Accounting for Management Decisions

Week 12

FINANCING THE BUSINESS

READING: TEXT Ch 14

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Accounting for Management Decisions

Week 12

FINANCING THE BUSINESS

READING: TEXT Ch 14

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 Learning Objectives

• Identify the main sources of finance available

to a business
• Explain the advantages and disadvantages of
each form
• Describe the concept of gearing and its
influence on the long-term financing decision
• Explain what influences the choice between
long-term or short-term finance
• Identify the so-called internal sources of
finance and explain them

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 Learning Objectives cont’d

• Explain the role and nature of the stock

exchange
• Explain the role of venture capital organisations
in financing businesses
• Discuss how share capital may be issued and
identify the reasons why a particular method
might be chosen

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 Sources of Finance

• Internal - sources that do not require approval

of others apart from managers or directors to
obtain eg retained profit
• External - requires the approval of s/holders
eg issue of new shares
• Long-term - expected to provide finance for
at least one year
• Short-term - typically for less than one year

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 External Sources of Finance
Ordinary
Ordinary
shares
shares Leases
Leases

Preference
Preference Long-
Long-
shares
shares term
term
Hire
Hirepurchase
purchase
agreements
agreements
Loans
Loans

Total
Totalfinance
finance

Bank
Bank
overdraft Invoice
Invoice
overdraft discounting
discounting
Short-
Short-
term
term
Debt
Debt
factoring
factoring Figure
Figure 14.1
14.1
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 Long-term Sources of Finance
Ordinary Shares:
• High-risk investments
• Higher expected returns
• Voting rights
• Limited loss liability, un-limited return potential
• From the company’s perspective:
- Can be useful to avoid paying a dividend
- Cost of financing can be high over the l/term
- Paying dividends does not bring any tax relief
making $1 of dividend more expensive than
$1 of loan interest

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 Long-term Sources of Finance cont’d

Preference Shares:
• Lower risk than ordinary shares
• Given priority over ordinary shares if co.
is wound-up
• Normally given a fixed rate of dividend
• Lower level of return than ordinary shares
• May be cumulative or non-cumulative
• No longer a major source of finance because:
- No tax effectiveness
- Preference shares are now seen as debt
when assessing borrowing capacity

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– Cumulative PS will accumulate any dividend that is not paid when
due.
– Any unpaid dividend is added to the amount payable the following
year and no dividends can be paid on ordinary shares until the
entire backlog of unpaid dividends on cumulative prefs is cleared.
– What Does Noncumulative Mean?
A type of preferred stock that does not pay the holder any unpaid
or omitted dividends. If the corporation chooses to not pay
dividends in a given year, the investor does not have the right to
claim any of those forgone dividends in the future.

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 Long-term Sources of Finance cont’d

Loans and Debentures

• Specified interest rate, term and repayment
schedule
• Secured by assets held by the co.
- May be either on the basis of a ‘fixed charge’
over assets eg freehold land, premises
- Or on the basis of a ‘floating charge’ over
the whole of a company’s assets
• Less risky than share capital
• Interest is tax deductible to co.
• Term Loans are established by negotiation, are
often cheap to set up and offer some flexibility
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 Long-term Sources of Finance cont’d
Loans and Debentures
• ‘Loan Stock’
Stock is a form of finance where debt
is divided into units and sold to investors, public
co’s loan stock is listed and traded on the stock
exchange
• ‘Debentures’
Debentures are loan stocks that are supported
with a trust deed
• Both loan stocks and debentures are now
mostly called ‘bonds’
bonds - see also ‘Eurobonds’
• Interest rates on loans and debentures may be
either fixed or variable
• ‘Deep-discount bonds’ are issued at a low or
zero interest rate and at a large discount to their
redeemable value
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 Long-term Sources of Finance cont’d
Convertible Loan Stock
• Gives the investor the right to convert the loan
into equity shares at a future date and at a
specified exercise price
• The investor remains a lender to the co. and
receives interest until the conversion takes place
• Can be a useful hedge/protection
hedge against risk
with start-up co’s
• For a co., this form of financing may be considered
because:
- The loan is self-liquidating
- A lower rate of interest may be offered
because of future potential gain for the investor
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 Long-term Sources of Finance cont’d

