Week 8- Source of Finance and Cost of Capital

Question 1

What are the three types of internal source of finance?

Answer 1

1) Retained Earnings
2) Trade Credit
3) Working Capital Management

Question 2

What are retained earnings?

Answer 2

Profits that are retained by the firm rather than distributed to shareholders as dividends

Question 3

What are the advantages of using retained earnings as a source of finance?

Answer 3

• No dilution of control or ownership
• No fixed obligation of interest payments
• No issue cost attached

Question 4

What is the catch of using retained earnings?

Answer 4

They are not “costless” because the cost to shareholders is the same as the cost of equity.

Question 5

What is Trade Credit?

Answer 5

Trade Payables- Buy now, pay later- helps with liquidity

Question 6

Is Trade Credit a costless source of finance?

Answer 6

No since you often have to pay the supplier for the privilege of paying later

Question 7

What is Working Capital?

Answer 7

Current Assets + Current Liabilities

Question 8

How is Working capital a source of finance?

Answer 8

You you use working capital to invest in something, the liquidity of the company will fall.

Question 9

what is the disadvantage of working capital as a source of finance?

Answer 9

A decrease in liquidity means companies are more at risk of defaulting on payments to creditors

Question 10

What are the six types of external sources of finance?

Answer 10

Overdraft- short term
Ordinary Shares
Preference Shares
Debt Capital
Debenture or Loan Stock
Bonds

Question 11

What is Ordinary Share Capital?

Answer 11

Represents the equity share capital of the firm

Question 12

What are the advantages from the firm perspective of Ordinary Share Capital as a source of finance?

Answer 12

• No obligation to pay dividends
• Capital does not have to be repaid

Question 13

What are the disadvantages from the from perspective of Ordinary Share Capital as a source of finance?

Answer 13

• High Cost (Costs of issue, payment of dividends)
• Loss of control of company
• Dividends cannot be used to reduce taxable profit

Question 14

In the event of liquation what is the order of payment?

Answer 14

1. Secured Creditors
2. Unsecured Creditors
3. Preference Shareholders
4. Ordinary Shareholders

Question 15

What is the difference between a preference share and an ordinary share?

Answer 15

Preference shares get a fixed rate of interest each year whereas ordinary shareholders are paid at the companies discretion

Question 16

What are the advanatages from a firm perspective of using preference shares as a long term source of finance

Answer 16

• No need to pay dividends if profits are poor
• Do not dilute ownership and control
• Unsecured so preserve debt capacity

Question 17

What are the disadvantages from a firm perspective of preference shares?

Answer 17

Higher cost compared to debt due to tax inefficiency

Question 18

what are the special types of preference share?

Answer 18

Convertible (into ordinary share)
Cumulative (dividend carried forward)
Redeemable (holders repaid their capital by firm)
Participating ( extra dividend give out in successful years)

Question 19

What are the advantages from a firm perspective of using Debt capital as a source of funding?

Answer 19

Less expensive than equity
Can be used to reduce taxable profit

Question 20

What is the disadvantages from a firm perspective of using debt capital as a source of funding?

Answer 20

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

Question 21

What is usually less risky for the creditor to hold: Debenture or Loan Stock?

Answer 21

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

Question 22

What are Bonds?

Answer 22

Long term contracts in which holders lend money to a company

Question 23

What are the three types of bond?

Answer 23

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

Question 24

What is Cost of Capital?

Answer 24

The minimum risk-adjusted rate of return a project must make in order to increase shareholder wealth and be acceptable to investors

Question 25

What is the Cost of Capital used for?

Answer 25

• Budget Analysis
• Capital Structure choice -> firms should choose capital structure that gives the lowest CoC
• Performance assessment

Question 26

What are the factors that affect CoC?

Answer 26

Tax and interest rates

Question 27

What does Ke mean?

Answer 27

Cost of equity

Question 28

what does P mean?

Answer 28

Cost of an all-equity financed firm

Question 29

what does kp mean?

Answer 29

Cost of preference share capital

Question 30

What does Kd mean?

Answer 30

Cost of Debt

Question 31

What does WACC stand for?

Answer 31

Weighted average cost of capital

Question 32

what does tc stand for?

Answer 32

Corporation tax

Question 33

What does B stand for?

Answer 33

market price

Question 34

What is teh cost of equity/market value of an ordinary share?

Answer 34

the present value of the sum of the expected dividend flow