26

Business f inance
Activity 26.1 (page 477)

1 Using the list of reasons why businesses require finance on page 476, identify:

• two business situations that are likely to need long-term finance (more than five
years) [2]
Expansion − a business needs to purchase new fixed assets, e.g. an airline
purchasing new aeroplanes.
Research and development − a pharmaceutical company, such as GSK,
financing research into new treatments.

• two business situations that might require only short-term finance. [2]
Building up stocks − a business needs to increase purchases of stocks
approaching a peak in seasonal demand.
Paying bills − a business needing to pay expenses such as rent for premises.

In each case, explain your answer. [6]

2 Sheila and her friend Alison have decided to run their own mobile hairdressing
business using the training they have received at college and the experience they both
gained working for three years for a local hairdresser. Investigate, locally, the equipment
and working stock they will need. From this, estimate the capital they will need to set
up the business and survive the first year. Write a brief report on your findings.

The report will need to identify:

Capital equipment costs, including:
• transport, e.g. car
• hairdressing equipment such as scissors, brushes and combs, protective gowns
• mobile phone, computer equipment
• hairdryer.

Working capital costs:

• hair products, e.g. shampoo and conditioners
• petrol.

Chapter 26 © Cambridge University Press 2010 1

Activity 26.2 (page 478): Directphone Ltd

1 Calculate the proposed increase in the working capital requirements of the business
resulting from the expansion. [6]

increase in stationery needs = 10% of $10,000 = $1,000.

increase in debtors = 50,000 – 40,000 = $10,000.
increase in cash reserves = 35,000 – 30,000 = $5,000.
increase in creditors = 50,000 – 40,000 = $10,000.
increase in working capital = increase in current assets – increase in current
liabilities = (1,000 + 10,000 + 5,000) – 10,000 = $6,000

2 Outline two ways in which this increase in working capital might be financed. [4]

• Overdraft − an overdraft is an external short-term source of finance that could

be used to fund the increase in working capital needed. Although an overdraft
is only temporary, it is possible for continued renewal of the agreement and
it can become, in effect, an indefinite source of finance. The overdraft would
provide immediate funds for increasing stocks of stationery.
• A bank loan − this would provide an injection of cash into the business, but
would have to be paid back according to the terms of the loan and would
increase Directphone’s expenses.
• Sale of shares − this would provide a permanent source of finance to fund the
increase in working capital. It would depend on whether existing shareholders
were prepared to buy more shares in the business.

Activity 26.3 (page 480): Internal finance

1 In each of the following cases, explain briefly why internal sources of finance might be
unavailable or inadequate:
• a business needs to pay creditors after a period when it has made losses and the
value of its assets have fallen [2]

If losses have been made, then there may have been an outflow of cash to cover
expenses which has not been matched by an inflow of cash from sales. If the value
of assets has fallen, then it may be difficult to sell those assets to raise finance.

• the rapid expansion of a business, which requires expenditure several times greater
than current profits [2]
As profits are insufficient to cover the expenditure, the business may have to
look toward external finance. As the business is expanding, it may not have
unused assets which it can sell.

• the purchase of additional stocks by a retailer just before Christmas. [2]

The firm may face seasonal demand for products and, therefore, be short of
working capital before Christmas as a high proportion of sales may be made
during the Christmas period.

Chapter 26 © Cambridge University Press 2010 2

Activity 26.4 (page 481): EIB loans €30m for aeronautics R and D

1 Do you agree that loan capital was the best source of finance for this company for this
project? Justify your answer. [12]

In considering sources of finance, it is usually considered advantageous to match

the terms of the finance with the nature of the expenditure. Thus, as the capital is
required for a long-term research and development project, it is appropriate to use
a long-term source of finance. The product of the research and development should
generate revenue to repay the loan in future years.

