How To Understand The Financial System

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1 E. BUSINESS FINANCE 1. Sources of, and raising short-term finance 2. Sources of, and raising long-term finance 3. Internal sources of finance and dividend policy 4. Gearing and capital structure considerations 5. Finance for small and medium-size entities Sources of, and raising short-term finance What are the sources of short-term finance available to businesses? Overdrafts Short-term loans Trade credit Lease finance What are short-term finances usually needed for? Short-term finance is usually needed for businesses to run their day-to-day operations including payment of wages to employees and inventory. What are overdrafts? Overdrafts are deficits financed by the bank it is result of payments exceeding income in the current account. Overdrafts can be arranged relatively quickly, and are flexible with regard to the amount borrowed at any time, and interest is only paid when the account is overdrawn. Overdrafts are set a limit that should not be exceeded. The purpose of an overdraft generally should be to cover short-term deficits. Repayment is technically on demand and security depends on the size of the facility. What is a Solid Core (hard core) overdraft? A solid core (hard core) overdraft is when a business customer has an overdraft facility, and the account is always in overdraft. If the hard core element of the overdraft appears to be becoming a long-term feature of the business, the bank might wish to convert the hard core of the overdraft into a loan, thus giving recognition to its more permanent nature. Otherwise annual reductions in the hard core of an overdraft would typically be a requirement of the bank. What are short-term loans? A term loan is a loan for a fixed amount for a specified period. It is drawn in full at the beginning of the loan period and repaid at a specified time or in defined instalments. A term loan is not repayable on demand by the bank. A term loan is conditional on a covenant that the borrower must comply with. If

2 the borrower does not act in accordance with the covenants, the loan can be considered in default and the bank can demand payment. What are the advantages of an overdraft over a loan? The customer only pays interest when he is overdrawn There is greater flexibility of an overdraft over a loan the facility can be increased or decreased easily The overdraft can accomplish the same purpose as a loan What are the advantages of a terms loan? Both customer and bank know exactly o what the repayments of the loan will be o how much interest is payable o when interest are payable The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility Loans normally carry a facility letter setting out the precise terms of the agreement How do you calculate the annual payments of a loan? Step 1: Calculate the annuity factor using the rate and period Step 2: Divide the loan amount by the annuity factor How do you set up a loan schedule? Step 1: Calculate the annuity factor using the rate and period Step 2: Divide the loan amount by the annuity factor Step 3: B/F Loan amount + Interest (B/F balance x interest %) annual payment What are trade credits? Trade credits represent an interest free short-term loan. This is where current assets may be purchased on credit with payment terms normally varying from between 30 to 90 days. What are leases? A business may lease an asset rather than buying an asset outright using available resources or borrowed funds. The lessor retains ownership of the asset. The lessee has possession and use of the asset on payment of specified rentals over a period.

3 What is a sale and leaseback? A sale and leaseback involves a company obtaining finance by selling its property for immediate cash and renting it back. What are the disadvantages of a sale and leaseback? The company loses ownership of the asset The asset may appreciate over time The future borrowing capacity of the firm will be reduced The company is contractually committed to occupy the property Sources of, and raising long-term finance What are the ranges of long-term sources of finance available to businesses? Debt Finance (Bonds/Loan notes) Leasing Venture capital Equity finance What are long-term finances used for? Major investments! Why would companies seek debt finance? Businesses may need long-term funds but may not wish to issue equity capital Current shareholders may be unwilling to contribute additional capital The company may not want to involve outside shareholders who may have burdensome requirements Debt finance is cheaper and easily available if the company has little or no existing debt finance Debt finance provides tax relief Availability: Only listed companies will be able to make a public issue of binds on a stock exchange. Smaller companies may have to obtain debt financing from their bank. Duration: If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan should match the length of time that the asset will be generating revenues.

4 Fixed or floating rates: Fixed rate finance may be more expensive but the business runs the risk of adverse upward rate movements if it chooses floating rate finance. Security and covenants: The choice of finance may be determined by the assets that the business is willing or able to offer as security and also the restrictions in covenant that the lenders wish to impose. What are Bonds? Bonds are long-term debt capital raised by a company for which interest is paid. Holders of bonds are therefore long-term payables for the company. Bonds have a nominal value, which is the debt owed by the company, and interest is paid at a stated coupon on this amount. Note: For exam purposes debt is often issue at par i.e. $100 payable per $100 nominal value What are debentures? Debentures are a form of loan note, the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. What are Deep discount bonds? Deep discount bonds are loan notes issued at a price which is a large discount to the nominal value of the notes, and which will be redeemable at par or above par when they eventually mature. Investors might be attracted by the large capital gain offered by the bonds. However, deep discount bonds carry a much lower rate of interest than other types of bond. What are Zero coupon bonds? Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them. What are the advantages of Zero Coupon bonds? Zero coupon bonds can be used to raise cash immediately and there is no cash payment 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 What are convertible bonds? Convertible bonds are bonds that give the holder the right to convert to other securities, normally ordinary share, at a pre-determined price or rate and time. Convertible bonds issue at par normally have a lower coupon rate of interest that straight debt. This lower interest rate is the price the investor has to

