OVERVIEW
Objective
¾
To appreciate the options available to a company for long, medium and short-term debt finance.LONG-TERM
FINANCE SHORT-TERM FINANCE OTHER SOURCES
¾ Preference shares
¾ Commercial paper
¾ Grants
¾ Effect on EPS of convertible debt
¾ Warrants
1
LONG-TERM FINANCE
1.1
Preference shares
Definition
Shares with a fixed rate of dividend having a prior claim on profits available for distribution.
Whilst legally equity, they are often treated as debt as they are similar in nature to debt.
1.1.1
Features
¾
Shares which have a fixed percentage dividend payable before ordinary dividend.¾
The dividend is only payable if there are sufficient distributable profits. However if theshares are cumulative preference shares the right of dividend is carried forward. Any arrears of dividend are then payable before ordinary dividends.
¾
As with ordinary dividends, preference dividends are not deductible for corporate tax purposes – they are a distribution of profit rather than an expense.¾
On liquidation of the company, preference shareholders rank before ordinary shareholders.1.1.2
Advantages
9
No voting rights; therefore no dilution of control.9
Compared to the issue of debt: Dividends do not have to be paid if profits are poor; Not secured on company assets;
Non-payment of dividend does not give holders the right to appoint a liquidator.
1.1.3
Disadvantages
8
Dividends are not tax deductible (unlike interest on debt).1.2
Debentures
Definition
A written acknowledgement of a debt, usually given under the company’s seal, containing provisions for payment of interest and repayment of principal. The debt may be secured on some or all of the company’s assets
Type
Secured debentures
Unsecured debentures
Security and
voting rights
¾
Can be secured on one or more specific assets - a “fixed charge” e.g. over property¾
Or a “floating charge” can be offered over a class of assets e.g. over net current assets (working capital)¾
On default the assets are sold anddebt repaid
¾
No voting rights.¾
No security.¾
Holders have the same rights as ordinary creditors.¾
No voting rights.Income
¾
A fixed annual amount, usuallyexpressed as a % of nominal value.
¾
A fixed annual amount, usually expressed as a % of nominal value.Amount of
capital
¾
A fixed amount per unit of loan stockor debenture.
¾
A fixed amount per unit of loan stock or debenture.In the UK debentures are usually issued with a face value of £100. They can then be traded on the bond market and reach a market price. Hence, if a debenture is said to be selling at a premium of £15%, this means that a debenture with a face value of £100 is currently selling for £115. This indicates that the rate of interest on this debenture is attractive when
compared with current market rates, creating demand for the debenture and a rise in price. In the US the face value of each debenture is usually $1000.
1.3
Deep discount bonds
Definition
Loan stock issued at a large discount to nominal value − redeemable at par on maturity
¾
Investors receive large capital gain on redemption, but low rate of interest during term of the loan.¾
Cash flow advantage to the borrower – useful for financing projects which produce weak cash flows in early years.Illustration 1
A five year $1000 3% Bond issued at $800 would generate the following cash inflows/(outflows) for the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 800
Interest (30) (30) (30) (30) (30)
Redemption (1000)
1.4
Zero coupon bonds
Definition
Bonds issued at a discount to face value and which pay zero annual interest
¾
No interest is paid.¾
Investors gain from the difference between issue and redemption price.¾
Advantages to borrowers: No cash payout until maturity;
Cost of redemption known at time of issue.
1.5
Tax relief on debt interest
¾
Interest expense is tax deductible and therefore reduces corporate tax payments.¾
Regarding the tax system the Issue of debt is preferable to the issue of shares asIllustration 2
Effective cost of debt in CoB
Interest 10
¾
The fact that interest on debt is tax allowable is referred to as the “tax shield”2
CONVERTIBLES AND WARRANTS
2.1
Convertibles
Definition
Bonds or preference shares that can be converted into ordinary shares.
¾
Pay fixed interest or dividend until converted.¾
They may be: converted into ordinary shares; on a pre-determined date; at a pre-determined rate; at the option of the holder.
¾
Advantages to investors − a relatively low risk investment with the opportunity to make high returns upon converting to ordinary shares.¾
Advantages to issuing company − can offer a lower rate of interest than on “straight” debentures.2.2
Effect on EPS (Earnings Per Share) of convertible debt
Convertible debentures require a “fully diluted” EPS to be calculated to indicate what EPS might be if debt is converted into equity.
Method
¾
Increase earnings by the loan interest saved, net of tax.¾
Increase the number of shares due to conversion.¾
Recalculate EPS2.3
Warrants
Definition
A right given to an investor to subscribe cash for new shares at a future date at a fixed price − the exercise price.
