Finance for Managers
Module Tutor: Burton Baldacchino
[email protected]
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Session 5 Outcomes
Sources of Finance
Internal Finance
Capital Structure
Equity Finance
Debt Finance
Timing of Finance
Starting a business
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Sources of Finance
Sources of finance
classification
Equity Other
( long term) Debt
Special
Internally New Long term loans Medium Short purpose
generated issue /bonds term e.g. term e.g. e.g .
retained ordinary /debenture/ leasing HP trade govt
earnings shares preference credit grant
shares
Sources long term finance Sources medium / short term finance
External Finance
Ordinary Loans/
shares debentures
Long-term
Preference
Leases
shares
Total finance
Bank Invoice
overdraft discounting
Short-term
Debt
factoring
Internal Finance
Retained
profit
Reduced Total Delayed
stock levels internal payment to
finance creditors
Tighter credit
controls
Capital Structure
A B
£ £
Ordinary shares 100,000 50,000
5% debentures - 50,000
100,000 100,000
20% ROCE 20,000 20,000
Interest on debentures - 2,500
Taxable profit 20,000 17,500
Taxation ( assume 40%) 8,000 7,000
Distributable profit 12,000 10,500
If all distributed, rate of dividend
would be: 12% 21%
Gearing Debt to Equty
Capital Gearing Ratio how much debt versus equity in a business
CGR = Short + Long term liabilities (debt) *100%
Equity capital + Reserves + Debt Capital
Compares owners Capital to overall debt in a business also
called Financial leverage
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Good Gearing
•A gearing ratio higher than 50% is typically considered highly
levered or geared.
Think about servicing debt and implications
•A gearing ratio lower than 25% is typically considered low-
risk by both investors and lenders
•A gearing ratio between 25% and 50% is typically considered
optimal or normal for well-established companies
•More debt increases payment implications
https://www.accountingtools.com/articles/2017/5/5/gearing-ratio
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Sources of Finance
Three major types of financing:
Retained Earnings
Equity
Debt
Pecking order theory -seminal work Myers S.C. & Majluf N.
(1984) Journal of Financial Economics 13 187-221
“Contracting costs and information signalling effects create a pecking order of
attractiveness of different sources of finance : internal finance in the form of
retained earnings are likely to be favoured over (in descending order of
attractiveness) ‘safe debt ’ such as bank loans, bond issues and then onto hybrid
finance such as convertibles and finally equity in the form of rights and new
issues.”
Ryan B. Corporate Finance and Valuation (2007:212)
Pecking Order
Pecking order theory (1984) suggests that companies
have a preferred order in which they seek to raise finance
First resource - retained earnings
Avoids issue costs /interest payments
Management decision so no need to reference a third
party
No additional obligations to consider the needs of finance
providers
Need to consider the opportunity cost
Equity Finance
Equity finance is permanent finance and so may be
preferred for investment projects with long lives
Public offering to domestic ordinary share equity
issued / rights / bonus issues
Private placement domestic or global to range of
financial institutions - reduces transaction costs
Types of shares Values
EPS – Earnings per share
What is EPS for M&S compare with
Next/ASOS/Primark
Ordinary Share Capital
Represents the business’s risk capital
High risk, so high return expected
Potentially returns unlimited, and..
Some control over the business
Limited loss liability, but ..
No fixed rate of dividend
For the business: no tax relief on dividends paid
Preference Shares
Lower risk than ordinary shares
Fixed rate of dividend, paid before ordinary dividend
Priority over ordinary shareholders if business wound up
For the business: similar to loans, but no tax relief on
dividends paid, so loans more attractive
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Raising Equity
Public Issues & offers for sale
Private Placings
Rights Issues
Additional shares offered to existing shareholders for cash
at a discounted price
relatively inexpensive
The Shareholder can
Exercise the rights
Sell the rights
Allow them to lapse.
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Debt Instruments
Amount, time period of loan, repayment terms and interest payable are all
Term Loans open to negotiation tailored to suit needs.
May be secured or unsecured loans.
Security
Loan evidenced by a trust deed. May be redeemable or irredeemable
Debenture Traded on the Stock Exchange ( if listed company )
Bearer bonds, issued by companies. Interest paid annually – volatile
value Eurobonds – issued in major currencies used to raise finance on
Bonds
international basis Not subject to host country regulations
Floating/Fixed interest rates, Deep discount bonds
Insolvency
1. Secured creditors (holders of mortgages, legal charges, fixed
charges.)
2. Preferential creditors - typically employees who might be owed
outstanding wages / holiday pay due and the like.
3. Holders of floating charge ie debentures
4. Unsecured creditors, including the like of VAT / PAYE etc.
https://www.begbies-traynorgroup.com/articles/insolvency/who-gets-paid-first-when-a-
company-goes-into-liquidation
Loan Security Covenants
Access to financial statements
Restriction on other lending
Limit payment of dividends
Require maintenance of specified level of liquidity minimum current
ratio
Loan Security Covenants
• Investor has the right to convert a loan into ordinary shares at a
given future date and at a specified price.
