Chapter 2: Finance options and investments

Question 1

What are the two main types of long-term finance?

Answer 1

1) equity finance -** involves the issue of shares to shareholders who become part-owners of the company**
* ordinary shares
* preference shares
* convertibles

2) debt finance
* debentures
* unsecured loan stock
* Eurobonds

Question 2

What are ordinary shares?

Answer 2

• The main way in which many companies are financed.
• Owners of them are part-owners of the company.
• As such they receive voting rights in proportion to the number of shares held. At annual general meetings they can vote for the board of directors, who run the company on their behalf.
• They might receive a share of the company’s profits as a dividend. But only after obligations to debt holders and preference shareholders have been met, and even then only at the discretion of the directors. There is no legal obligation to do it and some shareholders might not want it (they might prefer the profits be reinvested)

Question 3

When is an investment marketable?

Answer 3

If it can be sold easily without affecting the market price

Question 4

What are the advantages and disadvantages of owning ordinary shares?

From the POV of an investor

Answer 4

• Ordinary shares are one of the riskiest of all investments
• The shareholder earns two types of return. The dividend return and capital gain if they can sell the share for more than the purchased price. Both of these are very uncertain.
• There is also risk of company failure. Their liability is limited (to the price purchased) but if the company fails, lenders and preference shareholders are paid off first.

As compensation for the risk of company failure and the high variability of returns, they are offered:
* high potential returns.
* some protection against inflation (as dividends and share prices tend to rise with inflation)

Question 5

What are the advantages and disadvantages of companies raising finance by issuing shares?

From the POV of the issuing company

Answer 5

• For the company, ordinary shares are the least risky form of finance
• They do not need to pay a dividend if profit is low or they want to reinvest the profit
• Shares are usually irredeemable, the company never has to pay shareholders back

But:

• they need to keep the shareholders happy and have to consider the shareholders reaction to a dividend decision. And shareholders need to be rewarded for the risks they are running
• existing shareholders might fear a loss of control if too many shares with voting rights are issued to new investors.

Question 5

Compare the marketability of different types of shares

Answer 5

• For ordinary shares, it is higher for public listed companies than for private companies since their shares can be bought and sold more easily.
• It tends to increase with the size of share issue, but ordinary ones are likely to be more marketable than other sorts of investments (aside from government bonds) because of the large number and the frequent trading of ordinary shares

Question 5

What are preference shares?

Answer 5

• less common than ordinary shares
• classed as equity but sometimes seen as more similar to debt finance.
• do not normally have voting rights
• dividends are fixed and are almost always paid (but interest payments to debt holders are paid first)
• still paid at the director’s discretion
• must be paid before dividends to ordinary shareholders.
• if no dividends are paid, they are entitled to vote.
• most are cumulative, if the dividends are suspended, they accumulate and are carried forward to be paid later
• if the company were wound up and assets sold, preference shareholders are ranked below debt holders but above ordinary shareholders in the distribution of proceeds from the sale of assets.

Question 5

Would the expected return on preference shares be higher of lower than the expected return on ordinary shares?

Answer 5

• Should be lower as they are taking less risk - the dividend income is more certain, the share price is more stable, they rank above ordinary shareholders in a wind-up operation

Question 6

convertibles

Answer 6

• They begin life as either preference shares or unsecured loan stock but they give the holder the option to convert these into ordinary shares at a future date (either a single date or a series of possible dates)
• The rate of dividend (for pref share) or interest (for unsecured loan stock) is fixed

Question 7

How does the expected return on convertibles compare to other shares?

Answer 7

• Convertibles give a fixed income initially (unlike ordinarys) so they have a lower return to compensate for the lack of risk
• Convertibles offer the opportunity for a higher return from conversion into ordinary shares, this is valuable to the investor who would be willing to forego some income and/or pay a higher porice for it (compared to a preference share), meaning it has a lower return.
• If the holder does not convert, it might continue as a pref share for a period or be redeemed at the conversion date.
• As the conversion date approaches, it becomes clearer whether or not it will be converted, and it will be treated more like whichever share it is more likely to be

Question 8

What is debt finance?

