chapter 15 sources of finance
TRANSCRIPT
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CHAPTER 15
SOURCES OF FINANCE
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1. Selection of appropriate sources of finance
Firms need funds to:
- provide working capital short term
- invest in non-current assets long term
Retained earnings:
- main source but- insufficient
Firms need alternative source of finance
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1. Selection of appropriate sources of finance
Criteria for choosing between sources of finance
Factor Issue to consider
Cost Debt is usually cheaper
Duration Long-term finance is more expensive butsecure
Term structure of
interest rates
Relationship between interest and loan
durationshort term debt is cheaper (not
always)
Gearing Debt is cheaper but increases risk of default
Availability Not all sources of finance are available to all
firms
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2. The relation between risk and return
Investment risk- variability or
- uncertainty of returns
Higher investment risk - higher return required
Higher return required higher cost of capital
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3. Short-term sources of finance
Working capital is usually financed using short-term finance
- Bank overdrafts;
- Bank loans;
- Better management of working capital;
- Squeezing trade credit;- Operating lease (short-term)
- lease period < useful life of the asset;
- the lessor is responsible for maintenance and repairs
- the lease can sometimes be cancelled at short notice- Its substance is associated with that of a short-term
rental
- Sale and lease-back
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4. Long-term sources of finance - Equity
Equity shareholders
- the owners of the business;
- exercise ultimate control through the voting rights
Equity finance
- the investment by the ordinary shareholders
(ordinary sharescapital)- reserves
Equityrelates to ordinary shares only.
Preference shares (cumulative and non-cumulative)
- not part of equity;
- exhibit features of debt
- may acquire voting rights when dividend is in arrears
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5. Raising equity
Three sources of equity capital
- Internally generated funds- Retained earnings
- easiest to have access to (quickly raised)
- cheapest (free)
- Rights issues- Offers to existing shareholders to subscribe to new shares at a
discount
- New external share issues- Placings share are placed or sold to institutional investors
by way of a financial intermediary investment bank
- Public offersan invitation to apply for shares based on
information in a prospectus
- Fixed price offer
- Offer for sale by tender
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6. Rights issues
A rights issue
- an offer to existing shareholders
- to subscribe for new shares,
- at a discount to the current market,
- in proportion to their existing holdings.
Advantages:
- cheaper than public share issue
- made at the discretion of the directors without consent
from shareholders or Stock Exchange;
- it rarely fails
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6. Rights issues
The value of a right
Value of a right = TERP Issue (subscription) price
Shareholders options:
- Take up the rights by buying the specified proportion at
the price offered;
- Renounce his rights and sell them on the market
- Renounce part of his rights and take up the remainder
- Do nothing (let the rights expire)
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6. Rights issues
The value of a right
Market price
Issue price
Ex-rights price
(value afterwards)
DiscountValue of the
right
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7. Choosing between sources of equity
(1) Accessibility of the financeQuoted companies have access to all sources of equity finance
Unquoted companies have access to rights issues or placings
(2) The amount of finance
Rights issues limited by the existing shareholders financing powerPlacings larger sums
Public offers largest amounts
(3) Costs of the issue procedureRetained earnings cheapest
Placings and rights issues a bit more expensive
Public offers most costly
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7. Choosing between sources of equity
(4) Pricing of the issuePricing problems exist with public offers and placings
No pricing ploblems are with rights issues
(5) ControlRetained earnings and rights issues do not dilute control
Placings and Public offers dilute control
(6) Dividend policy
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7. Choosing between sources of equity
- costs of issue and
- ease of organization
Induce the following preference order
Retained earnings
Rights issues
New issues
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8. Long-term finance- Debt
A loan note
a written acknowledgement of debt by a
company, normally containing provisions as to
-payment of interestand
- the terms of repayment of principal
Loan notes/corporate bonds/loan stock/debentures
Used interchangeably
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8. Long-term finance- Debt
In UK or US,loan notes
- Are tradedon stock markets;
- Usually denominated in blocks of $100 nominalvalue;
- May be secured or unsecured
- May be
- Redeemable (principal repaid at a future date)
- Irredeemable (principal never repaid, interest paid in perpetuity)
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9. Characteristics of loan notes and other long-term debt
For the investor
Low risk
-Definite maturity
-Priority in interest payments-Priority on liquidation
-Fixed income
For the company
Cheap
Predictable flows
Does not dilute control
Advantages of long-term debt
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9. Characteristics of loan notes and other long-term debt
For the investor
-No voting rights
-Voting rights only if interestnot paid
For the company
- Interest must be paid
whatever the earnings- Inflexible
-Increases risk of default
at high levels of gearing
- Must be repaid
Disadvantages of long-term debt
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9. Characteristics of loan notes and other long-term debt
Hybrid debt instruments convertibles
Convertibles give the holder the right to convert to other securities
(usually ordinary shares) at either a:
- predetermined price;
- predetermined ratio(e.g. 1 loan note in 25 shares)
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9. Characteristics of loan notes and other long-term debt
Hybrid debt instruments loan notes with warrants
Warrants give the holder the right to subscribe, at a fixed future
date, for a certain number of ordinary shares at a predetermined
price.
If warrants are issued with loan notes, the loan notes are not
converted into equity. Bondholders:
- purchase shares for cash;
- retain the loan notes until redemption.
Used as sweeteners on debt issues:
- interest rate on the loan is low;
- right to buy equity set at an attractive price;
- warrants can be resold after buying the loan notes
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9. Characteristics of loan notes and other long-term debt
Advantages of hybrid debt instruments
Immediate finance at low cost- issued at below normal rates or with little to no security;
Self-liquidation- upon conversion the problem of repayment disappears;
Can provide cash-finance
- by design, exercise of warrants involves cash-payments forshares
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10. Long-term financeleasing
Operating lease (short term)
equivalent to renting an assetFinance lease (medium to long-term)
equivalent to borrowing to purchase the asset.
Finance leases- Finance leases exist for a period that covers most of the
useful life of the asset;
- Lessor does not retain risks and rewards of ownership.
Lessee responsible for repairs and maintenance
- Uncancellable the lessee has a liability for all payments
- Economic substance purchase of asset by lessee
financed by lessor.