Finance for Managers

Module Tutor: Burton Baldacchino

b.baldacchino@gcmalta.com

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Session 5 Outcomes

 Sources of Finance
 Internal Finance
 Capital Structure
 Equity Finance
 Debt Finance
 Timing of Finance
 Starting a business

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 Sources of Finance
Sources of finance
classification

Equity Other
( long term) Debt

Special
Internally New Long term loans Medium Short purpose
generated issue /bonds term e.g. term e.g. e.g .
retained ordinary /debenture/ leasing HP trade govt
earnings shares preference credit grant
shares

Sources long term finance Sources medium / short term finance

External Finance

Ordinary Loans/
shares debentures
Long-term

Preference
Leases
shares

Total finance

Bank Invoice
overdraft discounting

Short-term

Debt
factoring
Internal Finance

Retained
profit

Reduced Total Delayed

stock levels internal payment to
finance creditors

Tighter credit
controls
 Capital Structure
A B
£ £
Ordinary shares 100,000 50,000
5% debentures - 50,000
100,000 100,000

20% ROCE 20,000 20,000

Interest on debentures - 2,500

Taxable profit 20,000 17,500

Taxation ( assume 40%) 8,000 7,000

Distributable profit 12,000 10,500

If all distributed, rate of dividend

would be: 12% 21%
 Gearing Debt to Equty

Capital Gearing Ratio how much debt versus equity in a business

CGR = Short + Long term liabilities (debt) *100%

Equity capital + Reserves + Debt Capital

Compares owners Capital to overall debt in a business also

called Financial leverage
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 Good Gearing
•A gearing ratio higher than 50% is typically considered highly
levered or geared.
Think about servicing debt and implications

•A gearing ratio lower than 25% is typically considered low-

risk by both investors and lenders

•A gearing ratio between 25% and 50% is typically considered

optimal or normal for well-established companies

•More debt increases payment implications

https://www.accountingtools.com/articles/2017/5/5/gearing-ratio
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 Sources of Finance

 Three major types of financing:

 Retained Earnings
 Equity
 Debt
 Pecking order theory -seminal work Myers S.C. & Majluf N.
(1984) Journal of Financial Economics 13 187-221
 “Contracting costs and information signalling effects create a pecking order of
attractiveness of different sources of finance : internal finance in the form of
retained earnings are likely to be favoured over (in descending order of
attractiveness) ‘safe debt ’ such as bank loans, bond issues and then onto hybrid
finance such as convertibles and finally equity in the form of rights and new
issues.”
Ryan B. Corporate Finance and Valuation (2007:212)
 Pecking Order

 Pecking order theory (1984) suggests that companies

have a preferred order in which they seek to raise finance
 First resource - retained earnings
 Avoids issue costs /interest payments
 Management decision so no need to reference a third
party
 No additional obligations to consider the needs of finance
providers
 Need to consider the opportunity cost
 Equity Finance

 Equity finance is permanent finance and so may be

preferred for investment projects with long lives

 Public offering to domestic ordinary share equity

issued / rights / bonus issues

 Private placement domestic or global to range of

financial institutions - reduces transaction costs
Types of shares Values
EPS – Earnings per share

What is EPS for M&S compare with

Next/ASOS/Primark
Ordinary Share Capital

 Represents the business’s risk capital

 High risk, so high return expected
 Potentially returns unlimited, and..
 Some control over the business
 Limited loss liability, but ..
 No fixed rate of dividend

 For the business: no tax relief on dividends paid

 Preference Shares

 Lower risk than ordinary shares

 Fixed rate of dividend, paid before ordinary dividend

 Priority over ordinary shareholders if business wound up

 For the business: similar to loans, but no tax relief on

dividends paid, so loans more attractive

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 Raising Equity

 Public Issues & offers for sale

 Private Placings
 Rights Issues
 Additional shares offered to existing shareholders for cash
 at a discounted price
 relatively inexpensive
 The Shareholder can
 Exercise the rights
 Sell the rights
 Allow them to lapse.
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 Debt Instruments

Amount, time period of loan, repayment terms and interest payable are all
Term Loans open to negotiation tailored to suit needs.
May be secured or unsecured loans.
Security

Loan evidenced by a trust deed. May be redeemable or irredeemable

Debenture Traded on the Stock Exchange ( if listed company )

Bearer bonds, issued by companies. Interest paid annually – volatile

value Eurobonds – issued in major currencies used to raise finance on
Bonds
international basis Not subject to host country regulations
Floating/Fixed interest rates, Deep discount bonds
 Insolvency

1. Secured creditors (holders of mortgages, legal charges, fixed

charges.)

2. Preferential creditors - typically employees who might be owed

outstanding wages / holiday pay due and the like.

3. Holders of floating charge ie debentures

4. Unsecured creditors, including the like of VAT / PAYE etc.

https://www.begbies-traynorgroup.com/articles/insolvency/who-gets-paid-first-when-a-
company-goes-into-liquidation
 Loan Security Covenants

 Access to financial statements

 Restriction on other lending

 Limit payment of dividends

 Require maintenance of specified level of liquidity minimum current

ratio
 Loan Security Covenants

• Investor has the right to convert a loan into ordinary shares at a

given future date and at a specified price.