Answer 8

Companies can borrow large sums of money to finance their investment plans by issuing corporate bonds (or loan stock). A bond has the following features:
* usually long-term, eg 20 years
* the nominal (or par or face) value of the bond is usually £100
* normally issued at (or close to) par, the investor will pay the company approximately £100
* usually redeemed at par, the investor will receive a redemption payment of £100 at the end of the term
* interest is fixed, eg 6% bond pays £6 pa on £100 nominal
* interest is usually paid in the form of two coupons, eg £3 every six months
* bonds can be bought and sold, therefore the market price will vary with supply and demand
* rights of bondholders are set out in a loan agreement and a trustee, (often a bank) acts on behalf of the bondholders

Question 9

debentures

Answer 9

• secured loan stock
• against some or all of the assets of the company
• if the company fails to pay the coupon or redemption payment, the debenture holder can take possession of the assets and either obtain income from them, such as rent, or sell them.
• the loan can be secured against specific assets in which case it is called a fixed charge debenture
• otherwise it is called a floating charge debenture

Question 10

unsecured loan stock

Answer 10

• stock that is not secured on any of the company’s assets
• if the coupon is not paid, the holder can sue the company for non-payment and can apply to the courts to have the company wound up.
• holders rank below debenture holders in a wind-up operation

Question 11

Eurobonds

Answer 11

• unsecured bonds issued by large corporations (and also by governments and supra-national organisations) in a currency other than that of the country in which they are issued
• For example, a Japanese company might issue Eurodollar bonds in Luxembourg
• they are outside the legal and tax jurisdiction of any country and can be issued in many different currencies and with many different features.
• For example, some Eurobonds pay a variable rate of interest, floating-rate bonds
• Unlike other bonds, there is no central register of ownership, so they are bearer bonds, the owner is the holder of the certificate.
• Coupons are usually paid annually

Question 12

Pros and cons of buying corporate bonds

From the investors POV

Answer 12

• Offer a fairly certain income stream of coupon payments and a redemption value. Useful for financial planning
• if secured against an asset: as long as the asset holds its value, the sale should ensure repayment if wound up
• interest received on an unsecured bond for a company with a poor credit rating (a junk bond) might be relatively high. The interest received on a debenture with a sound company might be relatively low.
• income received from bonds might be eroded by inflation, especially over a long period. Purchasing power of payments fall as prices rise.
• full value of bond might not be repaid even if secured
• marketability is reduced by the tendency of companies to release many different issues of bonds (of different terms and different coupons), each of which is quite small.

Question 13

Pros and cons of a company issuing debt finance over issuing shares

eg corporate bonds or loan stock

Answer 13

• Cheaper than equity finance as bondholders take less risk and therefore require less return
• interest payments on loans are treated as business expenses and therefore reduce taxable profit (unlike with dividend payments) so there is a tax advantage
• shareholders might prefer the company to take on debt finance as they do not wish to lose control of the business to new shareholders
• interest on debt must be paid (fixed cost for the business) even if it is not doing well. There is a risk of it eating into profits
• Companies such as firms of lawyers/accountants, that have very few tangible assets on which to secure loans, might find it difficult to raise debt finance
• Even companies with tangible assets might resist secured loan capital as they do not like to be restricted in their use of their assets (eg might not be allowed to sell an asset if it were used as a security)

Question 14

interest-only loan

Answer 14

medium-term finance:
pay only the interest at regular payments, then full amount at the end

Question 15

repayment loan (or mortgage)

Answer 15

medium-term finance:
regular payments consisting of both interest and capital payments so at then end the entire loan is paid off

Question 16

hire purchase

Answer 16

medium-term finance:

