Sources of Finance

Sources of Finance:
Categorise the various sources of finance in terms
of time-frame – e.g. short-term, medium-term,
long-term

Categorise the various sources of finance in terms

of whether they necessitate ownership (in whole
or in part) of a business?

Matching principle: long-term finance used for

long-term assets, short-term finance used for
short-term assets
 Short-term Finance
and the Management of
Working Capital
Short-term finance
• Overdraft
• Short-term loan
• Trade credit
Analysis of assets
• Fixed assets
• Permanent current assets
• Fluctuating current assets
• Matching principle: long-term finance used for long-
term assets, short-term finance used for short-term
assets
https://news.sky.com/story/coronavirus-british-airways-owner-burning-178m-of-cash-a-week-12000240
Debtor management
• Debtor levels depend on terms of sale, ability of
company to finance debtors, pricing policy and debtor
collection procedures.
• Benefits of additional contribution must be set against
administrative and financial costs of offering credit.
• Administrative costs include recording, monitoring and
collecting debts: bad debt collection costs; and credit
insurance.
https://www.youtube.com/watch?v=7HmayYpsDYk
Debtor management
• Finance costs include investment in debtors and
losses due to bad debts.
• Credit analysis should be based on company’s own
experience, analysis of credit reports and analysis of
published information.
• Credit extended should reflect assessment of
creditworthiness of prospective client.
Debtor management
• Credit assessment should consider previous experience
of similar firms, credit reports and analysis of published
information.
• Company can ensure agreed terms of sale are kept
through periodic review of credit limits, aged debtor
analysis, efficient administration and agreed overdue
account procedures.
Debtor management
• Cash discounts may encourage early payment.
• Cost of discount must be compared with benefit of lower
financing charges and any decrease in risk of bad debts.
• Benefits should exceed costs.
Long-term Finance: Equity
 What is equity finance?
• Equity or Ordinary Shares gives Ownership
• Par or Nominal value versus Market value
• Par value = Nominal value = similar to face value of a concert/sport event ticket
• Share premium = difference between Par or nominal value and what was actually
paid for that share
• In Balance Sheet: Ordinary share capital is usually comprised of Ordinary shares
AND share premium. Eg 1,000 ordinary shares with a nominal value of €1 = capital
of €1,000. And if proceeds from sale of each share by the company to the
shareholders was €3: that means the share premium amount in the balance sheet
is 1,000 shares @ €2 = €2,000.
• Per balance sheet: ord share capital of €1,000 in €1 shares: how many shares?
• Ordinary share account and share premium account
• Authorised versus issued share capital. Authorised = maximum number allowed.
• Risk and the creditor hierarchy
• Shareholder returns not guaranteed
• Cost of equity higher than cost of debt or cost of preference shares
 Shareholder rights
A shareholder has the right to
• attend general meetings of company.
• vote on appointment of directors.
• vote on appointment, remuneration and removal of
auditors.
• receive annual accounts of company and report of
its auditors.
• receive a share of any dividend paid.
 Shareholder rights
A shareholder has the right to
• vote on important issues, such as permitting
repurchase of shares, using shares in a takeover
bid or a change in authorised share capital.
• receive a share of assets remaining after company
has been liquidated.
• participate in a new issue of shares of company
(the pre-emptive right).
 The stock exchange
Advantages of being listed
• Raising finance by coming to market
• Access to finance via capital markets
• Shares can be used in acquisitions
Disadvantages of being listed
• Costs of gaining/maintaining quotation
• Higher shareholder expectations
• Increased financial transparency
Stock Exchange – Function/Purpose
• To ensure a fair, orderly and efficient market for the
transfer of securities, and the raising of new capital
through the issue of new securities.
• Only suitable companies are allowed to have their
securities traded.
• All relevant information is made public as soon as is
possible.
• All investors deal on the same terms and at the same
price.
• The more efficient the market is perceived to be, the
more people will be willing to invest in it and the more
successful it will be.
 Market – Terminology
• Primary Market
– This is the name given to markets that deal with
the issuance of new securities.
• Secondary Market
– This is the name given to the markets for trading of
securities that have already been issued in an
initial private or public offering.
• Over-the-counter (OTC)
– This is a market for securities not listed on any
exchange and are traded infrequently.
• Specialist markets
Charging Bull statue on Wall Street
 Ordinary and Preference Shares
• Ordinary shares give Ownership
• Ord shares only get a dividend if the company decides to pay
a dividend
• There may be no dividend paid on ordinary shares
• Ordinary shareholders are the last people to get paid BUT if a
company is being wound-up and if there is a surplus
remaining after everyone else has been paid in full, then any
surplus belongs to the ordinary shareholders
 Ordinary and Preference Shares
• Preference share do not give Ownership
• Preference shares get preferential treatment compared to
ordinary shareholders i.e. they are effectively guaranteed to
be paid a dividend
• 5% Preference share with a nominal value of €1: this means
the preference share gets a dividend every year of 5% of the
nominal value of the preference share and NOT 5% of the
market value
 Preference shares
• Preference Shares do not give Ownership
• Equity or debt?
• Preferential right to receive dividend
• Although permanent capital, do not normally carry
voting rights
• Less risky than ordinary shares, more risky than
debt
• Cumulative and non-cumulative preference shares
 Preference shares
• Participating preference shares: both fixed and
variable dividend income
• Variable rate preference shares
• Convertible preference shares
• Popularity or otherwise of preference shares with
companies and investors
 Preference shares
Advantages of preference shares
• No need to pay dividend if profits are poor
• Do not dilute ownership and control
• Unsecured, so preserve debt capacity
• No right to appoint a receiver
Disadvantages of preference shares
• Higher cost compared to debt due to tax
inefficiency
Initial Public Offerings (IPOs)
 What is an IPO?
• An Initial Public Offering (IPO) is when a company’s
shares are listed on a stock market for the first time
• This is also called a flotation of the shares
 Things to watch for with IPOs
• What are the stated motives for proposed IPOs?
• Who are the existing shareholders? Are they maintaining /
reducing their stake?
• Is there Private Equity involvement?
• What are the historic / forecast price/earnings multiples, and
what does that say about the market?
• Would you buy shares in one of the proposed IPOs? Why?
Why not?
Benefits of Flotation
Access to capital both Easily accessed market for Increases the credibility and
the company’s shares, this reputation of the company
straight away and broadens the shareholder as stock exchanges typically
through further capital base and increases the have rigorous rules that
issues in the future. marketability of the shares. extend beyond company law.

