Financing Provided by Owners is Referred to as ______.

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Chapter 7 – Sources of finance

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Chapter objectives
Construction of the chapter
Sources of funds
Ordinary (equity) shares
Loan stock
Retained earnings
Banking concern lending
Leasing
Hire purchase
Government assistance
Venture capital
Franchising
Key terms

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Sourcing money may exist done for a diverseness of reasons. Traditional areas of need may be for capital asset acquirement – new machinery or the construction of a new building or depot. The development of new products can exist enormously costly and here again capital may be required. Normally, such developments are financed internally, whereas majuscule for the acquisition of machinery may come from external sources. In this day and historic period of tight liquidity, many organisations have to await for short term capital in the manner of overdraft or loans in guild to provide a cash flow cushion. Interest rates tin vary from organisation to organisation and also co-ordinate to purpose.

Chapter objectives

This chapter is intended to provide:

·
An introduction to the dissimilar sources of finance available to management, both internal and external

·
An overview of the advantages and disadvantages of the dissimilar sources of funds

·
An understanding of the factors governing the selection between different sources of funds.

Structure of the chapter

This last affiliate starts past looking at the various forms of “shares” equally a means to raise new capital and retained earnings equally some other source. However, whilst these may be “traditional” means of raising funds, they are by no means the but ones. There are many more sources available to companies who do not wish to go “public” by means of share bug. These alternatives include bank borrowing, government aid, venture uppercase and franchising. All have their own advantages and disadvantages and degrees of risk attached.

Sources of funds

A visitor might raise new funds from the following sources:

·
The capital markets:

i) new share bug, for example, past companies acquiring a stock market list for the first fourth dimension

ii) rights issues

·
Loan stock
·
Retained earnings
·
Bank borrowing
·
Government sources
·
Business expansion scheme funds
·
Venture capital
·
Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or ‘face’ value, typically of $ane or 50 cents. The market value of a quoted visitor’south shares bears no relationship to their nominal value, except that when ordinary shares are issued for greenbacks, the issue price must be equal to or be more than the nominal value of the shares.

Deferred ordinary shares

are a form of ordinary shares, which are entitled to a dividend only afterward a certain date or if profits rise to a higher place a sure corporeality. Voting rights might as well differ from those attached to other ordinary shares.

Ordinary shareholders put funds into their company:

a) by paying for a new issue of shares
b) through retained profits.

Simply retaining profits, instead of paying them out in the form of dividends, offers an of import, simple low-cost source of finance, although this method may non provide plenty funds, for example, if the firm is seeking to abound.

A new event of shares might be fabricated in a diverseness of different circumstances:

a) The company might desire to raise more cash. If information technology problems ordinary shares for cash, should the shares be issued pro rata to existing shareholders, and so that command or buying of the company is non affected? If, for case, a company with 200,000 ordinary shares in effect decides to issue 50,000 new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead?

i) If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, nosotros have a
rights issue.
In the example above, the fifty,000 shares would be issued as a one-in-four rights upshot, by offering shareholders ane new share for every four shares they currently concord.

two) If the number of new shares being issued is small compared to the number of shares already in effect, it might be decided instead to sell them to new shareholders, since ownership of the company would only be minimally affected.

b) The company might desire to result shares partly to raise greenbacks, but more importantly to bladder’ its shares on a stick substitution.

c) The company might issue new shares to the shareholders of another company, in order to accept it over.

New shares problems

A company seeking to obtain additional disinterestedness funds may be:

a) an unquoted visitor wishing to obtain a Stock Commutation quotation

b) an unquoted visitor wishing to issue new shares, only without obtaining a Stock Substitution quotation

c) a company which is already listed on the Stock Substitution wishing to event additional new shares.

The methods by which an unquoted company tin can obtain a quotation on the stock market place are:

a) an offer for sale
b) a prospectus issue
c) a placing
d) an introduction.

Offers for sale:

An offer for sale is a means of selling the shares of a visitor to the public.

a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to enhance cash for the company. All the shares in the visitor, not but the new ones, would then get marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general public. When this occurs, the company is not raising any new funds, but merely providing a wider market for its existing shares (all of which would become marketable), and giving existing shareholders the chance to cash in some or all of their investment in their company.

When companies ‘go public’ for the start time, a ‘large’ effect will probably have the form of an offer for sale. A smaller result is more probable to exist a placing, since the amount to be raised tin be obtained more cheaply if the issuing business firm or other sponsoring firm approaches selected institutional investors privately.

Rights issues

A rights issue provides a manner of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.