• hire an asset for an agreed term then buy it when the term is over.
• regular payments of part rent, part interest.
• once the final payment is made, the company owns the car

ownership is transferred at the end

Question 17

credit sale

Answer 17

medium-term finance:
very similar to a hire purchase except that legal ownership of the asset passes to the buyer at the outset.
If the buyer does not make payments (aka they default), the asset cannot be reclaimed, the seller would have to sue for non-payment.

ownership transfers at the start

Question 18

leasing

Answer 18

medium-term finance:
* The leasing company allows the other company to use the assets for a period of time in return for regular payments.
* ownership is never transferred, nor does responsibility.
* might have regular upgrades and servicing from the leasing company

Question 19

Types of medium-term finance

Answer 19

• interest-only loan
• repayment loan (or mortgage)
• hire purchase
• credit sale
• leasing

1-5 years

Question 20

Types of short-term finance

Answer 20

• Bank overdraft
• Bill of exchange (or commercial bill of exchange)
• Commercial paper
• Trade credit
• Factoring

under 1 year

Question 21

Bank overdraft

Answer 21

• A company can be given permission (by the bank) to have a negative balance on its current account of any amount up to an agreed limit.
• IOW the company is allowed to overdraft its current account
• company pays itnerest on the amount overdrawn, so overdrafts are flexible and are particularly useful when a company has a short-term shrotage of cash (eg whilst waiting for a large payment from a customer)
• However the itnerest charged can be high and banks can demand immediate repayment so it can be risky to rely on one

Question 22

Bill of exchange (or commercial bill of exchange)

Answer 22

• One company ‘promise to pay the bearer’ a certain amount on a certain date (normally in 91 days).
• They are guaranteed (usually by an investment bank), so the bank will pay instead if the company does not pay
• if the bearer wants the payment before the date on the bill, it can be sold (usually to a bank), and they will present it on the date

Question 23

Commercial paper

Answer 23

Similar to bills of exchange except it does not need to be guaranteed as it is issued only by very large companies that satisfy certain criteria, such as being listed on the London Stock Exchange

Minimum Size, £500,000

Question 24

trade credit

Answer 24

• an agreement to pay for supplies after the delivery date (eg 91 days later)
• this is very common practice and is a very improtant source of ‘free’ finance for business.
• no interest is explicitly charged; instead, discounts may be offered for cash purchases

Question 25

factoring

Answer 25

• if customers take too long to pay, companies may run short of cash. In this case they might obtain cash owed by its customers from a factor (usually a bank).
• the company can continue to chase up the customers for payment and repay the factor when the customers have paid, or else ask the factor to chase up the customers. the second option is more expensive as the factor is taking on the risk that the cutomers might not pay.
• It might also annoy the customer to be chased up by the factor and not the company itself.

Non-recourse is when the factor chases up

Question 26

A company is running short of cash because it is owed payment for a large order from a large company. It also needs a new computer to undertake a special type of work for a customer. What are its options?

Answer 26

In order to address this cashflow problem, they could:
* discuss the problem with its customer and encourage payment asap
* negotiate an overdraft with its bank
* obtain the amount owed from a factor (and either continue to chase the customer or get the factor to)
* delay payments for its own supplies to save cash
They could then:
* lease the computer
* if they think they need to actually own the computer they could take out a bank loan (interest only or repayment)
* or buy in instalments (hire purchase or credit sale

Question 27

Other investment options (not corporate equities or bonds)

Answer 27

• Government borrowing (bonds or bills of exchange)
• certificates of deposit
• property
• collective investment schemes

Question 28

government bonds

How do they differ from coporate bonds

Answer 28

• AKA ‘gilt-edged securities’ or ‘gilts’ in the UK.
• long-term loans to governments and operate in the same way as corporate bonds.
  They differ from bonds as
• they are more secure - in fact, they are sometimes said to be risk-free as there is very little risk of the government defaulting on its debt (though it does happen)
• they are more marketable - since the issues are much larger

