10. Financing a business

Question 1

What is a long-term internal source of finance?

Answer 1

Retained earnings

Question 2

What is a short-term internal source of finance?

Answer 2

• Reduced inventory levels
• Delayed payment to trade payables
• Tighter credit control

Question 3

What are some major long-term external sources of finance?

Answer 3

• Ordinary shares
• Preference shares
• Finance leases
• Hire-purchase agreements
• Securitisation of assets
• Borrowings

Question 4

What are some major short-term external sources of finance?

Answer 4

• Bank overdrafts
• Debt factoring/ Invoice discounting

Question 5

What is equity finance?

Answer 5

Equity finance is a method of raising capital by selling shares of the company to public, institutional investors, or financial institutions.

Question 6

What is the difference between “ordinary shares” and “preference shares”?

Answer 6

Ordinary shares give equity without priority for dividends or when in bankruptcy.

Preference shares have dividend priority over ordinary shares, normally with a fixed dividend rate, and sometimes without voting rights. They have a higher claim on assets in case of liquidation.

Question 7

What is the difference between a “primary” and “secondary” stock market?

Answer 7

Primary market is where new seucurities are originally sold to investors.

Whereas in the secondary market previously issued securities are traded amongst investors.

Question 8

What is the difference between an “Initial Public Offering (IPO)” and a “Seasoned Equity Issue (SEO)”?

Answer 8

An IPO is when a company issues its first equity to the public

An SEO is when a company issues new equity but that company has already previously issues securities to the public.

(Equity is a subset of securities)

Question 9

What are the two investment banking functions?

Answer 9

Firm commitment:

• Underwriter buys the entire issue of shares for less than the offering price and accepts the risk of not being able to sell them.

Best efforts:
- Underwriter acts as an agent, receiving a commission for each share sold. In this case the underwriter can return any unsold shares to the issuer without financial responsability.

Question 10

What is a rights issue?

Answer 10

When shares are sold to existing shareholders. (Some companies have an obligation to sell to existing shareholders first)

The main advantage of this is that there is no further dilution of control, and the costs are lower.

Question 11

What is the advantage of a “stock exchange listing”?

Answer 11

• Easier to raise funds
• Funds acquired at a lower cost
• Shares valued in an EFFICIENT manner
• Enables other businesses to be acquired for shares rather than cash
• share incentives for employees

Question 12

What is the disadvantage of a “stock exchange listing”?

Answer 12

• Cost (management time)
• Regulatory burden
• Close monitoring of actions and decisions
• Pressure to perform in the short-term

Question 13

What is an “efficient capital market”?

Answer 13

It is a market whose prices rapidly and rationally take account of all relevant information, implying that share prices represent the best estimate of ‘true’ value, on the basis of publicly known information.

Question 14

What are bonds?

Answer 14

Bonds are fixed-income securities that are issued by corporations and governments to raise capital.

The bond issuer (corporation /government) borrows capital from the bondholders (public/other financial institutions) and makes payments to them at a fixed or variable interest rate for a specified period.

Question 15

What are the 4 types of bonds?

Answer 15

Government Bonds:
– government borrows from the public by issuing treasury notes/bills/ bonds, maturity up to 100 years

Zero Coupon Bonds:
– a bond that pays no coupon at all, offered at a price much lower than the face value.

Floating Rate Bonds:
– the coupon payments are adjustable Inflation-linked bond

Bond Market Structure – OTC, no particular place where the buying and selling occurs, dealers are connected electronically and stand ready to buy and sell (LSE, Euronext, Deutsche borse)

Question 16

How does an investor make profit from “Zero-coupon bonds” if they don’t pay any interest income?

Answer 16

Investors can make a profit from zero coupon bonds through capital appreciation. The profit comes from the difference between the purchase price of the bond (which is typically at a discount) and the face value paid at maturity.

Question 17

Can bonds be sold?

Answer 17

Yes. On the secondary market.

