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EB2 Financial Management

Sources of Finance
Large variety of methods available to firms to raise finance/capital
(equity, debt, venture capital, back overdraft)
Type of finance a firm can avail of depends on the size and stage of
development of the firm (start up Vs reputable long standing)
For smaller firms short-term sources of finance are extremely
important (Bank Overdraft, Working capital)

Role of Financial Markets and Institutions

For successful financing decisions finance manager needs an


understanding of the financial markets.
The financial markets allow companies to raise money by selling new
financial assets (equity shares, bonds)
For example, if we decide to raise funds by issuing shares in our company
to the public we hire an investment bank to sell the shares to investors.
Small portion of issue is likely bought by individuals, like ourselves, but
the remainder is likely to be bought by financial institutions (e.g pension
funds and life assurance)
New issues of securities, which increase the amount of cash held by the
company and the amount of securities held by the public, take place in the
primary market.
Purchase and sales of existing securities take place in the secondary
market (i.e. where investor sells shares, bonds to other investors)

EB2 Financial Management

Instead of firms raising money directly from investors there is often a


financial intermediary in between. A financial intermediary is a firm that
raises money from many small investors and provides financing to business
by investing in their securities. Financial intermediaries invest primarily
in financial assets (e.g shares and bonds)
Banks, pension funds, and insurance companies would be the most familiar
form of financial intermediaries.
Functions of Financial Markets and Institutions
As well as providing finance for business, the markets and institutions
have other functions:
1. Payment System: Banks are providers of payment services that
contribute to the smooth functioning of the economy.
2. Borrowing and lending: Allow individuals to transfer expenditure
across time. Almost all institutions are involved in channelling savings
toward those who can best use them.
3. Pooling risk: Financial markets and institutions allow individuals to pool
their risks. Insurance companies are an obvious example. Mutual
funds and other forms of group investment also provide a means of
diversifying risk (reducing risk)

Capital Market Efficiency


Financing decisions can be perceived as easier than investment decisions.
1. Not the same degree of finality as investment decisions - they are
easier to reverse.
2. Harder to lose money by stupid financing strategies.
Hard to find cheap money as investor demands fair returns.
Hard to lose money as competition between investors prevents any one
group from demanding more than fair terms.

EB2 Financial Management

It is more difficult to generate positive NPV financing decisions. In


general, firms assume that securities they issue will sell for their true
values.
True value does not mean ultimate fair value (for it to do so investors
would need to be able to foretell the future). Instead means that the
price incorporates all information currently available to investors.
Leads to definition of efficient capital markets - if markets are
efficient, all securities are fairly priced in light of the information
available to investors.
Three Forms of the Efficient Market Theory
1) Weak-Form Efficiency
Situation in which market prices rapidly reflect all information
contained in the history of past prices.
Therefore, investors cannot profit by just studying past stock prices.
2) Semi-Strong-Form Efficiency
A market in which it is impossible to make superior profits from
publicly available information is said to be semi-strong-form efficient.
Researchers have looked at stock price movements after company
announcements. Most of the information contained in the
announcement is rapidly and accurately reflected in the price of the
shares, so that investors were not able to earn superior profits by
buying or selling immediately after the announcement.
3) Strong-Form Efficiency
Market in which prices reflect not just public information but all
available information (even insider information!!!)
Evidence on this form of efficiency is mixed.
The efficient market theory implies that financial managers are not able
to time issues (based on past prices) to avail of opportunities to acquire
cheap finance.

EB2 Financial Management

Long-Term Sources of Finance

Generally, categorised into two types:


1. Ownership Finance (equity)
2. Loan Finance

Ownership Finance
1) Ordinary Shares / Common Stock
Authorised Share Capital - maximum number of shares a company may
issue
The price at which each share is issued is known as the par value (e.g.
5p, 25p, 1)
Issued Share Capital - on the other hand is the number of shares
actually issued
Price that new shares are issued to shareholders may exceed par value.
The difference known as capital surplus or share premium
Important to distinguish between book value and market value. From a
finance perspective, we are always concerned with market value
The owners capital is generally permanent. And owners bear the
financial and business risk of the venture.
Shareholders take the ultimate risk of the business as all other
sources of finance (creditors, banks, preference shareholders) are
catered for prior to dividends to shareholders and in the event of
liquidation all other sources of finance are repaid before owners
receive anything
In addition, company is not obliged to pay any dividend on their
investment

EB2 Financial Management

Offsetting the risk disadvantage is the income and control advantages.


