Financing a business

Why do businesses need finance?

• purchase long-term assets, materials, employing people

• finance expansion

• develop new products

• enter new markets

• new premises

• pay for day to day

• takeovers

What are the two sources of Finance (SoF)?

• internal

• external

What are internal sources of finance?

• generated within the firm

• no obligations

• cheaper

What are external sources of finance?

• obtained from outside the firm

• conditions attached

• more costly

What are short + long term internal sources of finance?

Short term: working capital management

Long term: retained profit

What are short + long term external sources of finance?

Short term:

• bank overdraft

• bills of exchange

• debt factoring

• invoice discounting

• short term loans

Long term:

• ordinary shares

• preference shares

• long term debt

• leasing

What type of source of financing are retained profits?

Internal source of long term finance

What are the advantages of retained profits?

• no additional costs

• no annual interest cost

• no obligations with outside parties —> other than shareholders

What are the disadvantages of retained profits?

• Shareholders expect a return on their investment

• Some investors rely on dividends as a main source of income

• Decisions can negatively affect how the stock market views the company

What is Working capital management efficiencies?

how effectively a company manages its short-term assets and liabilities to keep operations running smoothly while minimising costs.

What are the efficiencies for working capital management?

• tighter credit control

• reducing inventory levels

• delaying payment to trade payables

How do tighter credit controls improve working capital management efficiencies?

encourages receivables to pay earlier - less cash tied up

How does reducing inventory levels improve working capital management efficiencies?

less money tied up

How do delaying payment to trade payables improve working capital management efficiencies?

‘free’ credit

What is the diagram for long term external sources of finance?

What do investors expect for riskand return in long-term finance?

High returns where higher risk is involved.

What does the graph for risk and return for long term finance look like?

What do ordinary shares represent?

equity share capital of the firm

Are shareholder returns guaranteed? and when do they get paid?

no - they are not guaranteed

They are the last to get paid

Who bears the greatest risk for owning shares?

ordinary shareholders

How does the cost of equity compare to the cost of debt for ordinary shares?

cost of equity > cost of debt

What are shareholder rights?

• attend general meetings

• vote

• receive annual accounts and reports

• receive a share of dividends paid

• receive a share of assets

• participate in new issues of shares

What can shareholders vote on?

• appointing directors

• appointing/removing auditors

• important issues - repurchase of shares

What are the advantages of ordinary shares from the firms perspective?

• no obligation to pay dividends

• capital does not have to be repaid

What are the disadvantages of ordinary shares from the firms perspective?

• higher cost

—> direct cost of issue

—> return required to satisfy shareholders

• loss of control

• dividends cannot be used to reduce taxable profits

What do preference shares offer?

their owners a fixed rate of dividend each year.

What happens to preference shares when the firm has insufficient funds?

the amount paid would be reduced, sometimes to zero

What is paid first the dividends on preference shares or ordinary shareholders?

Preference shares

Whats another name for preference shares? and what are their characteristics?

Hybrids - exhibit equity and debt

What are the advantages of preference shares from the firms perspective?

• no need to pay dividends if profits poor

• no dilution of ownership or control

• unsecured, so preserve debt capacity

What are the disadvantages of preference shares from the firms perspective?

Higher cost compared to debt due to tax inefficiency

What are the special types of preference shares?

• convertible

• cumulative

• redeemable

• participating

What are convertible preference shares?

preference shares can be converted into ordinary shares at some future date

What are cumulative preference shares?

if a dividend is not paid, it will be carried forward for payment at some future date

What are redeemable preference shares?

Holders will eventually be repaid their capital, usually at par

What are participating preference shares?

In a good year, the director may decide to declare an extra dividend for these preference shareholders

What are examples of financial debts?

bank loans, debentures, other loans

What 3 ways are borrowings secured?

• fixed (on specific property)

• floating charge (all assets)

• unsecured

How is the riskiness of a debt measured?

Rating agencies

Do lenders become owners of the company?

No

Must loan capital be repaid?

Yes, but it also can be convertible

Why don’t lenders benefit from a company’s extraordinary success?

Lenders receive fixed interest payments, so they generally do not share in the extra value created by a highly successful business.

What might lenders impose on the company? and what are they?

Loan covenants

• obligations and restrictions such as terms and conditions, limits to dividend payment, liquidity criteria

What can lenders do if they do not receive interest or capital when due?

initiate insolvency proceedings

What are insolvency proceedings?

legal processes that take place when a person or company cannot pay their debts.

What do the tax authorities regard companies paying interest as?

a cost of doing business - can be used to reduce the taxable profit

What are examples of borrowings?

• term loans

• mortgages

• loan notes / stocks / bonds

• eurobonds

• convertible bonds

What are finance leases?

Financial arrangements to acquire the right to use a particular asset for a specific purpose

When might finance leases occur?

Instead of buying a asset directly from a supplier business arranges for a bank to buy it and lease it to the business.

What is the lessor?

the bank that owns the asset

What is the lessee?

the business that leases the asset

Who has the ownership in the finance lease and who has the risks and rewards?

Ownership - lessor

risks and rewards - lessee

What are the advantages of leasing?

• Ease of borrowing (compared to other sources)

• Lower administration costs

• flexibility

• large outflows avoided

How do businesses raise finance?

selling assets to financial institutions and leasing it back

Are lease payments allowable for tax purposes?

Yes

What do businesses have when taking on long-term financing?

A pecking order

What is the businesses pecking order?

1. retained earnings used to finance the business

2. If retained earnings are inefficient, then loan capitals will be used

3. if loan capitals are inefficient, share capital is used

How do managers change new equity finance depending on shares?

High shares price = raise new equity finance

Low shares price = issue debts

What is asymmetrical information?

a situation where one party in a transaction has more or better information than the other.

Why might managers avoid issuing new shares when they believe their company is undervalued?

If managers know the company’s prospects are better than the market believes, shares will be undervalued. Issuing shares at this time would raise less capital than the company is worth, so managers prefer other sources of finance.

What is optimal capital structure?

best mix of debt and equity financing a company uses to maximise its value and minimise its cost of capital.

What are overdrafts?

Allow you to have a negative bank balance

What are the advantages of overdraft?

• availability

• flexibility

What are the disadvantages of overdraft?

• higher interest rates than term loans

• repayable on demand

• limit of overdraft depending on credit worthiness

What are Bills of exchange (BoE)?

A written order from one person to another, requiring them to pay a set amount at a future date.