Chapter 7

Sources of Finance
Considerations
1. Types of finance
2. Sources
3. Mix
4. Islamic finance

Short-term sources of finance

1. 0verdrafts

Amount Should not exceed limit, usually based on known income.

Margin Interest is charged at base rate plus margin on daily amount overdrawn. Fees may be charged
on large facilities

Purpose Generally to cover short-term deficits

Repayment Technically repayable on demand

Security Depends on size of facility

Benefits Customer has flexible means of short-term borrowing; the bank has to accept the
fluctuations.

2. Short-term loans
 A term – loan is a loan for a fixed amount for a specified period.
 It is drawn in full and at the beginning of the loan period and repaid at specified time or in defined
instalments.
 The interest and capital repayments are predetermined.

Main advantage to the bank

 Makes monitoring and control of the advance much easier.

 Loan covenant is a condition that the borrower must comply with. If the borrower does not act in accordance
with the covenants, the loan can be considered to be in default and the bank can demand payment.

Advantages of overdrafts over a loan

 Interest is paid only on overdrawn amounts
 It is flexible – can fluctuate up and down.
 Can do the same job as loan – a facility can simply be renewed every time it comes up for review.
 Can be arranged relatively quickly.

But
o Overdrafts are normally repayable on demand.

Advantages for a loan for longer term borrowing.

 Certainty of repayments of both principal and interest makes planning easier.
 An element of ‘security’ or peace of mind in being able to arrange a loan for an agreed term.

Calculation of repayment on a loan

Question 1
A $30,000 loan is taken out by a business at a rate of 12% over five years.

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 Required
What would be the annual payment?

Split between interest and capital repayments

Question 2
A loan of $100,000 is to be repaid to the bank over five years in equal annual year-end instalments made up of
capital repayments and interest at 9% per annum.

Required
Prepare a schedule for interest and principal repayments for the period

3. Trade credit
 This is the main source of short-term finance for businesses.
 The period of credit is typically 30 days to 90 days.
 It represents an interest free short-term loan.
 There is need to balance the need to balance the need to extend credit and the loss of discounts suppliers
offers for early settlement.

4. Government grants, loans and guarantees

 Government often encourage the formation of new businesses from time to time, from region to region and
help is offered.

 Government grants are usually very small, and direct loans are rare because governments see loan provision is
the job of financial institutions.
 In the UK, the government runs the Enterprise Finance Guarantee Scheme (EFGS). This is a loan guarantee
scheme intended to facilitate additional bank lending to viable small and medium sized entities (SMEs) with
sufficient security for a normal commercial loan. The borrower must be able to demonstrate to the lender that
they should be able to repay the loan in full. The government provides the lender with a guarantee for which
the borrower pays a premium.

 EFGS supports lending to viable businesses with an annual turnover of up to £25m seeking loans of between
£1,000 and £1 million.

5. Leasing
 A contract between the lessor and lessee for hire of a specific asset selected from a vendor.
 The lessor retains the ownership of the asset.
 The lessee has possession and use of the asset on payment of specified rentals over a period.
 Leasing is cheaper than borrowing because ;
(1) Large leasing companies have great bargaining power with suppliers so the assets cost them
less than it would cost the lessee. This can be partially passed on to the lessee.
(2) Leasing companies have effective ways of disposing of old assets, but lessees normally do
not.
(3) If the lease payments are not made, the leasing company has a form of built-in security in so
far as it can reclaim its asset.
(4) The cost of finance to a large, established leasing company is likely to be lower than the cost
to start –up the business.

6. Sale and leaseback

 Sale property for immediate cash and rent it back.

Disadvantages
 Loss of ownership of the property

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  Reduction in future borrowing capacity due to loss of security.
 The company is contractually committed to occupying the property for many years.
 Real cost is likely to be high, particularly as there will be frequent reviews.

7. Invoice discounting and factoring

 Before these methods can be used turnover usually has to be in the region of at least $200,000.
 Amounts due from customers as evidenced by invoices are advanced to the company.
 Typically 80% of an invoice will be paid within 24 hours. In addition to this service, factors also
look after the administration of the company’s receivables ledger.
 Fees are charged on advancing the cash (roughly at overdraft interest rates) and also factors will
charge about 1% of turnover for running the receivables ledger. Credit insurance can be taken out
for an additional fee. Unless that is taken the invoicing company remains liable for any bad debts.

