Session 2: Sources of Finance Flashcards
What does a company’s finance mix refer to?
A company’s finance mix refers to the proportion of a company’s assets that are financed by short-term, medium-term, and long-term finance.
What is the accepted rule of thumb in financing decisions?
The accepted rule of thumb in financing decisions is that the finance term (ex. term of loan) should match the term of the investment (the period over which the investment is expected to provide benefits or returns) and the repayment schedule should match the cash inflows from the investment.
How should investment in non-current and current assets be financed?
Investment in non-current assets should be financed with long-term financial commitments.
Investment in current assets should be financed with short-term financial commitments.
What is meant by ‘permanent current assets’?
Permanent current assets refer to the portion of investment in current assets that is permanent (though constantly turning over), requiring long-term financing that a company always needs to maintain to meet regular demand. ex. the minimum level of inventory
Why do companies need to finance temporary current assets?
Companies need to finance temporary current assets because few companies have constant demand and constant costs, leading to the need for additional temporary current assets.
What is the matching approach in financing an asset mix?
The matching approach aims to match the maturities of the investment/assets being financed with the term of finance.
Therefore, non-current assets and permanent current assets will be financed using mostly long-term finance.
What is the conservative approach in financing an asset mix?
The conservative approach aims to fully match the peak finance requirement of a company using long-term sources of finance.
This means that non-current assets, permanent, and temporary current assets are all financed by long-term and medium-term sources of finance.
What is the aggressive approach in financing an asset mix?
The aggressive approach aims to maximize the level of short-term finance and to minimize the level of long-term finance that a company uses.
Short-term sources are used to finance all temporary current asset requirements, a portion of the permanent current asset requirements, and, in extreme cases, some of the non-current asset requirements.
What are the key considerations when deciding on the asset/finance mix to minimize costs and maximize equity holder wealth?
Key considerations include:
- Finance Set-Up Costs: Commission, broker fees, administration, and management time.
- Interest Costs: Directly affect the overall cost of financing and profitability.
- Type of Finance: Tradable market sources, non-marketable, sustainable options affect costs and risks.
- Size of Company: Small and medium-sized companies often cannot access market-based finance.
- Security Available: Tangible assets can lead to cheaper debt financing.
- Gearing: Higher financial leverage (gearing) increases financial risk and financing costs.
- Business Risk: Companies with higher fixed costs face higher financing costs.
- Credit Reputation and Ethical Practices: Influence the ability to secure financing at favorable terms.
What knowledge and considerations are essential for business finance managers within the financial environment?
Economic Environment and Financial Markets: Business finance managers need to understand the potential influence of macroeconomic factors on a company’s operating activities and finances.
Finance Mix: The proportion of finance from short, medium, and long-term sources.
Asset Mix: The asset mix of a company will influence the finance mix, as a matching approach is deemed most appropriate.
Lending Decision Considerations: Banks may consider the 7Cs of credit (character, capacity, capital, collateral, conditions, coverage, and common sense) and require the preparation of a business plan.
What are the long-term sources of equity finance?
- Retained Earnings: Profits reinvested in the business rather than distributed as dividends.
- Issue of Shares: Selling new shares of stock to investors.
- Venture Capital: Investment from venture capitalists in exchange for equity in the business.
What are the characteristics of equity shares?
- Ownership: An equity share represents a portion of the ownership of a company.
- Types: Different types of ordinary shares, such as non-voting, golden, and preferred ordinary shares.
- Marketability: Some equity shares are traded (public companies) while others are not (private companies).
- Dividends: Distributions of profit may be made to equity holders.
- Nominal Value: Assigned monetary value to a share, which bears no relationship to market value.
- Pre-emptive Rights: Equity holders have pre-emptive rights in future share issues.
- Part of Equity: Retained earnings/profits also form part of the equity of the company.
What are the benefits of venture capital?
- Receive needed cash at a low issue price.
- If the investment is all equity, dividends can be waived.
- Access to the venture capitalist’s business expertise (financial planning, marketing advice) and trade contacts.
- Venture capitalists ultimately have the same objective as management which is to to foster a successful, growing company.
- Possible future capital injections from the venture capitalist in the future to support further growth and development.
What are the potential downsides for current equity holders when receiving venture capital?
- Loss of control.
- Need to justify decision-making.
- Increased accountability to the venture capitalist.
What are common exit strategies for venture capital investments?
- Flotation (most attractive): The process of offering a company’s shares to the public in a new stock issuance, typically through an Initial Public Offering (IPO).
- Management Buyback: When the company’s management team buys back the shares from the venture capitalist.
- Sale to an Institutional Investor: Selling the company’s shares to a large institutional investor such as a private equity firm.
- Sale of the Whole Company: Selling the entire company to another business or investor.
Why is equity considered the least risky form of external finance from a company’s perspective?
- Dividends Can Be Waived: Provides flexibility in managing cash flow.
- No Redemption Required: The issued share capital does not have to be repaid.
Why is raising equity finance considered costly?
- Issue Costs: Can range from 5% to 10% of funds raised.
- Fixed Fees: There is usually a minimum fixed level of fees, restricting this option to very large companies.
- Expenses: Include accountants’ fees, solicitors’ fees, broker fees, sponsor/issuing house fees, company registrar fees, preparing a prospectus, and advertising.
- Indirect Costs: Include administrative costs, transaction costs, managerial time, and the burden of servicing this finance in the future.
- Impact on WACC: Increasing the equity of a company may increase the weighted average cost of capital (WACC), resulting in a loss of equity value.
- Tax Deductibility: Dividends are not tax deductible, making them more expensive compared to interest expenses.
Why is equity considered the most risky investment from an investor’s perspective?
Last in Line: Equity investors are last to get claims met (dividends and capital repayment) if the company goes into liquidation.
