Chapter 7. Sources of Finance
Chapter 7. Sources of Finance
Chapter 7. Sources of Finance
Sources of Finance
Considerations
1. Types of finance
2. Sources
3. Mix
4. Islamic finance
Margin Interest is charged at base rate plus margin on daily amount overdrawn. Fees may be charged
on large facilities
Benefits Customer has flexible means of short-term borrowing; the bank has to accept the
fluctuations.
2. Short-term loans
A term – loan is a loan for a fixed amount for a specified period.
It is drawn in full and at the beginning of the loan period and repaid at specified time or in defined
instalments.
The interest and capital repayments are predetermined.
Loan covenant is a condition that the borrower must comply with. If the borrower does not act in accordance
with the covenants, the loan can be considered to be in default and the bank can demand payment.
But
o Overdrafts are normally repayable on demand.
Required
Prepare a schedule for interest and principal repayments for the period
3. Trade credit
This is the main source of short-term finance for businesses.
The period of credit is typically 30 days to 90 days.
It represents an interest free short-term loan.
There is need to balance the need to balance the need to extend credit and the loss of discounts suppliers
offers for early settlement.
Government grants are usually very small, and direct loans are rare because governments see loan provision is
the job of financial institutions.
In the UK, the government runs the Enterprise Finance Guarantee Scheme (EFGS). This is a loan guarantee
scheme intended to facilitate additional bank lending to viable small and medium sized entities (SMEs) with
sufficient security for a normal commercial loan. The borrower must be able to demonstrate to the lender that
they should be able to repay the loan in full. The government provides the lender with a guarantee for which
the borrower pays a premium.
EFGS supports lending to viable businesses with an annual turnover of up to £25m seeking loans of between
£1,000 and £1 million.
5. Leasing
A contract between the lessor and lessee for hire of a specific asset selected from a vendor.
The lessor retains the ownership of the asset.
The lessee has possession and use of the asset on payment of specified rentals over a period.
Leasing is cheaper than borrowing because ;
(1) Large leasing companies have great bargaining power with suppliers so the assets cost them
less than it would cost the lessee. This can be partially passed on to the lessee.
(2) Leasing companies have effective ways of disposing of old assets, but lessees normally do
not.
(3) If the lease payments are not made, the leasing company has a form of built-in security in so
far as it can reclaim its asset.
(4) The cost of finance to a large, established leasing company is likely to be lower than the cost
to start –up the business.
Disadvantages
Loss of ownership of the property
Ordinary shares
Advantages
Disadvantages
1. Issuing equity finance can be expensive in the case of a public issue
2. Problem of dilution of ownership if new shares issued.
3. Dividends are not tax-deductible
4. A high proportion of equity can increase the overall cost of capital for the company
5. Shares in listed companies are difficult to value and sell
Preference shares
1. Fixed dividend
2. Paid in preference to (before) ordinary shares.
3. Not very popular, it is the worst of both world, ie
Not tax efficient
No opportunity for capital gain (fixed return).
DEBT FINANCE
The loan of funds to a business without any ownership rights.
1. Paid out as an expense of the business (pre-tax)
2. Risk of default if interest and principal payments are not met.
(c) Amount
Bond issues are usually for large amounts. If a company wants to borrow only a small amount of money, a bank
loan would be appropriate.
(d) Duration
If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan
would match the length of time that the asset will be generating revenues.
Security
Charges
The debt holder will normally require some form of security against which the funds are advanced. This means
that in the event of default the lender will be able to take assets in exchange of amounts owing.
Bonds may be secured. Bank loans are often secured. Security may take the form of either fixed charge or a
floating charge.
Company cannot dispose of assets without Company can dispose of assets until default takes place
providing substitute/consent of the lender
In event of default lenders appoint receiver rather than lay
claim to asset
Covenants
A further means of limiting the risk to the lender is to restrict the actions of the directors through the means of
covenants. These are specific requirements or limitations laid down as a condition on debt financing. They
include:
1. Dividend restrictions
2. Financial ratios
3. Financial reports
4. Issue of further debt
Public debt
Refers to quoted bonds or loan notes: instruments paying a coupon rate of interest and whose market value
can fluctuate.
