Lecture07 - FIN2101 FIN2101 Business Finance II Module 6...

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Unformatted text preview: FIN2101 FIN2101 Business Finance II Module 6 Module 6 Sources of Finance Student Activities 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 Trade credit Short­term loans Bank overdraft Bills of exchange Promissory notes Factoring 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 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 CD 365 Cost = × 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 2 365 Cost = × 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 Short­term Loans Specific­purpose. Repaid by instalments. Fixed period. Fixed or floating interest rate. Bank Overdraft Bank Overdraft Relatively easy to obtain; flexible. At call. Secured. 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. Discount securities. Face values usually either $100 000 or $500 000. Bills of Exchange Bills of Exchange Bank bill vs commercial (non­bank) bill. Financial intermediary. Usually 30, 60, 90 or 180 days. Unsecured for large companies. Drawer, acceptor, discounter. CONTINGENT LIABILITY. Text pp. 562­4. Contingent Liability 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 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. Discount securities. 30 to 180 days. More liquid than term deposits. May provide a higher yield if interest rates fall. Long­term Debt 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) Unsecured notes Leasing Project finance 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. Secondary market. 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. Rights issues. 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 Private Placements Restricted. Usually to institutional investors. Guaranteed subscription. Quicker and less costly. Disliked by existing shareholders. Rights Issues 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 Date Cum Rights Period Announcement Date Ex Rights Date Closing Date Closing Date Ex Rights Date Ex Rights Period 20 May 18 August 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 X= 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 1-for-4 $3 5 000 5 000 Theoretical Value of A Right Theoretical Value of A Right N ( M - S) R= N+1 4 ( 5 - 3) = 4+1 = $1.60 Theoretical Ex Rights Share Price Theoretical Ex Rights Share Price ( N ×M) + S X= 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 $25 000 Ex rights 6 250 @ $4.60 28 750 Value increase $ 3 750 Less Subscription cost (1250 @ $3) 3 750 Final position $25 000 Change $ 0 Mr B decides to SELL RIGHTS: Post sale Sale proceeds Ex rights Cum rights Change 5 000 @ $4.60 1 250 @ $1.60 5 000 @ $5.00 $23 000 2 000 $25 000 25 000 $ 0 Conclusion 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 Callable Participating Converting Convertible 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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