SEC E BUSINESS FINANCE

Syllabus Objectives SEC E Business finance

1. Sources of and raising short-term finance 2. Sources of and raising long-term finance 3. Raising short and long term finance through Islamic financing 4. Internal sources of finance and dividend policy 5. Gearing and capital structure considerations 6. Finance for Small and Medium-size Entities (SMEs)

Key learning contents

Evaluate the source of short term finance available to business? What are the factors to be considered in choosing between debt and equity finance? Evaluate the source of long term finance available to business? Discuss other available source? Discuss various ways of obtaining listing? What are the advantage and disadvantage of getting enlisted in stock exchange? Discuss issues relevant to Islamic financing? How a business can internally generate finance? Explain the relationship between dividend policy and the financing decision? What are the factors to be considered prior taking decisions related to dividends? What are the available options? Describe the nature of the financing problem for small businesses in terms of the funding gap, the maturity gap and inadequate security? Identify appropriate sources of finance for SMEs and evaluate the financial impact of different sources of finance on SMEs?
Identify the types of gearing and discuss the problem of high levels of gearing?

Evaluate the impact of chosen source of finance on gearing, financial risk and S/H wealth?

Exam focus
This section have never missed any session, examined each semester till date. I have designed this considering syllabus objective; your task would be to get conceptually clear. The key knowledge here is to understand the impact on F/S of a chosen source of finance and conducting ratio analysis. Think and write step by step in exam scenario don t jump into conclusion early. Give a quick glance to the past questions below Pilot Paper 1c JUNE 08 2b,e JUNE 09 4b,c JUNE 10 2c,d DEC 07 3b,c DEC08 1a, 4a DEC09 2d,4a DEC10 4d

Evaluate the source of short term finance available to business?

Four alternatives are there starting from Overdraft This is where business has accounts in bank and it withdraws balances exceeding its own deposit. It s designed for day to day help. Even though interest rates charged would be high but still acceptable if used to invest in an opportunistic manner. The benefits are: Bank has flexibility to review, can be renewed and It won t effect gearing calculation Loans Most common choice if business has a good track record. It can serve medium term purpose. The terms of loans interest and repayment are set in advance. Banks can t withdraw loan facilities at short notice as they can do in overdraft. It s generally preferred that loan shouldn t exceed asset life. Business can also negotiate loan O/D mix. Trade credit or delaying payable This is an interest free source of finance by not paying creditors on time. This often proves out costly as suppliers retaliate i.e. adverse goodwill. It s a good choice if suppliers offer early settlement discount.

Operating lease Business in most case raise loan because of purchasing NCA. An alternative of doing this is to take the asset in rent; this will ensure no capital is tied up. This offers greater flexibility and in most cases cheaper than bank loan. The LESSOR is responsible for maintenance and other, the only outflow for lessee is the rent.

What are the factors to be considered in choosing between debt and equity finance?
.Ownership and control Issuing equity can have ownership implication for a company, particularly if the finance is raised by means of placing or offer for sale. S/H has the right to attend general meeting of the company and appoint directors and auditors. No such complicacy for debt finance. Redemption Equity finance is permanent capital that doesn t need to be redeemed, while debt finance needs to be redeemed at some future date. If the amount is large it can place a severe strain on company cash flow. Availability For debt finance it depends on company s gearing and credit rating, but for equity may not be available on favorable terms depends on whether stock market is bearish or bullish Cost Debt is cheaper than equity because debt is less risky from an investor s point of view. Moreover security offered i.e. Fixed or floating charge and most importantly the debt interest is an allowable deduction in calculating taxable profit. Flexibility Debt finance more flexible than equity, in that various amount can be borrowed at fixed or floating interest rate and for a range of maturities to suit the need for companies. Risk and return Debt finance will increase gearing and the finance risk of the company, while raising equity finance will lower gearing and financing risk. Financial risk arises since raising debt brings bring commitment to meet regular interest payment whether fixed or variable. In contrast, there is no right to receive dividend on ordinary shares, will only get it if directors declares. If profits are low dividends can be passed, but interest must be pad regardless of the level of profits

Evaluate the source of long term finance available to business?

