Sources of

finance

Selection of appropriate sources of finance

Firms need funds to:
 Provide working capital
 Invest in noncurrent assets.

The main source of funds available is retained earnings, but these are unlikely
to be sufficient to finance all business needs.

Criteria for choosing between sources of finance

A firm must consider the following factors:

A vast range of funding alternatives is open to companies and new

developments occur every day. Before examining the various sources of
finance available it is useful to consider some of the criteria, which may be
used to choose between them.

Cost
The higher the cost of funding, the lower the firm’s profit. Debt finance tends
to be cheaper than equity. This is because providers of debt take less risk
than providers of equity and therefore earn less return. Interest on debt
finance is also normally corporation tax deductible, while returns on equity are
not.

Duration
Finance can be arranged for various time periods. Normally, but not
invariably, long-term finance is more expensive than short-term finance. This
is because lenders normally perceive the risks as being higher on long-term
advances. Long-term finance does, however, carry the advantage of security,
whereas sources of short-term finance can often be withdrawn at short notice.
You should remember ’The Matching Principle’ that says:

‘Long-term assets should be financed by long-term funds and short-term

assets (to some extent) by short-term funds’.

We would generally expect to see working capital financed partly by short-

term facilities such as overdraft, whilst fixed assets should be funded by long-
term funds. This principle is commonly broken to gain access to cheap short-
term funds but the risks involved should be appreciated.

Term structure of interest rates

The term structure of interest rates describes the relationship between interest
rates charged for loans of differing maturities.

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While short-term funds are usually cheaper than long-term funds, this situation
is sometimes reversed and interest rates should be carefully checked.

Imagine the situation where the money markets expected interest rates to fall
in the long-term but remain high in the short-term. In this situation borrowing
short-term could prove quite expensive.

Gearing
Gearing is the ratio of debt to equity finance. Gearing will be investigated in
depth later, but for now we should appreciate that although high gearing
involves the use of cheap debt finance, it does bring with it the risk of having
to meet regular repayments of interest and principal on the loans. If these are
not met, the company could end up in liquidation.

On the other hand, too little debt could result in earnings dilution. For example
the issue of a large amount of equity to fund a new project could result in a
decrease in earnings per share (EPS), despite an increase in total earnings.

Accessibility
Not all companies have access to all sources of finance. Small companies
traditionally have problems in raising equity and long-term debt finance.
These problems are investigated later in this chapter but remember that many
firms do not have an unlimited choice of funding arrangements.

A quoted company is one whose shares are dealt in on a recognised stock

market, so shares in such a company represent a highly liquid asset. This, in
turn, makes it much easier to attract new investors to buy new shares issued
by the company because these investors know that they can always sell their
shares if they wish to realise their investment.

Investment in shares of unquoted companies represents the acquisition of a

highly illiquid investment. For this reason it is much more difficult for such a
company to raise finance by new share issues.

Short –term sources of finance

Sources of short-term finance include:
 Bank overdrafts
 Short-term bank loans
 Better management of working capital
 Trade credit
 Leasing
 Sale and leaseback

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Overdraft

Where payments from a current account exceed income to the account for a
temporary period, the bank may agree to finance a deficit balance on the
account by means of an overdraft.

Characteristics of overdraft
1. Amount
The bank specifies an overdraft limit. The overdrawn (negative) balance
on the account cannot exceed this limit. The bank usually decides the limit
with reference to the borrower's known income. Overdraft borrowing is
through the borrower's normal business bank account.

2. Margin
Interest charged at the bank's administrative base rate plus a margin. This
rate is usually higher than the rate for a short-term bank loan.

3. Purpose
Generally to cover short-term deficits in cash flows from normal business
operations.

4. Repayment
Technically, repayable on demand. If a bank ends an overdraft facility
without warning, the borrower could face a risk of insolvency.

5. Security
Depends on size of facility.The bank may ask for security (collateral) but
often does not.

6. Benefits
The customer has flexible means of short-term borrowing; the bank has to
accept fluctuations in amount of lending.

