CHAPTER 15 SOURCES OF FINANCE

1. Selection of appropriate sources of finance

Firms need funds to:

- provide working capital short term

- invest in non-current assets long term Retained earnings: - main source but - insufficient Firms need alternative source of finance

1. Selection of appropriate sources of finance

Criteria for choosing between sources of finance
Factor
Cost Duration Term structure of interest rates

Issue to consider
Debt is usually cheaper Long-term finance is more expensive but secure Relationship between interest and loan duration short term debt is cheaper (not always)

Gearing
Availability

Debt is cheaper but increases risk of default

Not all sources of finance are available to all firms

2. The relation between risk and return

Investment risk - variability or - uncertainty of returns Higher investment risk - higher return required Higher return required higher cost of capital

3. Short-term sources of finance

Working capital is usually financed using short-term finance

Bank overdrafts; Bank loans; Better management of working capital; Squeezing trade credit; Operating lease (short-term)
lease period < useful life of the asset; the lessor is responsible for maintenance and repairs the lease can sometimes be cancelled at short notice Its substance is associated with that of a short-term rental

- Sale and lease-back

4. Long-term sources of finance - Equity Equity shareholders - the owners of the business; - exercise ultimate control through the voting rights Equity finance - the investment by the ordinary shareholders (ordinary shares capital) - reserves Equity relates to ordinary shares only. Preference shares (cumulative and non-cumulative) - not part of equity; - exhibit features of debt - may acquire voting rights when dividend is in arrears

5. Raising equity Three sources of equity capital

- Internally generated funds

- Retained earnings - easiest to have access to (quickly raised) - cheapest (free)

Rights issues
Offers to existing shareholders to subscribe to new shares at a discount
Placings share are placed or sold to institutional investors by way of a financial intermediary investment bank Public offers an invitation to apply for shares based on information in a prospectus - Fixed price offer - Offer for sale by tender

- New external share issues

-

6. Rights issues
A rights issue

- an offer to existing shareholders - to subscribe for new shares, - at a discount to the current market, - in proportion to their existing holdings.
Advantages: - cheaper than public share issue - made at the discretion of the directors without consent from shareholders or Stock Exchange; - it rarely fails

6. Rights issues
TERP Theoretical ex-rights price

The (theoretical) share price after the issue of the rights

TERP = the weighted average of the old price and the rights price

Market value of shares already in issue

Ex-rights price =

Proceeds from the new issue

Number of shares in issue after the rights issue (ex-rights)

6. Rights issues
The value of a right

Value of a right = TERP Issue (subscription) price

Shareholders options:

Take up the rights by buying the specified proportion at the price offered;
Renounce his rights and sell them on the market Renounce part of his rights and take up the remainder Do nothing (let the rights expire)

6. Rights issues
The value of a right
Discount
Ex-rights price (value afterwards)

Market price

Value of the right

Issue price

7. Choosing between sources of equity

(1) Accessibility of the finance

Quoted companies have access to all sources of equity finance Unquoted companies have access to rights issues or placings

(2) The amount of finance

Rights issues limited by the existing shareholders financing power Placings larger sums Public offers largest amounts

(3) Costs of the issue procedure

Retained earnings cheapest Placings and rights issues a bit more expensive Public offers most costly

7. Choosing between sources of equity

(4) Pricing of the issue

Pricing problems exist with public offers and placings No pricing ploblems are with rights issues

(5) Control
Retained earnings and rights issues do not dilute control Placings and Public offers dilute control

(6) Dividend policy

7. Choosing between sources of equity

- costs of issue and

- ease of organization
Induce the following preference order

Retained earnings
Rights issues New issues

8. Long-term finance- Debt

A loan note

a written acknowledgement of debt by a company, normally containing provisions as to - payment of interest and - the terms of repayment of principal
Loan notes/corporate bonds/loan stock/debentures Used interchangeably

8. Long-term finance- Debt

In UK or US, loan notes

- Are traded on stock markets;

- Usually denominated in blocks of $100 nominal value; - May be secured or unsecured

- May be - Redeemable (principal repaid at a future date) - Irredeemable (principal never repaid, interest paid in perpetuity)

9. Characteristics of loan notes and other long-term debt

Advantages of long-term debt For the investor Low risk -Definite maturity -Priority in interest payments -Priority on liquidation -Fixed income

For the company Cheap Predictable flows Does not dilute control

9. Characteristics of loan notes and other long-term debt

Disadvantages of long-term debt For the investor - No voting rights -Voting rights only if interest not paid For the company - Interest must be paid whatever the earnings - Inflexible -Increases risk of default at high levels of gearing - Must be repaid

9. Characteristics of loan notes and other long-term debt

Hybrid debt instruments convertibles

Convertibles give the holder the right to convert to other securities (usually ordinary shares) at either a: - predetermined price; - predetermined ratio (e.g. 1 loan note in 25 shares)

9. Characteristics of loan notes and other long-term debt

Hybrid debt instruments loan notes with warrants

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. Bondholders: - purchase shares for cash; - retain the loan notes until redemption.
Used as sweeteners on debt issues: - interest rate on the loan is low; - right to buy equity set at an attractive price; - warrants can be resold after buying the loan notes

9. Characteristics of loan notes and other long-term debt

Advantages of hybrid debt instruments

Immediate finance at low cost

- issued at below normal rates or with little to no security;

Self-liquidation
- upon conversion the problem of repayment disappears;

Can provide cash-finance

- by design, exercise of warrants involves cash-payments for shares

10. Long-term finance leasing

Operating lease (short term) equivalent to renting an asset Finance lease (medium to long-term) equivalent to borrowing to purchase the asset. Finance leases - Finance leases exist for a period that covers most of the useful life of the asset; - Lessor does not retain risks and rewards of ownership. Lessee responsible for repairs and maintenance - Uncancellable the lessee has a liability for all payments - Economic substance purchase of asset by lessee financed by lessor.