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Sources of long term finance - Coggle Diagram
Sources of long term finance
Equity or ordinary shares
Permanent capital and a long term source of finance
Not retuned to shareholders in most circumstances other than in the event of liquidation
Ownership means that the equity shareholders bear the greatest risk
Equity shareholders receive dividends only after the payments of debts and dividends to preference shareholders have been made
To protect the interests of creditors, a company may declare a dividend only if it has sufficient profit available for the purpose
Advantages
Paid the residual funds in the form of dividends or the leftover funds in the event of liquidation after all other lenders and creditors are paid
From an investors liquidity point of view, equity shares of a quoted can be easily traded in the stock market
A company which raises capital from issuing equity shares may provide a positive outlook for the company
It delivers greater confidence amongst investor and creditors
Disadvantages
In return for accepting the risk of ownership, equity shares carrying voting rights through which equity shareholders jointly control the company
The equity shareholders have greater say in the management of the company although managerial control may be limited
The issue of additional equity shares may be unfavourable to the existing shareholders as it will dilute their existing voting rights
It may affect future dividends
Raising of equity shares
The order of preference for share issues is generally a rights issue, a placing and then an offer for sale to the general public. The next source is used as available funds are consumed
Setting the price correctly is the most difficult area for all share issues, for a public issue there is a danger of undersubscription if the price is set too high unlike placing which is pre-agreed and negotiated to be attractive enough to the subscribing institutions
New shares: public issue
Shares are offered to the general public by inviting the public to apply for shares in a company at a fixed price or by tender based upon information contained in a prospectus
A public listing increases the marketability of the company's shares to raise further equity finance
Listing a company is a time consuming process that incurs costs
Once listed, the company also has to face a higher level of regulation and public scrutiny
There is also a greater threat of dilution of control and takeover
New shares: placing
A company can use a placing to raise equity capital for the company by selling shares directly to third party investors (usually a merchant bank )
New shares: rights issue
A rights issue offers existing shareholders the right to buy new shares in proportion to their existing shareholders
A rights issue enables shareholders to retain their existing share of voting rights
Shareholders also the option to sell their rights on the stock market
Bonus share or scrip issue
Bonus shares are additional fee shares given to the current shareholders based upon their existing number of shares
This is achieved by a transfer from one or more components of equity to equity share capital and does not raise any funds for the company
Retained earnings
Equity finance in the form of undistributed profits attributable to equity shareholders
The proportion of the profits which is not distributed among the shareholders but retained to be used in the growth of a company
Preferred method of financing over other sources of finance
Not a cash amount
Advantages
Since these are internally generated funds, they are the cheapest source of capital in that there are no issue costs
Companies save on expenses related to issuing shares or bonds such as marketing pulbicility, printing nd other administrative costs
The cash is immediately available
There is no obligation on the part of the company to pay interest or pay back the earnings
The management have more flexibility to decide on how this money can be used
Part of equity therefore the company is able to better face adverse conditions during depressions and economic downturns
Shareholders may benefit from the use of retained earnings as they may be able to receive dividends out of them representing profits not distributing rom previous years
Disadvantages
Internally generated funds may not be sufficient for financing purposes - especially in new companies that require a lot of investment
The investment requirements might not match the availability and timing of the funds
If no suitable investments are available, shareholders money is being tied up in the company. This incurs an opportunity cost by having their money kept in the company
The excessive ploughing back of profits or accumulated retained earnings may result in overcapitalisation
Excessive savings may be misused against the interest of the shareholders
The money is not made available to those in the company who can use it. Devoting too much profit to growth may starve the company of cash it needs to fund ongoing operations
Preference Shares
Shares which carry preferential rights over equity shares on profits available for distribution and on the leftover funds in the event of liquidiation
Although legally equity, they may be treated as debt rather than equity for accounting purposes as they carry a fixed rate of dividend
Types of preference shares
Cumulative and non-cumulative
A cumulative preference share accrues or accumulates its annual fixed rate dividend in the following year if it cannot be paid in any year
If dividends are not paid due to insufficient distributable profits, the right to dividend for that year is carried forward to the next year and paid before any dividend is paid to equity shares
In case of non-cumulative preference shares, the right to dividend for that year is lsot
Redeemable and irredeemable
Redeemable preference shares are those which can be purchased back by the company within the lifetime of the company
These shares can be redeemed at a future date and the investment amount returned to the owner
Participating and non participating
Participating preference shares are entitled to a fixed rate of dividend and a share in the surplus profits which remain after dividend has been paid to equity shareholders
The surplus profits are distributed in a certain agreed ratio between participating preference shareholders and equity shareholders
