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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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)

29. 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)