C5 Sources of finance CFS

Capital Markets

Provide source of long-term funds for companies and an exit route for investors

Stock markets

LSE

AIM

Companies can issue new shares

Investors can buy and sell existing securities which creates liquidity

Bond (debt) markets

Companies can raise funds by issuing new bonds

Investors can buy and sell existing bonds

Loan stock/debenture/bonds

Banking system

Split into retail market (individudals and small businesses) and wholesale market (large companies)

Leasing

Allowing buisnesses to lease capital items instead of purchasing upfront

Debt factoring

Allowing businesses to borrow against the value of their receivables

Government grants

Financial assistance to help develop industry in underdeveloped areas

International markets

Available to larger companies

Allows companies to raise funds in multiple currencies

Crowdfunding

Use of internet based platforms to match companies with investors

Peer to peer lending

Use of internet based platforms to match lenders with borrowers, another recent innovation

Risk and return

Higher risk demands higher return

Debt holders require lower return than shareholders

• debt is generally secured

• Returns are more certain (interest vs dividends)

• Debt may be redeemable (set date for debt to be repaid)

  • Debtholders are paid before shareholders should the business fail

Preference shares

Rank below debtholders but before ordinary shareholders

Rights to vote at general meetings only if divided is in arrears

Fixed dividend must be paid before dividends to oridinary shareholders

Assume irredeemable

Dividends non tax deductible

Dividends subject to income tax

Gains on sale subject to CGT

Higher risk than debt, therefore demand higher return

If traded, can sell on secondary market

Debt

Ranks higher than preference and ordinary shareholders

May have security over specific assets

No voting rights, can exercise influence through covenants

Fixed amounts of interest (based on nominal value)

If redeemable, then redemption at nominal value (par) or a premium sometimes

If traded, can sell on secondary market

Interest is deductible from taxable profits, saves corporation tax

Interest subject to income tax

Likely exempt from CGT

Highest risk, highest reward

Ordinary shares

Rank last

Voting rights at general meetings

Discretionary divident from accumulated profits - paid after interest and preference dividends

No obligation to redeem

If listed company, then can sell on secondary market

Dividends non-tax deductible

Dividends subject to income tax

Gains on sale subject to CGT

Low risk, low reward

Equity finance

Ordinary shareholder funds

Retentions

Retaining profits rather than paying them out as dividends

Most important source of equity finance

Cheapest as there are no issue costs

Rights issues

Issue of new shares to existing shareholders in proportion to their existing holding

New issues to public

Issue of new shares to new shareholders

Lease often used and most expesnive of raising equity finance

Impacts of rights issue

New shares are issued at a discount to make offer relatively attractive to shareholders so rights issuance will be fully subscribed

Ex-rights price

Price at which the shares will settle immediately after the rights issue has been made

Theoretical ex-rights price (TERP)

Market cap pre-rights issue + rights proceeds + project NPV / total number of shares after the rights issue

Value of one right

Proceeds if shareholder sells their rights

Affect on shareholders

Terms and price do not affect shareholders who take up or sell their rights - they gain the same amount

Factors to consider when making rights issue

Issue costs (estimated at 4% of £2m, falls as proceeds rise)

Issuance price (needs to be sufficently below market rate to persuade shareholdres to subscribe)

Shareholders reactions (may react badly due to company asking for money, they may sell shares)

Control (no change to overall percentage ownership/control of company)

Unlisted companies (rights issuances may be difficult, shareholders may not be able to sell their rights or to raise funds to exercise them)

New issues of shares

Often used when company needs to raise a large amount of money

Most commonly an IPO

Two methods of IPO

Offer for sale - Issuing house as middle man

Direct offer or offer for subscription - direct to general public

Underwriting

In exchange for a fixed fee (usually 1-2% of total finance raised), an instituition undertakes to purchase any securities not subscribed for by the public

Ensures that total funds needed by company are raised

Undewriting is expensive therefore contributes to issue of new shares being expensive way of raising finance

