Sources of Finance

The need for 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.

Short Term Sources of Finance:

Overdraft:
Overdraft is a credit facility provided by the bank where payments from a current account exceed
income for a temporary period. Overdraft shares the most important source of short-term finance
available to businesses. They can be arranged relatively quickly, and offer a level of flexibility with
regard to the amount borrowed at any time, whilst interest is only paid when the account is overdrawn.

Advantages of Overdrafts

Flexible An overdraft is facility that is available with the business every time but it is going to cost only
when business uses it. It is customized and tailor made service hence flexible enough to cover short
term liquidity problems.
Quick Overdrafts are easy and quick to arrange, providing a good cash flow backup.
Disadvantages of Overdrafts
Cost Overdrafts carry interest and fees; often at much higher rates than loans. This makes them very
expensive for long term borrowing. Businesses also face large charges if it goes over the agreed
overdraft limit.
Recall Unless specified in the terms and conditions, the bank can recall the entire overdraft at any
time, so it means that technically it is repayable on demand. This may happen if business fails to make
other payments, or it has broken terms and conditions; though sometimes the banks simply change
their policies.
Security Overdrafts may need to be secured against your business assets, which put them at risk if you
cannot meet repayments.
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 installments. Term loans are offered with a
variety of repayment schedules. Often, the interest and capital repayments are predetermined.




Advantages:

1) The customer knows what he will be expected to pay back at regular intervals and the bank can
also predict its future income with more certainty, so both parties can better manage their cash
flows.
2) Once the loan is agreed, the term of the loan must be adhered to and hence it is not repayable
on demand by the bank.
Disadvantage:

1) As the bank provides the loan for a longer period of time therefor it often attaches covenants
with the bank loan agreement that the company must have to comply with.
2) Once the company has taken a loan from the bank it must have to bear the finance cost whether
it uses the cash or not.

Advantages of an overdraft over a loan
1) The customer only pays interest when he is 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.
Advantages of a loan for longer term lending
1) Both the customer and the bank know exactly what the repayments of the loan will be and how
much interest is payable, and when. This makes planning easier.
2) The customer does not have to worry about the bank deciding to reduce or withdraw an
overdraft facility.
3) Loans are not repayable on demand as in case of overdrafts.

However, in short, working capital may be financed through overdrafts in short run and for capital assets
loan would be a better source of finance as the benefits from capital assets usually takes longer time to
realize.

Calculation of repayments on a loan
For example, a $30,000 loan is taken out by a business at a rate of 12% over 5 years.
What will be the annual payment?

The annuity factor for 12% over 5 years is 3.605. Therefore:
$30,000 = 3.605 x annual payment.
Annual payment =30,000/3.605= $8,321.78

Trade credit
Trade credit is one of the main sources of short-term finance for a business. Current assets such as raw
materials may be purchased on credit with payment terms normally varying from between 30 to 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.
Unacceptable delays in payment will worsen a company's credit rating and additional credit may
become difficult to obtain.

Operating Lease:
Operating leasing is a popular source of finance for companies of all sizes and many reasons have been
advanced to explain this popularity.

An operating lease is seen as protection against obsolescence, since it can be cancelled at short notice
without financial penalty. The lessor will replace the leased asset with a more up-to-date model in
exchange for continuing leasing business. This flexibility is seen as valuable in the current era of rapid
technological change, and can also extend to contract terms and servicing cover.

Operating leasing is often compared to borrowing as a source of finance and offers several attractive
features in this area. There is no need to arrange a loan in order to acquire an asset and so the
commitment to interest payments can be avoided, existing assets need not be tied up as security and
negative effects on return on capital employed can be avoided.

Operating leasing can therefore be attractive to small companies or to companies who may find it
difficult to raise debt. Operating leasing can also be cheaper than borrowing to buy. There are several
reasons why the lessor may be able to acquire the leased asset more cheaply than the lessee, for
example by taking advantage of bulk buying, or by having access to lower cost finance by virtue of being
a much larger company. The lessor may also be able use tax benefits more effectively than the lessee. A
portion of these benefits can be made available to the lessee in the form of lower lease rentals, making
operating leasing a more attractive proposition that borrowing.

Operating leases also have the attraction of being off-balance sheet financing, in that the finance used
to acquire use of the leased asset does not appear in the balance sheet.

Finance leasing may have further advantages for the lessee:
1) The lessee may not have enough cash to pay for the asset, and would have difficulty obtaining a
bank loan to buy it. If so the lessee has to rent the asset to obtain use of it at all.
2) Finance leasing may be cheaper than a bank loan.
3) The lessee may find the tax relief available advantageous.

Sale and Lease back:
A company would raise more cash from a sale and leaseback arrangement than from a mortgage, but
there are significant disadvantages.
1) The company loses ownership of a valuable asset which is almost certain to appreciate over
time.
2) The future borrowing capacity of the firm will be reduced, as there will be fewer assets to
providesecurity for a loan.
3) The real cost is likely to be high, particularly as there will be frequent rent reviews.

