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Accounting for Management Decisions

Week 12

FINANCING THE BUSINESS

READING: TEXT Ch 14

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Accounting for Management Decisions

Week 12

FINANCING THE BUSINESS

READING: TEXT Ch 14

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Learning Objectives

Identify the main sources of finance availableto a business

Explain the advantages and disadvantages of

each form Describe the concept of gearing and its

influence on the long-term financing decision Explain what influences the choice between

long-term or short-term finance Identify the so-called internal sources of

finance and explain them

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Learning Objectives contd

Explain the role and nature of the stock

exchange

Explain the role of venture capital organisations

in financing businesses

Discuss how share capital may be issued and

identify the reasons why a particular methodmight be chosen

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Sources of Finance

InternalInternal - sources that do notnot require approval

of others apart from managers or directors to

obtain eg retained profit

ExternalExternal - requires the approvalapproval of s/holders

eg issue of new shares

LongLong--termterm - expected to provide finance for

at leastleast one year

ShortShort--termterm - typically forlessless than one year

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Long-term Sources of Finance

Ordinary Shares:HighHigh--riskrisk investmentsHigherHigherexpected returnsVotingVoting rightsLimited lossloss liability, un-limited return potentialFrom the companys perspective:

- Can be useful to avoidavoid paying a dividend- Cost of financing can be high over the l/term- Paying dividends does not bring any tax reliefmaking $1 of dividend moremore expensive than$1 of loan interest

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Long-term Sources of Finance contd

Preference Shares: LowerLowerrisk than ordinary shares Given prioritypriority over ordinary shares if co.

is wound-up Normally given a fixedfixed rate of dividend LowerLowerlevel of return than ordinary shares May be cumulative ornon-cumulative NoNo longer a major source of finance because:

- No tax effectiveness- Preference shares are now seen as debt

when assessing borrowing capacity

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Cumulative PS will accumulate any dividend that is not paid whendue.

Any unpaid dividend is added to the amount payable the followingyear and no dividends can be paid on ordinary shares until theentire backlog of unpaid dividends on cumulative prefs is cleared.

What Does NoncumulativeMean?A type of preferred stock that does not pay the holder any unpaidor omitted dividends. If the corporation chooses to not paydividends in a given year, the investor does not have the right toclaim any of those forgone dividends in the future.

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Loans and DebenturesSpecifiedSpecified interest rate, term and repaymentschedule

Secured by assetsassets held by the co.- May be either on the basis of a fixedfixed chargeover assets eg freehold land, premises

-Or on the basis of a floatingfloating charge overthe whole of a companys assets

LessLess risky than share capital Interest is tax deductibledeductible to co.Term Loans are established by negotiation, areoften cheap to set up and offer some flexibility

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Loans and Debentures Loan StockLoan Stock is a form of finance where debt

is divided into units and sold to investors, publiccos loan stock is listed and traded on the stock

exchange DebenturesDebentures are loan stocks that are supportedwith a trusttrust deed

Both loan stocks and debentures are nowmostly called bondsbonds - see also Eurobonds

Interest rates on loans and debentures may beeither fixed or variable

Deep-discount bonds are issued at a low orzero interest rate and at a large discount to their

redeemable value

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WarrantsWarrants - give the holder the right, but notnotthe obligation, to acquire ordinary shares in acompany at an agreed price

MortgagesMortgages - simply a form of long-term (eg 25 -30 years) loan that is securedsecured by freeholdproperty

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Loan CovenantsCovenants - enforceable conditionscontained within loan agreements that aredesigned to protectprotect lenders. May deal with

such matters as:AccessAccess to financial statementsApprovalApproval required before taking on otherloans

Dividend payments may be required to belimitedlimitedLiquidity may need to be maintained at aprescribedprescribed level

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Finance leases:A form oflendinglending - same effect as borrowingto purchase the asset

NoNo longer a tax-efficient form of financing due

to changes in tax lawsNevertheless, still growing in popularitybecause of:--EaseEase of borrowing, limited security andrecords required

-- CostCost-- FlexibilityFlexibility - option to cancel may be included-- CashflowCashflow - large outflows can be avoidedand spread over the life of the asset

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Sale and lease-back arrangements: Involves the business sellingselling an asset to raise

finance, with an agreement to leaselease the assetback so it can still be used by the business

Usually agreements are reviewedreviewed periodicallythroughout the lease, making future paymentsdifficult to predict

At the endend of the lease, the business must

eitherrenewrenew the lease or, in the case ofproperty, find alternativealternative premises

Capital gain is assessable on the sale of theasset and may present a taxtax liability

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Hire purchase (HP):

A form ofcreditcredit used to acquire an asset Under the HP agreement, the asset is paid for

by instalmentsinstalments over an agreed period Normally an initial depositdeposit is required The asset is taken possession of after the

deposit is paid, howeverlegallegal ownership is nottransferred until the finalfinal instalment is paid

Similar to a finance lease, main differencebeing that the business eventually becomesthe legal ownerownerof the asset

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Short-term Sources of Finance

Bankoverdraft: FlexibleFlexible form of borrowing that allows a

business to have a negative current accountbalance

Size of credit limit can be variedvaried dependingon requirement

Relatively easyeasy and inexpensive to arrange Should be self-liquidating SecuritySecurity is generally required Repayable on demanddemand from lender

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Short-term Sources of Finance contd

