Chapter – 04

Sources of Finance

Why do we need finance?

a. Setting up a business
b. Need to finance our day-to-day activities
c. Expansion
d. Research into new products
e. Special situations such as a fall in sales.

Criteria for choosing between sources of finance:

A firm considers the following factors:
 Cost: Debt usually cheaper than equity
 Duration: Long term finance more expensive but secure.
 Term structure of interest rates: change of interest rates in different loan maturities.
 Risk/Gearing: Usually mainly debt is cheaper but high gearing is risky
 Accessibility: Not all sources are available to all firms.

Where does finance come from?

There are two areas of finance. Internal (from within the company), and external (from outside the organization). It
can also be classified depending upon how long you need it for.
A. Internal Sources of Finance:
i) Profit.
ii) Sale of assets.
iii) Sale and lease back.
iv) Reductions in WORKING CAPITAL.
v) Depreciation

B. External Sources of Finance:

1. Long term sources of Finance:

i) Equity or Ordinary Share Capital

Equity finance is the investment in a company by the ordinary shareholders, represented by the issued ordinary
share capital plus reserve. Different forms of finance through equity are as follows:

Retained earnings This is the main source of finance for most companies. It comprises retained earnings
(undistributed profits) plus non- cash items (depreciation). Such finance is cheap and
quick to raise, requiring no transaction costs, professional assistance or time delay.
Rights issues It is an offer to existing shareholders to subscribe for new shares, at a discount to the
current market value, in proportion to their existing shareholdings.
Placing The most common form of issue for companies first coming to market. The investor
base in a placing is made up of institutional investors, contacted by the issuing house
Offer for sale Used by large companies looking to raise typically large amounts in a high profile (but
expensive) manner
Offer for subscription Rarely used – involves a company issuing shares directly to investors
Pricing for Public Issue: May be a) Underwriting form, or b) Offer for sale by tender (Fixed price vs Book Building)

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Md. Iqbal Hossain, FCA, FCMA
ii) Preference share Capital:
 Preference shares offer a fixed rate of dividend each year.
 This is not guaranteed however – if the company has insufficient profits the dividend may not be paid.
Advantages to the company Disadvantages to the company
The dividend is payable at the firm's discretion Preference shares are high risk compared to debt,
although lower risk than equity.
There is no dilution faced by the ordinary shareholders Dividends are not tax deductible
Surplus profits go to the ordinary shareholders Issue costs and process are similar to ordinary shares
Preference shares may take any of the following forms:
Option to Redemption Redeemable preference share Irredeemable preference share
Right to Participate in the Participating preference share Non-participating preference share
residual dividend
Option to convertible into Convertible preference share Non-convertible preference share
equity shares
Accumulation of dividend Cumulating preference share Non-cumulating preference share

iii) Debt:
Long term debt usually in the form of debentures or bonds, is frequently used as a source of long term finance as an
alternative to equity. It can be various types:
a) Loan notes e.g. corporate bonds or loan stock. They are traded in stock markets in same ways as shares.
b) Term Loan from bank or financial institutions
The above may be secured or unsecured and may be redeemable or irredeemable.
Moratorium period vs Grace Period???

iv) Hybrid Finance:

Some types of finance have elements of both debt and equity. e.g.
 Convertible loan notes: It gives the holder the right to convert to other securities, normally ordinary shares
at either a predetermined price or predetermined ratio. Conversion premium occur if Market value
convertible stock > market price of shares the stock is to be converted into.
 Loan notes with stock warrants: It gives the holder the right to subscribe a fixed future date for a certain
number of ordinary shares at a predetermined price.
 Innovative Hybrid finance: Financing through derivatives e.g. Forward, Futures, Swaps, Options etc..

vi) Venture Capital:

It is the provision of risk bearing capital, usually in the form of a participation in equity, to companies with high
growth potential. It provide start up and late stage growth of finance usually for small firms.
Venture capitalists will assess an investment prospect on the basis of its:
 Financial outlook
 Management credibility
 Depth of market research
 Technical abilities
 Degree of influence offered
 Exit route
How do the Venture Finance providers get their return?
The following are common exit routes, i.e. ways in which venture capitalists can liquidate their investment:
 A trade sale – the venture capitalists shares, or indeed the whole company, is sold to another company
 Flotation - the process of offering a company's shares for sale on the stock market for the first time.
 Redemption of shares (preference) at a premium
 Buy-back of shares on re-financing
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Md. Iqbal Hossain, FCA, FCMA
2. Medium term Sources of Finance
i) Hire Purchase
ii) Leasing (Finance lease vs Operating lease)
iii) Bridge finance:
A bridge loan is a type of short-term loan, typically taken out for a period of 2 weeks to 3 years against any
pending arrangement of longer-term financing. It is also known as ‘caveat loan’, or as ‘swing loan’. A bridge
loan is interim financing for the business until permanent financing is obtained. Money from the permanent
financing is generally used to pay back the bridge loan.