Long term sources of Finance

EQUITY
Equity relates to the ownership rights of the business

Ordinary shares

1. Owning a share confers part ownership

2. High risk investments offering higher returns
3. Permanent financing
4. Post-tax appropriation of profit, not tax efficient
5. Marketable if listed

Advantages

1. No fixed charges (e.g. interest payments)

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 2. No repayment required
3. Carries a higher return than loan finance
4. Shares in listed companies can be easily be disposed of at a fair value.

Disadvantages
1. Issuing equity finance can be expensive in the case of a public issue
2. Problem of dilution of ownership if new shares issued.
3. Dividends are not tax-deductible
4. A high proportion of equity can increase the overall cost of capital for the company
5. Shares in listed companies are difficult to value and sell

Preference shares

1. Fixed dividend
2. Paid in preference to (before) ordinary shares.
3. Not very popular, it is the worst of both world, ie
 Not tax efficient
 No opportunity for capital gain (fixed return).

DEBT FINANCE
The loan of funds to a business without any ownership rights.
1. Paid out as an expense of the business (pre-tax)
2. Risk of default if interest and principal payments are not met.

Reasons for seeking debt finance

 When shareholders are unwilling to contribute additional capital
 Less cost and easier availability
 Debt finance provides tax relief on interest payments

Factors influencing the choice of debt finance

(a) Availability
Only limited companies are able to make a public issue of bonds. With a ‘public issue’ bonds are listed on the
stock market. Most investors will not invest in bonds issued by small companies. Smaller companies are only
able to obtain significant amounts of debt finance from a bank.

(b) Credit rating

Larger companies may prefer to issue bonds if they have a strong credit rating. Credit rating are given to bond
issues by credit rating agencies. The credit rating given to a bond issue affects the interest yield that investors
will require. If a company’s bond will only be given a sub-investment grade rating (‘junk bond’ rating), the
company may prefer to seek debt finance from a bank loan.

(c) Amount
Bond issues are usually for large amounts. If a company wants to borrow only a small amount of money, a bank
loan would be appropriate.

(d) Duration
If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan
would match the length of time that the asset will be generating revenues.

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(e) Fixed or floating
Expectations of interest rate movements will determine whether a company wants to borrow at a fixed or
floating rate. Fixed rate finance may be more expensive, but the business runs the risk of adverse upward rate
movements if it chooses floating rate finance. Banks may refuse to lend at a fixed rate for more than a given
period of time.

(f) Security and covenants

The choice of finance may be determined by the assets that the business is willing or able to offer as security,
also on the restrictions in covenants that the lenders wish to impose.

Security
Charges
The debt holder will normally require some form of security against which the funds are advanced. This means
that in the event of default the lender will be able to take assets in exchange of amounts owing.

Bonds may be secured. Bank loans are often secured. Security may take the form of either fixed charge or a
floating charge.

Fixed charge Floating charge

Security relates to specific assets/group of Security in invent of default is whatever asset of the class
assets (land and buildings) secured (inventories/trade receivables) company then owns

Company cannot dispose of assets without Company can dispose of assets until default takes place
providing substitute/consent of the lender
In event of default lenders appoint receiver rather than lay
claim to asset

Covenants
A further means of limiting the risk to the lender is to restrict the actions of the directors through the means of
covenants. These are specific requirements or limitations laid down as a condition on debt financing. They
include:

1. Dividend restrictions
2. Financial ratios
3. Financial reports
4. Issue of further debt

Public debt
 Refers to quoted bonds or loan notes: instruments paying a coupon rate of interest and whose market value
can fluctuate.

 Usually bonds will be secured either by fixed or floating charges and can be redeemed or irredeemable.

 Well secured bonds in companies that are not too highly geared are low risk investments and bondholders
will therefore require relatively low returns.

 The cost of the bonds to the borrower falls even more after tax relief on interest is taken into account.

Types of debt
Debt may be raised from two general sources, banks or investors.