• Warrants - give the holder the right, but not

the obligation, to acquire ordinary shares in a
company at an agreed price

• Mortgages - simply a form of long-term (eg 25 -

30 years) loan that is secured by freehold
property

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 Long-term Sources of Finance cont’d

• Loan Covenants - enforceable conditions

contained within loan agreements that are
designed to protect lenders. May deal with
such matters as:
• Access to financial statements
• Approval required before taking on other
loans
• Dividend payments may be required to be
limited
• Liquidity may need to be maintained at a
prescribed level
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 Long-term Sources of Finance cont’d

Finance leases:
• A form of lending - same effect as borrowing
to purchase the asset
• No longer a tax-efficient form of financing due
to changes in tax laws
• Nevertheless, still growing in popularity
because of:
- Ease of borrowing, limited security and
records required
- Cost
- Flexibility - option to cancel may be included
- Cash flow - large outflows can be avoided
and spread over the life of the asset
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 Long-term Sources of Finance cont’d

Sale and lease-back arrangements:

• Involves the business selling an asset to raise
finance, with an agreement to lease the asset
back so it can still be used by the business
• Usually agreements are reviewed periodically
throughout the lease, making future payments
difficult to predict
• At the end of the lease, the business must
either renew the lease or, in the case of
property, find alternative premises
• Capital gain is assessable on the sale of the
asset and may present a tax liability
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 Long-term Sources of Finance cont’d

Hire purchase (HP):

• A form of credit used to acquire an asset
• Under the HP agreement, the asset is paid for
by instalments over an agreed period
• Normally an initial deposit is required
• The asset is taken possession of after the
deposit is paid, however legal ownership is not
transferred until the final instalment is paid
• Similar to a finance lease, main difference
being that the business eventually becomes
the legal owner of the asset

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 Short-term Sources of Finance
Bank overdraft:
• Flexible form of borrowing that allows a
business to have a negative current account
balance
• Size of credit limit can be varied depending
on requirement
• Relatively easy and inexpensive to arrange
• Should be self-liquidating
• Security is generally required
• Repayable on demand from lender

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 Short-term Sources of Finance cont’d

Debt factoring:
• Is a form of service offered by a financial
institution (a factor) - often a subsidiary of a
commercial bank
• Involves the factor taking over a co’s sales
ledger
• Usually offers to advance up to 85% of
approved trade debtors
• Fee is normally 2-3% of turnover
• Can deliver benefits such as more certain
cash flows, savings in credit management
• Some negatives can include high cost and
adverse customer reaction
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 Short-term Sources of Finance cont’d

Invoice discounting:
• Financial institution is approached for a loan
for 75-80% of value of approved sales
outstanding
• Repayment is made usually within 60-90 days
• Business remains responsible for debtors
collection
• Is confidential - customers unaware of it
• Cost is cheap compared with factoring
• Allows company to retain control of sales
ledger and relationship with customers
• Is proving to be growing in popularity more
than factoring
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 Long-term vs. Short-term Borrowing
Issues to consider when deciding between long-
term or short-term borrowing:
• Matching borrowing to nature of asset on
the basis of time or permanency
• Flexibility - aim to minimise costs incurred
if circumstances change eg early disposal of
asset
• Re-funding risk - short-term finance has to
be renewed more frequently
• Interest rates - differ between short and
long-term, other setup costs should also be
considered
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 Internal Sources of Finance

