Ch 4 Flashcards
External Sources of Finance
CAPITAL MARKETS
new share issues, rights issues, issues of marketable debt (e.g. bonds)
requires listing on recognized stock exchange
BANK BORROWINGS
l/t or s/t loans, including revolving credit facilities (RCFs) and money market lines
VENTURE CAPITAL FUNDS
high risk finance provided by specialists
challenge is that they often require significant equity participation and may also influence company policy
GOVERNMENT
or similar
Criteria for Selecting Sources of Finance
COST of different sources
DURATION - how long required?
LENDING RESTRICTIONS - security, debt covenants
GEARING LEVEL (aka capital structure)
LIQUIDITY IMPLICATIONS - ability to service debt while leaving cash to meet interest and capital repayment obligations
CURRENCY of CF associated with new project
impact of different options on F/S, tax position, financial st/h of entity
AVAILABILITY - based on creditworthiness of borrow, willingness of lenders to extend credit (bank borrowings) / liquidity of capital markets (equity, bonds)
Finance Criteria: Cost
Each source of finance has a different cost
Cost of debt capital to company = interest cost less tax relief on interest
Tax relief plus fact that debt providers are lower than equity providers => debt usually cheaper
Cost of equity capital = expected sh/g return = dividends and expectations of future dividends and share price growth
Although dividends not legally required, satisfactory return required to support share price - otherwise investors will not subscribe to new equity when org needs to raise new capital
Duration also relevant => l/t finance more expensive than s/t
Finance Criteria: Duration
Equity is l/t “permanent” capital vs debt is fixed term (s/t overdraft to l/t)
Bank loans usually m/t 5-7 yrs, bonds can be much longer
L/T Assets should be financed by L/T funds; S/T assets by a mix of S/T and L/T
e.g. working cap funded by S/T A/P and overdraft, NCA funded by L/T finance
rule may be broken to access cheap S/T funds (especially A/P with no obvious cost) – but this involves risk
Finance Criteria: Lending Restrictions
Security often required for debt finance - derived from existing assets or new assets to be acquired; land/buildings hold value and are easier for a lender to sell than plant/machinery
Debt covenants = clauses protecting lender’s interests by requiring borrower to satisfy criteria, e.g. interest cover must not <5, ratio of NCL to Equity not > 0.75:1
If covenants are not breached, lender is reassured that risk associated with borrow will not dramatically change
Finance Criteria: Gearing
Ratio of debt to equity finance
High gearing = very risky
Although high gearing involves use of cheap debt finance, high debt creates obligation to meet interest payment and debt principal repayment schedules – failing which, liquidation
l/t funding should be happy balance of equity and m/t and l/t debt – thus benefiting from lower cost of debt finance without exposure to risks from excessive debt obligations
Finance Criteria: Currency of CF associated with new project
If CF expected in foreign currency, entity may decide to raise finance in same currency to reduce risk of exchange rate mvmts – by matching project receipts with servicing costs of finance
Finance Criteria: Impact of Different Finance Options on F/S, Tax Position, Financial St/h
Financial st/h (debt holders and sh/h) will use ratio analysis to assess org perf, thus F/S effect of any new financing must be considered by mgmt
e.g. raising debt will affect ROE, interest cover, gearing; will create tax-deductible interest payments thus impacting tax position
Existing financial st/h (debt holders and sh/h) will monitor performance closely, so mgmt must clearly explain rationale for any financing which impacts F/S or tax position
Finance Criteria: Availability
small companies traditionally challenged in raising equity and l/t debt finance – many firms do not have an unlimited choice of funding arrangements
availability of debt enhanced by good credit rating
Definition of share
a fixed identificable unit of capital in an entity which normally has a fixed nominal value, which may be quite different from its market value
shh receive returns from investment in shares in the form of dividends, and also capital growth in share price
Ordinary shares vs Preference shares
ORDINARY SHARES
pay dividends at directors’ discretion
ordinary sh/h own company and have right to attend mtgs, vote on important matters
in winding-up, are subordinate to all other finance providers
PREFERENCE SHARES
form of equity paying a fixed dividend, paid in preference to ordinary sh dividends
winding-up => subordinate to debt holder, receive payout before ordinary sh/h
Comparison of Preference Shares with Debt and with Ordinary Shares
Pref shares pay fixed proportion of share’s nominal value as annual dividend - thus often considered to behave as debt > ordinary shares
however, pref share dividends out of post-tax profits, thus no tax benefit (unlike interest on debt finance)
