Raising Finance - Lecture 1b, 2a

Question 1

2 Characteristics of a limited company

Answer 1

Separate Legal Entity
Limited Liability

Question 2

What is Corporate Entity

Answer 2

Describes how a Limited Company is a legal personality (or “legal entity”) which is separate and distinct from its members. This means that the company can enter into contracts in its own name, and can sue and be sued in the courts.

Question 3

What is limited liability

Answer 3

the liability of the members
(shareholders), or ‘how much they stand to lose’, is limited to the amount they have invested.

Question 4

What is equity

Answer 4

the issuing and selling of shares

Question 5

What is seed-corn finance?

Answer 5

-‘Seed-corn’ describes initial funding up to approx. £500k in most cases
- Concerns pre-commercial launch Research & Development funding
- Founder management team (FMT) may have savings of their own
- There may also be friends and family who wish to invest
- Beyond this the FMT need to look externally (business angels or Venture Capitalists

Question 6

How are Ordinary Shares (equity) issued?

Answer 6

When a business takes on Company status (‘Ltd.’ or ‘Plc’), its owners become
known as shareholders. The capital of a company is divided into shares. These
can be of any denomination (named value).

Any denomination can be used for a share – this is known as the nominal value or par value and remains constant (although the ‘book’ value and ‘market’ value may go up or down).
All shares are ordinary shares (also known as ‘equities’) unless specified otherwise.

Question 7

2 Features of ordinary shares

Answer 7

• Carry voting rights
• Any person/party owning 50% + 1 of the issued equity, controls the company

Question 8

What is authorised capital?

Answer 8

The maximum the company is allowed to issue under its `Memorandum of Association’ (a document drawn up by the
founders upon incorporation). It does not reflect the actual capital raised (unless
the maximum has been reached).

Question 9

What is issued capital?

Answer 9

That part of the authorised capital of which the shared certificates are in circulation. The total issued capital may be the result of one or several issues.

Question 10

Why may people opt for an authorised capital which is greater than the current issued capital?

Answer 10

To leave room for future expansion

Question 11

Why are shares sometimes issued at a premium?

Answer 11

Less risk and more value.
The nominal value remains constant but over time the market value (i.e. the value a buyer is prepared to pay) may well rise. In future years there may well be new issues of shares with a nominal value that is no longer realistic. Such shares are therefore likely to attract a premium (higher price). The excess monies collected by the company constitute a capital reserve.

Question 12

If a £1 share is issued for £1.20 then:
What is the nominal value?
What is the share premium?
What is the issue price?

Answer 12

The nominal value is £1
The share premium is 20p
Making an issue price of £1.20

Question 13

Under the Companies Act 1985 a capital reserve…

Answer 13

• Can be used for investment in the company
• Cannot be used to pay dividends

Question 14

If a company makes a profit, there are 3 things that can be done…

Answer 14

1. give a cash reward to the shareholders (known as a dividend)
2. Retain it for future internal investment (expansion)
3. Make a ‘bonus issue’ of new shares (‘free’ shares to existing
   shareholders).

Question 15

What can be used to pay dividends?

Answer 15

• Current years profits or prior years’ revenue reserves

Question 16

What CANNOT be used to pay dividends?

Answer 16

Capital reserves (such as share premium) can never be used to pay a dividend, although they can be used to make bonus issues.

Question 17

What are bonus issues?

Answer 17

Occasionally a company will convert reserves into ‘free’ shares for existing shareholders. Shareholders receive these ‘pro-rata’ to the number of shares they already hold.

Question 18

What are rights issues?

Answer 18

A method of raising new funds for a company. In common with bonus issues, new shares are issues to existing shareholders on a pro rata basis. The key difference is that they are not free, in other words the shareholders pay for
them (although they usually receive a discount on the market price).

Question 19

What are preference shares?

Answer 19

If preference shares then shares :
- have priority over equities in the allocation of profits
- have a fixed dividend each year (as long as there is enough profit)
- do not carry voting rights

Question 20

What is venture capital

Answer 20

“A source of finance for new businesses or turn-around situations in which high
returns are offered but high risks are expected.”

Question 21

Providers of venture capital may seek to overcome the ‘principal-agency problem’ by

Answer 21

• demanding a specified level – perhaps even majority – of representation on board.
• structuring rewards so that the founders work hard – for example, specifying moderate salaries for the founders, so that they can only realise large
  rewards from appreciation of the value of their own stock, which will mean that the venture capitalist stocks will also rise.
• provide venture capital in stages, with interim audits taking place to confirm
  that earlier funds have led to the specified levels of progress of the firm.

Question 22

What do investors want and prefer from their investment?

