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.