Week 8- Source of Finance and Cost of Capital Flashcards
What are the three types of internal source of finance?
1) Retained Earnings
2) Trade Credit
3) Working Capital Management
What are retained earnings?
Profits that are retained by the firm rather than distributed to shareholders as dividends
What are the advantages of using retained earnings as a source of finance?
- No dilution of control or ownership
- No fixed obligation of interest payments
- No issue cost attached
What is the catch of using retained earnings?
They are not “costless” because the cost to shareholders is the same as the cost of equity.
What is Trade Credit?
Trade Payables- Buy now, pay later- helps with liquidity
Is Trade Credit a costless source of finance?
No since you often have to pay the supplier for the privilege of paying later
What is Working Capital?
Current Assets + Current Liabilities
How is Working capital a source of finance?
You you use working capital to invest in something, the liquidity of the company will fall.
what is the disadvantage of working capital as a source of finance?
A decrease in liquidity means companies are more at risk of defaulting on payments to creditors
What are the six types of external sources of finance?
Overdraft- short term
Ordinary Shares
Preference Shares
Debt Capital
Debenture or Loan Stock
Bonds
What is Ordinary Share Capital?
Represents the equity share capital of the firm
What are the advantages from the firm perspective of Ordinary Share Capital as a source of finance?
- No obligation to pay dividends
- Capital does not have to be repaid
What are the disadvantages from the from perspective of Ordinary Share Capital as a source of finance?
- High Cost (Costs of issue, payment of dividends)
- Loss of control of company
- Dividends cannot be used to reduce taxable profit
In the event of liquation what is the order of payment?
- Secured Creditors
- Unsecured Creditors
- Preference Shareholders
- Ordinary Shareholders
What is the difference between a preference share and an ordinary share?
Preference shares get a fixed rate of interest each year whereas ordinary shareholders are paid at the companies discretion
What are the advanatages from a firm perspective of using preference shares as a long term source of finance
- No need to pay dividends if profits are poor
- Do not dilute ownership and control
- Unsecured so preserve debt capacity
What are the disadvantages from a firm perspective of preference shares?
Higher cost compared to debt due to tax inefficiency
what are the special types of preference share?
Convertible (into ordinary share)
Cumulative (dividend carried forward)
Redeemable (holders repaid their capital by firm)
Participating ( extra dividend give out in successful years)
What are the advantages from a firm perspective of using Debt capital as a source of funding?
Less expensive than equity
Can be used to reduce taxable profit
What is the disadvantages from a firm perspective of using debt capital as a source of funding?
Interest needs to be paid regardless of firm performance
Creditors able to claim some or all of the firms assets if firm is uncompliant with repayments
What is usually less risky for the creditor to hold: Debenture or Loan Stock?
Debenture since they are usually secured via a floating or fixed charge and loan stocks are usually unsecured meaning that debenture creditors get paid first in teh event of liquidation
What are Bonds?
Long term contracts in which holders lend money to a company
What are the three types of bond?
1) Plain Vanilla: Fixed maturity date, fixed rate of interest
2) Zero coupon bonds: no periodic payment, sold at a discount
3) Floating rate (variable rate) bonds
What is Cost of Capital?
The minimum risk-adjusted rate of return a project must make in order to increase shareholder wealth and be acceptable to investors
