Financial Management [SOURCES OF FINANCE]

Sources of finance

Following are the two sources of finance

➢ Equity
➢ Debt

Criteria
The choice of source depends on following factors:

1. Cost
2. Duration
3. Security
4. Gearing
5. Availability

Debt finance

Security
• Fixed charge (specific assets)
• Floating charge (non-specific assets)

Covenants (A promise in an indenture, or any other formal debt agreement, that certain activities
will or will not be carried out)

• Dividend restrictions
• Ratios
• Debt restrictions

Types of debts

Short term

• Overdraft
• Short term loans
• Trade credit
• Leasing/sale and leaseback (operating lease)

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 Financial Management [SOURCES OF FINANCE]

Long term
• Bank finance
• Finance Lease
• Issued debt
• Bonds
• Debentures
• Convertible debt

Short term

Overdraft

From the point of view of the bank, the company should be expected to use its overdraft facility as
follows:

• The overdraft should be used to finance short-term cash deficits from operational activities. The
company’s bank balance ought to fluctuate regularly between deficit (overdraft) and surplus.
There should not be a ‘permanent’ element to the overdraft, and an overdraft should not be
seen as a long-term source of funding.
• The bank normally has the right to call in an overdraft at any time, and might do so if it
believes the company is not managing its finances and cash flows well.

Short-term bank loans

Short-term bank loans might be arranged for a specific purpose, for example to finance the purchase
of specific items. Unlike an overdraft facility, a bank loan is for a specific period of time, and there is a
repayment schedule.

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.

Activity

The split between interest and capital repayment

A loan of $100,000 is to be repaid to the bank in equal annual year-end installments made up of
capital repayments and interest at 9% pa.

Required:
Prepare interest allocation schedule

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Trade credit

Trade credit from suppliers has no cost, and is therefore an attractive method of short-term finance.
However, a company should honor its credit arrangements and pay its suppliers on time at the end of
the agreed credit period. It is inappropriate for a company to increase the amount of its trade
payables by taking excess credit and making payments late.

Operating leases

In some cases, operating leases might be an alternative to obtaining short-term finance. Operating
leases are similar to rental agreements for the use of non-current assets, although they might have a
longer term. (Rental agreements are usually very short term.).

Sale and leaseback

A company which owns its own premises can obtain finance by selling the property to insurance
Company or pension fund for immediate cash and renting it back.

A company would raise more cash from sale and leaseback arrangements than from a mortgage, but
there are significant disadvantages.

a) The company loses ownership of a valuable asset which is almost certain to appreciate over
time
b) The future borrowing capacity of the firm will be reduced, as there will be less assets to
provide security for a loan
c) The company is contractually committed to occupying the property for many years ahead
which can be restricting
d) The real cost is likely to be high, particularly as there will be frequent rent reviews

Long term sources

Bonds

Bonds are long-term debt capital raised by a company for which interest is paid, usually half yearly
and at a fixed rate. Holders of bonds are therefore long-term payables for the company.

The term bonds describe various forms of long-term debt a company may issue, such as loan notes or
debentures, which may be:

• Redeemable
• Irredeemable

Bonds or loans come in various forms, including:

• Floating rate debentures

• Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal
value of the notes, and which will be redeemable at par (or above par) when they eventually mature.

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

The investor gains from the difference between the issue price and the redemption value. There
is an implied interest rate in the amount of discount at which the bonds are issued (or
subsequently re-sold on the market).

(a) The advantage for borrowers is that zero coupon bonds can be used to raise cash
immediately, and there is no cash repayment until redemption date. The cost of
redemption is known at the time of issue. The borrower can plan to have funds available
to redeem the bonds at maturity.

(b) The advantage for lenders is restricted, unless the rate of discount on the bonds offers
a high yield. The only way of obtaining cash from the bonds before maturity is to sell them.
Their market value will depend on the remaining term to maturity and current
market interest rates.

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

Conversion value is the current market value of ordinary shares into which bonds may be
converted.