Convertible and non-convertible
The holder of convertible preference shares enjoys the right to convert the preference shares into equity shares at a future date
This gives the investor the benefit of receiving a regular fixed dividend as well as an option to gain futurthr benefit by covertingthe preference shares to equity shares
Advantages
Dividends are only payable if there are sufficient distributable profits available for the purpose
There is no loss of control as preference shares do not carry voting rights
Dividends do not have to be paid if there are not enough profits, the right to dividend for that year is lost except for cumulative preference shares
Unlike debt, the shares are not secured on the company's assets
Disadvantages
Unlike debt interest, dividends are not tax allowable
Preference shares pay a higher rate of interest than debt because of the extra risk for shareholders
On liquidation of a company, preference shares rank before equity or ordinary shareholders
Bonds and debentures
A bond is a general ter for various types of long term loans to companies including loan stock and debentures
The company issues a bond with a fixed interest rate and the duration of the loan which must be repaid at the maturity date
The issue price of a bond is typically set at par, usually £100 ($1,000 in the US) fee value per individual bond
The actual market price depends upon the expected yield and the performance of the company compared to the market environment at the time
Debentures are the most common form of long term loan used by large companies
A debenture is a written acknowledgement of a debt, most common used by large companies to borrow money at a fixed rate of interest. Debetnrues are written in a legal agreement or contract called indenture which acknowledges the long term debt raised by a company
Debentures can be traded on a stock exchange in units, they carry a fixed rate of interest expressed as a percentage of nominal vlaue
These loans are repayable on a fixed date and pay a fixed rate of interest
A company makes these interest payments prior to paying out dividends to its shareholders
Loan stocks refers to shares of common or preferred stock that are used as collateral to secure a loan from another party
The loan is provided at a fixed interest rate, much like a standard loan and can b secured or unsecured
Loan stock is valued higher if the company is publicly traded and unrestricted since thee loan stock shares can be easier to sell if the borrower is unable to repay the loan
Lenders will have control of the shares loan stock until the borrower pays off the loan
Types on bonds and debentures
Secured and unsecured
Bonds or debentures are either secured or unsecured against colleateral
Secured debts or debenture holders have first charge on the assets that are used as security if the company goes into liquidation
A company with a fixed charge debenture is restricted from selling the assets used as security until the loan is repaid in full
Without a floating charge it is free to dispose of its assets in the ordinary course of business
Redeemable and irredeemable
Debentures can be either redeemable or irredeemable
Redeemable debentures are debentures which he company has issued for a limited period of time
Debentures which are never repaid are irredeemable
Redeemable debentures are usually repaid at their nominal value but may be issued as repayable at a premium on nominal value, they are repayable at a fixed date in the future
Convertible and non-convertible
Convertible debentures have the option to covert into equity shares at a time and in a ratio decided by the company when issued
Non-convertible debentures cannot be converted into equity shares
Bonds with fixed interest
A company can issue bonds of a certain face value or par value for a fixed amount of time that promise to pay interest annually or semi-annually
The market price of such bonds depends upon the yield required or the rate of returned expect by the investor
The market value of the bond is determined by calculating the present value of the cash flows arising from the bond
Deep discount and zero-coupon bonds
These are bonds or debentures issued at a large discount in comparison to their nominal or face value but are redeemable at par on maturity
The interest is either low or there is no interest
Investors will receive a large bonus on maturity
Some investors may prefer zero coupon bonds because of the tax implications, as these bonds do not pay any interest, investors may save on tax payments by holding the bond
Growing companies can particuarly benefit from these bonds because they pay low or nil interest during the life of the bonds or debentures
The company could also possibly issue more convention debentures to finance the redemption when the time comes to redeem the original debetures
Eurobonds
A Eurobond is a bond issued for international investors
They are normally issued in a currency other than the home currency
The term Eurobond only means that the bond was issued outside of its home country, it does not mean the bond was issued in Europe
Commonly used Eurobonds are Eurodollar or Euroyen
Issuance is usually handled by an international financial institution on behalf of the borrower
Eurobonds are popular as they offer issuers the ability to choose the country of issuance based on the regulatory market, interest rates and activity of the market
They are also attractive to investors because they usually have low par values and high liquidity
Share warrants
Warrants are rights given to lenders allowing them to buy new shares in a company at a future date at a fixed, given price
Warrants are normally attached to a bond or a preference share to make it attractive for the investor by giving them the potential to earn a profit in the future
The price at which they can buy the share in the future is the exercise price
Advantages
Loans are repayable on a fixed date and pay a fixed rate of interest
The interest paid is usually less than the dividend paid to shareholders as debentures are considered less risky than shares by investors
Debentures are advantageous to the issuer because they have a fixed repayment date
Unlike dividends, the interest paid is tax allowable, reducing the net cost to the company
Unlike shares, there are no restrictions contained in company law regarding the terms of issue of debentures
