Introduction to Companies, Funding and the Capital Markets

Question 1

What do we mean by financial markets?

Question 2

What do we mean by capital markets?

Answer 2

Financial markets consist of large numbers of people and organisations with money
to invest and equally large numbers of people and organisations who want to borrow
that money. The intermediaries who bring the buyers (borrowers) and sellers
(lenders) together are retail and commercial banks, investment banks and brokers.

Question 3

What is the main function of financial markets?

Answer 3

Financial markets are a useful way of creating “liquidity” – i.e. enabling people to buy
and sell easily, when they want, at a fair price. Many financial markets provide
electronic access to continuous price information so that people can make day-to-day
decisions on a well-informed basis. For example, anyone can access up-to-date share
prices and foreign exchange rates online

Question 4

Name the different types of financial markets. (6)

Answer 4

Financial markets facilitate all sorts of activities associated with money:
* Borrowing and lending short-term, typically less than one year (money markets)
* Borrowing and lending long-term, typically more than one year (capital markets)
* Investing and trading investments such as bonds and shares (stock
markets/capital markets)
* Exchanging currencies (foreign exchange market)
* Trading commodities such as metals, wheat, coffee etc (commodities markets)
* Arranging insurance (insurance market).

Question 5

What is the difference between cash markets and derivative markets?

Answer 5

Cash markets allow trade for instruments with immediate deliver. An investor who buys a share in the cash market, owns that share immediately.

Derivatives markets allow trade for financial instruments on a future date or with an option. An investor who takes out a contract to buy something on a future date, at a price that is fixed now is using the derivatives market.

Question 6

What is a financial instrument?

Answer 6

A financial instrument or financial asset (or security) is something that gives the
owner a legal claim to some future benefit. Unlike a tangible asset (an asset you can
touch), the value is not related to the physical form of the asset. Instead, the value is
related to the future cash that the asset (or investment) is expected to generate.

Question 7

What is a government/company bond?

Answer 7

A government bond: The issuer is the government, who agrees to pay the investor
interest every 6 months and to repay the amount borrowed at the maturity date. A
company bond is similar, but the issuer is a company rather than a government.

Question 8

What is a share?

Answer 8

A share issued by a company: The issuer is the company, who agrees to pay the
investor dividends (if the directors decide to pay profits out of the company). The
investor also has a claim to a pro rata share of the net asset value of the company in
the case of liquidation. Otherwise, to get their money back, an investor must sell his
or her shares to another investor.

Question 9

What is the difference between an option and a future?

Question 10

What are the four main funding options available to a company?

Answer 10

1) Equity
2) Debt
3) Crowd Funding
4) Venture Capital

Question 11

What is the difference between debt and equity?

Answer 11

Debt is capital from banks or the capital markets in the case of bond issues. Lenders have a contractual right to interest and the repayment of their capital. This means that debt is more inflexible than equity for the company. However, debt is less expensive, lenders require a lower return to compensate for the lower risk than equity.

Equity is capital from shareholders who share in the ownership of the company, receiving dividends if appropriate. To get their money back, shareholders must sell their share on to another investor. Equity provides a business with a permanent source of capital, making it more flexible than debt. However, equity is more expensive because shareholders require a larger return to compensate them for the higher risk.

Question 12

Why would debt be a bad option for a start up?

Answer 12

A start up may not be able to afford the interest and may struggle with capital repayments.

Question 13

What does high gearing mean?

Answer 13

High gearing means that a company has high debt in the capital mix, which creates high variability of profits/losses. High financial leverage drives profit up in good times and down in bad times. This is suitable for a company with a stable revenue stream such as a utility.

Question 14

What is a security?

Answer 14

A tradable investment such as a bond or share.

Question 15

What is the secondary market?

Answer 15

The secondary market is the market for the trading of securities such as shares and bonds between investors.

Question 16

What is the primary market?

Answer 16

The primary market is the market for the issuance of financial instruments such as bonds and shares, e.g. share issues and bond issues are primary market transactions.

Question 17

What is liquidity?

Answer 17

Liquidity is the ability to exchange an investment for cash quickly, easily and at a reasonable price.

Question 18

Where does SSE’s funding come from?

Answer 18

On 31 March 2021, SSE had nearly £9bn of debt, just over half of which came from bonds. The average interest rate on the loans and bonds is around 3.1%.
The interest rate is linked to SSE’s credit rating which is BBB+. This is a strong investment grade rating which gives SSE easy access to debt at a reasonably low cost.

The value of SSE’s equity in the stock market (market capitalisation - number of shares x share price) is approx. £17bn (September 2021).
The value of the equity in SSE’s balance sheet on 31 March 2021 was approx. £7bn (lower than market cap because the balance sheet reflects historic rather than current values).

Question 19

How would you value a company?

Answer 19

Near term forecasts of future cash flows and long-term cash flows are discounted back to today’s value and added up, such that the value of an investment today is the net present value of all future cash flows. Investors want to see cash flows grow and that their investment will produce a return in the long run.

Question 20

What is total shareholder return?

Answer 20

Total shareholder return is the combination of growth in the value of a shareholder’s investment and dividends (a cash payment out of profit to shareholders).

Question 21

What is the difference between a bear and a bull market?

Answer 21

A bull market is a rising market (bulls attack upwards with their horns)
A bear market is a falling market (bears attack downwards with their paws).

