through government websites and literature.
- Government-funded projects are normally beneficial to the society and the public at large.
Disadvantages:
- Applications can be time consuming, requiring lots of paperwork.
- require outcomes that are beneficial to society, sometimes at the expense of financial profit.
- may be a long waiting period between applying and getting it approved.
- may be lot of competition from other companies applying for the same grant or loan.
- may have detailed requirements for eligibility.
