Short Term and Long Term Financing

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Module 7 and 8

Short Term and Long Term Financing

(chapter 9,10 and 11)

19/9/2007



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Learning Objectives

By the end of this section you should beable to: ± understand short-term sources of finance

± understand long-term sources of finance



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Financial Policy:

maturity matching principle Permanent investments (investments

more than one year): long term financing

Temporary investment (investments lessthan one year): short term financing



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Short-term Financing

Short-term financing is defined as debt due for repayment within a period of 12 months.

The major short-term borrowing choices available to Australian companies are:

± trade credit (account payable)

± Bank overdraft

± factoring

± money market sources Interbank deposit (cash rate)(Overnight loan)

issuing short-term marketable debt securities such aspromissory notes and bills of exchange



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Borrowing From Banks and Other FinancialInstitutions

Bank Overdraft

± An overdraft permits a company to run its current

(cheque) account into deficit up to an agreed limit. ± The cost of a bank overdraft includes the interest

cost (currently about 9.85% p.a.) and fees.

± The interest rate charged is usually at a marginabove an indicator rate, published regularly by thebank, and only on the amount by which the accountis overdrawn.





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Money Markets Resources (cont.)

Overnight loan

± Funds lent in the money market on the basis thateither party can terminate the loan by giving notice by

11 a.m. on the following day. Also known as 11 a.m.money.

± Interbank overnight interest rate (cash rate) is abetter indicator of conditions in short term money

market. ± 24-hour loans: funds lent in the money market, where

the loan may be terminated or renegotiated after 7days on 24 hours notice.



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Money Markets Resources (cont.)

Short-Term Marketable Debt

Companies can obtain short-term debt funding by

issuing (selling) securities such as promissory notesand commercial bills (bills of exchange). The securities are a promise to pay a sum of money on a

future date



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Short-Term Marketable Debt :

Promissory Notes

A promise to pay a stated sum of money (such as$500000) on a stated future date (such as a date 90

days hence). Issuer of the note----borrower, the only party with an

obligation to pay the face value at maturity, so alsoknown as one-name paper or commercial paper .

Discounter Purchaser of a short-term debt security such as a

promissory note or a bill of exchange.



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Short-Term Marketable Debt :Promissory Notes

Face Value

í Sum promised to be paid in the future on the debtsecurity.

Credit risk of a promissory note depends on thecredit standing of the issuer.

± Only large, reputable companies with a high creditrating and government entities are able to raise funds

by issuing promissory notes, for example, Shell Australia, BHP Finance, Australian Wheat Board.



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Short-Term Marketable Debt :Commercial Bills (Bills of Exchange)

CB are the means by which amounts of $100,000 or more can be borrowed for periods normally rangingfrom 90 to 180 days.

CB is a bill of exchange issued by a borrower (thedrawer) which directs another person ( the acceptor or drawee), usually a bank, to pay a stated sum of moneyon maturity of the bill to a specified person or to bearer (the payee or discounter).



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Drawer has bill accepted by Acceptor

Then the drawer has

the bill discounted by Discounter

The discounter lends the drawer an amount

of money in exchange for the bill

Source: Perison et al. (2006), Business Finance, McGraw Hill.



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Bills of Exchange (cont.)

The f ace value is paid to whoever holds the bill onthe maturity date.

The discounter has the choice of either holding the

bill until maturity, when payment will be receivedfrom the acceptor, or selling (rediscounting) the bill.However, if the bill is sold, the seller normallyendorses the bill at the time of sale.

Endorsement: acceptance by the seller of a bill in thesecondary market, of responsibility to pay the facevalue if there is default by the acceptor, drawer andearlier endorsers.



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Normal process of repayment

Current approaches the approaches the

Holder acceptor for repayment Acceptor drawer for Drawer recompense

Initially the acceptor pays The drawer reimburses the

the holder the face value acceptor for this payment

of the bill to the holder

Source: Perison et al. (2006), Business Finance, McGraw Hill.



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Source: Wilson et al. (2007), F inancial Management , 5th edn, Pearson, Australia



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Bank Bills

± Bill of exchange that has been accepted or

endorsed by a bank.

Non-bank Bills

± Any bill of exchange that has been neither accepted nor endorsed by a bank but fromthe other institutions.



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Long-term Financing

Major sources of long-term financing

± Equity securities

± Debt securities

± Hybrid securities



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Equity Finance

Limited companies

± Equity raised via the issue of ordinary andpreference shares to shareholders

Limited companies

± Ordinary shareholders

No prima facie right to a dividend unless

declared



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Equities---Ordinary Shares

Ordinary share features

± Par value: represents its unit value as described by a

company¶s authorised capital. Ex: I million ordinary

shares of $ 1each. ± Ownership: shareholders are part-owners of the company.

