Sources of Long-Term Finance: Debt Finance

Interest

Payment made before dividends in debt finance

Expected rate of return

Rate of return investors ask for in debt finance

Unsecured debentures

Debentures not backed by specific assets of the company

Debt finance

Financing through borrowing money

Equity finance

Financing through issuing shares of ownership

Risk perception

Investors perceive debt finance as less risky than equity finance

Secured debentures

Debentures backed by specific assets of the company

Floating charge debentures

Debentures secured by a floating charge on all present and future assets of the company

Fixed charge debentures

Debentures secured by specific assets of the company

Debenture interest

Interest paid on debentures regardless of company's profit

Debenture holders

Rank ahead of all other shareholders in claims on a company's assets

Unsecured loan stock

Riskier debentures with higher interest rates

Protective covenants

Specifications in loan agreement for unsecured loan stock

Convertible debentures

Debt instrument that can be converted into equity shares

Warrants

Debt instrument that allows purchase of equity shares at a future date

Bank borrowing

Term-loan provided by a bank at a variable or fixed interest rate

Fixed-interest securities

Securities with fixed promised payments

Coupon rate

Interest rate offered on the face value of a bond

Face value

Price at which a bond will be redeemed

Issue price

Price at which a bond is initially sold

Market price

Price at which a bond is being traded in the market

Valuing irredeemable debt

Calculating market price based on coupon rate and market interest rates

Valuing redeemable debt

Calculating redemption yield based on coupon rate and maturity value

Floating rate bonds

Debentures with variable coupon rates tied to interbank rate

Zero coupon bonds

Debentures with no interest offered, redeemed at a discount

Redemption of bonds

Ensuring funds are available to repay debt holders at redemption

Call provision

Option for the issuing company to repay debt before maturity

What are the distinguishing features of debt?

Perceived risk and cost

Why do investors perceive debt finance as less risky than equity finance?

Interest paid before dividends, debt is more senior in liquidation

What is a debenture?

A bond given in exchange for money lent to a company

What is the nominal value of debentures?

£100

Give an example of a debenture

7.25% Debenture Stock 2025/2030 (floating charge) £2.5 million

What is an irredeemable debenture?

A debenture with no specified redemption date

What are the two types of secured debentures?

Floating charge (blanket) debentures and fixed charge (mortgage) debentures

What assets are secured by floating charge debentures?

All present and future assets of the company without specifying particular assets

What assets are secured by fixed charge debentures?

Specific assets of the company, usually land and buildings

What are the advantages and rights of debenture holders?

Debenture interest must be paid regardless of company profitability, debenture holders rank ahead of all other shareholders in claims on company assets

What determines the interest rates on debentures?

Long-run rates prevailing in the market and the type of debenture

What are unsecured debentures?

Debentures with a higher interest rate due to additional risk

What are some common protective covenants for unsecured debentures?

Dividend restrictions, financial ratios, financial reports, and the issue of further debt

What are convertible debentures?

Debentures that can be converted into equity shares at the option of the holder

What are warrants?

Rights to purchase shares at a specific price

What is the rate of interest paid on convertible debentures compared to straight debt?

Lower

What are warrants?

Option to purchase equity shares without converting debenture

What is bank borrowing?

Obtaining a term loan from a bank at a variable or fixed interest rate

What is the typical interest rate for bank borrowing?

3-6% above the base rate

What determines the interest rate for bank borrowing?

Credit rating of the borrowing company

What are the characteristics of bank loans?

Secured on assets, may have restrictive covenants

How is irredeemable debt valued?

Based on coupon payments rather than principal

What factors affect the market price of a debenture?

Coupon rate, market interest rates, risk-class of the debt

What is the importance of principal payment in valuing redeemable debt?

Important to the investor

How is the redemption yield of debt calculated?

(Annual interest payment + principal payment) / market price

What are floating rate bonds?

Debentures with variable coupon rates tied to the interbank rate

Why were floating rate bonds introduced?

To address volatility in interest rates

What are deep discounted and zero coupon bonds?