For instance, a rights issue on a 1-for-4 ground at 280c per share would mean that a visitor is inviting its existing shareholders to subscribe for one new share for every 4 shares they hold, at a toll of 280c per new share.

A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are existence asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

Preference shares

Preference shares accept a fixed pct dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend tin simply be paid if sufficient distributable profits are available, although with ‘cumulative’ preference shares the correct to an unpaid dividend is carried forrad to afterwards years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.

From the company’south point of view, preference shares are advantageous in that:

·
Dividends exercise not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures).

·
Since they do not carry voting rights, preference shares avert diluting the control of existing shareholders while an event of equity shares would not.

·
Unless they are redeemable, issuing preference shares volition lower the company’s gearing. Redeemable preference shares are normally treated equally debt when gearing is calculated.

·
The issue of preference shares does not restrict the company’southward borrowing power, at least in the sense that preference share capital letter is not secured against assets in the business organisation.

·
The non-payment of dividend does non give the preference shareholders the right to appoint a receiver, a correct which is usually given to debenture holders.

However, dividend payments on preference shares are non tax deductible in the mode that interest payments on debt are. Furthermore, for preference shares to exist attractive to investors, the level of payment needs to exist higher than for interest on debt to compensate for the additional risks.

For the investor, preference shares are less attractive than loan stock because:

·
they cannot be secured on the company’south assets
·
the dividend yield traditionally offered on preference dividends has been much as well depression to provide an attractive investment compared with the involvement yields on loan stock in view of the boosted risk involved.

Loan stock

Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated “coupon yield” on this amount. For example, if a company bug 10% loan stocky the coupon yield will be x% of the nominal value of the stock, then that $100 of stock volition receive $x interest each year. The rate quoted is the gross rate, before tax.

Debentures are a form of loan stock, legally defined every bit the written acknowledgement of a debt incurred by a visitor, normally containing provisions almost the payment of interest and the eventual repayment of capital.

Debentures with a floating charge per unit of involvement

These are debentures for which the coupon rate of interest tin can be changed by the issuer, in accordance with changes in marketplace rates of involvement. They may be attractive to both lenders and borrowers when involvement rates are volatile.

Security

Loan stock and debentures will often be
secured.
Security may take the class of either a
fixed accuse
or a
floating charge.

a)
Fixed charge;
Security would be related to a specific asset or grouping of assets, typically land and buildings. The visitor would be unable to dispose of the asset without providing a substitute asset for security, or without the lender’south consent.

b)
Floating accuse;
With a floating charge on sure assets of the company (for instance, stocks and debtors), the lender’southward security in the event of a default payment is any avails of the appropriate class the company then owns (provided that some other lender does not have a prior charge on the assets). The company would be able, yet, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a item asset.

The redemption of loan stock

Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years. At the stop of this flow, they will “mature” and get redeemable (at par or possibly at a value to a higher place par).

Most redeemable stocks accept an earliest and latest redemption date. For example, xviii% Debenture Stock 2007/09 is redeemable, at whatever fourth dimension between the earliest specified date (in 2007) and the latest date (in 2009). The issuing company can choose the appointment. The decision by a company when to redeem a debt will depend on:

a) how much cash is available to the company to repay the debt
b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the current rate of interest is lower, say x%, the company may endeavour to enhance a new loan at 10% to redeem the debt which costs 18%. On the other paw, if electric current interest rates are xx%, the company is unlikely to redeem the debt until the latest engagement possible, because the debentures would be a cheap source of funds.

There is no guarantee that a company volition exist able to raise a new loan to pay off a maturing debt, and 1 item to expect for in a company’s residuum sheet is the redemption appointment of electric current loans, to establish how much new finance is likely to exist needed by the company, and when.

Mortgages are a specific type of secured loan. Companies place the championship deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified catamenia. Most organisations owning belongings which is unencumbered past any charge should be able to obtain a mortgage up to 2 thirds of the value of the property.

Equally far equally companies are concerned, debt upper-case letter is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax.

Retained earnings

For any company, the corporeality of earnings retained inside the business concern has a direct affect on the amount of dividends. Turn a profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and and then heighten new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do non cost anything, although this is not truthful. Nonetheless, it is true that the utilise of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in exercise determined by the directors. From their standpoint, retained earnings are an attractive source of finance considering investment projects tin be undertaken without involving either the shareholders or whatever outsiders.

c) The employ of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The utilise of retained earnings avoids the possibility of a modify in control resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company’s shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which volition only be taxed when shares are sold) than receive electric current income, then finance through retained earnings would exist preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds volition not be expected by investors (such equally banks) to pay generous dividends, nor over-generous salaries to possessor-directors.