Other relevant factors include:

• Interest rates are at an historical low due to the recession. This means that the
cost of borrowing is low. Debt finance has the disadvantage of having to pay
interest whatever the trading conditions. However, interest is an expense and,
therefore, reduces taxable profits, whereas dividends paid to shareholders are
not an expense.
• Suitability of loans depends partly on the gearing of the business.
• Raising finance through a share issue would be difficult because of volatility
in the stock market. Shareholders are nervous of making investments because
share prices may fall. An advantage of shareholder capital is that it does not have
to be repaid – it is permanent. Consequently, if the business is not profitable,
it could choose to reduce dividends. However, attracting shareholders may be
difficult because the benefits of R&D may be very long term and, consequently,
shareholders will not benefit from increased dividends in the short term.
• Selling shares may dilute ownership of the business as new shareholders
become part-owners of the business.
• Retained profits of the business may be insufficient to finance the project and
the firm may be building its cash reserves to guard against potential problems
as a result of the recession.

Activity 26.5 (page 483): Indian companies take AIM

1 Why do you think the Indian companies decided to join AIM rather than the full
Stock Exchange? [4]

The companies can get some of the benefits of a full listing, such as access to
international capital, but without the costs or controls of a full public listing.
AIM has a more flexible regulatory system. AIM is a flexible market that does not
stipulate minimum requirements for:
• company size
• track record
• the number of shares in public hands
• market capitalisation.

2 Peacocks decided to issue shares by prospectus to the general public. Why do you
think this method of selling shares was selected? [4]

Chapter 26 © Cambridge University Press 2010 3

 Peacocks was seeking to raise a substantial amount of capital. A share issue
by prospectus, although expensive, advertises the company to the public and,
therefore, will appeal to a broad cross-section of investors. Thus, it is more likely
that the share issue will successfully attract sufficient investors.

3 What did the managing director of Peacocks mean when he said that there were
advantages in selling shares to repay debt? What are the advantages of repaying
debts? [6]

Debts have to be serviced, that is interest paid on borrowing. Thus, if Peacocks

repays the debt, it will reduce the firm’s interest burden. Interest is an expense
and it, therefore, reduces profits. Further, interest payments must be made or the
business could be forced into insolvency. At a time of economic uncertainty, it will
be beneficial to reduce a firm’s exposure to debt interest.

Shareholders provide permanent capital, and, although over time dividends have to
be paid, it is possible for a business to declare no dividend in difficult trading times.

4 Why do you think Incitec Pivot decided to use a rights issue of shares to raise
capital? [4]

A rights issue is a cheaper way of raising capital than a public issue by prospectus
because Incitec does not have to incur the expense of advertising the shares
to the public. Further, a rights issue does not broaden share ownership in the
business. Although the shares are offered at a 40% discount, this does not
represent a cost to the business, simply an incentive to existing shareholders to
purchase more shares.

5 Evaluate whether a shareholder in Incitec Pivot would be advised to buy the rights
issue of shares being offered. [8]

Relevant issues include:

• A 40% discount is being offered – A$2.50 instead of the quoted price of A$4.17.
Thus, there is a substantial margin for a return to be made.
• The rights issue, by increasing the number of shares, will lead to a decrease in
the listed share price. This will reduce the capital gain that could be made.
• Incitec has tripled its profits over the last year. This is partly a result of a recent
takeover. This could suggest that the firm is being effectively managed.
• Fertiliser prices are volatile, so the increase in profits could be short term.
• As Incitec intends to repay debt this will reduce the interest payments and help
boost profits further.

Evaluation may consider:

Decision may be influenced by consideration of the likely share price in the future being
above A$2.50. This depends on many factors, including the state of the economy. With
volatile share prices around the world, Incitec are offering a substantial discount to
make the rights issue a success; that is, there is probably an expectation that share prices
will dip. However, the 40% discount offers the potential for a quick profit if the market
responds favourably to Incitec’s decision to reduce its debt burden.