Usually bonds will be secured either by fixed or floating charges and can be redeemed or irredeemable.
Well secured bonds in companies that are not too highly geared are low risk investments and bondholders
will therefore require relatively low returns.
The cost of the bonds to the borrower falls even more after tax relief on interest is taken into account.
Types of debt
Debt may be raised from two general sources, banks or investors.
Bank finance
Traded investments
Debt instruments sold by the company, through a broker, to investors. Typical features may include:
1. The debt is denominated in units of $100, this is called the nominal or par value and is the value at which
the debt is subsequently redeemed.
2. Interest is paid at a fixed rate on the nominal or par value.
3. The debt has a lower risk than ordinary shares. It is protected by charges and covenants.
A loan note is a written acknowledgement of a debt incurred by a company, normally containing provisions
about the payment of interest and the eventual repayment of capital
Investors will be attracted by the large capital gains offered by the bonds, which is the difference between the
issue price and the redemption value, but will carry lower interest than other types of bond.
The benefit to the company will be lower interest yield than on conventional bonds, but will pay a much larger
amount at maturity than it borrowed when bonds were issued.
The advantage to the borrower is that it can be used to raise cash immediately and there is no cash repayment
until redemption date. The cost of redemption is known at the time of the issue. The borrower can plan to have
the funds available to redeem the bonds at maturity.
The advantage for the lenders is restricted, unless the rate of discount on the bonds offers a high yield. The
only way of obtaining cash from the bonds before maturity is to sell them. Their market value will depend on
the remaining term to maturity and current market interest rates.
Redemption of bonds
Redemption is the term for the repayment of preference shares and bonds at maturity.
They are issued for a term of ten years or more. At the end of this period, they will ‘mature’ and become
redeemable (at nominal value and possibly a value above nominal value.
They have an earliest and latest redemption date.
Irredeemable bonds
Bonds that do not have a redemption date or undated.
A new issue of bonds is likely to be more preferable to a new issue of preference shares (Preference shares carry a fixed
rate of dividend.
Companies might wish to avoid dilution of shareholdings and increase gearing (the ratio of fixed interest capital to
equity capital) in order to improve their earnings per share by benefiting from tax relief on interest payments.
Convertible bonds
Convertibles start life as loan capital and can later be converted, at the lenders’ option, into shares. They are a clever and
useful device, particularly for younger companies because;
In the very early days of the company’s life, investors might not want to risk investing in equity, but might be prepared
to invest in the less risky debentures. However, debentures never hold out the promise of massive capital gains.
If the company does not do so well, the investors can stick to their safe convertible loan stock.
If the company does well, the investors can opt to convert and to take part in the capital growth of the shares.
Convertible bonds therefore offer a ‘wait and see’ approach. Because they allow later entry to what might turn out to be a
growth stock, the initial interest rate they have to offer is lower than with pure bonds- and that is good for the company that
is borrowing.
The conversion value will be below the value of the bond at the date of issue, but will be expected to increase as the date for
conversion approaches on the assumption that a company’s shares ought to increase in the market value over time.
Question 3
The 10% convertible bonds of Starchwhite are quoted at $142 per $100 nominal. The earliest date for
conversion is in four years time, at the rate of 30 ordinary shares per $100 nominal bond. The share price is
currently $4.15. Annual interest on the bonds has just been paid.
Required:
(a) Calculate the current conversion value
(b) Calculate the conversion premium and comment on its meaning.
Question 4
CD has issued 50,000 units of convertible bonds, each with a nominal value of $100 and a coupon rate of
interest of 10% payable yearly. Each $100 of convertible bonds may be converted into 40 ordinary shares of CD
in three year’s time. Any bonds not converted will be redeemed at 110 (that is, at $110 per $100 nominal value
of bond).
Debentures
Debt secured with a charge against assets (either fixed or floating), are low risk debt offering the lowest return
of commercially issued debt.
Unsecured loans
No security meaning the debt is more risky requiring a higher return.
