Week 4 - Sources Of Finance Dividend Policy And Intro To Gearing Flashcards by Nolz Inema

what are two main ways the companies can raise capital? (2)

• Debt finance
• Equity Finance

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What is formula for the value of a company?

Value = debt + equity

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Define equity/equity finance

Equity/equity finance is the whole or part ownership in a firm/shares sold by the firm to raise money

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Define debt finance

Debt finance is money borrowed from a bank or similar institution

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Define dividends

Dividends are the distribution of profits to shareholders where the company’s directors choose must decide how much profit of return to shareholders versus reinvesting in growth

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Define shareholders (2)

• Shareholders are equity owners in a firms (anyone who owns at least one share)
• Shareholders own what’s left of the firm when the debt/liabilities are covered

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Define share price

Share price is the market value (what the “market” assess the equity to be worth) of a firm divided by the number of shares

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Define equity

Equity is where the company has one or more shareholders who have a stake in the profits of the company

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What are the different types of equity finance? (6)

• IPO (Initial public offering)
• Retained earnings
• Rights share issue
• A new share issue
• Venture capital
• Bespoke investment

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What is an IPO (Initial public offering)?

An IPO is the first time a firm raises money from new shareholders with the aim to raise money for expansion of the business e.g. Facebook did this in 2012 selling part of the firm for $16bn

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What are the advantages of an IPO? (3)

• Raises large amounts of capital
• Increases company visibility and prestige
• Allowed early investors to cash out

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Disadvantages of an IPO (3)

• Expensive process with legal and regulatory costs
• Public companies must disclose financial information
• Increased scrutiny from investors and analysts

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Define retained earnings

Are profits earned by the company which is NOT given to shareholders but is owned by shareholders therefore is still equity finance

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Factors impacting on the decision to use retained earnings for financing (5)

• Amount of profit
• Pressure/expectations of shareholders - do they expect a dividend and can the firm afford it?
• Ease of raising finance from other sources
• Current cost of raising money elsewhere
• Use retained earning avoids the costs associated with a share issue

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What is venture capital and the role of venture capitalists? (3)

• Venture capital is the funding for early stage start up businesses with a high potential growth
• The venture capitalist usually takes a hands on involvement in the firm and offers advice and services
• Venture capitalists exchange the loan for a stake (equity) in the firm

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What is a bespoke investor? (Equity financing example)

Is a wealthy individual that make a significant investment e.g. Peter Thiel making a $500,000 investment into Facebook in 2004 resulting in a 10.2% ownership in the company

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List the different ways to borrow as debt (3)

• Bank loan
• Bonds
• Syndicated loan

What is a bank loan? (2)

• Is a loan provide by the bank repayable on a particular date
• Bank loans are usually secured against assets in the firm

What is a bond? (2)

• A bond is a debt “sold” to investors which has a market value
• Bonds are best used for higher risk investments

Why do ordinary shareholders bear the highest risk in company’s business activities? (4)

• This is due to the strict order of precedence when distributing funds if a company is liquidated
• Ordinary shareholders are last on the list with preference shareholders, unsecured creditors and secured creditors being paid first
• Therefore it is likely that ordinary shareholders received little or nothing unless there are surplus funds left over once all fixed claims
• However, as they take the highest risks they expect the highest returns compared to other investors

What are some of the important rights that shareholders have in a company they have equity in? (6)

• Attend company meetings
• Receive annual accounts of the company and the report of its auditors
• Receive a share of any dividend agreed to be distributed
• Voting rights on important company matters - including the appointment of directors and auditors of the company
• Recieve a share of any assets remaining after the company has been liquidated
• Participate in a new issue of shares in the company

5 Advantages of equity financing

• It’s less risky than a loan because you do not have to pay it back
• Networking opportunities from investors which can boost a business’ credibility
• Investors take a long term view
• Businesses have more cash on hand for expanding the business
• There is no requirement to payback the investment if the business fails

Disadvantages of equity financing (3)

• The investor will require some ownership of your company and a percentage of the profits.
• Will have to consult with investors before making decisions which can be time consuming and lead to disagreements
• Finding the right investors can waste time and effort for a company especially if they operate in fast changing environment

Advantages of debt financing (5)

• The bank has no say in the way you run your company and does not have any ownership in your business
• The business relationship ends once the money is paid back
• The interest on the loan is tax deductible
• Loans can be short term or long term
• Fixed payments can make cash flow planning easier

Disadvantages of debt financing (4)

• Money must be paid back within a fixed amount of time • If you carry too much debt you will be seen a “high risk” by potential investors • Debt financing can leave business vulnerable during hard times where they could face bankruptcy if unable to make repayments • Debt can make it difficult for a business to grow because of the high cost of borrowing and due to restrictive covenants where further borrowing is restricted

How does equity financing and debt financing differ in terms of Tax treatment? (2)

• Interest payments in debt are tax-deductible, reducing the company’s taxable profit • Where as dividends paid to ordinary and preference shareholders are non tax-deductible as they are a share of after-tax profits

How does equity financing and debt financing differ in terms of payment obligations? (2)

• Interest on debt must be paid • Whereas dividends to shareholders are optional and only distributed if the company’s directors choose to do so

How does equity financing and debt financing differ in terms of risk in the event of liquidation? (2)

• Debt holders have priority over shareholders in liquidation, meaning they are repaid before any funds go to shareholders • As a result shareholders may receive only part-payment or nothing at all

What is the difference between common shares and preferred shares? (2)

• Common shares are where the company’s directors choose issues shares to raise funds as equity • Preferred shares are a hybrid between debt and equity where dividends are offered but not voting rights (usually)

List the different types of debt financing (5)

• Bonds - long term debt securities issued by companies to raise capital • Bank loans - borrowed capital from financial institutions • Debentures - unsecured bonds that rely on the issuer’s creditworthiness • Secured debt - Debt backed by company assets (e.g. mortgages) • Convertible bonds - debt that can be converted into shares

Define Gearing (2)

• Gearing is how much debt a company has compared to the total of its debt and equity added together • Can be expressed as a % so can be thought of as the percentage of a company that is owned by the banks

Formula for Gearing

List the different ways of Equity financing (6)

• Common shares • Preferred shares • Initial public offering (IPO) • Secondary Stock offering - additional shares issued after an IPO • Venture capital • Private equity - investment firms buy ownership stakes in businesses

List ways that firms can raise finance without debt or equity (alternative finance) (7)

• Retained earnings • Income trusts - profits are distributed directly to investors • Crowdfunding - Raising small amounts of capital from a large number of individuals • Government grants and subsidies • Leasing - renting of equipment or assets instead of purchasing them outright • Trade credit - suppliers allow the company to buy now and pay later • Factoring - selling accounts receivable to a third party for immediate cash

Formula for Market Capitalisation

Market Capitalisation = number of shares x share price

How is profit divided in a business?

Through retained earnings or dividends - it is all owned by shareholders

Real life examples of equity financing (3)

• Peter Thiel making a $500,000 investment into Facebook in 2004 resulting in a 10.2% ownership in the company • Facebook IPO in 2012, raising $16 billion selling shares • Tesla in its early years issued new shares to fund R&D, production and expansion

Real life examples of debt financing (2)

• Apple in 2013 raised $17 billion through corporate bonds • Netflix have repeatedly raised capital through issuing junk bonds to fund content production

Real life example of hybrid financing

Amazon originally used equity to grow rapidly, then added debt financing to support its global infrastructure once its cash flows became more predictable

Summary of the reasons why firms may choose either debt financing or equity financing