FInance Topic 3 Flashcards
Importance of sources of finance
-firms cant exist operate or grow
-unable to create value/wealth
-restrict opportunity set
-in ability to pay for inputs
-lifeblood of every org
4 main categories of sources of finance
- internal (within/no obligation/cheap to obtain)
- External (external parties/conditions attached/more costly to obtain)
- ST (up to period of 2 years)
- LT (longer periods)
2 Internal sources of finance
- Working capital (efficient)
-cash, stock, creditors/debtors - Retained earnings (profit = reinvestment of profits to fund growth)
+ve - no additional costs, no annual interest no obligations with outside
-ve impact on stock market perception of company, some SH/owner need dividends, inv opps?
3 Short term External sources of finance
SHORT TERM
1. Overdraft (debt financing, -ve balance, // available/flexible // interest, repayable, limit)
- Debt (invoice) factoring (credit mngment to specialists, free up staff, ease cash flow, insure against bad debt // expensive fees and interest, loss of management of customer database, negative perception of service)
- Invoice discounting (provide loan based on % of face value of business trade debtors// control retain, confidential/flexible, lower service charge vs factoring // credit mngment and risks remain in business)
Balance sheet sources of finance
Equity
Residual right to participate beyond any pre defined limit in distributions
Residual right = equity investor gets to have anything left over without a predefined limit
Debt vs equity adv and dis
Debt cheaper than equity but more risky
Cheaper cost of debt capital (compared to equity)
Tax deductibility of debt interest payments
Increased financial risk
Increased risk of financial distress and insolvency
Share capital
Ordinary/equity
-limited companies, holders = all final profits after other claim holder receive their due, lost in order of asset claim - no legal obligations
Preference shares
-fixed level ahead of ordinary, priority of claims, no voting rights
5 Ways of raising ordinary share capital
- Private subscription
- Public issue (stock exchange, fixed price or tendering)
- Private placing (with financial insitutition that either sells or hold as inv)
- Rights issue (existing SH = right to buy allocation of shares at price slightly below current mkt price, right may be exercised or sold to someone else)
- Bonus issue (NOT a method to raise new capital but make more existing capital (reserves) permanent - ordinary shares)
Difference between share and debt capital
-lenders impose certain obligations - restrict borrowers e.g interest/loan payments = defined terms
-debt capital doesn’t make the lender a part owner
-debt capital most often has to be repaid
-lenders = right to initiate insolvency if don’t receive interest/repayment of capital
2 Types of markets
Primary - issuance of new securities (equity shares or bonds), issuing company receives funding via primary market issues e.g. rights and bond issue, private placement, seasoned equity offering, initial public offer
Secondary- deals with buying and selling of previously issued instruments, doesn’t provide new funding for companies whose instruments are traded
4 Long term External sources of finance
LONG TERM
1. Share capital (ordinary/equity shares or preference shares)
- Debt capital (secured by fixed or floating charge and can be converted to share capital)
- Leases (form of debt financing, acquire right to use particular asset for specified period, ownership remains in hands of lessor // +ve easy of cash flow and borrowing, flexibility, tax deductible payments
- ST financing deals
Rights issue
Existing - offer right to acquire new shares allocated in proportion to existing shareholdings
Right to acquire - has a value and can be sold
Decide whether to take up rights (additional inv) or sell (income)
Cheap and straightforward = high chance of appealing to existing
Usually offer at discount to current mkt price = seems attractive
Bonus or scrip issue
Provide new share to existing SHs in proportion to existing shareholdings but SHs don’t pay
New ordinary shares funded by transfer from reserves
NOT a way to raise additional capital
Way to switch part of owners capital (reserves) to permanent)
Rights value per existing share formulae
Cost of capital
Funds provided by lenders investors - hold various types of claims on firms cash flows (direct/indirect control)
Each category = confronted with risk level and each requires different rate of return
Rate of return req = cost of that type of capital to the business
Req rate = opp cost to investor of investing scarce resources elsewhere in opportunities with equivalent risk
SHs only accept project which increase wealth
Each project net cash flow earnings on risk adjusted basis enough to = pay inv expected rate of return, repay principal amount originally provided, increase SH wealth
Overall cost of capital = minimum risk adjusted rate of return project must make in order to be acceptable to SHs
Cost of equity vs cost of debt
COST of debt is LOWER than COST of equity
-lower risk perceived by fianance providers
— variability in return variance and SD = risk of returns
— protections and sanctions: debt covenants
— order of application of assets - where in the queue
-tax allowability of debt servicing costs
