Financial Management Flashcards
Which of the following functions is performed by freely fluctuating exchange rates?
A.They tend to correct a trade surplus or deficit
B.They make imports cheaper and exports more expensive
C.They eliminate the opportunity for currency speculation
D.They eliminate business’ exposure to currency risk
A. If imports exceed exports then supply of the home currency will exceed demand. Therefore, the home currency will depreciate, boosting demand for exports and naturally correcting the trade imbalance.
What is the primary purpose of supply side economic policy?
A.To raise the level of demand in the economy
B.To increase the provision of state services
C.To improve the ability of the economy to produce goods and services
D.To reduce interest rates by increasing the money supply
C.
Supply-side policies are mainly micro-economic policies designed to make markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output.
Which of the following government policies would NOT tend to raise national income over time?
A.Increased expenditure on infrastructure
B.Tax cuts to encourage higher spending by consumers
C.Supply side policies to increase labour flexibility
D.Incentives to encourage personal saving
D. If consumers increase the proportion of income that they save, they will demand less goods and services.
Which of the following is allowed or prohibited under Islamic financing principles.
use of debt
The financing of alcohol production
Selling something not owned
The use of debt: Debt itself is allowed in Islamic finance, but interest (riba) is prohibited. So, debt can be used as long as it doesn’t involve paying or receiving interest.
The financing of alcohol production: Alcohol production is prohibited in Islam because it is considered haram (forbidden), so financing such activities would also be prohibited.
Selling something not owned: Islamic finance principles emphasize that one must own something before selling it. Selling something that you don’t own is considered gharar (excessive uncertainty), which is prohibited in Islam.
Identify, by clicking on the relevant box in the table below, whether the following statements about the term structure of interest rates are true or false.
1.An inverted yield curve is where long-term interest rates are higher than short-term interest rates
2.A rising yield curve is caused when investors prefer to buy long-dated loan notes
If long-term interest rates are higher than short-term, this is described as a “normal” yield curve. If investors exhibit a preference for long-dates loan notes this will drive up their market prices and hence drive down their yields – leading to a falling, or “inverted” yield curve.
In relation to the term structure of interest rates, what is a “normal” yield curve?
A “normal” yield curve is where short-term interest rates are below long-term interest rates and can be explained by liquidity preference theory.
dentify, by clicking on the relevant box in the table below, whether the following statements about the efficient market hypothesis are true or false.
- TrueFalse In a strongly efficient market, the price/earnings ratios of all companies would be the same.
- True/FalseIn a semi-strong efficient market, a company’s share price should not change when its financial statements are made public
Both false - If the stock market operates at strong form pricing efficiency, investors have all information about each company. Different companies will have different growth potential and hence different P/E ratios. If the market is semi-strong then shares prices quickly react to new publicly available information.
Which of the following statements about interest rates is/are true?
In a period of high inflation, nominal interest rates are higher than in a period of low inflation.
Long-term interest rates are usually lower than short-term interest rates.
A.1 only
B.2 only
C.Both 1 and 2
D.Neither 1 nor 2
A.
Tutorial note: Nominal (money) interest rates include inflation, hence when inflation rises so do nominal interest rates. Long-term interest rates are usually higher than short-term rates, as (i) lenders require higher compensation for deferring their liquidity for a longer period, and (ii) the risk of default is higher on a long-term loan.
Freely floating exchange rates perform which of the following functions?
A.They tend to correct a lack of equilibrium between imports and exports
B.They make imports cheaper and exports more expensive
C.They impose constraints on the domestic economy
D.They eliminate the need to hedge against fluctuations in foreign exchange rates
A.
Tutorial note: If imports exceed exports then supply of the home currency will exceed demand. Hence the home currency will depreciate, boosting demand for exports and naturally correcting the trade imbalance.
What is the just in time system ?
It is used to avoid holding too many inventory in the warehouse(holding cost), save money for the business and the fact that money is tied up in holding inventory. Factors like flexibility, cost savings, speed, reliability, high quality should be taken into account to effective operate such a system of stock control/management.
What is the Linear Interpolation Formula
When cash flows are not perpetuities or annuities, the IRR is estimated as follows:
Calculate the NPV of the project at a chosen discount rate.
If NPV is positive, recalculate NPV at a higher discount rate (i.e. to get an NPV closer to zero).