The bank will generally charge a commitment fee when a customer is

granted an overdraft facility or an increase in their overdraft facility. This is a
fee for granting an overdraft facility and agreeing to provide the customer with
funds if and whenever they need them.

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

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reductions in the hard core of an overdraft would typically be a requirement of
the bank.

Short term loan

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
the borrower does not act in accordance with the covenants, the loan can be
considered in default and the bank can demand payment.

Advantages of an overdraft over a loan

1. The customer only pays interest when they are overdrawn.
2. 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.
3. An overdraft can do the same job as a loan: a facility can simply be
renewed every time it comes up for review.

Bear in mind, however, that overdrafts are normally repayable on demand.

Advantages of a terms loan

 Both customer and bank know exactly

 what the repayments of the loan will be
 how much interest is payable
 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
 The interest rate on the loan balance is likely to be lower than the interest
charged on overdrawn balances.

Trade credit
Trade credit is a major source of short-term finance for a may be purchased
on credit, with payment terms normally varying from between 30 and 90 days.
Trade credit therefore represents an interest-free short-term loan. In a period
of high inflation, purchasing via trade credit will be very helpful in keeping
costs down. However, it is important to take into account the loss of discounts
suppliers offer for early payment.

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Unacceptable delays in payment will worsen a company's credit rating and
additional credit may become difficult to obtain.

Leasing
Leasing is a means of financing the use of capital equipment, the underlying
principle being that use is more important than ownership. lt is a medium-term
financial arrangement, usually from one to ten years.
There are two main types of lease agreement:

1. Operating lease – Short term

2. Finance lease – Long term

This section will consider operating leases. Finance leases are considered
later in the chapter as a source of long-term finance.

1.Conditions Operating lease

1. Lease period:
The lease period is less than the useful life of the asset. The lessor relies
on subsequent leasing or eventual sale of the asset to cover his capital
outlay and show a profit.

2. Lessor’s business:
The lessor may very well carry on a trade in this type of asset.

3. Risks and rewards

The lessor is normally responsible for repairs and maintenance.

4. Cancellation
The lease can sometimes be cancelled at short notice.

5. Substance:
The substance of the transaction is the short-term rental of an asset.

Sale and leaseback

A company which owns its own premises can obtain finance by selling the
property to an insurance company or pension fund for immediate cash and
renting it back, usually for at least 50 years with rent reviews every few years.
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 fewer assets to provide security for a loan.

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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 finance

Debt Finance 12/08, 6/10, 12/10, 6/14

Long-term finance is used for major investments and is usually more

expensive and less flexible than short-term finance.

Reasons for seeking debt finance

1. Businesses may need long-term funds but may not wish to issue equity
capital
2. Current shareholders may be unwilling to contribute additional capital
3. The company may not want to involve outside shareholders who may
have burdensome requirements
4. Debt finance is cheaper and easily available if the company has little or
no existing debt finance
5. Debt finance provides tax relief

Factors influencing choice of debt finance 12/08, 12/10, 6/12

The choice of debt finance that a company can make depends on:
 The size of the company; a public issue of bonds is only available to a
large company
 The duration of the required financing
 Whether a fixed or floating interest rate is preferred (fixed rates are
more expensive, but floating rates are riskier)
 The security (collateral) that can be offered and the security that may
be demanded by a lender
 Company with good credit rating will be able to raise capital through
bond issues.
 Only listed companies are able to make public issue of bonds.
Most investors will not invest in bonds issued by small companies.
Smaller companies are only able to obtain significant amounts of debt
finance from a bank.

Bonds

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A written acknowledgement of a debt, usually given under the company's
seal, containing provisions for payment of interest and repayment of principal.
The debt may

 Redeemable
 Irredeemable

Zero coupon bonds

are sold at a large discount to the par value and the investor makes a capital
gain by holding the bond

Zero coupon bonds are an extreme form of deep discount bond.

