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Sources of Finance
Large variety of methods available to firms to raise finance/capital
(equity, debt, venture capital, back overdraft)
Type of finance a firm can avail of depends on the size and stage of
development of the firm (start up Vs reputable long standing)
For smaller firms short-term sources of finance are extremely
important (Bank Overdraft, Working capital)
Ownership Finance
1) Ordinary Shares / Common Stock
Authorised Share Capital - maximum number of shares a company may
issue
The price at which each share is issued is known as the par value (e.g.
5p, 25p, 1)
Issued Share Capital - on the other hand is the number of shares
actually issued
Price that new shares are issued to shareholders may exceed par value.
The difference known as capital surplus or share premium
Important to distinguish between book value and market value. From a
finance perspective, we are always concerned with market value
The owners capital is generally permanent. And owners bear the
financial and business risk of the venture.
Shareholders take the ultimate risk of the business as all other
sources of finance (creditors, banks, preference shareholders) are
catered for prior to dividends to shareholders and in the event of
liquidation all other sources of finance are repaid before owners
receive anything
In addition, company is not obliged to pay any dividend on their
investment
The return on debt capital is fixed, it does not vary with profits.
Therefore, the only risk to the lender is the risk of that he/she will
not get payment (default risk)
As lenders are not recognised as owners of the business, debt does not
carry any voting power.
The major advantage of debt is that the interest payments are tax
deductible.
Debt comes in a huge variety of different forms and is usually
categorised by five main characteristics:
1) Interest Rate
Usually fixed at the time of issue (e.g. debentures)
However, many direct bank loans carry a floating interest rate. The
interest charges depend on the general level of interest rates.
2) Maturity
The time to eventual maturity varies with different types of loans.
Debentures usually 10 to 30 years.
Firms may also issue debt with much shorter maturities.
3) Repayment Provisions
Long-term loans are generally repaid in a steady regular way
Some firms also reserve the right to call bonds. A callable bond may
therefore be bought back prior to the final maturity date. This
feature can be attractive to issuers as if interest rate decrease they
can call the bonds and re-issue new bonds at the lower interest rate.
4) Security
Debt may be subordinated or unsubordinated. Subordinated debt is
paid only after all senior creditors are satisfied.
Firms may also set aside certain assets as security for the loan. This
is termed collateral and the debt is said to be secured.
In the event of default, secured debt has first claim on collateral.
5) Denomination
Refers to both the units of currency (e.g. 100 or $1,000) or the
currency in which the debt is denominated.
For example, an Irish firm can borrow in US$.
Many firms now issue debt in currencies other than their domestic
currency.
Advantages of Debt Finance
1. Low after-tax cost.
2. No loss of voting or ownership rights.
3. Flexibility.
Disadvantages
1. Interest payments and repayment schedule are a fixed burden.
2. Can restrict management freedom of action (restrictive covenants).
Convertible Securities
Are securities where the investor has an option to convert instrument
into a share at some future point.
1) Warrant
Gives the purchaser/owner the right to buy a number of the companys
shares as a set price before a set date.
2) Convertible Bonds
Gives the owner of the bond the option to convert the bond into a predetermined number of shares.
No obligation to convert.
Key difference to warrants is that with a convertible the investor does
not pay extra cash for the shares instead exchanges the bond for shares
in the company.
Issuing Securities
The first sale of stock to the public is called an Initial Public Offering
(IPO).
An IPO is called a primary offering as new shares are sold to raise
additional capital for the firm.
When going public a firm needs to appoint underwriters. The
underwriters are a firm(s) that buys an issue of securities from a
company and resells it to the public. In fact they play a triple role providing advice to the firm, buying the stock and reselling it to the
public.
The Spread is the difference between what the underwriters pay for the
shares and price they are allowed to sell them on to the public at.
Part of the cost of the issue is the under pricing typically associated with
issues. Firm managers try to secure the highest possible price for the
shares, but underwriters are generally more cautious as they may be left
with any unsold shares if they over estimate investor demand.
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Venture capital
Equity capital in new, start-up businesses is known as venture capital and
is provided by specialist venture capital firms, wealthy individuals, and
investment institutions, such as pension funds.
Investing venture capital in a business is a high risk activity as a large
percentage of company start-ups fail. However, the rewards can also be
substantial if the business takes off.
If a start-up proves successful then the firm may decide to go public
(many years down the road)
The venture capitalist (VC) acquires an agreed proportion of the Equity
Share Capital of the business. The VC will usually have a representation
on the board of the company.
Venture Capital is a medium to long term investment with gains to the
investor expected when the company floats on the Stock Exchange of the
VC sells the holding in the company to make a capital gain.
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Because there are no new funds generated by the company this has no
effect on the value of the firm.
Used often to reduce the share price with the view to stimulating
interest in the stock
Scrip Dividends
A scrip dividend is where a company offers shareholders a choice of new
shares instead of their cash dividend. The effect of this is to convert
profits into Issued Share Capital.
This has the effect of increasing issued share capital (to improve
gearing) and avoids the cash outflow in respect of dividends.
Shareholders have the advantage of increasing their share holdings
without paying commissions, fees or duties on the transaction.
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