Bank finance

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For companies that are unlisted and for many listed companies the first port of call for borrowing money would
be the banks. These could be the high street banks or more likely for larger companies the larger number of
merchant banks concentrating on ‘securitised lending’.

This is a confidential agreement that is by negotiation between both parties.

Traded investments
Debt instruments sold by the company, through a broker, to investors. Typical features may include:
1. The debt is denominated in units of $100, this is called the nominal or par value and is the value at which
the debt is subsequently redeemed.
2. Interest is paid at a fixed rate on the nominal or par value.
3. The debt has a lower risk than ordinary shares. It is protected by charges and covenants.

Types of issued debt

They include:
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.

A loan note is a written acknowledgement of a debt incurred by a company, normally containing provisions
about the payment of interest and the eventual repayment of capital

Deep discounted bonds

These 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 redeemed at nominal value (or above nominal value) when they eventually mature.

Investors will be attracted by the large capital gains offered by the bonds, which is the difference between the
issue price and the redemption value, but will carry lower interest than other types of bond.

The benefit to the company will be lower interest yield than on conventional bonds, but will pay a much larger
amount at maturity than it borrowed when bonds were issued.

Zero coupon bonds

Bonds that are issued at a discount to their redemption value, but no interest is paid on them.

The advantage to the borrower is that it can be used to raise cash immediately and there is no cash repayment
until redemption date. The cost of redemption is known at the time of the issue. The borrower can plan to have
the funds available to redeem the bonds at maturity.

The advantage for the lenders is restricted, unless the rate of discount on the bonds offers a high yield. The
only way of obtaining cash from the bonds before maturity is to sell them. Their market value will depend on
the remaining term to maturity and current market interest rates.

Redemption of bonds
 Redemption is the term for the repayment of preference shares and bonds at maturity.
 They are issued for a term of ten years or more. At the end of this period, they will ‘mature’ and become
redeemable (at nominal value and possibly a value above nominal value.
 They have an earliest and latest redemption date.

Irredeemable bonds
 Bonds that do not have a redemption date or undated.

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 They could be redeemed by the company if it wishes to pay off the debt, but there is no obligation on the
company to do so.

Tax relief on loan notes

 Interest charges reduce the profits chargeable to corporation tax. Dividend payments to shareholders do not attract tax
relief. The after-tax cost of debt can therefore be much lower than the cost of equity.

 A new issue of bonds is likely to be more preferable to a new issue of preference shares (Preference shares carry a fixed
rate of dividend.

 Companies might wish to avoid dilution of shareholdings and increase gearing (the ratio of fixed interest capital to
equity capital) in order to improve their earnings per share by benefiting from tax relief on interest payments.

Convertible bonds
Convertibles start life as loan capital and can later be converted, at the lenders’ option, into shares. They are a clever and
useful device, particularly for younger companies because;

 In the very early days of the company’s life, investors might not want to risk investing in equity, but might be prepared
to invest in the less risky debentures. However, debentures never hold out the promise of massive capital gains.

 If the company does not do so well, the investors can stick to their safe convertible loan stock.

 If the company does well, the investors can opt to convert and to take part in the capital growth of the shares.

Convertible bonds therefore offer a ‘wait and see’ approach. Because they allow later entry to what might turn out to be a
growth stock, the initial interest rate they have to offer is lower than with pure bonds- and that is good for the company that
is borrowing.

The conversion value and the conversion premium

The current market value of ordinary shares into which a bond may be converted is known as the conversion value.

The conversion value will be below the value of the bond at the date of issue, but will be expected to increase as the date for
conversion approaches on the assumption that a company’s shares ought to increase in the market value over time.

Conversion value = conversion ratio x market price per share

Conversion premium = current market value – current conversion value

Question 3
The 10% convertible bonds of Starchwhite are quoted at $142 per $100 nominal. The earliest date for
conversion is in four years time, at the rate of 30 ordinary shares per $100 nominal bond. The share price is
currently $4.15. Annual interest on the bonds has just been paid.
Required:
(a) Calculate the current conversion value
(b) Calculate the conversion premium and comment on its meaning.