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 12/07, 12/12

Convertible bonds are bonds that give the holder the right to convert to other
securities, normally ordinary shares, at a predetermined price/rate an

1. Convertible bonds are fixed-rate bonds.

2. The coupon rate of interest is lower than on similar conventional bonds.

3. They give the bond holders the right (but not an obligation) to convert their
bonds at a specified future date into new equity shares of the company, at
a conversion rate that is also specified when the bonds are issued.

4. If bondholders choose not to convert their bonds into shares, the bonds
will be redeemed at maturity, usually at nominal rate.

5. The conversion value and the conversion premium

The current market value of ordinary shares into which a bond may be
converted is known as the conversion value. The conversion value will be
below the value of the bond at the date of issue, but will be expected to
increase as the date for conversion approaches on the assumption that a
company's shares ought to increase in market value over time.

Conversion value = Conversion ratio × market price per share

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Conversion premium = Current market value – current conversion
value

 The actual market price of convertible bonds will depend on:

1. The price of straight debt
2. The current conversion value
3. The length of time before conversion may take place
4. The market's expectation as to future equity returns and the risk
associated with these returns

Test your Understanding 1

The 10% convertible bonds of Starchwhite are quoted at $142 per $100
nominal. The earliest date for conversion is in 4 years' time, at the rate of 30
ordinary shares per $100 nominal bond. The share price is currently $4.15.
Annual interest on the bonds has just been paid.

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.
Required
(a) Calculate the current conversion value.
(b) Calculate the conversion premium and comment on its meaning.

Test your understanding 2

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

Deep discount bonds

Deep discount bonds are bonds or 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 nominal value (or above nominal value) when they eventually
mature.

For example, a company might issue $1,000,000 of bonds in 20X1, at a price

of $50 per $100 of bond, and redeemable at nominal value in the year 20X9.

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The coupon rate of interest will be very low compared with yields on
conventional bonds with the same maturity.

Investors might be attracted by the large capital gain offered by the bonds,
which is the difference between the issue price and the redemption value.

The only tax advantage is that the gain gets taxed (as income) in one lump on
maturity or sale, not as amounts of interest each year.
The borrower can, however, deduct notional interest each year in computing
profits.

The main benefit of deep discount bonds for a company is that the interest
yield on the bonds is lower than on conventional bonds.

Security
Bonds may be secured. Bank loans are often secured. Security may take the
form of either a fixed charge or a floating charge

Fixed charge
1. Security relates to specific asset/group of assets (land and buildings)
2. Company can't dispose of assets without providing substitute/consent
of lender

Floating charge
1. Security in event of default is whatever assets of the class secured
(inventory/trade receivables) company then owns
2. Company can dispose of assets until default takes place
3. In event of default lenders appoint receiver rather than lay claim to
asset

Investors are likely to expect a higher yield with unsecured bonds to

compensate them for the extra risk. Similarly, a bank may charge higher
interest for an unsecured loan

Long-term finance – leasing

The key difference between an operating lease (short-term) and a finance

lease (medium to long-term) is that the former equates to renting an asset
whereas the latter equates to borrowing money in order to purchase the
asset.

Long-term lease arrangements are likely to be a finance lease:

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Conditions

1. Lease period:

One lease exists for the whole useful life of the asset though may be a
primary and secondary period.

2. Lessor’s business:

The lessor does not usually deal directly in this type of asset.

3. Risks and rewards:

The lessor does not retain the risks or rewards of ownership. Lessee
responsible for repairs and maintenance.

4. Cancellation:
The lease agreement cannot be cancelled. The lessee has a liability for all
payments.

5. Substance:
The purchase of the asset by the lessee financed by a loan from the
lessor, i.e. it is effectively a source of medium- to long-term debt finance.

Venture capital
Venture capital is the provision of risk bearing capital, usually in the form of a
participation in equity, to companies with high growth potential.
Venture capitalists provide startup and late stage growth finance, usually for
smaller firms.
Venture capitalists will assess an investment prospect on the basis of its:
 Financial outlook
 Management credibility
 Depth of market research
 Technical abilities
 Degree of influence offered:
– Controlling stake?
– Board seat?
 Exit route.