Mezzanine finance
High risk finance raised by companies with limited or no track record and for which no other source of debt
finance is available. A typical use is to fund a management buy-out.
OTHER SOURCES
(a) Sale and leaseback
1. Selling good quality fixed assets such as high street buildings and leasing them back over many (over 25 +)
years.
2. Funds are released without any loss of use of assets.
3. Any potential capital gain on assets is forgone.
(b) Grants
1. Often related to regional assistance, job creation or for high tech companies.
2. Important to small and medium sized businesses (ie unlisted).
3. They do not need to be paid back.
4. Remember the EU is a major provider of loans.
(d) Warrants
1. An option to buy shares at a specified point in the future for a specified (exercise) price.
2. The warrant offers a potential capital gain where the share price may rise above the exercise price.
3. The holder has the option to buy the share. On a future date at a pre-determined date.
4. The warrant has many uses including:
Additional consideration when issuing debt
Incentives to staff
ISLAMIC FINANCE
The teachings of the Qur’an are the basis of Islamic Law or Sharia’a. Sharia’a Law is however not codified as
such the application of both Sharia’a Law and, by implication; Islamic finance is open to more than one
interpretation.
Financial transactions are strongly based on the sharing of risk and reward between the provider of funds
(the investor) and the user of funds (the entrepreneur)
Prohibited activities
In Sharia’a Law there are some activities that are not allowed and as such must not be provided by an Islamic
financial institution, these include:
1. Gambling (Maisir)
2. Uncertainty in contracts (Gharar)
3. Prohibited activities (Haram)
Riba
Interest in normal financing relates to the monetary unit and is based on the principle of time value of money.
Sharia’a Law does not allow for the earning of interest on money. It considers the charging of interest to be
usury or the ‘compensation without due consideration’. This is called Riba and underpins all aspects of Islamic
financing.
Instead of interest a return may be charged against the underlying asset or investment to which the finance is
related. This is the form of a premium being paid for a deferred payment when compared to the existing
value.
There is a specific link between the charging of interest and risk and earnings of the underlying assets. Another
way of describing it as sharing of profits arising from an asset between lender and user of the asset.
The Quranic ban on riba is absolute. Riba can be viewed as unacceptable from three different perspectives:
Mudaraba contract
A Mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal)
contributes capital, and the other (the mudarib) contributes skill and expertise. The contributor of capital has no
right to interfere in the day-to-day running of the business. Due to the fact that one of the partners is running the
business and the other is solely providing capital, the investor has to rely heavily on the mudarib, his ability to
manage the business and his honesty when it comes to profit share payments.
Project or
Enterprise
The role of and the returns received by the rab al mal and mudarib under a Mudaraba contract
Capital injection
The investor provides capital to the project or company. Generally, an investor will not provide any capital
unless a clearly defined business plan is presented to him. In this structure, the investor provides 100% of the
capital.
Project or
Enterprise
(a) All partners bring a share of the capital as well as expertise to the business or project. The partners do not
have to provide equal amounts of capital or equal amounts of expertise.
(b) Any profits will be shared between the partners according to the ratios agreed in the original contract. To
the contrary any losses that the project might incur are distributed to the partners strictly in
proportion to capital contributions. Although profits can be distributed in any proportion by mutual
consent, it is not permissible to fix a lump sum profit for any single partner.
Murabaha contract
A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the
purchase of goods for immediate delivery on deferred payment terms.
The buyer has full knowledge of the of the price and quality goods he buys
The buyer is also aware of the exact amount of mark-up he pays for the convenience of paying later
Musharaka Venture Profits are shared according to a pre-agreed contract. There are no
capital dividends paid. Losses are shared according to capital contribution.
Mudaraba Equity Profits are agreed according to a pre-agreed contract. There are no
dividends paid. Losses are solely attributable to the provider of capital.
Ijara Leasing Whether and operating or finance transaction, in Ijara the lessor is still
the owner of the asset and incurs the risk of ownership. This means that
the lessor will be responsible for major maintenance and insurance
which is different from a conventional finance lease.
Key point
You have limited time in an exam
Only calculate few key ratios and then move on and complete the question, than it is to calculate all the possible
ratios and fail to satisfy the requirement.