in certain cases, org can skip pref share dividends (e.g. insufficient distributable profits), whereas debt interest is an obligation (even if org cannot afford it)
lack of tax relief on dividends => relatively unattractive compared with bank borrowings or fixed-rate securities (bonds)
HOWEVER, some appeal to risk-averse investors looking for relatively reliable income stream
Four types of preference shares
CUMULATIVE
dividends must be paid, unpaid are rolled into next year
NON-CUMULATIVE
no build up of missed payments
PARTICIPATING
fixed dividends plus extra earnings based on certain conditions (similar to ordinary shares)
CONVERTIBLE
can be exchanged for specified # of ordinary shares on given future date
note - some preference shares are redeemable, meaning holders will be repaid their capital at some future date (usually at par)
Example - convertible preference shares
fixed-income securities, investor can choose to convert into set # of ordinary shares at specified point in time
fixed-income = steady income stream and some protection of investor capital
option to convert = opportunity to gain from rise in share price => attractive to participate in rise of hot growth companies while insulating against share privce drop
often used in context of Management Buyouts
Functions of Capital Markets
PRIMARY
enable companies to raise new equity or debt finance - by providing access to large pool of potential investors
(in UK, company must be plc before allowed to raise finance from the public on stock market)
SECONDARY
enable investors to sell investments to other investors
thus, listed org’s shares more marketable than unlisted, thus more attractive to investors
Private (Ltd) vs Public (plc) company
PRIVATE LIMITED COMPANY
sh/h with limited liability, shares not offered to public
sh/h liability limited to orignal capital invested (nominal + premium) - personal assets protected if org goes insolvent
PUBLIC LIMITED COMPANY
may sell shares to public
either unlisted, or listed on the stock exchange
Advantages of a listing on stock exchange
once listed, mkt will provide more accurate entity valuation than previously possible
realization of paper profits and mechanism for buying/seeling shares at will in future
raise profile of entity => revenue impact, credibility with suppliers and l/t fin providers
raise capital for future investment
make employee share schemes more accessible
Disadvantages of a listing on stock exchange
costly for small entity (flotation, underwriting costs, etc.)
making enough shares available to allow a market => loss of at least some control by original owners
more onerous reporting requiremenets
stringent stock exchange rules for obtaining a quotation
Impact of Stock Exchange Listing on Key Stakeholders
SHAREHOLDERS benefit as shares become more marketable = listing improves company reputation, thus share price may rise
listing builds company reputation and profile => benefits EMPLOYEES and MANAGERS = listed orgs tend to be larger, less likely to fail => can afford to offer better pay, career progression
improved rep of listed company improves credit rating, thus reduces non-payment risk to SUPPLIERS and LENDERS; former may grant generous credit terms
Two important capital markets in UK
STOCK EXCHANGE
market for larger companies
high entry costs, high scrutiny - but high profile thus very marketable shares
ALTERNATIVE INVESTMENT MARKET
smaller companies, lower associated costs, less stringent entry criteria
Operation of Stock Exchanges
Prices of shares are determined by forces of supply and demand
a company doing well will attract investors => demand pushes up price
a company doing poorly will drive investors to sell shares => supply in the market drives down price
Three most commonly used methods of issuing new shares
Initial Public Offering
Placing
Rights Issue
Initial Public Offering
offering may be completely new shares, or shares transfering from private to public ownership
issuing house, normally merchant bank, acquires shares and offers to public
offer either at fixed price set by company, or in tender whereby investors suggest their own price (with subsequent sale at best price offered)
offers usually made as a prospectus in newspapers, sometimes abbreviated - buying through the prospectus avoids dealing costs
examples of IPOs also include gov’t privatizations and privately held shares transferred to public
easier for investors to judge entities with track record > new entity
Placing
sale of securities to relatively small number of selected investors - usually large banks, mutual funds, insurance companies, pension funds
placement not publicly announced or registered; detailed fin information often not disclosed and need for prospectus waived
average investor only made aware of the placement after it has occurred
popular = cheaper and quicker to arrange than most other methods => HOWEVER does not lead to very actrive market for shares after flotation
