Chapter 12 Sources of Finance

Source of
Finance

Short-term Debt Venture Equity Finance for

Sources Finance Capital Finance SMEs

Overdrafts Loan IPO Financing

Notes Problems

Short-term Deep discounts Placing Potential Sources

loans bonds of Financing

Trade Zero coupon Introduction

Credit bonds

Leasing Convertible Rights

bonds issue

Multiple Choice Questions

1. Which of the following is not a benefit, to the borrower, of an overdraft as opposed to a

short-term loan?

A Flexible repayment schedule

B Only charged for the amount drawn down
C Easy to arrange
D Lower interest rates

2. The following statements have been made about the benefits of debt finance compared to
equity finance:

Statement 1: Interest payments on debt attract tax relief.

Statement 2: Control of the company is diluted.

Which of the above statements is true?

A Both of them
B Statement 1 only
C Statement 2 only
D Neither of them
3. Statement 1: Positive covenants are promises by a borrower to do something.
 Statement 2: Quantitative covenants are promises to keep within financial limits set by the
lender.

Which of the above statements is true/false?

Statement 1 Statement 2
A False True
B False False
C True False
D True True

4. Consider the following two statements concerning the returns to investors from debt capital.

(1) Junk bonds normally offer a higher rate of interest than investment-grade bonds
(2) Convertible bonds normally offer a higher rate of interest than non-convertible bonds

Which one of the following combinations (true/false) concerning the above statements is
correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

5. Which one of the following statements concerning sources of finance is correct?

A Retained earnings represent a free source of finance to the business

B Invoice discounting involves the administration of debtors by the invoice discounter
C A bank overdraft is normally regarded as a long-term source of finance
D Mezzanine finance normally has both a debt and an equity element

6. Consider the following statements.

1. A participating preference share gives the holder the right to participate in voting at the
Annual General Meeting.
2. A cumulative preference share gives the holder the right to dividends due but which
have not been paid in the past.

Which one of the following combinations (true/false) is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False
7. Consider the following two statements concerning convertible loan stock.

(i) The conversion value of convertible loan stock is normally below the face value of the
loan stock at the time of issue.
(ii) The coupon rate for convertible loan stock is normally lower than the coupon rate for
non-convertible loan stock.

Which of the following combinations (true/false) concerning the above statements is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

8. Consider the following statements concerning the issue of shares.

1. A bonus issue raises finance through an offer of shares to existing shareholders.

2. A placing of shares makes shares directly available to the general public.
3. An offer for subscription is an invitation to the general public to subscribe for shares
not yet in issue.
4. A rights issue raises finance through an offer of shares to existing shareholders.

Which two of the above statements are correct?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

9. Three important sources of long-term finance are loan capital, ordinary shares and preference
shares.

Which one of the following correctly ranks these sources of finance according to their
relative cost to the business? (Where 1 represents the source of finance that is normally the
most expensive and 3 represents the source that is normally the least expensive.)

Loan capital Ordinary shares Preference shares

A 1 2 3
B 2 3 1
C 3 1 2
D 2 1 3

10. Consider the following statements.

 (1) Both a stock split and a scrip issue convert equity reserves into ordinary share capital.
(2) Both a rights issue and a Stock Exchange placing exclude the general public from
subscribing to the issue of new shares.

Which one of the following combinations (true/false) concerning the above statements is
correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

11. Consider the following statements concerning sources of finance.

1. Invoice discounting requires the discounter to invoice the client’s customers for goods
or services provided.
2. A bank bill offers a bank customer the opportunity to discount the bill of exchange at
the bank.
3. Operating leases are rental agreements where the lessor retains responsibility for
servicing and maintaining the leased equipment.
4. ‘Junk bond’ is a term for bonds that have been given a rating by a credit-rating agency
that is below investment grade.

Which two of the above statements are correct?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

12. Which one of the following statements concerning sources of finance is correct?

A Warrant holders are eligible to receive a dividend on a company’s profits

B The coupon rate on convertible bonds is usually lower than the coupon rate on non-
convertible bonds
C Retained earnings represent a free source of finance to the business
D An operating lease is an asset rental agreement where the term of the lease is for most
or all of the useful life of the asset

13. Consider the following statements concerning loan finance:

1. Providers of mezzanine finance have a preferential right, ahead of other lenders, to the
repayment of capital if the business is liquidated.
2. Holders of junk bonds expect to receive a higher yield from their investment than
 holders of investment-grade bonds.

Which one of the following combinations (true/false) is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

14. Consider the following statements concerning sources of finance:

1. Retained earnings represent a free source of finance for a business.

2. Convertible loan notes are normally issued at a lower rate of interest than non-
convertible loan notes.
3. Under an operating lease, the lessor is responsible for the upkeep of the asset.
4. Under an invoice discounting arrangement, the invoice discounter will collect the
receivables on behalf of the client.

Which of the above statements are correct?

A 1 and 2
B 1 and 3
C 2 and 3
D 3 and 4

15. The following methods of issuing shares may be used by a quoted company:

1. An intermediaries’ offer
2. An offer for subscription
3. A rights issue
4. A placing

Which of the above methods allow the investing public to participate in the share issue?

