FIN2101
Business Finance II
Module 6
Sources of Finance
Student Activities
Reading
Text,Chapters 2 (pp,33-41),15 (pp,553-71) & 18 (pp.
661-6)
Text Study Guide,Chapters 2,15 & 18 (parts only)
Study Book,Module 6
Tutorial Activities
Tutorial Workbook,Self Assessment Activity 6.1
Sources of Finance
Internal Equity (Retained Earnings,
Dividend Reinvestment Plans).
External Equity (Ordinary and Preference
Share Issues,Rights Issues).
Debt (Long- and Short-term).
Convertible Securities.
Short-term Debt
Cash borrowings
Trade credit
Short-term loans
Bank overdraft
Bills of exchange
Promissory notes
Factoring
Certificates of deposit
(CDs)
Choosing Short-term Debt
Factors to consider:
the effective cost;
the availability in the amount needed and for the
period when financing is required;
the influence of the use of a particular source on
the cost and availability of other sources.
Cash Borrowings
Market restricted to firms of high credit
worthiness.
Rarely secured.
Typically overnight (11am money) or for 7
days (24-hour loans) (rarely for more than
3 months).
Trade Credit/Accounts Payable
Readily available and more or less free.
Effective management is important.
Cost of not taking discounts.
,Stretching” accounts payable.
Text pp,554-7.
Cost of Foregoing Discount
di s c ou n t t h e
n ot t a ki n gby de l a y e d bec a n
pa y m e n t da y s ofn u m be r t h e N
di s c ou n tc a s h t h e CD w h e r e
N
365
CD - 100%
CD
C os t
Cost of Foregoing Discount
XYZ Ltd sells goods for $1 000 to ABC Ltd on
the following terms,2/10,n/30.
What is the cost to ABC Ltd of foregoing the
discount offered?
Cost of Foregoing Discount
3 7,2 4 %o r 0,3 7 2 4
20
3 6 5
2 - 1 0 0
2
C o s t
Stretching Accounts Payable
Advantage
Firm has longer use of its cash.
Disadvantages
Fees/charges may apply to late payment.
Cost of discounts foregone.
Damage to credit standing/reputation,which may
lead to loss of credit facility.
Short-term Loans
Specific-purpose.
Repaid by instalments.
Fixed period.
Fixed or floating interest rate.
Bank Overdraft
Relatively easy to obtain; flexible.
At call.
Secured.
Variable interest rate – 0% to 5% above the
prime rate.
Terms negotiated with bank.
Text p,560.
Bills of Exchange
A promise to pay the holder of the bill an agreed
sum (the face value) on a certain date (the
maturity date).
Liquid market within the Australian money
market - negotiable instrument.
Discount securities.
Face values usually either $100 000 or $500 000.
Bills of Exchange
Bank bill vs commercial (non-bank) bill.
Financial intermediary.
Usually 30,60,90 or 180 days.
Unsecured for large companies.
Drawer,acceptor,discounter.
CONTINGENT LIABILITY.
Text pp,562-4.
Contingent Liability
If the acceptor is unable to pay (the holder on
maturity),then anyone who has endorsed the
bill may be obliged to pay a subsequent
holder of the bill.
Promissory Notes
A promise to pay a stated sum of money on a
stated future date.
Two parties - borrower and discounter.
Restricted market – unsecured.
Fixed interest rate.
7 to 364 days.
No contingent liability.
Text p,564.
Factoring
Companies sell their accounts receivables
at a discount to a third party,usually a
finance company.
Avoids need for,and cost of,following up
receivables.
Expensive.
Text pp,567-9.
Certificates of Deposit (CDs)
Short-term borrowing instruments of banks.
Similar to promissory notes,with the bank
being the drawer.
Discount securities.
30 to 180 days.
More liquid than term deposits.
May provide a higher yield if interest rates fall.
Long-term Debt
Debt with a maturity greater than 12
months.
Usually comprises 75% to 80% of the total
debt of listed Australian companies.
Secured vs unsecured debt.
Marketable vs non-marketable debt.
Secured vs Unsecured
If debt is secured,the lender has a legal claim
against the borrower and against the assets of
the borrower.
With unsecured debt,the lender has a claim
against the borrower but not against any
particular property or assets of the borrower.