The issue price and the market price of convertible bonds

The actual market price of convertible bonds will depend on
 The price of straight debt
 The current conversion value
 The length of time before conversion may take place.
 The market’s expectation as a future equity returns and the risk associated with these returns.

Question 4
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 year’s time. Any bonds not converted will be redeemed at 110 (that is, at $110 per $100 nominal value
of bond).

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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

Debentures
Debt secured with a charge against assets (either fixed or floating), are low risk debt offering the lowest return
of commercially issued debt.

Unsecured loans
No security meaning the debt is more risky requiring a higher return.

Mezzanine finance
High risk finance raised by companies with limited or no track record and for which no other source of debt
finance is available. A typical use is to fund a management buy-out.

OTHER SOURCES
(a) Sale and leaseback
1. Selling good quality fixed assets such as high street buildings and leasing them back over many (over 25 +)
years.
2. Funds are released without any loss of use of assets.
3. Any potential capital gain on assets is forgone.

(b) Grants
1. Often related to regional assistance, job creation or for high tech companies.
2. Important to small and medium sized businesses (ie unlisted).
3. They do not need to be paid back.
4. Remember the EU is a major provider of loans.

(c) Retained earnings

The single most important source of finance, for most businesses the use of retained earnings is the core basis of
their funding.

(d) Warrants
1. An option to buy shares at a specified point in the future for a specified (exercise) price.
2. The warrant offers a potential capital gain where the share price may rise above the exercise price.
3. The holder has the option to buy the share. On a future date at a pre-determined date.
4. The warrant has many uses including:
 Additional consideration when issuing debt
 Incentives to staff

ISLAMIC FINANCE

What is Islamic finance?

A form of finance that specifically follows the teachings of the Qur’an.

The teachings of the Qur’an are the basis of Islamic Law or Sharia’a. Sharia’a Law is however not codified as
such the application of both Sharia’a Law and, by implication; Islamic finance is open to more than one
interpretation.

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Wealth creation through trade and investment
 Making profits by lending alone and the charging of interest is forbidden under Sharia’a Law.
 Making money with money is deemed immoral and wealth should be generated via trade or trade based
investments

 Financial transactions are strongly based on the sharing of risk and reward between the provider of funds
(the investor) and the user of funds (the entrepreneur)

Prohibited activities

In Sharia’a Law there are some activities that are not allowed and as such must not be provided by an Islamic
financial institution, these include:
1. Gambling (Maisir)
2. Uncertainty in contracts (Gharar)
3. Prohibited activities (Haram)

Riba

Interest in normal financing relates to the monetary unit and is based on the principle of time value of money.
Sharia’a Law does not allow for the earning of interest on money. It considers the charging of interest to be
usury or the ‘compensation without due consideration’. This is called Riba and underpins all aspects of Islamic
financing.

Instead of interest a return may be charged against the underlying asset or investment to which the finance is
related. This is the form of a premium being paid for a deferred payment when compared to the existing
value.

There is a specific link between the charging of interest and risk and earnings of the underlying assets. Another
way of describing it as sharing of profits arising from an asset between lender and user of the asset.

The Quranic ban on riba is absolute. Riba can be viewed as unacceptable from three different perspectives:

 For the borrower

Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest
payments, turning his 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 resources in the economy and may contribute to the instability of the
system. In an interest based economy, capital is directed to the borrower with the highest creditworthiness rather
the borrower who would make the most efficient use of the capital

Forms of Sharia’a compliant finance

There are some specific types of finance that are deemed compliant and allow Islamic finance to offer similar
financial products to those offered in normal financing, these include,

 Murabaha - trade credit

 Ijara – lease finance

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 Mudaraba – a partnership contract
 Sukuk – debt finance
 Musharaka – venture capital

Mudaraba contract
A Mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal)
contributes capital, and the other (the mudarib) contributes skill and expertise. The contributor of capital has no
right to interfere in the day-to-day running of the business. Due to the fact that one of the partners is running the
business and the other is solely providing capital, the investor has to rely heavily on the mudarib, his ability to
manage the business and his honesty when it comes to profit share payments.

