Unformatted text preview: FIN2101
Business Finance II Module 6
Sources of Finance Student Activities
Reading Text, Chapters 2 (pp. 3341), 15 (pp. 55371) & 18 (pp. 6616)
Text Study Guide, Chapters 2, 15 & 18 (parts only)
Study Book, Module 6 Tutorial Activities Tutorial Workbook, Self Assessment Activity 6.1 Sources of Finance
Sources of Finance
Internal Equity (Retained Earnings, Dividend Reinvestment Plans). External Equity (Ordinary and Preference Share Issues, Rights Issues). Debt (Long and Shortterm). Convertible Securities. Shortterm Debt
Shortterm Debt Cash borrowings
Bank overdraft Bills of exchange
Certificates of deposit (CDs) Choosing Shortterm Debt
Choosing Shortterm Debt
Factors to consider: the effective cost; the availability in the amount needed and for the period when financing is required; the influence of the use of a particular source on the cost and availability of other sources. Cash Borrowings
Market restricted to firms of high credit worthiness. Rarely secured. Typically overnight (11am money) or for 7 days (24hour loans) (rarely for more than 3 months). Trade Credit/Accounts Payable
Trade Credit/Accounts Payable
Readily available and more or less free. Effective management is important. Cost of not taking discounts. “Stretching” accounts payable. Text pp. 5547. Cost of Foregoing Discount
Cost of Foregoing Discount
100% - CD N
where CD = the cash discount
N = the number of days payment
can be delayed by not taking
the discount Cost of Foregoing Discount
Cost of Foregoing Discount XYZ Ltd sells goods for $1 000 to ABC Ltd on the following terms: 2/10, n/30. What is the cost to ABC Ltd of foregoing the discount offered? Cost of Foregoing Discount
Cost of Foregoing Discount
100 - 2 20
= 0.3724 or 37.24% Stretching Accounts Payable
Stretching Accounts Payable Advantage Firm has longer use of its cash. Disadvantages Fees/charges may apply to late payment. Cost of discounts foregone. Damage to credit standing/reputation, which may lead to loss of credit facility. Shortterm Loans
Specificpurpose. Repaid by instalments. Fixed period. Fixed or floating interest rate. Bank Overdraft
Bank Overdraft Relatively easy to obtain; flexible.
Variable interest rate – 0% to 5% above the prime rate.
Terms negotiated with bank.
Text p. 560. Bills of Exchange
Bills of Exchange A promise to pay the holder of the bill an agreed sum (the face value) on a certain date (the maturity date).
Liquid market within the Australian money market negotiable instrument.
Face values usually either $100 000 or $500 000. Bills of Exchange
Bills of Exchange Bank bill vs commercial (nonbank) bill.
Usually 30, 60, 90 or 180 days.
Unsecured for large companies.
Drawer, acceptor, discounter.
Text pp. 5624. Contingent Liability
If the acceptor is unable to pay (the holder on maturity), then anyone who has endorsed the bill may be obliged to pay a subsequent holder of the bill. Promissory Notes
Promissory Notes A promise to pay a stated sum of money on a stated future date.
Two parties borrower and discounter.
Restricted market – unsecured.
Fixed interest rate.
7 to 364 days.
No contingent liability.
Text p. 564. Factoring
Companies sell their accounts receivables at a discount to a third party, usually a finance company. Avoids need for, and cost of, following up receivables. Expensive. Text pp. 5679. Certificates of Deposit (CDs)
Certificates of Deposit (CDs) Shortterm borrowing instruments of banks.
Similar to promissory notes, with the bank being the drawer.
30 to 180 days.
More liquid than term deposits.
May provide a higher yield if interest rates fall. Longterm Debt
Debt with a maturity greater than 12 months. Usually comprises 75% to 80% of the total debt of listed Australian companies. Secured vs unsecured debt. Marketable vs nonmarketable debt. Secured vs Unsecured
Secured vs Unsecured If debt is secured, the lender has a legal claim against the borrower and against the assets of the borrower.
With unsecured debt, the lender has a claim against the borrower but not against any particular property or assets of the borrower. Marketable vs Nonmarketable
Marketable vs Nonmarketable Marketable debt includes notes, bonds or debentures and can be traded in a secondary market.
Nonmarketable debt refers to loans arranged privately between two parties where the lender is usually a bank or other financial intermediary. Types of Longterm Debt
Types of Longterm Debt Term loans
Fully drawn advances (FDAs)
Debentures (corporate bonds)
Mortgage finance Term Loans
Term Loans Fixed period, between 1 and 25 years.
Used for capital expenditures.
Repayments flexible interest only, principal and interest basis, or a combination of both.
Fixed or floating (variable) interest rates.
Secured. Fully Drawn Advances (FDAs)
Fully Drawn Advances (FDAs) Sometimes seen as similar to an overdraft.
Usually drawn down, in full, at the time of approval.
Regular repayment schedule.
Interest rate usually slightly higher than that for term loans. Debentures (Corporate Bonds)
Debentures (Corporate Bonds) Fixed interest (coupon) security.
Secured with either a fixed or floating charge over the assets of the borrower.
Fixed term between 2 and 10 years.
Coupons usually paid semiannually.
Text, pp. 337. Unsecured Notes
Unsecured Notes Similar to debentures.
