1、1Paper F9Financial Management Accounting School 2Source of financeChapter 123Topic listShort-term source of financeDebt financeVenture capitalEquity finance4Exam guideSource of finance are a major topicYou may be asked to describe appropriate sources of finance for a particular company and discuss i
2、n general terms when different sources of finance should be utilized and when they are likely to be available.51 Short term source of financeFast forwardA range of short term sources of finance are available to businesses including overdrafts,short-term loans,trade credit and lease finance.61.1 Over
3、draftsWhere payments from a current account exceed income to the account for a temporary period,the bank finances the deficit by means of an overdraft.Overdrafts are the most important source of short term finance available to business.QuickFlexibility(borrowed at any time)Low cost-interest is only
4、paid when the account is overdraw.71.1 OverdraftsoverdraftsAmount Should not exceed limit,usually based on known incomeMargin Interest charged at base rate plus margin on daily amount overdrawn and charged quarterly.Fee may be charged for large facilityPurpose Generally to cover short term deficitsR
5、epaymentTechnically repayable on demandSecurity Depends on size of facilityBenefits Customer has flexible means of short term borrowing;bank has to accept fluctuation81.1 OverdraftsThe bank will generally charge a commitment fee when a customer is granted an overdraft facility or an increase in his
6、overdraft facility,this is a fee for granting an overdraft facility and agreeing to provide the customer with funds if and whenever he needs them.91.2 Short term loansA 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
7、 a specified time or in defined installments.The interest and capital repayments are predetermined.The main advantages of bank loans is that it makes monitoring and control of advance much easier101.2 Short term loansThe customer knows he will be expected to pay back at regular intervals and the ban
8、k can also predict its future income with more certainty.Once the loan is agreed,the term of the loan must be adhered to,provided that the customer does not fall behind with his repayments,.It is not repayable on demand by bank.Because the bank will be committing its funds to a customer for a number
9、 of years,it may wish to insist on building certain written safeguards into the loan agreement,to prevent the customer from becoming over-extended with his borrowing during the course of the loan.A loan covenant is a condition that the borrower must comply with.If the borrower does not act in accord
10、ance with the covenants,the loan can be considered in default and the bank can demand payment.111.3 Overdrafts and short-term loans comparedIn most case,when a customer wants finance to help with day to day trading and cash flow needs,an overdraft would be the appropriate method of financing.The cus
11、tomer should not be short of cash all the time,and should expect to be in credit in some days,but in need of an overdraft on others.When a customers wants to borrow from a bank for only a short period of time,even for the purchase of a major fixed asset such as an item of plant or machinery,an overd
12、raft facility might be more suitable than a loan,because the customer will stop paying interest as soon as his account goes into credit.121.3 Overdrafts and short-term loans comparedAdvantages of an overdraft over a loanThe customer only pays interest when he is overdrawnThe bank has the flexibility
13、 to review the customers overdraft facility periodically,and perhaps agree to additional facilities,or insist on a reduction in the facility.Bear in mind that overdrafts normally repayable on demand.131.3 Overdrafts and short-term loans comparedAdvantages of a loan for longer term lendingBoth the cu
14、stomer and the bank know exactly what the repayments of the loan will be and how much interest is payable,and when.This makes planning simpler.The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility before he is in a position to repay what is owed.Ther
15、e is an element of security or peace of mind in being able to arrange a loan for an agreed term.Loans normally carry a facility letter setting out the precise terms of the agreement.141.4 Trade creditKey termTrade credit credit granted from one business to another.Trade liabilities money owed to sup
16、pliers.Trade credit represents an interest free short term loan.It is important to take into account the loss of discounts suppliers offer for early payment.Unacceptable delays in payment will worsen a companys credit rating and additional credit may become difficult to obtain.151.5 LeasingLeasing c
17、an be defined as a contract between lessor and lessee for hire of a specific asset selected from a manufacture or vendor of such assets by the lessee.The lessor retains ownership of the asset.The lessee has possession and use of the asset on payment of specified rentals over a period.Lessor bank;ins