Chapter 26 © Cambridge University Press 2010 4

Activity 26.6 (page 486): Sources of finance

1 Copy the following table and complete it by ticking the appropriate boxes alongside
each source of finance. [9]

Available Available
Long- Medium- Short- Available to to private to public
Sources of term term term unincorporated limited limited
finance finance finance finance businesses companies companies
Sale of
shares to  
the public
Sale of
  
debentures
Leasing    
Debt
   
factoring
Loans from
   
family
Take on
  
partners
Rights
issue of   
shares
Ten-year
   
bank loan
Bank
   
overdraft

Activity 26.7 (page 488): Going exclusive with ice cream

1 What is meant by a ‘venture capitalist’? [3]

A venture capitalist is an organisation that specialises in lending money to, or

purchasing shares in, businesses that find it difficult to raise money from other
sources. They specialise in high-risk investments that have the potential for good
profit.

2 Outline the benefits for Omah and Sara in preparing a detailed business plan for their
new proposal. [8]

Business plans provide a number of benefits including:

• Planning for the future reduces the risk of failure.
• The plan provides focus and direction for the ice-cream bar. It will force Omah
and Sara to consider all relevant aspects of running the business.
• A plan helps test the viability of the business proposal through financial
forecasts.

Chapter 26 © Cambridge University Press 2010 5

 • The plan enables a review of the business’s progress in meeting targets.
• The bank will not lend money without a detailed plan. Without further capital,
Omah and Sara cannot start the ice-cream bar.

3 Discuss what ‘further work’ on the business plan the bank manager might have been
requesting Omah and Sara to undertake. [8]

• Further market research – Omah and Sara had only asked friends and work
colleagues.
• More detailed break-down of start-up and working capital required – ‘about
$50,000’ is a little vague.
• Cash-flow forecasts should be provided.
• Projected income statement should be provided.
• Clarifying the short- and long-term goals of the business – Omah and Sara
appear to have differing expectations of the business.

4 To what extent would a bank loan be preferable to venture capital to finance this new
business start-up? [10]

• Venture capital may be more expensive because it is typically taken because

banks are unwilling to lend money.
• Sara and Omah will retain control of the business if they secure a bank loan.
• If venture capital is used, the venture capitalist may wish to take an equity
stake in the business. This would mean that Sara and Omah do not control the
business by themselves – the venture capitalist may also exert some control over
the direction of the business.
• Sara wants to be her own boss. If a venture capitalist supports the start-up, there
is more likely to be interference in the direction of the business.
• If an equity stake is given, then the venture capitalist will take a dividend from
the business indefinitely, whereas a bank loan has a fixed repayment date and
interest payments stop once the loan is repaid.
• Venture capitalists will charge substantial arrangement fees for their investment.

The extent to which a loan is preferred will depend, in part, on the form in which
venture capital is being offered. If the venture capital is in return for a stake in the
business and, therefore, a share of future profits, Sara and Omah are likely to prefer
a bank loan.

5 Evaluate two factors that might determine the success of this new venture. [8]

Many factors could be considered including:

• Securing sufficient financing to fund the start-up – many businesses fail in their
first year as a result of being underfinanced. Sara and Omah have estimated that
they need $80,000 – will this be enough?
• Competition – are there established franchises in the same city?
• State of the economy – as the product is high-priced and a luxury, if there
is a downturn in the economy, demand may fall substantially. Friends and
colleagues felt that the suggested price of $2 per standard cone was high
– do you agree?

Chapter 26 © Cambridge University Press 2010 6

Activity 26.8 − answer provided on Student’s CD-ROM.

Activity 26.9 (page 489): Telkonet raises $3.5m by sale of

debentures

1 Explain the terms:

• convertible debentures [2]

A debenture is a long-term bond. If it is convertible, then after a period of time
the debenture can be converted into shares and, therefore, the borrower never
has to pay the debenture back.

• working capital. [2]

In accounting terms, this is the difference between current assets and current
liabilities. Working capital is the day-to-day finance required for running the
business.

