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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

Chapter 12

Sources of finance



Sources of finance


Debt finance


Venture capital


Equity finance

overview sources of finance
Overview – sources of finance

Maximisation of

shareholder wealth







Short-term finance

Long-term finance

sources of finance1
Sources of finance
  • Range of short-term sources

– overdrafts: quickly and flexibility

– short-term loans

– trade credit

– lease finance

– factoring

  • Range of long-term sources

– debt finance

– leasing

– venture capital

– equity finance

sources of finance2


Sources of finance


Where payments from a current account exceed income to the account for a temporary period, the bank finances the deficit by means of an overdraft.

sources of finance4
Sources of finance
  • Overdrafts an short-term loans compared:

(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.

sources of finance5
Sources of finance
  • Advantages of an overdraft over a loan
  • The customer only pays interest when he is overdrawn.
  • The bank has the flexibility to review the customer’s overdraft facility periodically, and perhaps agree to additional facilities, or insist on a reduction in the facility.
  • An overdraft can do the same job as a loan; a facility can simply be renewed every time it comes up for review.
sources of finance6
Sources of finance
  • Advantages of a loan for longer term lending
  • Both the customer and the bank know exactly what the repayments of the loan will be and how much interest is payable, and when. This makes planning(budgeting) simpler.
  • The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility before he is in a position to repay what is owed. There is an element of ‘security’ or ‘peace of mind’ in being able to arrange a loan for an agreed term.
  • Loans normally carry a facility letter setting out the precise terms of the agreement.
sources of finance7
Sources of finance
  • Trade credit:


sources of finance9
Sources of finance

A company would raise more cash from a sale and leaseback arrangements than from a mortgage.


debt finance
Debt finance

Factors to choose debt finance

debt finance2
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

debt finance4
Debt finance
  • Zero coupon bonds:

-are bonds that are issued at a discount to their redemption value, but no interest is paid on them.

  • Advantages:

Evaluation of long term debt finance from company

  • Disadvantage
  • interest paid regardless of profit
  • raise gearing and risk
  • with fixed maturity dates, provision must be made in advance
  • Advantage
  • cheap, as less risky
  • cost is limited to interest
  • no dilution of control
  • interest cost tax deductible

Advantages of long term debt finance

Bonds (debentures/loan notes)

Bank loans

  • Available to most companies
  • Supported by the loan guarantee scheme for small businesses
  • Quick to arrange
  • Often cheaper because avoid bank fees & liquid investment
  • Can be convertible
  • Can be zero coupon
  • Can be in foreign currency (Eurobond)

Evaluation of long term debt from investor


no voting right



priority in interest payment and liquidation

fixed interest whatever profit is

  • Convertibles

– are bonds that give the holders the right to convert to other securities, normally ordinary shares, at a pre-determined price/rate and time.

  • Convertibles

– 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

  • Characteristics of convertible debentures
  • convertibles can provide immediate finance at lower cost since the conversion option effectively reduces the interest rates payable.
  • convertibles represent attractive investments to investors since they are effectively debts risks for future equity benefits. Hence, finance is relatively easy raised.
  • convertibles allow for higher gearing levels than would
  • otherwise be the case with straight debt, because costs are
  • potentially lower with convertibles.
  • where company wish to raise equity finance, but share prices are currently depressed, convertibles offer a safeguard share issue method.
  • where convertibles are converted into shares, the problem of repayment disappears.
  • Delayed equity and dilute EPS
  • Market value of convertible

– issued at a low conversion value to maximize conversion premium

– low coupon rate of interest

– price depend on

  • price of straight debt
  • current conversion value
  • length of time before conversion
  • market’s expectation
  • Secured and unsecured
  • fixed charge: specific assets
  • floating charge: general charge on all assets
  • unsecured with higher rates
  • Redemption of loan notes
  • preference shares
  • debentures
  • Tax relief on loan interest
venture capital
Venture capital

Very high growth potential


Very significant amounts

Very high returns

venture capital1
Venture capital
  • Venture capital: is risk capital, normally provided in return for an equity stake.
  • Venture capital funds
  • Finding venture capital

– want an equity stake

– the company can be successful

– have a representative or have an independent director

venture capital2
Venture capital
  • Factors in investment decisions

第十条 发行人申请首次公开发行股票应当符合下列条件:



















equity finance
Equity finance
  • Ordinary shares
  • classification of shares
  • market value and par value
  • purposes of new issue of shares

raise fund

float its shares

merge and acquisition

  • Equity fund
  • cash from retained earning
  • new share issues
  • rights issues
equity finance1
Equity finance
  • Why listing
  • access to a wider pool of finance
  • improved marketability of shares
  • transfer of capital to other uses
  • enhancement of the company image
  • facilitation of growth by acquisition
  • obtain funds for other projects
  • Disadvantage of listing
  • loss of control to wider investors
  • risk of being take over
equity finance2
Equity finance
  • Methods of obtaining a listing

– initial public offer (IPO)

– a placing

– an introduction

  • Typical costs of a share issue

– underwriting costs

– listing fee

– fees of the issuing house, solicitors, auditors and consultants

– charges for printing and distributing the prospectus

– advertising


Equity finance

Initial public offer

-is an invitation to apply for shares in a company based on information contained in a prospectus.

