Transcript Document

2BUS0197 – Financial Management
Short- and Long-Term
Sources of Finance
Lecture 5
Dr Francesca Gagliardi
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Learning outcomes
By the end of the session students should be able to appreciate:

The role of working capital as a short-term source of finance

The cash conversion cycle

The need of working capital policies

The key features of long-term equity and debt finance

The different ways that a company can issue new equity
finance

The types of long-term debt finance available to a company

Value different types of bonds
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Working capital management

Working capital is concerned with short-term
resources and short-term funding
Net working capital = Current Assets – Current Liabilities

Effective working capital management requires
balancing the need for liquidity against the need
for profitability
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Working capital policies

Policies cover level of investment in working
capital and its components, and the extent to
which it is financed from short-term

Policies should take account of nature of
business, credit policy, seasonal factors and
manufacturing period
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Level of investment in working capital

Aggressive policy: a company chooses to operate
with lower levels of stock, debtors and cash for a
given level of activity. Both profitability and risk
increase

Conservative policy: maintains a large cash balance,
offers more generous credit terms to customers and
holds higher levels of stock. Risk and profitability are
reduced

Moderate policy: in between aggressive and
conservative policies. Will have lower risk and lower
profitability
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Level of investment in working capital
Conservative policy
Level
of
funds
Moderate policy
Aggressive policy
Time
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Short-term finance

Overdraft

Short-term loan
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Trade credit

Short-term finance is cheaper and more flexible
than long-term finance

Short-term finance is riskier than long-term finance
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Analysis of assets

Fixed assets: long-term assets expected to produce
benefits over several periods

Permanent current assets: core level of investment needed
to sustain normal level of trading activity

Fluctuating current assets: variations in the level of current
assets arising from normal business activity

Principle of matching funding policy: long-term finance
used for long-term assets, short-term finance used for
short-term assets
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Cash conversion cycle

The cash conversion cycle is the average time
between paying for inputs and receiving cash from
sales

The length of the cash conversion cycle helps
determine the level of working capital: the longer the
cash conversion cycle, the greater the amount of
investment required in working capital

It is measured as:
CCC = stock days + debtor days – creditor days
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Overtrading

Overtrading occurs when a company’s capital base is
too small to support the volume of trade

Overtrading may be caused by rapid growth in
turnover or erosion of the capital base

Overtrading can be indicated by: deterioration in key
financial ratios; decreasing liquid resources;
increasing reliance on short-term finance

To deal with overtrading can: introduce new capital;
improve working capital management; reduce
business activity
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Inventory management

Seeks to minimise the costs of holding stock for
production or resale. These costs include: holding
stocks; replacement costs, the cost of the stock, the
opportunity cost of the cash tied up

The economic order quantity (EOQ) model calculates
the optimum order size if the annual demand, holding
cost and ordering cost are known

An alternative approach to EOQ is the adoption of
just-in-time (JIT) purchasing policies
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Cash management

Holding cash for short-term needs incurs opportunity cost of lost profit.
Cash management aims to optimise the amount of cash available

Efficient cash management means credit collection in line with agreed
terms; prompt banking; full use of credit offered by suppliers

Causes of cash flow problems: making losses on a continuing basis;
inflation; growth; seasonal factors; significant expenditure

Cash flow shortages can be eased by postponing expenditure,
accelerating income and finding new cash resources

Invest short-term cash surpluses in appropriate short-term instruments
that have no risk of capital loss: e.g. term deposits; treasury bills; bank
certificates of deposit
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Debtor management

Debtor levels depend on terms of sale, pricing policy and debtor
collection procedures
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The benefits from offering credit to customers must be set against
the administrative and financial costs of offering credit
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Credit assessment should consider previous experience of similar
firms, credit reports and analysis of published information

Company should ensure that agreed terms of sale are kept through
periodic review of credit limits, aged debtor analysis, efficient
administration and agreed overdue account procedures
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Cash discounts may encourage early payments

Factoring companies can administers sales ledger and collect
amounts due
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Equity finance