Bank lending

Borrowings from banks are an important source of finance to companies. Banking concern lending is withal mainly curt term, although medium-term lending is quite common these days.

Brusque term lending may exist in the class of:

a) an overdraft, which a company should keep within a limit set past the bank. Interest is charged (at a variable rate) on the corporeality past which the company is overdrawn from day to day;

b) a curt-term loan, for up to 3 years.

Medium-term loans are loans for a period of from iii to ten years. The rate of involvement charged on medium-term depository financial institution lending to large companies will exist a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the charge per unit of interest charged will exist adapted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

Lending to smaller companies volition exist at a margin to a higher place the bank’s base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a
floating rate loan.
Longer-term banking concern loans will sometimes be available, normally for the purchase of property, where the loan takes the form of a mortgage. When a broker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic
PARTS.

–
Purpose
–
Amountain
–
Repayment
–
Term
–
Southecurity

P	The purpose of the loan A loan request will be refused if the purpose of the loan is not adequate to the bank.
A	The corporeality of the loan. The customer must state exactly how much he wants to infringe. The banker must verify, as far as he is able to practise so, that the amount required to make the proposed investment has been estimated correctly.
R	How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments?
T	What would exist the elapsing of the loan? Traditionally, banks have offered brusk-term loans and overdrafts, although medium-term loans are now quite common.
S	Does the loan require security? If so, is the proposed security adequate?

Leasing

A lease is an agreement between two parties, the “lessor” and the “lessee”. The lessor owns a capital nugget, merely allows the lessee to use it. The lessee makes payments under the terms of the charter to the lessor, for a specified period of fourth dimension.

Leasing is, therefore, a class of rental. Leased avails have usually been found and mechanism, cars and commercial vehicles, but might also be computers and office equipment. In that location are two bones forms of lease: “operating leases” and “finance leases”.

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

c) the period of the lease is adequately short, less than the economical life of the asset, then that at the end of the lease understanding, the lessor can either

i) lease the equipment to someone else, and obtain a good hire for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are charter agreements betwixt the user of the leased nugget (the lessee) and a provider of finance (the lessor) for most, or all, of the nugget’south expected useful life.

Suppose that a visitor decides to obtain a company car and finance the conquering by ways of a finance lease. A motorcar dealer volition supply the auto. A finance firm will concur to act as lessor in a finance leasing arrangement, and so volition purchase the motorcar from the dealer and charter it to the company. The company will have possession of the car from the car dealer, and make regular payments (monthly, quarterly, half dozen monthly or annually) to the finance house nether the terms of the charter.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this at all.

b) The lease has a primary menstruum, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the nugget to someone else, as the nugget would exist worn out. The lessor must, therefore, ensure that the lease payments during the primary menses pay for the full cost of the asset likewise as providing the lessor with a suitable return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to charter the nugget for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lessor’s behalf (since the lessor is the possessor) and to keep most of the sale gain, paying only a minor per centum (perhaps 10%) to the lessor.

Why might leasing be popular

The attractions of leases to the supplier of the equipment, the lessee and the lessor are as follows:

·
The supplier of the equipment is paid in full at the outset. The equipment is sold to the lessor, and apart from obligations under guarantees or warranties, the supplier has no further financial business about the nugget.

·
The lessor invests finance by purchasing assets from suppliers and makes a render out of the charter payments from the lessee. Provided that a lessor can find lessees willing to pay the amounts he wants to make his render, the lessor can make expert profits. He volition also get capital letter allowances on his buy of the equipment.

·
Leasing might exist attractive to the lessee:

i) if the lessee does not have enough cash to pay for the asset, and would accept difficulty obtaining a banking concern loan to buy it, and so has to hire it in one way or another if he is to have the employ of it at all; or

two) if finance leasing is cheaper than a depository financial institution loan. The cost of payments under a loan might exceed the cost of a lease.

Operating leases have further advantages:

·
The leased equipment does non need to be shown in the lessee’south published residuum sheet, and then the lessee’s residue canvass shows no increase in its gearing ratio.

·
The equipment is leased for a shorter period than its expected useful life. In the example of high-engineering science equipment, if the equipment becomes out-of-engagement before the stop of its expected life, the lessee does not have to continue on using information technology, and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand.

The lessee volition be able to deduct the charter payments in calculating his taxable profits.

Hire purchase

Rent purchase is a grade of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the rent purchase customer on payment of the concluding credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements commonly involve a finance house.

i) The supplier sells the goods to the finance house.
ii) The supplier delivers the appurtenances to the customer who will eventually purchase them.
iii) The rent purchase arrangement exists betwixt the finance house and the customer.

