Sources of Finance

Question 1

What do financing decision involve knowing?

Answer 1

• raising appropriate finance
• at what time required
• for lower cost
• internal - retained earnings (cheaper as avoids transaction costs and adverse selection problems)
• external - equity and debt

Question 2

What are the financial instruments?

Answer 2

• shares = ordinary, preference (equity instruments)
• bonds/debt = government (gilts, treasury bills), corporate (bonds - debenture and loan, stock(equity), bills - bills of exchange and commercial paper) (debt instrument)
• loans (debt instrument)

Question 3

What are retained earnings?

Answer 3

cash available to the company to invest in real assets, generated from operations, available to distribute or retain. Primary source of finance for new investments in US, UK, Germany and Japan.

Question 4

How much is payed to shareholders from retained earnings?

Answer 4

the more paid out as dividends, the less that is retained for reinvestment, some companies will buy back shares instead of issuing dividends.
We get the rest from debt and equity to make the investment.

Question 5

Are retained earnings good?

Answer 5

Retained earnings are available, easy to access and there is no issue cost.
BUT it avoids market discipline and manager can avoid having to explain and promote a project if they do not raise funds externally.

Question 6

What is debt?

Answer 6

Debt is a contract between company and bank, pay interest annually then repay principal, generally not tradeable.
Arrangement fee payable at start, may be secured against assets (charge)

Question 7

What are fixed or floating rates?

Answer 7

LIBOR+ = London Interbank Offered Rate - average rate at which major global banks are willing to lend to one another in the short term.
LIBOR+ is a risk premium pay on top of debt, reflects the borrowers specific credit risk, market conditions or profits for the lender - allows interest rates to adjust with market.

Question 8

What is a bank loan (amortising)?

Answer 8

repayment schedule agreed, bank projects its position by imposing covenants.
Restriction on what company can do - cannot pay dividends, cannot issue new debt, cannot sell asset on which loan is secured.

Question 9

What happens if a company is a start-up when wanting a bank loan?

Answer 9

If the company is a start up they are riskier, in order to secure a loan, they may have to agree collateral with the bank such as a building - if they don’t pay the bank back then the asset will be seized.

Question 10

What does long term debt financing involve?

Answer 10

Fixed interest securities - which includes loan stock (corporate bonds), debentures (secured bonds).
May be convertible, par value in UK typically £100 market value depends on supply and demand in bond market.
Repaid before shareholders in the event of liquidation, less risky than shares - lower return required by debt holders.

Question 11

What are debenture?

Answer 11

written acknowledgement of indebtedness - debenture trust deed.
They are secured against corporate assets, fixed charge on specified assets, assets cannot be disposed of while dept is outstanding.

Question 12

What is a floating charge?

Answer 12

Floating charge on a class of assets, can be engineered to suit the needs of company and investors - coupon issue, price, redemption price, warrants, convertible debt.

Question 13

What are restrictive covenants of the sources of finance?

Answer 13

• used to protect debt holders
• they restrict management powers
• example -> limit amount of other debt, target for gearing or current ratios
• intentions is to prevent the risk profile of the company being changed
• breach of covenants is a serious issue that can lead to forced early repayments

Question 14

What are bond ratings?

Answer 14

key features of bonds or debentures. Measure of investment risk. How likely is it that company will pay interest?
How likely is it that company will repay principal?

Question 15

What commercial organisations rate bonds?

Answer 15

Moody’s
Standard and Poor’s
Fitch IBCA

Question 16

What are bond ratings based on?

Answer 16

company’s financial performance, economic environment. Investors risk policy can limit investment in bonds to ‘investment grade’.
A downgrading of a bond rating can trigger a requirement to sell, causing a fall in the bond price and an increase in its yield.

Question 17

What are the first types of A bonds?

Answer 17

• AAA - prime: best quality, low risk
• AA - high grade: good quality but higher risk than AAA.
  -A - upper medium - potential future impairment/

Question 18

What are the second type of B bonds?

Answer 18

-BBB - medium - adequate protection but some speculative aspects
- BB - non-investment grade
- B - highly speculative, bonds lacking investment characteristics, low levels of protection.

Question 19

What other bond ratings are there?

Answer 19

S & P and Fitch format (Moody’s look slightly different)
C is even worse than B
D is in default.

Question 20

What are new issues of bond finance?

