CHAPTER 9: SOURCES OF FINANCE

SOURCES OF FINANCES

SHORT TERM LONG TERM ISLAMIC FINANCE

Trade credit Long Term Debt Murabaha

Overdraft Equity Finance Musharaka

Factoring Preference Shares Mudaraba

Short Term Lease Venture Capital Ijara

Short Term Loan Sukuk

Sources of Finance for SMEs

Short Term Finance

Overdraft

● Overdraft is a short term finance and is arranged through current account.

● It is repayable on demand and normally used to support working capital

● Interest charged by the bank will be only to the extent that the customer uses the facility and goes into
overdraft.

● However the bank will charged a committed fee when customer is granted an overdraft facility or
increase its overdraft facility

● It can be arranged quickly and offer a level of flexibility with regard to the amount borrowed at any time

Nur Aini Deraman/FM/SM'21

 Term loan

● A term loan is a loan that is drawn in full at the beginning of the loan period and repaid at a specified
time or in defined instalments.

● Once the loan is agreed, the term of loan must be adhered to

● Interest payments are based on the full amount borrowed

Overdraft vs Term Loan

Overdraft Term Loan

Suitable for short term borrowing needs Suitable for medium and long term borrowing
needs

Interest is paid only on the overdrawn balance Usually has a lower rate of interest than more
flexible option (overdraft)

Due to its short term nature, the balance of the Both customer and bank know exactly what
overdraft is not normally included in the calculation of the repayments of the loan will be and how
the business's gearing much interest is payable and when. This
makes planning simpler

Generally easy and quick to arrange, with immediate

access to funds once the facility has been agreed

Long Term Finance

Bank loans
Long-term Debt Loan notes/Bonds /Debentures
Long term lease

Term Loan

● Long term loan is required when financing a long term investment

● However company normally need to provide security either fixed or floating charge against a company's
assets

● In addition, bank may also imposed a covenants into the loan agreement

● Loan covenants act as additional security for lenders and involve the borrower taking on certain
obligations in addition to the repayments terms

Nur Aini Deraman/FM/SM'21

● If the borrower does not comply with the covenants, the loan can be considered in default and the bank
can demand payment.

● Types of covenants:

1. Positive covenants - require a borrower to do something. For eg provide annual financial

statements/management accounts, maintain certain levels of ratios

2. Negative or restrictive covenants - Limit a borrower's behaviour, promises by a borrower

not to do something. For eg the company promise not to borrow more money until the
current loan is repaid

3. Quantitive covenants - set limitations on the borrower's financial position. For eg gearing
ratio within a certain threshold

Loan notes/Bonds /Debentures

● Loan notes are long term debt capital raised by a company in which interest is normally paid half yearly
and at fixed rate

● Holder of loan notes are therefore long term creditors of the company

● Loan notes can be redeemable or irredeemable

● Loan notes will often be secured and security may be either fixed charge or floating charge:

1. Fixed charge: e.g land and buildings

2. Floating charge: e.g inventories/receivables

● Unsecured loan notes normally carry higher yield

Nur Aini Deraman/FM/SM'21

● Conventional loan notes
● Conventional loan notes are fixed rate redeemable securities

● Interest is paid at a stated coupon rate on nominal value. The rate quoted is the gross rate,
before tax.

● Debt is often issued at nominal value and subsequent changes in market conditions will
cause the market price of the bond to fluctuate

● Deep discount loan notes

● Deep discount loan notes are issued at a price which is at a large discount to the nominal
value

● It would be redeem at nominal value or above nominal value when they eventually mature

● Deep discount loan notes normally carry a much lower rate of interest

● Eventhough interest is lower, however the issuer need to pay a much larger amount at
maturity than it borrowed when the loan notes were issued

● Due to this, investors might be attracted by the large capital gain offered by the loan notes,
which is the difference between the issue price and the redemption value

● Zero coupon loan notes

● Zero coupon loan notes are issued at a discount to their redemption value, but no interest is
paid on them

● Zero coupon loan notes are an extreme form of deep discount bond

● The redemption value is known at the time of issue

● Investor will gains from the difference between the issue price and the redemption value

Nur Aini Deraman/FM/SM'21

● Convertible loan notes

● Convertible loan notes are fixed return securities that may be converted, on pre-determined
dates and at the option of the holder, into ordinary shares of the company at a pre-
determined rate.

● Convertible loan notes carry lower interest rate compared to similar conventional loan notes
as the loan note holders can sell these shares at a favourable price

● The current market value of ordinary shares into which a unit of notes may be converted is
known as the conversion value.

● The loan notes will be redeemed at maturity if the holders choose not to convert

● For the companies issuing them, convertibles may be viewed as a delayed form of equity
which does not immidiately affect EPS.