— debt interest is allowable against calculation of profit for corp tax purpose
Debt vs equity
Variability of return to debt (SD) is minimal = low risk vs return to equity = variable = high risk and high SD ( as go up and down with the business cycle)
Debt is perceived as risk in the view of investor more debt is higher risk perceived by debt providers
Cost of equity vs cost of debt tax allowability
Corporations pay tax on taxable profits = PCTCT which are calculated via tax computation - not financial accounting income statement tho looks similar and could be seen as adjusted income statement
Corp tax (PCTCT x corp tax rate) is included in income statement
-dividends paid to SHs not allowable expenses in tax computation to arrive at PCTCT
-interest payments on debt are allowable expenses in tax computation to arrive at PCTCT
PCTCT
Profits chargeable to corporation tax
Doesn’t appear on income statement
Comparing costs:
Different perspectives views on debt and equity
Investor perspective:
-debt = less risk, cost of debt is a return
-equity = more risky, cost of equity is a return
-cost of debt is lower than cost of equity
(Standard risk/return association)
Company perspective
-debt is more risky, cost of debt is a cost of capital
-equity is less risky, cost of equity is a cost of capital
-trade off, debt is cheaper but more risk
Cost of equity share capital methods
Dividend valuation models
1. Constant dividend model
2. Constant dividende growth model
- Capital asset pricing model (CAPM)
Constant dividend model
Cost of equity
Intended to continue indefinitely
Constant dividend growth model
Cost of equity
Calculation of growth rate
Calculation of sustainable growth rate
Capital asset pricing model (CAPM)
Proxies for M and Rf
M - by broadly based market index
Rf - by yield on short dated low risk bonds
Cost of retained earnings
RE - readily available funding for business (equity, internal LT)
NOT regarded as cost-free form of financing (earnings retained on behalf of equity SHs)
Cost of retained earnings = costs of equity
Absence of issue costs
Cost of preference shares
Constant divided model usually appropriate
Assume preference shares = perpetual
Cost of perpetual debt
Constant interest model = appropriate
Debt = may be irredeemable bond, or perpertual loan
Interest expense is and allowable deduction in calculating profit chargeable to tax, so net cost to business of interest is reduced
Cost of redeemable debt
IRR calculation required
XD & XI
Divided/interest is about to be paid - remove value from market price (cum dividend = with)
Dividend/interest has just been paid - market price doesn’t need adjusting (ex-dividend)
Weighted average cost of capital
-companies founded by variety of sources, which have different costs of capital
WACC - calculates value weighted average cost of capital to business
If return > WACC, firm value & SH wealth is increased
WACC used as hurdle rate or discount rate in new project appraisal (appropriate of funding/inv/completing project doesn’t affect business/operational risk & financial risk)
WACC calculation
What does β measure
Systematic risk
Sensitivity of returns on asset to changes in returns on market portfolio
+ve/-ve/zero
Interdependence of inv and financing decisions
Firm pre existing WACC = appropriate discount rate for new project appraisal if….
1. Business risk is not altered by new project
2. Financial risk is not altered by funding and performing the new project
What does standard deviation measure
Measures total risk
Can only be zero or 1
Sensitivity of returns
Share/portfolio beta vs Description of share/portfolio
> 1 - sensitive to market
1 - of unit sensitivity to market
< 1 but +ve - low senstitivity to market
-ve - hedge for market
Invest in positive or higher positive beta assets/portfolios if market is expected to consistently rise
Systematic risk terms
Market risk
Non company specific risk
Non unique risk
Non diversifiable risk
Non systematic risk
Non market risk
Company specific risk
Unique risk
Diversifiable risk
Example sources of risk
Sources of systematic = economy wide effect, but don’t mean affect every firm (share) same extent (depends on company)
Non systematic risk impact on particular firms
Diversification
Reduces non systematic risk
Can’t diversify away systematic risk
Different shares & add to product portfolio, reasonable size & sufficiently diverse
Implications of diversification
-all investors assumed to avail themeselves of ability to diversity away non-systematic risk
— inv in portfolio = reasonsable no. Of shares varying characteristics (costs = transaction/trading/monitor)
Returns don’t compensation investors for taking non-systematic risk, returns compensation investors only for exposure to systematic risk — investors in only single securities/poorly defined portfolios = bear risk without compensation
OLS regression line
Ordinary least squares
which a straight line is used to estimate the relationship between two interval/ratio level variables
Stability of betas
-no single/correct beta for individual asset (Share)
-changing things can alter calculated beta
4 Factors that alter beta
- Choice of M (or choice of proxy for M)
- Freq of returns data used
- Length of period of returns data considered
- Absolute period of data
Debt vs Equity