Answer 20

issued via an investment bank in the new issues market. Lead bank will sell blocks of debentures to clients prior to issue data - ‘book building’.
Attractive bons will be over subscribed if they are attractive. Companies can increase the bonds on offer if there is a lot of demand for the bonds.

Question 21

What is equity?

Answer 21

external long term finance, equity = ownership = ordinary shares.
Holders of equity finance are the owners of the company. They have the right to the residual cash flows. Can be listed on stock exchange or unlisted (private)

Question 22

What is the process of public offering for equity?

Answer 22

1. Authorisation - firms board approves the issue.
2. Preliminary registration - filling a prospectus with regulators.
3. Roadshow - marketing to potential investors
4. Pricing and allocation - deciding the offer prices and distribution securities
5. Final sale - shares are sold to the public.

Question 23

What are ordinary shares?

Answer 23

issued by company. Held by investors/shareholders.
London Stock exchange - used to be primarily UK private individual but now mainly financial institutions and international investors.
Pensions funds, insurance companies and mutual funds.

Question 24

What is a shareholder?

Answer 24

Owner of company control is linked to an entitlement to vote, can attend and vote at annual general meeting - in person or proxy and many do not vote.
Vote on appointment of directors, the appointment remunerations and removal or auditors, the approval of the dividends declared by the directors.
Receive - annual report, dividends if they are declared and approved a share of residual assets on winding up.
Participate in a new issue of shares - pre-emption rights.
Generally do not run the company.

Question 25

What are pre-emption rights?

Answer 25

Rights issue, have to offer new shares to existing shareholders first, offered on a pro-rata basis. Cheaper than a public offering on the market, no dilution of control, usually issued at a discount to encourage investment.

Question 26

What are director's?

Answer 26

Key pat of corporate governance. Management act as agents for shareholders (principals) independent directors represent shareholders, appointed for fixed term, UK corporate governance codes give specific requirements. Annual re-appointment for FTSE 350 companies, for others, every 3 years.

Question 27

What are preference shares?

Answer 27

offers a fixed series of payments to investors, company can choose not to pay a preferred dividend. If it does not pay a preferred dividend, it cannot pay an ordinary dividend, if preference dividend are not paid, preference shares hold may gain voting rights. Preference shares may be cumulative - have to clear all past dividends before an ordinary dividend can be paid.

Question 28

What is the order of settlement in the event of liquidation?

Answer 28

secured creditors (debentures holders and banks) - unsecured creditors (suppliers) - preference shareholders - ordinary shareholders (significant risk that the ordinary shareholders will receive nothing)

Question 29

What is involved in risk and return on equity?

Answer 29

ordinary shareholders bear the residual risk. Bear business risk arises from the industry in which the company operates, they bear financial risk arising from how the company is financed. Greatest risk is borne by ordinary shareholders so they will expect the greatest return. Return required by shareholders is the cost of equity for the company. Cost of equity is higher than the cost of preference shares and cost of debt.

Question 30

What are initial public offerings (IPOs)?

Answer 30

first time a private company offers shares to the public. Firms hire underwriters (investment banks) who: - help with legal requirements, advise on pricing, sometimes guarantee the sale by buying the shares themselves (firm commitment) or best efforts to sell

Question 31

What price do IPOs set?

Answer 31

often set a price below the market value. Causes a 'first day pop' - average IPO stock price, jumps when trading begins. Reason to attract investors, manage uncertainty and ensure a successful offering.

Question 32

What are the pro's of IPOs?

Answer 32

exit route for current owners, access to a bigger pool of finance, uses shares to acquire other companies, increases and improves company profit.

Question 33

What are the con's of IPOs?

Answer 33

cost of listings - legal exchange, recurring fees for lists, shareholder expectations (focus on) things that only give short term outcomes to keep shareholders happy, short termism, public scrutiny, open to takeover bids.

Question 34

What is the argument for debt?

Answer 34

Debt is a contract with the company, receives interest, receives repayment of principal, interest is a business cost and it is tax deductible. Debt issuance is less damaging to the share price than equity issuance (Lower negative, signalling effect)

Question 35

What is the argument for equity?

Answer 35

controls company has a vote, owns retained profit, receives dividends, dividends paid from profit.

Question 36

How does a company decide between sources of finance?

Answer 36

- amount of finance required. - period finance is required for. - cash available to repay. - alternative use of internal resources. - cost of raising finance - issues costs. - arrangement fees. - availability of finance. - cost of finance. - dividend policy.