If NPV is negative, recalculate at a lower discount rate (again to get an NPV closer to zero).
Use the following formula to estimate the IRR by “linear interpolation”:
IRR ~ A + the fraction with numerator cap N sub cap A and denominator cap N sub cap A minus cap N sub cap B (B − A)
Where: A = Lower discount rate
B = Higher discount rate
NA = NPV at rate A
NB = NPV at rate B
The linear interpolation formula always “works”, although care must be taken with + and − signs.
Which of the following statements is true if the net present value of a project is negative $4,000 and the required rate of return is 5%?
A.The project’s IRR is less than 5%
B.The required rate of return is lower than the IRR
C.The project would increase shareholders’ wealth
D.The NPV would be positive if the IRR was equal to 5%
The correct answer is A.
A negative NPV necessarily implies that the IRR is less than the required rate of return. Here, since the required rate of return is 5%, it must be the case that the IRR is less than 5%.
If the NPV is negative at the 5% required rate of return, it means the project is not earning enough to cover its costs at that rate.
The IRR is the rate at which the NPV would be zero. Since the NPV is negative at 5%, it indicates that the IRR is less than 5% because at a lower rate (less than 5%), the NPV would become zero or positive.
Information
- Never deduct depreciation because it is not a cash flow.
- Never deduct finance costs because the cost of finance is measured in the discount rate and has already been taken into account.
- Financial accounting depreciation is not a tax-allowable expense; however, the tax regime may allow a business to claim tax-allowable depreciation on non-current assets.
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4.To deal with inflation, inflate cash flows and use a nominal discount rate (except when all cash flows are inflating at the same general inflation rate).
5. Changes to working capital balances are relevant cash flows: inventory + accounts receivable − accounts payable.
what is Hard capital rationing ?
– the capital markets limit the amount of finance available.
What is Capital rationing ?
– a situation in which there is not enough finance (capital) available to undertake all available positive NPV projects. Therefore, capital has to be rationed.
What is Soft capital rationing and Single-period capital rationing ?
Soft capital rationing – the company sets internal limits on finance availability.
Single-period capital rationing – capital is in short supply in only one period.
What is Multi-period capital rationing ?
– capital is rationed in two or more periods.
what are the steps for a divisible/infinitely divisible project?
A project is divisible if any partial or proportionate investment can be made in it (i.e. between 0% and 100%). However, the project cannot be repeated.
1. Calculate a profitability index for each project:
Profitability index = NPV of net cash inflows/Initial investment
2. Rank projects according to their index.
3. Allocate funds starting with the highest ranking to maximise NPV.
What are the steps for Non-divisible Projects/
What are the implications of borrow to but on financing ?
- The bank loan (or loan notes) will be recorded in non-current liabilities, increasing the reported level of financial gearing (debt to equity ratio).
- Interest on the debt will reduce interest cover (i.e. earnings before interest and tax (EBIT) divided by interest expense).
- However, the overall effect also depends on the profits generated by the asset as these will increase EBIT, and any retained profit would increase the level of equity.
What are the implications of leasing on financing ?
- Both the asset and a related liability would be recognised in the statement of financial position (as for the borrow-to-buy option). Therefore, reported financial gearing would rise initially.
- However, as lease payments would be allocated to interest expense and principal repayments, the liability would amortise (i.e. reduce) over time and ultimately fall to zero. Interest expense in early years would be relatively high, tending to reduce interest cover, but lower in later years.
The accounting treatment above applies to any lease longer than 12 months. For leases less than 12 months, payments are simply a rental expense, which does not affect the statement of financial position.
What are the non-financial factors to buy an asset?
- The asset is of fundamental importance to the business and is in constant use.
- Management wants to have absolute control over the asset.
- To update or upgrade the asset to scale up capacity is relatively easy.
- The asset is easily maintained (e.g. under a supplier’s warranty).
- There is an active second-hand market for the asset (so it is not only financially more affordable, but can be disposed of easily).
What are the non-financial factors to buy an asset?
To lease an asset may be the preferred option if, for example:
The asset may only be needed for a short time or there is significant uncertainty about how long it may be used.
The asset requires specialist support or maintenance that is provided by the lessor.
The asset needs to be regularly updated or upgraded for any reason (e.g. due to technical obsolescence or rapid expansion).