DEBT FINANCING

When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes it is
called debt financing. In return for lending the money, the individuals or institutions become creditors or
lenders and receive a promise that the principal and interest on the debt will be repaid.





Bond:
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. Bonds have a
nominal value, which is the debt owed by the company, and interest is paid at a stated 'coupon' on this
amount.
Debt is often issued at par, i.e. with $100 payable per $100 nominal value. Where the coupon rate is
fixed at the time of issue, it will be set according to prevailing market conditions given the creditrating of
the company issuing the debt. Subsequent changes in market (and company) conditions will cause the
market value of the bond to fluctuate, although the coupon will stay at the fixed percentage of the
nominal value.

Deep discount bonds:
These 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.

Attractions:
Investors might be attracted by the large capital gain offered by the bonds.
The gain gets taxed in one lump on maturity or sale, not as amounts of interest each year.
However, deep discount bonds will carry a much lower rate of interest than other types of bond.

Zero coupon bonds :
These bonds 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

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.

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 marketvalue will
depend on the remaining term to maturity and current market interest rates.Investors might be
attracted by the large capital gain offered by the bonds.The gain gets taxed in one lump on maturity or
sale, not as amounts of interest each year.

Convertible bonds:
Thesebonds give the holder the right to convert to other securities, normally ordinary shares, at a pre-
determined price and time.

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 MPS (ordinary shares)
Conversion premium = Current market value current conversion value
Example:
The 10% convertible bonds of Starch white are quoted at $142 per $100 nominal. The earliest date
forconversion is in four 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.
Required:
(a) Calculate the current conversion value.
(b) Calculate the conversion premium and comment on its meaning.

A company will aim to issue bonds with the greatest possible conversion premium as this will mean that,
for the amount of capital raised, it will, on conversion, have to issue the lowest number of new ordinary
shares.The premium that will be accepted by potential investors will depend on the company's growth
potential and so on prospects for a sizeable increase in the share price.

Convertible bonds issued at par normally have a lower coupon rate of interest than straight debt.
It is, of course, also one of the reasons why the issue of convertible bonds is attractive to a company,
particularly one with tight cash flows around the time of issue, but an easier situation when the notes
are due to be converted.

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 value falls to this
minimum, it follows that the market attaches no value to the conversion rights.
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

Most companies issuing convertible bonds expect 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 issue or because the issue of equity shares would result in an
immediate and significant drop in earnings per share. There is no certainty, however, that the security
holders will exercise their option to convert; therefore the bonds may run their full term and need to be
redeemed.

Example:
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

Warrants give the holder the right to subscribe at a fixed future date for a certain number of ordinary
shares at a predetermined price.
If warrants are issued with loan notes, the loan notes are not converted into equity. Instead bond
holders:
make a cash payment for the shares
retain the loan notes until redemption.

Often used as sweeteners on debt issues:
interest rate on the loan is low and loan may be unsecured
right to buy equity set at an attractive price.
bond holders can sell the warrants after buying the loan notes, thereby decreasing the cost of buying
the loan notes

Security:
Bonds will often be secured. Security may take the form of either a fixed charge or a floating charge.
Fixed Charge:
Security relates to specific asset/groupof assets (land and buildings)
Company can't dispose of assets without providing substitute/consent of lender
Floating Charge:
Security in event of default is whatever assets of the class secured (inventory/trade receivables)
company then owns
Company can dispose of assets until default takes place
In event of default lenders appoint receiver rather than lay claim to asset

Not all bonds are secured. Investors are likely to expect a higher yield with unsecured bonds to
compensate them for the extra risk.

Venture Capital:
Venture capital is a type of business financing provided by investors to startup firms and small
businesses with perceived long-term growth potential. This is a very important source of funding for
startups that do not have access to capital markets. It typically entails high risk for the investor, but it
has the potential for above-average returns.

Types of venture capital investments include:
1) Business start-ups. When a business has been set up by someone who has already put time
andmoney into getting it started, the group may be willing to provide finance to enable it to get
off theground.
2) Business development. The group may be willing to provide development capital for a
companywhich wants to invest in new products or new markets or to make a business
acquisition, and sowhich needs a major capital injection.
3) Management buyouts. A management buyout is the purchase of all or parts of a business from
itsowners by its managers.

Venture capitalists look for following points in the investment company:
1) The institution will want an equity stake in the company.
2) It will need convincing that the company can be successful.
3) It may want to have a representative appointed to the companys board, to look after its
interests,or an independent director.
4) Safe exit of investment.



Equity Financing:

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

Ordinary shares are issued to the owners of a company. Ordinary shareholders are the ultimate bearers
of risk as they are at the bottom of the creditor hierarchy in liquidation. This means there is a significant
risk they will receive nothing after all of the other tradepayables have been paid.
This greatest risk means that shareholders expect the highest return of long-term providers of finance.
The cost of equity finance is therefore always higher than the cost of debt.


Advantages of listing:
A company can obtain a stock market listing for its shares through a public offer or a placing.

Advantages:
1) Access to wider pool of finance.
2) Better marketability of shares.
3) Enhanced public reputation and image.
4) Easier to growth as it can acquire other companies.
5) Owners will have easy exit to their investment by selling shares.