¾
Warrants are sometimes attached to loan stock, to make the loan stock more attractive.¾
Warrants are basically share options¾
The holder of the warrants may sell them rather than keep them. Advantages to issuing company9
The warrants themselves do not involve the payment of any interest or dividends.9
When they are initially attached to loan stock, the interest rate on the loan stock will belower than for comparable straight debt. This due to the additional benefit for the investor of potential equity shares at an attractive price.
3
MEDIUM-TERM FINANCE
3.1
Bank loans
3.1.1
Advantages
9
The loan will be for a fixed term: no risk of early recall;9
Interest rate may be fixed.3.1.2
Disadvantages
8
Inflexible;8
May require security,8
May require “covenants” – restrictions on the company e.g. limits on dividend payments, limits on further borrowing.3.2
Leasing
3.2.1
Advantages
9
Many willing providers;9
Remains off-balance sheet if an operating lease;9
Matches finance to the asset ;9
Very flexible packages available, some of which include maintenance.3.2.2
Disadvantage
8
Can be costly.3.3
Sale and leaseback
Property is sold to an institution, such as a pension fund, and then leased back to the company.
3.3.1
Advantages
9
Releases significant funds;9
May improve ratios such as ROCE (Return on Capital Employed).3.3.2
Disadvantages
3.4
Mortgage loan — a loan secured on property.
3.4.1
Advantages
9
Given the security, the loan will attract a lower interest rate than other debt;9
Institutions will be willing to lend over a longer term;9
Still participate in the growth in value of the property.3.4.2
Disadvantage
8
Default may result in a key asset being liquidated4
SHORT-TERM FINANCE
4.1
Bank overdraft
4.1.1
Advantages
9
Flexible;9
Provides instant finance.4.1.2
Disadvantages
8
Repayable on call, unless the bank offers a “revolving line of credit”8
High and variable interest rate.4.2
Trade credit
4.2.1
Advantages
9
Generally cheap;9
Flexible.4.2.2
Disadvantages
4.3
Bills of exchange
Definition
An acknowledgement of a debt to be paid at some time in the future e.g. by a customer. Such a bill may then be ”discounted” i.e. sold to a third party for a % of face value
4.3.1
Advantages
9
Improves cash flow.9
Flexible.4.3.2
Disadvantages
8
Fees.Illustration 3
X sells $2m worth of goods to Y. X writes out (“draws”) a bill of exchange for $2m payable in 2 months (say) which it sends to Y. Y signs the bill to
acknowledge the debt and returns it to X.
X can hold on to the bill for 2 months until Y pays the debtor sell it at a discount e.g. at 98%of face value. The buyer of the bill then receives the $2m and makes a gain.
4.4
Commercial Paper
Definition
Commercial paper is short-term (usually less than 270 days) unsecured debt issued by high quality companies. The paper can then be traded by investors on the bond markets.
4.4.1
Advantages
9
Large sums can be raised and relatively cheaply9
No security required4.4.2
Disadvantages
5
OTHER SOURCES
Commentary
The following are particularly suitable for small and medium sized enterprises (SME’s) which are of particular interest to the examiner as they often have difficulty finding debt finance. Such difficulties may be caused by”asymmetry of information” – where banks fear making loans to companies which are not well known and without published credit ratings.
5.1
Grants
Depending upon the location and nature of the business local, regional, national or European grant assistance may be available.
5.2
Loan guarantee scheme
Just as small/medium sized companies find it hard to raise equity, they can also find it hard to raise debt, due to their high perceived risk. The Loan Guarantee Scheme is a UK
government-backed scheme where, for a fee, a substantial proportion of the loan may be guaranteed. Hence potential providers of that loan are willing to lend, as most of their risk has been eliminated.
5.3
Business angels
Business angels are rich individuals who are prepared to invest money in small companies if they see high potential for growth
Such angels are often retired businesspeople who became wealthy as entrepreneurs in the high-tech sector.
Key points
³
Preference shares are in substance debt as they pay a fixed committed dividend in priority to any ordinary dividend. They also rank ahead of ordinary shareholders upon liquidation (although after “real” debt such as bank loans and debentures)³
Preference shareholders therefore face lower risk than ordinary shareholders and require lower returns³
However banks and bondholders take even lower risks, as they rank ahead of preference shareholders upon bankruptcy, and their debts may be secured by fixed or floating charge over assets. Providers of loans therefore require lower returns than other providers of finance.³
Hence loans are the least expensive source of finance for a company, particularly if the effect of the tax system is introduced (loan interest is a tax allowable expense, unlike dividends.)³
Unfortunately debt also has a dark side – too much debt may increase the risks faced by shareholders to unacceptable levels.FOCUS
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