Venture capital

Firm or individual investing in a company in return for equity stake (ordinary shares) in high growth potential

Seek high retun and accept that investments are high risk

Characteristics of venture capital financing

Usually expect 20 - 49.9% of shares of a company - enough to exert some control but avoid being majority shareholder

Able to provide advice and influence management

Exit route often achieved after three to five years via selling shares to another company or by stock market flotation

Angel investors

An individual who invests their own money in a company (usually start up) in return for minority stake (10-25%)

Often provide mentorship and expertise along with capital

Convertible loans

Fixed return securities which may be converted at option of the holder into ordinary shares at either

• conversion ration (set number of shares per £100 of loan stock)

  • conversion price (set amount of loan notinal value per share)

Benefits of convertible loans for issuing company

Obtaining funds at lower rate of interest due to benefit of conversion

Encouraging investors

Introducing an element of short term gearing

Avoiding redemption problems (if debt is converted into equity)

Being able to issue equity cheaply

Loan stock with warrants

Loan stock is not convertible to shares

Comes with call options (warrants) allowing holder to separately buy shares in future at set price

Allows issuer to pay lower interest

Loan documentation

Representations and warranties

• Legality of borrowing

  • legally allowed to borrow?

  • does loan breach existing covenants?

• Financial condition

  • Do account show true and fair view

  • impending court cases

Guarantees

• lender seeks guarantee from guarantor

  • parent guarantees loan payments of subsidiary

  • subsidiary can guarantee a parent loan repayments

Covenants

• Providing information

  • Provide financial statements / management accounts

• Negative pledges

  • pleding not to use assets as security for other borrowings

• Financial convenants

  • financial limits placed on borrower, maxmium gearing, minimum interest cover

• Restrictions

  • restrictions on taking on more debt, paying dividends, significant investments

Debt vs equity issues to consider

Impact on financial performance

• measured by earnings per share, return on shareholder funds, compare to historic performance/industry average

Impact on financial position

• Measured by gearing, interest cover, compare to historic performance/industry average

• high gearing and/or low interest cover means greater financial risk

Cost of finance/impact on WACC

• Cost of debt is cheaper than cost of equity

• Use traditional theory / M&M to discuss expected impact on WACC

Impact on shareholders

• consider impact control of the company

• shareholders may not want to fund project

Matching to term/risk

• will source of finance last as long as proposed investment

Cryptocurrency

Digital asset secured by cryptography to prevent counterfeiting and fradulent transactions

Does not involve third party, could save money on transactions

Volatile

Could be issues with security and privacy

Dsitributed ledger tecnology (DLT)

encompasses a range of decentralised database systems where transactions are recorded and validated across multiple sites

Blockchain

Specific form of DLT used by cryptocurrencies

Crowdfunding

Allows company to access finance by using online crowdfunding platform to pitch for finance from a large number of investors

Good for start up companies

Helps to attract customers and build awareness

Quick process

Fee payable to crowdfunding site

Legal / advisory costs

Administrative cost of dealing with investor requests for more information

Intial coin offering

More regulations so now less attractive

Investor receives a token (could be for a share or entitlement to use product/service)

Payment is made in cryptocurrency

Price volatility

Early stage projects

High risk

Peer to peer lending

Usually facilitated via online platofrm that connects business with investors without traditional banks

Available for short & long term as secured or unsecured debt

Usually require borrowers to have trading track record, submit financial accounts and perform credit checks

Allows customers, friends, family to share in returns of the business

Usually lower interest rate

Can be quicker to arrange

More accessible if lower credit rating

Revenue based finance

Method of raising capital from investors who receive a percentage of company’s ongoing revenues in exchange for the money they invest

Repayment duration is normally between 1 to 5 years depending on capital raised

Short to medium term capital requirements

Typically a maximum repayment amount, often calculated as a multiple of initial investment

No fixed repayments or interest on outstanding balance

Repayments adjust based on business performance

More practical than traditional debt finance for a company with unpredictble future cash flows e.g. start ups, small businesses, seasonal revenue fluctuations