5 pay for the conversion rights. When convertible bonds are traded on a stock market, their minimum market price or floor value will be the price of straight bonds with the same coupon rate of interest. If the market falls to this minimum, it follows that the market attaches no value to the conversion rights. Conversion value = conversion ration x market price per share Conversion premium = Current market value current conversion value Why will a company aim to issue bonds with the greatest possible conversion premium? A company will aim to issue bonds with the greatest possible conversion premium because this will mean that for the amount of capital raised it will on conversion have to issue the lowest number of new ordinary shares. What will the actual market price of convertible bonds depend on? 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 takes place The market s expectation as to the future equity returns and the risk associated with these returns Why do many companies issue convertible bonds? Many companies issue convertible bonds expecting them to be converted. They view the bonds as delayed equity. They are often used either because the company s ordinary share price is considered to be particularly depressed at the time of the issue or because the issue of equity shares would result in an immediate and significant drop in earnings per share. What are the different forms of security? Fixed charge Floating charge What is a fixed charge security? Fixed charge security is security that relates to specific asset or group of assets. Companies cannot dispose of the assets without providing substitute assets or consent from the lender. What are floating charge security? Floating charge security allows the company to be able to dispose of assets without consent within a class but in the event of a default the floating charge crystallizes on the class of assets.

6 What are irredeemable or undated bonds? Irredeemable or undated bonds are bonds without redemption dates they may be redeemed by a company that wishes to pay off the debt but there is no obligation on the company to do so. What is Venture Capital? Venture capital is risk capital, normally provided in return for an equity stake. What is Equity finance? Equity finance is raised through the sale of ordinary shares to investors via a new issue or a rights issue. What are ordinary shares? Ordinary shares are issued to the owners of a company. Ordinary share have a nominal or face value. The market value of a quoted company s shares bears no relationship to their nominal value. When ordinary shares are issued for cash the issue price must be equal to or more than the nominal value of the shares. What are the rights of an Ordinary shareholder? Shareholders can attend company general meetings They can vote on important company matters They are entitled the annual report and accounts The will receive a share of any assets remaining after liquidation They can participate in any new issue of shares Which is more costly Debt or Equity? The cost of equity is always higher than the cost of debt because of the risk they bear i.e. in the event of a default shareholders are at the bottom of the creditor hierarchy in liquidation. Therefore, this greatest risk means that shareholders expect the highest return of long-term providers of finance. What are the Advantages of listing on the stock market? Access to a wider pool of finance Improved marketability of shares Enhanced public image Easier to seek growth by acquisition Original owners realising holding Original owners selling holding to obtain funds for other projects

7 What are the Disadvantages of listing on the stock market? Greater public regulation, accountability and scrutiny The legal requirements the company faces will be greater The company will be subjected to the rules of the stock exchange on which its share are listed The company will be exposed to a wider circle of investors with more exacting requirements Additional cost in making share issues such as, brokerage commissions and underwriting fees What are the methods of obtaining a listing? An unquoted company can obtain a listing on the stock market by means of a Initial public offer Placing Introduction What is an Initial Public Offer (IPO)? An initial public offer is a means of selling the shares of a company to the public at large. When companies go public for the first time, a large issue will probably take the form of an IPO know as flotation. An IPO entails the acquisition by an issuing house of a large block of shares of a company, with a view to offering them for sale to the public and investing institutions. What is placing? Placing is an arrangement whereby the shares are not all offered to the public but instead offered to a small number of investors. Placing involves approaching institutional investors privately to obtain finance. What are the advantages of Placing over IPO? Placings are much cheaper. Placings are likely to be quicker Placings are likely to involve less disclosure of information What are the disadvantages of Placing over IPO? Placing means that most of the shares are unlikely to be available for trading after flotation and that institutional shareholders will have control of the company The maximum proportion of shares that can be placed is 75% What is a stock exchange introduction? With a stock exchange introduction no shares are made available to the market, neither existing nor newly created shares; nevertheless the stock market grants a quotation. This will only happen where the shares are in a large company and are already widely held so that the market can be seen to exist.