The finance firm volition ever insist that the hirer should pay a eolith towards the purchase price. The size of the eolith will depend on the finance company’s policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not exist required to make any large initial payment.

An industrial or commercial business can apply rent purchase as a source of finance. With industrial hire purchase, a concern customer obtains hire purchase finance from a finance house in order to purchase the stock-still asset. Goods bought past businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance

The regime provides finance to companies in cash grants and other forms of directly assistance, as function of its policy of helping to develop the national economy, especially in high engineering industries and in areas of high unemployment. For case, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to help small ethnic businesses in that country.

Venture capital

Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A man of affairs starting up a new business will invest venture capital letter of his ain, simply he will probably need extra funding from a source other than his own pocket. However, the term ‘venture capital’ is more specifically associated with putting money, unremarkably in return for an equity stake, into a new business organisation, a direction buy-out or a major expansion scheme.

The institution that puts in the money recognises the chance inherent in the funding. At that place is a serious risk of losing the entire investment, and it might have a long time before whatever profits and returns materialise. Just in that location is as well the prospect of very loftier profits and a substantial return on the investment. A venture capitalist volition require a high expected rate of return on investments, to recoup for the high risk.

A venture capital system will not want to retain its investment in a business indefinitely, and when information technology considers putting money into a concern venture, information technology volition also consider its “leave”, that is, how it will be able to pull out of the business organisation eventually (after five to seven years, say) and realise its profits. Examples of venture uppercase organisations are: Merchant Bank of Cardinal Africa Ltd and Anglo American Corporation Services Ltd.

When a visitor’s directors look for help from a venture uppercase establishment, they must recognise that:

·
the institution will want an equity pale in the company
·
information technology will need convincing that the company can exist successful
·
information technology may desire to have a representative appointed to the company’s board, to look later its interests.

The directors of the company must then contact venture capital organisations, to attempt and find i or more which would be willing to offer finance. A venture uppercase system volition only give funds to a company that it believes can succeed, and earlier it will make whatsoever definite offer, it will desire from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the well-nigh recent trading figures of the company, a balance canvass, a greenbacks flow forecast and a profit forecast

d) details of the management team, with evidence of a broad range of management skills

e) details of major shareholders

f) details of the company’southward current banking arrangements and any other sources of finance

k) whatsoever sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial screening, and only a small pct of all requests survive both this screening and further investigation and result in actual investments.

Franchising

Franchising is a method of expanding business organization on less uppercase than would otherwise be needed. For suitable businesses, it is an alternative to raising extra upper-case letter for growth. Franchisors include Upkeep Rent-a-Car, Wimpy, Nando’s Chicken and Craven Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor’s trade proper name. The franchisor must bear sure costs (mayhap for architect’due south work, establishment costs, legal costs, marketing costs and the price of other support services) and volition charge the franchisee an initial franchise fee to embrace set-up costs, relying on the subsequent regular payments past the franchisee for an operating profit. These regular payments will commonly be a percent of the franchisee’s turnover.

Although the franchisor volition probably pay a large part of the initial investment cost of a franchisee’s outlet, the franchisee will exist expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost.

The advantages of franchises to the franchisor are as follows:

·
The capital outlay needed to expand the concern is reduced substantially.
·
The image of the concern is improved considering the franchisees will be motivated to achieve good results and will have the say-so to accept whatsoever action they think fit to improve the results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises, although bounds might exist leased from the franchisor) together with the backing of a large organisation’south marketing attempt and experience. The franchisee is able to avert some of the mistakes of many small businesses, because the franchisor has already learned from its own past mistakes and adult a scheme that works.

Now try exercise seven.1.

Practise 7.one Sources of finance

Outdoor Living Ltd., an possessor-managed visitor, has developed a new type of heating using solar power, and has financed the development stages from its own resource. Market research indicates the possibility of a large book of need and a significant amount of additional capital letter will be needed to finance production.

Advise Outdoor Living Ltd. on:

a) the advantages and disadvantages of loan or disinterestedness majuscule

b) the various types of capital likely to be available and the sources from which they might be obtained

c) the method(s) of finance likely to be well-nigh satisfactory to both Outdoor Living Ltd. and the provider of funds.

Key terms

Bank lending
Uppercase markets
Debentures
Deferred ordinary shares
Franchising
Authorities assistance
Hire purchase
Loan stocks
New share event
Ordinary shares
PARTS
Preference shares
Retained earnings
Rights issue
Sources of funds
Venture uppercase

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