Investing Partner Business partner

(Rab al mal) (Mudarib)

Profit Capital Expertise

‘and loss Profit
‘and loss

Project or
Enterprise

The role of and the returns received by the rab al mal and mudarib under a Mudaraba contract

 Capital injection
The investor provides capital to the project or company. Generally, an investor will not provide any capital
unless a clearly defined business plan is presented to him. In this structure, the investor provides 100% of the
capital.

 Skill and expertise

The business manager’s contribution to the partnership is his skill and expertise in the chosen industry or area.

 Profit and loss

Any profits will be shared between the partners according to the ratios agreed in the original contract. Any
losses are solely attributable to the investor due to the fact that he is the sole provider of all the capital to the
project. In the event of a loss, the business manager does not receive any compensation ( mudarib share) for his
efforts. The only exception to this is when the business manager has been negligent, in which case he becomes
liable for the total loss.

Musharaka partnership contract

Musharaka transactions are typically suitable for investments in business ventures or specific business projects,
and need to consist of at least two parties, each of which is known as musharik. It is widely used in equity
finance.

General Partner General partner

(Musharik) (Musharik)

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 Profit Capital Capital
‘and loss & expertise & expertise Profit
‘and loss

Project or
Enterprise

(a) All partners bring a share of the capital as well as expertise to the business or project. The partners do not
have to provide equal amounts of capital or equal amounts of expertise.

(b) Any profits will be shared between the partners according to the ratios agreed in the original contract. To
the contrary any losses that the project might incur are distributed to the partners strictly in
proportion to capital contributions. Although profits can be distributed in any proportion by mutual
consent, it is not permissible to fix a lump sum profit for any single partner.

Murabaha contract
A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the
purchase of goods for immediate delivery on deferred payment terms.

1. Deliver goods today

Seller Buyer
2. Pay for goods later

The buyer has full knowledge of the of the price and quality goods he buys
The buyer is also aware of the exact amount of mark-up he pays for the convenience of paying later

Summary of Islamic finance transactions

Islamic finance Similar to Differences

transactions

Murabaha Trade credit/ There is a pre-agreed mark-up to be paid, in recognition of the

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

Mudaraba Equity Profits are agreed according to a pre-agreed contract. There are no
dividends paid. Losses are solely attributable to the provider of capital.
Ijara Leasing Whether and 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.

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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

Analysing the suitability of financing alternatives

1. Financial performance and position
When considering the sources of finance to be used by a company, consider;
- Recent financial performance
- The current financial position
- The expected future financial performance

2. Evaluating financial performance

Key areas
1. Growth in turnover
2. Growth in operating profit
3. Growth in profit after or before tax
4. Movement in profit margins
5. Return on capital employed
6. Return on equity

Key point
 You have limited time in an exam
 Only calculate few key ratios and then move on and complete the question, than it is to calculate all the possible
ratios and fail to satisfy the requirement.

3. Evaluating the current financial position

Key consideration
 Establish the financial risk of the company
Key ratios
1. Financial gearing: which shows the financial risk using data from the statement of financial position
2. Interest cover: which shows the financial risk using data from the income statement
3. The split between short- and long-term financing
4. The reliance of the company on overdraft finance

Note: considerations
- Industry sector data provided.
If not provided, state you would want to consider such comparative data.

Recommendation of a suitable financing method

Cost and ease of issue
Debt finance is generally cheaper and easier to raise than equity and, hence, a company will often raise debt rather than
equity. Raising equity is often difficult, time consuming and costly.

Cash flows
The ability of the company to generate cash. If the company is currently cash generating, then it should be able to pay the
interest and debt finance could be a good choice. If the company is currently using the cash base, it is investing heavily in

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research and development for example, then the cash may not be available to service interest payments and the company
would be better to use equity finance.

Risk
The directors of the company must control the total risk of the company and keep it at a level where the share holders and
other key stakeholders are content.

Total Risk

Financial Risk Business risk

-the company may seek to reduce its

Financial risk.
 Business risk is going to rise
because the company is
diversifying into riskier areas or
operating gearing is increasing.

The company may be able to accept more if the business risk is expected to fall
‘financial risk

Security and covenants

 From the data given, establish whether suitable security may be available.
 Covenants, such as those that impose an obligation on the company to maintain a certain liquidity level, may be
required by debt providers and directors must consider if they will be willing to live with such covenants prior to taking
on the debt.