Marketable vs Non-marketable
Marketable debt includes notes,bonds or
debentures and can be traded in a secondary
market.
Non-marketable debt refers to loans arranged
privately between two parties where the lender is
usually a bank or other financial intermediary.
Types of Long-term Debt
Term loans
Fully drawn advances (FDAs)
Debentures (corporate bonds)
Unsecured notes
Leasing
Project finance
Mortgage finance
Term Loans
Fixed period,between 1 and 25 years.
Used for capital expenditures.
Repayments flexible - interest only,principal and
interest basis,or a combination of both.
Fixed or floating (variable) interest rates.
Secured.
Fully Drawn Advances (FDAs)
Sometimes seen as similar to an overdraft.
Usually drawn down,in full,at the time of
approval.
Regular repayment schedule.
Interest rate usually slightly higher than that for
term loans.
Debentures (Corporate Bonds)
Fixed interest (coupon) security.
Secured with either a fixed or floating charge
over the assets of the borrower.
Fixed term between 2 and 10 years.
Coupons usually paid semi-annually.
Secondary market.
Text,pp,33-7.
Unsecured Notes
Similar to debentures.
Holders are unsecured creditors who rank below
any secured creditors for the repayment of debt.
Higher risk than debentures.
Higher interest rate on unsecured notes.
Leasing
A lease is an agreement under which the owner
of the asset (the lessor) gives another (the lessee)
the right to possess and use an asset for a
specified period in return for rental/lease
payments.
Covered in detail in module 8.
Project Finance
Used for large projects involving large outlays.
Usually in the form of a loan.
High debt-to-equity ratios a feature.
Larger banks,merchant banks and some
international banks manage project finance.
Mortgage Finance
The borrower conveys an interest in the land or
property to the lender.
The mortgage is discharged when the loan is
fully repaid.
Largest of the long-term debt markets in
Australia.
Long-term Finance - Equity
Internal equity sources.
Public issue of ordinary shares
flotation of initial issue;
secondary issues.
Private issue or placement of shares.
Rights issues.
Preference shares.
Internal Equity
Once provided up to 60% of a firm’s finance
but this has dropped to below 50% in recent
times.
Dividend imputation has resulted in firms
increasing their dividend payout ratios.
Lower cost alternative,control of firm
unaffected,convenient source of finance.
Dividend Reinvestment Plans
Allows shareholders the choice of using their
dividends to purchase additional shares instead
of receiving cash.
A major source of equity for listed companies.
Allows company to meet the demand for
distribution of franking credits without straining
cash resources.
Flotation of Initial Issue
Issue costs
underwriting fees;
Prospectus.
Delays in receiving funds.
Secondary Issues
All share issues made by a company after
the initial flotation.
Usually in the form of a private placement
or a rights issue.
Private Placements
Restricted.
Usually to institutional investors.
Guaranteed subscription.
Quicker and less costly.
Disliked by existing shareholders.
Rights Issues
An invitation to existing shareholders to take
up additional shares in proportion to their
current holding at the EXERCISE or
SUBSCRIPTION PRICE.
Rights Issue - Key Dates
Announcement date
Closing date
Ex rights date
Cum rights period
Ex rights period
Rights Issue – Key Dates
Announcement
Date ClosingDateEx RightsDate
Cum Rights Period Ex Rights Period
Announcement Date 20 May
Ex Rights Date 18 August
Closing Date 23 September
Rights Issues
Renounceable issue – existing shareholders
can sell their rights to a third party.
Non-renounceable issue – unable to sell to a
third party,Must either exercise rights or let the
offer lapse.
Not usually underwritten,except for some non-
renounceable issues or if subscription price is
close to market price of shares.
Rights Issues
Rights have a value and may be traded.
Calculate theoretical value of the right to one new
share.
Calculate the theoretical value of one share ex
rights.