The lease agreement includes options to upgrade to newer models or other flexibility.
End-of-life disposal of the asset is subject to strict regulations.
What is Sensitivity analysis ?
The analysis of changes made to significant variables to determine their effect on a planned course of action.
What are the steps in Sensitivity analysis ?
Sensitivity analysis has TWO steps:
Step 1 Calculate the NPV of the project based on best estimates.
Step 2 For each element of the decision (cash flows, cost of capital), calculate the change necessary for the NPV to fall to zero.
The sensitivity can be expressed as a percentage change for an individual cash flow:
Sensitivity = (NPV/ PV of relevant cash flow) × 100
what is Simulation?
a technique that allows more than one variable to change simultaneously.
What are the Stages in a Monte Carlo Simulation?
- Specify the major variables (e.g. revenue and costs).
- Specify the relationship between the variables (e.g. revenue minus costs equals profit).
3.Attach probability distributions to each variable and assign random numbers to reflect the distribution (e.g. a 10% probability that costs are $1,000, a 50% probability that they are $10,000 and a 40% probability that they are $12,000). - Simulate the environment by generating random numbers for revenue and costs. For example, using random numbers from 00 to 99:
assign 00 to 09 to $1,000 cost with 10% probability;
assign 10 to 59 to $10,000 with 50% probability assigned to it, and so on. - Record the outcome of each simulation (e.g. the profit based on the revenue and costs randomly selected).
- Repeat the simulation many times to obtain a probability distribution of the possible outcomes (e.g. the probabilities of achieving various profit levels).
What is Expected value and what is the formula?
Expected value – the quantitative result of weighting uncertain events by the probability of their occurrence.
An expected value is calculated as follows:
Expected value = weighted arithmetic mean of possible outcomes= ∑xp(x)
Where x = value of an outcome
P(x) = the probability of outcome x
∑ = sum
What is Discounted payback period ?
This is the length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment. Sometimes referred to as the adjusted payback period.
What is over trading and overcapiyalisation ?
Overtrading often arises from a rapid increase in sales revenue
Overcapitalisation results in a relatively low current ratio
Information
1.An increase in dividends (the dividend decision), will reduce the level of retained cash available and increase the need for external finance (the financing decision) to fund capital investment projects (the investment decision).
2.An increase in asset expenditure (the investment decision ),would also increase the need for finance (the financing decision) which may be sourced internally by reducing dividends (the dividend decision).
Therefore, directors must decide whether to pay a dividend or retain earnings.
what are Practical factors have a significant influence on the company’s dividend policy-legal Constraints?
3.1.1 Legal Constraints
In most countries, a dividend can only be paid if there is a credit balance in the retained earnings account in the statement of financial position. No distributable reserves means no dividends.
If a company has brought forward losses from previous years, the balance on retained earnings may be a debit (“negative”), even if a profit was made in the current year.
This restriction on paying dividends for the foreseeable future could damage the company’s ability to attract new equity investors to finance its growth. Therefore, some countries allow a debit balance on retained earnings to be written-off against other reserves, allowing the company to resume paying dividends.
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3.1.3 Shareholder Expectations
Most shares in quoted companies are held by influential institutional investors (e.g. pension funds). Therefore, the directors of quoted companies have to manage investor expectations of dividends carefully.
If a large dividend is paid in the current year, this may create expectations of the same, or even higher, in future. If these expectations are not met, key investors may sell their shares.
In smaller owner-managed companies, there is no such agency problem. The dividend decision is influenced more by the personal tax position of the owner-managers than sensitivity over expectations.
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Signalling
In quoted companies, where there is a significant “divorce of ownership and control”, investors do not have access to all information about the company’s operations and prospects; they only have what is publicly available. Therefore, public announcements of the level of proposed dividends are signals of company’ strength or weakness.
A surprise cut in dividend may be interpreted as a signal of liquidity problems, even if the cut is actually to finance attractive projects.
A surprise increase may be taken as a signal of company strength, although some investors may question why the directors have not found suitable strategies for reinvesting surplus cash.
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Stability
Companies often strive for a stable level of dividends or a constant level of growth. This is done to avoid sharp movements in share price.
Companies will try to maintain the level of dividends in the face of fluctuating earnings.
