Module 7 Flashcards
Principles of raising finance (2)
- Matching
- Relationship between risk and return
Matching
Should attempt to match the life of the funding with the life of the asset being funded
If borrowing company can pledge security to the lender
The return the lender will expect to receive will fall
Financial priorities to consider when deciding appropriate source of finance for firm (borrower) (4)
- Liquidity
- Diversification of source
- Flexibility
- Cost
Business plan details
The structure of the business in both financial and operational terms
Lender concerns to be considered in business plan (5)
- Market rather than product focus
- Some track record (of product/ management)
- Recognition of lender’s needs
- Management control
- Credible projections
Factors to consider when advising on the most appropriate finance package (4)
- Type of business/ industry
- Stage of development
- Size of operation
- Intended use of funds (long/ short term)
Key aim of financial package
To minimise the cost and risk to the business
Four main categories of long-term finance
- Equity
- Debt
- Preference Shares
- Quasi-Equity
Equity (or ordinary shares) =
Shares or ownership rights in a business.
Primary risk capital of a company
Expensive source of finance due to the high return required by shareholders to compensate their risk
Equity (ordinary shares) > Providers of finance
Institutional investors (aim is to achieve real growth and returns above the risk free rate)
Equity (ordinary shares) > Cost
Dividends - must be sustainable
Capital growth/ dividend income are of different levels of importance to investors at
Different stages of company’s development
Equity (ordinary shares) > Investors’ rights
- Last in line to be paid in case of liquidation
- Voting rights
Equity (ordinary shares) > Impact on gearing
Reduces gearing ratio > enables company to increase debt capacity in the future
Debt vs equity
Debt is cheaper than equity because of relationship between risk and return, and tax-deductibility of interest
Debt > Cost
Cheaper than equity. After-tax cost of debt capital is important measure.
Cost depends on:
- Company’s perceived credit risk (incl level of leverage)
- Supply and demand for credit
- Market level of interest rates and margins
- Prevailing tax rates
Debt > Investors’ rights (3)
- No right to vote
- Seniority - repaid ahead of ordinary shareholders in case of winding up (if funds available)
- Can determine pre-requisites in covenants of loan
Debt > Impact on gearing
Increase the gearing ratio and financial risk of the company
Leasing =
Type of debt finance
Leasing > legal ownership
Does not pass to the lessee but remains with the lessor
Advantages of leasing (2)
- Tax benefits (passing on capital allowances)
- Flexibility/ cash flow
Hire Purchase (debt)
Finance company buys equipment that hiree requires then allows them to use the equipment in return for a series of regular payments
Hire Purchase > Features (3)
- HP company remains legal owner until all payments repaid
- Legal ownership passes to hiree at end of agreement
- Payments cover interest charges and contribute to paying off principle
Hire Purchase > Advantages (3)
- Small initial outlay
- Easy to arrange
- Certainty
Hire Purchase > tax relief (2)
- Asset can be subject to WDA on capital expenditure
- Interest payments are tax deductible
Preference shares =
Part of shareholder’s funds but not equity share capital. Do not usually benefit from good performance of the firm in the form of higher dividends.
Preference shares > Providers of finance
Investors - offer regular income at higher rate than available on debt (dividend is not guaranteed)
Preference shares > Cost (2)
- Not tax deductible
- Higher than debt providers, but lower than equity shareholders
Preference shares > Investors’ rights (3)
- Fixed dividend paid annually (can increase if ‘participating’
- Reimbursement of principle value of share in liquidation prior to ordinary shareholders
- Usually no voting rights
Types of preference share (4)
- Participating
- Cumulative
- Redeemable
- Convertible
Participating preference share
Possibility of receiving dividend linked to company’s profits
Cumulative preference share
If dividend is not paid due to insufficient profits, amount due will accumulate and paid when there are sufficient profits
Convertible preference share
Converts preference shares to ordinary shares at specific dates and on pre-set terms (yield may be lower)
Redeemable preference share
Business needs to arrange finance for redemption - can be viewed as debt
Quasi-equity
Hybrid between debt and equity eg convertible bond issues and bonds with equity warrants
Convertibles
Debt instrument issued first but embedded with right or option to exchange for shares in the company (usually at price which is a premium to current share price)
Convertibles > Providers of finance
Investors - attractive as they can participate in growth in value in underlying shares but at reduced risk.
Way of attracting venture capital.
Convertibles > Cost
Opportunity to raise funds at lower interest than straight non-convertible debentures
Convertibles > Investors rights (3)
- Usually unsecured obligation
- In liquidation holder ranks ahead of ordinary and preference shareholders but behind senior debt providers
- Conversion depends on performance of underlying share price
Convertibles > Impact on gearing
Initially increases gearing ratio, however upon conversion the ratio will subsequently reduce
Advantages of convertibles to the business (4)
- Cost
- Cash flow benefit
- Fewer restrictions
- Build capital base
Bonds with equity warrants
Company issues bond with fixed rate of interest with fixed maturity. Accompanying bond is one or more warrants which entitle holder to purchase a fixed number of ordinary shares at fixed price for fixed period. Warrant is ‘detachable’ and can be removed from bond and traded separately.
Financing needs > Stage 1 - Introduction
Significant amount of cash needed for R&D and start up capital (owners’ personal money/ VC/ debt/ leasing/ HP)
Financing needs > Stage 2 - Take off
Cash to market the business and its’ products
Financing needs > Stage 3 - Slow down
Similar to stage 1 + 2 but also retained earnings
Financing needs > Stage 4 - Maturity
Period of consolidation. Now has history of funding so better position to obtain further funding from banks or others/ sell shares to the public
Financing needs > Stage 5 - Decline
If not used funding from stage 4 effectively, may suffer decline. Increased capital costs will diminish profits.
Different sources of equity funding available for start ups (6)
- Personal funds
- Venture capital
- Corporate venturing
- Business angel
- Investment crowdfunding
- Internally generated funds/ retained profits and reserves
Different sources of debt funding available for start ups (7)
- Bank borrowing (loan/ overdraft)
- Enterprise Finance Guarantee (EFG) (guarantees on bank loans)
- Government grants
- Soft loans (eg pubs)
- Hire purchase/ leasing
- Factoring
- Local enterprise companies
Crowdfunding
When unlisted business brings together large group of investors to raise finance for new investment opportunity - equity based or reward based
Equity based crowdfunding
Investors buy shares in company, gain ownership rights based on number of shares acquired and receive dividend if the company performs well
Reward-based crowdfunding
If owners do not wish to have their ownership share diluted due to issuing further equity, reward based crowdfunding could be considered.
Investors offered reward eg unique perk/ acknowledgments/ tickets/ option to buy new product first
Peer to peer lending
Similar to crowdfunding, money is raised from a large number of people who pool together. Money is raised using dedicated peer-to-peer lending site eg Funding Circle.
Peer to peer lending - key points (3)
- Not suitable for start ups, borrowers must demonstrate creditworthiness and capability to repay.
- No bank involvement - lender gets better interest than bank savings account, borrower pays less than bank interest loan.
- No guarantee money will be repaid.
Islamic finance key principles (4)
- Asset based
- Taking or receiving interest at exorbitant rates (riba) is not allowed
- Risk in any transaction must be shared
- Speculative behaviour eg gambling/ derivatives is prohibited
Main Islamic finance instruments (2)
- Shariah-compliant current and savings accounts
- Murabaha (cost-plus sale)