Debenture holders typically have no right to vote or have a voice in the management
Disadvantages
Debenture holders are creditors of a company, secured debenture holders have first charge on the assets that are used as security if the company goes into liquidiation
Debenture holders receive interest payments regardless of the amount of profit or loss at the stipulated time. The interest payments are due prior to paying out dividends to shareholders
There is still risk of deafult, the higher the amount of debt finance, the higher the debt or gearing ratio, this may make the company more volatile
Bank and Institutional Loans
Bank and institutional loans are the most popular type of finance
Bank loans are generally a quick and straightforward option
They are usually provided over a fixed period of time and can be short term or long term depending on the purpose of the loan
Lending to companies for more than one year is considered a long term loan
Loans can be negotiable, the rate of itnerest, repayment dates and security for the capital offered must be agreed depending on the risk and credit standing of the company
Long term loans are more stringent and may only be offered to established companies with a good credit profile
They are repaid in regular payments over a set period of time
The payment includes the principal and interest repayments
A covenant is a promise in any debt agreement that a company will remain within a determined range of financial measures and performance
Normally covenants are added by lenders to protect their investment and minimise the risk of defaulting on payments by the company
Covenants are usually described in terms of financial ratios that must be maintained within a specific range of value
Leasing
A leasing agreement is formed between two parties: a lessor (who owns the asset) and lessee (uses the asset)
The lessor purchases the asset and provides it for use by the company
The lessor is considered to be the legal owner and can claim capital allowances for the asset
Advanatages
Cash outflow related to leasing are spread out over several years hence saving the burden of one time significant cash payment to purchase an asset outright, this helps a business to maintain a steady cash flow profile
While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense. Given this agreement, it becomes plausible for a business to invest in good quality assets which might look unaffordable or expensive otherwise
Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for the business to fund its other needs or to save money for a better capital investment decision
Leasing expense or lease payments are considered as operating expenses and are tax deductble
Lease expenses usually remain constant for over the asset's life or lease tenure or grow in line with inflation. This helps in planning expense or cash outflow when undertaking a budgeting exercise
For businesses operatig in sectors where there is a high risk of technology becoming obsolete, leasing yields great returns and saves the business from the risk of investing in a technology that might soon become outdated
At the end of the leasing period, the lessee holds the right to buy the property and terminate the leasing contract thus providing flexibility to business
Disadvantages
At the end of the leasing period, the lessee does not become the owner of the asset despite paying a significant amount of money towards the asset over the years
The lessee remains responsible for the maintenance and proper operation of the asset being leased
Lease payments can become a burden in cases where the use of asset does not serve the requirmeent
If paying lease payments towards a land, the lessee cannot benefit from any appreciation in the value of the land
Although a lease does not appear on the SOFP, invetors still consider long term lease as debt and adjust their valuation to include leases
Given that investors treat long term leases as debt, it might become difficult for a business to access capital markets and raise further loans or other forms of debt from the market
Sale and leaseback
A sale and leaseback agreement arrangement is a structured transaction in which the owner sells an asset to another party while maintaining the legal rights to use the asset from the buyer or lessor
The main advantage of this method of financing is that the company can raise more money than from a normal mortgage arrangeent
Securitisation of assets
Securitistion is the financial practice of polling together illiquid assets and repackaging them into an interest bearing security that can be traded to raise more finance
Commonly practiced by financial insitituions to reduce their risk on the illiquid assets by selling or removing them from its SOFP
Through securitaition, various cash flow generating assets are pooled together and their related cash flows are sold to investors as securities which may be described as bonds, pass through securities, or collateralised debt obligations
The pooled assets are essentially debt obligations that serve as collateral
Securities backed by mortgage receivables are called mortgage backed securities while the backed by other types of receivables are asset backed securities
Investors are repaid from the principal and interest cash flows collected from the underlying debt
A SPV provides a funding structure whereby the pooled assets are transferred to a SPV for legal and tax reasons, the SPV then issues interest bearing securities such as MBS which are used to raise more finance
Normally a company transfers assets to the SPV to finance a large project thereby narrowing its goals without putting the entire firm at risk
SPVs are commonly used to securitise loans and other receivables
Securitiation offers investor a diversification of risks from a pool of assets, SPVs usually have excellent credit ratings
Investors get the benefit of the payment structure closely monitored by an independent trustee and yields that are higher than those of similar debt instrument
Securitisation provides the flexibility to tailor the instrument to meet the investors risk appetite
Advantages
Securitisation is an efficient way of raising large amounts of funding
SPVs are entirely separate from the originating company, they allow off balance sheet treatment of asset that are wiped off from the originators fiancial statements
