09. Debt Finance

Question 1

What are some advantages of preference shares?

Answer 1

1. No voting rights; therefore no dilution of control.
2. Compared to the issue of debt:
   - preferred dividends do not have to be paid in any specific year, especially if profits are poor.

• preferred shares are not secured on company assets; and
• non-payment of dividend does not give holders the right to appoint a liquidator.

Question 2

What are two disadvantages of preference shares?

Answer 2

1. Preferred dividends are not tax deductible (unlike interest on debt which is a tax allowable expense). Preference shares are a relatively rare source of finance in practice because of this.
2. To attract investors to buy preferred shares, the company needs to pay a higher return to compensate for the additional risk compared to debt.

Question 3

State two ways bonds may be secured.

Answer 3

1. A floating charge over a specified asset (e.g. a specific building) which cannot therefore be sold unless the debt is repaid; or
2. A floating charge over a class of asset which changes (e.g. inventory). On default, the floating range crystallises as a fixed charge, and the asset class can no longer be traded until the debt is repaid.

Question 4

What is a deep discount loan note?

Answer 4

Deep discount loan notes are issued at a large discount to nominal value (ie issued well below nominal value) and are redeemable at nominal value upon maturity.

Investors receive a large capital gain on redemption but are paid a low coupon during the term of the loan.

They offer a cash flow advantage for borrower and are useful for financing projects with weak cash flows in early years.

Question 5

What are zero-coupon loan notes?

Answer 5

Zero-coupon loan notes are issued at a discount to nominal value and pay no coupon.

Question 6

What are the advantages of zero-coupon loan notes?

Answer 6

1. The issuing company pays no interest and the only cash payout is at the loan note’s maturity.
2. Return to investors is wholly in the form of a capital gain (the difference between issue and redemption price).

Question 7

What are convertibles?

Answer 7

The are loan notes or preference shares which can be converted into a pre-determined number of ordinary shares.

Question 8

What are some advantages of convertible loan notes?

Answer 8

1. For investors, the are a relatively low-risk investment with the opportunity to make high returns on conversion to ordinary shares.
2. For the issuer, they can offer a lower coupon/dividend rate than would have to be paid on a non-convertible (straight) loan notes/preference shares (because the conversion option has value).
3. For younger companies, investors may not want to risk investing in equity but may be prepared to invest in less risk loan notes. If the company does well, investors can opt to convert and benefit from capital growth, or otherwise keep the safe loan notes.

Question 9

What is a warrant?

Answer 9

The investor’s right, but not the obligation, to purchase new shares at a future date at a fixed price. The fixed price is also called the exercise or subscription price.

Question 10

What are some of the advantages of warrants for the issuing company?

Answer 10

1. When initially attached to the loan note, the coupon rate on the loan note will be lower than for comparable straight debt. This is because the investor has the additional benefit of the potential purchase of equity shares at an attractive price.
2. They may make an issue of unsecured debt possible when the company’s assets are inadequate to secure the debt.
3. They are a way of issuing equity (albeit with a delay) without the usual negative signal associated with an equity issue.

Question 11

What is an advantage of bank loans?

Answer 11

1. As the loan is for a fixed term, there is no risk of early recall (unlike overdrafts that are repayable on demand).

Question 12

What are some disadvantages of bank loans?

Answer 12

1. Inflexible.
2. May require security.
3. May require covenants, which are restrictions on the company (e.g. limits on dividend payments, limits on further borrowing), designed to protect the debt holder and could reduce the interest rate on the debt.

Question 13

What are some advantages and disadvantages of leases?

Answer 13

Advantages
1. There are many willing providers (often associated with asset manufacturers and therefore offering attractive terms).

2. Matches finance to the asset.
3. Very flexible packages available, some of which include maintenance.

Disadvantage
1. May be expensive.

Question 14

Under a sale and leaseback, a company sells property to an institution, such as a pension fund, and then leases it. What are some disadvantages of this?

Answer 14

• Company no longer owns the property and so cannot participate in any future increase in its value.
• The future borrowing capacity of the company will be reduced, as there will be fewer assets to provide security for a loan.
• Net effect is equivalent to secured borrowing. A ROU asset will be capitalised (potentially at a higher amount than the carrying amount of the leased asset) and a lease liability recognised. Gearing will increase.

Question 15

A mortgage loan is a loan secured by a property. Outline 3 advantages and 2 disadvantages associated with these loans.

Answer 15

Advantages:
1. Given the security, the loan will have a lower rate of interest than other debt.

2. Institutions will be willing to lend over a longer term.
3. The company can still participate in the growth of the property’s value.

Disadvantages
1. There are likely to be restrictive covenants concerning the use of the property and its potential disposal.