This approach is widespread for quoted companies.
What is a Borrowing Covenants
A loan agreement may include a clause that limits dividend payments (e.g. to a specified proportion of earnings) to help ensure the loan is more secure. If less cash is paid as dividends, liquidity might be better (though cash can still be consumed on the purchase of non-current assets).
Borrowing Covenants
A loan agreement may include a clause that limits dividend payments (e.g. to a specified proportion of earnings) to help ensure the loan is more secure. If less cash is paid as dividends, liquidity might be better (though cash can still be consumed on the purchase of non-current assets).
What are three Alternative Dividend Policies -Constant Dividend, Constant Growth &Constant Payout Ratio ?
Alternative Dividend Policies
3.2.1 Constant Dividend
A constant dividend policy avoids surprises and signals stability to shareholders, but shareholders might be dissatisfied if they receive relatively low dividends if earnings are rising. As the proportion of retained earnings increases, shareholders might question whether the company can find enough suitable investment opportunities.
3.2.2 Constant Growth
Constant growth is predictable and favoured by shareholders but again the dividend growth rate might not match the earnings growth rate.
3.2.3 Constant Payout Ratio
A constant payout ratio means paying a dividend that is a fixed proportion of each year’s earnings. Although this approach sounds logical, the variability in the absolute amount of dividends creates uncertainty and is rarely adopted by quoted companies.
What is the
Residual Dividend Policy
Under the residual dividend policy, retained earnings fund all positive NPV projects. Any remaining earnings not needed to support such projects are paid out as a dividend.
This links to pecking order theory (i.e. retained earnings are the cheapest source of new finance, so they should be used to fund projects first).
A residual dividend policy is likely to lead to fluctuating dividends, so although it may excuse a cut in an otherwise stable dividend pattern, it is not common for quoted companies.
3.2.5 Zero Dividend Policy
A high-growth company may find that, in the early years, all surplus cash can be profitably reinvested back into the business – particularly if the company lacks access to external finance.
However, at some point, when fewer positive NPV projects are available, the company should start paying dividends.
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Difficulties in Raising Finance
SMEs are private companies with a limited number of shareholders and, unless those shareholders are wealthy, there is a limit to how much they can invest in the company.
Therefore, SMEs have to rely heavily on retained earnings for equity finance, but this source is limited, especially when profits are low. They may have to rely on debt if restricted in the amount of equity they can raise.
4.2.1 Perceptions of Risk and Uncertainty
SMEs are often viewed as unattractive investment opportunities because they have high levels of risk and uncertainty attached to them.
Larger businesses have a track record, and a long-term relationship with their bankers. New businesses, typically SMEs, obviously do not have a track record.
SMEs internal controls are often non-existent or very limited.
Larger businesses conduct more of their activities in public than do SMEs. If information is public, there is less uncertainty. A company that is quoted on a stock exchange will be subject to press scrutiny and stock exchange rules that regulate its activities, including publishing accounts that have been audited. Many SMEs do not require audits (or even publish full accounts), and the press is not interested in them. Therefore, they have fewer external controls.
The fact that potential investors in an SME have much less information about the business than its managers (i.e. asymmetry of information) contributes to their perception of high risk.
Often, SMEs have one dominant owner-manager whose decisions are rarely questioned.
They tend to have limited assets to offer as security (see below).
4.2.2 Absence of Security
If an SME seeks a bank loan, the bank will look to see what security (collateral) is available for any loan provided. This is likely to involve an audit of the entity’s assets.
Collateral is important because it can reduce the level of risk a bank is exposed to in granting a loan to a new business.
Many SMEs are based in the service sector, where the main asset is likely human capital rather than physical assets. Therefore, the directors may be required to pledge personal assets (e.g. their homes) to secure business loans.
4.2.3 Shares Lack Marketability
The equity issued by small companies is unquoted and difficult to buy and sell.
Sales are usually on a matched bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy.
This lack of marketability means that small companies may be unable to offer new equity to anyone other than family and friends.
4.2.4 Tax Considerations
The tax system may encourage individuals with cash to invest via large institutional investors rather than directly into small companies.
In many countries, personal tax incentives are offered on contributions to pension funds.
