Week 9b - Financing a Business Flashcards
State the three main sources of finance
• Equity: from shareholders • Debt: from banks or other lenders - Long term as debentures, bonds - Short term as bank overdraft, short term loan • Retained Profit
Draw a diagram showing the main sources of finance and where they come from
Week 9b page 4
State the two types of shareholder’s capital
Ordinary shares
Preference shares
What is an ordinary share?
- Shares entitle owners (i.e. the shareholders) to dividends
- Shares offer limited liability to shareholders
- Ordinary shareholders bear most risks
What is the Share Premium Account?
• Nominal value is the par value
- E.g. initial par value of shares may be £1 each
• Shares can be sold at a premium (above par)
- Creates the Share Premium Account
With reference to external funding, what is a ‘Rights Issue’?
• Rights issue
- Is a way established companies raise extra funds by issuing shares
- Existing shareholders have the option to buy new shares at lower price than current market price
- If shareholders take up all the rights to which they are entitled, they will continue to own the same proportion of the company
Rights issue = An issue of shares offered at a special price by a company to its existing shareholders in proportion to their holding of old shares.
What are bonus shares?
• Bonus shares
- Given to existing shareholders
- No extra cash received by company (a bonus share is not a source of finance)
Rights Issues: Example
Company X has 1 million shares which have a market value of £2 each
They offer existing shareholders one share for every five that they already hold, at a price of £1.50
Calculate the theoretical value of the company after the rights issue using the information provided
Company X has 1 million shares which have a market value of £2 each
Existing 1 million shares at £2 each = £2,000,000
They offer existing shareholders one share for every five that they already hold, at a price of £1.50
Cash raised from rights issue 200,000 at £1.50 = £300,000
After the rights issue the theoretical value of the company will be:
Value of the company = £2,300,000
Number of shares after issue = 1,200,000
Share Price after Rights Issue = £1.92
Rights Issues: Challenge
Company Y has 10 million shares which have a market value of £3 each
They offer existing shareholders one share for every ten that they already hold, at a price of £2.50
Calculate the theoretical value of the company after the rights issue using the information provided
Company Y has 10 million shares which have a market value of £3 each
Existing 10 million shares at £3 each = £30,000,000
Cash raised from rights issue 1,000,000 at £2.50 = £2,500,000
After the rights issue the theoretical value of the company will be:
Value of the company = £32,500,000
Number of shares after issue = 11,000,000
Share Price after Rights Issue = £2.95
What is a preference share?
• Preference shareholders earn fixed dividends
- Such shareholders face less risk and less rewards
- They have preferential treatment over ordinary shares
for dividend payments
- Preference shares are usually cumulative, meaning that arrears of dividends must be paid before any dividends to ordinary shareholders
• Preference shares can be participative
- Receive higher level of dividends when the company
does well, and ordinary dividends are beyond some
predetermined level
• Preference shares can be convertible
- Can be converted to ordinary shares at a predetermined rate
• Preference shares are more like liabilities
State some basic features of borrowing
• Regular interest payments
• Debt holders do not own companies
• Debt financing has tax benefits, because interest
payments are tax deductible
• Borrowing is a flexible source of finance
What are some of the problems associated with borrowing?
• Need for security
- Earnings are not always above the required level of interest payments
• Restrictive covenants
- Lenders may lay down conditions to restrict a company’s ability to borrow more
• High debt increases risks
- A firm with increasing gearing will find it increasingly difficult and expensive to borrow - especially when all assets have already been used as collateral
- Reputation as being ‘high risk’ = suppliers, customers, investors, etc.
Compare and contrast the effect on net income when EBIT increases by 20% in a low and high geared company
Low Debt - Interest Payments of £1m
High Debt - Interest Payments of £6m
EBIT (year 1) = £10m
Low Debt - Interest Payments of £1m
Year 1 Year 2 Earnings Before Interest and Tax (EBIT) 10 12 +20% Interest 1 1 Pre-tax profit 9 11 Tax 30% 2.7 3.3 Profit after tax 6.3 7.7 +22.2%
A 20% increase in EBIT leads to a 22.2% increase in net income.
High Debt - Interest Payments of £6m
Year 1 Year 2 Earnings Before Interest and Tax (EBIT) 10 12 +20% Interest 6 6 Pre-tax profit 4 6 Tax 30% 1.2 1.8 Profit after tax 2.8 4.2 +50%
A 20% increase in EBIT leads to a 50% increase in net income.
•In other words, high gearing makes the net income more sensitive to the change in EBIT
Characterise the risk and return of sources of long-term finance
Week 9b page 18
State some basic features of retained profits, a source of internal financing
- Retained profits = Net profits - Dividends
- Internal source of finance
- Depends on company dividend policy
What factors should be taken into consideration by a company when deciding on the dividend policy?
• How much dividend to pay?
• What proportion of profits are to be paid out as dividends?
• A dividend policy requires a balance between (1) paying out all profits as dividends and (2) paying no dividends at all
• Dividend payments require cash
- Is there an alternative use for cash which is more
profitable?
• Different investors may prefer different policies
• Dividend policies send signals to investors
- Companies need to consider what signal any change in dividends gives to the investors
What are some reasons as to why a business may choose to pay out dividends?
- Some investors like to receive a regular income from dividend payments
- If dividends are not paid, the retained funds may be invested in value-destroying activities (e.g. disastrous diversification, unsuccessful takeovers)
What are some reasons as to why a business may choose not to pay out all profits as dividends?
• Investors generally want to see dividends increasing steadily each year
• Companies increase dividends modestly in good years, so that there is scope for maintaining/increasing dividends in the lean years
• Inflation means that companies need to retain some
of their profits to maintain the existing level of operations
What is dividend smoothing?
Profits can fluctuate; however, attempts are made to
keep dividends steady
State some scenarios where a business may choose not to pay out a dividend
- When a company is making significant losses
- When a company has massive borrowings
- When a company is at an early stage of their development
- If a company can invest the retained profits and earn a better rate of return than the shareholders can themselves, there is a case for the company to keep the money
What steps can be taken by a business to minimise the need to raise finance?
• Leasing rather than purchasing
- Usually premises
- Also equipment and vehicles
- Importance of credit worthiness
• Sale and leaseback
- Sell the asset and then rent back from finance company
- Increases EPS if the sale of the asset increases profit
• Reduce number of assets held that are surplus to needs
• Outsourcing activities
- E.g. catering, security, IT, accounting
- Frees up assets which can be sold to release funds
• Reducing working capital provides additional funds
• Factoring receivables or invoice discounting
- Releases cash from receivables
• Increasing profits
- By reducing costs or increasing sales
• Reducing dividends
• Careful cash budgeting
- E.g. delay capital expenditure
