Ch.4 - Sources of finance

Question 1

What are risks and benefits of using retained earnings as source of finance?

Answer 1

Benefits:

• readily available
• low cost
• immediate
• no change in control

Risks:

• cash may not be available
• may have impact on firm’s dividend policy

Question 2

What are risks and benefits of using rights issue as source of finance?

Answer 2

Benefits:

• issue costs are lower than for new issue
• no change in control (unless rights are sold)
• pricing is much easier than for new issue as no wealth is being shares with new investors

Risks:
- shareholders may be unwilling or unable to invest (difficult especially for unlisted companies when selling the shares)

Question 3

What are risks and benefits of using new issue as source of finance?

Answer 3

Benefits:
- finance is generally to be found somewhere

Risks:

• can have very high issue costs
• will reduce the control of existing shareholders (needs approval - pre-emption rights)
• pricing is difficult (high price - issue will fail, low price - existing shareholders will suffer)

Question 4

What is the calculation of the share issue?

Answer 4

Theoretical ex-issue/ex-rights price (TERP) = (MV of shares in issue + Proceeds from new issue + project NPV) / No. of shares after issue

Theoretical value of a right = TERP - exercise price

Question 5

What are risks and benefits of using term loans as source of finance?

Answer 5

Benefits:

• arrangement fees are small compared to loan stocks
• may have fixed or floating rates of interest
• interest payments attract tax relief

Risks:
- generally secured on company assets and so may not be available if company doesn’t have strong balance sheet

Question 6

What are risks and benefits of using loan stocks (bonds or debentures) as source of finance?

Answer 6

Benefits:

• may be unsecured
• can be sold on by the original investor (provides flexible exit route)
• flexibility - redeemable or irredeemable, issue prices and redemption values can be at premium or discount
• can be offered with conversion rights (lower interest rates and potential to avoid CF problems) or warrants entitle the holder to subscribe for shares at set date and price)

Risks:

• high issue costs
• often have higher interest rates than a term loan (due to lower security)

Question 7

What are risks and benefits of using international money markets?

Answer 7

Benefits:

• interest rates tend to be cheaper because there is less regulation
• access to wider market of investors
• where investment in foreign country is required, borrowing in the same currency tends to protect against FX movements

Risks:

• issue costs can be high (unless borrowing substantial amounts)
• FX rates might have changed adversely

Question 8

What are forms of efficient market hypothesis (EMH)?

Answer 8

Strong = share price at all times incorporates all information that exists about the company; impossible to beat by insider trading; doesn’t exist

Semi-strong = share price incorporates all information that has been made public about the company; possible to beat by insider trading; more or less exists

Weak = share prices don’t react instantly to new events, only all information about past price movements are at all times incorporated in the share price; possible be beat by insider trading or analysing new public information; slightly exists

Question 9

What behavioral factors cause inefficiency in a market?

Answer 9

• overconfidence and miscalculation of probability
• conservatism and cognitive dissonance (Discomfort experienced by a person who holds two or more contradictory beliefs, ideas, or values. This discomfort is triggered by a situation in which a person’s belief clashes with new evidence perceived by the person.)
• availability bias and narrow framing (over-reliance on one factor or observation rather than a broad view)
• representativeness and extrapolative expectation (tendency to believe that history will repeat itself; following the crowd)