It is the foundation of companies’ financial structure, hence it should
be the source of most of the long-term finance
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Equity finance is raised through the sale of ordinary shares to
investors. Shares can be issued to new owners and/or to existing
shareholders by means of a rights issue

Ordinary shares must have a par value (nominal value) and cannot
be issued below it. Shares’ par value is not related to their market
value

New shares generally issued at a premium to their par value. Their
nominal value is represented in the balance sheet by the ordinary
share account

The funds exceeding the par value are reflected in the share
premium account
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Ordinary shareholders’ rights
An ordinary shareholder has the right to:

attend the general meetings of the company
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vote on the appointment of directors
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vote on appointment, remuneration and removal of auditors
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receive company’s annual accounts and its’ auditors report
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receive a share of any dividend paid

vote on important issues, such as permitting repurchase of
shares, using shares in a takeover bid or a change in
authorised share capital

receive a share of the assets remaining after the company
has been liquidated
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participate in a new issue of company’s shares (the preemptive right)
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Ordinary shareholders’ risk and return

Ordinary shareholders are the ultimate bearers of
the risk associated with the business activities


They are the bottom of the credit hierarchy governing the
distribution of the proceeds of liquidation in the event a
company goes out of business
To compensate for this greater risk, ordinary
shareholders expect the return they receive through
capital gains and ordinary dividends to be higher
than either interest payments or preference
dividends
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New issue methods
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Placing: large blocks of shares are issued at a fixed
price to institutional investors



Public offer: shares offered to the general public
normally at fixed price




Cheaper than public offer
Narrower spread of public ownership
More expensive than placing
Gives widespread public ownership
Used for very large issues
Introduction: shares of a company with wide ownership
base become listed but no funds are raised
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New issue methods

Which method is used depends on issue costs,
ownership spread, aims and size of issue

Placing is the most popular method of obtaining a stock
market quotation

Public offers account for most of the finance raised
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Companies insure against the possibility of a new issue
being unsuccessful by having it underwritten

Underwriters accept the shares not taken up by the market. This
allows companies to raise the required finance

Main underwriter is usually the sponsor. Also insurance companies
and pension funds
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Pros and cons of stock exchange
quotation

Advantages of being listed

Raising finance by coming to market
 Access to finance via capital markets
 Shares can be used in acquisitions

Disadvantages of being listed

Costs of gaining/maintaining quotation
 Higher shareholder expectations
 Increased financial transparency
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Rights issues

Pre-emptive right means that new shares are offered first
to existing shareholders on a pro rata basis

Rights issues are cheaper than public offers but amount
of funds that can be raised is lower

Rights issues offered at a discount to the current market
price (15-20%) to guard against adverse share price fall
before issue
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Scrip issues, share splits, scrip dividends

Scrip issues (or bonus issues) convert existing capital
reserves into ordinary shares distributed pro rata to existing
shareholders
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Share splits increase the number of issued shares by
reducing their nominal value. Lower par value should increase
the marketability of shares

Scrip dividends offer new shares to existing shareholders as a
partial or total alternative to a cash dividend
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Share repurchases occur when a company purchases its own
shares from ordinary shareholders. Reasons for doing this
are: increase EPS (since number of issued shares
decreases); increase ROCE (since capital employed
decreases due to cash spent on buying back shares) etc.
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Preference shares

Holders have preferential rights to receive dividend and
the proceeds of assets’ disposal in the event of
liquidation
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Although permanent capital, preference shares do not
normally carry voting rights

Less risky than ordinary shares but more risky than debt:
They are not secured on company assets
- Preference dividends cannot be paid until interest
payments on debt have been covered
- In the event of liquidation, preference shareholders will not
be paid off until the claims of debt holders have been
satisfied
-
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Types of preference shares