18、urance comopaniesOffice equipment and computersCars and commercial vehiclesAircraftShips and buildings161.5 LeasingSale and leasebackAdvantages Would raising more cash DisadvantagesThe company loses ownership of a valuable asset which is almost certain to appreciate over time.The future borrowing ca
19、pacity of the firm will be reduced,as there will be less assets to provide security for a loan.The company is contractually committed to occupying the property for many years ahead which can be restrictingThe real cost is likely to be high,particularly as there will be frequent rent reviews.17Short
20、term source of financeThe best combination of alternative source of short term financing depending on considerations of cost,availability,timing,flexibility,and the degree to which the assets of the firm are encumbered(burdened with legal claims)182 Debt financeFast forwardA range of long term sourc
21、e of finance are available to businesses including debt financing,leasing,venture capital and equity finance.Long term finance is used for major investments and is usually more expensive and less flexible than short term finance.192.1 Reason for seeking debt financeAdvantage of debtDebt is cheap and
22、 easier availability.Because it is less risky than equity for an investor,debenture holders will accept a lower rate of return than shareholders.Also,debt is an allowable expense for tax.The interest against tax,so the effective cost of debt is after tax cost.Cost is limited to the stipulated intere
23、st payment.There is no dilution of control when debt is issued.202.2 Sources of debt financeThe types of non-equity financeSource of medium-and short-term financeDebt and other source of financeLong-termlBondsldebentureMedium-termBank loansLeasingHPhybrids uConvertibleuwarrantsShort-termBank overdra
24、ftShort term loansTrade creditOperating leaseShort-termGovernment grants and loans212.3 Factors influencing choice of debt financeFast forwardThe choice of debt finance that a company can makes depends upon:The size of the business(a public issue of loan stock is only available to a large company)Th
25、e duration of the loanWhether a fixed or floating interest rate is preferred(fixed rates are more expensive,but floating rates are riskier)The security that can be offered.222.3 Factors influencing choice of debt financeAvailabilityDurationFixed or floating rateSecurity and covenants232.4 Loan notes
26、Fast forwardThe term bonds describes various forms of long term debt a company may issue,such as loan notes or debenture,which may be:RedeemableirredeemableBonds or loans come in various forms,including:Floating rate debentureZero coupon bondsConvertible loan stock242.5 Deep discount bondsKey termDe
27、ep discount bonds 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.Deep discounted bonds are those where the coupon rate being offered is below the market rate at the time of i
28、ssue.The return to the investor of deep discount bonds and zero coupon bonds is mainly in the form of a high redemption value.The discount element of the bond is amortized and allowed annually against corporation tax.252.6 Zero coupon bondsKey termZero coupon bonds are bonds that are issued at a dis
29、count to their redemption value,but no interest is paid on themZero coupon bonds-a bond that pays no interest but sells at a deep discount from its face value;it provides compensation to investors in the form of price appreciation.The investor gains from the difference between the issue price and th
30、e redemption value.262.6 Zero coupon bondsThe advantages for borrowers is that zero coupon bonds can be used to raise cash flow immediately,and there is no cash flow repayment until redemption date.The cost of redemption is known at the times of issue.The borrower can plan to have funds available to
31、 redeem the bonds at maturityThe 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 market value will depend on the remaining term to maturity and current market interst
32、rates.272.7 Convertible loan notesFast forwardConvertible loan notes are bonds that give the holder the right to convert to other securities,normally ordinary shares,at a pre-determined price/rate and time.Convertible terms often vary over time.Once converted,convertible securities cant be converted
33、 back into the original fixed return security.Is an hybrids of debt and equity282.7 Convertible loan notesThe conversion rights on convertible securities are either stated in terms of a conversion ratio or in terms of a conversion price Conversion ratio-The number of shares of common stock into whic
34、h a convertible security can be converted.It is equal to the value of the convertible security divided by the conversion price.Conversion price-the price per share at which common stock will be exchanged for a convertible security.It is equal to the face value of the convertible security divided by