Short-term Long-term

Reduced
inventories levels Retained
profits

Total
Delayed payment internal
to trade payables
finance

Tighter
credit control

Figure 14.5
Major internal sources of finance

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 Internal Sources of Finance cont’d
Retained profit:
• Is the main source of finance for most co’s
• No issue or establishment costs
• No dilution of shareholder interest
• No waiting - funds are immediately available
• Often less scrutiny from investors
• Potential tax-efficiency for s/holders when
retained profits deliver increased share prices
• Typically the retention/dividend ratio is not
more than 50% of profit

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 Internal Sources of Finance cont’d
Tighter credit control:
• Important to weigh the cost against the benefits
• Credit policy must be determined appropriately
Reduced inventory levels:
• Reduces opportunity cost
• Depends on nature and condition of inventory
• May not be easy to liquidate obsolete items
Delayed payment to creditors:
• Extends period of interest-free loan BUT:
• At the risk of jeopardising relations
Spontaneous sources of funds:
• Eg accrued wages, PAYG instalments,
Superannuation contributions
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 The Role of the Stock Exchange
• Primary Market - enables co’s to raise new
capital
• Secondary Market - enables investors to
transfer their securities with ease
Negatives:
• Costs of becoming ‘listed’ are high
• Mandatory compliance with strict rules
• Half-yearly financial reporting
• Scrutiny by analysts, journalists and other
companies
• Pressure for short-term performance

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 Venture Capital and Long-term Financing

Definitions:
• L/term capital provided by certain institutions to
small and medium-sized businesses to exploit
relatively high-risk opportunities
• Private equity is equity finance primarily for
small and medium-sized businesses provided
by venture capitalists and/or business angels
Venture capital providers may be interested in:
• Business start-ups
• Early stage capital
• Expansion capital
• Buy-out or buy-in capital
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Venture Capital and Long-term Financing
cont’d

• Generally regarded as higher risk due to

nature of products or lack of trading record
• Normally the investment is taken in the form of
ordinary shares in the business
• A representative of the venture capitalist is
usually on the board of directors as a condition
of the finance
• Private equity is capital invested in a private co.
that is not listed on the stock exchange

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Venture Capital and Long-term Financing cont’d

Business angels:
• Wealthy individuals who are prepared to invest
up to $250,000 in a start-up or young business
• Normally take a minority equity stake in the
business
• Fill a gap in the market that does not appeal to
venture capitalists
• Can often bring a lot of business experience
to budding tycoons
• May be prepared to accept lower returns
than venture capitalists to be involved with a
project that has interest for them
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 Share Issues

Rights issues:
• Offers existing s/holders the right to acquire
new shares in the company for cash
• Issue price is usually significantly below
current market value
• Cheap and straightforward for the company
• No dilution of ownership control provided
offer is taken up
• Simpler than other forms of shares issue

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 Share Issues cont’d
Bonus issues:
• Is an issue of new shares made to s/holders
proportionally to their holdings
• As distinct from a rights issue, the shares in a
bonus issue are not paid for by the s/holders
• Funded from reserves rather than cash
payment
• Often used as a strategy to reduce share
price, making them more marketable
• Increases the capital base and hence, lender
confidence
• Positive market signal to investors
• An alternative to paying cash dividends
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 Share Issues cont’d
Offer for sale:
• Involves a public limited co. selling shares to
an issuing house
• Issuing house then has responsibility and
risk of marketing shares to the public
• Generally used for new listings on the stock
exchange
Public issue:
• Where the co. makes a direct invitation to
the public to purchase shares
• Issuing house may be used to help administer
the issue
• Price is either set up-front or can be set by
a ‘tender’ process (not widely used, not popular
with investors)
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 Share Issues cont’d
Private placing:
• Shares are ‘placed’ with selected investors
such as large financial institutions
• Quick and cheap way of raising equity funds
• May lead to concentrated ownership in a few
hands
• Usually used by unlisted companies seeking
relatively small sums of cash
• ASX imposes a limitation on companies of
15% of their capital on these issues in a 12-
month period, or more than 15% if
accompanied by a share purchase plan (SPP)
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