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Equity finance and preference shares 6/11, 6/13
Equity finance is raised through the sale of ordinary shares to investors via a
new issue or a rights issue.

Ordinary Shares
Ordinary shares are issued to the owners of a company.

Ordinary shareholders have rights as a result of their ownership of the shares.

a) Shareholders can attend company general meetings.
b) They can vote on important company matters such as the
appointment and re-election of directors; approving a takeover bid
for another company, where the financing arrangements will involve a
large new issue of shares; the appointment of auditors; or (possibly,
as in the UK) approving the company's remuneration policy for
senior executives.
c) They are entitled to receive a share of any agreed dividend.
d) They will receive the annual report and accounts.
e) They will receive a share of any assets remaining after liquidation.
f) They can participate in any new issue of shares, unless they agree to
waive this right.

Ordinary shareholders are the ultimate bearers of risk, as they are at the
bottom of the creditor hierarchy in a liquidation.

This high equity risk means that shareholders expect the highest return of
long-term providers of finance, in the form of dividend yields, dividend growth
and share price growth.

The cost of equity finance is therefore always higher than the cost of debt.

Methods of obtaining a listing

An unquoted company that is becoming listed for the first time can issue
shares on the stock market by means of:
 An initial public offer (IPO)
 A placing
 An introduction

Initial public offer

An initial public offer (IPO) is a means of selling the shares of a company to
the public at large for the first time. When companies 'go public' for the first
time, a large issue will probably take the form of an IPO. This is known as
flotation.

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Subsequent issues are likely to be placings or rights issues, described
later.

An IPO entails the acquisition by an issuing house (an investment bank acting
for the company) of a large block of shares of a company, with a view to
offering them for sale to the public and investing institutions.

The issuing house accepts responsibility to the public, and gives to the issue
the support of its own standing.

A placing
A placing is an arrangement whereby, instead of offering the shares to the
general public, the sponsoring investment bank 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.

The choice between an IPO and a placing

Is a company likely to prefer an IPO of its shares, or a placing?
a) Placings are much cheaper. Approaching institutional investors
privately is a much cheaper way of obtaining finance, and thus placings
are often used for smaller issues.
b) Placings are likely to be quicker.
c) Placings are likely to involve less disclosure of information.
d) However, most of the shares will be placed with a relatively small
number of (institutional) shareholders, which means that most of the
shares are unlikely to be available for trading after the flotation, and
that institutional shareholders will have control of the company.
e) When a company first comes to the market, there may be a restriction
on the proportion of shares that can be placed, or a minimum
proportion that must be offered to the general public.

A stock exchange introduction

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. This will only happen where shares in a large
private 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.

Costs of share issues on the stock market

Companies may incur the following costs when issuing shares.
 Underwriting costs (see below)

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 Stock market listing fee (the initial charge) for the new securities
 Fees of the issuing house (investment bank), solicitors, auditors and
public relations consultant
 Charges for printing and distributing the prospectus: (the prospectus is
the document in which the company offers its shares for sale)
 Advertising in national newspapers

Underwriting
A company about to issue new securities in order to raise finance may decide
to have the issue underwritten. Underwriters are financial institutions, which
agree (in exchange for a fixed fee, perhaps 2.25% of the finance to be raised)
to buy at the issue price any securities, which are not subscribed for by the
investing public.

Underwriters remove the risk of a share’s issue being undersubscribed, but at

a cost to the company issuing the shares. It is not compulsory to have an
issue underwritten. Ordinary offers for sale (IPOs) are likely to be
underwritten, although rights issues may be as well.

Rights issues 12/07, 6/08, 12/08, 6/09, 12/09, 12/10, 6/14

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, and in
proportion to their existing shareholding.

The major advantages of a rights issue are as follows.