35、the conversion ratio.Sometime,the conversion price increase during the convertibility-this is done to stimulate early conversion.292.7 Convertible loan notesConversion value the current market value of ordinary shares into which a loan note may be converted is known as the conversion value.It is equ
36、al to the conversion ratio times the current market price per share of the common stock.Conversion premium-the market price of a convertible security minus its conversion value.noteofvalueConversionnoteofvalueissuepremiumConversion302.7 Convertible loan notesThe actual market price of convertible lo
37、an note will depend onThe price of straight debt(debt cant be converted for another asset)The current conversion valueThe length of time before conversion may take placeThe markets expectation as to future equity returns and the risk associated with these returns312.7 Convertible loan notesThe actua
38、l market price of convertible loan note will depend onThe convertible bond may be viewed as straight debt plus an option to purchase common stock in the corporation.Both the value of the debt and the value of the option components are affected by the volatility of the companys cash flows.The greater
39、 this volatility,the lower the value of the debt component but the higher the value of the option component.valuebondeConvertiblvalueOptionvalueDebt322.8 SecurityLoan notes and debentures will often be secured.Security may take the form of either a fixed charge or a floating charge.Not all loan note
40、s are secured.Investors are likely to expect a higher yield with unsecured loan notes to compensate them for the extra risk.Fixed chargeFloating chargeSecurity relates to specific asset/group of asset(land and building)Security in the even of default is whatever assets of the class secured(inventory
41、/trade receivable)company then ownsCompany cant dispose of asset without providing substitute/consent of lenderCompany can dispose of assets until default takes place.In even of default lenders appoint receiver rather than lay claim to asset332.9 The redemption of loan notesKey termRedemption is rep
42、ayment of preference share and bonds.If the debt is redeemable the principal will be repayable at a future date.Irredeemable debt is not repayable at any specified time in the future.Instead,interest is payable ad infinitum.As well as some debentures,preferred stocks are often irredeemable.Undated l
43、oan notes might be redeemed by a company that wishes to pay off the debt,but there is no obligation on the company to do so.342.10 Tax relief on loan interestAs far as companies are concerned,debt capital is a potentially attractive source of finance because interest charges reduce the profits charg
44、eable to corporation tax.A new issue of loan notes is likely to be preferable to a new issue of preferred share.Companies might wish to avoid dilution of shareholding and increase gearing in order to improve their earnings per share by benefiting from tax relief on interest payments.353 Venture capi
45、talKey termVenture capital is risk capital,normally provided in return for an equity stake.363.1 Venture capital fundsVenture capital funds are raised from investors and invested in management buyouts or expanding companies.The venture capital fund managers usually reward themselves by taking a perc
46、entage of the portfolio of the funds investments.373.2 Finding venture capitalWhen a companys directors look for help from a venture capital institution,they must recognize that:The institution will want an equity stake in the companyIt will need convincing that the company can be successful.A ventu
47、re capital organization will only give funds to a company that it believes can secceed.It may want to have a representative appointed to the companys board,to look after its interests,or an independent director 383.1 Venture capital fundsFactors in investment decisionThe nature of the companys produ
48、ctViability of production and selling potentialExpertise in productionTechnical ability to produce efficientlyExpertise in managementCommitment,skills and experienceThe market and competitionThreat from rival producers or future new entrantsFuture profitsDetailed business plan showing profit prospec
49、ts that compensate for riskBoard membershipTo take account of VCs interests and ensure VC has say in future strategyRisk borne by existing ownersOwners bear significant risk and invest significant part of their overall wealth394 Equity financeFast forwardEquity finance is raised through the sale of
50、ordinary shares to investors via a new issue or a right issue.404.1 Ordinary sharesOrdinary shares are issued to owners of a company.Ordinary shares have a nominal or face value,typically 1$or 50c.The market value of a quoted companys share bears no relationship to their nominal value,except that wh
