SGS 6: Debt Finance Flashcards
Which is lower / higher geared between equity or finance?
- Equity = lower geared
- Finance = higher geared
What effect does EQUITY have on the balance sheet and future ability to raise money?
- Total equity in balance sheet increases
- Lower gearing: more attractive to banks in the future, as risk of inability to meet debt is reduced
- Earnings per share drop so company is less attractive to equity investors.
What effect does DEBT have on the balance sheet, and the effect to raise future money?
- Company has existing loan so new loan ↑ non-current liabilities on balance sheet
- Higher gearing so risky if company hits financial trouble
- Harder to raise debt finance in future e.g. bank may req. earlier loan to be discharged or comprehensive security over the assets of the borrower.
- Possible ↑ in earnings per share
What effect does EQUITY finance have on funding costs?
- Dividends paid out only if declared, and so long as the company is profiting (otherwise directors can postpone declaring dividends)
- Not tax-deductable.
What effect does DEBT finance have on funding costs - e.g. the return the investor may expect to receive?
- Investor will get interest paid to him regardless of profitability.
- Floating rate interest – if interest rates low, debt may be cheaper than equity.
- Loan interest payments are tax-deductible so may make a corporation tax saving.
What effect does EQUITY FINANCE have re restrictions on a Company affecting ability to raise funds?
- May need shareholder approval to allot new shares where there is a cap on share capital in AoA
- Private companies can’t offer their shares to the public s755
- Limited market for private (Ltd) companies
What effect does DEBT FINANCE have re restrictions on a Company affecting ability to raise funds?
• Borrowing restrictions in Company’s constitution.
• Contractual limits from other loan agreements.
• this is Generally more straightforward
Describe the degree of regulation and procedure for EQUITY finance?
- Share issue > various BRs and OR/SRs.
- Opposing shareholders could use voting power to obstruct new shares being granted.
Describe the degree of regulation and procedure for DEBT finance?
- Borrowing limits in AoA
- No statutory procedure
What is the effect on the balance of power within the company of EQUITY finance?
• Dilution of voting power of existing shareholders if voting shares are given
What is the effect of the balance of power within the company of DEBT finance?
• None – bank has no direct say on decision making
What is the degree of scrutiny of company affairs of EQUITY finance?
- Shareholders only have say in key decisions.
- If new investor has high voting power, then may have big influence on company (e.g. passing special resolutions, appointing directors)
What is the degree of scrutiny of company affairs of DEBT finance?
- Undertakings made by borrower to lender to do or not to do something – representations, undertakings & events of default.
- Security restrictions on disposal of some assets.
What is the effect of EQUITY FINANCE on a companys future profitability?
• Profits do not have to be distributed by way of dividend anymore – can be “locked away” as a reserve on the balance sheet.
What is the effect of DEBT FINANCE on a companys future profitability?
• Regular interest payments have to be met out of trading profits.: harder to build up reserves on balance sheet
• Greater potential because can make much bigger investments which have better potential for a high return.
What are the risks for a company if they experience financial difficulty with EQUITY FINANCE?
- There is No obligation to declare dividend if insufficient profits
- Bad performance will impair capital value of the shares
Less financial liability because using money within its means – only losing its own money.
What are the risks for a company if they experience financial difficulty with DEBT FINANCE?
- Loan agreement may contain certain financial performance targets – financial covenants…
- …Banks can call event of default for breach of any covenant – acceleration of loan, enforcement of security and/or winding up of the company.
- Scope for company to make larger losses by increasing the size of the company’s operations compared to shareholders’ funds.
- Loan interest must be paid regardless of profit.
What are the key stages in a Loan Transaction?
- Bank checks in the financial standing of the borrower
- Bank sending over the draft term sheet
- Lawyers instructed
- Negotiating the loan agreement & security document
- BM
- Money wired to borrowers account by the bank
- Register the security at CH
- Interest payments
- Refinance of the same amount from the same bank on renegotiated terms or defaults (s876)
- In event of default - lender calls money in early.
Why does the bank need to do bank checks financial standing of borrower?
- This is internal risk management
- Credit committee consulted – decides whether bank is overexposed in a certain industry sector & what interest rate should be
- Anti-money laundering checks & due diligence
- Check accounts & balance sheet checks
When the bank sends over the draft term sheet, why do they do this and what is the effect?
- This is not legally binding
- Sets out main terms that the parties agree to:
- Include: (1) Undertakings > Terms in LA (negative pledge, event in default); (2) Security (fixed/floating charge, guarantee)
Explain what happens when the lawyers are instructed?
- S39, s28, s40
• Borrower’s checks AoA for restrictions – ensures that borrower has the power to borrow and/or grant security
• s39 – Means bank need not worry about agreement being ultra vires (NB – Possibility of SH injunction & Ds being personally liable)
Under the 1985 act, company could have had restricted objects in memorandum, and s28 of the 2006 Act treats those as restrictions in the company’s articles.
• Also checks no restrictions in AoA on directors & that they have appropriate authority to act
• s40 – Bank need not worry – Ds have power to act (NB – Possibility of SH injunction & Ds being personally liable – unlikely here)
What will happen during the BM when doing a loan transaction?
- Review documents (approve terms of) & enter loan agreement (simple contract) & security document (executed as a deed) – acting to promote the success of the company under s172.
- Sign documents – s44 & AoA as to how this is done (authorize any director to execute the loan agreement on behalf of the company)
- Fulfill conditions precedent
Explain what happens when money is wired to borrowers account by the bank?
– The amount sent across is net of the bank’s costs (legal costs & any fees).
What happens when, for a Loan Transaction, you register the security at Companies House?
- s859 within 21 days of the date of creation of the security (bank’s solicitors) – s860(1) and s870(1)…If not then void against liquidator s874(1)(a)
- Bank has most to lose so will usually register, although anyone ‘interested’ in the charge can – Form MR01 + certified copy of security document + relevant fee
- Borrower keeps a copy for inspection – s859P
- Where to be kept – s859Q(3)
- How to register – s859 A-Q
- If not registered, then void & immediately repayable + fines s874(3) and the firm will be sued for negligence s859H
- Failure to register a security turns a term loan into an overdraft because not only is it void under s859I, but the loan also becomes instantly payable (akin to an overdraft).
