Tutorial 6 (Week 7) Solutions

Ch05 - Holmes
 Exercises

1. What is the ‘finance gap’? How does the existence of such a gap affect small enterprise?
Discuss whether the gap is actually fostered by the majority of small enterprise owners.
q. 1
The finance gap is discussed in detail within pages 129-140 of this chapter. The finance gap is a term
used to summarise the barriers which may exist to prevent SMEs obtaining funding on the terms and
in the forms considered appropriate. In addition, comparisons are often drawn with the capital
structure and terms of funding for large firms. There are two key components: 1. Knowledge Gap –
apparent restricted use of debt because owners have limited knowledge/information of the sources
and types of finance available; and (2) Supply Gap – funds are simply not available to small
businesses, or the cost and terms exceed those available to large firms. The empirical literature tends
to support the finance gap view. Owners do appear to have limited knowledge of the funding
options, however, this may be because their options are in fact limited. SMEs have relatively higher
application costs and administration fees. This is a function of the relatively lower level of funds
involved and in the lending institutions effectively shifting the costs of loan evaluation to the loan
applicant. However, the literature indicates that there is no widespread significant difference in the
actual cost of debt (interest rates) once secured. One reason for this is that banks do not lend on risk,
but against a set of fixed criteria, which you either meet or you don’t, this includes security for debt.
Although there are such differences, the capital structures of small and large firms are similar.
Perhaps this is a function of the institutional framework in which the private sector (economy)
operates. Finally, the gap may be a result of a preference on the part of small firm owners for less
“intrusive debt”. That is, they prefer short-term debt and additions of their own funds to the
reporting requirements of banks and shareholders associated with longer-term debt and the addition
of external equity. This is referred to as the constrained pecking order. See pp.136-139. The gap, if it
reflects some form of discrimination against small firms, obviously means that small firms confront
liquidity constraints. This is reinforced to some degree by the fact that most small firms stay small
and a major reason for bankruptcy, according to the annual bankruptcy reports is “liquidity
problems”. To some extent the preferences of owners will underpin the gap view, as most owners are
reluctant to enter into funding arrangements that alter, or impact on, their existing level of control
over the business.

2. Why finance gap is often referred to as an ‘equity gap’? In your answer use and defend the
‘pecking order framework’ explanation proposed by Holmes and Kent (1991). q.3
The “equity gap” refers to the fact that most small firms will flatly refuse any addition of new equity
by additional (new) owners. The reason for this reluctance is the dilution of control additional equity
brings. This means that the level of debt a firm can access is restricted as there will be a maximum
ratio of debt to equity acceptable to lenders, so if no new equity is admitted then debt will also be
capped. Chapter 4 outlines the traditional pecking order framework developed by Myers (1984),
where managers have an order of preference for access to debt and equity. Holmes and Kent (1991)
 suggested that for small firms the preference function is constrained in that the admission of
additional (new equity) is simply not an option at all for most small firms. This is a function of owner
preference, but also because there are very few avenues for ready access to equity funding for small
firms.
3. Describe the stages of development of the small enterprise, the sources of finance that
would be available at each stage, the problems that may arise at each stage and the
implications for financial characteristics and performance. q.11

4. How can we measure business growth? What actions should management take in
preparation for a growth phase? How does management’s role change during a growth
phase? q. 12
Business growth is normally measured as the increase in business turnover from the previous period,
normally quarterly or monthly. If a monthly increase is adopted then an increase on the previous
month’s turnover of 5% or more is usually considered significant, but it obviously depends on the size
of the denominator. Other measures of growth can be adopted such as increase in number of
employees, orders received, assets operated by the business, net profit. However, the most
commonly adopted is changes in turnover. It is normally difficult to plan for a growth phase as they
tend to be unplanned (particularly the level of growth). Some growth phases can be expected or
predicted, such as those based on current performance trends or because of the adoption of
strategies designed to encourage growth (increased sales force, increased promotion, decline of a
competitor). As growth needs to be monitored, particularly periods of significant growth, owners
should consult with their accountant concerning the types of reporting systems they should put in
place and the types of reports they should review on a regular basis. The systems will not simply
relate to financial performance, but also the physical flow of assets and resources and the
performance of employees, and will assist in identifying when existing resources reach capacity.
Research has found a relationship between growth and business planning, however, the plans tend
to follow growth, which means growth is the trigger for more refined information systems.
Management needs to take a very serious role in monitoring and directing responses to growth and
growth options, this may threaten some “comfort zones” as decisions may require consultation and
ultimately allocating control and some decision making capacity to non-owners.
 Case Study
Enterprise Experience: Just screening for success, pp. 135-136
1. Why would Mr Muggleton negotiate a personal loan for $30 000 as opposed to a business loan?