Conversion value = Conversion ratio x market price per share

Conversion premium = Current MV of loan notes - current conversion value of

shares

● Irredeemable loan notes

● Also known as undated or perpetual loan notes

● These are rare in reality and typically issued by governments, not companies

Equity Finance

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

● Ordinary shares

● The holder of ordinary shares are the ultimate bearers of risk, as they are at the bottom of
the creditor hierarchy in a liquidation

● High equity risk means the SHH expect the highest return in the form of dividend yileds,
dividend growth and share price growth

Nur Aini Deraman/FM/SM'21

● Stock market listing

● When company comes to the stock market for the first time and floats its shares on the
market, the owners of the company can realise some of the value of their shares in cash.

● Stock market is more regulated and it enforces certain rules of conducts for its listed firms so
that the investors have the assurance that companies whose shares are traded on the
Exchange and traders who operate there are reputable.

● Advantages of a stock market listing

1. Access to a wider pool of finance

2. Improved marketability of shares

3. Enhanced public image

4. Easier to seek growth by acquisition

5. Original owners selling holding to obtain funds for other projects

6. Original owners realising holding

● Disadvantages

1. There will be greater public regulation, accountability and scrutiny

2. A wider circle of investors with more exacting requirements

3. Additional cost to issue shares, eg underwriting fees

● Method of obtaining listing

● An unquoted company can obtain listing on the stock market by means of:

Nur Aini Deraman/FM/SM'21

 1. Offer for sale

a) Initial public offer

● IPO is an invitation to the public to apply for shares in a company
based on information contained in a prospectus - through issuing
house (investment bank)

b) Offer for sale by tender

● A minimum price for shares will be fixed and subsribers will be invited
to tender for shares at prices equal to or above minimum.

● The shares will be allotted at the highest price at which they will all
be taken up

2. Placing

● The 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

3. Introduction

● No shares are made available to the market, neither existing nor

newly created shares; nevertheless the stock market grants a
quotation

● This happen where shares in a large company are already widely held
so that a market can be seen to exist

● Underwriting

● Company may 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 undersubsribed

Nur Aini Deraman/FM/SM'21

● Rights issues

● RI is an offer to an existing SHH enabling them to buy more shares, usually at a

price lower than the current MV

● Existing SHH have pre-emption rights when new shares are issued so its rights are
not diluted.

● SHH have a number of choices, they can: 1) Buy the new shares 2) Sell their right
to buy shares 3) Buy half sell half

● The RI will be offer in proportion to their existing holdings

Theoretical ex-rights price (TERP) = The theoretical price after the rights issue

Value of right = The price at which a right can be sold (TERP minus right issue
price)

● Set-up

1) If RI ratio is given:

Existing shares x Current MV = XX

New shares x RI price = XX

A B

TERP = B/A

2) If ratio is not give: a) Determine amount to be raised

b) Determine RI price

c) Calculate new no of shares ( A/B)

d) Calculate TERP

Nur Aini Deraman/FM/SM'21

 ● Scrip dividends, scrip issues and stock splits
● These are not methods of raising new equity funds but they are methods of:

1. Altering the share capital structure of a company

2. Increasing the issued share capital of the company

● Scrip dividends
● is a dividend payment which takes the form of new shares instead of
cash. It converts profit or loss reserves into issued share capital

● Scrip issues / bonus issue

● is an issue of new shares to existing SHH, by converting equity
reserves (premium) into issued share capital

● By creating more shares, it will make the shares cheaper and easily
marketable

● Stock splits
● Purposes is to create cheaper shares with greater marketability

Preference Shares

● Preference shares are shares which have a fixed % dividend, payable in priority to any dividend paid to
the ordinary shareholders

● Preference shares do not carry voting rights

● Types of preference shares:

1. Cumulative
● The right to an unpaid dividend is c/f to later years when the company is profitable. The
arrears of dividend must be paid before any dividend is paid on ordinary shares.

2. Non-cumulative
● If there are insufficient distributable profits to pay the dividend in the current year, the entity
never has to pay this dividend

Nur Aini Deraman/FM/SM'21

 3. Participating
● The owner of participating share has the right to receive the fixed preference dividend or the
ordinary dividend - whichever is higher

4. Redeemable
● It means the company will effectively buy it back at some time in future. The redemption
date is usually agreed when the shares are issued

5. Convertible
● Holder of convertible preference shares will have the right at some time in the future to
convert these into ordinary shares.