These institutional investors usually invest in larger companies (e.g. listed companies) to maintain an acceptable risk profile and ensure a steady stream of income to meet ongoing liabilities. This reduces the potential flow of funds to small companies, although the government may try to mitigate this effect by offering tax advantages for investment in SMEs.
4.2.5 Funding Gap and Maturity Gap
Initial owner finance is nearly always the first source of finance for an SME, whether from the owner or family connections. Many of the assets may be intangible at this stage, making sourcing external financing difficult. The “funding gap” is the difference between the finance available to SMEs and the funding they could productively use.
Bank loans may become available at a later stage. However, with small businesses, longer-term loans are often easier to obtain than medium-term loans because the longer-term loans are easily secured with mortgages against property. The fact that medium-term loans are hard to obtain is a well-known feature of SMEs, and many resort to financing medium-term assets with short-term finance such as an overdraft. This is known as the maturity gap as there is a mismatch of the maturity of the assets and liabilities within the business, which is not ideal.
Due to the gaps in funding and maturity, an SME may have to take an innovative approach to financing. Possible financing solutions are discussed below.
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Financing Solutions
Government policies can influence the level of funds available. For example:
Tax policy such as higher taxes on dividends (meaning less income for investors) or concessions to encourage companies to invest (e.g. tax-allowable depreciation).
Interest rate policy, for example, low rates, meaning borrowing becomes cheaper, and the supply of funds increases as there is less incentive for investors to save.
4.3.1 Venture Capital
Venture capitalists are a potential source of financing for an SME. Venture capital is equity capital provided to small and growing businesses. It is usually offered by a wealthy individual, a venture capital firm (e.g. the 3i Group) that manages a venture capital fund, or a high-risk, potentially high-return subsidiary of an organisation with significant cash to invest (e.g. a bank). Typically, a $1m minimum is involved for any one investment.
Before investing, the providers look for:
a product or products with strong potential (e.g. an innovation);
solid management; and
potential for high returns.
To invest, providers of funds would normally expect:
typically, 25% to 49% of the equity;
a business plan with medium-term cash flow and profit projections;
board representation (to monitor their investment and give advice);
a dividend policy which promotes growth (i.e. high reinvestment of earnings);
an “exit route” for selling their investment (e.g. proposed time-scale for seeking a market quotation); and
the provision of regular management accounting information.
Venture capital trusts (VCTs) also serve as a potential financing source.
VCTs are listed investment trust companies which invest at least 70% of their funds in a spread of small unquoted trading companies.
Many governments give tax incentives to individual investors in VCTs (e.g. Australia, Canada, France, Singapore, the UK and the US).
4.3.2 Private Equity Funds
A private equity fund attempts to gain control over a company by putting it through a restructuring programme before either selling to another fund or listing the company on the stock market.
The difference between private equity and venture capital is that private equity funds usually seek total control of the target company. In contrast, venture capitalists provide growth finance in return for partial control.
Private equity funds do not only target SMEs; they also buy large quoted companies, take them off the stock market, restructure them, and then re-list them on the stock market.
4.3.3 Business Angels
Business angels are private individuals (or small groups of individuals) prepared to invest equity (or perhaps debt) into small businesses with considerable potential.
Angels are often entrepreneurs who made their fortunes in the high-tech sector, were wise enough to sell before the “dot.com” bubble burst, and now invest in small business as a hobby (although they expect to make gains).
Angels not only provide finance, they also offer advice, experience and business contacts. A typical business angel will hold a portfolio of investments and may, for example, add an investment in an entity that makes health drinks to complement existing investments in fitness clubs.
Angels receive many applications for finance, and will only be prepared to invest in a business with an innovative product and talented management.
4.3.4 Government Assistance
Governments are often keen to support SMEs in raising finance for profitable investments:
to avoid lost investment opportunities and national wealth being lower than it could be;
to support innovation (an area in which SMEs often excel); and
to boost employment.
Forms of government assistance include:
Providing grants and guaranteeing loans (see Chapter 9).
Providing tax breaks or incentives to those willing to take the risk of investing in SMEs.
Providing advice. For example, in Scotland, “Business Gateway” is a government-funded organisation which assists those setting up and running a business, including advice on raising finance.
Providing equity investment. Many countries have government-backed venture capital organisations willing to invest in the equity of SMEs. This is often done on a matching basis, where the organisation will match any equity investment raised from other sources. For example, “Enterprise Capital Funds” in the UK and the “Small Business Investment Company” programme in the US.