High Risk: Equity investments are considered the most risky form of finance.
What are the potential rewards for equity investors?
High Rewards: Investors can reap the highest rewards when a company performs well, benefiting from increases in share price and large dividends.
High Return Demand: Equity investors demand the highest return of all financiers of a company
What rights do equity investors have?
- Annual Reports: Right to receive the annual report each year.
- AGM Participation: Right to attend and vote at the annual general meeting.
- Sell Shares: Right to sell their shares at any time.
- Liquidity: If shares are quoted, investors can sell them at short notice, making the investment liquid.
What are the long-term sources of debt finance?
- Loan Stock
- Other Long-term Debt Sources
- Preference Shares
- Debentures / Zero Coupon Bonds
- Deep Discount Bonds / Eurobonds
- Convertibles / Options / Warrants
What factors do lenders consider before advancing long-term debt funds?
- Purpose of the Loan
- Term of the Loan
- Repayment Capacity
- Credit History
- Amount of Loan
- Security Required
- Character of Borrower
- General Economic Conditions
- Specific Market Conditions
What are the characteristics of term loans?
- Advances made by a bank to a borrower for a pre-determined period.
- Normally secured on assets (can also be referred to as mortgage loans).
- Quick to obtain.
- Flexible terms.
- Not repayable on demand.
- Available to all sizes of company.
What are syndicated loans and why are they used?
Syndicated Loans: Large loans provided by several lenders through one main lead bank who administers the loan.
Purpose: To diversify the credit risk across several lenders.
What are the features of bonds as a long-term source of finance?
- Tradable loans arranged by borrowers and bought by investors.
- Can be redeemable or irredeemable.
- Redeemable bonds have a typical maturity of between 7 - 30 years.
- Irredeemable debts do not have a maturity date but can be redeemed at the borrower’s request. - Can be issued publicly with a prospectus and traded on stock exchanges like the London Stock Exchange and Euronext Dublin.
What is a convertible bond?
A hybrid finance instrument that starts as a plain vanilla bond which can be converted into equity rather than being redeemed, usually at a premium.
Attractive to companies as they are more marketable and often have a lower coupon rate.
No cash outflow required on conversion, and gearing is reduced on conversion.
What are preference shares?
- Part of a company’s share capital but not usually considered equity.
- May be issued at a premium above their nominal value.
- Usually carry a fixed dividend and do not confer voting rights.
- May be redeemable and/or convertible.
- Costly to issue and the return required by preference shareholders is quite high.
- Rank after bondholders but before equity holders in claim hierarchy.
What are some other long-term sources of finance?
- Asset Backed Finance: Includes methods such as sale and leaseback.
- Securitisation of Assets: Converting assets into tradable securities.
- Factoring: Includes credit protection and invoice discounting.
- Government Assisted Finance: Grants and provision of expertise.
What is credit protection in the context of factoring?
Credit Protection: A service provided by factoring companies where they assume the risk of bad debts, ensuring the company receives payment even if the customer defaults.
What is invoice discounting?
Invoice Discounting: A financing method where a company sells its trade receivables (invoices) to a financial institution at a discount, providing immediate cash flow while retaining the responsibility for collecting the debts.
What is sale and leaseback as a source of finance?
Sale and Leaseback: A company sells an asset and then leases it back.
Internal Sale: The sale may be made to a newly established subsidiary company that has been formed to raise equity capital. The parent company enters into a lease agreement to pay lease rentals to the subsidiary in return for the use of the asset.
External Sale: The sale is made to an external company and the asset is leased back, which is riskier. The risk with this agreement is that lease payments in the period beyond the lease term may be costly.
Why is market-sourced finance only viable for large companies?
Cost Involved: The high costs associated with market-sourced finance make it viable only for large companies.
Why is equity considered the least risky source of finance from a company’s perspective but the most risky from an investor’s perspective?
Company’s Perspective: Equity is the least risky because dividends can be waived and it does not need repayment.
Investor’s Perspective: It is the most risky because equity holders are last in line to receive claims in the event of liquidation.
How do debt holders rank in comparison to preference and equity shareholders in yearly distributions and liquidation?
Debt Holders: Rank first in claims.
Preference Shares: Rank after debt holders.
Equity Shares: Rank after preference shares.
How is the cost of each source of finance correlated to the risk undertaken by investors?
Debt: Least expensive due to lower risk.
Preference Shares: More expensive than debt but less expensive than equity.
Equity: Most expensive due to highest risk.
What are the medium-term sources of finance?
- Leasing: Includes finance leases and operating leases.
- Hire Purchase: Agreement to pay for an asset in installments.
- Term Loan: Loans with fixed or variable interest rates, secured or unsecured, with specific repayment terms.
What are the short-term sources of finance?
- Bank Overdraft: Contingency funding with flexible borrowing limits.
Improved Working Capital Management: Efficient management of receivables, payables, and inventory. - Euro-currency Facilities: Loans, lines of credit, and revolving credit facilities in foreign currencies.
What are term loans and how do they compare to short-term bank loans?
Term Loans: Loans arranged for periods of over one year.
Comparison: Similar to short-term bank loans in terms of interest options, repayment options, and security.
What is a revolving credit facility and its associated costs?
Revolving Credit Facility: A hybrid between a term loan and an overdraft facility, where the repaid capital can be accessed again over the agreed life of the facility up to the original agreed sum i.e. any amount of the loan that has been repaid can be borrowed again during the term of the facility, up to the original maximum limit agreed upon.
For example, if you have a revolving credit facility of $100,000 and you repay $20,000, you can borrow that $20,000 again, maintaining access to the full $100,000 limit over the life of the loan.
Security: Usually secured on the working capital of a company.
Commitment Fee: An additional cost, typically a percentage of the undrawn balance.
