Sources of Finance Flashcards
What policies and criteria may a company use to choose between sources of Finance?
The initial consideration is what the requirement for Funds relates to:
- Providing Working Capital
- Investing in Non Current Assets.
Where a business cannot fully fund the requirement from retained earnings then the following points must be considered:
- Cost - Debt is usually cheaper than equity. It’s cheaper to take out loan than to issue shares.
- Duration - Long term finance is more costly but also more secure, usually practice is to match duration to the underlaying asset.
- Term structure of Interest Rates - usually short term debt is cheaper, but not always.
- Gearing - High gearing is risky to the business, so although debt is cheaper equity may be a better choice to keep gearing lower.
- Accessibility - Not all sources of finance are available to all firms.
What is the relationship between risk and return and how does this relate to different securities?
Investment risk is the result of returns being variable and uncertain, as a result this means that when the risk of an investment increases the returns are also expected to increase.
Consider:
- Building society investment vs Investment in Equities (Higher risk)
- Investment in Food retailing vs Investment in Computer electronics (Higher risk)
What is equity finance and other types of Share capital?
Equity finance = investment by ordinary shareholders in the business. Gives ownership and control. In the BS this is the ordinary share capital and reserves.
Preference shares - while these are share capital their behaviour is more like long term debt as the preference dividend must be paid irrespective of profit levels. Treated as part of Debt for calculations. Two types available:
- Cumulative - Paid a fixed dividend per year, arrears accumulate and must be paid before ordinary dividend. Rank after all creditors but before ordinary shareholders.
- Non-Cumulative - Paid a fixed dividend per year, arrears do not accumulate.
What are internally generated funds and what or the advantages/disadvantages of using this as a source of finance?
Internally generated funds are essentially earnings retained in the business.
- Cheap and quick to raise - no transaction costs, professional assistance or delays.
- Assuming the company is profitable it will continue to internally generate funds.
- Finance required may exceed that available from retained earnings.
- Watch out for the Retained earnings figure on the financial statements having already been used for earlier projects.
What are the benefits and disadvantages of Lease finance as a source of long term finance?
- Leasing an asset can be a way to obtain access to equipment without initial large outflows of Funds.
- The lessor is generally responsible for repairs and maintenance.
- Risk related to the asset does not pass to the lessee.
- The lessee also cannot access reward - i.e. no tax allowable Dep’n although the lease cost is a tax allowable expense.
- Asset reverts back to lessor at the end of the lease, so no ale or disposal proceeds.
- Leases can sometimes be terminated at short notice - i.e. asset is no longer required
What is a rights issue and how is the theoretical ex rights price calculated in relation to this?
A rights issue is an offer to existing share holders to subscribe to additional shares in proportion to their existing holding at a rate discounted in relation to market value.
Shareholders may choose to:
- Take up the rights issue - the net of the cost of buying the shares and the increase in their overall share value will maintain wealth.
- Sell the rights - the gain from the sale will offset the reduction in their overall share value.
- Do nothing - overall share value will decrease with no offsetting gain.
TERP (Theoretical Ex Rights Price)
Calculated as - (market price of shares already in issue + proceeds from new share issue)/ No. shares in issue after rights issue.
Value of a right
Calculated as Ex rights price - issue price (discounted)
Value per existing share - Right value/No. shares needed to obtain right
In relation to shares what is meant by placing and listing, and how does this relate to quoted and unquoted companies?
Placing
- May be used by both quoted and unquoted companies
- Used for smaller issues of shares, usually up to £15 million.
- Bank advising “places” (sells) shares with an institution, shares can then be purchased from the institution
Public offer, which can be further broken down to Fixed price or sale by tender.
- Public offer = invitation to apply for shares in a company either by:
- Fixed Price offer - offer details are published in a prospectus detailing company performance act.
- By tender - no price set, potential investors bid. Price of sale referred to as “strike Price”
Quoted = listed on the stock market.
this will serve to increase a companies pool of investors.
How should the decision between sources of equity finance be approached.
