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

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.

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.

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

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 markets 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
companys 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.

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 companys 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

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.

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?

(Old shares @ market price + new share @ 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 companys 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

 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 companys gearing level
o The companys 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

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 companys 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 companys 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.

Gearing and capital structure considerations

What is gearing?
Gearing is the amount of debt finance a company uses relative to its equity finance.

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 companys 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
companys 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 companys 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.

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 markets appraisal of the shares future prospects.
What is the formula for Dividend cover?
Dividend cover = Earnings per share / Dividend per share

What is the formula for dividend yield?

Dividend yield = gross dividend per share / market price per share x 100%

Finance for small and medium-size entities

What are the characteristics of SMEs?
SMEs are generally:
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.

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.

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