Question 29

Pros and cons of an investor buying government bonds

Answer 29

Pros:
* very secure and offer a certain stream of coupon and redemption payments
* highly marketable, so they are easy to sell if the investor needs to cash them in

Cons:
* expected return is low, generally the lowest rate of return of all investments
* As with corporate bonds, inflation may erode the value of the coupon and the redemption payments, so that the real return is uncertain (real - after allowing for inflation)

Question 30

Types of government bond

Answer 30

1) Index-linked bonds
* Aim to guarantee a real return to investors by increasing coupon and redemption payments in line with prices as indicated by an inflation index.
* However as it takes time to publish the inflation index and to calculate the revised payments, the payments are usually adjusted according to the index with a time-lag
2) Bonds with optional redemption dates give the borrower (or possibly the lender) the right to choose when to redeem the bond. This could be on a coupon date within a certain period or it could be after a certain date (in which case the bond is undated. Optional redemption dates create uncertainty for investors
3) Strips are bonds which are divided into two parts; one bond pays the coupon payments only and the other pays the redemption payment only
4) Zero-coupon bonds are bonds that pay only the redemption payment. For example an investor might pay £60 for a bond that will pay £100 in 10 years

Question 31

government bills (of exchange)

Answer 31

• AKA a Treasury bill in the UK and US, is a short-term loan to government.
• It is often 3 months/13 weeks/ 91 days.
• often sold below par value (issued at a discount and redeemed at par so the investor earns a return from the difference between purchase price and par value.
• The investor can also sell the bill to another before the period is over.
• Most secure form of short-term investment and are highly marketable, consequently the return (often regarded as risk-free) is low

Question 32

certificates of deposit

Answer 32

• ** issued by banks to customers (usually companies) for making large deposits for a fixed term**
• cannot be withdrawn on demand and the investor receives interest and principal (or capital) only at the end of the fixed term.
• interest rate credited may be fixed at the outset or may vary over the term of the deposit
• can be sold from one customer to another, therefore providing companies a way of dealing with cash shortages and surpluses

Question 33

property

Answer 33

• Not a financial asset
• Land or buildings e.g. offices, shops, factories, houses or apartments
• This investment demands more of the investor than simply buying the property. Some buy with intention of renovating it to re-sell at a higher price, others want to rent out as a long-term investment.
• Tenants usually sign a lease agreement to use the property for a specified period of time in return for an agreed level of rent.
• Rents are often reviewed every three to five years.
• Expenses include renovation expenses as well as ongoing mainenance costs
• In return investor might earn rental income plus capital gain from the increased price of the property

Question 34

Property vs shares

Answer 34

• Lenders are generally happier to provide funds for an investment in property becasue property (at least the land) is immobile (so the borrower cannot disappear with the asset) and likely to appreciate in value. Finance is likely to be provided over a longer term and at more favourable rates for a property investment.
• Large and indivisible so the investor cannot sell part of the investment to raise cash. So it is less flexible
• Every property is different, so it is difficult to determine a fair market value. Also property sales are infrequent an dselling prices are sometimes confidential, thys adding to the problem. Since very little market information is available, valuation is difficult and subjective. To obtain as objective a view as possible, an experienced surveyor is requiredd, thus making valuation expensive
• Can be very difficult to sell, so it might take time to liquidate
• Higher transaction costs such as estate agent fees, legfal fees, suveyors’ fees, mortgage arrangement fees, insurance and taxes. Theses suggest property is a long-term investment
• Maintenance costs. If it is not maintained, it will deteriorate and decrease in rental value will fall
• rental income tends to be reviewed every three to five years (whereas dividends usually increase each year)
• might be difficult to rent out at times, in which case no rental income is received.