Debt finance The loan of funds to a business without any ownership rights. Types of debt Either banks or investors. Bank finance For unlisted and for many listed companies the first port of call for borrowing money would be the banks by securitized 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. E.g. Deep discount and zero coupon bonds. 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 the Charges and Covenants. Equity finance Equity relates to the ownership rights in a business. Ordinary shares Owning a share confers part ownership. It s high risk investment offering higher returns. It s permanent finance. As they get Post-tax appropriation of profit, not tax efficient. Advantages 1. No fixed charges (e.g. interest payments). 2. No repayment required. 3. Carries a higher return than loan finance 4. Shares in listed companies easily saleable at a fair value. Disadvantages 1. Issuing equity finance to public can be expensive. 2. Problem of dilution of ownership if new shares issued. 3. Dividends are not tax-deductible. 4. Excess equity can increase the overall cost of capital for the company. 5. Shares in unlisted 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 worlds, i.e. Not tax efficient and No opportunity for capital gain (fixed return). RAISING EQUITY FINANCE Unlisted companies Equity finance for Small and medium sized enterprises (SMEs) and unquoted companies include: 1. Own funds 2. Retained earnings 3. Friends and family 4. Venture Capital. 5. Business Angels 6. Private placing EQUITY ISSUES BY QUOTED COMPANIES A listed or quoted company is better able to raise equity finance. Rights issues 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 fail. 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-rights. Theoretical Ex-rights price (TERP)=
Value of existing shares + proceeds from issue No. of shares in issue after the rights issue Value of a right= TERP issue price Value of a right per existing share = Value of a right /No. of shares needed to have a right.

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 the amounts owing. Covenants are the means of limiting risk to the lender by restricting the actions of the directors. These are specific requirements or limitations laid down as a condition of taking on debt financing. They may include: 1. Dividend restrictions 2. Financial ratios 3. Financial reports 4. Issue of further debt.

DISCUSS OTHER SOURCES OF FINANCE? Sale and Leaseback: This is where a good quality
fixed asset is sold such as office building and then it is rented/leased back from the new owner for a longer time frame, say 30 years. The consequence is: We have the funds released without any loss of use of assets and any potential gain on asset is forgone Venture Capital: This is a risk capital which is provided only if an equity stake is offered or board representation given. Innovative investment plans get the attention of venture capitalist, since this gave high growth potentials with a higher return. E.g. Available for business start ups, new product/market development etc Convertible loan stock A debt instrument that may, at the option of the debt holder, be converted into shares. The terms are determined when the debt is issued and states the rate of conversion (debt: shares) and the date or range of dates at which conversion can take place. The convertible is offered to encourage investors to take up the debt instrument. The conversion offers a possible capital gain (value of shares value of debt)

Grants: This often related to regional

assistance, job creation or for high tech companies. It is important to small and medium sized businesses (i.e. unlisted). They do not need to be paid back, complying with terms and conditions of grant would be enough. EU is a major provider of such grants. Warrants: An option to buy shares at a specified point in the future for a specified (exercise) price. The warrant offers a potential capital gain where the share price may rise above the exercise price. The holder has the option to buy the share on a future date at a pre-determined date. The warrant has many uses including: As being an alternative when issuing debt. It can also be used as Incentives to staff. 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. Remember, here no equity stake is offered, its debt.

Discuss various ways of obtaining listing? What are the advantage and disadvantage of getting enlisted in stock exchange? Methods of obtaining a listing Fixed price offer for sale Offered to the general
public at a fixed price. It has the potential to raise the highest possible price for the company by being offered to the widest possible market. The problem is the cost associated with floatation which can t be prohibitive. Offer for sale by tender Investors are able to bid for shares and the shares are issued only to those investors who have bid at striking price or above. Placing Shares are placed with/ sold to institutional investors, keeping the cost of the issue to a minimum. Stock exchange introduction Shares are introduced to the exchange without any new shares being issued. Intermediaries offer this might be from finance house that also plays the roles of issue managers. Advantages of enlisting -Access to wider pool of equity finance -Higher public profile and investor s confidence -It allows owners to realize some of their investments at fair value -Enlistment allows business to offer share options for incentive to employees, can use shares for takeovers too. Disadvantages -Complying with regulations has high cost -In bearish trends, with low share price the company s vulnerable to takeovers -Greater restrictions and responsibilities on director s actions thus it s difficult for them to work for strategic success alone. -Adverse price sensitive information would immediately affect the market value of shares, company don t have much to do to prevent it.

