External vs.

internal finance

Long-term vs. short-term finance

Equity vs. debt finance

Factors that influence the financing decision

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External refers to the involvement of outside parties
other than the management of the companies, e.g.
shareholders have to agree before any new shares can
be issued.

Internal sources means that sources are from within so
consent from shareholders or other parties is not
required.

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Debentures Lease

Long-term
Ordinary Securitisation
shares of assets

Preference
shares

Total finance

Bank overdraft Factoring

Short-term
Bills of exchange Invoice discounting
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It is the backbone of the financial structure of a
business.

It represents the risk capital of the business.

Gives voting rights, i.e. holders have a say in the
company

Requires high rate of return to shareholders due to
the nature of risk.

Financing can be obtained through initial public
offering (IPO), rights issue or private placement.

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Advantages:

No fixed rate of dividend,
only gives dividends to
shareholders

Share issue rarely fail

Unsecured, no collateral
needed

No legal action if unable to
give back capital
Disadvantages:

If the business is not
prudent, share prices may
go down so the cost of
financing may become
higher if shareholders are
uncertain about future
dividend

High return expected so
cash flow may be affected

No tax relief on dividends,
i.e. double tax
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Features:

Lower level of risk than ordinary shares

Holders usually receive fixed dividend

First priority before ordinary shares, meaning
that if the business bankrupts, holders claim first

No voting rights

Cumulative preference gives holders the right to
receive dividend in arrears, while non-
cumulative preference is the opposite.

Participating preference gives the holders the
rights to share the profits.

Similar to loans but dividends are not tax-
deductible, so it is less attractive
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Lenders will seek collateral or security for the loans

Security is usually non-perishable assets that have high
value and easily sold

Loans can be either fixed charge or floating charge on a
particular assets own by the business

In the event of default, lenders have the right to sell the
assets to obtain the amount of money owed by the
business and the balance will be returned to the
business

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Term loan :
 offered to suit business needs
 open to negotiation
 cheap and relatively flexible

Mortgages:
 loans secured on property such as land and
building

Convertible loans:
 gives the rights to the holders to convert a loan
into ordinary share at a future date and specified
price.

Zero coupon rate

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Instead of buying the asset direct from vendor, a
business may arrange a bank or another party to
purchase the asset on its behalf, and then lease it to
the company.

The party that bought the asset and then lease it to
the business is called `lessor’. The business is called
the `lessee’.

The lessor retains the ownership.

The lessee has possession and use of asset over the
rental period.

Usually at the end of the lease period, the business is
required to buy back the asset.

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Can be arranged
Cash flows can be
easily, cheaply and smoothed out over
quickly assets life

No down payment
Reduces the risk of

Rental cost matched obsolescence
with revenue
Saving of maintenance

Rental is tax costs
deductible
Minimizes the level of

Flexibility if there is gearing
an option to cancel the
lease

Avoid large cash
outflows

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A business which already owns an asset (building),
agrees to sell the asset to a financial institution or other
party and then immediately to lease it back.

Advantages:

immediate access to liquid fund arising from the
sale of asset

retaining the use of asset without having to relocate

tax deductible
Disadvantages:

reduction in borrowing power because have less
asset

rents may be reviewed and increased

may loose benefits of price appreciation

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Involves bundling of illiquid financial assets or physical
assets in order to provide backing for issuing securities.

Firstly used to bundle mortgages to provide asset
backing for the issue of bonds.

The bonds were considered low risk as they were also
backed by a guarantee from the bank.

It helps to lower the rates of interest of the bonds as
the bonds are now backed by assets.

It has become a major source of finance for a variety of
illiquid assets such as credit card payables and ticket
sales.

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It capitalises the claims of future benefits, and the capitalised
amount is sold to obtain financing.

Requires Special Purpose Vehicle (SPV) that will acquire the
illiquid assets from the business that needs financing.

SPV will arrange securities issuance.

Repayment of the financing will be matched by the receipts of the
securitised assets.

Assets usually of high quality with reliable and predictable income
stream.

It also useful to manage risk by spreading the risk of exposure to
other parties.

Examples of assets: credit card receivables, housing mortgages,
ticket sales

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q Usually refers to less than one year term of borrowing.
q Bank overdrafts:
 flexible form of borrowing
 rates depend on credit worthiness of the business
q Bills of exchange:
§ IOU notes, i.e. the business agrees to pay in future date.
§ The bills can be shown to bank that will pay the supplier
the face value of the bill, less the service cost. The bank
will then collect the full amount from the buyer.
q Factoring:
§ Service offered by banks that take over the debt
collection of the business.
§ A convenient arrangement to business.
§ Save in credit management and reliable cash flow
§ Service charge 2-3% of sales.

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Invoice discounting:
 similar to factoring but lower service charge.
 business obtains a loan of 75-80% of sales value.
 banks do not manage debt collection.
 gaining higher acceptance in the UK because the
business keeps the clients information, hence,
confidentiality is maintained by the business

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Costs of finance and available tax relief

Duration of finance are matched with cash flows, i.e. whether
cash flows are sufficient to repay loans

Flexibility, e.g. whether there is any penalty for early settlement
of loans

Refunding risks, i.e. availability of funds for short-term loans

Interest rates, i.e. how much is offered by the banks

Security required, i.e. how much collateral needed

Effect on gearing, i.e. the level of gearing preferred

Restriction on future borrowing, i.e. any restriction imposed by
the government or shareholders

Ease of obtaining funds

Effect on ownership & control, i.e. the level of ownership and
control preferred by the management and shareholders
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Retained profits are the main source of funds

Retained profits are not source of free finance as investors
will require levels of return similar to those from ordinary
shares

Ways to increase short-term internal finance:
 Tighter credit control, i.e. ask debtors to pay their debts on
time while maintaining good relationship with debtors
 Reducing stock levels, i.e. increase sales & reduce the
period of stock holding
 Delaying payments to creditors, i.e. ask permission from
creditors to delay payment without losing their confidence
in the ability of the business to repay loans

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Advantages

more flexible

easy to obtain

controllable

ownership will not be diluted

no restriction on further borrowing

no issuing costs

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