Sources and Cost of Finance Flashcards
What is capital structure?
Capital structure refers to the way in which an organisation is financed, by a combination of long-term capital (such as equity capital, bonds and bank loans) and short-term liabilities (such as a bank overdrafts and trade payables). It refers in particular to:
the balance between equity and debt capital, and
the balance between long-term and short-term finance.
What is ‘gearing’?
The term ‘gearing’ (or ‘leverage’) is used to refer to the proportion of debt capital in a company’s capital structure.
What are some of the short term sources of finance for a company?
Short-term finance is usually needed for businesses to run their day-to-day operations including payment of wages to employees, inventory ordering and supplies.Businesses with seasonal peaks and troughs and those engaged in international trade are likely to be heavy users of short-term finance. A range of short-term sources of finance are available to businesses including overdrafts, short-term loans and trade credit.
What are the factors influencing choice of Debt Finance?
The choice of debt finance that a company can make depends upon:
availability which is in part a function of the size of the business (a public issue of bonds is only available to a large company)
the duration of the loan
whether a fixed or floating interest rate is preferred (fixed rates are more expensive, but floating rates are riskier)
the security that can be offered.
What are Bonds?
Bonds are long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of bonds are long term creditors of the company. Bonds have a nominal value, which is the debt owed by the company, and interest is paid at a stated ‘coupon’ on this amount.
What are Debentures?
Debentures are long term debt securities, Debenture notes are loans made to a company for a fixed period for a fixed rate of interest.
What are Deep Discount Bonds?
Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal value of the notes, and which will be redeemable at par (or above par) when they eventually mature. Investors might be attracted by the large capital gain offered by the bonds, which is the difference between the issue price and the redemption value. However, deep discount bonds will carry a much lower rate of interest than other types of bond. The only tax advantage is that the gain gets taxed (as income) in one lump on maturity or sale, not as amounts of interest each year. The borrower can, however, deduct notional interest each year in computing profits.
What are Zero Coupon Bonds?
Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them. The investor gains from the difference between the issue price and the redemption value. There is an implied interest rate in the amount of discount at which the bonds are issued or subsequently re-sold on the market.
The advantage for borrowers is that zero coupon bonds can be used to raise cash immediately, and there is no cash repayment until redemption date. The cost of redemption is known at the time of issue. The borrower can plan to have funds available to redeem the bonds at maturity.
The advantage for lenders is restricted, unless the rate of discount on the bonds offers a high yield. The only way of obtaining cash from the bonds before maturity is to sell them. Their market value will depend on the remaining term to maturity and current market interest rates. The tax advantage of zero coupon bonds is the same as that for deep discount bonds.
What are Convertible Bonds?
Convertible bonds are bonds that give the holder the right to convert to other securities, normally ordinary shares, at a pre-determined price/rate and time.
Conversion value = conversion ratio × current market value per share
Conversion premium = current market value of debt – current conversion value
The actual market price of convertible bonds will depend on:
the price of straight debt
the current conversion value
the length of time before conversion may take place
the market’s expectation as to future equity returns and the risk associated with these returns.
Question:
The 10 per cent convertible bonds of Starchwhite are quoted at $142 per $100 nominal. The earliest date for conversion is in four years’ time, at the rate of 30 ordinary shares per $100 nominal bond. The share price is currently $4.15. Annual interest on the bonds has just been paid.
a. Calculate the current conversion value.
b. Calculate the conversion premium and comment on its meaning.
a. Conversion value = conversion ratio x current market value per share
Conversion ratio is $100 bond = 30 ordinary shares
Current market value per share = $4.15
Conversion value =30 × $4.15 = $124.50
b. Conversion premium = current market value of debt - current conversion value
Conversion premium = $(142 – 124.50) = $17.50 or 17.50/124.50× 100% = 14% The share price would have to rise by 14 per cent before the conversion rights became attractive
Debt vs Preference Shares
Preference shares are part of the share capital of a business. However, they usually carry no voting rights but attract a fixed dividend that must be paid in priority to any dividend on ordinary shares. There is no right to share in profits in excess of the fixed dividend. Commercially, there is little difference between preference shares and unsecured debt. Both preference shares and debt:
normally pay a fixed annual return (interest or dividends)
may be irredeemable, redeemable at a pre-set value or convertible.
The only true difference that arises is in respect of the risk to investors:
if profitability is low a company can cut any preference dividend, but it cannot avoid interest on debt
if a company becomes insolvent, preference shareholders rank below all debt holders, even subordinated debt. To compensate for this additional risk, preference shareholders are likely to receive a higher return than long-term debt holders.
What are the rights of ordinary shareholders?
Ordinary shareholders have rights as a result of their ownership of the shares:
Shareholders can attend company general meetings.
They can vote on important company matters such as the appointment of directors, using shares in a takeover bid, changes to authorised share capital or the appointment auditors.
They are entitled to receive a share of any agreed dividend.
They will receive the annual report and accounts. They will receive a share of any assets remaining after liquidation.
They can participate in any new issue of shares.
What is a rights issue?
A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a price lower than the current market price, in proportion to their existing holdings.
Rights issues can be renounceable or non-renounceable. If shareholders choose not to take up renounceable rights on the new shares, they can sell them on to others. Non-renounceable rights must be taken up or forfeited.
Seagull can achieve a profit after tax of 20 per cent on the capital employed. At present its capital structure is as follows.
$200 000 ordinary shares of $1 each 200 000
Retained earnings 100 000
300 000
The directors propose to raise an additional $126 000 from a rights issue. The current market price is $1.80.
a. Calculate the number of shares that must be issued if the rights price is: $1.60; $1.50; $1.40; $1.20.
b. Calculate the dilution in earnings per share in each case.
The earnings at present are 20 per cent of $300 000 = $60 000. This gives earnings per share of 30c.
The earnings after the rights issue will be 20 per cent of $426 000 = $85 200.
The total number of shares will be the number of existing shares (200,000) plus the number of new shares (see below).
Rights Price @ $1.60
No of new shares ($126 000 / rights price) = 78,750
EPS ($85 200 / total no of shares) = $ Cents 30.6
Dilution Cents + 0.6
Rights Price @ $1.50
No of new shares ($126 000 / rights price) = 84,000
EPS ($85 200 / total no of shares) = $ Cents 30
Dilution Cents 0
Rights Price @ $1.40
No of new shares ($126 000 / rights price) = 90,000
EPS ($85 200 / total no of shares) = $ Cents 29.4
Dilution Cents -0.6
Rights Price @ $1.20
No of new shares ($126 000 / rights price) = 105,000
EPS ($85 200 / total no of shares) = $ Cents 27.9
Dilution Cents -2.1
Note that at a high rights price the earnings per share are increased, not diluted. The breakeven point (zero dilution) occurs when the rights price is equal to the capital employed per share: $300 000 / 200 000 = $1.50.
Fundraiser has 1 000 000 ordinary shares of $1 in issue, which have a market price on 1 September of $2.10 per share. The company decides to make a rights issue, and offers its shareholders the right to subscribe for one new share at $1.50 each for every four shares already held. After the announcement of the issue, the share price fell to $1.95, but by the time just prior to the issue being made, it had recovered to $2 per share. This market value just before the issue is known as the cum rights price. What is the theoretical ex-rights price?
Value of the portfolio for a shareholder with four shares before the rights issue:
$ 4 shares @ $2.00 8.00
1 share @ $1.50 1.50
5 shares 9.50
So the value per share after the rights issue (or TERP) is 9.50 / 5 = $1.90.