Question 22

What is WACC?

Answer 22

Weighted Average Cost of Capital.

Question 23

What can be said about a value creating business?

Answer 23

The return on capital for a value creating business will be greater than the cost of capital.

ROC/ROCE/ROI must be greater than WACC in the long run.

Question 24

What are the top 5 Macro-Economic issues affecting the economy?

Answer 24

1) Inflation
2) Interest Rates
3) Economic Growth
4) Commodities and Currencies
5) Politics, conflict, and trade wars.

Question 25

What are the trade-offs between equity and debt?

Answer 25

Debt:
- Must be repaid.
- Compulsory interest (tax deductible).
- Covenants (legal restrictions liked to financial ratios)
- Cheaper (lower risk for the lender).

Equity
- Permanent capital
- Dividends at directors’ discretion.
- Votes (including board of directors).
- More expensive (more risk for investor)

Question 26

Describe the company life cycle.

Answer 26

1) Most companies start out privately-owned
2) Then they may seek private equity funding (shareholders who specialise in buying shares in unlisted companies e.g. Blackstone & Cinven)
3) Private equity investors will look to exit at some point (typically within 3-5 years) to realise their investment
4) The exit options are IPO (float on the stock market), trade sale (sale to another company) or recycle the investment to another private equity firm specialising in later-stage investments
5) In later life, companies can be taken private or bought out from larger groups with the help of private equity investment

Question 27

Is SSE suitable for high leverage?

Answer 27

SSE has mix of business therefore some of the businesses are suitable for high leverage and cheap debt
Whereas other parts of the business such as renewables are less suitable for high leverage.
Therefore SSE needs a mix.
If rating agencies believe you have taken on cheap debt, you will be downgraded.

Question 28

What is a covenant?

Answer 28

Covenants are promises that the company makes to the lender – for example, not to borrow more than a certain amount or not to let financial ratios fall below or go above a certain level
Potential or actual breach of covenants usually means the company must re-negotiate with its lenders and may be in serious financial difficulty.

Question 29

Define the following bond jargon:

1) Coupon
2) Par Value
3) Due Date
4) Rating

Answer 29

Coupon - is the interest rate received by the holder of the bond each year. It is contractually fixed on issuance depending on the rating at the time.

Par value is the price of the bond on issuance and the amount to be repaid.

Due date is the fixed repayment date.

Rating is the current rating (reviewed regularly by rating agencies).

Question 30

What are bond ratings and why are they important?

Answer 30

Companies pay to have their debt rated and investors pay to see the ratings reports
BBB and above are investment grade ratings
BB and below are junk bonds (high yield bonds because they are high risk)
S&P and Fitch use + or – (e.g. AA+ or AA-) to adjust ratings further; Moody’s adds digits e.g. Ba1 beats Ba2
Most conventional fund only invest in investment grade bonds so the junk bond market is quite specialised and much smaller
Changes to debt ratings may affect a company’s share price, especially if the ratings agency has picked up on an issue that equity investors have not considered.

Question 31

What are green bonds?

Answer 31

Green bonds, money borrowed that can only be invested in ESG projects.
Many companies will accept lower interest rates on green bonds.
As SSE’s current bonds mature, interest rates will go up.
SSE is biggest issuer of green bonds in corporate sector.

Question 32

What are bonds?

Answer 32

Issued by companies and governments to raise capital
Attractive to investors looking for a relatively safe investment providing regular income via interest
Bond issues are primary market transactions (between companies and investors)
Bonds are traded subsequently on secondary markets (between investors)
Market for bonds = fixed income market

Question 33

What are shares?

Answer 33

A share (equity security) gives the investor ownership in the company

Attractive to investors happy to take risk and looking for capital growth and/or income via dividends
Share issues are primary market transactions (between companies and investors)
IPOs (first time a company issues shares publicly)
Rights issues (issue of shares to existing investors)
Placings (issue of shares to new investors)
Shares are traded subsequently on secondary markets (between investors)
Market for shares = equity market
Publicly traded shares are listed on one or more stock exchanges and traded via those stock exchanges and/or multilateral trading facilities (MTFs)

Question 34

What is an ADR?

Answer 34

An ADR (American Depository Receipt) represents title to a number of shares (in the case of GSK, 2 shares)
ADRs trade and pay dividends in dollars and are US financial instruments, making it easier for US shareholders to invest in overseas company shares
Several shares usually make up one ADR because normal share prices are higher in the US than they are in the UK (not necessarily more valuable – just higher denominations)
SSE’s ADR represents just one share.

Question 35

How can a company create value for shareholders?

Answer 35

A company creates value for shareholders when the return on capital meets or beats the cost of that capital sustainably over time
TSR (total shareholder return) meets or beats cost of equity (shareholders requirements)
ROCE (return on capital employed) or ROI (return on investment) meets or beats WACC (weighted average cost of capital)

Question 36

What is the task of company management in managing capital? (5)

Answer 36

1)Raise capital in a way that gives an efficient capital structure without too much risk whilst minimising the cost of that capital
2) Allocate that capital to investments that will help the company grow and make adequate returns
3) Constantly review capital allocation to ensure that the capital is being used efficiently
4) Focus on improving profitability by driving revenue and controlling costs
5) Explain the strategy so that the market can value the company appropriately