Conversion value = Conversion ratio × MPS (ordinary shares)

Conversion premium = Current market value – current conversion value
Floor value= market price of straight bond with same interest rate

The actual market price of convertible bonds will depend on

• The price of straight debt

• The current conversion value
• The length of time before conversion may take place
• The market's expectation as to future equity returns and the risk associated with these
returns

Example: Convertible bonds

CD has issued 50,000 units of convertible bonds, each with a nominal value of $100 and a
coupon rate of interest of 10% payable yearly. Each $100 of convertible bonds may be
converted into 40 ordinary shares of CD in three years’ time. Any bonds not converted will
be redeemed at 110 (that is, at $110 per $100 nominal value of bond).

Estimate the likely current market price for $100 of the bonds, if investors in the bonds now
require a pre-tax return of only 8%, and the expected value of CD ordinary shares on the
conversion day is:

(a) $2.50 per share

(b) $3.00 per share

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 Financial Management [SOURCES OF FINANCE]

Preference shares

Near-debt is a term to describe finance that is neither debt nor equity, but is closer to debt in
characteristics than equity..

Types of preference shares

A company might issue different classes of preference shares. Each class of preference shares might have
different characteristics; for example one class of shares might pay a dividend of 5% and another might
pay a dividend of 6%; one class might be redeemable preference shares and other irredeemable shares,
and so on.

The different types of preference shares are summarized below.

• Redeemable preference shares are redeemable by the company, typically at their par
value, at a specified date in the future. Irredeemable preference shares are perpetual
shares and will not be redeemed.
• Cumulative preference shares are shares for which the dividend accumulates if the
company fails to make a dividend payment on schedule. For example, if a company fails to
make a dividend payment to its cumulative preference shareholders in one year, because it
does not have enough cash for example, the unpaid dividend is added to the next year’s
dividend. The arrears of preference dividend must be paid before any dividend payments on
equity shares can be resumed. With non-cumulative preference shares, unpaid dividends
in any year do not accumulate, and will not be paid at a later date.
• Participating preference shares: These shares give their owners the right to participate, to
a certain extent, in excess profits of the company when it has a good year. The dividend rate is
therefore not necessarily fixed each year. For this reason, the coupon dividend rate tends to be
lower than for other types of preference shares.
• Convertible preference shares: These are similar to convertible bonds. They give the
shareholders the right to convert their shares at a future date into a fixed quantity of equity
shares in the company.

Advantages and disadvantages of preference shares

The advantages of preference shares for companies are that:

• The annual dividend is fixed, and so predictable (with the possible exception of participating
preference shares).
• Dividends do not have to be paid unless the company can afford to pay them, and failure to
pay preference dividends, unlike failure to pay interest on time, is not an event of default.

The disadvantages of preference shares for companies are that:

• dividends are not an allowable cost for tax purposes
• they are not particularly attractive to investors.

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 Financial Management [SOURCES OF FINANCE]

Equity finance

Equity finance is raised through the sale of ordinary shares to investors via a new issue or a rights
issue.

Advantages of stock market listing

Disadvantages

There will be significantly greater public regulation, accountability and scrutiny. The legal requirements
the company faces will be greater, and the company will also be subject to the rules of the stock
exchange on which its shares are listed.

• A wider circle of investors with more exacting requirements will hold shares.
• There will be additional costs involved in making share issues, including brokerage commissions
and underwriting fees.

Obtaining a Stock Market Listing

An unquoted company can obtain a listing on the stock market by means of a:

• Initial public offer (IPO)

• Placing
• Introduction

Public offer
A public offer is an offer of new shares to the general investing public. Because of the high costs
involved with a public issue, these are normally large share issues that raise a substantial amount of
money from investors.

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A public offer might be used to bring the shares of a company to the stock market for the first time.
The US term for this type of share issue is an Initial Public Offering or IPO.

The shares that are offered to investors in an IPO might be a combination of:
• new shares (issued to raise cash for the company) and
• shares already in issue that the current owners are now selling.

Only the new shares issued by the company in the IPO will provide new equity capital for the
company.

Placing
A placing involves the sale of a relatively small number of new shares, usually to selected investment
institutions. A placing raises cash for the company when the company does not need a large amount of
new capital. A placing might be made by companies whose shares are already traded on the stock
exchange, but which now wishes to issue a fairly small amount of new shares.

Rights issue
A rights issue is a large issue of new shares to raise cash, by a company whose shares are already traded
on the stock market. The share price of the new shares in a rights issue should be lower than the current
market price of the existing shares. Pricing the new shares in this way gives the shareholders an
incentive to subscribe for them. There are no fixed rules about what the share price for a rights issue
should be, but as a broad guideline the issue price for the rights issue might be about 10% - 15% below
the market price of existing shares just before the rights issue.