Availability
Will depend on the nature of company seeking funds:
e.g. Small or medium sized unlisted company
 difficult to raise equity for these!! ‘and if you consider that the company requires more equity, you must be ready to
suggest potential sources e.g. venture capital, business angels and be aware of the drawbacks of such sources.
 If recent or forecast financial performance is poor, all providers are likely to be very wary of investing.
Given the recent performance and the good forecasts, the company is likely to have many finance sources available to it.
Debt providers should be willing to lend and shareholders would be likely to support a rights issue. Equally, other investors
may well wish to invest in the equity of the company. As the finance is required to finance a permanent expansion of the
company, long-term finance should be raised. To the extent that expansion requires investment in additional working capital,
some short-term finance could be raised. Consideration should be given to the fact that the existing bonds of the company
are due to be repaid. Subject to early redemption penalties, it may be worth looking into refinancing this debt at the same
time as raising the new debt especially as the cost of the new debt appears lower.

Maturity
 The term of finance should match the term of need. (i.e. short-term project should be financed by short-term finance).
But can be flexed, if the project is short-term but other short-term opportunities are expected to arise in the future – the
use of longer term finance could be justified.

 Consider the maturity debts of debt finance in questions of this nature and this may have a bearing in financing the
repayments.

Control
If debt is raised then there will be no change in control. However, if equity is raised, control may change. Rights issue will
only cause a change in control if shareholders sell their rights to other investors.

Yield curve
Consider the term structure of interest rates e.g. if the curve is becoming steeper this shows an expectation that interest rates
will rise in the future. In these circumstances, a company may become more wary of borrowing additional debt or may prefer
to raise fixed rate debt, or may look to hedge the interest rate risk in some way.

Suitable financing sources

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Be able to suggest suitable financing sources
For each source know;
- How and when it could be raised
- The nature of finance
- Its potential advantages and disadvantages.

Question 5
The following forecast financial position statement as at 31 May 2014 refers to Mtoso Co, a stock exchange listed company,
which is seeking to spend K180m in cash on a permanent expansion of its existing trade.
Km Km
Assets
Non-current assets 260
Current assets 208
Total assets 468

Equity and liabilities

Share capital 120
Retained earnings 172
Total equity 292
Non-current liabilities
Long-term borrowings 140
Current liabilities
Trade payables 36
Total liabilities 176
Total equity and liabilities 468

The forecast results for Mtoso Co, assuming the expansion occurs from 1 June 2014, are as follows:

Year ending 31 May 2014 2015 2016 2017

Km Km Km Km
Revenue 143.4 158.4 182.6 197.2
Operating profit 48.8 57.0 67.4 74.2

Notes:
1. The long-term borrowings are 8% bonds that were issued in 1998 with a 20-year term
2. The current assets include K36m of cash, of which K30m is held on deposit
3. Mtoso Co has consistently grown its profits and dividends in real terms
4. No new finance has been raised in recent years
5. The sector average financial gearing (debt/equity on book value basis) is currently 85%
6. The sector average interest cover is currently 2.9 times
7. The company estimates that it could borrow at a re-tax rate of 7.2% per year
8. The company pays tax on its pre-tax profits at a rate of 28%

Required:

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 (a) Discuss, with supporting figures, the financial performance and financial risk of Mtoso Co for the period to
2017. (12 marks)
(b) Discuss the factors that Mtoso Co should consider prior to choosing a financing method.
(8 marks)
(c) Suggest the suitable financing method that should be adopted by Mtoso Co. (5 marks)
(Total = 25 marks)

Raising equity finance

Unlisted companies
Equity finance for small and medium sized enterprises (SMEs) and unquoted companies include:
1. Own funds
If they start as an incorporated business, the distinction between owner’s capital and owner’s loans is almost irrelevant.

If it starts as an incorporated business or turns into one, there are important differences between share capital and loans.
Share capital is more or less permanent and can give suppliers and lenders some confidence that the owners are being
serious and is willing to risk significant resources.

If the owners’ friends and families do not themselves want to invest (perhaps have no money to invest) then the owners
will have to look for outside sources of capital.

