ACCOUNTING FOR MANAGEMENT DECISIONS WEEK 12 FINANCING THE BUSINESS READING: TEXT CHAPTER 14

Learning Objectives Identify the main sources of finance available to 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

Learning Objectives cont’d 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 method might be chosen

Sources of Finance Internal - sources that do not require the approval of others apart from managers or directors to obtain e.g. retained profit External - requires the approval of shareholders e.g. issue of new shares Long-term - expected to provide finance for at least one year Short-term - typically for less than one year

External Sources of Finance Ordinary shares Preference Loans Total finance Bank overdraft Debt factoring Leases Hire purchase agreements Invoice discounting Long- term Short- Figure 14.1

Long-term Sources of Finance Ordinary Shares: High-risk investments Higher expected returns Voting rights Limited loss liability, un-limited return potential From the company’s perspective: Can be useful to avoid paying a dividend Cost of financing can be high over the long term Paying dividends does not bring any tax relief making $1 of dividend more expensive than $1 of loan interest

Long-term Sources of Finance cont’d Preference Shares: Lower risk than ordinary shares Given priority over ordinary shares if company is wound-up Normally given a fixed rate of dividend Lower level of return than ordinary shares May be cumulative or non-cumulative No longer a major source of finance because: No tax effectiveness Preference shares are now seen as debt when assessing borrowing capacity

Long-term Sources of Finance cont’d Loans and Debentures Specified interest rate, term, and repayment schedule Secured by assets held by the company May be either on the basis of a ‘fixed charge’ over assets e.g. freehold land, premises Or on the basis of a ‘floating charge’ over the whole of a company’s assets Less risky than share capital Interest is tax deductible to company Term Loans are established by negotiation, are often cheap to set up and offer some flexibility

Long-term Sources of Finance cont’d Loans and Debentures ‘Loan Stock’ is a form of finance where debt is divided into units and sold to investors, public companies’ loan stock is listed and traded on the stock exchange ‘Debentures’ are loan stocks that are evidenced with a trust deed Both loan stocks and debentures are now mostly called ‘bonds’ - see also ‘Eurobonds’ Interest rates on loans and debentures may be either fixed or variable ‘Deep-discount bonds’ are issued at a low or zero interest rate and at a large discount to their redeemable value

Long-term Sources of Finance cont’d Convertible Loan Stocks Give the investor the right to convert the loan into equity shares at a future date and at a specified exercise price The investor remains a lender to the company and receives interest until the conversion takes place Can be a useful hedge against risk with start-up companies For a company, this form of financing may be considered because: The loan is self-liquidating A lower rate of interest may be offered because of future potential gain for the investor

Long-term Sources of Finance cont’d Warrants - give the holder the right, but not the obligation, to acquire ordinary shares in a company at an agreed price Mortgages - simply a form of long-term (e.g. 25 - 30 years) loan that is secured by freehold property Loan Covenants - enforceable conditions contained within a loan agreement which are designed to protect the lenders. May deal with matters such as: Access to financial statements Approval required before taking on other loans Dividend payments may be required to be limited Liquidity may need to be maintained at a prescribed level

Long-term Sources of Finance cont’d Finance leases: A form of lending - same effect as borrowing to purchase the asset No longer a tax-efficient form of financing due to changes in tax laws Nevertheless, still growing in popularity because of: Ease of borrowing, limited security and records required Cost Flexibility - option to cancel may be included Cash flow - large outflows can be avoided and spread over the life of the asset

Long-term Sources of Finance cont’d Sale and lease-back arrangements: Involves the business selling an asset to raise finance, with an agreement to lease the asset back so it can still be used by the business Usually agreements are reviewed periodically throughout the lease, making future payments difficult to predict At the end of the lease, the business must either renew the lease or, in the case of property, find alternative premises Capital gain is assessable on the sale of the asset and may present a tax liability

Long-term Sources of Finance cont’d Hire purchase: A form of credit used to acquire an asset Under the HP agreement, the asset is paid for by installments over an agreed period Normally an initial deposit is required The asset is taken possession of after the deposit is paid, however legal ownership is not transferred until the final installment is paid Similar to a finance lease, main difference being that the business eventually becomes the legal owner of the asset

Short-term Sources of Finance Bank overdraft: Flexible form of borrowing that allows a business to have a negative current account balance Size of credit limit can be varied depending on requirement Relatively easy and inexpensive to arrange Should be self-liquidating Security is generally required Repayable on demand from lender

