Sources of finance & Cost of capital Flashcards
(64 cards)
capital
finances to begin and maintain business operations and fund its assets
cost that business incurs
sources of finance
equity and debt
company raises capital by issuing equity (shares) and debt capital (loans)
capital structure
how the company is financed
optimal capital structure
mix of debt and equity is important
balance should be found between using sufficient debt to take advantage of tax benefits
entity will want to use cheapest source of capital
capital must not be destroyed or misused in order to meet investor’s expected return
equity cost expl.
most expensive source
funders expect high return because uncertainty on repayments is high
debt cost expl.
less expensive
investors expect lower return because the uncertainty on repayments is less - guaranteed periodic interest payments and repayment of capital sum on maturity
equity/share capital form
funds from shareholders
-ordinary shares
-preference shares
-retained income
long term debt form
funds from debtholders
-bonds
-debentures
-long term loan
-mortgage bonds
-leases
ordinary shares
right of ownership of part of company
take highest risk of any providers of capital therefore expect high return
ranked behind debtholders and preference shareholders in event of liquidation
shares may be listed on stock exchange
right to:
-attend shareholder meetings
-elect board of directors
-receive a share in profits (dividends)
-share surplus on assets if company liquidates
stock exchange markets
primary market: first share issue to raise capital
process involves an IPO(Initial public offering) which allows public to buy shares in company for the first time
secondary market: matches investors who want to buy or sell. stock market.
SA’s stock exchange: Johannesburg Stock Exchange JSE, USA’s stock exchange: NYSE
preference shares
receive divided before ordinary shareholders but behind debt finance
preference on sharing of surplus assets on liquidation before ordinary shareholders.
no right to vote at shareholder’s meeting
receive a fixed rate dividend in return, which offers lower expected return to funders
have debt characteristic - referred to as hybrid instrument (quasi debt)
types of preference shares
convertible
- may convert into ordinary shares in future depending on circumstances
cumulative
- dividend accumulates in event that it is not paid when due (entity might not have enough to pay a certain year)
-may receive voting rights when preference dividend in arrears
participating preference shares
-receive fixed dividend & share in profits w ordinary shareholders as agreed between parties
redeemable preference shares
-redeemed at some point in future
retained income
accumulated/net profit earned by company nor paid out as dividends
retained for growth of company
ordinary shareholders regard retained earnings as a share of their investment
bonds & debentures
number of non-current debt instruments, including debentures
long term loan from public @fixed rate of interest w specified repayment terms
fixed interest/coupon rate paid until maturity
secured against immovable property (if borrower defaults on repayment, funder may sell company’s assets to raise funds needed to fulfill loan)
ranked first in event of liquidation
mortgage bonds
non-current loan usually secured against property of an entity
incurs interest at a variable rate
long term loans
can be obtained from various institutions eg. bank
leasing
-lessor agrees to give the right to use an asset for a specific period of time to a lessee in return for a/a series of lease payments
-considered medium debt but w same financial risk as any other borrowing
-does not appear on sofp as asset is used by company but not owned/purchased by company
sources of short term finance
trade creditors (trade payables)
bank overdraft
cost interest
trade creditors
purchases of inventory made on credit from suppliers
come w credit terms and seem to be without cost
supplier benefits from ability to sell more goods
customer benefits from delayed settlement
bank overdraft
bank allows an entity to withdraw money from its bank account such that the available balance drops below zero
accounts receivable
money that a business is owed by its clients, often in the form of unpaid invoices
considered CA
handing over the accounts receivable to a third party for collection in return for a substantial portion of the debts due.
company receives cash upfront and saves on administration fees
however bad debts are still responsibility of company not the 3rd party, so business is still exposed to risk
break even point
total revenue = total costs
no profit/loss
knowing point assists in planning and budgeting
entities that do not achieve a return more than its cost of capital will be unable to attract future capital, and be unable to expand
expectations of shareholders
shareholders carry highest risk as providers of capital.
if company does not perform well, all other providers of capital are repaid before shareholders
due to risk, expect compensation
incentive to invest in shares is driven by expectation of returns higher than those that will accrue to debt holders
expectation of long-term lenders
have own prescribed interest rates that depend upon perceived risk of loan and interest rate ruling at time of issue