• Not obliged to convert – will only do so if market price of shares at
conversion date exceeds the conversion price
• For the business: attractive – self liquidating form of finance
• But, some dilution of control and earnings for existing shareholders
if loans converted
Stock Exchange
Primary market - enables businesses to raise capital
Secondary market - enables investors to sell their securities (shares
and loan capital)
Disadvantages of a listing:
• high costs of obtaining a listing
• closer scrutiny of operations / management
• pressure to perform
• additional levels of financial disclosure
Stage of growth
Early
Start-up capital
Growth capital
Buy-out or buy-in capital
Share capital purchase
Recovery capital
Trouble Attraction to the investor is the prospect of a high return
for the risk borne
Will normally demand a high shareholding and have a
representative on the Board
Looking for a return in the medium term via a listing / sale,
or refinancing of the business
Other sources of external
finance – video clip 1
Business Angels:
Starts ups
Young developing companies,
Relatively small investments 10 000 – 100,000,
In return for a share holding.
Government
Grants – matched funding
Small firms loan Guarantee scheme.
Tax incentives
Leasing
Legal ownership of asset rests with the lessor
Lessee has right to use the asset ( all rewards
and risks of ownership transferred)
Lease covers significant part of the life of the
asset – may be extended for `peppercorn’
rent at and of primary period
Leasing
Legal ownership of asset rests with the lessor
Lessee has right to use the asset ( all rewards
and risks of ownership transferred)
Lease covers significant part of the life of the
asset – may be extended for `peppercorn’
rent at and of primary period
Attractions Of Leasing
Ease of borrowing - readily available – asset as security
Cost - competitively priced lease rentals
Flexibility - not tied to ownership – avoid obsolescence
Eases cash flow - avoids up-front purchase cost – rentals tailored to
match income from use of asset
Sale and Leaseback
Immediate injection of funds
right to continued use of the asset
rent payment is allowable against profits for tax purposes
allows business to focus on core activities
Disadvantages:
periodic rent reviews
have to renegotiate at the end of term
tax liability if capital gain on sale to financial institution
loss of benefit of capital appreciation of asset
Short term finance
Overdraft - very flexible, relatively inexpensive to arrange rate of interest
varies with creditworthiness, normally unsecured, but not always
cash flow forecasts will be required
Drawback – repayable on demand (in theory)
Other: debt factoring & invoice discounting
Short term finance
Overdraft - very flexible, relatively inexpensive to arrange rate of interest
varies with creditworthiness, normally unsecured, but not always
cash flow forecasts will be required
Drawback – repayable on demand (in theory)
Other: debt factoring & invoice discounting
ID or factoring – video clip 2
1 Goods
Supplying firm
Customer
(seller)
2 Right to receive payment
on sale of invoice to factor
4 Customer pays
3 80% of customer
debt to factor
debt available to
seller immediately
Factor
Provides finance,
5 20% payable, less factor’s sales ledger admin.,
fees and interest, after credit insurance.
customer pays factor
Invoice Discounting
Invoices are pledged to the finance house in return for an immediate payment of up to 90% of
the face value
Supplying company guarantees to pay the amount on the invoice and is responsible for
collecting the debt from the customer
Regardless of whether customer has paid, supplier is committed to handing over full amount,
and in return receives remaining 10% less service fees and charges ( usually lower than for
factoring )
Finance provider will only advance money under invoice discounting if the business is well
established, profitable and has an effective and professional sales administration system.
Time of Finance
Issues taken into account:
Matching
Flexibility
For the three strategies how would you
Re-financing risk
finance them and why?
Interest rates
Timings
Total Fluctuating
fund current assets Short-term
s finance
Long-term
Permanent finance
current assets
Fixed assets
Time
Debt Finance
Short term Bank overdraft Working capital assets
Trade credit Stock / debtors
Bank loan Machinery
Medium term Hire purchase Vehicles
Leasing Computers
Long term loans Longer term assets
Long
/ debentures Land, buildings
term
Venture capital Start-ups
Equity finance Management buy-outs
Acquisitions
Debt Finance
Borrower Rates of interest / term
Repayment obligations
Covenants attached
Gearing implications
Credit profile
Lender Purpose
Risk / return
Track record
Existing level of borrowing
Security available / quality
Management capability
Debt Finance
If there are insufficient retained earnings available then debt or equity finance
-requires public or private placement either in ones own country or a global
offering
Preferred if company has not yet reached its optimal capital structure
Debt finance cheaper than equity
Issuing debt can lead to a reduction Weighted Average Cost of Capital (WACC)
and hence an increase in the market value of the company
Debt is higher in the creditor hierarchy than equity - ordinary shareholders are
paid out last in the event of liquidation
Debt Finance
Share issue £100m pay 10% Borrow £100m at 10%
dividend interest
P&L £m P &L £m
Sales 90 sales 90
Less costs 40 Less costs ( 40 50
+10% interest )
Net profit 50
Net profit 40
Less tax 20% 10
less tax 20% 8
Less 10
dividend10% No dividend 0
Profit after tax and
30 Profit after tax and
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dividend dividend
Starting a business
You are setting up a new business in your teams
Please read the guide
https://thebusinessfinanceguide.co.uk/wp-content/uploads/2016/06/the
businessfinanceguide2016.pdf
Now create a business plan for your business for 5 years trading – what
sources of finance are you using and why? How are your cash flows
looking and what is your gearing ratios?
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