Long-term and Short-term Financing Sources Flashcards
- Long-term finance sources:
Equity and debt are the foundation of the financial capital structure of a company and should be the source of most of its long-term finance:
What is equity?
What is debt?
Equity:
- is raised through the sale of ordinary shares to investors
(long-term) Debt:
- a bank loan or an issue of fixed interest securities such as bonds.(>1 years loan)
- Equity finance
2 Examples?
Ordinary shares are bought and sold regularly on ______ ____________ throughout the world and ordinary shareholders (as firm owners want a ___________ _________ on their _____________)
Ordinary shareholders are the ultimate bearers of risk related to the business activities of the companies they own. This is because an order of precedence governs the distribution of the proceeds of liquidation in the event of a company going out of business:
- E.g., a sale of shares to new owners, perhaps through the stock market as part of a company’s initial listing
- E.g., a sale of shares to existing shareholders by means of a rights issue.
Ordinary shares are bought and sold regularly on stock exchanges throughout the world and ordinary shareholders (as firm owners want a satisfactory return on their investment)
ORDER:
- Secured creditors: debenture holders and banks (entitled to receive in full both unpaid interest and the outstanding capital or principal.)
- Unsecured creditors: suppliers of goods and services
- Preference shareholders
- Ordinary shareholders: are not entitled to receive any of the proceeds of liquidation until the amounts owning to creditors, both secured and unsecured, and preference shareholders have been satisfied in full.
- Equity finance: nominal value vs market value vs book value (3,3,2)
Nominal value (par value or face value):
- The value shown on the face of the ordinary shares (securities).
- It is the original cost of the shares as listed on the certificate.
- Ordinary shares of a company must have a par value (nominal value or face value) by law and can’t be issued for less than this amount. E.g., 1p, 5p, 10p, 25p, 50p, or £1
Market value (marketcapitalization):
- The value at which the share is traded on the listed stock exchange.
- Nominal value bears no relation to its market value. E.g., ordinary shares with a par value of 25p may have a market value (price) of several pounds.
- Market value per share = total value of the company in the market / total number of shares issued by the company
NOTE: New shares, whether issued at the foundation of a company or subsequently, are almost always issued at a premium to their nominal value. The nominal value of shares is represented in the balance sheet (one of three main financial statements) by the ordinary share account. The additional funds raised by selling shares at an issue price greater than the par value are represented by the share premium account
Book value:
- The value of share in the company’s books.
Book value per share = (total assets – total liabilities)/total number of shares issued by the company
OR
Book value per share = ((Equity share capital + reserves and surplus) /total number of shares issued by the company
- P/B (price to book value): highly useful comparison tool while taking an investment decision
- Equity finance: Major sources of equity finance: a. Retained Earnings
What is it?
How can dividends be distributed and what is their effect?
What is the formula?
What question should be asked about this?
What factors affect RE?
The portion of a business’s net profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business.
Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings (RE).
The formula is: Beginnning Period retained earnings = Net income/loss - (cash dividends + stock dividends)
Should a company retain the profits within the business or pay the profits out in dividends?
Factors affect RE: factors affect net income (e.g.,
- sales revenue,
- cost of goods sold,
- depreciation,
- other operating expenses) and
- dividends.
- Equity finance: Major sources of equity finance: b. New issue of shares
- New shares can be offered to any investors, ____ and __________
If the company is newly listed where will it be listed?
What if it is already listed?
Who needs approval from who and to do what and why?
- New shares can be offered to any investors, new and existing.
- Usually if the company is newly listing, it will be listed on the FTSE AIM (Alternative Investment Market).
- If already listed, then additional shares will be added to the existing ones.
- Directors need approval by the shareholders to do this (company law area regarding legality on this) as introducing new shares may have a major impact on the existing shareholders.
b. Lecture Example 1: New issue of shares:
Johan is the managing director of Brighton Wines. The company is very successful but has now reached a point where it needs to expand its warehousing capacity to allow it to continue to grow. The directors are contemplating applying for a quotation on the AIM. The company will issue a further 500,000 shares in addition to the 1,000,000 already in issue. The company hopes to be able to sell the shares at £2.50 each.
The board of directors have invited you to their meeting to discuss the flotation. They are keen to raise the finance, but they are worried about the implications of being quoted on AIM. They want you to outline any possible problems they could face.
Suggested answers (5)
Suggested answer:
- Additional regulation: they will need to produce additional published financial reports. Additional compliance costs often involve more staff to deal with the extra requirements.
- Extra capital will be raised, but there will be legal and other professional fees involved. These could be 10% of the total raised, if not higher. If the company is hoping to raise £1,250,000, fees could be £125,000 or more. - This needs factoring into their cash flow workings for the new warehouse.
- Directors need to be prepared for the additional scrutiny and PR that surrounds being listed – meeting financial journalists, for example.
- Share price may fluctuate which directors need to consider regarding their duty to maximise shareholder wealth.
- Impact on dividend payments for the future – 50% increase in the number of shares will affect the level of dividends payable – how will that affect directors’ personal ‘salary’?
c. Rights issue of shares
What is it?
What effect does it usually have?
What is the issue expressed as?
What can shareholders that don’t take the offer do?
What do we need to consider and what is that?
What is the formula for it?
A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the current market value, in proportion to their existing holdings.
This usually has the effect of diluting the existing share price and hence has an impact for existing shareholders
The issue is expressed as:
1 for XX shares at £X
Shareholders not wishing to take up their rights can sell them on the stock market.