3. Short term sources of finance:

i) Bank Overdrafts: Revolving credit agreement vs Non-revolving Line of credit
ii) Better management of working capital
iii) Trade credit - Stock purchased for sale and not paid for until a month or two latter. This has no interest
cost, and so is excellent for buying raw materials, especially as most firms would aim to have sold the goods
on to their customers before payment is due.
iv) Factoring: If a firm sells goods on credit it may run into cash-flow problems while waiting for payment. This
is where factoring comes in. Company ‘sells’ the debt (i.e. Accounts/Bills receivable) to a factoring firm who
pay to the co., say, 80% of the value of the debt now. Then, when payment is made, the factoring company
receives 100% of the debt. That is how they make their profit. This is expensive as well.
v) Short term commercial paper
vi) Credit Cards
vii) Securitization/Asset-backed borrowing
viii) Money market
ix) Pension funds

DEBT Vs EQUITY: Which is right for which organization?

Debt:
 As no shares are sold, the ownership of the company is undiluted.
 Loans will be repaid eventually
 Lenders have no voting rights on company policy
Equity
 It never has to be repaid, unlike a loan
 Dividends do not have to be paid, unlike interest on a loan, which MUST be repaid. This makes equity more
suitable for risky projects, if the returns are less certain.

Efficient Market Hypothesis (EMH)

It is concerned with the information-processing efficiency of markets, particularly with the processing efficiency of
the stock market in terms of share prices. Basically it is a market where shares cannot be bought 'on the cheap' and
sold on immediately at a profit.
The efficient market hypothesis (EMH) is tested by considering three forms of efficiency – weak, semi strong and
strong – the difference being in terms of what information is reflected in share prices.
1. Weak form efficiency: Future price movements cannot be predicted from past price movements.
2. Semi-strong efficiency: Share prices incorporate all publicly available information (published accounts,
press releases about earnings, dividends, new products, government economic data etc.). Once it has been
published or appeared in the papers nothing can be done about it as the share price will have already
reacted to it! Such news is rapidly reflected in share prices.
3. Strong form efficiency: Share prices reflect all information, published or not. No investor could beat the
market by having superior information as it does not exist.
Implications if the market is efficient in all three forms:
Investors cannot consistently beat the market but if it is not strong form efficient, then they can make money from
insider dealing – and there is much evidence to suggest that the stock market is not strong form efficient.
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Md. Iqbal Hossain, FCA, FCMA
Q#1
The directors of Winton Electrical plc (Winton), a listed electrical contracting company, are currently considering the possibility
of a one-for-four rights issue at a 20% discount to the current share price. Issue costs for the rights issue will be 3% of the gross
proceeds and the net proceeds will be invested in a project with an estimated net present value of £1 million. At the present
time, details of this project have not yet been made known to the market, the book value of the company’s ordinary share capital
(50p ordinary shares) is £4 million and the market capitalization of the company is £40 million.

Requirements
a) Calculate
(i) The theoretical ex-rights price per share; and
(ii) The value of the right to subscribe per existing share.
b) Prepare calculations to demonstrate the impact of each of the following scenarios on the wealth of an investor who
owns 1,000 shares in Winton:
(i) The investor takes no action with regard to the rights issue;
(ii) The investor sells his rights under the rights issue;
(iii) The investor takes up 70% of his entitlement under the rights issue and sells the other 30% of his entitlement.
c) Describe the reasons why, in practice, an ex-rights share price might differ from the theoretical ex-rights price.
d) As an alternative to the rights issue, the directors are considering reducing the current year’s dividend to release the
funds required to invest in the new project. Discuss the issues that the directors should consider before deciding to
take this alternative course of action.
Q#2
The Moorgate Company has issued 100,000 CU1 equity shares which are at present selling for CU3 per share. The company has
plans to issue rights to purchase one new equity share at a price of CU2 per share for every four shares.

Requirements
a. Calculate the theoretical ex-rights price of Moorgate's equity shares.
b. Calculate the theoretical value of a Moorgate right before the shares sell ex-rights.
c. The chairman of the company receives a telephone call from an angry shareholder who owns 1,000 shares. The
shareholder argues that he will suffer a loss in his personal wealth due to this rights issue, because the new shares are
being offered at a price lower than the current market value.
The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the shareholder takes
appropriate action.
I. Is the chairman correct?
II. What should the shareholder do?
Prepare a statement showing the effect of the rights issue on this particular shareholder's wealth, assuming
I. He sells all the rights
II. He exercises half the rights and sells the other half
III. He does nothing at all.
d. Are there any real circumstances which might lend support to the shareholder's claim? Explain.

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Md. Iqbal Hossain, FCA, FCMA