Sources of finance

Question 1

Money V Capital Market

Answer 1

The Money Market provides a low return on investment, as the instruments have a low interest rate and a low-profit margin. In contrast, the Capital Market provides a high return on investment, as the instruments have a high-interest rate and a high profit margin.

Question 2

Formal and over-the-counter

Answer 2

Formal- JSE Derivatives Market (SAFEX), JSE Debt Market
- Highly regulated
- Narrow range of instruments
- Accessible to small investors
- Standardised instruments

Over-the-counter- Foreign exchange
- Telephone and computers
- Custom (OTC permit the parties to innovate in accordance to their needs.)
- Currencies

Question 3

Cash and Derivative Market

Answer 3

In a cash (spot) market, purchasers take immediate possession of goods at the point of sale. This can be contrasted with derivatives markets, where investors purchase the right to take possession at some future date. Stock exchanges are considered cash markets because shares are exchanged for cash at the point of sale. Derivatives include futures contracts, options contracts, and credit default swaps.

Question 4

Debt Market

Answer 4

Types of bond instruments:

• Fixed interest rate
• floating rate
• zero coupon
• Inflation
• commercial paper
• mortgage back security

Debt Instruments

1. Debentures
   - A contract between the company & investor
   - Usually fixed interest
   - Usually secured
   - Can include a call option (A call option isa contract between a buyer and a seller to purchase a certain stock at a certain price up until a defined expiration date.)
2. Bonds
   - Usually not secured
   - Can include a call option
   - Credit rating
   - Larger companies
   - Fixed interest – currently low
3. Notes
   - Medium-term: 3 - 5 years
   - Usually variable interest rate
   - Often R1m per note
   - Credit rating

Types of conditions:

• Secured: over certain assets of the company
• Convertible: into any other security (usually shares). If converted into ordinary shares - dilution in control of existing shareholders
• Redeemable: before maturity on specified date
• Fixed rate: interest rate fixed to maturity
• Floating rate: interest varies linked to reference rate (JIBAR)
• Participating: also receive fixed proportion of profits of company

Question 5

Value of a right

Answer 5

N(Mc-S)/ N + 1

Mc - Share price cum-rights (before rights issue)
S - Subscription price
R - Rights ratio
N - No. of shares required to acquire 1 right

Question 6

Role of the JSE

Answer 6

• Negotiate loans
• facilitate the trading of shares
• help companies raise capital (share issues)
• Improve disclosure
• Finance acquisition by issuing shares
• Share buybacks

Question 7

Market liquidity?

Answer 7

How easy is it to convert shares into cash?
The market is liquid if shares can be
sold and bought easily and the effect on share price is relatively small

Question 8

Comparing equity

Answer 8

Return
Specific interest-
- There is tax on debt
Tax deductions-
- Dividends is not tax deductible
- Interest is usually tax deductible (If in the production of income)
Cost-
- JSE is expensive
- equity is usually more expensive than debt
- Debt is over a certain period whereas equity is infinite

Risk
Commitment-
- Dividends are optional
- Interest in compulsory

Control
Dilution:
- Ordinary Shares reduce control over the company as the company itself has less power to make decisions
- Debentures and preference shares don’t give voting rights therefore they don’t have control
level of control:
-Debt could lead to loss of flexibility due to loan covenants or assets pledged as security

Others
Complying with listing requirements