Interest rates on securitised bonds are normally lower than those on corporate bonds
Private companies get access to wider capital markets
Shareholders cna maintain undiluted ownership of the company
Intangible assets such as patents and copyrights can be used for security to raise cash
The assets in the SPV are protected reducing the credit risk for investors and lowering the borrowing costs for issuers raising finance
An SPV usually has an excellent credit rating and low borrowing costs
Disadvantages
Securitisation can be a complicated and expensive way of raising long term capital compared to traditional types of debt such a bank loan
It may restrict the ability of the company to raise money in the future
There is a risk from loss of direct control of some of the company assets
Transactions may not always lead to off balance sheet treatment
The company may incur substantial costs to close the SPV and reclaim the underlying assets
Private finance initatives
Governments and public institutions require long term finance to execute their projects
In order to share the risks and rewards of such projects, the private finance initiative (PFI) was introduced in the UK as a means of obtaining private finance for public sector projects
A PFI is an important and controversial procurement method which uses private sector investment to provide funds for major public sector capital investment
Private firms are contracted to complete, manage and handle the upfront costs of public projects
Typically a PFI contract is repaid by the government over a 30 year period
It places the risks of buying and maintaining the asset with the private sector while allowing the public sector to procure high quality and cost-effective public services while avoiding the need to raise taxes in the short term
Advantages
The main advantage of PFI is that the public sector does not have to fund large capital outflows at the start of the project
Allows the public sector to procure high quality and cost effective public services whilst avoiding financing through higher borrowing and taxes
The public obtains valuable operational and management expertise and overall cost efficiencies from the private sector and vice versa. There is the opportunity for the development of new ideas and the transfer of skills in both sectors
The private sector takes on the risks of financing, constructing and then managing the project
It is expected that there would be higher value for money through PFI than through public sector financing
Extra investment can kickstart more projects, bringing economic and social benefits
PFI projects are nearly all fixed price contracts in which the private sector is not paid until the asset has been delivered.
PFI firms eventually pay tax making the overall costs cheaper for the government
All PFI projects go through a bidding process, encouraging competition for design and quality of delivery
Disadvantages
The biggest disadvantage is the typically high annual costs charged to the public sector for the projects
The costs have been significantly larger than annual cost of comparable projects, many projects have run over budget
Since the asset ownership is transferred to the private sector, it may lead to a loss of control and accountability from the public sector
The ultimate risk of inflexibility and poor value for money with a project lies with the public sector, there have been many stories of flawed projects and wasteful spending
There have been many stories
Repair or maintenance costs may be higher
The administration cost of spending on advisers and lawyers and the costs of the bidding process could cost millions
Government grants and assistance
Governments also provide fiancnail support to companies in the form of grants, loans and government assistance
Government grants are financial grants provided by government bodies and trusts to normally support projects that are beneficial to the society and the public
Government grants are available in all forms, from cash awards or benefits to reductions in cost and free equipment
There is usually no obligation to repay the initial investment
GOvenrent loans are normally provided to companies that are not able to receive financial support from the normal commercial market and are provided at an interest rate that is much lower than any commercial market rate
Enterprise Investment Scheme:
Provides added incentives for investors to invest in small or medium sized enterprises by providing benefits in terms of tax relief on the investment amount and having great control in the management of the compnay
Investors must adhere to EIS conditions
Designed to encourage investment in ventures by providing exemption from CGT and claim leases tax relief for capital losses
Enterprise Finance Guarantee
A loan guarantee scheme intended to facilitate additional bank lending to viable SMEs that have been turned down for debt finance due to inadequate security or lack or proven track record
Covid Schemes:
Business Interruption Loan Scheme; up to £5m per company. Government guaranteed 80% of the finance to the lender and paid interest and any fees for first 12 months
Business Bounce Back Loan Scheme: Up to £50,000 per company, aimed at helping smaller companies access financial support more quickly, government guaranteed 100% of the loan and there were no fees or interest for the first 12 months
Job retention scheme: under which companies could furlough staff who were not actively deployed by the business instead of making them redundant, the government paid 100% of their salaries up to a maximum of £2,500 per employee per monh
Advantages
Government assistance is a cheap form of financial support
Interest rates on government loans are much lower than market rates
Unlike loans, most government grants don't have to be repaid
Information about grants is easily accessible through government websites and literature
Government funded projects are normally beneficial to society and the public at large
Disadvantages
Applications can be time consuming
They may require outcomes that are beneficial to society, sometimes at the expense of financial profit
There may be a loan waiting period between applying for the grant or loan and approval
There may be a lot of competition from other companies applying for the same grant or loan
There may be detailed requirements for eligiblity