Sources of Finance Flashcards

1
Q

What are the two main sources of finance for a company?

A

The two main sources of finance are: 1. Equity: Funds raised by issuing shares of the company’s stock. 2. Debt: Funds borrowed from external sources, such as banks or bonds, which need to be repaid with interest.

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2
Q

How does the amount required influence the choice between debt and equity?

A

The amount required affects the choice because: - Debt: Access to long-term bank lending may be limited by the risk appetite of banks. For large amounts, banks might not be willing to provide the necessary funds. - Equity: If a large amount of capital is needed, raising funds through the sale of equity shares might be necessary, as it doesn’t require immediate repayment but dilutes ownership.

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3
Q

What costs should be considered when choosing between debt and equity?

A

The costs to consider are: - Ongoing Servicing Costs: Debt: Interest payments are required regardless of company performance. Equity: Dividends may be paid to shareholders, which can be costly but is not obligatory. - Initial Arrangement Costs: Debt: May include loan arrangement fees. Equity: Raising equity might involve higher costs due to underwriting and other fees.

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4
Q

How does the duration of financing impact the decision between debt and equity?

A

Duration considerations are: - Short-Term Financing (Debt): Typically used for short-term assets or needs. - Long-Term Financing (Debt or Equity): Used for long-term assets. Equity is often used for longer-term investments as it doesn’t have a fixed repayment schedule.

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5
Q

Why might equity be considered more flexible than debt?

A

Equity is more flexible because: - Companies can choose not to pay dividends in years with low profits or losses. - Debt: Requires regular interest payments regardless of financial performance, reducing financial flexibility.

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6
Q

What should a company consider regarding repayment when choosing debt?

A

A company should: - Carefully forecast future cash flows to ensure it can meet fixed repayment schedules. - For example, if a company takes out a 10-year loan, it must generate enough cash flow to repay the loan by the due date.

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7
Q

How does financing impact a company’s financial statements?

A

The impact includes: - Equity Financing: Dilutes ownership but does not affect cash flows directly. - Debt Financing: Increases liabilities and interest expenses, which affects profitability and financial ratios. Stakeholders use financial statements to assess risk based on how the company manages its financing.

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8
Q

What are the two main ways equity shareholders gain a return on their investment?

A

Equity shareholders gain a return in two ways: 1. Capital Gains: The value of their share increases as the company’s value rises. 2. Dividends: Companies pay cash to shareholders through dividends.

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9
Q

What happens when a company issues new shares?

A

Issuing new shares dilutes the control of existing owners because new investors gain ownership stakes.

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10
Q

Compare the dividend rate, distribution, and repayment order of ordinary and preference shares.

A

Dividend Rate: Ordinary Shares: Variable – higher in good years, lower in bad years. Preference Shares: Fixed (e.g., 4% per annum). Dividend Distribution: Ordinary Shares: Paid only after preference dividends. Preference Shares: Paid before ordinary shareholders. Liquidation: Ordinary Shares: Last to be repaid. Preference Shares: Repaid before ordinary shares.

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11
Q

What are the differences in voting rights between ordinary and preference shares?

A

Ordinary Shares: Typically come with voting rights on major decisions, with each share usually getting one vote. Preference Shares: Typically do not come with voting rights.

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12
Q

What are the five principal methods for raising equity finance?

A

The five methods are: 1. Initial Public Offer (IPO) 2. Private Placing 3. Introduction 4. Right Issue 5. Bonus Issue

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13
Q

What is an Initial Public Offer (IPO)?

A

An IPO is the process of offering shares of a company to the public for the first time. Shares are offered at a fixed price, and the process often involves underwriting by an issuing house or banks. It is usually the most expensive method of raising capital and is used by larger companies.

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14
Q

What distinguishes a private placing from an IPO?

A

Private Placing: Shares are sold directly to institutional investors through a broker, not the general public. It is cheaper and quicker than an IPO but results in a narrower shareholder base.

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15
Q

What does the method of introduction involve?

A

Introduction involves a company with widely held shares (typically 25% of share capital) becoming publicly tradable on a recognized stock market. It aims to enhance marketability and access to future capital.

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16
Q

What is a right issue?