Note: considerations
- Industry sector data provided.
If not provided, state you would want to consider such comparative data.
Cash flows
The ability of the company to generate cash. If the company is currently cash generating, then it should be able to pay the
interest and debt finance could be a good choice. If the company is currently using the cash base, it is investing heavily in
Risk
The directors of the company must control the total risk of the company and keep it at a level where the share holders and
other key stakeholders are content.
Total Risk
The company may be able to accept more if the business risk is expected to fall
‘financial risk
Availability
Will depend on the nature of company seeking funds:
e.g. Small or medium sized unlisted company
difficult to raise equity for these!! ‘and if you consider that the company requires more equity, you must be ready to
suggest potential sources e.g. venture capital, business angels and be aware of the drawbacks of such sources.
If recent or forecast financial performance is poor, all providers are likely to be very wary of investing.
Given the recent performance and the good forecasts, the company is likely to have many finance sources available to it.
Debt providers should be willing to lend and shareholders would be likely to support a rights issue. Equally, other investors
may well wish to invest in the equity of the company. As the finance is required to finance a permanent expansion of the
company, long-term finance should be raised. To the extent that expansion requires investment in additional working capital,
some short-term finance could be raised. Consideration should be given to the fact that the existing bonds of the company
are due to be repaid. Subject to early redemption penalties, it may be worth looking into refinancing this debt at the same
time as raising the new debt especially as the cost of the new debt appears lower.
Maturity
The term of finance should match the term of need. (i.e. short-term project should be financed by short-term finance).
But can be flexed, if the project is short-term but other short-term opportunities are expected to arise in the future – the
use of longer term finance could be justified.
Consider the maturity debts of debt finance in questions of this nature and this may have a bearing in financing the
repayments.
Control
If debt is raised then there will be no change in control. However, if equity is raised, control may change. Rights issue will
only cause a change in control if shareholders sell their rights to other investors.
Yield curve
Consider the term structure of interest rates e.g. if the curve is becoming steeper this shows an expectation that interest rates
will rise in the future. In these circumstances, a company may become more wary of borrowing additional debt or may prefer
to raise fixed rate debt, or may look to hedge the interest rate risk in some way.
Question 5
The following forecast financial position statement as at 31 May 2014 refers to Mtoso Co, a stock exchange listed company,
which is seeking to spend K180m in cash on a permanent expansion of its existing trade.
Km Km
Assets
Non-current assets 260
Current assets 208
Total assets 468
The forecast results for Mtoso Co, assuming the expansion occurs from 1 June 2014, are as follows:
Notes:
1. The long-term borrowings are 8% bonds that were issued in 1998 with a 20-year term
2. The current assets include K36m of cash, of which K30m is held on deposit
3. Mtoso Co has consistently grown its profits and dividends in real terms
4. No new finance has been raised in recent years
5. The sector average financial gearing (debt/equity on book value basis) is currently 85%
6. The sector average interest cover is currently 2.9 times
7. The company estimates that it could borrow at a re-tax rate of 7.2% per year
8. The company pays tax on its pre-tax profits at a rate of 28%
Required:
If it starts as an incorporated business or turns into one, there are important differences between share capital and loans.
Share capital is more or less permanent and can give suppliers and lenders some confidence that the owners are being
serious and is willing to risk significant resources.
If the owners’ friends and families do not themselves want to invest (perhaps have no money to invest) then the owners
will have to look for outside sources of capital.
2. Retained earnings
No good for start-ups.
No good for the first few years of a business’s life when only losses or very modest profits are made.
Assuming the business is successful, profits should be made and the earned profits are not distributed in the form
of dividends and are retained to finance growth.
4. Venture capital
A company willing to invest in your own company. Normally it is a company looking for a medium term strategy
and in which case there is need to have an exit strategy. When the venture capitalist comes in, there must be a way
of how they will get their money out. They need to invest millions of funds in a relatively large company. They
take an unlisted company with a good and innovative idea and grow it quickly in a few years time and then sell it
off.
Venture is high risk capital, normally provided by a venture capital firm or individual venture capitalist, in return
for an equity stake.
