Sources Of Finance

Question 1

What is the criteria for choosing a source of finance?

Answer 1

Cost – debt is usually cheaper than equity
Duration – long-term finance is more expensive but more secure than short-term
Term structure of interest rates (Short-term usually cheaper but not always)
Gearing – what is current level? Adding debt is usually cheaper than equity but high gearing is risky
Accessibility – not all sources available to all firms

Question 2

What are some short-term sources of finance?

Answer 2

Bank overdrafts (flexible, only used when needed)
Bank loans (secure, may only be available if have assets to use as security)
Better management of working capital (profitability vs liquidity decisions)
Leasing (spread the cost of the asset)
Sale and leaseback (generates cash to be used for other purposes)

Question 3

What is long-term finance equity?

Answer 3

Equity shareholders (ordinary shareholders) are the owners of the business and exercise ultimate control through their voting rights.
 Equity finance is the investment in a company by the ordinary shareholder, represented by the issued ordinary share capital plus reserves. 
While strictly preference shares are an equity source of finance, their characteristics bear more resemblance to debt finance and so for the purposes of such calculations as gearing they are considered to be part of debt rather than equity.

Question 4

How can a company raise equity?

Answer 4

Internally generated funds (retained earnings not already paid out as dividends or used for prior investment. Quick and cheap source of finance if available) 
Rights issues (the issue of new shares to existing shareholders in proportion to their existing shareholdings at a discount to the current market value) 
New external share issues (placings, offers for sale, etc.)

Question 5

What are rights issues?

Answer 5

More expensive than internally generated funds but cheaper than a new issue.
Shareholders can sell their rights instead of taking them up.
Issuing new shares at a discount will cause the share price to fall.
Theoretical ex-rights price (TERP)

Question 6

How do you calculate the Theoretical Ex-rights prices (TERP)?

Answer 6

Value of existing shares + proceeds from issue / no of shares in issue after the rights issue

Question 7

How do you calculate the value of a right?

Answer 7

TERP - issue price

Question 8

How do you calculate the value of a right per existing share?

Answer 8

Value of right / No. of shares needed to have a right

Question 9

What are shareholder options when it comes to a rights issue?

Answer 9

take up the rights by buying the specified proportion of shares at the price offered
renounce the rights and sell them in the market.
Renounce part of the rights and take up the remainder
Do nothing (will lose wealth as shares held will fall in value to the TERP)

Question 10

What are some issues with new external share issues?

Answer 10

expensive
may fail
may require business to become quoted – stringent criteria to adhere to
via placing, enterprise investment scheme, public offer, fixed price offer, offer for sale by tender
dilution of control for existing shareholders.

Question 11

What is long-term finance debt?

Answer 11

Long-term debt (bonds), usually in the form of debentures or loan notes, is frequently used as a source of long-term finance as an alternative to equity.
A bond is a written acknowledgement of a debt by a company, normally containing provisions as to payment of interest and the terms of repayment of the principal.
Features:
traded on stock markets
usually denominated in blocks of $100 nominal value
may be secured or unsecured (security may come in the form of a fixed charge over specific assets or a floating charge over all assets or a category of assets)
may be redeemable or irredeemable (if redeemable the repayment date will be specified in the terms of the bond

Question 12

What are the investor viewpoints of long-term debt?

Answer 12

Low risk, therefore low return acceptable

No voting rights (no control)

Question 13

What are the company viewpoints of long-term debt?

Answer 13

Cheap, predictable, does not dilute control

Inflexible, increases risk at high levels of gearing, must be repaid

Question 14

What are deep discount bonds?

Answer 14

issued at a discount to nominal value and redeemable at par and above

Question 15

What are Zero coupon bonds?

Answer 15

like deep discount but no interest is paid whilst in issue

Question 16

What are hybrid-convertible bonds?

Answer 16

Give the bond holder the right to convert (if they choose at the time) the debt into other securities, normally ordinary shares, at a future date.
– converted at either a pre-determined price or ratio
– conversion premium occurs if the market value of the convertible stock is greater than the market value of the shares the stock can be converted into
– floor value is the minimum market price of the note, calculated as the PV of the future interest plus the PV of the cash redemption value.

Question 17

What are loan notes with warrants?