1. Rights issues are cheaper than IPOs to the general public. This is
partly because no prospectus is normally required, partly because the
administration is simpler and partly because the cost of underwriting
will be less.
2. Rights issues are more beneficial to existing shareholders than
issues to the general public. New shares are issued at a discount to the
current market price to make them attractive to investors. A rights issue
secures the discount on the market price for existing shareholders,
who may either keep the shares or sell them if they wish.
3. Relative voting rights are unaffected if shareholders all take up their
rights.
4. The finance raised may be used to reduce gearing in book value
terms by increasing share capital and/or to pay off long-term debt,
which will reduce gearing in market value terms.

When a rights issue is announced, all existing shareholders have the right to
subscribe for new shares, and so there are rights attached to the existing
shares. The shares are therefore described as being 'cum rights' (with

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rights attached) and are traded 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' (without rights attached).

After the announcement of a rights issue, share prices normally fall.

Test your understanding 3

Fundraiser has 1,000,000 ordinary shares of $1 in issue, which has a market
price on 1 September of $2.10 per share. The company decides to make a
rights issue, and offers its shareholders the right to subscribe for one new
share at $1.50 each for every four shares already held. After the
announcement of the issue, the share price fell to $1.95, but by the time just
prior to the issue being made, it had recovered to $2 per share. This market
value just before the issue is known as the cum rights price. What is the
theoretical ex-rights price?

The theoretical gain or loss to shareholders

The possible courses of action open to shareholders are:

1. To 'take up' or 'exercise' the rights; that is, to buy the new shares at
the rights price. Shareholders who do this will maintain their percentage
holdings in the company by subscribing for the new shares.
2. To 'renounce' the rights and sell them on the market. Shareholders
who do this will have lower percentage holdings of the company's
equity after the issue than before the issue, and the total value of their
shares will be less.
3. To renounce part of the rights and take up the remainder. For
example, a shareholder may sell enough of their rights to enable them
to buy the remaining rights shares they are entitled to with the sale
proceeds, and so keep the total market value of their shareholding in
the company unchanged.
4. To do nothing. Shareholders may be protected from the
consequences of their inaction because rights not taken up are sold on
a shareholder's behalf by the company. If new securities are not taken
up, they may be sold by the company to new subscribers for the benefit
of the shareholders who were entitled to the rights.

Test your understanding 4

Gopher has issued 3,000,000 ordinary shares of $1 each, which are at
present selling for $4 per share. The company plans to issue rights to
purchase 1 new equity share at a price of $3.20 per share for every 3 shares
held. A shareholder who owns 900 shares thinks that they will suffer a loss in
their personal wealth because the new shares are being offered at a price

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lower than market value. On the assumption that the actual market value of
shares will be equal to the theoretical ex-rights price, what would the effect on
the shareholder's wealth be if:

a. They sell all the rights

b. They exercise half the rights and sell the other half
c. They do nothing at all

Test your understanding 5 – TERP

Babbel Co, which has an issued capital of 2 million shares, having a current
market value of $2.70 each, makes a rights issue of one new share for every
two existing shares at a price of $2.10.
Required: Calculate the TERP.

Test your understanding 6 – TERP

ABC Co announces a 2 for 5 rights issue at $2 per share. There are currently
10 million shares in issue, and the current market price of the shares is $2.70.
Required:
Calculate the TERP

Test your understanding 7 – The value of a right

What is the value of the right in Babbel Co?

Test your understanding 8 – The value of a right

What is the value of the right in ABC Co?

Test your understanding 9

Alpha Co has issued share capital of 100 million shares with a current market
value of $0.85 each. It announces a 1 for 2 rights issue at a price of 40c per
share. It therefore plans to raise $20 million in new funds by issuing 50 million
new shares.
Calculate the exrights price and for a shareholder, B, holding 1,000 shares in
Alpha, consider his wealth if he:

i. takes up his rights

ii. sells his rights
iii. buys 200 shares and sells the rights to a further 300
iv. takes no action.

Test your understanding 10

Sagitta is a large fashion retailer that opened stores in India and China three
years ago. This has proved to be less successful than expected and so the

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directors of the company have decided to withdraw from the overseas market
and to concentrate on the home market. To raise the finance necessary to
close the overseas stores, the directors have also decided to make a one for
five rights issue at a discount of 30% on the current market value. The most
recent statement of profit or loss of the business is as follows.