8 What costs may companies incur when issuing shares? Underwriting costs Stock market listing fee Fees of the issuing house, solicitors, auditors and public relations consultant Charges for printing and distributing the prospectus Advertising in national newspaper How are prices set on shares for a stock market? Price similar to quoted companies According to current market conditions According to future trading prospects Desire for immediate premium P/E Ratio comparisons What are rights issues? A rights issue is an offer to existing shareholders enabling them to buy more shares usually at a price lower than the current market price. A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings. What are the advantages of a rights issue? Rights issues are cheaper than IPOs Rights issues are more beneficial to existing shareholder because new shares are issued at a discount to the current market price Relative voting rights are unaffected if shareholders all take up their rights The financing raised may reduce gearing Why must care be taken in setting a price for a rights issue? A company making a rights issue must take care in setting a price that is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share. Cum rights are shares with rights attached Ex rights are shares without rights attached Note: all existing shareholders have the right to subscribe for new shares. The shares are therefore described as being Cum rights. On the first day of dealings in the newly issued shares the rights no longer exist and the old shares are now ex rights. How would you calculate the theoretical ex-rights price?

9 (Old market price + new issue price) / # of shares after rights Internal sources of finance and dividend policy What are internal sources of finance? Retained earnings Increasing working capital management efficiency What is retained earnings? Retained earnings is surplus cash that has not been needed for operating costs, interest payments, tax liabilities, asset replacement or cash dividends. Retain earning is earnings the business has made that have been retained within the business rather than utilized. Retained earnings belong to shareholders and are classed as equity financing. What are the advantages of using retained earnings? Retained earnings are a flexible source of finance no specific repayments Using retained earnings does not dilute control Retained earnings have no issue costs What are the disadvantages of using retained earnings? Shareholders may be sensitive to the loss of dividends Potential opportunity cost that if dividends were paid the cash received could be invested by shareholders How can increasing working capital management efficiency be a good source of internal finance? By increasing working capital management efficiency savings can be generated through efficient management of trade receivables, inventory, cash and trade payables. Efficient working capital management can reduce bank overdraft and interest charges as well as increasing cash reserves. Dividend Policy: Dividends are paid out of retained earnings Large fluctuations in dividends payments can undermine investors confidence Dividends may be treated as a signal to investors about the company s health The amount of earnings retained within the business has a direct impact on the amount of dividends paid A company that is looking for extra funds, say from a bank, will not be expected to pay generous dividends The dividend policy of a business can affects the total shareholder return and therefore shareholder wealth

10 Shareholder have the power to vote to reduce the size of the dividend at the AGM but not the power to increase the dividend In practice shareholders will usually be obliged to accept the dividend policy that has been decided on by the directors, or otherwise to sell their shares When deciding upon the dividends to pay out to shareholders one of the main considerations of the directors will be the amount of earnings they wish to retain to meet financing needs Other influences on dividends policy include: o The need to remain profitable an unprofitable company cannot for ever pay dividends o The law on distributable profits o Government impositions on the amount of dividends companies can pay o Dividend restraints imposed by covenants on loan agreements o The effect of inflation o The company s gearing level o The company s liquidity position the company must have cash to pay dividends o The need to repay debt in the near future o The ease with which the company could raise extra finance from sources other than retained earnings o The signalling effect of dividends to shareholders and the financial markets in general What are the different Theories of dividend policy? Residual theory Traditional view Irrelevancy theory The residual theory: The residual theory states that if a company can identify projects with positive NPVs it should invest in them and that only when these investment opportunities are exhausted should dividends be paid. Traditional view: The traditional view of dividends policy states that focus should be put on the effects of share price. The price of a share depends upon the mix of dividends, given shareholders required rate of return, and growth. Irrelevancy theory: Modigliani and Miller proposed that in a tax-free world, shareholders are indifferent between dividends and capital gains, and the value of a company is determined solely by the earning power of its assets and investments. Modigliani and Miller argued that if a company with investment opportunities decides to pay a dividend, so that retained earnings are insufficient to finance all its investments, the shortfall in funds will be made up by obtaining additional funds from outside sources. Modigliani and Miller argued

11 that each corporation would tend to attract to itself a clientele consisting of those preferring its particular payout ratio so dividends payment would be irrelevant. What are the strong arguments against Modigliani and Miller? Differing rates of taxation on dividends and capital gains can create a preference for high dividend or one for high earnings Dividend retention would be preferred by companies in a period of capital rationing Due to imperfect markets and the possible difficulties of selling shares easily at a fair price, shareholders might need high dividends in order to have funds to invest in opportunities outside the company Because of transaction costs on the sale of shares, investors who want some cash from their investments will prefer to receive dividends rather than to sell some of their shares to get the cash they want Information available to shareholders is imperfect Shareholders will tend to prefer a current dividend to future capital gains because the future is more uncertain What are Scrip dividends? Scrip dividend is a dividend paid by the issue of additional company shares rather than by cash. What are the advantages of scrip dividends? The can preserve a company s cash position Investors may be able to obtain tax advantages if dividends are in the form of shares Investors can expand their holdings can do so without incurring the transaction costs A small scrip dividends issue will not dilute the share price significantly A share issue will decrease the company s gearing What are Stock splits? A stock split occurs where each ordinary share is split into two or more shares, thus creating cheaper shares with greater marketability. What is the difference between a stock split and a scrip issue? The difference between a stock split and a scrip issue is that a scrip issue coverts equity reserves into share capital, whereas a stock split leaves reserves unaffected. What is gearing? Gearing and capital structure considerations Gearing is the amount of debt finance a company uses relative to its equity finance.