Disadvantages:
The owners of a company seeking a stock market listing must take the following disadvantages into
account:
1) There will be significantly greater public regulation, accountability and scrutiny.
2) The legalrequirements the company faces will be greater, and the company will also be subject
to the rulesof the stock exchange on which its shares are listed.
3) A wider circle of investors with more exacting requirements will hold shares.
4) There will be additional costs involved in making share issues, including brokerage
commissionsand underwriting fees.

Methods of obtaining a listing
An unquoted company can obtain a listing on the stock market by means of a:
Initial public offer (IPO)
Placing
Introduction

Initial public offer
An initial public offer (IPO) is an invitation to apply for shares in a company based on information
contained in a prospectus. An initial public offer (IPO) 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. This is known as flotation.

Placing
A placing is an arrangement whereby the shares are not all offered to the public, but instead, the
sponsoring market maker 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:
1) Placings are much cheaper. Approaching institutional investors privately is a much cheaper way
ofobtaining finance, and thus placings are often used for smaller issues.
2) Placings are likely to be quicker.
3) Placings are likely to involve less disclosure of information.
4) 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 afterthe flotation, and that institutional shareholders will have control of the company.

Stock Exchange introduction:
It is usually done whereshares in a large company are already widely held, so that a market can be seen
to exist. A company mightwant an introduction to obtain greater marketability for the shares, a known
share valuation forinheritance 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
Stock market listing fee (the initial charge) for the new securities
Fees of the issuing house, solicitors, auditors and public relations consultant
Charges for printing and distributing the prospectus
Advertising in national newspapers

Underwriting:
A company about to issue new securities in order to raise finance might decide to have the issue
underwritten. Underwriters are financial institutions which agree to buy at the issue price any securities
which are not subscribed for by the investing public.
Underwriters remove the risk of a share issue's being under-subscribed, but at a cost to the company
issuing the shares. It is not compulsory to have an issue underwritten. Ordinary offers for sale are most
likely to be underwritten although rights issues may be as well.

Rights issues:
A rights issue is an offer to existing shareholders to subscribe for newshares, at a discount to the current
market value, in proportion to theirexisting holdings.
This right of preemption:
enables them to retain their existing share of voting rights
can be waived with the agreement of shareholders.
Shareholders not wishing to take up their rights can sell them on the stock market.
Advantages:
it is cheaper than a public share issue
it is made at the discretion of the directors, without consent of the shareholders or the Stock
Exchange.
it rarely fails.

Theoretical Ex Right Price:
The new share price after the issue is known as the theoretical ex rights price and is calculated by finding
the weighted average of the old price and the rights price, weighted by the number of shares.


The formula is:
Market value of shares already in issue + proceeds from new share issue
Exrights=
price Number of shares in issue after the rights issue ('ex rights')

Example: 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.

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.

The value of a right:
To make the offer relatively attractive to shareholders, new shares are generally issued at a discount on
the current market price.

Value of a right = theoretical ex rights price issue (subscription) price
Since rights have a value, they can be sold on the stock market in the period between:
the rights issue being announced and the rights to existing shareholders being issued, and
the new issue actually taking place.

What is the value of the right in Babbel Co?
What is the value of the right in ABC Co?

Shareholders options
The shareholders options with a rights issue are to:
(1) take up his rights by buying the specified proportion at the price offered
(2) renounce his rights and sell them in the market
(3) do nothing.

Example:
Using the information in test your understanding 1, a shareholder B had 1,000 shares in Babbel Co
before the rights offer. Calculate the effect on the net wealth of B of each of the following options:
(1) Take up the shares.
(2) Sell the rights.
(3) Do nothing.
The facts were:
Rights issue 1:2
Cum rights price: $2.70
Exrights price: $2.50
Issue price $2.10
Note:
Cum rights price = market value of the share before the rights issue.
Buyers of shares quoted cum rights are entitled to forthcoming rights.

Example:
Musk currently has 4,000,000 ordinary shares in issue, valued at $2 each, and the company has annual
earnings equal to 20% of the market value of the shares. A one for four rights issue is proposed, at an
issue price of $1.50. If the market continues to value the shares on a price/earnings ratio of 5, what
would be the value per share if the new funds are expected to earn, as a percentage of the money
raised:
(a) 15%?
(b) 20%?
(c) 25%?
How do these values in (a), (b) and (c) compare with the theoretical ex rights price? Ignore issue costs.

a) If the additional funds raised are expected to generate earnings at the same rate as existing
funds, the actual market value will probably be the same as the theoretical ex rights price.
b) If the new funds are expected to generate earnings at a lower rate, the market value will fall
belowthe theoretical ex rights price. If this happens, shareholders will lose.
c) If the new finds are expected to earn at a higher rate than current funds, the market value
shouldrise above the theoretical ex rights price. If this happens, shareholders will profit by
taking up theirrights.
The decision by individual shareholders as to whether they take up the offer will therefore
depend on: The expected rate of return on the investment (and the risk associated with it)
The return obtainable from other investments (allowing for the associated risk)