Does not require personal guarantees, can make it quicker to organise

Investors do not have direct ownership of the business therefore owners do not give up control

Artificial intelligence

Ability of computer systems to perform tasks that traditionally require human intelligence such as learning from data, problem solving and language processing

Often uses machine learning

Characterised by ability to adapt to new information or environments, operate with degree of autonmy and make informed decisions

Using AI to influence finance decision

Risk assessment and credit scoring - analyse large volumes of data, bank statements credit scores, social media profiles to calculate risk

Loan approval - automates many tasks involved and speeds up process, minimises human bias

Matching lenders and borrowers - analyse large amounts of data, credit history, financial information, loan preferences and borrower profiles to identify suitable matches

Protection against fradulent activities - detects patterns indicative of suspicious behaviour, reduces risk of human error

Real time financial analysis - enables viewing, analysing and measuring data immediately after its collected, enables quick decision making, better risk management and cost reduction

Predictions and forecasts - AI can make predictures about future trends by analysing data patterns, enables business to make informed decisions about future financial strategy

ESG lending

Encompasses social loans, green loans and sustainability linked loans

Green finance

Financing of investments that provide environmental benefits as part of a broader context of encouraging environmentally sustainable development

Could include crowdfunding for small scale, comunity schemes or green bond issuance for major infrastructure projects

Methods of financing green

Green loans - loans specifically to help finance green projects, rapidly growing market, lenders may offer better terms if borrower shows they are reducing environmental impact

Sustainability linked loans - Used for any purpose but pricing mechanism means that loan is cheaper if borrower achieves certain sustainability related targets

Green bonds - fixed interest bond used to raise money for climate and environmental projects, typically secured and same credit rating as company’s other debt obligations, may come with tax incentives

Green funds - targets investments in companies with higher standards of social responsbility, many stock markets produce an index of firms that satisfy social and environmental criteria

Social bonds - used to raise funds for projects that address or mitigate specific social issues and/or seek to achieve positive social outcomes

Green loan principles

Sets out frameowrk enabling all market participants to clearly understand characteristics of a green loan

Use of proceeds - designated green projects should provide clear, quantifiable and measurenle economic benefits that are reported by the borrower

Process for evaluation and selection - borrower should clearly communicate

• environmental sustainability objectives

• how it appraises and selects its environmental projects

• how it identifies and manages material environmental risks

Management of proceeds - borrowers should establish internal governance process where they can track allocation of funds towards green projects

Reporting - borrwers should make available up to date information on the use of proceeds

Ethics Fundamental principles

Intergrity

Objectivity

Professional competence and due care

Confidentiality

Professional behaviour

Capital market efficiency

Prices on bond / stock market are fair if market is efficient

Price reflects all known information about the business and its prospects

Efficient market hypothesis

An efficient market is one where:

Share prices are fair (can’t be bough cheap and immediately sold at profit)

No individual dominates the market

Transaction costs are not significant

Share prices follow a random walk (rise on good news, fall on bad news)

Share prices change quickly to reflect information about a company

Weak form efficiency

Share prices reflect information about past price moves and past information which has become fact

Can beat market using analysis of forecasts and the actions of the company

A positive NPV project is reflected in share price when its value has been evidenced e.g. reflected in published accounts

Semi-strong efficiency

Share prices reflect all publicly available information

Only way to beat market is insider trading

A positive NPV project is reflected in share price when project is announced

Strong form efficiency

Share prices reflect all information about a company

Only way to beat market is luck

A positive NPV project is reflected in share price when board agree to undertake project

Behavioural finance

Can appear inefficient

Share prices not moving in expected way after release of new information

Behaviourla finance factors that cause prices to move in strange ways

Overconfidence - lack of knowledge & high self belief

Representativeness - over reaction to new (based on perceived trends)

Narrow framing -

Miscalculation of probabilities

Ambiguity aversion

Positive feedback

Cognitive dissonance

Availability bias

Conservatism