KCB WEEK 6 - Sources of long-term financing Flashcards
Main sources of long-term financing (3)
1 - Retained earnings
2 - Preference share capital
3 - Debt Capital
Advantages and disadvantages of retained earnings as a source of long-term financing
Advantages
* No issue costs
* Available within company
* No obligation to pay interest/repay
* Flexibility
* Reduces risk of takeover
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Disadvantages
* May not be sufficient if investment large
* Investment may not match timing and availability
* If not used properly retained profit may incur opportunity cost
* Too much RE may result in over-capitalisation
* Large about of RE may attract hostile takeover bids
Overview of preference share capital
Not as popular anymore. Carry preferential rights over equity shares on profits available for distribution – characteristics of debt capital whilst being part of equity – usually on left over funds in case of liquidation/right to dividend.
Usually earn a fixed amount on dividends in preference to those on ordinary dividends.
- Cumulative- where dividend is not paid in year, carried over to next year and must be paid before any ordinary dividend (non-cumulative)
- Redeemable – can be purchased back by company within its lifetime subject to i issue terms – at a future date/investment amount is returned to the owner
- Irredeemable - go on forever
- Convertible - enjoys right to convert into equity at future date, benefit of receiving a regulator fixed dividend and an option to convert them into equity shares
- Non-convertible - cannot convert
Advantages and disadvantages of preference share capital as a source of long-term finacning
Advantages
* Only payable if sufficient profs available for the purpose (unlike fixed interesting)
* No loss of control – no voting rights
* Unlike debt – no need to pay dividends if no profits
* Right to dividend where low profits lost except cumulative pref shares
* Unlike debt – shares are not secured on assets of the company
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Disadvantages
* Unlike debt interest, not tax allowable – use is rare these days given tax advantages of debt
* Pref shares pay higher rate of interest than debt due to extra risk for shareholders
* On liquidation – preference shares rank before equity/ordinary shareholders
Types of debt capital (3)
Bonds
* General term for types of long term loans to companies
* Used by companies/govs/semi-gov bodies to raise money and finance projects and activities
* Owners of bonds are accounted for as creditors of issuing company
* Company may issue bonds directly to investors instead of obtaining loans from a bank
* Company issues bond at fixed term interest (coupon rate) – and duration of the loan – must be paid at end of period (maturity date)
* Issue price of bond usually at par – usually £100 ($1000) – face value per individual bond - can be issued at discount
* Actual market price depends on expected yield and the performance of the company compared to the market environment at the time
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Debentures
* Most common form of long-term loan used by large companies
* Written acknowledgement of debt – most common for large companies to borrow money at a fixed rate of interest
* Written in a legal agreement/contract called ‘indenture’ which acknowledges the long-term debt raised by the company
* Can be traded on stock exchange normally in units – carry a fixed rate of interest expressed as a % of nominal value
* Payable at fixed rate – fixed interest
* Company makes interest payments prior to paying out dividends to shareholders
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Loan Stock
* Shares of common/preferred stock used as collateral to secure loan from another party
* Loan provided at fixed interest rate like a standard loan- secured or unsecured
* It is valued higher if company PLC / unrestricted – since these can be easier to sell if borrowers are unable to repay the loan/already a market price valuation available (less risk, knows precise value of the security)
* Lenders will have control of lender’s loan stock until borrower pays off the loan – once loan term expires shares are returned to the borrower as they are no longer needed as collateral
Types of debenture
- Secured/unsecured : against collateral or not
- Secured - first charge on assets used as security in liquidation
- Fixed charge debenture – restricted from selling assets used as security until loan fully repaid
- Floating charge- free to dispose of its assets in the ordinary course of business
- Unsecured debentures – backed only by the reputation and trust of the issuer
- IRREDEEMABLE = PERPETUAL – go on and on until company is liquidated, rate these days because interest rats fluctuate in short-term
Advantages and disadvantages of debentures
ADVANTAGES
* Loans repayable fixed date – fixed interest
* Interest usually less than dividends as debentures considered less risky
* Advantageous to issuer because fixed repayment date
* Unlike divis – interest paid is tax allowance – reduces net cost to company
* Unlike shares- no comapny law restriction regarding terms of issue
* Debenture holders typically no rights to ovte/have voice in management of company
* Preferred as a source of finance if any dilution of control is not desireable
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DISADVANTAGES OF DEBENTURES
* Holders are creditors of company - secured debenture holders have first charge on assets used as security if company goes into liquidation
* Holders receive interest payents regardless of amounts of profit or loss at the stipulated time. Interest payments are due prior to paying dividends to shareholders
* Risk for an investor of investing in debentures / other loans is less than the risk of investing in shares – but still a risk of default
* The higher the amount of debt finance – the higher the debt/gearing ratio. These may make the company volatile and could lead to insolvency.
Conversion ratio/conversion price and conversion premium - calculation
Example - Issued 10% convertible loan stocks
Can convert t equity in 3 yrs time
25 shares per £100 nominal value of loan stock (1)
Share price at time of issue is £2
Conversion ratio – 25 shares/£100 = 0.25 shares / £1 of loan stocK
Conversion price - £100/25 = £4
Conversion premium - £4 - £2 = £2 (conversion price – current price)