± Limited liability but without priority for dividends or in

bankruptcy.

± Permanent capital: an issue of ordinary shares representsan irredeemable source of funds. The company is

prohibited from buying back these shares.

± Company flotations



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Shareholders¶ Rights

The right to share proportionally in dividends paid.

The right to share proportionally in assets remaining

after liabilities have been paid in liquidation.

The right to elect the directors and to vote on

important shareholder matters (one share = one vote).

The right to share proportionally in any new shares

sold (pre-emptive right).



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Flotation: New Issues

Flotation is the initial offering of securities to the public(Initial Public Offering, IPO).

R easons for a private company may be floated?

e.g,

± convert from a private company to a public company for the first time.

± form a new public company

± privatise a public organisation



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Secondary Issues

When additional equity funds are needed and sought fromthe market, two methods can be chosen in terms of thecosts.

Private placements²securities are offered and sold to alimited number of investors who are often the currentmajor investors in the business.

R

ig hts issues²issue of shares made to all existingshareholders, who are entitled to take up the new shares

in proportion to their present holdings.



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Rights Issues: Basic Concepts

Rights Issues

Issue of ordinary shares to existing shareholders.

Allows current shareholders to avoid the dilution thatcan occur with a new share issue.

µRights¶ are given to the shareholders specifying:

± number of shares that can be purchased

± purchase price ± time frame.

Shareholders can either exercise their rights or sell them.They neither win nor lose either way.



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Processes of Issuing Securities to the Public

Analyse funding needs and how they can be met.

Approval from board of directors for a publicissue.

Outside expert opinions sought for support of issue.

Pricing, time-tabling, prospectus prepared,

marketing. Prospectus filed with ASIC and ASX.



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Processes of Issuing Securities to the Public

Underwriting agreement executed. Prospectus registered. Public announcement of offering.

Funds received. Shares allotted, holdings registered. Shares listed for trading on ASX.



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Underwriting

The underwriter undertakes to guarantee that the shareissue is fully subscribed and to purchase any unsoldshares.

± Firm underwriting

A guarantee t hat funds will be made available to acompany at a specific time on agreed terms and

conditions.

± Best efforts underwriting

Underwriter must use µbest efforts¶ to sell t hesecurities at t he agreed offering rate.



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Underwriting

Role of underwriter

± pricing the issue

± marketing the issue ± engaging sub-underwriters

± placing the shortfall

Sub-underwriter

± A group of underwriters formed to reduce therisk and to help to sell an issue.



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Underwriting Fees

The underwriter¶s fee is a reflection of the:

± size of the issue

± issue price

± general market conditions

± market attitude towards shares

± time period required for underwriting.

Fees also include brokerage and management

fees.





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Advantage and Disadvantage of Using EquitySecurities as a Source of Financing

Advantages Disadvantages

The organisation is under nocontractual obligation to pay a

fixed dividend. This is particularlyimportant for companies thatexperience cash flow shortages

Equity is an expensive form of finance as dividends are not tax

deductible and issue costs arehigh

There is no obligation to pay outthe shareholder at a future date; it

is like a permanent loan

Issuing new equity shares canalter the percentage ownership of

a company, i.e. ownership can bediluted

By issuing equity an organisationeffectively increase its financebase and this increase its capacityto increase debt levels



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Other sources of equity fund

Private equity: security issued to investors

are not publicly traded (venture capital) Internal finance: retained earnings

But it will be affected by dividend policy of

the company.



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Debt Securities

An obligation to pay a specific amount of money toanother party.

Corporations try to create debt securities that are reallyequity to get the tax benefits of debt and the bankruptcybenefits of equity.

Interest on debt is fully tax deductible, so the distinctionis important for tax purposes.



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Types of Long-term Debt Security

Marketable long-term debt: Debentures andunsecured notes

Long-term loans



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Types of Long-term Debt

Marketable long-term debt

Debentures²secured debt are sold through public offer in a similar manner to equity and offer assets as security

(issued amounts of at least $1,000 to 10,000)

Unsecured notes (corporate bonds): long-term, fixinterest debt security with coupon payments every 6 months, issued by non-government entities in amounts

of at least $500000 per investor.. ± Corporate bonds require high credit ratings




Main differences between cor porate bonds anddebentures are that corporate bonds:

± are usually issued as unsecured notes

± have less restrictive trust deeds ± are placed privately with institutional investors

± do not need a prospectus, if placed with institutionalinvestors

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Australian companies obtain long-term debtfinance largely by loans, rather than by issuingtheir own debt securities.