Value of A Right
R =
N M - S
N + 1
Ex Rights Share Price
1 + N
S + M N
= X
Rights Issue Example
Company Z - All Equity - 5m Shares @ $1
Current Market Price (M) $5
Renounceable Rights Issue 1-for-4
Subscription Price (S) $3
Shareholdings - Ms A 5 000
Mr B 5 000
Theoretical Value of A Right
R =
N M - S
N + 1
=
4 5 - 3
4 + 1
= $1.60
Theoretical Ex Rights Share Price
$4.60 =
1 + 4
3 + 5 4
=
1 + N
S + M N
= X
Subscribing Shareholder’s Position
Cum Rights 5 000 shares @ $5.00
Ex Rights 6 250 shares @ $4.60
Value to the Shareholder
Shareholder Ms A decides to SUBSCRIBE:
Cum rights 5 000 @ $5.00 $25 000
Ex rights 6 250 @ $4.60 28 750
Value increase $ 3 750
Less Subscription cost (1250 @ $3) 3 750
Final position $25 000
Change $ 0
Mr B decides to SELL RIGHTS:
Post sale 5 000 @ $4.60 $23 000
Sale proceeds 1 250 @ $1.60 2 000
Ex rights $25 000
Cum rights 5 000 @ $5.00 25 000
Change $ 0
Conclusion
Shareholder’s wealth is not directly affected
by a rights issue.
Information content could have a positive
effect on market price of shares.
Preference Shares
Entitle shareholder to preferred dividend
payments over payments to ordinary
shareholders.
Characteristics vary according to terms of issue.
Either public or private issues.
Less attractive today from an investor’s
perspective than other forms of financing.
Text pp,40-1.
Types of Preference Shares
Cumulative
Callable
Participating
Converting
Convertible
Study Book,p,6.10
Advantages of Equity
No requirement to pay a dividend.
Ordinary shares do not have a maturity date and
there is no obligation to redeem them.
The more equity,the lower the risk for potential
lenders and the lower the cost of debt.
Disadvantages of Equity
Dilution of ownership if the company raises
funds through the issue of more ordinary shares.
Greater transaction costs incurred in issuing
shares.
Double taxation of dividend income (not in
Australia).
Convertible Securities
A preference share or a debt issue that can be
exchanged for a specified number of ordinary
shares.
Convertible unsecured notes.
Convertible preference shares.
Converting preference shares.
Text pp,661-6.
Debt vs Equity
Cost
Debt may be cheaper after tax.
Flexibility
Debt can be borrowed,repaid and reborrowed in
variable amounts at any time,Debt is more readily
available.
Control
Equity cedes control,whereas debt doesn’t.
Business Finance II
Module 6
Sources of Finance
Student Activities
Reading
Text,Chapters 2 (pp,33-41),15 (pp,553-71) & 18 (pp.
661-6)
Text Study Guide,Chapters 2,15 & 18 (parts only)
Study Book,Module 6
Tutorial Activities
Tutorial Workbook,Self Assessment Activity 6.1
Sources of Finance
Internal Equity (Retained Earnings,
Dividend Reinvestment Plans).
External Equity (Ordinary and Preference
Share Issues,Rights Issues).
Debt (Long- and Short-term).
Convertible Securities.
Short-term Debt
Cash borrowings
Trade credit
Short-term loans
Bank overdraft
Bills of exchange
Promissory notes
Factoring
Certificates of deposit
(CDs)
Choosing Short-term Debt
Factors to consider:
the effective cost;
the availability in the amount needed and for the
period when financing is required;
the influence of the use of a particular source on
the cost and availability of other sources.
Cash Borrowings
Market restricted to firms of high credit
worthiness.
Rarely secured.
Typically overnight (11am money) or for 7
days (24-hour loans) (rarely for more than
3 months).
Trade Credit/Accounts Payable
Readily available and more or less free.
Effective management is important.
Cost of not taking discounts.
,Stretching” accounts payable.
Text pp,554-7.
Cost of Foregoing Discount
di s c ou n t t h e
n ot t a ki n gby de l a y e d bec a n
pa y m e n t da y s ofn u m be r t h e N
di s c ou n tc a s h t h e CD w h e r e
N
365
CD - 100%
CD
C os t
Cost of Foregoing Discount
XYZ Ltd sells goods for $1 000 to ABC Ltd on
the following terms,2/10,n/30.
What is the cost to ABC Ltd of foregoing the
discount offered?
Cost of Foregoing Discount
3 7,2 4 %o r 0,3 7 2 4
20
3 6 5
2 - 1 0 0
2
C o s t
Stretching Accounts Payable
Advantage
Firm has longer use of its cash.
Disadvantages
Fees/charges may apply to late payment.
Cost of discounts foregone.
Damage to credit standing/reputation,which may
lead to loss of credit facility.