The UK Enterprise Investment Scheme (EIS) is an example of a scheme to help SMEs attract equity finance.
The EIS scheme encourages private investors to buy shares in unlisted trading companies.
Tax relief, at an income tax rate of 30%, is available for investors.
Maximum annual tax relief is £1m (£2m if at least £1m is invested in knowledge-intensive companies).
Shares must be held for at least three years (otherwise tax reliefs are withdrawn/ withheld).
4.3.5 Crowdfunding
Definitions
Crowdsourcing – using a large, evolving, relatively open group of people (usually assembled via the internet) to provide goods, services or finance.
Crowdfunding – is crowdsourcing, to fund a project. Under crowdfunding, there is no financial intermediary: each individual in the crowd has a direct relationship with the entity funded.
Crowdfunding may be appropriate for the early stages of “seed” finance for an SME.
The crowdfunding model is driven by:
the project initiator who proposes the idea or project to be funded;
individuals or groups who support the idea; and
a moderating organisation (the “platform”) that brings the parties together to launch the idea.
Crowdfunding lets people invest in projects or ideas that they believe in or are interested in, so they might be willing to take relatively higher risks and accept relatively lower returns. In addition, the “crowd” aspect means supporters often encourage others to invest.
Crowdfunding can be particularly beneficial for SMEs as it allows them to reach out directly to investors who may be happy with the risks associated with funding innovations and technologies often pioneered by SMEs.
The main types of crowdfunding are:
- Donation-based-any crowdfunding campaign without financial returns to the investors or contributors (e.g. fundraising for disaster relief, charities, NPOs and medical bills). It may also be suitable to obtain support from a local community.
- Reward-based− where entrepreneurs pre-sell a product or service to launch a business concept without incurring debt or issuing equity to outside investors. This is best for businesses with a marketable product and need funding before generating revenues.
- Equity-based − where investors receive unlisted shares, usually in the company’s early stages, in exchange for the money provided. This is typically best for businesses that can grow and scale quickly.
Explain convertibles
Convertible - loan notes or preference shares which can be converted into a pre-determined number of ordinary shares.
.
Convertible loan notes and convertible preference shares:
Pay a fixed coupon or dividend until converted.
May be converted into ordinary shares:
on, or by, a pre-determined date;
at a pre-determined rate (the conversion ratio); and
at the holder’s option.
May have a conversion ratio which changes during the loan term to stimulate early conversion.
Convertible loan notes require the calculation of “fully diluted” earnings per share (EPS) to indicate what the EPS might be if the debt is converted into equity
What is warrant ?
Warrant – the investor’s right, but not the obligation, to purchase new shares at a future date
at a fixed price (the exercise or subscription price).
They may be attached to loan notes to make them more attractive.
They are an option to buy shares in the issuing company.
They may be separated from the underlying debt so the holder of the warrants may sell them rather than keep them (i.e. they are traded independently).
What are the advantage of Warrants ?
for the issuing company:
- When initially attached to the loan note, the coupon rate on the loan note will be lower than for comparable straight debt. This is because the investor has the additional benefit of potentially purchasing equity shares at an attractive price.
- They may make an issue of unsecured debt possible when the company’s assets are inadequate to secure the debt.
- They are a way of issuing equity (albeit with a delay) without the usual negative signal associated with an equity issue.
Companies agree to borrow from the bank at a fixed rate for a specified period and with an agreed repayment schedule. what are the advantages?
- As the loan is for a fixed term, there is no risk of early recall (unlike overdrafts that are repayable on demand). This helps with financial stability.
- a predetermined repayment schedule makes it easier to budget and plan for loan repayments. This helps cash flow management.
- Interest will usually be tax deductible; reducing the company’s overall tax liability is cost effective.
Instead of buying an asset outright, using retained earnings or borrowed funds, a company may lease an asset. Under a lease contract, the lessee has the right to use an asset owned by the lessor in exchange for a series of payments.
What is the advantage and disadvantage?
Advantages
1. There are many willing providers (often associated with asset manufacturers and therefore offering attractive terms).
2. A lease “matches” finance to the right to use the asset. A company can use assets
that might be too expensive to buy outright.