A

A right issue allows existing shareholders to buy new shares in proportion to their existing holdings (e.g., 1 for 1), usually at a discounted price.

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17
Q

What is a bonus issue and how does it differ from a right issue?

A

Bonus Issue: The company issues new shares to existing shareholders by capitalizing reserves. No new capital is raised; it increases the number of shares in circulation and liquidity, but the average value per share decreases. Right Issue: Shares are issued in exchange for consideration that typically increases company assets, such as cash.

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18
Q

What are the types of short-term and long-term debt finance?

A

Short-term Debt Finance: Overdraft, Short-term bank loan, Certificate of deposit, Treasury bill, Trade credit. Long-term Debt Finance: Bonds, Loan stock, Debentures, Loan notes, Euro bonds, Convertible bonds and warrants, Long-term bank loan.

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19
Q

What is the difference between redeemable and irredeemable debt?

A

Redeemable Debt: Repayable on maturity. Irredeemable Debt: No repayment required; typically considered perpetual.

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20
Q

What factors should be considered when choosing debt finance?

A
  1. Availability: Some types of debt may only be available to listed companies or larger firms. 2. Duration: Match the repayment period with the asset’s revenue generation period. 3. Fixed or Floating Rates: Choose based on interest rate expectations; fixed rates mitigate risk of rate increases. 4. Security and Covenants: Consider the assets available as security and the restrictions lenders may impose.
21
Q

What are the advantages and disadvantages of debt for investors?

A

Advantages: Entitled to a fixed return each year. Can appoint a liquidator if interest is unpaid. Debt can be secured against company assets. Higher rank in liquidation for recovery. Disadvantages: No voting rights. Fixed interest may be limiting in high-profit situations. Unsecured debt is high-risk.

22
Q

What are the advantages and disadvantages of debt for companies?

A

Advantages: Cheaper than equity due to tax savings on interest. No dilution of earnings or dividends. Fixed interest payments are predictable. Lower issuance costs compared to equity. Disadvantages: Requires security which may limit asset use. Fixed interest must be paid regardless of profit. Non-payment of interest can lead to liquidation. Reduces future borrowing capacity due to security constraints.

23
Q

What are the key differences between commercial paper, loan notes, debentures, and bonds?

A

Commercial Paper: Very short-term (less than 9 months). Loan Note: Shorter-term (less than 12 months for government, less than 5 years for companies). Debenture: Unsecured long-term loan. Bond: Secured long-term loan (typically 5 to 20 years).

24
Q

What is the difference between a fixed charge and a floating charge on loan stock?

A

Fixed Charge: Applied to specific assets that cannot be sold while the loan is outstanding. Floating Charge: Applied to a class of assets where sale of some assets is permitted.

25
Q

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A

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26
Q

What is a deep discounted bond?

A

A bond with a low coupon rate and offered at a large discount on the par value, with a significant portion of the return coming from capital gain at redemption rather than through interest payments.

27
Q

What is a zero coupon bond?

A

A zero coupon bond has no periodic interest payments and is issued at a deep discount. All returns to the investor come from capital appreciation at maturity.

28
Q

What is a Euro bond?

A

A Euro bond is denominated in a currency not native to the country where it is issued, e.g., Eurodollar bonds or Euro yen bonds. They offer high liquidity and flexibility in choice of issuing country.

29
Q

What are convertible bonds and how do they work?

A

Convertible bonds are fixed interest securities that can be converted into ordinary shares at a predetermined rate and date. If not converted, they are redeemed at maturity.

30
Q

What is a warrant?

A

A warrant gives the holder the right to buy stock at a set price, which can be traded separately from the bond. Unlike convertible bonds, they do not convert the underlying debt into equity.

31
Q

What are key features of convertible securities?

A

Interest: Paid at an agreed rate. Conversion Rate: The price at which bonds can be converted into shares. Conversion Value: Market value of shares into which the bond may be converted. Conversion Premium: Difference between market price of bond and its conversion value.

32
Q

What are the differences between bank loans and loan stock?

A

Bank Loans: Flexible terms, Confidential, Quick to arrange, Lower issuance costs, Restricted by collateral and covenants. Loan Stock: Fixed terms, Public information requirements, Slower to arrange, Higher issuance costs, Less restrictive.