2. In the event of default in repayments, the bank may force the sale of the property to recover the loan.

Question 16

What are some advantages and disadvantages of bank overdrafts?

Answer 16

Advantages:
1. Flexible.
2. Provides instant finance.

Disadvantages:
1. Usually technically repayable on demand.
2. Expensive if used regularly.

Question 17

What are some advantages and disadvantages of using trade credit as a source of finance?

Answer 17

Advantages:
1. Generally cheap.
2. Flexible.

Disadvantages:
1. May lose settlement (prompt payment) discounts.
2. Temptation to delay payment beyond formal payment terms may trigger penalties or lose supplier goodwill.

Question 18

What is a bill of exchange?

Answer 18

An acknowledgment of a debt to be paid on a stated date.

In international trade, an exporter typically requires a customer to accept a bill before releasing documents of title to the goods.

The exporter may then:
1. Hold the bill to maturity (and receive payment from the customer) or
2. Discount the bill with a bank to receive cash earlier. If the customer doesn’t pay then the bank has recourse to the exporter for payment:

Question 19

What is commercial paper? State some advantages and disadvantage of commercial paper.

Answer 19

Commercial paper - short-term unsecured debt issued by high-quality companies. The paper can then be traded by investors on the secondary market.

Commercial paper is appropriate for short-term liabilities.

Advantages:
1. Large sums can be raised relatively cheaply.
2. No security is required.

Disadvantages:
1. Only available to large companies with investment grade credit ratings.

Question 20

What are some advantages and disadvantages of short-term bank loans?

Answer 20

Advantages:
1. Available to most companies (assuming a well-functioning banking system).
2. Typically unsecured (ie no need to provide collateral).
3. Short-term interest rates are usually lower than long-term interest rates, due to lower credit risk on short-term debt.

Disadvantages:
1. Arrangement fees may be high when expressed as an annual effective cost.
2. Refinancing risk (rollover risk). Every time a short-term loan matures, the borrower faces the risk that it cannot easily be replaced or refinanced, or that interest rates have risen.

Question 21

What are some sources of debt finance available to SMEs?

Answer 21

1. Trade credit
2. Factoring and invoice discounting
3. Leasing
4. Bank finance
5. Business angels
6. Supply chain financing
7. Peer-to-peer (P2P) lending

Question 22

What are some government sources of financing available to SMEs?

Answer 22

1. Grants
2. Subsidies - eg low interest rate loans.
3. Government loan guarantee schemes.

Question 23

Outline supply chain financing.

Answer 23

This is the use of financial instruments, practices and technologies to optimise the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners.

Examples include bank offering extended payment terms on invoices.

Question 24

Outline peer-to-peer lending. State some of its advantages.

Answer 24

P2P lending is a method of debt financing that enables individuals to lend money to small businesses without the use of an official financial institution as an intermediary.

Advantages:
1. Loans generate interest income for lenders, which can often exceed that which would be earned on a bank deposit account.

2. Borrowers have access to finance when banks refuse credit or would charge very high interest rates.
3. By effectively cutting out the middleman (ie the formal banking system), interest rates can be relatively attractive to both lenders and borrowers.

Examples of platforms are Lending Club.

Question 25

List some examples of long term debt finance.

Answer 25

1. Preferred shares
2. Bonds
3. Deep discount loan notes
4. Zero-coupon loan notes

Question 26

List some examples of medium term debt finance.

Answer 26

1. Bank loans
2. Leasing
3. Sale and leaseback
4. Mortgage loans

Question 27

List some examples of short term debt finance.

Answer 27

1. Bank overdraft
2. Trade credit
3. Bills of exchange
4. Commercial paper
5. Short-term bank loans

Question 28

What are some factors to consider in recommending a suitable financing method?

Answer 28

1. Availability - finance may be limited if recent or forecast performance is poor and an SME will always find it difficult to raise equity.
2. Cash flow - debt requires a company to pay out cash in the form of interest and therefore the company’s ability to generate cash will be relevant.
3. Control - raising equity can lead to a change in control, debt will not.
4. Cost - debt finance is cheaper than equity finance, so if the company can take on more debt, there could be a cost advantage.
5. Ease and cost of issue - raising equity is more difficult, takes more time and is more expensive than raising debt.
6. Maturity - in general, the term of the finance should match the term of the need (matching principle). The maturity dates of existing debt should also be considered however.
7. Risk - company directors must control the total risk (financial risk and business risk). If business risk is rising, the company may seek to reduce financial risk and vice versa.
8. Security and covenants - debt may require security (is this available?) or covenants (are these acceptable?) such as to maintain a certain liquidity level.
9. Yield curve - if, for example, the yield curve is getting steeper, there is an expectation that interest rates will rise. Therefore, a fixed-rate debt may be appropriate if a company wishes to take on more debt.