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