33
Q

What are the characteristics of overdrafts?

A

Short-term borrowing facility, Repayable on demand, Interest is only paid when the account is overdrawn, Penalties for breaching limits.

34
Q

What is the difference between a finance lease and an operating lease?

A

Finance Lease: Transfers substantially all risks and rewards of ownership; title may or may not transfer. Operating Lease: A lease that does not transfer risks and rewards of ownership.

35
Q

What are the two important principles of Islamic finance?

A
  1. Each transaction must be related to a real underlying economic transaction. 2. The lender cannot charge Riba (interest) from the borrower; parties entering into the contracts share profit/loss and risks associated with the transaction.
36
Q

What is Murabaha in Islamic finance?

A

Murabaha is a cost-plus transaction where the seller discloses the cost of a commodity and sells it to another person by adding a mutually agreed profit margin, resulting in an absolute price.

37
Q

What are the basic features of Murabaha?

A
  1. The subject matter must exist at the time of sale. 2. The seller must own the subject matter at the time of sale. 3. The subject matter must be in the seller’s possession when sold. 4. The sale must be prompt and absolute. 5. The subject matter must be valuable. 6. Delivery must be certain and not contingent on chance. 7. The price must be absolute and agreed upon. 8. The sale must be unconditional. 9. Terms of sale must be clear and unambiguous.
38
Q

What are the key aspects of Ijarah?

A
  1. Ijarah is a lease contract where the lessor retains ownership of the asset. 2. The lessor bears risks such as maintenance and insurance. 3. The lessee covers operational expenses and damage due to negligence. 4. The lessor cannot charge a late payment penalty. 5. Lease and sale agreements must be separate. 6. The lease can be terminated with mutual consent.
39
Q

What is Mudaraba?

A

Mudaraba is a profit-sharing partnership where one party provides capital (rab al maal) and the other provides labor and management (mudarib).

40
Q

What are the types of Mudaraba?

A
  1. Restrictive Mudaraba: The investor specifies investment details, restricting the mudarib’s scope. 2. Unrestrictive Mudaraba: The mudarib has freedom to invest as they choose, within lawful limits, and is responsible for avoiding unlawful or high-risk investments.
41
Q

What is Musharaka?

A

Musharaka is a joint venture where all partners contribute capital and share profits according to pre-agreed ratios. Losses are borne in proportion to each partner’s investment.

42
Q

What is venture capital (VC)?

A

Venture capital refers to capital provided to a private company by specialist investment institutions, sometimes with support from banks. The company must demonstrate a clear strategy and business plan. Investment is typically for 3-7 years, after which the VC aims to realize profits and exit the investment.

43
Q

What factors determine the appropriateness of venture capital?

A
  1. VC is important for management buy-outs. 2. VC can help take young private companies to the next level. 3. VC may provide funds for start-ups, though this is less common.
44
Q

What are business angels?

A

Business angels are wealthy individuals who invest directly in small businesses by purchasing new equity shares, usually at the start of the company’s life. They typically do not involve themselves in the management of the company.

45
Q

What is private equity?

A

Private equity involves equity in operating companies that are not publicly traded on a stock exchange. Private equity funds often take large stakes in mature businesses and aim to enhance value by addressing inefficiencies or driving growth.

46
Q

What are the key factors of private equity funds?

A
  1. Private equity funds usually take a large stake (around 30%) in a company and appoint directors. 2. It is a method for private companies to raise equity finance when they cannot do so from the market.
47
Q

What is asset securitization?

A

Asset securitization is the process of converting existing assets or future cash flows into marketable securities. For example, a company can set up a special purpose vehicle (SPV) to issue securities to investors, using the asset as security and raising cash.

48
Q

What are the types of securitization?

A
  1. Asset-backed securitization: Converting existing assets into marketable securities. 2. Future-flows securitization: Converting future cash flows into marketable securities.
49
Q

What are the factors to consider for asset securitization and sale?

A
  1. Securitization is extensively used in the financial services industry. 2. It allows the conversion of non-marketable assets into marketable ones. 3. It enables borrowing at rates aligned with the asset’s rating, potentially lowering borrowing costs.