Short-term Loans
Specific-purpose.
Repaid by instalments.
Fixed period.
Fixed or floating interest rate.
Bank Overdraft
Relatively easy to obtain; flexible.
At call.
Secured.
Variable interest rate – 0% to 5% above the
prime rate.
Terms negotiated with bank.
Text p,560.
Bills of Exchange
A promise to pay the holder of the bill an agreed
sum (the face value) on a certain date (the
maturity date).
Liquid market within the Australian money
market - negotiable instrument.
Discount securities.
Face values usually either $100 000 or $500 000.
Bills of Exchange
Bank bill vs commercial (non-bank) bill.
Financial intermediary.
Usually 30,60,90 or 180 days.
Unsecured for large companies.
Drawer,acceptor,discounter.
CONTINGENT LIABILITY.
Text pp,562-4.
Contingent Liability
If the acceptor is unable to pay (the holder on
maturity),then anyone who has endorsed the
bill may be obliged to pay a subsequent
holder of the bill.
Promissory Notes
A promise to pay a stated sum of money on a
stated future date.
Two parties - borrower and discounter.
Restricted market – unsecured.
Fixed interest rate.
7 to 364 days.
No contingent liability.
Text p,564.
Factoring
Companies sell their accounts receivables
at a discount to a third party,usually a
finance company.
Avoids need for,and cost of,following up
receivables.
Expensive.
Text pp,567-9.
Certificates of Deposit (CDs)
Short-term borrowing instruments of banks.
Similar to promissory notes,with the bank
being the drawer.
Discount securities.
30 to 180 days.
More liquid than term deposits.
May provide a higher yield if interest rates fall.
Long-term Debt
Debt with a maturity greater than 12
months.
Usually comprises 75% to 80% of the total
debt of listed Australian companies.
Secured vs unsecured debt.
Marketable vs non-marketable debt.
Secured vs Unsecured
If debt is secured,the lender has a legal claim
against the borrower and against the assets of
the borrower.
With unsecured debt,the lender has a claim
against the borrower but not against any
particular property or assets of the borrower.
Marketable vs Non-marketable
Marketable debt includes notes,bonds or
debentures and can be traded in a secondary
market.
Non-marketable debt refers to loans arranged
privately between two parties where the lender is
usually a bank or other financial intermediary.
Types of Long-term Debt
Term loans
Fully drawn advances (FDAs)
Debentures (corporate bonds)
Unsecured notes
Leasing
Project finance
Mortgage finance
Term Loans
Fixed period,between 1 and 25 years.
Used for capital expenditures.
Repayments flexible - interest only,principal and
interest basis,or a combination of both.
Fixed or floating (variable) interest rates.
Secured.
Fully Drawn Advances (FDAs)
Sometimes seen as similar to an overdraft.
Usually drawn down,in full,at the time of
approval.
Regular repayment schedule.
Interest rate usually slightly higher than that for
term loans.
Debentures (Corporate Bonds)
Fixed interest (coupon) security.
Secured with either a fixed or floating charge
over the assets of the borrower.
Fixed term between 2 and 10 years.
Coupons usually paid semi-annually.
Secondary market.
Text,pp,33-7.
Unsecured Notes
Similar to debentures.
Holders are unsecured creditors who rank below
any secured creditors for the repayment of debt.
Higher risk than debentures.
Higher interest rate on unsecured notes.
Leasing
A lease is an agreement under which the owner
of the asset (the lessor) gives another (the lessee)
the right to possess and use an asset for a
specified period in return for rental/lease
payments.
Covered in detail in module 8.
Project Finance
Used for large projects involving large outlays.
Usually in the form of a loan.
High debt-to-equity ratios a feature.
Larger banks,merchant banks and some
international banks manage project finance.
Mortgage Finance
The borrower conveys an interest in the land or
property to the lender.
The mortgage is discharged when the loan is
fully repaid.
Largest of the long-term debt markets in
Australia.
Long-term Finance - Equity
Internal equity sources.
Public issue of ordinary shares
flotation of initial issue;
secondary issues.
Private issue or placement of shares.
Rights issues.
Preference shares.
Internal Equity
Once provided up to 60% of a firm’s finance
but this has dropped to below 50% in recent
times.
