Business Finance

Introduction
 Factors to consider in choosing Finance
 Cost of funds (Normally debt is cheaper)

 Since secured hence low risk for provider

 Guaranteed returns

 Definite maturity

 Tax saving by interest

 Duration of need (Matching)

 Gearing ratio (High gearing  High risk)

 Accessibility - Generally difficult for small co. to raise debt

 Areas to cover in Business Finance
 Source of Finance

 Debt

 Equity

 Preference shares

 Valuing the Right Issue and whether they are acceptable to shareholders

 Problems for raisning Finance for SMEs and possible sources of finance for them

 Suitability of the source of finance using ratio analysis

 Dividend policies

 Islamic Finance
Business Finance
Equity
 Types of Equity Finance
Ordinary Shares

 Owning a share confers part ownership.

 High risk investments offering higher returns.

 Permanent financing.

 Post-tax appropriation of profit, not tax efficient.

 Marketable if listed

Retained Earnings ( Retain funds)

These are readily available and have no issuance cost however they may be not sufficient to

fund large projects.

 Advantages and disadvantages of using Equity
Advantages

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

 No repayment required.

 Shares in listed companies can be easily disposed of at a fair value

 Decrease Financial Gearing and hence decrease the financial risk

Disadvantages

 Issuing equity finance can be expensive in the case of a public issue (see later).

 Problem of dilution of ownership if new shares issued.

 Carries a higher return than loan finance.

 Dividends are not tax-deductible.

 A high proportion of equity can increase the overall cost of capital

 Stock Market Listing
Advantages

 Access to wider pool of finance

 Better image

 Releasing capital for other uses

 Possibilities of acquisition and growth

Disadvantages

 Increased public scrutiny of the company

 Possibility of dilution of control

 Increased costs e.g. corporate governance, internal audit

 New Share Issuance
 Offer for Sale ( By tender or at fixed price)

 Placing

 Rights Issue

Comparison Between Offer for Sale of its Shares & Placing

 Placing is much cheaper.

 Placing is a relatively quicker method

 Placing involves less disclosure of information

 Placing might give institutional shareholders the control of the company

 Right Issues
It provides that any new issue of shares shall first be offered to the existing shareholders in the

ratio of their shareholdings. This preserves the existing pattern of shareholding and control.

Advantages

 It is a cheaper method of financing as compared to a public offer.

 The existing shareholders get shares at a low price and their shareholding is not diluted.

Disadvantages

The amount that can be raised is limited

 Theoretical Ex-right Price (TERP)
Theoretical ex rights price (TERP)

𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 + 𝐹𝑢𝑛𝑑𝑠 𝑅𝑎𝑖𝑠𝑒𝑑

𝑇𝐸𝑅𝑃 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑕𝑎𝑟𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 𝑟𝑖𝑔𝑕𝑡 𝑖𝑠𝑠𝑢𝑒

Fund Raised= Right issue shares × right issue price

Value of rights = TERP – Rights issue price

Is the Right Issue Beneficial For Shareholders?

Funds raised through rights issue can be used to repay a loan this will reduce interest expense

and earnings would increase or can be used to invest in new project increasing the returns. From

both the market value after the right issue will be changed. So if,

The revised market value > TERP, then shareholders wealth will be Maximized
 Example
Existing Shares = 1,000,000

Existing Share Price = $4/Share

Company wants to raise $600,000 using a rights issue.

Right Price = $3/Share

Expected share price after the right issue is $3.90

Required

Calculate the TERP

Whether the right issue are acceptable to shareholders

What is the Value of the right issue per existing share

Business Finance
Debt
 Debt Finance
The loan of funds to a business without any ownership rights. It is Paid out as an expense of the

business (pre-tax) and there is a risk of default if interest and principal payments are not met

Security
The debtholder 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 the amounts owing.

Covenants
These are specific requirements or limitations laid down as a condition of taking on debt
financing.
 Dividend restrictions
 Financial ratios
 Financial reports
 Issue of further debt
 Types of Debt Finance
Non Tradable Bank Finance

Debentures

Typical features may include:

 Generally the par value of such debt is $100

 Interest paid on the debt is stated as a percentage of nominal value ($100 as stated). This is

known as the coupon rate.

 Since they are traded in the market they should have a market price.