Advantages and disadvantages of rights issues

Rights issues give existing shareholders the right to buy the new shares in a share issue. If an issue did not
have to be a rights issue, the company would be able to offer the shares to all investors.

Advantages
The advantages of a rights issue are as follows:
• A rights issue gives shareholders the right to retain the same percentage of the company’s total
share capital, and so avoid a ‘dilution’ in the proportion of the company that he owns.
• A rights issue prevents the company from selling new shares at below the current market price
to other investors.

Disadvantages The disadvantages of a rights issue are as follows:

• The company might want to raise a large amount of cash for new investment, but the existing
shareholders might be unwilling or unable to invest in the new shares.
• Shareholders can retain the same proportion of shares in the company by subscribing for new
shares in the issue.
• If a new share issue is offered to all investors, the issue price might be at or near the current
market price, instead of at a discount to the current ‘cum rights’ price.

Cost associated with issuance of share in stock market

Companies may incur the following costs when issuing shares.

• Underwriting costs
• Stock market listing fee (the initial charge) for the new securities
• Charges for printing and distributing the prospectus
• Advertising in national newspapers

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Practice Questions

Question 1
i) Augrus plc has issued capital of 5,000,000 shares at current market price of $5 per share.
Currently company wants to raise fund of $4,000,000 and makes a right issue of one new share
for every four existing share.
Calculate
a) Theoretical Ex-Rights Price
b) Value of a Right

ii) A shareholder had 10,000 shares in augrus plc before the rights offer.
Calculate the effect on his net wealth of each of the following options:
a) Take up the shares,
b) Sell the rights,
c) Do nothing

Question 2
i) Marcus plc, which has an issued capital of 4,000,000 shares, having a current market value of
£2.80 each, makes a rights issue of one new share for every three existing shares at a price of £2.0.
Calculate
a) Theoretical Ex-Rights Price
b) Value of a Right

ii) A shareholder had 10,000 shares in Marcus plc before the rights offer.
Calculate the effect on his net wealth of each of the following options:
a) Take up the shares,
b) Sell the rights,
c) Do nothing

Question 3
i) The Memogate Company has issued 100,000 $1 par ordinary shares which are presently selling
for $3 per share. The company has plans to issue rights to purchase one share at a price of $2 per
share for every four existing shares.
Calculate
a) Theoretical Ex-Rights Price
b) Value of a Right

ii) The chairman of the company receives a telephone call from an angry shareholder who owns
1,000 shares. The shareholder argues that he will suffer a loss in his personal wealth due to this
right issue, because the new shares are being offered a price lower than the current market
value.
The chairman assures him that his wealth will not be reduced because of the rights issue, as long
as shareholder takes appropriate action. Is the chairman correct?
iii) Prepare a statement showing the effect of the right issue on this particular shareholder’s wealth
assuming:
a) he sells all the rights
b) he exercises half the rights and sells the other half
c) he does nothing at all

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Venture capital

Venture capital is risk capital, normally provided in return for an equity stake. There are now quite a
large number of such organisations like:

• The British Venture Capital Association

• 3i group

The types of venture that the 3i group might invest in include the following.

(a) Business start-ups. When a business has been set up by someone who has already put time
and money into getting it started, the group may be willing to provide finance to enable it
to get off the ground.

(b) Business development. The group may be willing to provide development capital for a
company which wants to invest in new products or new markets or to make a business
acquisition, and so which needs a major capital injection.
(c) Management buyouts. A management buyout is the purchase of all or parts of a business
from its owners by its managers.
(d) Helping a company where one of its owners wants to realise all or part of his investment.
The 3i group may be prepared to buy some of the company’s equity.

3i major investment
• Etanco
• Coremetrics
• Civica etc

Finding venture capital

When a company’s directors look for help from a venture capital institution, they must recognise that:

(a) The institution will want an equity stake in the company.

(b) It will need convincing that the company can be successful (management buyouts of
companies which already have a record of successful trading have been increasingly
favoured by venture capitalists in recent years).
(c) It may want to have a representative appointed to the company’s board, to look after its
interests, or an independent director (the 3i group runs an Independent Director Scheme).

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