Shareholders have ultimate control of the companys affairs as it is
the risk taker who controls the company. Ordinary shareholders have
the right to elect directors who manage the company on their behalf.
Also, debt and preference shares offer a fixed return. After these
payments all the remainder of the profits is available to the owners.
Hence, the phrase that equity is a residual claim on the firm.
Retained earnings also form part of the equity capital of a company. In
effect the company is providing funds from profits for further
investment. These retained earnings are owned by the shareholders of
the firm.
Advantages of retained earnings
1. No change in control pattern of the firm.
2. Reduce the financial risk of the firm (ratio of debt to equity).
3. Readily available and do not involve issuing costs.
4. No fixed charges.
5. No fixed maturity.
6. No increase in the number of shares.
Disadvantages
1. Firm management may not be as careful with retained earnings as it
would be with an alternative source of finance.
2. May not be most suitable source of capital at all times. A firm with no
debt and stable earnings may be able to raise debt capital more
efficiently than using retained earnings.
3. Cost may be high. Management often view retained earnings as a
costless source of finance. This is not true, their cost is the same as
raising new shares, apart from issuing costs.

EB2 Financial Management

2) Preference Share Capital


Some investors are unwilling to take the full risk which attaches to
owners funds. For lower levels of risk they are willing to accept lower
levels of returns.
Preference shareholders have preference or priority over ordinary
shareholders but are paid after debt-holders. They occupy an
intermediate position.
Preferred share capital offers a fixed dividend payment. However, is
still classified as equity as the payment is usually at the discretion of
the directors. The obligation is merely that no ordinary dividends can
be paid until preferred dividend has been paid. (This claim is usually
cumulative if company does not declare preference dividend 1 year,
amount rolls forward to next year)
In liquidation (when a company fails) preference shareholders usually
rank after debt-holders but before common shareholders. Therefore,
they participate in risk and profits but not to the same extent as
ordinary shareholders. Preference shares combine some of the
characteristics of debt and equity.
Very rarely confer full voting rights. This can be an advantage to a
firm who wishes to raise new money without sharing control.
One major disadvantage of preferred shares from a firm perspective is
that the dividends are not deductible from taxable income i.e. they are
paid from after-tax income. This can be a serious deterrent to issuing.

Loan Finance (Debt)


Commitment by the firm to make regular (fixed) interest payments and
to repay the principal.

EB2 Financial Management

The return on debt capital is fixed, it does not vary with profits.
Therefore, the only risk to the lender is the risk of that he/she will
not get payment (default risk)
As lenders are not recognised as owners of the business, debt does not
carry any voting power.
The major advantage of debt is that the interest payments are tax
deductible.
Debt comes in a huge variety of different forms and is usually
categorised by five main characteristics:
1) Interest Rate
Usually fixed at the time of issue (e.g. debentures)
However, many direct bank loans carry a floating interest rate. The
interest charges depend on the general level of interest rates.
2) Maturity
The time to eventual maturity varies with different types of loans.
Debentures usually 10 to 30 years.
Firms may also issue debt with much shorter maturities.
3) Repayment Provisions
Long-term loans are generally repaid in a steady regular way
Some firms also reserve the right to call bonds. A callable bond may
therefore be bought back prior to the final maturity date. This
feature can be attractive to issuers as if interest rate decrease they
can call the bonds and re-issue new bonds at the lower interest rate.
4) Security
Debt may be subordinated or unsubordinated. Subordinated debt is
paid only after all senior creditors are satisfied.

EB2 Financial Management

Firms may also set aside certain assets as security for the loan. This
is termed collateral and the debt is said to be secured.
In the event of default, secured debt has first claim on collateral.
5) Denomination
Refers to both the units of currency (e.g. 100 or $1,000) or the
currency in which the debt is denominated.
For example, an Irish firm can borrow in US$.
Many firms now issue debt in currencies other than their domestic
currency.
Advantages of Debt Finance
1. Low after-tax cost.
2. No loss of voting or ownership rights.
3. Flexibility.
Disadvantages
1. Interest payments and repayment schedule are a fixed burden.
2. Can restrict management freedom of action (restrictive covenants).