3. Very flexible packages available, some of which include repairs and maintenance.
4. This helps reduce the costs and operational burden of asset maintenance.
Disadvantages
1. Over the long term, leasing can be more expensive than outright purchase;
cumulative lease payments can exceed the cost of buying the asset.
2. At the end of the lease term, the company typically does not own the asset unless it
has an option to purchase it, at an additional cost.
3. Leases can include restrictions on the use of the asset or penalties for early
termination. These terms may restrict the company’s operational decisions.
Under a sale and leaseback, a company sells property to an institution, such as a pension fund, and then leases it.
What is the advantage and disadvantage ?
Advantages
1. Immediate injection of cash into the business can be used for investment opportunities, debt reduction (interest savings) or working capital requirements.
2. Operational continuity in using the asset without disruption.
3. It may realise a profit on the sale (subject to IFRS requirements).
Disadvantages
1. As the company no longer owns the property it will not benefit from any appreciation in its value.
2. The future borrowing capacity of the company will be reduced, as there will be fewer assets to provide security for a loan.
3. The net effect is equivalent to secured borrowing. A right-of-use asset and a lease liability will be recognised. If the right-of-use asset is greater than the carrying amount of the leased asset, gearing (the proportion of debt finance to equity finance) will increase.
A bank overdraft is a borrowing facility associated with a current account.
What is the advantage and disadvantage of a bank overdraft ?
Advantages
1. Flexible terms of borrowing and repayment allow businesses to borrow funds as needed up to an approved limit, and repay when cash flow permits.
2. Overdrafts can be established relatively quickly, providing immediate access to cash.
3. Interest paid on the amount of the facility used is more cost effective.
Disadvantages
1. Potential uncertainty as banks can withdraw or reduce facilities with little notice: overdrafts are technically repayable on demand.
2. Overdrafts are unsuitable for long-term financing needs and ongoing cash flow issues.
3. Interest rates can be higher than other forms of short-term financing, making overdrafts expensive if used regularly.
Customers can take advantage of trade credit by delaying payments to existing suppliers or using more of the credit offered.
What is the advantage and disadvantage of trade credit ?
Businesses that offer trade credit invoice their customers with payment terms, for example, 30, 60 or 90 days.
1.Trade credit allows a company to delay payment, providing interest-free finance for a period.
2.Extending the time between receipt of goods/services and payment improves cash flow management.
3. Used responsibly (i.e. adhering to terms) can build supplier relationship, potentially leading to more favourable terms and discounts.
Disadvantage
1. The loss of settlement (prompt payment) discounts is potentially costly
2. As it is specific to purchases from suppliers, it does not meet other short-term needs (e.g. meeting payroll obligations).
3. Late payments may result in penalties and damage supplier relationships.
What is Bill of exchange ? advantage and disadvantage ?
it is an acknowledgement of a debt to be paid on a stated date.
1.Bills of exchange provide short-term financing that can help bridge temporary gaps in cash flow.
2. They facilitate payments between parties in different countries, promoting international trade.
3. As negotiable instruments they can be bought, sold or discounted in secondary markets, providing liquidity.
Disadvantage
1. There is a risk that the party obligated to pay the bill may not accept it or default on payment, leading to financial losses.
2. The documentation and verification processes involved can be administratively complex.
3. As their main use is trade-related they may not be suitable for all short-term financing needs
What is Commercial paper ? advantages and disadvantages ?
short-term unsecured debt issued by high-quality companies. Investors can then trade the paper on the secondary market. It is is appropriate for financing short-term liabilities.
What is the advantages and disadvantages of Commercial paper ?
- It is a cost-effective option as large sums can be raised at lower interest rates than other short-term sources.
- No security is required; it relies on the creditworthiness of the company.
- Commercial paper can be issued in various denominations with different maturities to match specific needs.
Disadvantage
1. Only available to large companies with investment-grade credit ratings.
2. Concerns about the issuing company can affect the marketability of the paper.
3. Issuers of commercial paper must comply with regulatory requirements that add administrative and legal costs.
What is the advantage and disadvantage of Short-term Bank Loans?
A short-term cash injection can help companies in need of working capital. Short repayment terms are typically from three months to one year.
Advantage
1. quick access to funds for immediate financial needs is available to most companies (assuming a wellfunctioning banking system).