 At redemption date they can be redeemed at par, discount or at premium

 Types of Debentures
 Irredeemable (No redemption date is given. Usually considered as infinite life)

 Redeemable (Redemption date is provided)

 Convertible (Option to convert into certain number of shares)

 Non-Convertible (can only be redeemed at a pre agreed redemption value)

 Appropriateness of Debt financing
 When company has lower financial risk

 The gearing and interest cover are close to industry average

 When company is in healthy comparative position

 Cash flows and profit margins are stable

 Tangible assets are available to be offered as a security

Business Finance
SMEs
 Small & Medium Enterprises (SMEs)
SMEs can often face difficulties when raising finance since investing in an SME is inherently more

risky than investing in a larger company due to:

 the lack of business history or proven track record

 the lower level of public scrutiny over accounts and records

 Sources of Finance for SMEs
 Various government solutions including:

 Marketability of shares

 Tax incentives

 supply chain financing

 Peer to Peer funding

 Venture capitalists
 Venture Capitalists
Venture capital is a risk capital, normally provided against returns for an equity stake. Venture

capital requires representative in BOD.

Types of Venture
 Business start-ups
 Business development
 Management buyout
 Helping a company where one of its owners wants to realize all or part of his investment
Factors to consider by Venture capitalist
 Product Expertise
 Management Expertise
 Competition
 Financials
 Boards representation
 Exit Routes
Business Finance
Dividends
 Dividend Policy Theories
Irrelevancy theory

According to CAPM & MM theory dividends are irrelevant, it does not matter, what actually

matters that is earning power. Investors are indifferent to whether they receive their earnings by

way of dividends or capital gains.

Relevancy Theory

Markets are not perfect, dividends play a role of signal: A dividend which differs from

shareholders expectations about dividends might send signals to the market and affect share

price.
 Factors Effecting Dividend Policy
 Liquidity Preference by Investors

 Tax Position

 The need to remain profitable and counter inflation

 The government impose direct restrictions on the amount of dividends companies can pay

 Any dividend restraints that may be imposed by loan agreements

 The company’s gearing level

 The need to repay debt in near future

 The ease with which the company can raise extra finance

 The signaling effect of dividends to shareholders

Business Finance
Islamic Finance
 Islamic Finance
Riba

In Islamic finance Riba is non-permisable.

Riba is generally regarded as being the equivalent of interest. The concept is wider than pure

interest as it includes any form of profit or premium that must be paid on a financial transaction

without any consideration.

Islamic Finance Contracts

 Modaraba – equity finance

 Musharaka – venture capital

 Murabaha – trade credit

 Ijarah – lease finance

 Sukuk – debt finance

 Modaraba

Mudarib Rabi-ul-Maal
(Business Partner) (Islamic Bank)

Expertise Capital
Project

Pre-Agreed Profit ratio Pre-Agreed Profit ratio

 Musharaka

Musharik Musharik
(Partner) (Partner)

Expertise & capital Expertise & capital

Project

Pre-Agreed Profit ratio Pre-Agreed Profit ratio

 Murabaha
Seller

Goods bought by
Bank at cash

Goods sold to customer for credit

on profit
Islamic Bank Customer
 Ijarah

1. Provide the Asset

Lessor 2. Pay Periodic Rentals Lessee

(Islamic Bank) (The Company)

3. Sell the Asset

 Sukuk

1. Sell the Asset but hold possession

2. Pay Periodic Rentals

Company General Public

3. Sold back the asset to company

Business Finance
Ratio Analysis
 Shareholder’s Wealth
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒
 Dividend Yield= 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑕𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝑋100%

𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒−𝑜𝑝𝑒𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒

 Capital Gains = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑕𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
𝑋100%

 Total Return (Dividend Yield + Capital Gains) =

𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒−𝑜𝑝𝑒𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒+𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑕𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
𝑋100%

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑆𝑕𝑎𝑟𝑒

 Dividend Cover = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑆𝑕𝑎𝑟𝑒

𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑕𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒

 Price/Earning Ratio = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑆𝑕𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒

 Earning Yield = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑕𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝑋100%
 Performance and Financial Risk
Performance Ratios

𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

 Return on Capital Employed = 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑋100%

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

 Return on Equity = 𝑋100%
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

Financial Risk

𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡
 Financial Gearing = 𝑋100% OR 𝐸𝑞𝑢𝑖𝑡𝑦 𝑋100%
𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦

𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

 Interest Cover Ratio = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
 Example
The Extract of financial statements of the company is given below
Income Statement
$
PBIT 500,000
Less: Interest -180000
Profit before Tax 320,000
Tax (25%) -80000
Net earnings 240,000
Statement of finacial position
$
Loan Notes @ 6% 3,000,000

Equity
Ordinary Shares @ $1 3,000,000
Reserves 2,000,000
The company is planning to issue 500,000 new share at a price of $3 and to redeem the some of

the loan notes which are quoted in market at par

Estimate the effect on EPS, Interest cover and Financial Gearing