Sources & Forms of Finance

• Finance can be classified as either short-term, medium-term, or long-term.
• Finance can be either secured, where the finance provider has first claim over a specified asset in the case of default, or unsecured.
• Finance can be further classified as equity, debt, hybrid (properties of debt and equity, such as preference shares), or mezzanine (claims rank above equity but below all other forms of finance, such as preference shares).
• The money market is a short-term financial market where borrowers and lenders are brought together by banks and other financial institutions.
• The capital market is a longer-term financial market where debt and equity securities are traded.
• In the primary market, new securities are sold, with money flowing from investors to the company.
• In the secondary market, existing securities are traded between investors, either over-the-counter (OTC) or on a formalised securities exchange.
• If the capital investment appraisal indicated that a particular investment should be made, the next step is to determine how the investment should be financed.
• The financing of an investment must be considered in relation to the target capital structure of the company.
• Companies will not always be at their target capital structure and may be in a position of temporary disequilibrium.
• However, companies will always strive to move closer towards the target capital structure when new funds are raised.
• The calculation should be performed using market values and not book values.
• If finance is split then duplicate issue/transaction costs will be incurred.
• When convertible debt or preference shares convert into equity, this does not provide extra funds for the company.
• Depending on the structure of the agreement, the lessee may have the option to cancel with the payment of a cancellation fee.
• A lease may be preferable if the investment has a high risk of failure or if the industry faces rapid changes in technology.
• If the lessor covers the cost of insurance, repairs and maintenance in the lease calculation, these costs should be included as a saving for the lessee.
• Debt finance often has lending conditions such as security/collateral, which restricts the company’s ability to borrow funds in the future.
• If the preference shares are cumulative and there is no cash available to pay a dividend in a particular year, it must be caught up in subsequent years.
• Debt is normally cheaper than equity for the following reasons: providers of debt capital are prepared to accept a lower return because they are exposed to less risk, interest and capital payments are agreed upon in advance and must be paid regardless of financial performance, and in most instances debt is secured against assets.
• Participating preference shareholders receive ordinary dividends over and above the preference dividend.
• If the company is confident that the investment will have a positive net present value, they should rather buy the asset and get tax benefits of ownership.
• The useful life of the asset and the payback period of the finance should match, so that the cash inflows generated from the investment can be used to settle the financing cash outflows.
• Interest and capital repayments on debt are agreed upon in advance and must be paid regardless of financial performance, which could have a negative impact on cash flows (liquidity).
• In the tax calculation for the lease, the wear and tear forfeited as an opportunity cost should be added back.
• Debt normally has lower issue costs than equity, however, there are no issue costs involved where the company uses its own existing funds in the form of reserves (e.g. retained earnings if cash is available).
• A lender will normally charge a higher rate of interest on longer term debt (shorter payback periods are less risky for the lender ), however, where security is provided on long-term debt the risk to the lender is reduced and therefore a lower rate of interest is often charged.
• Leasing is generally more expensive than other forms of finance.
• Preference dividends must be paid before ordinary dividends.
• Interest on debt is tax deductible whereas dividends on ordinary and preference shares are not.
• Dividends on ordinary and preference shares do not need to be paid if profits are poor.
• Issue costs are only paid once in respect of convertible debt or preference shares.
• Another benefit of a lease is that the lessor often covers the cost of insurance, repairs and maintenance.
• Where convertible debt or preference shares are issued, an investor is usually prepared to accept a lower initial dividend/interest rate hoping to participate in the future growth of the share price.
• You should select the alternative which will take the company closer towards the target capital structure.
• The following forms of finance will not increase the company’s gearing, allowing it to borrow more in the future: non-redeemable preference shares, convertibles, and bank overdraft.
• If the company’s cash flows deteriorate unexpectedly or if interest rates increase, they may have difficulty meeting capital and interest payments.
• The headings provided should be studied and used as a trigger for your discussion.
• Redeemable preference shares should be treated as debt when calculating gearing.
• Interest rate risk can be hedged by entering into an interest rate swap.