Chapter 8

Question 1

Main internal source of finance

Answer 1

Retained earnings

Question 2

Main internal source of finance

Answer 2

Retained earnings

Question 3

Ways to improve working capital management

Answer 3

Reducing the time taken to receive payments from customers (e.g. by offering discounts for quick payment or outsourcing debt collection to a factor).
Reduction in the amount of inventory (e.g. through improved supply chain management or even moving to Just-in-Time (JIT) production).
Taking increased credit from suppliers. However, care must be taken not to lose settlement discounts or compromise relationships with key suppliers.

Question 4

Rights issue

Answer 4

the existing shareholders are offered more shares (usually at a discount to the current market price) in proportion to their existing holding

Question 5

Pre emptive rights

Answer 5

the right to purchase new shares before they can be offered to other investors). This is to protect shareholders from dilution of their control.

Question 6

What is theTERP - theoretical ex rights price

Answer 6

The expected share price following the rights issue

Question 7

Points to note for the calculation of the TERP per share

Answer 7

Proceeds of the rights issue should be added net of any issue costs.
If the project has already been announced, and if the market is operating at the semi-strong level of efficiency, the project’s NPV will already be reflected in the existing share price and it should not be included again in the formula above.

Question 8

Formula for TERP

Answer 8

​the fraction with numerator Pre minus existing value of equity plus proceeds of rights issue plus project NPV and denominator Number of shares after the rights issue

Question 9

Methods of issuing shares

Answer 9

Offer for sale
Placing
Rights issue
Offer for subscription
Offer for sale or subscription by tender

Question 10

Offer for subscription

Answer 10

A direct sale to the general public. This is generally the most expensive method of issuing new shares.

Question 11

Offer for sale

Answer 11

An indirect sale to the public accomplished by selling shares directly to an issuing house (merchant/investment bank), which then sells them to the public

Question 12

Placing

Answer 12

In a placing, the sponsor (normally a merchant bank) places the shares with its clients (usually pension funds and insurance companies) rather than the shares being offered to the general public. This is generally the least expensive method of issuing new shares.

Question 13

Rights issue

Answer 13

An offer to allow existing shareholders to buy new shares in proportion to their existing holdings.

Question 14

Offer for sale or subscription by tender

Answer 14

Like an auction, with the public being invited to bid for shares. Useful where setting a price for the shares is difficult.

Question 15

Options for unquoted companies

Answer 15

To become quoted (i.e. raise new equity finance at the same time as becoming listed). This is known as an initial public offering (IPO). The method could be an offer for subscription or sale, tender, or placing. It is an expensive process.
To stay unquoted. Use a rights issue or private placing. However, there may be a limited source of funds from either existing owners or new private investors.
To engage in what is known as “introduction”.
No shares (neither existing nor newly-created) are made available to the market, so no new finance is raised.
Stock market grants a quotation, given that shares must already be widely held, so that a market can be seen to exist.

Question 16

Why do ordinary shareholders take more risk

Answer 16

ordinary dividends are discretionary (i.e. the company has no legal obligation to pay an ordinary dividend); and
ordinary shareholders rank last in the event of bankruptcy/liquidation.

Question 17

Factors to consider before doing an IPO

Answer 17

Legal restrictions.
Costs including:
Underwriting costs (i.e. the fees that must be paid to an investment bank to underwrite/guarantee the share issue) which are typically 5% to 7% of the offering.
Stock market listing fee (initial charge) for the new shares.
Fees for the issuing house (investment bank), solicitors, auditors, PR.
Cost of printing and distributing the prospectus (the document in which the shares are offered for sale).
Advertising in national newspapers.
Valuation: the setting of a price for the new shares to be issued.
Stock exchange rules.
Timing.

Question 18

Bonus issue

Answer 18

In a bonus issue, reserves (e.g. revaluation surplus or share premium accounts) are converted into share capital, which is distributed as new shares to existing shareholders in proportion to their existing holdings).

Question 19

Bonus issue

Answer 19

The purpose is to increase the marketability of the shares, as it increases the number of shares in existence and reduces their price. This creates a more active secondary market for the shares, which will help future issues to raise cash (e.g. rights issues).

Bonus issues are also called “scrip issues” or a “capitalisation of reserves” and signal a company’s strength to the market.

Question 20

Constant dividend

Answer 20

A constant dividend policy avoids surprises and signals stability to shareholders, but shareholders might be dissatisfied if they receive relatively low dividends if earnings are rising. As the proportion of retained earnings increases, shareholders might ques

Question 21

Constant growth

Answer 21

Constant growth is predictable and favoured by shareholders but again the dividend growth rate might not match the earnings growth rate

Question 22

Constant payout ratio

Answer 22

A constant payout ratio means paying a dividend which represents a constant proportion of each year’s earnings. Although this approach sounds logical it creates uncertainty and is therefore rarely adopted by quoted companies.

Question 23

Residual dividend policy

Answer 23

Under the residual dividend policy, retained earnings are used to fund all positive NPV projects and any remaining earnings not needed to fund such projects are paid out as a dividend.

Question 24

Zero dividend policy

Answer 24

A high growth company may find that, in early years, all surplus cash can be profitably reinvested back into the business − particularly if the company lacks access to external finance.

Question 25

Bird in the hand theory

Answer 25

The “bird-in-the-hand” theory argues that shareholders prefer higher dividends (and therefore lower potential capital gains) because a cash dividend today is without risk, whereas future share price growth is uncertain.

Although persuasive, this is incorrect. Market forces should mean that a share price is correctly set for the level of risk and returns. If more dividends are paid out as cash the investor has to decide how to invest it. In another investment with higher returns and higher risk or lower returns and lower risks? According to the capital asset pricing model (see Chapter 12), diversified investors should be happy with either because extra returns correctly compensate for extra risk.

