Finance / Financial

Management
Week 10 Part 1
Financing Decision
 Finance (Business Finance or Financial
Management)
 This part of the course is concerned with finance decisions
involving:
This lecture

Raising funds

Investing funds Examples:

- Buildings
- Equipment
- Other assets

2
 Week 10
Chapters 11 & 12 - Financing Decisions and Working Capital
Management

LEARNING OUTCOMES
You should be able to
identify the main sources of finance available to a
business and explain the advantages and
disadvantages of each source;

outline the ways in which share capital

may be issued;

explain the role and nature of the Stock Exchange;

discuss the ways in which smaller businesses may

seek to raise finance.
 Financing a Business

Sources of finance
Long-term

Internal
Short-term

Long-term
External
Short-term
 Internal

Shareholders (owners) (external)

Management / directors (Internal)

By internal sources we mean sources that do

not require the agreement of anyone beyond
the directors and managers of the business.
 Major internal sources of finance

Short term Long term

Reduced
Inventory (asset) Retained
inventories
profits
levels
Trade payables
(liability) Total
Delayed
Working payment to trade internal
capital payables finance

Trade debtors (asset)

Tighter
credit control
 Financing a Business

Sources of finance
Long-term a

Internal
Short-term a

Long-term
External
Short-term
 The major external sources of finance
Ordinary
Leases
shares

Preference Long Hire purchase

Long-term shares term agreements

Loans

Total finance

Bank Invoice
overdraft discounting
Short-term Short
Debt term
factoring
 Manchester United Manchester City Balance
Balance Sheet Equation Sheet Equation

*Excluding finance lease charges

Source: Financial Statement of the respective companies shown above.
 Debt Financing vs. Equity Financing
When financing a company, "cost" is the measurable expense of obtaining capital.

 With debt, this is the interest expense a company pays on its debt.

 With equity, the cost of capital refers to the claim on earnings provided to shareholders
for their ownership stake in the business.
 Debt Financing vs. Equity Financing
Debt Financing

When a firm raises money for capital by issuing debt, it is known as debt financing. In return for
lending the money, the individuals or institutions become creditors and receive a promise that
the principal and interest on the debt will be repaid on a regular schedule.

(Note: Principal is the amount of money that a firm borrows that is required to be paid back.
Interest is the cost of borrowing the principal).

Equity Financing

Equity financing is the process of raising capital through the sale of shares in a company.

With equity financing comes an ownership interest for shareholders.

Equity financing may range from a few thousand £’s/£m’s raised by an entrepreneur from a
private investor, to an initial public offering (IPO) on a stock exchange running into the billions.
 Debt Financing vs. Equity Financing

For example, say you run a small business and need £50,000 of financing, options available
to you are either:

1) take out a £50,000 bank loan at a 10 percent interest rate, or

2) you can sell a 25 percent stake in your business to an investor for £50,000.

The business earns £25,000 per year.

 Debt Financing vs. Equity Financing

1) Option – Debt Financing 2) Option – Equity Financing

Take out a £50,000 bank loan at a 10 Conversely, if you used equity financing,
percent interest rate: you would have zero debt (and as a result,
no interest expense),
- Interest: 10% x £50,000 = £5,000
but would keep only 75 percent of your
profit (the other 25 percent being owned
by your new investor).
If you took the bank loan, your interest
expense (cost of debt financing) would be Therefore, your personal profit would only
£5,000, leaving you with £20,000 in profit. be £18,750 (i.e 75% x £25,000).

£25,000 profit £25,000 profit

(£5,000) interest £6,250 25% to new owner
£20,000 profit after interest £18,750 75% left to you based on new %
 Debt Financing vs. Equity Financing

From this example, you can see how it can be less expensive for the original shareholder of
your company, to issue debt as opposed to equity.
 The risk/return characteristics of long-term capital

From an investor’s perspective

Return

Ordinary
shares
Preference
shares
capital
Loan

Risk
 Loan capital and risk

Lenders may reduce the risk of lending by

Requiring security
(fixed or floating charge on assets)

Including covenants in the loan contract

 Loan covenants

May deal with matters such as the

following:

Access to financial statements

Other loans

Dividend payments

Liquidity
 The major external sources of finance
a Ordinary
Leases
shares

Preference Long Hire purchase

a
shares term agreements

a Loans

Total finance

Bank Invoice
overdraft discounting
Short
Debt term
factoring
Lease / Hire Purchase Considerations

Ease of
borrowing

Cost Main Improved

benefits cash flows

Flexibility
The major external sources of finance
Ordinary
Leases
shares

Preference Long Hire purchase

shares term agreements

Loans

Total finance

Bank Invoice
overdraft discounting
Short
Debt term
factoring
 The factoring process

Goods supplied on
credit
Client (1)
Credit
business customer

Factor Factor
Factor pays 20% pays 80% invoices Customer
balance to to client credit pays
client (less fees) immediately customer amount
when credit (3) (2) owing
customer pays to factor
amount owing (4)
(5)

Factor
Long-term versus short-term borrowing

There are many issues that

should be taken into account.
These include

Matching

Flexibility

Refunding risk

Interest rates
Short-term and long-term financing requirements

Total
funds Short-term
Fluctuating current
(£) finance
assets

Long-term
Permanent finance
current assets

Non-current
assets

Time
 Common methods of share issue

Common
Rights
issue Placing
issue
methods

Bonus Offer for Public

issue sale issue
The Stock Exchange

Two important roles

Primary market

Secondary market
Stock Exchange listing – advantages
Advantages for a business

Easier to raise funds

Funds acquired at lower cost

Raises profile

Shares valued in an efficient manner

Broadens investor base

Enables other businesses to be

acquired by shares rather than cash

Can help attract and retain

employees (share incentives)
Stock Exchange listing – disadvantages

Disadvantages for a business

Cost (including management time)

Increased regulatory burden

Close monitoring of actions and decisions

Increased vulnerability to takeover

 %

50
55

5
10

Rest of the
54

world
Insurance
6

companies
3

Pension funds

Individuals
12

Unit trusts
9

Investment
2

Source: Office for National Statistics (2015) ‘Ownership of UK Quoted Shares’, 2 September.

trusts
Other financial
7

institutions
1

Charities

Private
2

non-financial
Ownership of UK listed shares, end of 2014

companies
3

Public sector

Banks
1
Providing long-term finance for the small business (Equity Finance)

Venture capital

Business angels

Government assistance
External financing of small businesses
 Week 10
Chapters 11 - Financing Decisions

LEARNING OUTCOMES
You should be able to
identify the main sources of finance available to a
business and explain the advantages and
disadvantages of each source;

outline the ways in which share capital

may be issued;

explain the role and nature of the Stock Exchange;

discuss the ways in which smaller businesses may

seek to raise finance.