Loans ± variable rate loans

± fixed rate term loans

± mortgage loans

± Foreign bond

± Eurobond

Long-Term Loans



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Variable Rate Loans

Borrowers are charged an interest rate that is variableat the bank s discretion.

Consists of a base rate that is published weekly, plus acredit margin that varies between borrowers.

Fixed Rate Term Loans

Pay an agreed fixed interest rate for a period of atleast 1 year

Interest rate can be fixed from 5 to 10 years.

Mortgage Loans

Borrower pledges property as security for a loan.

Long-Term Loans (cont.)



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F oreign bond- bond issued outside t he borrower¶scountry and denominated in t he currency of t he country in w hic h it is issued

Ex: bonds denominated in US dollars and issued in t he US

domestic market

Eurobonds²unsecured fixed-interest borrowings withmaturity of five to ten years, denominated in a currency of a country other than its country of issue.

Ex: An Australian dollar Eurobond is a debt securitydenominated in Australian dollars but issued outside Australia with a view to attracting non Australian investor.



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Advantage and Disadvantage of UsingLong-term Debt as a Source of Financing


Long term is less expensive

Interest payment is taxdeductible

Default of interest paymentscan force an organisationinto bankruptcy

Debt holders do not havevoting rights

Debt must be paid but atmaturity and thereforerequires a rolling over or a

large cash outflow

Issue costs for debt aregenerally lower than equity

Restrictive debt covenantscan affect an organisation¶sability to raise finance in the

future



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Hybrids of Debt and Equity Finance

Preference shares

Convertible notes



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A form of equity financing with characteristics of debt securities.

Normally holders have no voting rights.

Normally entitled to receive a specified fixedreturn out of a firm s net profit.

Rank ahead of ordinary shares with respect to

dividend payments, and usually with respect toclaims on assets in the event of a liquidation.

Preference shares



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Cumulative or non-cumulative

± A company that issues cumulative preferenceshares is required to pay any accumulatedpreference dividends before a distributionmay be made to ordinary shareholders.

± Non-cumulative preference shares do notoblige the company to pay any pastaccumulation of unpaid preference dividends.

Preference shares



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Redeemable, irredeemable, converting or convertible

± Redeemable preference shares are similar todebentures, giving them the same status as lenders.

± Irredeemable preference shares are similar to ordinaryshares.

± Converting preference shares automatically convert toordinary shares at some specified time in the future.

± Convertible preference shares can be converted toordinary shares at the option of the holder.

Preference shares



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Participating or non-participating

± A company may issue participating preference shares

that allow the holders to share in any profit earned inexcess of a certain amount.

± These participating preference shareholders can obtaina dividend in excess of the preference dividend rate.

± Non-participating preference shareholders are notentitled to a dividend in excess of the stated dividendrate.

Preference shares



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Preference Shares

Most preference shares issued are

cumulative, irredeemable and non-

participating



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Reasons for Issuing Preference Shares

Redeemable preference shares can be used to enhancethe balance sheet by increasing the equity base.

As subordinate debt, they can be included in a bank¶s

capital base. They can be used to avoid the threat of bankruptcy that

exists for debt.

Companies unable to take advantage of the tax

deductibility of debt favour preference shares. A means of raising equity without surrendering control.



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Convertible Note

± A convertible note is a debt instrument issued for a fixedterm at a stated interest rate, which gives the holder theright to convert the note into ordinary shares at specifiedfuture dates.

± If the holder choose not to exercise the right to convert, thesecurity will be redeemed at maturity.

± Notes are usually issued at an interest that is lower than thatoffered on straight debt instruments. Why?

± Have terms up to 10 years

± Can be listed on the ASX for trade

e.g10-year 8 per cent convertible notes with a face value of $10that maturity can be converted to shares at a conversion ratio of

one to one.

Hybrids of Debt and Equity Finance:Convertible Notes



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Advantage and Disadvantage of UsingHybrid Securities as a Source of Financing


Non payment of dividends

does not force anorganisation into bankruptcy

Hybrid securities are more

expensive than debtThey are not tax deductible

Preference shareholders do

not have voting rights and donot (generally) participate inprofiles

The cumulative nature of

preference dividendsrequires that a % must bepaid at some time

Documents

Short Term and Long Term Financing