Short-term Sources of Finance cont’d Debt factoring: Is a form of service offered by a financial institution (a factor) - often a subsidiary of a commercial bank Involves the factor taking over a company’s sales ledger Usually offers to advance up to 85% of approved trade debtors Fee is normally 2-3% of turnover Can deliver benefits such as more certain cash flows, savings in credit management Some negatives can include high cost and adverse customer reaction

Short-term Sources of Finance cont’d Invoice discounting: Financial institution is approached for a loan for 75-80% of value of approved sales outstanding Repayment is made usually within 60 - 90 days Business remains responsible for debtors collection Is confidential - customers unaware of it Cost is cheap compared with factoring Allows company to retain control of sales ledger and relationship with customers Is proving to be growing in popularity more than factoring

Long-term vs. Short-term Borrowing Issues to consider when deciding between long-term or short-term borrowing: Matching borrowing to nature of asset on the basis of time or permanency Flexibility - aim to minimise costs incurred if circumstances change e.g. early disposal of asset Re-funding risk - short-term finance has to be renewed more frequently Interest rates - differ between short and long-term, other setup costs should also be considered

Internal Sources of Finance Reduced inventories levels Delayed payment to trade payables Tighter credit control Total internal finance Retained profits Short-term Long-term Figure 14.5 Major internal sources of finance

Internal Sources of Finance cont’d Retained profit: Is the main source of finance for most companies No issue or establishment costs No dilution of shareholder interest No waiting - funds are immediately available Often less scrutiny from investors Potential tax-efficiency for shareholders when retained profits deliver increased share prices Typically the retention / dividend ratio is not more than 50% of profit

Internal Sources of Finance cont’d Tighter credit control: Important to weight the cost against the benefits Credit policy must be determined appropriately Reduced inventory levels: Reduces opportunity cost Depends on nature and condition of inventory May not be easy to liquidate obsolete items Delayed payment to creditors: Extends period of interest-free loan BUT: At the risk of jeopardising relations Spontaneous sources of funds: E.g. accrued wages, PAYG installments, Superannuation contributions

The Role of the Stock Exchange Primary Market - enables companies to raise new capital Secondary Market - enables investors to transfer their securities with ease Negatives: Costs of becoming ‘listed’ are high Mandatory compliance with stringent rules Half-yearly financial reporting Scrutiny by analysts, journalists and other companies Pressure for short-term performance

Venture Capital and Long-term Financing Definitions: Long-term capital provided by certain institutions to small and medium-sized businesses to exploit relatively high-risk opportunities Private equity is equity finance primarily for small and medium-sized businesses provided by venture capitalists and / or business angels Venture capital providers may be interested in: Business start-ups Early stage capital Expansion capital Buy-out or buy-in capital

Venture Capital and Long-term Financing cont’d Generally regarded as higher risk due to nature of products or lack of trading record Normally the investment is taken in the form of ordinary shares in the business A representative of the venture capitalist is usually on the board of directors as a condition of the finance Private equity is capital invested in a private company that is not listed on the stock exchange

Venture Capital and Long-term Financing cont’d Business angels: Wealthy individuals who are prepared to invest up to $250,000 in a start-up or young business Normally take a minority equity stake in the business Fill a gap in the market that does not appeal to venture capitalists Can often bring a wealth of business experience to budding tycoons May be prepared to accept lower returns than venture capitalists to be involved with a project that has interest for them

Share Issues Rights issues: Offers existing shareholders the right to acquire new shares in the company for cash Issue price is usually significantly below current market value Cheap and straightforward for the company No dilution of ownership control provided offer is taken up Simpler than other forms of shares issue

Share Issues cont’d Bonus issues: Is an issue of new shares made to shareholders proportionally to their holdings As distinct from a rights issue, the shares in a bonus issue are not paid for by the shareholders Funded from reserves rather than a cash payment Often used as a strategy to reduce share price, making them more marketable Increases the capital base and hence, lender confidence Positive market signal to investors An alternative to paying cash dividends

Share Issues cont’d Offer for sale: Public issue: Involves a public limited company selling shares to an issuing house Issuing house then has responsibility and risk of marketing shares to the public Generally used for new listings on the stock exchange Public issue: Where the company makes a direct invitation to the public to purchase shares Issuing house may be used to help administer the issue Price is either set up front or can be set by a ‘tender’ process (not widely used, not popular with investors)

Share Issues cont’d Private placing: Shares are ‘placed’ with selected investors such as large financial institutions Quick and cheap way of raising equity funds May lead to concentrated ownership in a few hands Usually used by unlisted companies seeking relatively small sums of cash ASX imposes a limitation on companies of 15% of their capital on these issues in a 12-month period, or more than 15% if accompanied by a share purchase plan (SPP)