Answer 22

• Less risk to more risk
• More return to less return
• The return sooner rather than later
• More liquidity to less liquidity

Question 23

In order to attract external investors early stage companies need
to:

Answer 23

1. assure investors of the quality of the management team
2. offer potential super-normal profits and high capital gains
3. offer potential liquidation of the investment
4. inform and involve investors regularly (the accountability issue)

Question 24

What do venture capitalists look for when choosing investments? (in order of importance)

Answer 24

1. global sustainable underserved market need
2. strong management team
3. defensible technological advantage
4. believable plans
5. 60% internal rate of return
6. an exit route

Question 25

What is a callable bond also known as

Answer 25

Redeemable bond

Question 26

What are bonds and debentures?

Answer 26

A means of dividing the debt into smaller denominations

Question 27

Short term borrowing

Answer 27

repayable within one year e.g:
- overdrafts (repayable on demand)
- bridging finance (plugging a gap between longer loan periods)

Question 28

Medium term borrowing

Answer 28

repayable within 1-7 years

Question 29

Long term borrowing

Answer 29

repayable over 7 years

Question 30

Who buys bonds and debentures?

Answer 30

• Pension funds
• Mutual funds
• Insurance companies
• Banks
• Wealthy individuals

Question 31

Bonds:

Answer 31

• The company borrows money in return for a formal ‘IOU’, plus interest
• Bonds are generally fixed interest securities
• Are generally long term contracts
• Most bonds are unsecured. Secured bonds are known as debentures.
• Higher risk bonds are likely to be bought by venture capitalists and venture capitalist trusts

Question 32

Debentures:

Answer 32

• A more secure type of bond because the company’s assets (e.g. machines or buildings) will be put up as ‘collateral’.
• If the company does not pay interest or repayments to the bondholders then those assets may be sold and the funds returned to the bondholders.
• Since the debenture holders enjoy such extra security (lower risk) the ‘return’ (interest rate) of these bonds also tends to be lower.

Question 33

Convertible bonds:

Answer 33

The money is originally invested as bonds, but for the investor there is the option to convert them into equity at a later date.

Offer the attraction of a mix of risk and return to the investor.

For the issuer - benefits are that the finance is likely to be cheaper as the interest rate will be lower due to the extra attraction it has for the prospective investor. The future conversion rate is specified at the issue date, hence the opportunity for capital gains.

Question 34

Deep-Discount bonds (‘Zero-coupon’ bonds)

Answer 34

Normally bonds pay an annual fixed interest return (sometimes called the
‘coupon’). But some bonds earn no interim interest payments, because they are issued at a considerable discount – i.e., below their par value. They are redeemable at their par value, thus providing a guaranteed gain. For example, a £100 zero coupon bond could be issued at a discount of 20%.
This means that the investor would pay £80 now and would receive £100 when the bond matures. The profit of £20 would be compensation for not receiving any annual dividend or ‘coupon’.

Question 35

Debt is cheaper for the company than equity because:

Answer 35

• Equity must offer a higher return to compensate for the increased risk.
• Debt attracts tax relief

Question 36

Debt VS Equity

Answer 36

-Debt is cheaper for the company than equity
-Issuing debt brings no dilution of equity

Question 37

Gearing

Answer 37

Debt is cheaper than equity but only up to a certain point, beyond this point the company can run the risk of financial distress.
Why?
More debt leads to higher interests and repayments
These responsibilities are unavoidable (unless the debt can be re-scheduled)
Equity carries No such responsibilities – ‘no dividends’ acceptable, even
expected in early stage companies
Default carries high costs – e.g: penalty clauses.

Question 38

Optimum level of debt graph IMPLICATIONS:

Answer 38

• At 0% debt, the WACC ( weighted average cost of capital), is equal to the cost of equity (the shareholders minimum desired return).
• As the company takes on debt: the WACC falls because debt is cheaper than equity
• As the company takes on really high levels of debt: the WACC rises again because the risk of default/ financial distress increases so there is an optimal level of gearing.
• The optimum level of gearing differs with individual firms and industries. Some
  analysts dispute the existence of an optimum level of gearing at all.

Question 39

Drawbacks of loans

Answer 39

1- Loan Covenants: Clauses put into loan contracts to enforce the borrowers to comply with certain obligations.

2. Future Borrowing: The more highly-geared a firm, the higher-risk it becomes to the potential investor. Therefore arranging further loans becomes more difficult and/or expensive.

Question 40

Is it better for ordinary shareholders to be high or low geared when profits are low?

Answer 40

Low

Question 41

Is it better for ordinary shareholders to be high or low geared when profits are high?

Answer 41

High

Question 42

Gearing formulae:

Answer 42

Long Term Debt x 100
/
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