12 What is the cost of debt finance? Debt finance is relatively low risk for the debt holder as it is interest-bearing and can be secured. The cost of debt for the company is therefore relatively low, however, the greater the level of debt the more financial risk to the shareholder of the company and the more return they will require. How can the financial risk of a company s capital structure be measure? Gearing ratio Debt ratio Debt/Equity ratio Interest cover What is financial gearing? Financial gearing measures the relationship between shareholders capital and reserves, and either prior charge capital or borrowings or both. With financial gearing a company is neutrally geared if the ratio is 50%, low geared below that, and highly geared above that. Financial gearing is an attempt to quantify the degree of risk involved in holding equity shares in a company, both in terms of the company s ability to remain in business and in terms of expected ordinary dividends from the company. The more geared the company is, the greater the risk will be available to distribute by way of dividend to the ordinary shareholders. Gearing ultimately measures the company s ability to remain in business. Financial gearing: Prior charge capital / Equity capital (including reserves) x 100%, or Prior charge capital / Equity plus prior charge capital x 100%, or Prior charge capital / Total capital employed x 100% Market value of prior charge capital / Market value of equity + market value of debt What is prior charge capital? Prior charge capital is capital which has a right to the receipt of interest or of preferred dividends in precedence to any claim on distributable earnings on the part of the ordinary shareholders. What is operational gearing? Operational gearing is one way of measuring business risk. Operational gearing = Contribution/Profit before interest and tax (PBIT) Contribution = Contribution is sales minus variable cost of sales Business risk refers to the risk of making low profits, or even losses, due to the nature of the business that the company is involved in.

13 If contribution is high but PBIT is low, fixed cost will be high and only just covered by contribution. Business risk, as measured by operational gearing, will be high. If contribution is not much bigger than PBIT, fixed costs will be low, and fairly easily covered. Business risk, as measured by operational gearing, will be low. What is the formula for the interest coverage ratio? Interest coverage ratio = PBIT / Interest A ratio of less than 3 times is considered low. A ratio of more than seven is usually seen as safe. What is the formula for Debt ratio? Debt ratio = Total debts: Total assets Debt does not include long-term provisions and liabilities such as deferred taxation Cost of debt The cost of debt is likely to be lower than the cost of equity, because debt is less risky from the debt holders viewpoint. Interest has to be paid no matter what the level of profits and debt capital can be secured by fixed and floating charges. Interest rate on long-term debt may be higher than interest rates on shorter-term debt, because many lenders believe longer-term lending to be riskier. Earnings per share The relationship between EPS and PBIT can be used to evaluate alternative financing plans by examining their effect on earnings per share over a range of PBIT levels. Its objective is to determine the PBIT indifference points amongst the various alternative financing plans. The indifference points between any two methods of financing can be determined by solving for PBIT the following equation: (PBIT I) (1 T)/S1 = (PBIT I) (1 - T)/S2 Where T = tax rate, I = interest payable, S1 and S2 = # shares after financing for plans 1 and 2 What is the formula for the Price-earnings ratio? P/E ratio = market price per share/earnings per share What is the P/E ratio? The P/E ratio reflects the market s appraisal of the share s future prospects. What is the formula for Dividend cover? Dividend cover = Earnings per share / Dividend per share

14 What is the formula for dividend yield? Dividend yield = gross dividend per share / market price per share x 100% What are the characteristics of SMEs? SMEs are generally: Finance for small and medium-size entities Unquoted firms Owned by a few individuals Act as a medium for self-employment of the owners What are the sources of finance available to SMEs? Owner financing Overdraft financing Equity finance Bank Loans Trade credits Leasing Venture capital Business angle financing Factoring What is owner financing? Owner financing is whereby resources or provided by the owner or owners of the entity from their personal resources or those of their family connections. What is equity financing? Equity financing can be achieved by SMEs by placing privately their shares. The problem with equity financing and SMEs: Difficult to obtain SMEs do not offer an easy exit rout for investors who want to sell their shares What are business angels? Business angels can be an important initial source of business finance. Business angels are wealthy individuals or groups of individuals who invest directly in small businesses. They are prepared to take high risks in the hope of high returns.

15 What are Grants? A grant is a sum of money given to an individual or business for a specific project or purpose. A grant usually covers only part of the total costs involved. THE END.