2. Retained earnings
 No good for start-ups.
 No good for the first few years of a business’s life when only losses or very modest profits are made.
 Assuming the business is successful, profits should be made and the earned profits are not distributed in the form
of dividends and are retained to finance growth.

3. Friends and family

4. Venture capital
 A company willing to invest in your own company. Normally it is a company looking for a medium term strategy
and in which case there is need to have an exit strategy. When the venture capitalist comes in, there must be a way
of how they will get their money out. They need to invest millions of funds in a relatively large company. They
take an unlisted company with a good and innovative idea and grow it quickly in a few years time and then sell it
off.

 Venture is high risk capital, normally provided by a venture capital firm or individual venture capitalist, in return
for an equity stake.

Exit strategies
List the company in the stock exchange market
Trade sale to another company.

Key feature
The venture capital is only available if the venture capital firm believes that the companies they are investing have some
potential for super normal growth.

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

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 Expertise in management Commitment, skills and experience

The market and competition Threat from rival producers or future new entrants
Detailed business plan showing profit prospects that compensate for
Future profits risks
To take account of VC’s interests and ensure VC has say in future
Board membership strategy
Risk borne by existing owners Owners bear significant risk and invest and invest significant part of
their overall wealth.

5. Business Angels
People with substantial amounts of money invest in small businesses. They will invest in tens or hundreds
of dollars, for a longer term outlook. Someone with money ties up with a company without money and
work together, for a few numbers of years into the future. The individual bringing the money may also
bring some skills they have learned elsewhere.

Key feature
Both parties must work well into the future through the marriage of ideas of the two.

6. Private placing
Shares are sold to individuals without the company being listed.
Issue
- Difficulty to market as there is no recognised market
- Difficult to value a share due to absence of benchmark.

Because of this most companies will not be able to privately place.

Why do they arise?
They arise where a company has a reason to protect profits into the future
For example;
- The company has long term contracts with the government that will ensure long term profits
- The company has strong brands or patents that enable it to earn solid profits into the future.

Stock markets - considerations

The stock exchange suggests the following 7 considerations:

1. Prestige
2. Growth
3. Access
4. Visibility
5. Accountability
6. Responsibility
7. Regulation

Stock market listing

Access to wider Improved marketability
‘pool of finance of shares

Easier to
‘seek growth WHY SEEK A STOCK Enhanced public
‘by acquisition MARKET LISTING? Image

Original owners selling

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 ‘holding to obtain funds Original owners
‘ for other projects realising holding

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.

Gaining a listing opens up a huge source of potential new capital. However, with listing come increased
scrutiny, comment and responsibility. Although this will help the standing and respectability of the company,
the founders of the company having been used to running their own company in their own way, often resent
outside interference even though that is to be expected now that the ownership of shares is more widespread.

Methods of obtaining a listing

 Initial public offer
 Placing
 Introduction

Initial Public Offering (IPO)

An initial public offering is the first occasion on which shares are offered to the public. A company seeking a listing has to
issue a prospectus, which is a legal document describing the shares being offered for sale, and including matters such as a
description of the company’s business, recent financial statements, details of the directors and their remuneration.
Listing

Offer for Placing Introduction

Sale

Sale of shares to the -Sale of shares to a few -Introduce existing shares

General public financial institutions to the stock market
Ways e.g. -the cheapest
1. .Prospectus – fixed price and -pension funds -raise no equity
‘ sent out a prospectus to each -investment trusts
‘and every individual e.g. newspaper, -insurance companies
‘advertisements
2. 2. Tender – where the price is
‘determined by the market. Benefits
Each investor bids for shares. -Cheaper than an offer for sale
-Quicker
Advantages -Less disclosure of information
- Sale to the public can be the Problem
‘broadest type of ownership and _May end up with relatively very few
‘probably gets the best price investors and may have strong influence
‘in company decisions.
Down side
-very expensive. Costs associated
‘with making sure that the share
‘issue is taking place

Costs of share issues on the stock market

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 Underwriting costs
 Stock market listing fees (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 prospectors: (the prospectus is a document in which the company offers its
shares for sale)
 Advertising in national newspapers

Underwriting
Underwriters are financial institutions which agree (in exchange for a fixed fee, perhaps 2.25% of the finance to be raised) 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 under-subscribed, but at a cost to the company issuing the shares.