We need to consider the TERP (theoretical ex-rights price) - The new share price after the issue and it is calculated by finding the weighted average of the old price and the rights price, weighted by the number of shares.
TERP (ex-rights price) = (𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑙𝑟𝑒𝑎𝑑𝑦 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒 + 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑓𝑟𝑜𝑚 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠𝑠𝑢𝑒 )/(𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑟𝑖𝑔ℎ𝑡𝑠 𝑖𝑠𝑠𝑢𝑒 (𝑒𝑥 𝑟𝑖𝑔ℎ𝑡))
Right issues - advantages (4) vs disadvantages (3)
Advantages:
- Cheaper than a public share issue
- is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange
- rarely fails
- existing shareholders’ equity stakes are not diluted, provided they take up their rights.
Disadvantages:
- There is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much.
- Will affect Earning per Share (EPS) which affects Price/Earnings (P/E)
- If shareholders do not take up their rights, then their shareholding will be diluted.
- Debt finance
What are the types? (7)
- Bank term loan
- Straight bond
- Zero coupon
- Unsecured bond
- Convertible bond
- Straight bond with warrants attached
- Leasing
- Debt finance - Bank Term loan
What is it?
This is _________ _____ of ______ __________ and can be arranged by ____________ of all _____ and ______.
What are the loans normally secured on?
When is repayment?
The interest rate charged by the bank can either be…
The interest rate is fixed by the finance provider, depending on…?
Bank term loan
- A loan from a bank or other financial institution that is repayable on a certain date in the future.
- This is simplest form of debt financing and can be arranged by companies of all sizes and types.
- The loans are normally secured on the assets of the company.
- Repayment of the principal can be at the end of the period, or over of period of time.
- The interest rate charged by the bank can be fixed or floating.
- The interest rate is fixed by the finance provider, depending on the risk they perceive of the borrower.
- Debt finance - Straight bond
What are other ways of saying this?
What situation do they refer to?
The issuing company must?
The debt carries…?
What is a crucial difference between this type of debt and bank lending?
This type of debt is a lot more…?
Example
Straight bond
- Straight bond, marketable debt, loan note and debenture basically all mean the same thing.
- They refer to a situation where a company issues a - block of debt to investors through the Stock Exchange which is normally secured on the assets of the company.
- Therefore, the issuing company must be listed on the stock exchange and the debt is bought and sold through the stock exchange in a similar way to shares.
- The debt carries a fixed rate of interest set on the date that the debt is issued.
- A crucial difference between this type of debt and bank lending is that an investor buying a bond can sell that bond at any time.
- This type of debt is therefore a lot more ‘liquid’ to an investor, than bank lending.
Example: The market price of a straight bond is normally quoted per $100 nominal value of the bond. Interest is calculated on the basis of the nominal value. If a 12% bond was trading as $92 for example, this would mean that an investor would be prepared to pay $92 for a block debt with a nominal value of $100. The investor would then receive 12% x $100 = $12 of interest each year, but at a cost of $92.
- Debt finance - Zero coupon
How does it work compared and what is the difference?
How much interest is paid?
What would be similar?
What is its main benefit?
What is its drawback?
Zero coupon
- This works in principle the same as a straight bond, except a zero coupon bond is one that is issued at a significant discount to the redemption value.
- No interest is paid but the investor will obtain a significant known return in the form of a capital gain between the date of issue and the redemption date.
- A deep discounted bond is similar except that a small amount of interest is payable each year.
- The main benefit of a zero bond is that a company avoids having to pay significant amounts of cash to an investor until the debt is redeemed. This is most useful if a company is financing a long term investment that will not generate cash returns for some time.
- However, the overall percentage return that an investor will demand will be higher than the return on a normal bond. It is therefore relatively expensive. The company will also need to find a large amount of cash to redeem the debt on the redemption date.
- Debt finance - Unsecured bond
What is it and what is it aka?
Who would rank higher, an investor in mezzanine finance or an investor in secured debt?
Extra point? When is it used?
Unsecured bond
- This is also known as mezzanine finance. This is a bond issued without security on the assets of the company.
- An investor in mezzanine finance would therefore rank below an investor in secured debt in the event of the company going bankrupt or winding up.
- High risk debt -> the return that the company needs to offer investors is often extremely high. It is therefore used mainly where companies do not have assets to use as security.
- Debt finance - Convertible bond
What is it? What is paid each year?
The interest payable tends to be… and why?
Therefore…?
What happens if conversion takes place?
Convertible bond
- This is a type of bond which provides the holder with the option to convert the bond into a certain number of shares at a future date or alternatively, to have the bond redeemed for a cash lump sum. Interest is paid on the bond each year up to the date of conversion or redemption.
- As the investor has the potential to makes a capital growth on the bond through the increase in the share price, the interest payable on the bond tends to be low by comparison to other similar bonds.
- The company will therefore benefit from paying less interest over the period of the bond, but there is no detrimental impact on the company irrespective of the share price movement.
- If conversion takes place, the company has a huge advantage of not having to find the cash to redeem the bond, but there will be negative impact on the EPS / P/E ratio / share price of the company’s shares.
- Debt finance - Straight bond with warrants attached
What is it similar to?
What is a warrant?
Straight bond with warrants attached
- This is similar to the straight bond described above, but when the investor purchases the straight bond, they are also given warrants to buy shares in the company which normally mature on the redemption date of the straight bond.
- A warrant is an option to buy shares in the company, issued by the company itself. If the warrant is exercised by the holder, the company issues new share capital for cash.