A placing:

-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.

equity finance3
Equity finance
  • The choice between an IPO and a placing
equity finance4
Equity finance
  • A stock exchange introduction:

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.

equity finance5
Equity finance
  • Pricing shares for a stock market launch
equity finance6
Equity finance
  • Pricing shares for a stock market launch

– price of similar quoted companies

– current market conditions

– desire for immediate premium

– future trading prospects

  • Underwriting

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。


第九条 发行人自股份有限公司成立后,持续经营时间应当在3年以上,但经国务院批准的除外。


第三十三条 发行人应当符合下列条件:








询 价








  第六条 上市公司的组织机构健全、运行良好

  第七条 上市公司的盈利能力具有可持续性,

  第八条 上市公司的财务状况良好;

  第九条 上市公司最近三十六个月内财务会计文件无虚假记载

  第十条 上市公司募集资金的数额和使用应当符合规定




第十三条 向不特定对象公开募集股份(简称“增发”),除符合本章第一节规定外,还应当符合下列规定:




第十二条 向原股东配售股份(简称“配股”),除符合本章第一节规定外,还应当符合下列规定:

(一) 拟配售股份数量不超过本次配售股份前股本总额的百分之三十;

(二) 控股股东应当在股东大会召开前公开承诺认配股份的数量;













right issue
Right issue
  • Key term:

– new share offers made to existing shareholders at a lower price

  • Advantages of a right issue

– cheaper than offer for sale

– more beneficial to existing shareholders

☆new shares at a discount price

– relative voting rights are not affected

– reduce gearing

right issue1
Right issue
  • Cum-right price and Ex-right price


cum-right price

issue price

ex-right price


  • Value of rights

n = number of shares required to buy 1 new share

  • difference between ex-right price and exercise price for each right
  • can be divided by n for each existing share
right issue2
Right issue
  • Theoretical gain or loss to shareholders

The possible courses of action open to shareholders are:

right issue3
Right issue
  • The actual market price after a right issue
dividend policy

Chapter 13

Dividend policy



Internal sources of finance


Dividend policy

overview dividend policy

Investment decision

Financing decision

Makes it

difficult to pay

a dividend?

Debt finance

may enable a

dividend to be


A reflection

of investment

and financing


Dividend decision

Overview – dividend policy

Maximisation of

shareholder wealth

Investment decision

internal sources of finance
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

dividend policy1
Dividend policy
  • Factors influencing dividend policy
  • Dividends as a signal to investors
  • Theories of dividend policy
  • residual theory
  • traditional view
  • irrelevancy theory

Dividend policy

(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.

  • The ease with which the company could raise extra finance from sources other than retained earnings.

(j) The signalling effect of dividends to shareholders and the financial markets in general-see below.

  • Factors influencing dividend policy
dividend policy2
Dividend policy

Scrip dividends

  • key term: dividend payment takes the form of new shares
  • converts profit and loss reserve into share capital

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

dividend policy3
Dividend policy
  • Stock splits

– split one share into several small shares

– cheaper and more marketable

  • Share repurchase
dividend policy4
Dividend policy

Advantages of share repurchase

  • a use for surplus cash
  • increase in earnings per share
  • increase in gearing
  • readjustment of the company’s equity base
  • preventing a takeover

Disadvantages of share repurchase

  • can be hard to arrive at a price
  • the company cannot make better use of the funds
  • taxed on a capital gain

Dividend policy - summary

Mature company

Young company

0 / low dividend

High dividend

gearing and capital structure

Chapter 14

Gearing and capital structure





Effect on shareholder wealth


Finance for small and medium-sized entities

overview gearing and capital structure
Overview – gearing and capital structure

Maximisation of

shareholder wealth

Investment decision

Investment decision

Financing decision

Dividend decision

How much debt finance?

  • financial risk: financial gearing
  • business risk: operating gearing

Financial gearing

Operating gearing

= contribution/PBIT

  • the relationship between shareholders’ capital plus reserves,
  • and either prior charge capital or borrowings or both
  • based on book value
  • based on market value

Total gearing

the sum of operating gearing and financial gearing

Interest cover

= profit before interest and tax/interest

Debt ratio


Operating gearing

Financial gearing

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.

capital structure
Capital structure
  • Capital structure

– the way in which an organization is financed, by a

combination of long-term capital and short-term liabilities.

  • Matching assets with funds

– 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.

  • Long-term capital requirements

– maintenance of current operations: internal sources

– growth: external sources

capital structure1
Capital structure

Restrictions on capital structure

– attitudes to risk and return

– loss of control

– costs

– commitments

– present sources of finance

– availability of capital

– future trends

– restrictions in loan agreements

– maturity dates

capital structure2
Capital structure

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

dilute control.

– 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.

capital structure3
Capital structure

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.

practical influences on the level of debt
Practical influences on the level of debt




Operational gearing


Stability of revenue



stock market ratios
Stock market ratios
  • Dividend yield

= (gross dividend per share/market price per share)×100%

  • Interest yield

= (gross interest/market price of loan stock)×100%

EPS and fully diluted EPS

  • P/E

= market price of share in pence/EPS in pence

  • Dividend cover
  • Dividend payout ratio

reflects the market’s appraisal of the share’s future prospects

problems for sme finance
Problems for SME finance

Characteristics of SMEs

unquoted –

owned by a small numbers of individuals –

not micro-businesses –

Problems for SME finance

– uncertainty

– no long track record

– less public exposure

– low asset

sources of sme finance
Sources of SME finance

Owner financing

Overdraft financing

Bank loan


Trade credit

Equity finance


Business angel financing

Venture capital

sources of sme finance1
Sources of SME finance
  • Capital structure of SMEs

– lack of separation between ownership and management

– lack of equity finance

  • Government aids

– Loan guarantee scheme

– Enterprise initiative: grants

– Development agencies

– Enterprise investment scheme: tax benefit

– Venture capital trust: tax benefit

  • Student accountant

– Business finance and the SME sector(2001)

– Selecting sources of finance for business(2003)


Gearing - summary

High gearing

Low gearing

Young company (SME)

Mature company

  • High growth /investment needs
  • Wants to minimise debt
  • Lower growth
  • Able and willing to take on debt

Gearing - summary

Low gearing

High gearing

Young company (SME)

Mature company