Chapter 12. Sources of finance. Contents. 1. Sources of finance. 2. Debt finance. 3. Venture capital. 4. Equity finance. Overview – sources of finance. Maximisation of shareholder wealth. Investment decision. Financing decision. Dividend decision. Short-term finance.
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Sources of finance
Sources of finance
– overdrafts: quickly and flexibility
– short-term loans
– trade credit
– lease finance
– debt finance
– venture capital
– equity finance
(a) In most cases, when a customers wants finance to help with ‘day to day’ trading and cash flow needs, an overdraft would be the appropriate method of financing.
(b) When a customer wants to borrow from a bank for only a short period of time, even for the purchase for a major fixed asset, an overdraft facility might be more suitable than a loan, because the customer will stop paying interest as soon as his account goes into credit.
A company would raise more cash from a sale and leaseback arrangements than from a mortgage.
Factors to choose debt finance
Fixed rate debenture
Debentures with floating rate of interest
Deep discount bonds
– issued at a large discount and redeemable at par (or above par) in maturity
– no or very low interest
– taxed in lump sum rather than annual interest income
Zero coupon bonds
– raise cash immediately
– advantage for lenders is restricted
-are bonds that are issued at a discount to their redemption value, but no interest is paid on them.
Evaluation of long term debt finance from company
Bonds (debentures/loan notes)
Evaluation of long term debt from investor
no voting right
priority in interest payment and liquidation
fixed interest whatever profit is
– are bonds that give the holders the right to convert to other securities, normally ordinary shares, at a pre-determined price/rate and time.
– fixed return security and may be converted into ordinary shares
– conversion value
value of share to be converted by 1 loan stock
– conversion premium
difference between the market value of the stock and conversion value at issue date
– issued at a low conversion value to maximize conversion premium
– low coupon rate of interest
– price depend on
Very high growth potential
Very significant amounts
Very high returns
– want an equity stake
– the company can be successful
– have a representative or have an independent director
float its shares
merge and acquisition
– initial public offer (IPO)
– a placing
– an introduction
– underwriting costs
– listing fee
– fees of the issuing house, solicitors, auditors and consultants
– charges for printing and distributing the prospectus
Initial public offer
-is an invitation to apply for shares in a company based on information contained in a prospectus.
-is an arrangement whereby the shares are not all offered to the public, but instead, the sponsoring market maker arranges for most of the issue to be bought by a small number of investors, usually institutional investors such as pension funds and insurance companies.
This will only happen where shares in a large company are already widely held, so that a market can be seen to exist.
A company might want an introduction to obtain greater marketability for the shares, a known share valuation for inheritance tax purposes and easier access in the future to additional capital.
By this method of obtaining a quotation, no shares are made available to the market, neither existing nor newly created shares; nevertheless, the stock market grants a quotation.
– price of similar quoted companies
– current market conditions
– desire for immediate premium
– future trading prospects
第八条 发行人应当是依法设立且合法存续的股份有限公司。第八条 发行人应当是依法设立且合法存续的股份有限公司。
– new share offers made to existing shareholders at a lower price
– cheaper than offer for sale
– more beneficial to existing shareholders
☆new shares at a discount price
– relative voting rights are not affected
– reduce gearing
n = number of shares required to buy 1 new share
The possible courses of action open to shareholders are:
Internal sources of finance
Internal sources of finance
– retained earnings
– increasing working capital management efficiency
Advantages of using retentions
– a flexible source
– does not involve a change and on dilution of control
– have no issue costs
Disadvantages of using retentions
– shareholders may be sensitive to the loss of dividends
– there is an opportunity cost
(a) The need to remain profitable.
(b) The law on distributable profits.
(c) The government which may impose direct restrictions on the amount of dividends companies can pay.
(d) Any dividend restraints that might be imposed by loan agreements.
(e) The effect of inflation, and the need to retain some profit within the business just to maintain its operating capability unchanged.
(f) The company’s gearing level.
(g) The company’s liquidity position.
(h) The need to repay debt in the near future.
(j) The signalling effect of dividends to shareholders and the financial markets in general-see below.
Advantages of scrip dividends
– preserve cash position
– tax advantages
– expand holding without incurring the transaction cost
– do not dilute the share price significantly
– decrease gearing, enhance the borrowing capacity
– split one share into several small shares
– cheaper and more marketable
Advantages of share repurchase
Disadvantages of share repurchase
0 / low dividend
Gearing and capital structure
Effect on shareholder wealth
Finance for small and medium-sized entities
How much debt finance?
the sum of operating gearing and financial gearing
= profit before interest and tax/interest
Firms with high levels of fixed costs are usually regarded
as high operating gearing and the operating earnings are more
volume-sensitive, because fixed costs must be made irrespective
of the level sales volume. Hence a company with higher
operating gearing will have greater variability in earnings before
interest and tax (EBIT) relative to a given level of variability in
High financial gearing is risky, for fixed interest payment
must be made regardless of the level of earnings. Therefore, a
company with higher financial gearing will have greater
variability in returns to shareholders relative to a given level of
variability in earnings before interest and tax (EBIT).
Relationship between financial and operating gearing
If the sales of a company vary, the ultimate variability of returns to shareholders will be determined by the level of operating gearing-which determines the EBIT variability- as ‘amplified’ by the level of financial gearing. So there is a trade off between operating and financial gearing, if a firm has a high degree of operating gearing, then unless sales were stable, it would prefer to avoid high financial gearing, and vice versa.
– the way in which an organization is financed, by a
combination of long-term capital and short-term liabilities.
– as a general rule, assets that yield profits over a long period of time should be financed by long-term funds, but instead finance short-term assets partly with short-term funding and partly with long-term funding.
– maintenance of current operations: internal sources
– growth: external sources
Restrictions on capital structure
– attitudes to risk and return
– loss of control
– present sources of finance
– availability of capital
– future trends
– restrictions in loan agreements
– maturity dates
Choosing between equity and debt
– Growth and stability of sales. If growth rate is high or
stable, high gearing can maximize the gain for equity, debt is
a choice then.
– Control. Debt is irrelevant to control, while equity will
– Tax position. If the tax shield doesn’t work, the company
may still suffer agency and insolvent costs. In this situation
debt financing is not attractive.
– Asset quality. Company with a high proportion of
intangible assets will be required to pay a higher return by its
creditors, because creditors know it’s harder to get the money
back than company having land and buildings.
Comparing debt and equity finance
– commonly debt is cheaper than equity on an after-tax
basis. One reason is debt is less risky, the other reason is tax shield.
– debt is more flexible because it can be borrowed, repaid and re-borrowed in general terms.
– debt is normally evidenced by a straightforward contract, creating rights and obligations on both sides. Equity carries with the additional benefits of ownership of the business, including the right to elect directors and appoint auditors.
– however, debt still has some weakness.
Stability of revenue
= (gross dividend per share/market price per share)×100%
= (gross interest/market price of loan stock)×100%
EPS and fully diluted EPS
= market price of share in pence/EPS in pence
reflects the market’s appraisal of the share’s future prospects
Characteristics of SMEs
owned by a small numbers of individuals –
not micro-businesses –
Problems for SME finance
– no long track record
– less public exposure
– low asset
Business angel financing
– lack of separation between ownership and management
– lack of equity finance
– Loan guarantee scheme
– Enterprise initiative: grants
– Development agencies
– Enterprise investment scheme: tax benefit
– Venture capital trust: tax benefit
– Business finance and the SME sector(2001)
– Selecting sources of finance for business(2003)
Young company (SME)
Young company (SME)