Discuss issues relevant to Islamic financing? The principle concept of Islamic law is it s strictly forbidden to use money for the purpose of making money i.e. it s forbidden to charge interest (RIBA). Financial institutions cannot therefore make money by charging interest, but instead provide services for a fee or enter into agreement with client in which risk and profits /losses are shared between them. Trade credit (MURABAHA): This is effectively a form of credit sale, where the customer receives goods but pays for later on a fixed date. However instead of charging interest, a fixed price is agreed before delivery- the mark up effectively including the time value of money. Debt finance (SUKUK) equivalent to debt finance i.e. Islamic bonds. SUKUK must have an underlying intangible asset and the holders of the SUKUK certificates have ownership of a proportionate share of the asset, sharing revenues from the asset but also sharing the ownership risks. E.g. a financial institution purchased an asset 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 sales proceeds. 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 Although there can be a secondary market as with conventional debt i.e. the purchase and sale of certificates on the stock exchange, it is currently very small. Most SUKUK are bought and held-virtually all of any trading is done by institutions. Venture capital (MUSHARAKA) this is again is similar to 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. Lease finance (IJARA) 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 on operating lease) or might sell it to the lessee (effectively a finance lease- IJARA-WAIQTINA) Equity finance (MUDARABA) it is a special kind of partnership where 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)

How a business can internally generate finance? Explain the relationship between dividend policy and the financing decision? How a business can internally generate finance? Retained earnings: This is the single most
important internal source of finance, for most businesses the use of retained earnings is the core basis of their funding. Before doing this it s important to evaluate the consequences of cutting dividend or not paying it. Retaining profits help directors to invest without seeking permission from investors Avoids new share issues, change of control and issue cost.

Explain the relationship between dividend policy and the financing decision
This is a clean fact that not paying dividend or cutting dividend can help business to be self dependent. But the dilemma is will it result in adverse reaction from our finance providers. One perspective is It doesn t really matter if the dividend irrelevance theory is accounted. The dividend irrelevance theory states if a company doesn t pays dividend it might mean low immediate cash for S/H but as this retained funds are invested the share value increases further (i.e. EPS. Share price and market capitalization) i.e. in theory S/H will be indifferent because the increase in value of their shares will compensate them for the low dividend. Another perspective is it matters if there is a trend of paying constant dividend in past i.e. they have developed a clientele effect. This S/H would get annoyed because of their tax position and their need for income(Pension schemes) A reduction of dividend might be seen by the market as a sign of company weakness i.e. signaling effect If we pay dividends it signals good prospects to S/H, ensure share price stability and those S/H requiring regular income having it

Working capital management efficiency:

This involves ensuring funds are not tied up in inventory for substantial time and receivables collected on time. I.e. a balance should exist between us paying suppliers and us receiving from customers. Delaying payable, speeding up receipt, using cash management models and implementing JIT all this can free funds for business at-least in the short run. Other internal source includes disposal of unused assets, further contribution from owners etc

What are the factors to be considered prior taking decisions related to dividends? What are the available options? Factors include Legal constraints:
A plc may only pay dividend if its net assets are, at the time, greater than the aggregate of its called up share capital and its un-distributable reserves. Un-distributable reserves are: Share premium account, Capital redemption reserve, any reserve which the company is prohibited from distribution by statute.

Dividend options
Cash dividend Most traditional form of dividend i.e. paying cash on face value of shares, e.g. KARIM holds 2000 shares with face value $100 of XYZ co, current market value $320 , the company declares 20% cash it would mean he would get $20 on per share he is holding at record date i.e. a total of 40,000 taka. Bonus or scrip issue This is the turning of reserves into share capital and issuing free shares to existing S/H. The new shares are issued in proportion to S/H s existing share holdings. They are issued free and are therefore not a source of finance They have the effect of reducing the market value per share of all the shares in issue, and can thus make the shares more marketable. E.g. If 20% bonus is declared KARIM would get 400 shares at nil cost but the market value is likely to be adjusted by at-least by 15 to 20% theoretically. Scrip dividends i.e. Right issue This is the offering to S/H of new shares instead of a cash dividend. The incentive for S/H is that it is a cheaper way of acquiring new shares then buying them on the stock exchange, and also there can be tax advantages. For the company, this is a source of new finance in that new shares are issued for cash. It is a cheap way of raising finance and does not risk upsetting S/H by cutting or not paying dividend. E.g. If 20% or 5:1 right is issued at $150, then KARIM would get the opportunity to buy 400 shares @150 taka.