2 Explain the benefits to both companies of raising finance through sale of debentures
rather than either selling shares or taking a long-term bank loan with variable interest
rates. [10]

This approach offers a number of benefits:

• Interest is fixed. This will help Telkonet and CuraGen plan cash flows in the
future, whereas a variable-rate bank loan may result in substantial changes in
interest payments.
• The success of a share issue will depend, in part, on the stability of the stock
market. Telkonet is trying to raise finance at a time when stock markets are
suffering from falling share prices.
• The interest paid on debentures is an expense and thus reduces taxable profit.
Issuing shares will result in dividend payments; however, dividends are not
treated as an expense.
• For CuraGen, the advantage of issuing a convertible debenture is that it will
reduce interest payments. Lower interest is offered because the debenture
holder will be further rewarded, after seven years, when the debenture is
converted into stock.

Revision case study 1 (page 490): Sharma Taxis needs finance

as it expands

1 Identify the stages of this business’s development where additional finance was
required. [4]

• start-up
• growth to purchase additional vehicles and a small garage
• growth and diversification into road haulage
• expansion through takeover of taxi business

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2 At each of the stages you have identified, explain what type of finance was needed. [4]

• start-up – long-term finance (owner’s savings) required to purchase vehicle

• growth – long-term finance (capital from a new partner) for purchase of further
fixed assets
• diversification – long-term finance (equity finance) to purchase fixed assets and
short-term finance to boost working capital and offer business clients credit
• expansion – long-term finance (retained profits and further equity finance)

3 In your opinion, how could the increase in spare parts and debtors of the business
have been financed? [4]

A number of options could have been available including:

• trade credit for spare parts
• overdraft facility to provide funding for spare parts and debtors.

As the increase in spare parts and debtors requires an increase in working capital
over the long term, Sharma Taxis might also consider a longer-term injection of
capital into the business through, for example, a bank loan.

4 Examine the decision by the directors to float the company on the AIM. [8]

• This is cheaper than a full stock market listing and the AIM is less regulated.
• It gives access to international capital rather than depending on existing
shareholders.
• It will dilute ownership of the business and will reduce the control of the
original partners.
• Equity finance is permanent and never has to be repaid.
• It avoids debt finance with the associated risk of operational profits being
insufficient to cover interest payments.
• Using debt finance has the advantage of there being no loss of control and
interest being an expense that reduces tax paid.

5 If the company were to expand further, evaluate the case for and against financing
this expansion with a long-term loan. [10]

For:
• Interest is an expense to the business and, therefore, reduces taxable profits.
• It avoids further dilution of ownership of the business.

Against:
• Interest payments have to be paid, whereas dividends do not.
• Interest rates can change, leading to a potentially costly increase in interest
payments.

Evaluation may consider:

• The amount required.
• The current and future level of interest rates.
• The extent to which the owners want to retain control of the business.

Chapter 26 © Cambridge University Press 2010 8

Revision case study 2 (page 491): easyJet takes off to
342p share price

1 easyJet’s sale of shares to the public raised £195 million. What did management
intend to spend this capital on? [4]

The capital was needed to purchase new aircraft to enable easyJet to expand its
operations over the subsequent four-year period. easyJet wanted to more than
double the size of its fleet of aircraft.

2 Explain possible reasons why Stelios, the founder and chairman, chose to ‘go public’
with easyJet rather than take out loan finance. [8]

• Equity finance is permanent and does not have to be repaid.

• Loans would increase the gearing of easyJet. The more highly geared a business is,
the greater the risk taken. easyJet was seeking to raise nearly £200 million – 25%
of the total share capital of the business. This would have had a substantial impact
on gearing if it had been borrowed.
• Debt has to be serviced, that is interest paid. A good example of the impact
of this is Liverpool FC. When the football club was purchased by its current
owners, they borrowed the money to fund the acquisition. As a consequence,
Liverpool now has to use its operational profits to pay interest. In 2009, as a
result of the £350 million debt, the club’s parent company made a loss of over
$42 million with interest payments accounting for over £36 million of the loss.
• The timing of the share issue was beneficial as the stock market was performing
well and, therefore, it was likely that the share issue would be successful.