A 1 and 2
B 2 only
C 3 and 4
D 4 only

16. Which of the following is least likely to be a reason for seeking a stock market listing?

A Enhancement of the company’s image

B Transfer of capital to other users
C Improving existing owners’ control over the business
 D Access to a wider pool of finance

17. Which of the following is a key feature of debt as a source of finance?

A Interest must be paid irrespective of the level of profits generated by the company
B Debt holders are repaid last in the case of a winding up of the company
C Debt holders hold full voting rights
D Debt holders suffer relatively high levels of risk, compared to providers of other sources
of finance, and therefore debt attracts the highest return

18. Which two of the following statements are correct?

(1) Bank overdrafts are repayable on demand

(2) Warrants give the holder the right to subscribe at a fixed future date for a certain number
of ordinary shares at a predetermined price
(3) Preference dividends are paid before loan interest is paid
(4) Deep discount bonds are issued at a discount to their redemption value and no interest
is paid on them

A (1) and (2)

B (1) and (3)
C (2) and (4)
D (3) and (4)

19. Which of the following best describes the term 'coupon rate' as applied to loan notes?

A The rate of stamp duty applicable to purchases of the loan notes

B The total rate of return on the loan notes, taking into account capital repayment as well
as interest payments
C The annual interest received divided by the current ex interest market price of the loan
notes
D The annual interest received on the face value of the units of the loan notes

20. Hera plc has 5 million shares in issue that have a current market value of $10·00 per share.
The company has decided to make a one-for-four rights issue at a discount of 20% on the
current market value.

What will be the theoretical value of the rights attached to each original share?

A $0.40
B $0.50
C $1.60
D $2.40

21. Agate plc is a company that is listed on the London Stock Exchange. It intends to announce
immediately a one-for-four rights issue at an issue price of $5·00. The current share price of
 the company is $8·00.

What will be the theoretical value of the rights attached to each original share?

A $2·40
B $1·85
C $0·75
D $0·60

22. Selene plc has ordinary shares in issue and the directors of the company have decided to
make a one-for-three rights issue. The current market value of each share is £8·00 and the
rights shares will be offered at a discount of 40% on this current market value.

What will be the theoretical value of the rights attached to each original share?

A $0·60
B $0·80
C $1·80
D $2·40

23. Columbus plc has 10 million shares in issue and has a market capitalisation of $60 million.
The company has recently announced a one-for-four rights issue at a discount of 40% on the
current market value. What is the theoretical value of the rights attached to each original
share?

A $0·48
B $0·60
C $1·38
D $1·92

24. Sayan Co is listed on a stock market and is about to announce a one-for-three rights issue at
an issue price of $12·00. The current share price of the company is $16·00.

What will be the theoretical value of the rights attached to each original share?

A $0·75
B $1·00
C $1·33
D $3·00

25. A plc has announced a 1 for 5 rights issue at a subscription price of $2.30. The current cum-
rights price of the shares is $3.35.

What is the new ex-div market value of the shares?

A $3.18
B $3.81
 C $2.97
D $2.48

26. Consider the following statements concerning the financing problems of a SME.

(i) Funding gap

(ii) Maturity gap
(iii) Inadequate security
(iv) Uncertainty concerning the business

Which of the above statements are the financing problems of a SME?

A (i), (ii) and (iii) only

B (i), (iii) and (iv) only
C (ii), (iii) and (iv) only
D (i), (ii), (iii) and (iv)

Islamic Financing
Islamic
Finance

Principles Interest (Riba) Islamic

and financial
permissible instruments
investment

Meaning Riba - Permissible 1. Trade credit

cannot investment (Marabaha)
charge 2. Lease finance
(Ijara)

Differences between 3. Equity finance

Islamic & conventional 1. Equities (Mudaraba)
finance 2. Mutual funds 4. Debt finance
(Sukuk)

3. Fixed income funds 5. Venture capital

4. Islamic financial (Musharaka)
securities
 Islamic finance Conventional finance
1. Adherence to Islamic principles 1. Do not have to follow rules of any
religion
2. Islamic laws denounce receipt & 2. Receipt & payment of interest are
payment of interest allowed
3. Prohibition on speculation, i.e. risk 3. No prohibition on speculation
contracts not allowed
4. Goods forbidden under Islam are 4. No prohibition on goods
invalid
5. Trading in non-existent goods is void 5. Trading in non-existent goods with
mutual consent of buyer and seller
6. Transaction before ownership of the 6. Ownership of subject of trade is not
subject of trade is void necessary
7. Seller must have the possession of 7. No restriction on possession of
subject of sale subject of sale
8. Sale must be instant & absolute 8. Sale can be made on future date
9. Sale must be unconditional 9. Sale can be conditional

Multiple Choice Questions

1. With reference to Islamic finance, the term Riba refers to

A a form of equity where a partnership exists and profits and losses are shared
B the predetermined interest collected by a lender, which the lender receives over and
above the principal amount that it has lent out
C a form of credit sale
D a form of lease

2. Which of the following describes a sukuk?

A A bond in Islamic finance where the lender owns the underlying asset and shares in the
risks and rewards of ownership.
B Equity in Islamic finance where profits are shared according to a pre agreed contract –
dividends are not paid as such.
C Trade credit in Islamic finance where a pre agreed mark up is agreed in advance for the
convenience of paying later.
D A lease in Islamic finance where the lessor retains ownership and the risk and rewards
of ownership of the underlying asset.