The following factors should be considered:
- Accessibility of finance - how easily can the company access the markets, quoted will be easier than unquoted. Only Plc’s can sell shares to the general public. And floatations on the stock market are expensive.
- Amount of Finance - A rights issue will be limited by the number and resources of existing shareholders.
- Costs of issue procedures - cheapest to most expensive - Internally generated, placings, rights issues, public offers.
- Pricing of issue - incorrect pricing will result in either the issue not being fully taken up or benefits of the project accruing to new shareholders rather than old.
- Control - how will the choice affect the control of the company?
What are the sources of long term debt finance and what are the benefits/disadvantages of this?
Long term debt - Debentures (Bonds) or loan notes.
- Traded on the stock markets.
- Usually denominated in blocks of £100 value.
- May be secured or unsecured.
- May be redeemable - principle will be repaid at a specified date, or irredeemable - not repayable at a specific time, interest is payable in perpetuity.
It’s impact will have advantages and disadvantages for the company and the investor:
- For investors it is low risk, however for companies will increase gearing, is inflexible and repayments must normally be meet resulting in increased risk.
- For companies it does not dilute control, which can be viewed as a disadvantage for investors.
- It is also cheap and offers certainly as the cash flows related to it are predictable.
What types of bonds might be available for long term debt finance?
- Deep Discount Bonds - issued at a large discount to nominal value, redeemable at nominal value once matured. Low interest (Coupon) rate to balance out discount.
- Zero Coupon Bonds - no interest payable, issued at a discount to nominal value.
- Convertible loan notes - may be converted to ordinary shares on maturity. Conversion premium will be the difference between the market value of the stock and the value of the shares it will be converted in to (occurs when MV Stock > MV Shares)
What are the other types of long term finance a company may access?
- Long term Lease - similar to short term except, usually fo the full life of the asset, cannot be cancelled.
- Venture Capital - usually aimed at smaller firms with high growth potential, provides risk bearing capital in the form of participation in Equity. Will usually look at floatation as the exit route.
How do small and medium businesses face difficulties in accessing finance and what are the available options?
SME’s -
- Unquoted with a small number of owners and low levels of seed capital.
- May lack business history or proven track record.
- Subject to lower levels of audit and public scrutiny on their accounts.
Funding Gap - where the business need for finance extends beyond the methods easily accessible to it, i.e. bank borrowing, but unable to move to the stock exchange or alternative investment market. May look to business angels, Venture Capitalists or Government assistance.
Maturity Gap - SME can find long term finance easier to obtain than short term (Mortgage over property) which will potentially result in a mismatch between assets and liabilities.
What are the principles behind Islamic finance?
Basic principles are:
- Sharing of Profit and losses
- No Interest (Riba) Allowed.
- Finance is restricted to Islamically acceptable transactions.
Main sources of Finance within Islamic Banking are:
- Murabaha - Trade Credit
- Ijara - Lease finance
- Sukuk - Debt Finance
- Mudaraba - Equity Finance
- Musharaka - Venture Capital
What are the three main theories on the impact a cut in dividend will have on a company and it’s shareholders?
- Dividend Irrelevancy Theory - In a perfect capital market the payment and level of dividends is irrelevant as shareholders will only be concerned about increasing wealth not the form the increase comes in.
- Residual Theory - Dividends are important, the pattern is not. So also long as the PV of dividend stream remains constant timing of payments is irrelevant. So firms should invest in positive NPV projects first (before paying dividend) thus increasing the potential for higher dividends in the future.
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Dividend Relevance - Changes in dividend policy can impact shareholder wealth:
- Reductions in dividend convey “bad news” - Dividend Signalling
- Changes in policy may conflict with investor liquidity requirements.
- May up set investor Tax planning (Clientele effect)
What other factors may influence Dividend Policy?
Legal restrictions - Rules on distributable Profits and covenants on bond/loan agreements restricting dividend levels.
Liquidity - Cash is required to actually pay a dividend, but also for working capital purposes.
