Wk 9 Financing a Business Flashcards
What are sources of internal finance?
Long term - retained profit
Short term - reducing inventories, tighter credit control, delaying payment to suppliers
What are sources of external finance?
Long term - shares, debentures, long term bank loans, grants
Medium term - leasing, hire purchase, medium term loans
Short term - bank overdraft, debt factoring, invoice discounting
What are the 3 key types of debt financing?
- preference shares
- loans
- debentures
What are preference shares?
- treated as a non-current liability
- contain the right to receive a dividend before an ordinary shareholder, dividend of a fixed percentage each year
What are debentures?
- borrowed capital of a company
- offered by a company to a potential investor, form of security granted to a lender in exchange for funding
- written documents setting out the terms of a loan (rate of interest, repayment schedule etc)
- can be secured/unsecured or transferrable
- offers a consistent rate or return, also may offer the right to convert to shares on maturity
What is the cost of capital?
Cost incurred to the company when it finances itself through equity or debt
What is the cost of equity?
Rate of return expected from shareholders, difficult to assess but based upon dividend expectations and increase in investment value
What is the cost of debt?
Cost company incurs through debt financing, rate of interest charged on the debt
Why should a company know the cost of capital?
Represents the minimum return a company need to achieve in order to justify the cost of a capital project, e.g. cost of capital 10%, returns from investment should be at least 10% of investment per year
What is the WACC?
Weighted average cost of capital, methods used by companies to work out cost of capital if financed through a mix of debt and equity - weighted by the proportions that equity and debt comprise the total value/capital of the firm
What is the WACC formula?
(E/V) * Re + ( (D/V) * Rd * (1-Tc))
E - market value of firm’s equity
D - market value of firm’s debt
V - E + D
Re - cost of equity
Rd - cost of debt
Tc - corporate tax rate
What is investment appraisal?
Process of analysing whether an investment project is worthwhile or not, can justify the investment or not
What are the 4 methods of investment appraisal?
- accounting rate return (ARR), average accounting operating profit as a % of investment
- payback period (PP), time for initial investment to be repaid
- internal rate of return (IRR), yield from a particular investment excluding external factors
- net present value (NPV), works out NPV of cash inflows and outflows
What is the net present value?
Considers all costs and benefits of each investment opportunity, represents the difference between the present value of cash inflows and the present value of cash outflows over a period
What is the time value of money?
Concept that the current value of money is higher than its future value, given its potential to earn in the years to come