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MAY 20X4

$m
Sales 1,400

Net profit before interest and taxation 52

Interest payable 24

Net profit before taxation 28

Company tax 7

Net profit after taxation 21

Dividends paid are $14 million

The capital and reserves of the business as at 31 May 20X4 are as follows.
$m
$0.25 ordinary shares 60.0
Accumulated profits 320.0
380.0

The shares of the business are currently traded on the stock exchange at a
P/E ratio of 16 times. An investor owning 10,000 ordinary shares in the
business has received information of the forthcoming rights issue but cannot
decide whether to take up the rights issue, sell the rights or allow the rights
offer to lapse.
Required
a) Calculate the theoretical ex-rights price of an ordinary share in Sagitta.
b) Calculate the price at which the rights in Sagitta are likely to be traded.
c) Evaluate each of the options available to the investor with 10,000
ordinary shares.
d) Discuss, from the viewpoint of the business, how critical the pricing of a
rights issue is likely to be.

Stock split
A stock split occurs where, for example, each ordinary share of $1 each is
split into two shares of 50c each, thus creating cheaper shares with greater
marketability. There is possibly an added psychological advantage in that
investors may expect a company which splits its shares in this way to be
planning for substantial earnings growth and dividend growth in the future.

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As a consequence, the market price of shares may benefit. For example, if
one existing share of $1 has a market value of $6, and is then split into two
shares of 50c each, the market value of the new shares might settle at, say,
$3.10 instead of the expected $3, in anticipation of strong future growth in
earnings and dividends.
A stock split changes the share capital but does not raise any new equity
finance for the company. It also leaves the company's reserves (as shown in
its statement of financial position) unaffected.

Scrip issue
A scrip issue occurs when a company issues new shares to existing
shareholders in proportion to their existing holdings at no charge. The issue is
made out of distributable reserves (retained profits).
A scrip issue, like a stock split, raises no extra finance for the company.
The difference between a stock split and a scrip issue is that a scrip issue
converts equity reserves into share capital, whereas a stock split leaves
reserves unaffected.
A company may make a scrip issue when it wants to pay a dividend to
shareholders, but would prefer not to pay the dividend in cash.

Preference shares
Preference shares are shares which give the right to receive dividends
(typically a fixed percentage of the nominal value of the shares) before any
dividends can be paid to ordinary shareholders.
As a source of finance, preference shares have several advantages over debt
capital.
a. Dividends do not have to be paid if company performance is poor,
whereas interest must be paid on debt capital regardless of profit.
b. Preference shares are not secured on company assets.
c. Preference shareholders usually have no voting rights so there is no
dilution of control.

There is, however, a fairly significant disadvantage.

a) Preference share capital is not as tax efficient as debt capital, as
dividends paid are not tax deductible, whereas interest on debt is.

Homework questions
1. Which of the following is a key feature of debt as a source of finance?
A. Interest must be paid irrespective of the level of profits generated by

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 Sources of
finance
the company
B. Debt holders are repaid last in the case of a winding up of the company
C. Debt holders hold full voting rights
D. Debt holders suffer relatively high levels of risk, compared to providers
of other sources of finance, and therefore debt attracts the highest
return

2. Which two of the following statements are correct?

1) Bank overdrafts are repayable on demand
2) Warrants give the holder the right to subscribe at a fixed future date for
a certain number of ordinary shares at a predetermined price
3) Preference dividends are paid before loan interest is paid
4) Deep discount bonds are issued at a discount to their redemption value
and no interest is paid on them

3. Which of the following best describes the term 'coupon rate' as applied to
loan notes?
A. The rate of stamp duty applicable to purchases of the loan notes
B. The total rate of return on the loan notes, taking into account capital
repayment as well as interest payments
C. The annual interest received divided by the current ex-interest market
price of the loan notes
D. The annual interest received on the face value of the units of the loan
notes

4. Compared to ordinary secured loan notes, convertible secured loan notes

are
A. Likely to be more expensive to service because of their equity
component
B. Likely to be less expensive to service because of their equity
component
C. Likely to be more expensive to service because converting to equity
requires the holders to make additional payments
D. Likely to be less expensive to service because they must rank after
ordinary secured loan stock

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 Sources of
finance 5.
In relation to finance leases, which of the following statements is not true?