3 Explain why Stelios might be reluctant to sell a further 63 million shares in easyJet to
raise additional capital. [4]

• Stelios and his brother and sister will wish to retain control of the business.
They currently control 75% of the shares; if another 63 million shares were
issued, their stake in the business would fall to around 60%.
• Profits would be shared among more shareholders and, therefore, the dividend
received by Stelios would, potentially, be reduced.

4 Use the internet to research:

• easyJet’s current share price. Comment on whether buying the company’s shares
has been a good investment since 2000.
• easyJet’s latest profit figures (www.easyjet.com).

How are the profits of a business such as this likely to be affected by world economic
growth or recession? [8]

Have easyJet’s shares been a good investment since 2000?

• Current share price is 399 pence (January 2010). As the share price has risen
since 2000 shareholders will make a capital gain if they sell their shares.
However, share prices fluctuate considerably and the price of easyJet shares has
been below the original offer price of 310 pence at various points during the

Chapter 26 © Cambridge University Press 2010 9

 last ten years. For example, in 2009 easyJet’s share price fluctuated from a low of
262p in July to a high of 411p in November.
• Shares are not purchased just for a possible capital gain; they also provide
dividend payments. The level of dividends paid out over the years should
be taken into account in assessing whether easyJet shares have been a good
investment.

Latest profit figures:

• Profits for the year ended September 30th 2009 – easyJet made an underlying
pre-tax profit of £43.7 million.
• The profits of easyJet will not be affected as much as airlines such as British
Airways that depend more on business and first-class passengers. As easyJet is a
low-cost carrier it has seen passenger numbers continue to grow as households
focus more on value for money in their purchasing decisions.

Essay
1 a Outline the main sources of long-term external finance available to a limited
company. [10]

Long-term external
finance Commentary
Loans • Business repays the capital borrowed with the addition
of interest.
• For a fixed-rate loan, repayments are known in advance.
Fixed rates provide certainty of repayment amounts.
• Variable-rate loans change as interest rates go up or
down.
• Collateral may be required.
• These are a form of debt finance.
Venture capital • This may be in the form of a loan or in return for an
equity stake.
• Venture capitalists specialise in high-risk ventures that
offer potentially high returns.
Commercial • This is similar to a long-term loan.
mortgage • It is used to purchase property.
• The property acts as security for the lender.
• This is a form of debt finance.
Debentures • These are long-term bonds issued by companies.
• They can be for as long as 25 years.
• They usually have a fixed rate of interest.
• They can be secured to company assets.
• These are a form of debt finance.
Share capital • All limited companies have share capital when formed.
• Further shares can be issued up to the authorised share
capital.
• Shares cannot be sold publicly if it is a private limited
company.
• This is a form of equity finance.
• Share capital is permanent and is never repaid (unless
the business is wound up).
• Dividends paid to ordinary shareholders are at the
discretion of the board.

Chapter 26 © Cambridge University Press 2010 10

 b Explain why a business might be reluctant to finance long-term expansion plans with
a long-term loan. [15]

• A long-term loan is a form of debt finance and requires interest to be paid.

Interest is an expense to the business so, although it reduces the taxable profit
of a business, it has to be paid whatever the trading conditions. Therefore,
increasing the level of debt finance carries more risk than securing equity
finance. A business needs to consider its ability to cover interest payments from
its revenues and after other expenses have been paid.
• If a business has a low interest-cover ratio, it might be unwise to borrow more,
as interest payments will increase and it may be some time before expansion
generates the cash inflows to pay the interest.
• Gearing is also an important factor. A business with a high debt-to-equity ratio
is at much greater risk of defaulting on its loan repayments. Further borrowing
will increase that risk.
• In contrast, equity finance does not have to be repaid, and, if trading conditions
are poor, directors can choose not to declare a dividend.
• Interest rates can increase over time, resulting in a significant increase in loan
repayments.
• Loans may have to be secured against the assets of the business, putting those
assets at risk in the event of defaulting on repayments.

Further reading
Consider the case of Liverpool Football club; see:
http://www.timesonline.co.uk/tol/sport/football/premier_league/liverpool/
article6433469.ece

Chapter 26 © Cambridge University Press 2010 11