Topic 2

SOURCE OF
FINANCE
 Sources of Finance

Common sources of finance:

 Share capital Ordinary shares

Preference shares
 Debt finance
 Term loans
 Leasing
 Overdraft
 Share Capital

Ordinary Shares

 Represent a share of the company’s assets and a share of

profits earn on those assets.
 Owners of the company.
 No agreement on the company’s part to return to the
shareholders the amount of their investment.
 Referred to risk capital of a business as equity shareholders
bear most of the risk.
 Vary dividend payment depending on company’s dividend
policy
 Share Capital

Preference Shares

 Entitle the holder to a fixed rate of dividend every year and

not-tax deductible.
 To be paid first before ordinary shareholders receive their
dividend.
 Carry part-ownership.
 A hybrid between equity and debt.
 Fixed dividend payment.
 Factors Affecting Dividend Policy

 Liquidity. In order to pay dividends, a company will require

access to cash.
 Repayment of debt. Dividend pay-out may be made
difficult if debt is scheduled for repayment.
 Restrictive covenants. Some forms of debt may have
restrictive covenants limiting the amount of dividend
payments or the dividend rate of growth.
 Rate of expansion. The funds may be needed for business
expansion.
 Control. The use of funds as retained earnings to finance
new projects limit the dividend pay-out.
 Factors Affecting Dividend Policy

 Stability of profits. Company with stable profits is more

likely to be able to pay out a higher percentage of earnings
than a company with fluctuating profits.
 Policy of competitors. Dividend policies of competitors may
influence corporate dividend policy.
 Signaling effect. Dividends are seen as signals from the
company to the financial markets and shareholders.
Investors perceive dividend announcements as signals of
future prospects for the company.
 Raising Share Capital

 Traded in stock market

 Companies may become publicly quoted by making shares

available by way of :
(i) Introduction
- existing shareholders willing to sell their share at a
stated price
(ii) New issuance
- raising additional funds to existing or new investors
 New Issues

Offer for Sale

 Completely new shares or shares derive from the privately
held shares transfer to the public of shares.
 An issuing house, normally a merchant bank, acquires the
shares and then offers them to the public at a fixed price.
 The offers are usually made in the form of a prospectus in
Financial Times or newspaper.
 New Issues

Offer for Sale by Tender

 Similar to offer for sale except the shares are not issued at a
fixed price.
 Subscribers must tender for the shares at, or above, a
minimum fixed price.
 The shares are allotted at the highest price - strike price.
 New Issues

Prospectus Issues
 Company offers its shares direct to public.
 An issuing house act as an agent, but this type of issue will
not be underwritten which make it risky and rare.

Placing
 Not offered to the public, but the issuing house will arrange
for the shares to be issued to its institutional clients.
 Become the most popular method of issue as it is cheaper
and quicker to arrange.
 Debt Finance - Debentures

 A document issued by a company containing

acknowledgement of indebtedness.
 A debenture-holder is a creditor to the issuing company
and will be repaid with interest income and principal at
maturity.
 Two types:
- Secured
- Unsecured
 Some debentures might have restrictions known as
‘restrictive covenants’.
 Debt Finance - Convertibles

 Hybrids between equity capital and debt finance.

 Offers investors a fixed return, and gives right to convert
into a certain number of ordinary shares.
 Advantage  cheaper than ordinary debentures due to the
conversion options allow the security to be issued at a lower
coupon rate.
 Minimize any loss of control for existing shareholders since
the number of shares issues via a convertible will be smaller
than if straight equity issued.
 Conversion Premium & Value

 Conversion premium
- measures how much more expensive it is to buy the
convertible debentures than the ordinary shares
directly from the market

 Conversion value
- calculated as the market value of ordinary shares
(MPS) that is equivalent to one unit of the convertible
 Example

Oldham plc issued a convertible bond with a coupon

rate of 10 per cent. Each RM100 nominal is
convertible into 20 ordinary shares. The market
price of the convertible is RM108, while current
ordinary share price is RM4.80 per share.
Calculate
(1) conversion premium (2) conversion value.
 Solution