Exit strategies
List the company in the stock exchange market
Trade sale to another company.
Key feature
The venture capital is only available if the venture capital firm believes that the companies they are investing have some
potential for super normal growth.
The nature of the company’s product Viability of production and selling potential
The market and competition Threat from rival producers or future new entrants
Detailed business plan showing profit prospects that compensate for
Future profits risks
To take account of VC’s interests and ensure VC has say in future
Board membership strategy
Risk borne by existing owners Owners bear significant risk and invest and invest significant part of
their overall wealth.
5. Business Angels
People with substantial amounts of money invest in small businesses. They will invest in tens or hundreds
of dollars, for a longer term outlook. Someone with money ties up with a company without money and
work together, for a few numbers of years into the future. The individual bringing the money may also
bring some skills they have learned elsewhere.
Key feature
Both parties must work well into the future through the marriage of ideas of the two.
6. Private placing
Shares are sold to individuals without the company being listed.
Issue
- Difficulty to market as there is no recognised market
- Difficult to value a share due to absence of benchmark.
1. Prestige
2. Growth
3. Access
4. Visibility
5. Accountability
6. Responsibility
7. Regulation
Easier to
‘seek growth WHY SEEK A STOCK Enhanced public
‘by acquisition MARKET LISTING? Image
Gaining a listing opens up a huge source of potential new capital. However, with listing come increased
scrutiny, comment and responsibility. Although this will help the standing and respectability of the company,
the founders of the company having been used to running their own company in their own way, often resent
outside interference even though that is to be expected now that the ownership of shares is more widespread.
Underwriting
Underwriters are financial institutions which agree (in exchange for a fixed fee, perhaps 2.25% of the finance to be raised) to
buy at the issue price any securities which are not subscribed for by the investing public.
Underwriters remove the risk of a share issue’s being under-subscribed, but at a cost to the company issuing the shares.
Advantages
1. Low cost
2. Protect ownership rights
3. Rarely fails
Question 6
Marcus plc, which has an issued capital of 4,000,000 shares, having a current market value of $2.80 each, makes
a rights issue of one new share for every three existing shares at a price of $2.0.
Value of a right
The new shares are issued at a discount to the existing market value; this gives the rights some value.
Required:
Calculate the theoretical ex-rights price
Shareholders’ options
The shareholders’ options with a rights issue are to:
1. Take up (buy) the rights
2. Sell the rights
3. A bit of both
4. Do nothing
Question 8
Seagull can achieve a profit after tax of 20% on capital employed. At present its capital structure is as follows:
$
200,000 ordinary shares at $1 each 200,000
Retained earnings 100,000
300,000
The directors propose to raise an additional $126,000 from a rights issue. The current market price is $1.80.
Required:
(a) Calculate the number of shares that must be issued if the rights price is: $1.60; $1.50; $1.40; $1.20
(b) Calculate the dilution in earning per share in each case.
Required:
1. If the market continues to value the shares on a price/earnings ratio of 5, what would be the value per share if
the new funds are expected to earn, as a percentage of the money raised:
(a) 15%
(b) 20%
(c) 25%
How do these values in (a), (b) and (c) computation
Question 10
Pepe is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at 15% discount to the market
price of $4.00 per share. Issue costs are expected to be $220,000 and these costs will be paid out of the funds raised. It is
proposed that the rights issue funds raised will be used to redeem some of the existing loan stock at par. Financial
information relating to Pepe is as follows:
(b) What alternative actions are open to the owner of 1,000 shares in Pepe as the regards the rights issue? Determine
the effect of each of these actions on the wealth of the investor. (6 marks)
(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to
redeem some of the existing loan notes. (6 marks)
(d) Evaluate whether the proposal to redeem some of the loan notes would increase the wealth of the shareholders of
Pepe. Assume that the price/earnings ratio of Pepe remains constant. (3 marks)
(e) Discuss the reasons why a rights issue could be an attractive source of finance for Pepe. Your discussion should
include an evaluation of the effect of the rights issue on the debt / equity ratio and interest cover.
(7 marks)
(25 marks)