● Pro and cons of preference shares:

● Preference shares are not secured on company assets

● Preference shareholders usually have no voting rights so there is no dilution of control

● Preference share capital is not as tax efficient as debt capital

Venture Capital

● Venture capital is risk capital and normally provided by wealthy individual or venture capital firm that
manages a venture capital fund

● Venture capital is capital invested in private companies in return for equity stake

● Venture capitalists seek to invest cash in return for shares in private companies with high growth
potential. The return is often realised through a stock market listing

● Venture capitalist want to invest in companies that will be successful and are ambitious

● The types of venture that might attract venture capitalist:

1. Business start-ups: Venture capitalist may be willing to provide finance to enable a business
to get off the ground

Nur Aini Deraman/FM/SM'21

 2. Business development: Venture capitalist may be willing to provide development capital for
a company which wants to invest in new products or new markets or to make a business
acquisition, and so which needs a major capital injection

3. Management buyouts: A management buyout is the purchase of all or parts of a business

from owners by its manager

4. Expansion: A private company might want to invest more capital in an expansion

programme, but is unable to raise the funds internally or from a bank loan. It might therefore
seek venture capital

● They are less interested in providing the money to finance running expenditure and working capital
requirements

● By providing capital to a company, venture capitalist in return will require:

1. Equity stake

2. It may want to have a representative appointed to the company's board, to look after its
interests or an independent director

● When venture capitalist invests in new equity for a company, the company's bank may also be prepared
to lend more because the company is now seen as a lower credit risk

● Failure to hit targets set by the venture capitalist can lead to extra shares being transferred to their
ownership at no additional cost. This is called an equity ratchet

Islamic Finance

● Islamic finance transactions are based on the concept of sharing risk and reward between the investor
and the user of funds

Nur Aini Deraman/FM/SM'21

● Riba is forbidden under Sharia law. Making money with money is considered to be immoral

Finance for SMEs

● SMEs normally will face a problem to acquire funds when compared to large and public listed company -
this is known as funding gap

● Funding gap is due to several reasons:

1. SMEs often associated with family owned business or unlisted company. Therefore they will
have a very small pool of investors

2. They may also have lack asset to offer as a security and poor reputation compared to larger
enterprises.

Nur Aini Deraman/FM/SM'21

 3. SME need to compete for funds. However they may not have the business history or larger
track record to provide to potential investor

4. Investors are not confident to invest in SMEs due to the risk as it is subjected to less
regulatory and public scurity. There is also a greater failure rate among SMEs

● SMEs also in particular have a difficulty in obtaining medium term finance which is known as maturity
gap

● Maturity gap refers to the difficulty in obtaining medium-term finance when SME assets are primarily
longer-term in nature

● An initiative taken by Government to help the SMEs includes giving grants and underwriting
(guaranteeing) a proportion of the value of loans made to SMEs

Sources of finance for SMEs

SOURCES OF FINANCES FOR SME

Overdraft Equity finance Owner financing Business Angel

Bank loans Factoring Venture Capital Supply Chain

Trade credit Leasing
Government Aid
Crowdfunding/Pee
r to Peer Funding

Owner Financing

● Finance from the owner personal resources or family connections is the best sources of funds available
when it is difficult to get external funding

Nur Aini Deraman/FM/SM'21

 Equity Finance

● SMEs may also have a problem in obtaining equity finance when they are formed - this is known as
equity gap

● SMEs do not necessarily need to seek a market listing to obtain equity finance as shares can be placed
privately

● A major problem with obtaining equity finance can be the inability of the SMEs to offer an easy exit
route for any investor who wish to sell their stake

Business Angel

● Business angels are wealthy individuals or groups of individuals who invest directly in small business

● Business angels are often more patient than other providers of finance and they are prepared to take
larger risks in the expectation of large returns on their investment. However, the money available from
individual business angels may be limited

● The arrangement business angel financing also informal in terms of a market therefore raising of the
funds can be speeded up but this can also be difficult to set up.

● However, due to this informality, there may be less documentation to be prepared by the company

Supply Chain Finance (SCF)

● SCF is the use of financial instruments, practices and technologies to optimise the management of the
WC and liquidity tied up in supply chain processes for collaborating business partners

● The most widely used form of SCF is reverse factroing

● Reverse factroing is a method of financing by selling invoice at a small discount in order to obtain cash in
advance of the invoice due date

● This can be done through an intermediary fund provider such as a bank who provides early payment to
the supplier in exchange for the discount, and in turn receives later payment from the buyer

Nur Aini Deraman/FM/SM'21

● SCF relies on efficient automation and real time visibility of invoice information

● Funding provider relies on the creditworthiness of the buyer and the buyer is usually a large company
with a good credit rating

Crowdfunding / Peer to Peer Funding

● Crowdfunding is the funding of a project by raising money from a large number of people

● It is usually carried out via the internet to reach a large pool of potential investors who may believe in
the project which their funds will be used

Nur Aini Deraman/FM/SM'21