(1) Conversion premium

RM100 convertible bond = 20 shares

Therefore, 1 share = RM5 convertible bond

Cost of buying RM5 convertible bond

= RM5 x (RM108/RM100) = RM5.40

Conversion premium = RM5.40 – RM4.80 = 12.5%

RM4.80
 Solution

(2) Conversion value

Conversion value = conversion ratio x MPS

= 2o shares x RM4.80
= RM96

From this, conversion premium may also be calculated as:

= Market price of convertible – conversion value

Conversion value
= RM108 – RM96 = 12.5%
RM96
 Debt Finance - Warrants

 Warrants are options to buy shares in the company at a

given price within a given period.
 Investors will find warrants more attractive than a
convertible since they can sell warrants separately.
 Warrants enable the coupon rate to be reduced on the debt
instrument depending on the value of warrant.
 Warrants if exercised will result to new capital being raised,
and this will be useful for expansion of existing project or
investment.
 Debt issued with warrants are not self-liquidating and thus
required additional finance for redemption.
 Debt Finance - The Euromarkets

 Refer to an investment in a currency held outside its home

country.
 An effective ‘stateless’ money whereby any transaction will
not subjected to domestic rules and regulations of financial
centre.
 Can be deposited or borrowed for short periods – 3 months
 Eurobond issued in Euromarket – not accountable to any
particular government, domestic rules and regulations.
 Term Loans

 A fixed amount of loan with a fixed repayment schedule.

 Interest rate is slightly lesser than a bank overdraft.
 Lender will require security to cover the amount borrowed,
and an arrangement fee is payable dependent on the
amount borrowed.
 Can be negotiated easily and quickly.
 Banks also may offer some flexible repayment i.e no capital
repayment for certain period.
 Variable interest rates.
 Leasing

 A business may buy equipments, machineries or buildings

but some may just prefer leasing it.
 The distinguishing feature of leasing compare with buying
is that the lessee obtains the use of an asset only for a
certain period of time, whereas the legal ownership of the
asset remains with the lessor.
 The leasing agreement does not give the lessee the right of
final ownership.
 Three types of leasing : (1) Finance lease
(2) Sale and leaseback
(3) Operating lease
 Leasing – Finance Lease

 An agreement whereby the lessee obtains the use of the asset

for the whole, or substantially of the asset’s useful life.
 Are essentially term loans.
 It has to be shown in the lessee’s accounts as assets and
liabilities, and the depreciation and financing charged against
profits.
 The agreement will not be cancellable and will not provide for
any maintenance of the asset.
 At the end of the lease period there will be an agreement
where the sale proceeds from the asset are shared between the
lessor and lessee, or can continue to use the asset for payment
of a nominal amount each year, called a peppercorn rent.
 Leasing – Sale & Leaseback

 An arrangement to convert certain assets which the

company owns into funds, and yet still continue using it.
 Company able to gain immediate cash inflow by selling the
assets.
 The only cash outflow is rental for leasing it back (tax-
deductible) but may be subjected to capital gain tax.
 Leasing – Operating Lease

 They do not appear on the lessee’s balance sheet, and the

fee for the lease is charged directly against profits.
 These agreements will usually not last for the full life of an
asset.
 Company decide for operating lease when purchasing and
the maintenance cost is much more expensive.
 The lease assets can be cancelled and returned.
 Are particularly useful for industries where there is a rapid
change in technology which makes it necessary to have the
latest equipment, e.g. computers, photocopier machine.
 Overdraft

 One of the most important external sources of short-term

finance, particularly for small firms.
 Features that make overdraft finance popular are:
- Flexibility. The bank will agree to a maximum
overdraft limit, or facility. The borrower may not require
the full facility immediately, but may draw funds up to the
limit as and when required.
- Minimal documentation. Key elements of the
documentation will be to state the maximum overdraft
limit, the interest rate payable, and the security required.
- Interest is only paid on the amount borrowed, not the full
facility.
 Managing Cash Surplus

 The treasurer will need to consider opportunities for short-

term investment in order to put any cash surpluses to
generate more positive returns.
 The following considerations should be made in assessing
how to invest short-term cash surpluses:
- Length of time for which the funds are available
- Amount of funds available
- Return offered on the investment in relation to the
amount involved
- Risks associated with calling in the investment earlier
 Managing Cash Surplus

 Example of short-term investment opportunities:

- Treasury bills — issued at a discount and can be sold

anytime
- Bank deposits — term deposits and certificate of
deposit
- Money market accounts — at variable rates of interest