Cumulative: if distributable profits are insufficient to pay the
preference dividend, the right to receive it is carried forward and will
be settled in future years before ordinary dividends
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Non-cumulative: if distributable profits are insufficient to pay the
preference dividend, the dividend is lost
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Participating: both fixed and variable dividend income are paid
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Non-participating: fixed preference dividend is paid
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Convertible: holder has the option to convert them into ordinary
shares on given terms in prescribed circumstances
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Variable rate: pay a variable rate dividend, which is periodically
adjusted
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Pros and cons of preference shares

Advantages of preference shares
 No
need to pay dividend if profits are poor
 Do not dilute ownership and control since do not carry
general voting rights
 Unsecured, so preserve debt capacity
 No right to appoint a receiver if dividend is not paid

Disadvantages of preference shares
 Higher
cost compared to debt (e.g. debenture) due to
tax inefficiency
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Debt finance: risk, return and
security

Debt is less risky than equity
 Statutory
right to interest payments
 Position of debt in creditor hierarchy
 Security

Debt is cheaper than equity
 Lower
risk, so lower return required
 Interest payments are tax-deductible (tax efficiency)
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Debentures and loan stock
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Debentures: long-term debt securities – bonds that are secured
by a trust deed against corporate assets
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Par value usually £100 in the UK
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Loan stocks: long-term unsecured bonds

Interest rate: fixed or floating (i.e. linked to a market interest
rate), usually paid twice per year, tax deducible

On maturity, issue should be redeemed or refinanced

Restrictive covenants written to restrict management actions,
hence protecting investors
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Other types of debt

Deep discount bonds: issued at deep discount to
its par value in exchange for a lower interest rate
coupled with redemption at par (or at premium) on
maturity. The revenue return is traded for capital
gain

Zero coupon bonds: pay no interest so return is
entirely capital gain
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Bank and institutional debt

Bank loans are not traded, so no market value can be
placed on the debt

Fixed or variable interest rate

Secured on company’s assets

Repayment schedule includes both interest and capital
elements

Through securitisation financial institutions parcel up debts
as securities and sell them on securitised debt markets

Small businesses may obtain government assistance when
seeking debt finance
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Eurobonds

Bonds outside the control of the country in whose
currency they are denominated

Unsecured bonds, so issuing company must have
excellent credit rating

Sold in different countries at the same time by large
companies and governments

Typical maturity of 5 to 15 years; interest rate can be
fixed or floating

Common issue currencies are US dollars (Eurodollars),
yen (Euroyen), sterling (Eurosterling)
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Convertible bonds

Fixed interest debt securities which can be converted to ordinary
shares at option of the holder. If not converted, can be redeemed at
a given date
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Option to convert leads to interest being lower than on straight debt

Conversion terms should be designed to make conversion attractive
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The floor value (minimum price) is that of an ordinary bond with the
same interest rate, maturity and risk
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The actual market value depends on:

Current conversion value
 Time to conversion
 Expected conversion value
 Market expectation re-conversion
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Pros and cons of convertibles

Advantages of convertibles
Self-liquidating, so avoids redemption
 Share prices do not fall on conversion
 In the long-term, gearing is lowered
 Conversion increases debt capacity
 Lower coupon than straight debt
 Interest is tax deductible
 Attractive to the cautious optimists


Disadvantages of convertibles
Short-term increase in gearing
 Possible dilution of earnings per share
 Possible dilution of existing shareholders’ control

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Warrants

A warrant is the right to buy new ordinary shares at a future
date at a set price (exercise price)

Warrants are usually attached to a loan stock to make it
more attractive to investors
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Warrants can be detached from the loan stock and traded

Exercising warrants has no effect on the loan stock, which
continues to trade to redemption

Warrants offer additional income to the initial investor or the
opportunity to participate in equity growth

For a small outlay, warrants offer a large return in
percentage terms (gearing effect)
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Summary
Today we looked at the different ways a
company can raise finance:
Short-term sources
 Long-term financing

 Equity
 Debt
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Readings

Watson D. and Head A., (2009), Corporate Finance
Principles and Practice, 5th edition, FT Prentice Hall,
Chapters 3, 4, 5
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