• Not obliged to convert – will only do so if market price of shares at

conversion date exceeds the conversion price

• For the business: attractive – self liquidating form of finance

• But, some dilution of control and earnings for existing shareholders

if loans converted
 Stock Exchange

Primary market - enables businesses to raise capital

Secondary market - enables investors to sell their securities (shares

and loan capital)

Disadvantages of a listing:

• high costs of obtaining a listing

• closer scrutiny of operations / management
• pressure to perform
• additional levels of financial disclosure
 Stage of growth

Early
Start-up capital
Growth capital
Buy-out or buy-in capital
Share capital purchase
Recovery capital

Trouble Attraction to the investor is the prospect of a high return

for the risk borne

Will normally demand a high shareholding and have a

representative on the Board

Looking for a return in the medium term via a listing / sale,

or refinancing of the business
 Other sources of external
finance – video clip 1

 Business Angels:
 Starts ups
 Young developing companies,
 Relatively small investments 10 000 – 100,000,
 In return for a share holding.

 Government
 Grants – matched funding
 Small firms loan Guarantee scheme.
 Tax incentives
 Leasing

 Legal ownership of asset rests with the lessor

 Lessee has right to use the asset ( all rewards
and risks of ownership transferred)
 Lease covers significant part of the life of the
asset – may be extended for `peppercorn’
rent at and of primary period
 Leasing

 Legal ownership of asset rests with the lessor

 Lessee has right to use the asset ( all rewards
and risks of ownership transferred)
 Lease covers significant part of the life of the
asset – may be extended for `peppercorn’
rent at and of primary period
 Attractions Of Leasing

 Ease of borrowing - readily available – asset as security

 Cost - competitively priced lease rentals

 Flexibility - not tied to ownership – avoid obsolescence

 Eases cash flow - avoids up-front purchase cost – rentals tailored to

match income from use of asset

 Sale and Leaseback

 Immediate injection of funds

 right to continued use of the asset
 rent payment is allowable against profits for tax purposes
 allows business to focus on core activities

Disadvantages:

 periodic rent reviews

 have to renegotiate at the end of term
 tax liability if capital gain on sale to financial institution
 loss of benefit of capital appreciation of asset
 Short term finance

Overdraft - very flexible, relatively inexpensive to arrange rate of interest

varies with creditworthiness, normally unsecured, but not always
cash flow forecasts will be required

Drawback – repayable on demand (in theory)

Other: debt factoring & invoice discounting

 Short term finance

Overdraft - very flexible, relatively inexpensive to arrange rate of interest

varies with creditworthiness, normally unsecured, but not always
cash flow forecasts will be required

Drawback – repayable on demand (in theory)

Other: debt factoring & invoice discounting

ID or factoring – video clip 2

1 Goods
Supplying firm
Customer
(seller)

2 Right to receive payment

on sale of invoice to factor

4 Customer pays
3 80% of customer
debt to factor
debt available to
seller immediately

Factor
Provides finance,
5 20% payable, less factor’s sales ledger admin.,
fees and interest, after credit insurance.
customer pays factor
 Invoice Discounting

 Invoices are pledged to the finance house in return for an immediate payment of up to 90% of
the face value

 Supplying company guarantees to pay the amount on the invoice and is responsible for
collecting the debt from the customer

 Regardless of whether customer has paid, supplier is committed to handing over full amount,
and in return receives remaining 10% less service fees and charges ( usually lower than for
factoring )

 Finance provider will only advance money under invoice discounting if the business is well
established, profitable and has an effective and professional sales administration system.
Time of Finance

Issues taken into account:

Matching

Flexibility

For the three strategies how would you

Re-financing risk
finance them and why?

Interest rates
 Timings

Total Fluctuating
fund current assets Short-term
s finance

Long-term
Permanent finance
current assets

Fixed assets

Time
 Debt Finance

Short term Bank overdraft Working capital assets

Trade credit Stock / debtors

Bank loan Machinery

Medium term Hire purchase Vehicles
Leasing Computers

Long term loans Longer term assets

Long
/ debentures Land, buildings
term
Venture capital Start-ups
Equity finance Management buy-outs
Acquisitions
 Debt Finance

Borrower Rates of interest / term

Repayment obligations
Covenants attached
Gearing implications
Credit profile

Lender Purpose
Risk / return
Track record
Existing level of borrowing
Security available / quality
Management capability
 Debt Finance

 If there are insufficient retained earnings available then debt or equity finance
-requires public or private placement either in ones own country or a global
offering

 Preferred if company has not yet reached its optimal capital structure

 Debt finance cheaper than equity

 Issuing debt can lead to a reduction Weighted Average Cost of Capital (WACC)
and hence an increase in the market value of the company

 Debt is higher in the creditor hierarchy than equity - ordinary shareholders are
paid out last in the event of liquidation
 Debt Finance

Share issue £100m pay 10% Borrow £100m at 10%

dividend interest

P&L £m P &L £m
Sales 90 sales 90
Less costs 40 Less costs ( 40 50
+10% interest )
Net profit 50
Net profit 40
Less tax 20% 10
less tax 20% 8
Less 10
dividend10% No dividend 0
Profit after tax and
30 Profit after tax and
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dividend dividend
 Starting a business

 You are setting up a new business in your teams

 Please read the guide

 https://thebusinessfinanceguide.co.uk/wp-content/uploads/2016/06/the
businessfinanceguide2016.pdf

 Now create a business plan for your business for 5 years trading – what
sources of finance are you using and why? How are your cash flows
looking and what is your gearing ratios?

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