Question 18

When it comes to loan capital, one of the main risks if that companies are unable to pay interest payments and the borrowed amount. What can lenders do to reduce this risk?

Answer 18

• Use COVENANTS in the loan agreement.

Covenants are legally binding clauses within the agreement that dictate obligations or restrictions on the business

eg.
* restriction on further borrowing
* restriction on the right to sell certain assets
* restriction on dividend payment
* maximum level of gearing

Question 19

Why do “ordinary shares” have greater return than “preference shares”?

Answer 19

Dividends for prefence shares are fixed. However, for ordinary shares dividends may vary depending on the company’s profitability and the decision of the board of directors.

If the company does well, ordinary shareholders may benefit from higher dividends.

Question 20

What is “Finance leasing”?

Answer 20

A financial arrangement where the asset title remains with the owner (the lessor) but the lease agreement transfers virtually all or a substantial part of the rewards and risks to the business (the lessee).

Advatanges:
* Ease of borrowig
* Flexibility
* Improved cash flows

Question 21

What is the “securitisation process”?

Answer 21

Securitisation involves bundling together illiquid financial or physical assets of the same type, so as to provide financial backing for an issue of bonds. ‘Illiquid’ in this sense means not readily able to be sold.

Question 22

Securitisation example:

Answer 22

Consider a bank that has a portfolio of mortgages. The bank decides to securitize these mortgages.

1. The bank pools a set of similar mortgages into a portfolio.
2. The bank creates an SPV, often a trust, to hold the mortgages.
3. The mortgages are legally transferred to the SPV, removing them from the bank’s balance sheet.
4. The SPV issues mortgage-backed securities (MBS), representing ownership in the cash flows generated by the pooled mortgages.
5. The MBS are sold to investors in the capital markets.
6. As homeowners make mortgage payments, the SPV collects cash flows and distributes them to MBS holders based on the terms of the securities.

Securitization allows the bank to free up capital, diversify its risk, and provide investors with an opportunity to invest in a broader range of assets. Investors, in turn, receive returns based on the performance of the underlying mortgages.

Question 23

What is a “bank overdraft”?

Answer 23

enables business to keep a negative balance in their bank account. It’s flexible, the size of the overdraft can be increased or reduced relatively quickly, and interest rates are often very competitive .

Question 24

What is another name for “debt factoring”?

Answer 24

Invoice discounting

Question 25

What is "debt factoring/ invoice discounting"?

Answer 25

After a good is supplied on credit, the factor will pay 75-80% of the amount to the cleint immediately and factor an invoice to the credit customer. The customer than pays what they owe to the factor, who will consequently pay the remaining 20% balance (minus fees) when the credit customer has paid the amount they owe.

Question 26

Why is "debt factoring" used?

Answer 26

Provides the business with a large part of the credit sale IMMEDIATELY. Very useful for businesses who are facing cash shortages.

Question 27

What is the "Trade-Off theory of capital structure"

Answer 27

That a firm should borrow up to the point where the tax benefit from an extra pound in debt is exactly equal to the cost that comes from the increased probability of financial distress, and therefore leading to the lowest overall cost of capital.

Question 28

What are the benefits/costs of deciding on equity OR debt?

Answer 28

Borrowing has a tax advantage, and interest expenses are tax deductible, leading to a lower tax burden. However, the higher the debt the lower the benefits of debt are. As high debt will lead to higher likelihood of financial distress and costs associated with them.

Question 29

What is "private equity"?

Answer 29

Non-public sale of securities to a limited number of investors. Private equity is a general term used to describe all kinds of funds that pool money from a number of private investors in order to amass large amounts of money that are then used to acquire stakes in companies.

Question 30

What is a "venture capital"?

Answer 30

Technically, venture capital is private equity, but venture capital often goes into younger companies, generally with high level of risk. Typically, they look for promising young businesses that need an injection of cash in order to grow.