Question 26

Dividend irrelevance theory

Answer 26

Modigliani and Miller (finance theorists) argue that under certain conditions, shareholders are indifferent to dividend policy.

If a company pays no dividend, the share price should rise due to reinvestment of earnings.
Any shareholder who requires a dividend can sell part of their holding to create a capital gain (i.e. to manufacture a “home-made dividend”).
Under this theory, the pattern of dividends is irrelevant to shareholder wealth. However, Modigliani and Miller made a series of assumptions which may not hold in practice:

No distortions from the personal tax system (i.e. dividends and capital gains are taxed at the same rate in the hands of investors).
No transactions costs (i.e. investors can sell shares to create a home-made dividend without incurring any trading costs).
Perfect markets (i.e. if the company defers the payment of dividend, the current share price will fully reflect its value).

Question 27

Scrip dividend

Answer 27

A scrip dividend is a choice between a cash dividend and shares in lieu of cash. Shareholders can choose to acquire new shares (if they do not need the cash dividend) without transactions costs. The company conserves cash for reinvestment (the preferred source of finance under pecking order theory).

Question 28

Special dividends

Answer 28

If a quoted company announces a larger than expected dividend, this may raise market expectations that future dividends will also be higher.
Therefore, to avoid creating expectations of an unsustainable level, a larger dividend may be announced as a “special” dividend − basically a bonus dividend.
The directors are communicating to the markets that, from time to time, any exceptional cash surplus will be returned in this way, but that this should not be built into dividend per share forecasts.
Like a buyback, the company distributes cash. Also, all shareholders will receive cash (whereas, under a buyback, only those who sell receive cash)

Question 29

Share buyback program me

Answer 29

The buyback can be performed either by writing directly to all shareholders with an offer to buy shares at a fixed price (a tender offer) or by purchasing shares via the stock market at the prevailing price.
The shares are either cancelled (and a non-distributable reserve created) or held by the company as treasury shares for possible future reissue. If held by the company, the shares carry no voting rights and receive no dividends.
Distributable reserves must be reduced by the full value of the buyback.
As there will be fewer shares in issue after the buyback, the share price should rise.
Ratios such as earnings per share (EPS) and return on equity (ROE) should also improve.
In many countries, a share buyback is treated as a capital gain in the hands of the investor rather than as income. This can have tax advantages if capital gains are taxed at a lower rate than dividends

Question 30

Characteristics of SME

Answer 30

the entity is likely to be unquoted;
ownership of the business is restricted to few individuals, typically a family group; and
it is not a micro business (i.e. a very small business that acts as a vehicle for self-employment of the owners).

Question 31

Why are SME’s perceived as unattractive ?

Answer 31

SMEs, obviously do not have a track record with long term borrowings
SMEs internal controls are often non-existent or very limited.
Larger businesses conduct more of their activities in public than do SMEs. If information is public, there is less uncertainty. Many SMEs do not have to have audits, certainly do not publish their accounts to a wide audience and the press are not really interested in them. They therefore have fewer external controls.
The fact that potential investors in an SME have much less information about the business than its managers (i.e. asymmetry of information) contributes to their perception of high risk.
Often SMEs have one dominant owner-manager whose decisions are rarely questioned.
They tend to have limited assets to offer as security

Question 32

Why would a bank want collateral from an SME ?

Answer 32

he bank will look to see what security (collateral) is available for any loan provided. This is likely to involve an audit of the entity’s assets.

Collateral is important because it can reduce the level of risk a bank is exposed to in granting a loan to a new business.
Many SMEs are based in the service sector where the main asset is likely to be human capital as opposed to physical assets. The directors may therefore be required to pledge personal assets (e.g. their homes) to secure business loans.

Question 33

How SME shares lack marketability ?

Answer 33

Sales are usually on a matched bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy.
This lack of marketability means that small companies are likely to be very limited in their ability to offer new equity to anyone other than family and friends.

Question 34

Tax considerations for SME’s

Answer 34

Individuals with cash to invest may be encouraged by the tax system to invest via large institutional investors rather than directly into small companies.

In many countries, personal tax incentives are offered on contributions to pension funds.
These institutional investors themselves usually invest in larger companies (e.g. listed companies) in order to maintain what they see as an acceptable risk profile, and in order to ensure a steady stream of income to meet ongoing liabilities. This reduces the potential flow of funds to small companies, although the government may try to mitigate this effect by also offering tax advantages for investment in SMEs.

Question 35

Funding gap

Answer 35

is the difference between the finance available to SMEs and the funding they could productively use.

Question 36

Why are medium term loans hard to obtain for SME’s ?

Answer 36

The fact that medium-term loans are hard to obtain is a well-known feature of SMEs, and many resort to financing medium-term assets with short-term finance such as an overdraft. This is known as the maturity gap as there is a mismatch of the maturity of the assets and liabilities within the business, which is not ideal.

Question 37

What are pre emptive rights and why are they important

Answer 37

The right for existing shareholders to be offered new shares before other people in order to protect them from dilution of their control

Question 38

Introduction

Answer 38

as the listing of existing shares without any new finance being raised.

Question 40

Clientele theory

Answer 40

A company should maintain a stable dividend or risk losing investors

Question 41

What would venture capitalists expect

Answer 41

Board representation to monitor their investment and give advice. They usually want 25% to 49% of equity, a dividend policy that promotes growth and an exit route

Question 42

Bonus(scrip) issue

Answer 42

A bonus issue is a capitalisation of reserves; new shares are issued at nominal value carrying voting rights but no new cash is raised