A business loan may not have been an option. The business had no ongoing trading record and
obviously few assets. A personal loan guaranteed by the owner would have been the only option.
Anyway at the time Michael was a sole trader.

2. Why would the bank refuse to lend Mr Muggleton the funds to buy a fixed asset to be used in the
business?

Banks lend against lending criteria and Michael obviously did not meet it. They are looking for a
track record of successful operations; assets in place to secure debt. A printing machine would also
be considered too specific an investment to use the machine as security, the bank would be looking
for something more readily tradeable such as a house or land.

3. As both partners needed to work full-time in other jobs to fund the business, it would appear that
Mr Muggleton opted for a partner with experience in screenprinting, rather than someone who
could inject much needed cash. Is this consistent with the priorities of small firm owners?

The approach is very consistent with small business practice. The focus is on operating activities and
so someone with the required technical or operating skills would be a priority. Also this person
would have a similar focus and interest in the business and would be less demanding of changes or
financial performance. It is also unlikely that Michael would have gained funding, so the next best
option is to trade and make the funds.

4. Why do owners like Mr Muggleton rely on short-term funds to fund long-term assets? Is it within
their control, or is it a function of the finance gap? Explain.

Two main reasons for using short-term funds to acquire long-term assets are: 1. Short-term funding
is usually not tied to particular assets and is a less obtrusive form of debt (banks are less likely to
seek regular reports concerning operations); 2. Owners seek to avoid most forms of external
contracting so in many owners minds’ short-term funding means the relationship can be readily
terminated if they make sufficient profits to eliminate the debt. Remember, there are two sides to
the finance gap – supply and demand.
Ch08 – Ross et al.
Consider the following two mutually exclusive projects:

Year Cash flow (A) Cash flow (B)

Outlay 456,250 50,000
1 47,500 25,370
2 58,700 19,000
3 77,500 17,620
4 568,700 14,000

a. Calculate the payback period for each project and explain which project you would
choose based on this criterion.
b. Calculate the Profitability Index for each project and explain which project you would
choose based on this criterion.
c. Suppose NPV was also used to evaluate these projects.
i. Calculate the NPV for each project.
ii. After analysing the results of a to c above, explain which project you would
choose.

a. The payback period for each project is:

A: 3 + ($272 550/$568700) = 3.48 years

B: 2 + ($5630/$17620) = 2.32 years

The payback criterion implies accepting project B, because it pays back sooner than project A.

b. The profitability index for each project is:

A: PI = ($47 500/1.12 + $58 700/1.122 + $77 500/1.123 + $568 700/1.124) / $45 6250 = 1.11

B: PI = ($25 370/1.12 + $19 000/1.122 + $17 620/1.123 + $14 000/1.124) / $50 000 = 1.19

Profitability index criterion implies accept project B because its PI is greater than project A’s.

c. The NPV for each project is:

A: NPV = –$456 250 + $47 500/1.12 + $58 700/1.122 + $77 500/1.123 + $568 700/1.124 = $49 538.09

B: NPV = –$50 000 + $25 370/1.12 + $19 000/1.122 + $17 620/1.123 + $14 000/1.124 = $9237.29

NPV criterion implies we accept project A because project A has a higher NPV than project B.

In this instance, the NPV criterion implies that you should accept project A while payback period and the
profitability index imply that you should accept project B. The final decision should be based on the NPV since it
does not have the ranking problem associated with the other capital budgeting techniques. Therefore, you should
accept project A.