Liquidity:
If the company is considering cash dividend, share premium account can t be used since it s for bonus issue only. Thus liquid cash availability is a key matter. Paying cash I difficult for companies with high paid up capital.

S/H expectations and stock market efficiency:

Composition of types of S/H is a key issue. Since there preference of dividend or high share price can be understood then. Institutional investors are likely to be closely associated with the governing body thus will know better why the dividend policy was changed. However, for the mass S/H in public it depends on their circumstances and whether they have access to information about the company. Circumstance can be divided as need for regular income and tax preference on capital gain or stock dividend.

Other issues (not dividend but +VE for S/H) Stock splits It occurs when the shares are split in value, say 1 share of face value $100 is now split into 10 shares of face value $10. The total share capital of the company is unchanged but there will be more shares in issue. As the MV per share reduces it increase the marketability of shares.

Other issues (not dividend but +VE for S/H) Share re-purchase It s the use of surplus cash to buy back its own shares from the market. This reduces the stress on company of paying high cash dividend each year. This result in increased EPS with increased gearing. It may prevent a takeover or enable a quoted company to withdraw from stock market.

Identify appropriate sources of finance for SMEs and evaluate the financial impact of different sources of finance on SMEs?

Describe the nature of the financing problem for small businesses in terms of the funding gap, the maturity gap and inadequate security?

Identify the types of gearing and discuss the problem of high levels of gearing?

GEARING TYPES Gearing is a measure of risk. There are two measures of gearing: Operating gearing Risk associated with the level of fixed costs within a business. The higher the fixed cost earning profit becomes that difficult too. The level of fixed cost is normally determined by the type of industry and cannot be changed. Financial gearing Risk associated with debt financing. The company can decide the level of financial risk it wishes to take on. Impact A company can/must accept some level of risk, and is willing to trade additional risk for additional gain. The effect of risk is cumulative: if a company already has high operating gearing it will have to be more conservative with its financial gearing. A company cannot use too much debt for fear of encountering bankruptcy when economic conditions decline. Companies need to take a variety of factors into consideration when deliberating the use of Debt, factors include: Capital structure constraints (D:E) Term of borrowing (Cash flow projections and repayment dates) Currency and interest rate base (fixed/floating, whether hedging is done) Security ( What assets do we have)

GEARING Should we finance the business using debt or equity? There are two basic considerations: 1. Cost. 2. Risk. 1. Cost Any finance will incur servicing costs, debt will require interest payments and equity will require payment of dividends or at least capital growth. On the basis of cost of servicing we would always pick debt over equity. Debt should be less expensive for two reasons: Tax Debt is tax deductible because the debt holders are not owners of the business. Equity however will receive a return after tax because they receive an appropriation of profits. Debt is therefore tax efficient saving 30 %. Risk The debt holder is in a less risky position than the shareholder. If there is lower risk then the debt holder should be willing to expect a lower return. The lower risk is due to two factors: 1. Fixed coupon A legal obligation to pay interest. 2. Security Charges or covenants against assets. 2. Risk from the perspective of the company Risk may be split into two elements: Business risk Business risk is inherent to the business and relates to the environment in which the business operates. It s anything that prevents us to achieve objectives. Financial risk is risk when the company finances by debt and fails to pay interest payments as they fall due.

Evaluate the impact of chosen source of finance on gearing, financial risk and S/H wealth?
Profitability Return on capital employed Return on equity Asset turnover Operating profit margin Investor EPS PE ratio Dividend cover Dividend yield Gearing Operating gearing Financial gearing Capital gearing measure Interest cover

Interpretation is the key skills that are needed to ensure you can tackle this question. Be prepared to re-draft the F/S due to a chosen source of finance. Use proper heading with brief introduction in questions where a report is asked. If you are not told what ratios are to be used, consider the objective of the person whom you are reporting, think what ratios would be of relevance to him? Try to avoid giving certain answer, it s better to mention various options and what are the pro s and con s of choosing those.