Chapter 15 Sources of Finance

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CHAPTER 15

SOURCES OF FINANCE


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1. Selection of appropriate sources of finance

Firms need funds to:

- provide working capital short term

- invest in non-current assets long term

Retained earnings:

- main source but- insufficient

Firms need alternative source of finance


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1. Selection of appropriate sources of finance

Criteria for choosing between sources of finance

Factor Issue to consider

Cost Debt is usually cheaper

Duration Long-term finance is more expensive butsecure

Term structure of

interest rates

Relationship between interest and loan

durationshort term debt is cheaper (not

always)

Gearing Debt is cheaper but increases risk of default

Availability Not all sources of finance are available to all

firms


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2. The relation between risk and return

Investment risk- variability or

- uncertainty of returns

Higher investment risk - higher return required

Higher return required higher cost of capital


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3. Short-term sources of finance

Working capital is usually financed using short-term finance

- Bank overdrafts;

- Bank loans;

- Better management of working capital;

- Squeezing trade credit;- Operating lease (short-term)

- lease period < useful life of the asset;

- the lessor is responsible for maintenance and repairs

- the lease can sometimes be cancelled at short notice- Its substance is associated with that of a short-term

rental

- Sale and lease-back


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4. Long-term sources of finance - Equity

Equity shareholders

- the owners of the business;

- exercise ultimate control through the voting rights

Equity finance

- the investment by the ordinary shareholders

(ordinary sharescapital)- reserves

Equityrelates to ordinary shares only.

Preference shares (cumulative and non-cumulative)

- not part of equity;

- exhibit features of debt

- may acquire voting rights when dividend is in arrears


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5. Raising equity

Three sources of equity capital

- Internally generated funds- Retained earnings

- easiest to have access to (quickly raised)

- cheapest (free)

- Rights issues- Offers to existing shareholders to subscribe to new shares at a

discount

- New external share issues- Placings share are placed or sold to institutional investors

by way of a financial intermediary investment bank

- Public offersan invitation to apply for shares based on

information in a prospectus

- Fixed price offer

- Offer for sale by tender


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6. Rights issues

A rights issue

- an offer to existing shareholders

- to subscribe for new shares,

- at a discount to the current market,

- in proportion to their existing holdings.

Advantages:

- cheaper than public share issue

- made at the discretion of the directors without consent

from shareholders or Stock Exchange;

- it rarely fails


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6. Rights issues

The value of a right

Value of a right = TERP Issue (subscription) price

Shareholders options:

- Take up the rights by buying the specified proportion at

the price offered;

- Renounce his rights and sell them on the market

- Renounce part of his rights and take up the remainder

- Do nothing (let the rights expire)


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6. Rights issues

The value of a right

Market price

Issue price

Ex-rights price

(value afterwards)

DiscountValue of the

right


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7. Choosing between sources of equity

(1) Accessibility of the financeQuoted companies have access to all sources of equity finance

Unquoted companies have access to rights issues or placings

(2) The amount of finance

Rights issues limited by the existing shareholders financing powerPlacings larger sums

Public offers largest amounts

(3) Costs of the issue procedureRetained earnings cheapest

Placings and rights issues a bit more expensive

Public offers most costly


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(4) Pricing of the issuePricing problems exist with public offers and placings

No pricing ploblems are with rights issues

(5) ControlRetained earnings and rights issues do not dilute control

Placings and Public offers dilute control

(6) Dividend policy


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- costs of issue and

- ease of organization

Induce the following preference order

Retained earnings

Rights issues

New issues


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8. Long-term finance- Debt

A loan note

a written acknowledgement of debt by a

company, normally containing provisions as to

-payment of interestand

- the terms of repayment of principal

Loan notes/corporate bonds/loan stock/debentures

Used interchangeably


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8. Long-term finance- Debt

In UK or US,loan notes

- Are tradedon stock markets;

- Usually denominated in blocks of $100 nominalvalue;

- May be secured or unsecured

- May be

- Redeemable (principal repaid at a future date)

- Irredeemable (principal never repaid, interest paid in perpetuity)


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9. Characteristics of loan notes and other long-term debt

For the investor

Low risk

-Definite maturity

-Priority in interest payments-Priority on liquidation

-Fixed income

For the company

Cheap

Predictable flows

Does not dilute control

Advantages of long-term debt


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For the investor

-No voting rights

-Voting rights only if interestnot paid

For the company

- Interest must be paid

whatever the earnings- Inflexible

-Increases risk of default

at high levels of gearing

- Must be repaid

Disadvantages of long-term debt


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Hybrid debt instruments convertibles

Convertibles give the holder the right to convert to other securities

(usually ordinary shares) at either a:

- predetermined price;

- predetermined ratio(e.g. 1 loan note in 25 shares)


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Hybrid debt instruments loan notes with warrants

Warrants give the holder the right to subscribe, at a fixed future

date, for a certain number of ordinary shares at a predetermined

price.

If warrants are issued with loan notes, the loan notes are not

converted into equity. Bondholders:

- purchase shares for cash;

- retain the loan notes until redemption.

Used as sweeteners on debt issues:

- interest rate on the loan is low;

- right to buy equity set at an attractive price;

- warrants can be resold after buying the loan notes


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Advantages of hybrid debt instruments

Immediate finance at low cost- issued at below normal rates or with little to no security;

Self-liquidation- upon conversion the problem of repayment disappears;

Can provide cash-finance

- by design, exercise of warrants involves cash-payments forshares


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10. Long-term financeleasing

Operating lease (short term)

equivalent to renting an assetFinance lease (medium to long-term)

equivalent to borrowing to purchase the asset.

Finance leases- Finance leases exist for a period that covers most of the

useful life of the asset;

- Lessor does not retain risks and rewards of ownership.

Lessee responsible for repairs and maintenance

- Uncancellable the lessee has a liability for all payments

- Economic substance purchase of asset by lessee

financed by lessor.

Documents

Chapter 15 Sources of Finance