Enables the market to

Increased public profile
Provides a quick exit place an objective value
as Plcs get more media
route for equity investors. on the company’s
attention.
business.

Plcs can easily set up

employee share schemes, Companies can issue
Provides a platform for
which can motivate and shares and use these to
the purchase and sale of
encourage employees’ purchase other
commitment to the whole companies.
companies.
company.
Disadvantages of Flotation
• Price is vulnerable to market fluctuations that are
Market risk beyond a company’s control.

• Issue costs are high and yearly compliance costs are

Costs substantial.

• The directors have to consider the interests of the equity

Agency theory holders, not just their own. This may lead to conflict.

• Original owners may lose control and ultimately the

Loss of control company may be taken over by another company.

• Increased responsibility on directors to ensure that

Regulatory burden appropriate regulatory requirements are adhered to.

• This means that other areas of the business are

Managerial time tied up deprived of managerial attention.

• If share options only offered to some employees, this may

Employee demotivation cause others to become disgruntled.
 Method of Floating Shares on the Stock Market – IPO

Offer for sale by • Shares offered by a sponsor/issuing house to private individuals or

prospectus institutional investors.
• The issue is normally underwritten.

Offer for sale • Similar to sale by prospectus except it is partially underwritten.

by subscription • The company sets a minimum bid price – final price not fixed.
(tender) • The issue price is the price at which enough shares are sold to bring in the
level of financing required

Placing Private issue – shares are not issued to the public at large. There are three
types:
• sponsor offer – sponsor sells to a small number of large investors;
• intermediaries offer – the company goes direct to institutional investors;
and
• vendor placing – company exchanges shares for the shares in the target
company (and cancel them). The shareholders of the target company
then sell the shares they have received.

An introduction • Company already partially listed, or listed on a sister exchange.

• New existing shares get introduced.
Long-term Finance:
Debt Finance, Hybrid
Finance and Leasing
Risk, return and security
• Debt is less risky than equity
• Statutory right to interest payments
• Position of debt in creditor hierarchy
• Security
• Debt is always cheaper than equity
• Lower risk, so lower return required
• Interest payments are tax-deductible (tax efficiency)
Debentures and loan stock
• Fixed or floating interest rate
• Par value of loan stock is €100
• On maturity, issue must be redeemed
• Debentures are secured:
• fixed charge
• floating charge
• Covenants written to protect investors
Other types of debt
• Subordinate debt
• Junk bonds
• Deep discount bonds: issued at deep discount to
par, so lower coupon as revenue return traded for
capital gain
• Zero coupon bonds: pay no interest so return is
entirely capital gain
• Eurobonds
Leasing
• Asset acquired even if short of cash
• Tax advantages via lease payments
• Leasing can avoid obsolescence
• Off-balance sheet financing possible
• Lessors’ size advantages
• Easier to lease than to borrow
 Operating leases
• Several lessees over useful economic life
of asset
• Maintenance costs borne by lessor
• Lease payments are tax-allowable
• Effectively a rental agreement
• Accounted for ‘off-balance sheet’
• Includes cars, computers etc.
Finance leases
• Primary lease period equal to Useful Economic Life
• Lessee responsible for maintenance and has ‘risks
and rewards of ownership’
• Accounting treatment is capitalisation of leased
asset in balance sheet, which shows both asset and
liability
• Secondary lease period at nominal rent
Venture Capital & other sources

• Comprehensive business plan essential

• Management buy-outs (MBOs) usually
financed by debt and equity
• Equity finance
• Managers prefer controlling equity stake
• Venture capitalists need exit route
• Debt finance
• Mezzanine finance