Convertible Securities
Are securities where the investor has an option to convert instrument
into a share at some future point.

1) Warrant
Gives the purchaser/owner the right to buy a number of the companys
shares as a set price before a set date.

EB2 Financial Management

Usually offered to make a bond issue more attractive (sweetener).


Gives the bond-holder an opportunity to participate in an increase in
the value of the companys shares.

2) Convertible Bonds
Gives the owner of the bond the option to convert the bond into a predetermined number of shares.
No obligation to convert.
Key difference to warrants is that with a convertible the investor does
not pay extra cash for the shares instead exchanges the bond for shares
in the company.

Issuing Securities
The first sale of stock to the public is called an Initial Public Offering
(IPO).
An IPO is called a primary offering as new shares are sold to raise
additional capital for the firm.
When going public a firm needs to appoint underwriters. The
underwriters are a firm(s) that buys an issue of securities from a
company and resells it to the public. In fact they play a triple role providing advice to the firm, buying the stock and reselling it to the
public.
The Spread is the difference between what the underwriters pay for the
shares and price they are allowed to sell them on to the public at.

Part of the cost of the issue is the under pricing typically associated with
issues. Firm managers try to secure the highest possible price for the
shares, but underwriters are generally more cautious as they may be left
with any unsold shares if they over estimate investor demand.
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EB2 Financial Management

As a result underwriters typically try to under price the issue (Example


Telecom Eireann, now Eircom) i.e. setting the offering price below the
true value of the security. They argue that this is essential to tempt
investors to buy the stock.
In addition to the under pricing and spread there are other costs
associated with a new issue. These are mainly administration costs such
as the cost of management time, legal and accounting fees.
Overall the costs of an IPO can be amount to a substantial proportion
of the overall capital raised => Company must be sure before it goes
Public

Venture capital
Equity capital in new, start-up businesses is known as venture capital and
is provided by specialist venture capital firms, wealthy individuals, and
investment institutions, such as pension funds.
Investing venture capital in a business is a high risk activity as a large
percentage of company start-ups fail. However, the rewards can also be
substantial if the business takes off.
If a start-up proves successful then the firm may decide to go public
(many years down the road)
The venture capitalist (VC) acquires an agreed proportion of the Equity
Share Capital of the business. The VC will usually have a representation
on the board of the company.
Venture Capital is a medium to long term investment with gains to the
investor expected when the company floats on the Stock Exchange of the
VC sells the holding in the company to make a capital gain.

Raising Additional Finance


From time to time firms will need to raise additional funds by issuing
shares or bonds.

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EB2 Financial Management

Can issue by either a rights issue or a general cash offer.


Rights Issue
Limited to existing shareholders. Gives the shareholders an opportunity,
or right, to buy new shares in proportion to their existing holding.
Usually offered at a price below the current market price (discount).
This is done to make the offer attractive to the shareholders.
The overall wealth of the existing shareholders will not be altered by
the rights issue.
Example:
Ireland PLC has 500,000 shares outstanding, selling at 5 per share. To
finance a new project it plans a rights issue, allowing one new share to be
purchased for each two share currently held. The issue price will be 4
per share.
How many new shares will be issued and how much money will be raised?
Answer:

250,000 new shares issued


250,000 x 4 raised = 1 million

Increasing marketability of shares


Scrip/Bonus Issues
New shares issue to existing shareholders in proportion to their existing
holding. No payment is required.

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EB2 Financial Management

Because there are no new funds generated by the company this has no
effect on the value of the firm.
Used often to reduce the share price with the view to stimulating
interest in the stock

Scrip Dividends
A scrip dividend is where a company offers shareholders a choice of new
shares instead of their cash dividend. The effect of this is to convert
profits into Issued Share Capital.
This has the effect of increasing issued share capital (to improve
gearing) and avoids the cash outflow in respect of dividends.
Shareholders have the advantage of increasing their share holdings
without paying commissions, fees or duties on the transaction.

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