2. Typically unsecured (i.e. no need to provide collateral).
3.Short-term interest rates are usually lower than long-term interest rates due to lower credit risk on short-term debt.
Disadvantage
1. Arrangement fees may be high when expressed as an annual effective cost.
2.If security is required, this can tie up valuable assets.
3.Refinancing risk (rollover risk). Every time a short-term loan matures, the borrower faces the risk that it cannot be easily replaced or refinanced or that interest rates have risen.
What is the Sources of debt finance available to SMEs ?
1.Trade credit (i.e. obtaining goods or services from suppliers on credit terms).
2. Factoring and invoice discounting (whereby a company effectively raises finance against the security of its outstanding receivables. These forms of short-term financing may be more expensive than a bank overdraft, but the finance available grows as the SME grows
3. Leasing is useful for SMEs as it avoids raising capital to acquire assets. For SMEs, leasing can be cheaper than borrowing because:
-Large leasing companies have bargaining power with suppliers, and so the reduced cost of assets can be partially passed on to lessees.
-Leasing companies can usually dispose of old assets more effectively than SMEs.
-The lease company can reclaim the asset if the lessee defaults on the lease payments, so the agreement has built in security.
-The finance cost to a large established leasing company will likely be less than that for an SME.
4. Bank finance, typically an overdraft or longer-term loans secured on major assets, is usually supported by business plans including cash flow forecasts and backed by personal guarantees of the owner-manager of the SME.
Grants and Subsidies
Grants and Subsidies
Depending on the location and nature of the SME, regional, national or even international grants may be available, either to help start up the business or to contribute towards expansion costs. Subsidies may take the form of government loans offered to SMEs at interest rates below commercial levels.
Government Loan Guarantee Schemes:
Government loan guarantee schemes exist in various countries to support businesses and stimulate economic activity. Under such schemes, the government act as a guarantor for commercial loans to SMEs.
Who are Business Angels ?
business angels are wealthy individuals prepared to invest money and time in small companies if they see high growth potential.
If prepared to invest in debt, they also may want the opportunity for future equity participation Therefore, convertible debt or debt with warrants may be appropriate.
What is Supply Chain Finance ?
Supply Chain Finance (SCF) – the use of financial instruments, practices and technologies to optimise the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners.
SCF provides short-term credit that optimises working capital for both the buyer and the seller. It generally involves using a technology platform to automate transactions and track invoice approval and settlement processes from initiation to completion.
What is peer-to-peer lending/debt-based crowdfunding ? and advantages
Peer-to-peer (P2P) lending – a method of debt financing that enables individuals to lend money to small businesses without using an official financial institution as an intermediary.
- Loans generate interest income for lenders, often exceeding that earned on a bank deposit account.
- Borrowers have access to finance when banks refuse credit or would charge very high interest rates.
- By effectively cutting out the middleman (i.e. the formal banking system), interest rates can be relatively attractive to lenders and borrowers.
What should you consider when selecting a suitable financing (9) ?
- Availability. Finance may be limited if recent or forecast performance is poor and an SME will always find it difficult to raise equity.
- Cash flow. Debt requires a company to pay out cash in the form of interest; therefore, the company’s ability to generate cash will be relevant.
- Control. Raising equity can lead to a change in control, but debt will not.
- Cost. Debt finance is cheaper than equity finance, so if the company can take on more debt, there could be a cost advantage.
- Ease and cost of issue. Raising equity is more difficult, time consuming and expensive than raising debt.
- Maturity. In general, the term of the finance should match the term of the need (matching principle). However, the maturity dates of existing debt should also be considered.
- Risk. Company directors must control the total risk (financial risk and business risk). If business risk rises, the company may seek to reduce financial risk and vice versa.
- Security and covenants. Debt may require security (is this available?) or covenants (are these acceptable?) to maintain a certain liquidity level.
- Yield curve. If, for example, the yield curve is getting steeper (see Chapter 2), there is an expectation that interest rates will rise. Therefore, fixed-rate debt may be appropriate if a company wishes to take on more debt.
What is A variable (floating) interest rate ?
Variable (floating) interest rate loan notes would automatically adjust their interest payment in line with an agreed market benchmark (e.g. SFOR). Therefore, such variable-rate debt should maintain its value.