Answer 17

Give the bond holder the right to subscribe at a fixed future date for a certain number of ordinary shares at a predetermined price.
– the loan notes are not converted. They remain in place after the subscription date
– can be used to make the debt more attractive and able to set a low coupon rate
– holder gets right to buy shares at attractive price
– holder can sell on the warrants, effectively reducing the cost of purchasing the debt.

Question 18

What is short-term finance leasing?

Answer 18

With the exception of leasing and sale and leaseback, all other short-term sources have been discussed – overdrafts, working capital management, factoring etc
Leasing as a short-term source of finance is growing in popularity:
Lease period is less than the useful life of the asset
Lessor normally responsible for repairs and maintenance
Lease can sometimes be cancelled at short notice

Question 19

What is short-term sale and lease back?

Answer 19

A company that owns its own premises can obtain finance by selling the property for cash and renting it back off the acquirer.
Immediate source of cash but number of disadvantages:
Company loses ownership of the property (miss out on any appreciation of value)
Rental agreement (usually >50 years) which is restrictive
Future borrowing capacity of company will reduce (less security)
Rent will be subject to regular reviews

Question 20

What is long-term leasing?

Answer 20

Long-term lease arrangements would be used as debt finance for assets that have a useful life over the medium to long-term period.
Lease generally covers the whole useful life of the asset
Risks and rewards of ownership generally passed to the lessee
Lease agreement cannot be cancelled.

Question 21

What is the funding gap?

Answer 21

Unquoted SMEs may find they have an inability to raise funding without becoming quoted. 
This may be bridged by using: 
business angels or venture capitalists 
government assistance 
crowdfunding, peer-to-peer funding.

Question 22

What is the maturity gap?

Answer 22

SMEs may find it easier to obtain long-term finance secured against their assets than short or medium-term finance.
But for short to medium-term assets it would prefer to raise short to medium-term finance to match the term of its assets against its liabilities and keep funding costs down.
The inability to do this is known as the maturity gap.

Question 23

What are financial investors?

Answer 23

Small firms considered more risky. This is a particular issue for newer businesses which may:
Lack proper financial control systems
Have inexperienced management teams
Not have an established track record
Lack sufficient good quality assets to offer as security (it is common for the owners of the business to be asked for personal guarantees).
Although banks remain reluctant to invest heavily, investment may become available from:
Venture capitalists
Business angels

Question 24

How can banks offer finance?

Answer 24

Traditionally, small businesses have borrowed by means of loans and overdrafts from banks.
Main issues have been
Lack of security
Risk-averse attitude of banks (new, untested project)

Question 25

What is venture capital?

Answer 25

Venture capital is the provision of risk-bearing capital, usually in the form of a participation in equity, to companies with high growth potential.
Venture capitalists provide start-up and late stage growth finance, usually for smaller firms and will often look for an exit route in the form of flotation of the company enabling them to sell their investment.

Question 26

What are business angels?

Answer 26

Although venture capitalists are the main providers of equity finance to small businesses, they are highly selective and normally don’t invest amounts under £100,000 in the UK.
Business angels – private individuals who normally have a business background.
Make investments in small businesses in return for an equity stake
Can also offer the businesses the benefits of their own management expertise.

Question 27

What are some government solutions as sources of finance?

Answer 27

Tax incentives, Enterprise investment schemes, Venture capitalists, share incentive schemes, regional support (government on a local scale ie the council)

Question 28

What is crowdfunding?

Answer 28

Asking a large number of people each for a small amount of money
Uses internet to talk to thousands – if not millions – of potential funders.
Those seeking funds will set up a profile of their project on a website

Question 29

What is peer-to-peer lending?

Answer 29

Borrowing or lending money between unrelated individuals or ‘peers’, without going through a traditional financial intermediary such as a bank.
No necessary common bond or prior relationship between borrowers and lenders
Intermediation takes place by a peer-to-peer lending company and all transactions take place online, with a view to the lender making a profit
Lenders may choose which borrowers to invest in and the loans are unsecured

Question 30

What is Islamic finance?

Answer 30

Islamic finance operates in accordance with the principles of Sharia law: 
Sharing of profits and losses 
No interest (riba) allowed 
Restricted to Islamically accepted transactions, i.e. no investment in alcohol, gambling, etc. 
Main sources of Islamic finance are: 
Murabaha (trade credit) 
Ijara (lease finance) 
Sukuk (debt finance) 
Mudaraba (equity finance) 
Musharaka (venture capital).