Debentures with zero or below-market coupon rates, offered at a discount

How do companies ensure funds for debt repayment?

Issuing more debt, using profits, or placing funds into a sinking fund reserve

What is a call provision?

Option for companies to repay debt before maturity

What are the potential disadvantages for investors with call provisions?

Unexpected changes in yield or ability to service their own liabilities

What is equity finance?

Capital paid into or kept in the business by shareholders.

What is debt finance?

Money invested in the business by third parties.

How is finance generated?

Internally (retained earnings) and externally (equity and debt finance).

What are the main types of equity finance?

Ordinary and preference share finance.

What are the main types of debt finance?

Corporate bonds and bank borrowing.

What is the most popular form of funding investments?

Using retained earnings.

What are preference shares?

Hybrid securities falling between equity and debt.

What is the debt feature of preference shares?

They entitle holders to a fixed rate of dividend.

Do preference shares have voting rights?

Usually no, except in the event of liquidation.

What are the preferential rights of preference shareholders?

Regarding dividends and ultimate repayment of capital.

Are preference shareholders part-owners of the company?

Yes, they participate in the appropriation of profits.

What must debenture holders receive?

Interest payments regardless of company profits.

What are the main factors to consider when choosing long-term finance?

Risk, ownership, duration, and debt capacity.

What does risk refer to in long-term finance?

The level of risk associated with the finance option.

What does ownership refer to in long-term finance?

The extent of ownership given to the finance provider.

What does duration refer to in long-term finance?

The length of time the finance is required for.

What does debt capacity refer to in long-term finance?

The ability of the firm to take on additional debt.

What is the purpose of equity finance?

To provide long-term capital and attract high returns.

What is the purpose of debt finance?

To provide shorter-term capital with lower risk and return.

What is the duration of equity financing?

Infinite, obligation to pay dividends forever.

What is the duration of fixed-maturity, redeemable debt?

Fixed term until maturity.

Why is equity usually more expensive than debt?

Higher risk and potential for higher returns.

Under what circumstances may debt be more expensive than equity?

When the company has a high level of risk or poor creditworthiness.

What are the six main methods of financing described in the lecture notes?

Offer for Sale, Public Issue, Private Placing, Tender Offer, Rights Issues, and Script Dividends.

Are there more methods of financing beyond the six main ones?

Yes, there are many more methods that can be found in the provided reading.

What are the advantages of preference shares?

No voting rights, limited participation in profits, lower cost compared to ordinary shares.

What are the disadvantages of preference shares?

Fixed cost, cumulative dividends, priority in dividend payment, priority in liquidation.

What are the characteristics of ordinary shares?

Voting rights, full participation in profits.

What are the characteristics of preference shares?

No voting rights, limited participation in profits.

What is the cost of preference shares to the company?

Normally less than the cost of ordinary share finance.

What is the risk associated with preferred stock dividends?

They represent a fixed cost.

What is the advantage of preferred stock dividends being cumulative?

Unpaid dividends accumulate and must be paid in the future.

What is the disadvantage to the company of preferred stock dividends?

They must be paid before ordinary share dividends.

What is the priority of preference shareholders in liquidation?

They get paid before ordinary shareholders.

What should be done to understand the characteristics of ordinary and preference shares?

Read the lecture notes and do the reading.

What is the main difference between equity financing and fixed-maturity, redeemable debt?

Equity financing has infinite duration, while debt has a fixed term until maturity.

Why is equity financing more expensive than debt?

Higher risk and potential for higher returns.

When can debt be more expensive than equity?

When the company has a high level of risk or poor creditworthiness.

What is equity-based crowdfunding?

Use of small amounts of capital from individuals to finance a new business venture.

How do investors benefit from equity-based crowdfunding?

Investors receive shares in the company.

Which online platforms are commonly used for equity-based crowdfunding?

Kickstarter, Indigogo, GoFundMe.

How do crowdfunding sites generate revenue?

By taking a percentage (usually 5-12%) of the funds raised.