EQUITY ISSUES BY QUOTED COMPANIES

A listed or quoted company is better able to raise equity finance.
Rights issue
A rights issue is the right of existing shareholders to subscribe to new share issues in proportion to their existing
holdings. This is to protect the ownership rights of each investor.

Advantages
1. Low cost
2. Protect ownership rights
3. Rarely fails

Theoretical ex-rights price (TERP)

The new share price after the issue is known as the theoretical ex-rights price and is calculated by finding the
weighted average of the existing market price and the issue price, weighted by the number of shares ex-price.

Theoretical MV of shares (cum rights) + Proceeds from rights issue

Ex-rights = Number of share (ex-rights)
Price

Question 6
Marcus plc, which has an issued capital of 4,000,000 shares, having a current market value of $2.80 each, makes
a rights issue of one new share for every three existing shares at a price of $2.0.

Value of a right
The new shares are issued at a discount to the existing market value; this gives the rights some value.

Value of a right = Ex – rights price – Issue price

Required:
Calculate the theoretical ex-rights price

Shareholders’ options
The shareholders’ options with a rights issue are to:
1. Take up (buy) the rights
2. Sell the rights
3. A bit of both
4. Do nothing

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Question 7
A shareholder had 10,000 shares in Marcus plc before the rights offer.
Required:
Calculate the effect on his net wealth of each of the following options:
(a) Take up the shares
(b) Sell the rights
(c) Do nothing

Question 8
Seagull can achieve a profit after tax of 20% on capital employed. At present its capital structure is as follows:
$
200,000 ordinary shares at $1 each 200,000
Retained earnings 100,000
300,000

The directors propose to raise an additional $126,000 from a rights issue. The current market price is $1.80.

Required:
(a) Calculate the number of shares that must be issued if the rights price is: $1.60; $1.50; $1.40; $1.20
(b) Calculate the dilution in earning per share in each case.

Question 9 (expected yield from new funds raised)

Musk currently has 4,000,000 ordinary shares in issue, valued at $2 each, and the company has annual earnings equal to 20%
of the market value of the shares. A one for four rights issue is proposed at an issue price of $1.50.

Required:
1. If the market continues to value the shares on a price/earnings ratio of 5, what would be the value per share if
the new funds are expected to earn, as a percentage of the money raised:
(a) 15%
(b) 20%
(c) 25%
How do these values in (a), (b) and (c) computation

Question 10
Pepe is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at 15% discount to the market
price of $4.00 per share. Issue costs are expected to be $220,000 and these costs will be paid out of the funds raised. It is
proposed that the rights issue funds raised will be used to redeem some of the existing loan stock at par. Financial
information relating to Pepe is as follows:

Current statement of financial position

$’000 $’000
Non-current assets 6,550
Current assets
Inventory 2,000
Receivables 1,500
Cash 300
3,800
10,350

Ordinary shares (par value 50c) 2,000

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Reserves 1,500
12% loan notes 20X16 4,500
Current liabilities
Trade payables 1,100
Overdraft 1,250
2,350
10,350
Other information:
Price/earnings ratio of Pepe: 15.24
Overdraft interest rate: 7%
Tax rate: 30%
Sector averages: debt / equity ratio (book value): 100%
Interest cover: 6 times
Required:
(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:
(i) The theoretical ex rights price per share;
(ii) The value of rights per existing share. (3 marks)

(b) What alternative actions are open to the owner of 1,000 shares in Pepe as the regards the rights issue? Determine
the effect of each of these actions on the wealth of the investor. (6 marks)

(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to
redeem some of the existing loan notes. (6 marks)

(d) Evaluate whether the proposal to redeem some of the loan notes would increase the wealth of the shareholders of
Pepe. Assume that the price/earnings ratio of Pepe remains constant. (3 marks)

(e) Discuss the reasons why a rights issue could be an attractive source of finance for Pepe. Your discussion should
include an evaluation of the effect of the rights issue on the debt / equity ratio and interest cover.
(7 marks)
(25 marks)

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