F2 - 6. Financing Capital Projects Flashcards
What are the 6 main sources of finance for capital projects?
- Ordinary shares
- Preference shares
- Bank loan/overdraft
- Bonds
- Convertible debt
- Grants
What are ordinary shares?
Owners of the business, who have voting rights and are paid variable dividends on a discretionary basis
What are preference shares?
Shares with a fixed divided, but limited or no voting rights. Preference shares rank before ordinary shares in the event of liquidation.
Can preference shares be secured on a company’s assets?
No
What are redeemable preference shares?
Preference shares where the company agrees to pay the original investment back at a set date
What are participating preference shares?
Preference shares that carry the right to fixed dividends plus an additional dividend if ordinary dividends exceed a certain level
What are convertible preference shares?
Preference shares that can be converted into ordinary shares after a specified time, which would be chosen if the total market value of the shares exceeds the market value of the convertible preference shares
What are bonds?
A negotiable instrument offering a fixed interest rate (coupon rate) over a fixed period of time and with fixed redemption value
What a capital markets?
Long term (>12 month) debt (bonds) and equity (shares) markets
What is the primary function of capital markets?
Initial share issue (enabling companies to raise new finance)
What is the secondary function of capital markets?
Securities are traded once they have been issued (existing investors can buy / sell their investments)
What are the 6 functions of the stock market?
- Enabling existing companies to raise new finance
- Enable existing investors to buy / sell investments
- Enable private company shareholders to realise their investment by floating the company
- Allow shares to be offered as part of incentive schemes
- Raise a company’s profile
- Provide a more accurate share valuation
What are the 3 downsides of listing on the stock exchange?
- Can be costly
- Can involve a change in control
- Stock exchange rules and disclosure are onerous
What are the 3 factors influencing share pirce?
- Economy
- Industry
- Company/history
What are the 3 categories of share issue?
- Rights issue
- Public Offer
- Placing
What is a rights issue?
An invitation to existing shareholders to purhcase additional shares in the company (typically at a discounted price) in the same proportion as their current holding
What is an offer for sale?
Shares are offered via an issuing house and are underwritten, requiring a national advert
What is a public issue?
Shares are offered directly to the public and not necessarily underwritten
What is share placing?
Issuing shares to a select group of institutional investors (cheaper)
Who are the 3 main advisors in a share issuing?
- Investment bank
- Registrars
- Underwriters
What should the share price represent?
The future cash flow likely to be generated by the company and returned to shareholders, discounted back to today
What 3 ways might debt providers reduce the risk arising from default on debt?
- Fixed charges (specific assets)
- Floating charges (on underlying assets)
- Covenants
What are the 4 types of bond?
- Irredeemable
- Redeemable
- Convertible
- Warranted
Why do investors require a higher return than debt providers?
More risky
How does a business set its minimum return required on projects?
Shareholders minimum return
How do you find the cost of capital if there are multiple sources of finance?
The weighted cost of capital
What is more expensive, debt or equity financing?
Equity - more risky, and payments not tax deductible
What is the equation for the cost of zero growth dividend shares?
dividend / current ex-div share price
What is the equation for the cost of growing dividend shares?
current dividend * (1 + growth rate) / current ex div share price, + growth rate
What are the 2 methods for estimating dividend growth?
- Gordon’s growth model (return on capital employed x % reinvested funds)
- Historic growth (nth root latest/historic) - 1
What is the equation for the cost of preference shares?
dividend / current ex-div share price
What is the equation for the cost of irredeemable debt?
interest x (1 - tax rate) / current ex-interest price
What is the equation for the cost of redeemable debt?
Use the IRR formula (equate inflows to outflows), adjusting the interest paid for tax
What is yield to maturity?
The return on a bond to the investor
What is the main difference between cost of debt and yield to maturity?
Tax impact is ignored
What is the equation for yield to maturity on irredeemable debt?
interest / current ex-interest price
What is the equation for yield to maturity on redeemable debt?
Use the IRR formula (equate inflows to outflows), NOT including tax
What are the main use of the WACC?
Hurdle rate for appraisal
What are the 3 considerations when using WACC to appraise new projects?
- It is worth doing a project whose returns exceeds the current WACC
- Only use WACC if the new investment has the same business risk profile
- Do not use for projects that will affect finance providers view of the company