Dividend imputation has resulted in firms
increasing their dividend payout ratios.
Lower cost alternative,control of firm
unaffected,convenient source of finance.
Dividend Reinvestment Plans
Allows shareholders the choice of using their
dividends to purchase additional shares instead
of receiving cash.
A major source of equity for listed companies.
Allows company to meet the demand for
distribution of franking credits without straining
cash resources.
Flotation of Initial Issue
Issue costs
underwriting fees;
Prospectus.
Delays in receiving funds.
Secondary Issues
All share issues made by a company after
the initial flotation.
Usually in the form of a private placement
or a rights issue.
Private Placements
Restricted.
Usually to institutional investors.
Guaranteed subscription.
Quicker and less costly.
Disliked by existing shareholders.
Rights Issues
An invitation to existing shareholders to take
up additional shares in proportion to their
current holding at the EXERCISE or
SUBSCRIPTION PRICE.
Rights Issue - Key Dates
Announcement date
Closing date
Ex rights date
Cum rights period
Ex rights period
Rights Issue – Key Dates
Announcement
Date ClosingDateEx RightsDate
Cum Rights Period Ex Rights Period
Announcement Date 20 May
Ex Rights Date 18 August
Closing Date 23 September
Rights Issues
Renounceable issue – existing shareholders
can sell their rights to a third party.
Non-renounceable issue – unable to sell to a
third party,Must either exercise rights or let the
offer lapse.
Not usually underwritten,except for some non-
renounceable issues or if subscription price is
close to market price of shares.
Rights Issues
Rights have a value and may be traded.
Calculate theoretical value of the right to one new
share.
Calculate the theoretical value of one share ex
rights.
Value of A Right
R =
N M - S
N + 1
Ex Rights Share Price
1 + N
S + M N
= X
Rights Issue Example
Company Z - All Equity - 5m Shares @ $1
Current Market Price (M) $5
Renounceable Rights Issue 1-for-4
Subscription Price (S) $3
Shareholdings - Ms A 5 000
Mr B 5 000
Theoretical Value of A Right
R =
N M - S
N + 1
=
4 5 - 3
4 + 1
= $1.60
Theoretical Ex Rights Share Price
$4.60 =
1 + 4
3 + 5 4
=
1 + N
S + M N
= X
Subscribing Shareholder’s Position
Cum Rights 5 000 shares @ $5.00
Ex Rights 6 250 shares @ $4.60
Value to the Shareholder
Shareholder Ms A decides to SUBSCRIBE:
Cum rights 5 000 @ $5.00 $25 000
Ex rights 6 250 @ $4.60 28 750
Value increase $ 3 750
Less Subscription cost (1250 @ $3) 3 750
Final position $25 000
Change $ 0
Mr B decides to SELL RIGHTS:
Post sale 5 000 @ $4.60 $23 000
Sale proceeds 1 250 @ $1.60 2 000
Ex rights $25 000
Cum rights 5 000 @ $5.00 25 000
Change $ 0
Conclusion
Shareholder’s wealth is not directly affected
by a rights issue.
Information content could have a positive
effect on market price of shares.
Preference Shares
Entitle shareholder to preferred dividend
payments over payments to ordinary
shareholders.
Characteristics vary according to terms of issue.
Either public or private issues.
Less attractive today from an investor’s
perspective than other forms of financing.
Text pp,40-1.
Types of Preference Shares
Cumulative
Callable
Participating
Converting
Convertible
Study Book,p,6.10
Advantages of Equity
No requirement to pay a dividend.
Ordinary shares do not have a maturity date and
there is no obligation to redeem them.
The more equity,the lower the risk for potential
lenders and the lower the cost of debt.
Disadvantages of Equity
Dilution of ownership if the company raises
funds through the issue of more ordinary shares.
Greater transaction costs incurred in issuing
shares.
Double taxation of dividend income (not in
Australia).
Convertible Securities
A preference share or a debt issue that can be
exchanged for a specified number of ordinary
shares.
Convertible unsecured notes.
Convertible preference shares.
Converting preference shares.
Text pp,661-6.
Debt vs Equity
Cost
Debt may be cheaper after tax.
Flexibility
Debt can be borrowed,repaid and reborrowed in
variable amounts at any time,Debt is more readily
available.
Control
Equity cedes control,whereas debt doesn’t.