Debt factoring: Is a form of service offered by a financial

institution (a factor) - often a subsidiary of acommercial bank

Involves the factortakingtaking over a cos salesledger Usually offers to advanceadvance up to 85%85% of

approved trade debtors FeeFee is normally 22--3%3% of turnover Can deliverbenefitsbenefits such as more certain

cash flows, savings in credit management Some negatives can include high cost and

adverseadverse customerreactionreaction

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Short-term Sources of Finance contd

Invoice discounting: Financial institution is approached for a loanloan

for7575--80%80% of value of approved salesoutstanding

Repayment is made usuallyusually within 60-90 days Business remainsremains responsible for debtors

collection Is confidential - customers unawareunaware of it Cost is cheapcheap compared with factoring Allows company to retainretain control of sales

ledger and relationship with customers Is proving to be growinggrowing in popularity more

than factoring

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Long-term vs. Short-term Borrowing

Issues to consider when deciding between long-term or short-term borrowing: MatchingMatching borrowing to nature of asset on

the basis oftimetime or permanency FlexibilityFlexibility - aim to minimise costs incurred

if circumstances change eg early disposal ofasset

Re-funding riskrisk - short-term finance has to

be renewed more frequently InterestInterest rates - differ between short and

long-term, other setup costs should also beconsidered

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Internal Sources of Finance

Reducedinventories levels

Delayed paymentto trade payables

Tightercredit control

Totalinternalfinance

Retainedprofits

Short-term Long-term

Figure 14.5Major internal sources of finance

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Internal Sources of Finance contd

Retained profit: Is the mainmain source of finance for most cos

No issue or establishment costscosts

No dilutiondilution of shareholder interest

No waiting - funds are immediatelyimmediately available

Often lessless scrutiny from investors

PotentialPotential tax-efficiency for s/holders when

retained profits deliver increased share prices Typically the retention/dividend ratio is notnot

more than 50% of profit

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Internal Sources of Finance contd

Tighter credit control: ImportantImportant to weigh the cost against the benefitsCredit policypolicy must be determined appropriatelyReduced inventory levels:

Reduces opportunity costcostDepends on nature and conditioncondition of inventoryMay notnot be easy to liquidate obsolete items

Delayed payment to creditors:ExtendsExtends period of interest-free loan BUT:At the riskrisk of jeopardising relations

Spontaneous sources of funds:Eg accrued wages, PAYG instalments,Superannuation contributions

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The Role of the Stock Exchange

PrimaryPrimary Market - enables cos to raise newnewcapital

SecondarySecondary Market - enables investors totransfertransfertheir securities with ease

Negatives: Costs of becoming listed are highhigh Mandatory compliance with strictstrict rules Half-yearly financial reporting ScrutinyScrutiny by analysts, journalists and other

companies Pressure forshortshort--termterm performance

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Venture Capital and Long-term Financing

Definitions: L/term capital provided by certain institutions to

small and medium-sized businesses to exploitrelatively highhigh--riskrisk opportunities

Private equity is equity finance primarilyprimarily forsmall and medium-sized businesses providedby venture capitalists and/orbusiness angelsbusiness angels

Venture capital providers may be interestedin:

Business start-ups Early stage capital Expansion capital Buy-out or buy-in capital

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Venture Capital and Long-term Financing contd

Generally regarded as higherhigherrisk due tonature of products or lack of trading record

Normally the investment is taken in the form of

ordinary sharesshares in the business A representative of the venture capitalist is

usually on the board ofdirectorsdirectors as a conditionof the finance

Private equity is capital invested in a private co.that is notnot listed on the stock exchange

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Venture Capital and Long-term Financing contd

Business angels:Business angels:WealthyWealthy individuals who are prepared to investup to $250,000 in a start-up or young business

Normally take a minorityminority equity stake in the

businessFill a gapgap in the market that does not appeal toventure capitalists

Can often bring a lot of business experienceexperience

to budding tycoonsMay be prepared to accept lowerlowerreturnsthan venture capitalists to be involved with aproject that has interest for them

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Share Issues

Rights issues:

Offers existingexisting s/holders the right to acquirenew shares in the company for cash

Issue price is usually significantly belowbelowcurrent market value

CheapCheap and straightforward for the company

NoNo dilutiondilution of ownership control providedoffer is taken up

SimplerSimplerthan other forms of shares issue

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Share Issues contd

Bonus issues: Is an issue ofnewnew shares made to s/holders

proportionally to their holdings As distinct from a rights issue, the shares in a

bonus issue are notnot paid for by the s/holders Funded from reservesreserves rather than cashpayment

Often used as a strategy to reducereduce shareprice, making them more marketable

IncreasesIncreases the capital base and hence, lenderconfidence

PositivePositive market signal to investors An alternativealternative to paying cash dividends

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Share Issues contd

Offer for sale: Involves a public limited co. sellingselling shares to

an issuing house Issuing house then has responsibilityresponsibility and

risk of marketing shares to the public Generally used fornewnew listings on the stockexchange

Public issue: Where the co. makes a directdirect invitation to

the publicpublic to purchase shares Issuing house may be used to helphelp administer

the issue PricePrice is either set up-front or can be set by

a tender process (not widely used, not popularwith investors)

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Share Issues contd

Private placing: Shares are placed with selected investorsinvestors

such as large financial institutions Quick and cheap way of raising equityequity funds

May lead to concentratedconcentrated ownership in a fewhands

Usually used by unlistedunlisted companies seekingrelatively small sums of cash

ASX imposes a limitationlimitation on companies of15% of their capital on these issues in a 12-month period, or more than 15% ifaccompanied by a share purchase plan (SPP)

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