A. The lease agreement cannot be cancelled.

B. One lease exists for the whole of useful life of the asset

C. The lessor retains the risks and rewards of ownership

D. The lessee is responsible for repairs and maintenance

6. In relation to preference shares as a source of capital for a company, fill in

the gaps below to complete the sentence.

Preference shares are a form of ........ Capital which carry ....... risk than
ordinary shares.

Choose from the following:

 Equity
 Loan
 Lower
 Higher

7. Brash Co can buy a new piece of sophisticated machinery for $500,000 by

borrowing under asecuredloanat8%. Lt has also researched the possibility
of leasing the asset.

The company's finance director is a little rusty on leasing issues as the

business has never leased before and he has worked in Brash Co for 20
years. He said 'I studied leasing years ago but I think leasing is always
cheaper than borrowing because the lease company has access to greater
amounts of finance and so benefits from economies of scale on that front'.

The managing director is sceptical, arguing that leasing companies are

commercial and so each deal must be assessed on its merits. He
commented: 'We have to careful here, I know the lease companies are
always responsible for the maintenance but that can't be free!'

The lease offer is as follows:

The lease will be an operating lease over 5 years with lease payments of
$146,000 annually in advance. Tax is payable 1 year after the accounting
year-end and the corporation tax rate is 25%. Maintenance is payable by
the lessor and costs $20,000 per annum payable at the end of each year,
including the last year in preparation for sale. The residual value is

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 Sources of
finance
expected to be $40,000 (the expected tax written down value at the end of
the lease) and the lessor will retain that.

A. Which of the statements made by the finance director and the managing
director are true?
a) Both statements are true
b) Both statements are false
c) Only the finance director is correct
d) Only the managing director is correct

B. In a calculation to compare the cost of leasing with cost of borrowing to

buy the asset above, which of the following costs are not relevant?
a) The interest cash flows saved on borrowing
b) The saving on maintenance
c) The residual value
d) The tax-allowable depreciation

C. What is the present value of the maintenance cash flows, after tax?

D. What is the present of the tax relief on the lease payments, after tax?

E. Which of the following statements about the potential affect the lease
would have on gearing are true?

a) An operating lease is off balance sheet finance and so would never

have an effect on traditional gearing ratios
b) If shareholders perceive that there is a significant operating lease in
place then they may perceive an increase in risk

8. Kelvin Co is considering an extensive rights issue to raise new finance. lt

currently has 4 million shares and has been very successful over a
prolonged period.

The terms of the deal are as follows:

 One new share for every 4 held at a price of 90% of the existing market
value per share
 The existing market value is $20 per share (the cum rights price)

One of the directors is unhappy with offering any discounts to existing

shareholders. He claims that the companies past success should be
enough to encourage shareholders to increase their investment.

20
 Sources of
finance A.
W
hat is the theoretical ex rights price (TERP) per share?

B. What would be the effect on the TERP value if the new shares were
offered at a 20% discount level whilst raising the same total amount of
finance?
a) The TERP value would not change since the total amount raised would
be the same
b) The TERP would increase
c) The TERP would fall
d) The TERP would fall to a level unacceptable to existing shareholders

C. Which of the following actions by shareholders would be the worst thing

that they could do in relation to a rights issue as far as shareholder wealth
is concerned?

a) Accept the rights offer without negotiation

b) Renounce their rights and sell them on the open market

c) Save their investment and do nothing

d) Sell 50% of their rights on the open market whilst ignoring the rest

D. Which of the following actions will result in the least dilution of control for
existing shareholders?

a) Accept the rights offer without negotiation

b) Renounce their rights and sell them on the open market

c) Save their investment and do nothing

d) Sell 50% of their rights on the open market

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