Transcript Slide 1

Accounting for Management Decisions
Week 12
FINANCING THE BUSINESS
READING: TEXT Ch 14
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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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
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Sources of Finance
• Internal - sources that do not require approval
of others apart from managers or directors to
obtain eg retained profit
• External - requires the approval of s/holders
eg 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
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External Sources of Finance
Ordinary
shares
Preference
shares
Leases
Longterm
Hire purchase
agreements
Loans
Total finance
Bank
overdraft
Shortterm
Debt
factoring
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Invoice
discounting
Figure 14.1
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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 l/term
- Paying dividends does not bring any tax relief
making $1 of dividend more expensive than
$1 of loan interest
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Long-term Sources of Finance cont’d
Preference Shares:
• Lower risk than ordinary shares
• Given priority over ordinary shares if co.
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
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Long-term Sources of Finance cont’d
Loans and Debentures
• Specified interest rate, term and repayment
schedule
• Secured by assets held by the co.
- May be either on the basis of a ‘fixed charge’
over assets eg 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 co.
• Term Loans are established by negotiation, are
often cheap to set up and offer some flexibility
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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
co’s loan stock is listed and traded on the stock
exchange
• ‘Debentures’ are loan stocks that are supported
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
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Long-term Sources of Finance cont’d
Convertible Loan Stock
• Gives 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 co. and
receives interest until the conversion takes place
• Can be a useful hedge/protection against risk
with start-up co’s
• For a co., 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
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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 (eg 25 30 years) loan that is secured by freehold
property
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Long-term Sources of Finance cont’d
• Loan Covenants - enforceable conditions
contained within loan agreements that are
designed to protect lenders. May deal with
such matters 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
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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
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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
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Long-term Sources of Finance cont’d
Hire purchase (HP):
• A form of credit used to acquire an asset
• Under the HP agreement, the asset is paid for
by instalments 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 instalment is paid
• Similar to a finance lease, main difference
being that the business eventually becomes
the legal owner of the asset
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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
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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 co’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
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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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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Long-term vs. Short-term Borrowing
Issues to consider when deciding between longterm 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 eg 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
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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
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Internal Sources of Finance cont’d
Retained profit:
• Is the main source of finance for most co’s
• 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 s/holders 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
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Internal Sources of Finance cont’d
Tighter credit control:
• Important to weigh 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:
• Eg accrued wages, PAYG instalments,
Superannuation contributions
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The Role of the Stock Exchange
• Primary Market - enables co’s to raise new
capital
• Secondary Market - enables investors to
transfer their securities with ease
Negatives:
• Costs of becoming ‘listed’ are high
• Mandatory compliance with strict rules
• Half-yearly financial reporting
• Scrutiny by analysts, journalists and other
companies
• Pressure for short-term 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 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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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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 co.
that is not listed on the stock exchange
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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 lot 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
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Share Issues
Rights issues:
• Offers existing s/holders 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
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Share Issues cont’d
Bonus issues:
• Is an issue of new shares made to s/holders
proportionally to their holdings
• As distinct from a rights issue, the shares in a
bonus issue are not paid for by the s/holders
• Funded from reserves rather than 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
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Share Issues cont’d
Offer for sale:
• Involves a public limited co. 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 co. 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
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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 12month period, or more than 15% if
accompanied by a share purchase plan (SPP)
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