Transcript Slide 1

ACCOUNTING FOR
MANAGEMENT DECISIONS
WEEK 12
FINANCING THE BUSINESS
READING: TEXT CHAPTER 14
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 longterm or short-term finance
• Identify the so-called internal sources of finance and
explain them
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
External Sources of Finance
Ordinary
shares
Preference
shares
Leases
Longterm
Hire purchase
agreements
Loans
Total finance
Bank
overdraft
Debt
factoring
Shortterm
Invoice
discounting
Figure 14.1
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Short-term Sources of Finance
cont’d
Invoice discounting:
• Financial institution is approached for a loan for 7580% 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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Internal Sources of Finance
Short-term
Long-term
Reduced
inventories levels
Delayed payment
to trade payables
Retained
profits
Total
internal
finance
Tighter
credit control
Figure 14.5
Major internal sources of finance
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Venture Capital and Long-term
Financing
Definitions:
Long-term capital provided by certain institutions to small
and medium-sized businesses to exploit relatively highrisk 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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Share Issues cont’d
Offer for sale:
• 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)
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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)
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia