SOURCES OF FINANCE, ACCA

9. SOURCES OF FINANCE
Outline:
- Short-term sources of finance
- Debt Finance
- Venture Capital
- Equity Finance & Preference Shares
- Islamic Finance
- Finance for SMEs

1. Short-term sources of finance

A range of short-term sources of finance are available to businesses including overdrafts, short-
term loans, trade credit and operating lease finance.

Short-term finance is usually needed for businesses

- To run their day to day operations including payment of wages to employees, inventory
ordering and supplies.
- Support to businesses with seasonal peaks and troughs and
- Those engaged in international trade

Overdrafts
Where payments from a current account exceed income to the account for a temporary period,
the bank may agree to finance a deficit balance on the account by means of an overdraft.
- Quickly available
- Flexible
- Interest is paid only when excess amount is drawn
Features includes:
 Limit (extent to which they can be overdrawn)
 Interest rate (usually higher than other short-term loans
 Purpose – to meet short term deficits of funds
 Repayment – on demand
 Security – depends on size, purpose and policies

Short-term loans
A term loan is a loan for a fixed amount for a specified period, usually from a bank.
- The loan may have a specific purpose, such as the purchase of an asset.
- It is drawn in full at the beginning of the loan period and repaid at a specified time or in
defined instalments.
- Offered with a variety of repayment schedules. Often, the interest and capital
repayments are predetermined.

Trade credit
Trade credit is a major source of short-term finance for a business.
- Current assets such as raw materials may be purchased on credit, with payment terms
normally varying from between 30 and 90 days.
- Trade credit therefore represents an interest-free short-term loan.

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- In a period of high inflation, purchasing via trade credit will be very helpful in keeping
costs down.
- However, it is important to take into account the loss of discounts suppliers offer for
early payment.
- Unacceptable delays in payment will worsen a company's credit rating and additional
credit may become difficult to obtain.

Leasing
Leasing is a contract between the leasing company, the lessor, and the customer (the lessee). The
leasing company buys and owns the asset that the lessee requires. The customer hires the asset
from the leasing company and pays rental over a pre-determined period for the use of the asset.
There are two types of leases:
1: Finance Leases
An agreement where the lessor receives lease payments to cover its ownership costs. The lessee
is responsible for maintenance, insurance, and taxes. Some finance leases are conditional sales or
hire purchase agreements.
2: Operating Leases
The lease will not run for the full life of the asset and the lessee will not be liable for its full
value. The lessor or the original manufacturer or supplier will assume the residual risk. This type
of lease is normally only used when the asset has a probable resale value, for instance, aircraft or
vehicles.

Sale and leaseback

A company which owns its own premises can obtain finance by selling the property to an
insurance company or pension fund for immediate cash and renting it back.
A company would raise more cash from sale and leaseback arrangements than from a mortgage,
but there are significant disadvantages.
a) The company loses ownership of a valuable asset.
b) The future borrowing capacity of the firm will be reduced.
c) The company is contractually committed to occupying the property for many years
ahead which can be restricting.
d) The real cost is likely to be high, particularly as there will be frequent rent reviews.

Factoring
- Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money
- Factoring allows company to raise finance based on the value of your outstanding
invoices.
- Factoring also gives company the opportunity to outsource your sales ledger operations
and to use more sophisticated credit rating systems.
- Offers 80 – 85% of the total invoice value
- Company pays factoring fees

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2. Debt finance
A range of long-term sources of finance are available to businesses including debt finance
(debentures, bonds), leasing, venture capital and equity finance.
Long-term finance is used for major investments and is usually more expensive and less flexible
than short-term finance.
The choice of debt finance that a company can make depends on:
- The size of the company
- Availability of finance in the market
- Credit rating of company
- Amount of financing
- The duration of the required financing
- Whether a fixed or floating interest rate is preferred (fixed rates are more expensive, but
floating rates are riskier)
- The security (collateral) that can be offered and the security that may be demanded by a
lender
- Debt covenants

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

The term bonds describes various forms of long-term debt a company may issue, such as loan
notes, which may be:
- Redeemable
- Irredeemable
Bonds or loans come in various forms, including:
- Floating rate loan notes
- Zero coupon bonds
- Convertible bonds

Conventional bonds
Conventional bonds are fixed-rate redeemable bonds.
- Bonds have a nominal value, which is the debt owed by the company, and interest is paid
at a stated coupon' on this amount.
- Where the coupon rate is fixed at the time of issue, it will be set according to prevailing
market conditions given the credit rating of the company issuing the debt.
- Subsequent changes in market (and company) conditions will cause the market value of
the bond to fluctuate, although the coupon will stay at the fixed percentage of the nominal
value.

Deep discount bonds

 Deep discount bonds are bonds or loan notes issued at a price which is at a large discount
to the nominal value of the notes, and which will be redeemable at nominal value (or above
nominal value) when they eventually mature.

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 Investors might be attracted by the large capital gain offered by the bonds, which is the
difference between the issue price and the redemption value.
 However, deep discount bonds will carry a much lower rate of interest than other types of
bond.
 The only tax advantage is that the gain gets taxed (as income) in one lump on maturity or
sale, not as amounts of interest each year. The borrower can, however, deduct notional
interest each year in computing profits.

Zero coupon bonds

Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no
interest is paid on them.
a. The advantage for borrowers is that zero coupon bonds can be used to raise cash
immediately, and there is no cash repayment until redemption date.
b. The advantage for lenders is restricted, unless the rate of discount on the bonds offers a
high yield. Their market value will depend on the remaining term to maturity and current
market interest rates.
The tax advantage of zero coupon bonds is the same as that of deep discount bonds

Example 1: A Co issued bond for $750 with 5 years of maturity redeemable at $1000. What
is yield from the bond? Hints: 5.92%
Example 2: Cube Bank intends to subscribe to a 10-year this Bond having a face value of
$1000 per bond. The Yield to Maturity is given as 8%. What is the value of Bond? Hints:
$463.19

Convertible bonds
Convertible bonds are bonds that give the holder the right to convert to other securities,
normally ordinary shares, at a predetermined price/rate and time.
The actual market price of convertible bonds will depend on:
o The price of straight debt
o The current conversion value
o The length of time before conversion may take place
o The market's expectation as to future equity returns and the risk associated with
these returns
The current market value of ordinary shares into which a bond may be converted is known as the
conversion value.
Conversion value = Conversion ratio × market price per share
Conversion premium = Current market value – current conversion value
Example 3: CD has issued 50,000 units of convertible bonds, each with a nominal value of $100
and a coupon rate of interest of 10% payable yearly. Each $100 of convertible bonds may be
converted into 40 ordinary shares of CD in three years' time. Any bonds not converted will be
redeemed at 110 (that is, at $110 per $100 nominal value of bond).
Estimate the likely current market price for $100 of the bonds, if investors in the bonds now
require a pre-tax return of only 8%, and the expected value of CD ordinary shares on the
conversion day is:
(a) $2.50 per share
(b) $3.00 per share
Hints: (a) $113.11; (b) $121.05

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5. Venture capital
Venture capital is risk capital, normally provided by a venture capital firm or individual venture
capitalist, in return for an equity stake.
Venture capitalists want to invest in companies that are ambitious. The characteristics of an
attractive investment will might include the following:
 Highly motivated individuals with a strong management team in place
 A well-defined strategy aiming at market leadership
 A clearly defined target market
 Best in class strategic, operational and financial practices.

The types of venture that a venture capitalists might invest in include the following.
 Business start-ups.
 Business development. Provide development capital for a company which wants to invest
in new products or new markets or to make a business acquisition.
 Management buyouts.
 Helping a company where one of its owners wants to realise all or part of their
investment.

Venture capital funds

 Some other organisations are engaged in the creation of venture capital funds.
 In these the organisation raises venture capital funds from investors and invests in
management buyouts or expanding companies.
 The venture capital fund managers usually reward themselves by taking a percentage of the
portfolio of the fund's investments
 The venture capital organisation (VC) will take account of various factors in deciding
whether or not to invest.
Factors in investment decisions
Factors in investment decisions
 The nature of the company's product - Viability of production and selling potential
 Expertise in production - Technical ability to produce efficiently
 Expertise in management - Commitment, skills and experience
 The market and competition - Threat from rival producers or future new entrants
 Future profits - Detailed business plan showing profit prospects that compensate for risks
 Board membership - To take account of VC's interests and ensure that VC has say in future
strategy
 Risk borne by existing owners - Owners bear significant risk and invest significant part of
their overall wealth

Ordinary shares
Ordinary shares are issued to the owners of a company.
Ordinary shares in many countries have a nominal or 'face' value, typically $1 or 50c. In some
countries, equity shares no longer have a nominal value.
Ordinary shareholders have rights as a result of their ownership of the shares.
 Shareholders can attend company general meetings.
 They can vote on important company matters such as the appointment and re-election of
directors; approving a takeover bid for another company

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 They are entitled to receive agreed dividend.

 They will receive the annual report and accounts.
 They will receive a share of any assets remaining after liquidation.
 They can participate in any new issue of shares, unless they agree to waive this right.

A company can obtain a stock market listing for its shares through a public offer or a placing.
Disadvantages of a stock market listing
a) There will be significantly greater public regulation, accountability and scrutiny.
b) A wider circle of investors with more exacting requirements will hold shares.
c) There will be additional costs involved in making share issues, including brokerage
commissions and underwriting fees.

Methods of obtaining a listing

An unquoted company that is becoming listed for the first time can issue shares on the stock
market by means of:
1. An initial public offer (IPO)
An initial public offer (IPO) is an invitation to apply for shares in a company based on
information contained in a prospectus for the first time.
2. A placing
A placing is an arrangement whereby, instead of offering the shares to the general public, the
sponsoring investment bank arranges for most of the issue to be bought by a small number
of investors, usually institutional investors such as pension funds and insurance companies.

Is a company likely to prefer an IPO of its shares, or a placing?

a) Placings are much cheaper..
b) Placings are likely to be quicker.
c) Placings are likely to involve less disclosure of information.
d) Relatively small number of (institutional) shareholders, and that institutional
shareholders will have control of the company.
e) When a company first comes to the market, there may be a restriction on the proportion of
shares that can be placed, or a minimum proportion that must be offered to the general
public.

Costs of share issues on the stock market

Companies may incur the following costs when issuing shares.
 Underwriting costs:
A company about to issue new securities in order to raise finance may decide to have the
issue underwritten. Underwriters are financial institutions which agree to buy at the
issue price any securities which are not subscribed for by the investing public.
Underwriters remove the risk of a share issue's being undersubscribed, but at a cost to
the company issuing the shares.
 Stock market listing fee (the initial charge) for the new securities
 Fees of the issuing house (investment bank), solicitors, auditors and public relations
consultant
 Charges for printing and distributing the prospectus: (the prospectus is the document in
which the company offers its shares for sale)
 Advertising in national newspapers

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Rights issues
A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a
price lower than the current market price, and in proportion to their existing shareholding
The major advantages of a rights issue are as follows.
a) Rights issues are cheaper than IPOs to the general public. This is partly because no
prospectus is normally required.
b) Rights issues are more beneficial to existing shareholders than issues to the general public
as new shares are issued at a discount to the current market price.
c) Relative voting rights are unaffected if shareholders all take up their rights.
d) The finance raised may be used to reduce gearing in book.

The market price of shares after a rights issue: the theoretical ex-rights price
When a rights issue is announced, all existing shareholders have the right to subscribe for new
shares, and so there are rights attached to the existing shares. The shares are therefore described
as being 'cum rights' (with rights attached) and are traded cum rights. On the first day of
dealings in the newly issued shares, the rights no longer exist and the old shares are now 'ex-
rights' (without rights attached).

The value of rights

The value of rights is the theoretical gain a shareholder would make by exercising their rights.

Example 4: Rights issue

Fundraiser has 1,000,000 ordinary shares of $1 in issue, which have a market price on 1
September of $2.10 per share. The company decides to make a rights issue, and offers its
shareholders the right to subscribe for one new share at $1.50 each for every four shares already
held. After the announcement of the issue, the share price fell to $1.95, but by the time just prior
to the issue being made, it had recovered to $2 per share. This market value just before the issue
is known as the cum rights price.
What is the theoretical ex-rights price?
What is the value of rights?
What is the value of rights per share?
Hints: $1.90; $0.40; $0.10

The theoretical gain or loss to shareholders:

The possible courses of action open to shareholders are:
(a) To 'take up' or 'exercise' the rights;
(b) To 'renounce' the rights and sell them on the market.
(c) To renounce part of the rights and take up the remainder.
(d) To do nothing.

Example 5: Gopher has issued 3,000,000 ordinary shares of $1 each, which are at present selling
for $4 per share.
The company plans to issue rights to purchase 1 new equity share at a price of $3.20 per share
for every 3 shares held. A shareholder who owns 900 shares thinks that they will suffer a loss in
their personal wealth because the new shares are being offered at a price lower than market
value. On the assumption that the actual market value of shares will be equal to the theoretical

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ex-rights price, what would the effect on the shareholder's wealth be if:
(a) They sell all the rights
(b) They exercise half the rights and sell the other half
(c) They do nothing at all
Hints: (a) Wealth $3,600 no gain or loss; (b) Wealth $4,080 np gain or loss; Wealth $3,420 loss
($180);

Preference shares
Preference shares are shares which give the right to receive dividends (typically a fixed
percentage of the nominal value of the shares) before any dividends can be paid to ordinary
shareholders.
As a source of finance, preference shares have several advantages over debt capital.
 Dividends do not have to be paid if company performance is poor, whereas interest must be
paid on debt capital regardless of profit.
 Preference shares are not secured on company assets.
 Preference shareholders usually have no voting rights so there is no dilution of control.

There is, however, a fairly significant disadvantage.

 Preference share capital is not as tax efficient as debt capital, as dividends paid are not tax
deductible, whereas interest on debt is.

Islamic finance
 Islamic finance is finance that is compliant with Sharia'a law. Islamic finance has gone
through an exceptional growth period in recent years.
 The number of fully Sharia'a compliant banks continues to increase worldwide and
Sharia'a compliant financial products are not only offered by Islamic banks but also by
conventional banks using specific distribution channels.
 The term 'conventional' is used to identify the financial institutions that have formed part
of the financial infrastructure for a long time and are not specifically based on Islamic
principles.

Islamic finance transactions are based on the concept of sharing risk and reward between the
investor and the user of funds.

Riba
Riba (interest) is forbidden in Islamic finance.
For the borrower
Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the
interest payment, turning their profit into a loss.
For the lender
Riba creates unfairness for the lender in high inflation environments when the returns are likely
to be below the rate of inflation.
For the economy
Riba can result in inefficient allocation of available resources in the economy and may contribute
to instability of the system. In an interest-based economy, capital is directed to the borrower with
the highest creditworthiness rather than the borrower who would make the most efficient use of
the capital.

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Islamic finance contracts

1. Mudaraba – a partnership contract
 This is similar to equity finance, or a special kind of partnership.
 The investor provides capital and the business partner runs the business.
 Profits are shared between both parties, but all losses are attributable to the investor
(limited to the capital provided).

2. Musharaka – a form of equity where a partnership exists and profits and losses are shared
 This again is similar to a partnership, but here both parties provide both capital and
expertise.
 Profits are shared between the parties according to whatever ratio is agreed in the
contract, but losses are shared in proportion to the capital contributions.
 It is regarded as being similar to venture capital.

3. Murabaha – a form of credit sale

 This is effectively a form of credit sale, where the customer receives the goods but pays
for them later on a fixed date.
 However, instead of charging interest, a fixed price is agreed before delivery – the
markup effectively including the time value of money.

4. Ijara – a form of lease

 This is effectively a lease, where the lessee pays rent to the lessor to use the asset.
 Depending on the agreement, at the end of the rental period the lessor might take back the
asset (effectively an operating lease) or might sell it to the lessee (effectively a finance
lease – Ijara-wa-Iqtina).
 Whatever the agreement, the lessor remains the owner of the asset and is responsible for
maintenance and insurance, thus incurring the risk of ownership.

5. Sukuk – similar to a bond

 This is the equivalent of debt finance (Islamic bonds).
 Sukuk must have an underlying tangible asset, and the holders of the Sukuk certificates
have ownership of a proportional share of the asset, sharing revenues from the asset but
also sharing the ownership risk.
 The Sukuk manager is responsible for managing the assets on behalf of the Sukuk holders
(and can charge a fee). The Sukuk holders have the right to dismiss the manager.
An example may be where the financial institution purchases a property financed by
Sukuk certificates and rents it out at fixed rent. The certificate holders receive a share of
the rent (instead of interest) and a share of the eventual sale proceeds.

Summary of Islamic Finance Transactions

Islamic finance Similar to Differences
transaction
Murabaha Trade credit / There is a pre-agreed mark-up to be paid in recognition of
loan the convenience of paying later for an asset that is
transferred immediately. There is no interest charged.
Musharaka Venture Profits are shared according to a pre-agreed contract. There

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capital are no dividends paid. Losses are shared according to capital

contribution
Mudaraba Equity Profits are shared according to a pre-agreed contract. There
are no dividends paid. Losses are solely attributable to the
provider of capital.
Ijara Leasing Whether an operating or finance transaction, in ijara the
lessor is still the owner of the asset and incurs the risk of
ownership. This means that the lessor will be responsible for
major maintenance and insurance which is different from a
conventional finance lease.
Sukuk Bonds There is an underlying tangible asset that the sukuk holder
shares in the risk and rewards of ownership. This gives the
sukuk properties of equity finance as well as debt finance.

Finance for small and medium-sized entities

Small and medium-sized entities (SMEs) have the following characteristics.
(a) Firms are likely to be unquoted private companies.
(b) The business is owned by a few individuals, typically a family group.
(c) They are not micro businesses – very small businesses that act as the owners' medium for
self-employment.

The problems of financing SMEs

 SMEs often have a limited track record in raising investment and providing suitable returns
to their investors
 SMEs often have non-existent or very limited internal controls
 SMEs often have few external controls. Indeed, in the UK many SMEs are no longer
required to have their annual accounts audited
 SMEs often have one dominant owner-manager whose decisions may face little questioning
 SMEs often have few tangible assets to offer as security.

POTENTIAL SOURCES OF FINANCE FOR SMES

The SME owner, family and friends
 This is potentially a very good source of finance because these investors may be willing
to accept a lower return than many other investors as their motivation to invest is not
purely financial.
 The key limitation is that, for most of us, the finance that we can raise personally, and
from friends and family, is somewhat limited.

The business angel

 A business angel is a wealthy individual willing to take the risk of investing in SMEs.
 One limitation is that these individuals are not common and are very often quite
particular about what they are prepared to invest in.
 Once a business angel is interested they can become very useful to the SME, as they will
often have great business acumen themselves and are likely to have many useful contacts.

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Trade credit
 SMEs, like any company, can take credit from their suppliers. However, this is only
short-term and potentially risky.

Factoring and invoice discounting

 Both of these sources of finance effectively let a company raise finance against the
security of their outstanding receivables. Again, this finance is only short-term and is
often more expensive than an overdraft.

Leasing
 Leasing assets rather than buying them is often very useful for an SME as it avoids the
need to raise the capital cost.
 However, leasing is only really possible on tangible assets such as cars, machines, etc.

Bank finance
 Banks may be willing to provide an overdraft of some sort and may be willing to lend in
the long term where that lending can be secured on major assets such as land and
buildings.
 However, raising medium-term finance to fund operations is often more difficult for
SMEs as banks are traditionally rather conservative.
 Hence, many SMEs end up financing medium-term, and potentially longer-term assets,
with short-term finance such as an overdraft.
 This is poor matching and very much less than ideal. This issue is often known as the
‘maturity gap’ as there is a mismatch of the maturity of the assets and liabilities within
the business.
 Furthermore, banks will often require personal guarantees from the owner-manager of the
SME, which means the owner-manager has to risk his personal wealth in order to fund
the company.

The venture capitalist

 For many SMEs, operating in regular business, venture capitalist financing may not be
possible.
 Furthermore, a venture capitalist rarely wants to remain invested in the long term and,
hence, any proposal to them must show how they will be able to ‘exit’ or release their
value after a number of years.

Listing
 By achieving a listing on a stock exchange an SME would become a quoted company
and, hence, raising finance would become less of an issue.
 However, before a listing can be considered the company must grow to such a size that a
listing is feasible. Many SMEs can never hope to achieve this.

Supply chain financing/Reverse factoring

 In supply chain financing (SCF) the finance follows the value as it moves through the
supply chain.
 SCF is relatively new and is different to traditional working capital financing methods,
such as factoring or offering settlement discounts, because it promotes collaboration

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between buyers and sellers in the supply chain.

 Reverse factoring is a method of financing by selling invoices at a small discount
(interest rate) in order to obtain the cash in advance of the invoice due date.
 This is achieved through an intermediary fund provider such as a bank, who provides
early payment to the supplier in exchange for the discount, and in turn receives later
payment from the buyer

Crowdfunding
 Crowdfunding involves funding a venture by raising finance from a large number of
people (the crowd) and is very often achieved over the internet.
 The internet platforms are set up and run by moderating organisations who bring together
the project initiator with the idea, and those organisations and individuals who are willing
to support the idea.
 Different platforms have different policies with regard to assessing the ideas seeking
support and checking those willing to provide the finance.
 Finance provided by crowdfunding may be invested in the debt or the equity of the
ventures seeking the finance.
 Some crowdfunding is done on a ‘keep it all’ basis where any funds raised are kept by the
recipient, whereas some is done on an ‘all or nothing basis’ where the recipient only
receives the funds if the total required to fund the particular project is raised within a
given time frame.
 Crowdfunding has the potential to be very beneficial to SMEs. It allows them to contact
and appeal directly to investors, who may be willing to take the risk involved in funding
the new technologies and innovations, which SMEs are often so good at producing.

HOW DO GOVERNMENTS HELP FINANCE SMES?

A number of key ways governments assist include the following:
 Providing grants.
 Providing tax breaks/incentives
 Providing advice – for instance.
 Guaranteeing loans – for instance.
 Providing equity investment

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