Holders are unsecured creditors who rank below any secured creditors for the repayment of debt.
Higher risk than debentures.
Higher interest rate on unsecured notes. Leasing
Leasing A lease is an agreement under which the owner of the asset (the lessor) gives another (the lessee) the right to possess and use an asset for a specified period in return for rental/lease payments.
Covered in detail in module 8. Project Finance
Project Finance Used for large projects involving large outlays.
Usually in the form of a loan.
High debttoequity ratios a feature.
Larger banks, merchant banks and some international banks manage project finance. Mortgage Finance
Mortgage Finance The borrower conveys an interest in the land or property to the lender.
The mortgage is discharged when the loan is fully repaid.
Largest of the longterm debt markets in Australia. Longterm Finance Equity
Longterm Finance Equity Internal equity sources.
Public issue of ordinary shares flotation of initial issue; secondary issues.
Private issue or placement of shares.
Preference shares. Internal Equity
Internal Equity Once provided up to 60% of a firm’s finance but this has dropped to below 50% in recent times.
Dividend imputation has resulted in firms increasing their dividend payout ratios.
Lower cost alternative, control of firm unaffected, convenient source of finance. Dividend Reinvestment Plans
Dividend Reinvestment Plans Allows shareholders the choice of using their dividends to purchase additional shares instead of receiving cash.
A major source of equity for listed companies.
Allows company to meet the demand for distribution of franking credits without straining cash resources. Flotation of Initial Issue
Flotation of Initial Issue Issue costs underwriting fees; Prospectus. Delays in receiving funds. Secondary Issues
Secondary Issues All share issues made by a company after the initial flotation. Usually in the form of a private placement or a rights issue. Private Placements
Restricted. Usually to institutional investors. Guaranteed subscription. Quicker and less costly. Disliked by existing shareholders. Rights Issues
An invitation to existing shareholders to take up additional shares in proportion to their current holding at the EXERCISE or SUBSCRIPTION PRICE. Rights Issue Key Dates
Rights Issue Key Dates
Announcement date Closing date Ex rights date Cum rights period Ex rights period Rights Issue – Key Dates
Rights Issue – Key Dates Announcement
Cum Rights Period Announcement Date
Ex Rights Date
Closing Date Closing
Date Ex Rights
Ex Rights Period 20 May
23 September Rights Issues
Rights Issues Renounceable issue – existing shareholders can sell their rights to a third party.
Nonrenounceable issue – unable to sell to a third party. Must either exercise rights or let the offer lapse.
Not usually underwritten, except for some nonrenounceable issues or if subscription price is close to market price of shares. Rights Issues
Rights Issues Rights have a value and may be traded. Calculate theoretical value of the right to one new share. Calculate the theoretical value of one share ex rights. Value of A Right
Value of A Right R= N ( M - S)
N+1 Ex Rights Share Price
Ex Rights Share Price ( N × M) + S
N +1 Rights Issue Example
Rights Issue Example
Company Z - All Equity - 5m Shares @ $1
Current Market Price (M)
Renounceable Rights Issue
Subscription Price (S)
Shareholdings - Ms A
Mr B $5
5 000 Theoretical Value of A Right
Theoretical Value of A Right
N ( M - S)
4 ( 5 - 3)
= $1.60 Theoretical Ex Rights Share Price
Theoretical Ex Rights Share Price
( N ×M) + S
N +1 ( 4 × 5) + 3
4 +1 = $4.60 Subscribing Shareholder’s Position
Subscribing Shareholder’s Position Cum Rights 5 000 shares @ $5.00 Ex Rights 6 250 shares @ $4.60 Value to the Shareholder
Value to the Shareholder
Shareholder Ms A decides to SUBSCRIBE:
Cum rights 5 000 @ $5.00
6 250 @ $4.60
$ 3 750
Less Subscription cost (1250 @ $3) 3 750
0 Mr B decides to SELL RIGHTS:
Change 5 000 @ $4.60
1 250 @ $1.60
5 000 @ $5.00 $23 000
Conclusion Shareholder’s wealth is not directly affected by a rights issue. Information content could have a positive effect on market price of shares. Preference Shares
Preference Shares Entitle shareholder to preferred dividend payments over payments to ordinary shareholders.
Characteristics vary according to terms of issue.
Either public or private issues.
Less attractive today from an investor’s perspective than other forms of financing.
Text pp. 401. Types of Preference Shares
Types of Preference Shares Cumulative
Study Book, p. 6.10 Advantages of Equity
Advantages of Equity No requirement to pay a dividend.
Ordinary shares do not have a maturity date and there is no obligation to redeem them.
The more equity, the lower the risk for potential lenders and the lower the cost of debt. Disadvantages of Equity
Disadvantages of Equity Dilution of ownership if the company raises funds through the issue of more ordinary shares.
Greater transaction costs incurred in issuing shares.
Double taxation of dividend income (not in Australia). Convertible Securities
Convertible Securities A preference share or a debt issue that can be exchanged for a specified number of ordinary shares.
Convertible unsecured notes.
Convertible preference shares.
Converting preference shares.
Text pp. 6616. Debt vs Equity
Debt vs Equity Cost Flexibility Debt may be cheaper after tax.
Debt can be borrowed, repaid and reborrowed in variable amounts at any time. Debt is more readily available. Control Equity cedes control, whereas debt doesn’t. ...
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