Question 35

Collective Investment Schemes (CISs)

Answer 35

• Provides structures for the management of investments on a pooled basis.
• Opportunity for wide spread of investments and therefore a lower portfolio risk.
• Managers of CISs generally have management expertise, particularly in specialist areas such as overseas investment, which is otherwise available only to the largest institutional investors

Question 36

Two types of CIS

Answer 36

Close-ended
* e.g. an investment trust,
* once the initial tranche of money has been invested, the fund is closed to new money.
* After launch, the only way of investing is to buy shares from a willing seller

Open-ended
* e.g. a unit trust or open-ended investment company
* managers can create or cancel units in the fund as new money is invested or disinvested

Question 37

Hedge funds

Answer 37

• Special type of CIS, designed to enable fund managers to take risks or pursue investment strategies that would not typically be permitted for normal CISs
• Often achieved by locating the hedge fund in an offshore location where regulations are much more relaxed and restrictions are seldom imposed, or by setting up the fund so that only sophisticated investors and institutions are allowed to invest
• Typically has minimum investment sizes and ‘lock-in’ periods during which no di-investment is allowed from the fund
• almost always charge much higher fees than typical CISs

Question 38

What does financial manager need to work effectively?

Answer 38

• thorough knowledge of fund raising options (investment banks often provide a range of services)
• understanding of the current state of the markets for these forms of finance
• good working relationships with providers of finance

Question 39

market

Answer 39

brings together buyers and sellers

Question 40

capital market

Answer 40

• market for long-term finance for both government and industry
• Channels savings of individuals and companies into long-term investments of government and industry via 2 main routes - bonds and shares
• Bond/share market bring together demanders and suppliers of finance and so prices indicate the state of the two markets

Question 41

money market

Answer 41

market for short-term finance for both government and industry, such as bills

Question 42

primary market

Answer 42

• the market for new long-term finance
• When a company wants to raise long-term finance,it does so on this.
• Usually hires an investment bank to make arrangements for a new bond issue or a new equity issue

Question 43

secondary market

Answer 43

• market for second-hand bonds and shares
• most transactions take place here
• what goes on here can have a major impact on the ability of the company to raise new finance

Question 44

How might increased selling of a company’s bonds on the bond market affect the company’s ability to raise new debt finance?

Answer 44

• The increase selling of bonds increase supply of bonds ->
• reduces price
• Since coupons are fixed, the coupon becomes a higher proportion of the selling price -> increases return on bonds
• the bonds are out of favour with the market, -> company has to sell any new bonds at a lower price or with a higher coupon to attract buyers

Question 45

Why might investors sell bonds?

Answer 45

• profits might be falling and investors might be worried about the company’s ability to pay the coupon in the future
• value fo assets of the businees might be falling and debt holders might be concerned that in the event of a wind-up, the value of the assets might not cover the amount owed to debt holders.
• business might be undertaking riskier activites -> less likely to cover coupon payments and redemption values in future years.
• more attractive investment opportunities have appeared, such as new government bonds offering a high coupon rate

Question 46

What can you imply from a share price?

Answer 46

• For companies listed on a stock market, this can be monitored over time, with porices available on a regular basis.
• It reflects the perception of the company by the market at a particular point in time, with the share price taking into account current and expected future performance

Question 47

Why might a company’s share price change?

The 2 main types of reason

Answer 47

• general economy or industry-wide factors, for example if a country moves into a re3cession
• issues very specific to this particular company, for example the announcement of the appointment fo a new chief executive

Question 48

Example Q: What are the most important factors affecting the price of shares in BP plc

The multinational oil company

Answer 48

• Prospects for the UK economy generally may well affect demand for oil products in the UK and elsewhere, and hence the amount BP can sell
• price of oil on the international markets
• amount of investment made by BP in bringing new oilfields on stream
• amount of oil being produced by BP’s competitors in the market place
• price, demand for and supply of alternative energy sources (e.g. coal, liquid, petroleum gas), which will affect the corresponding figures for oil. If alternative poroducts become much cheaper and mor eplentiful, this may reduce the demand for oil products and hence the amount of profit BP can make.