ACCA paper f9 financial management study materials F9FM session09 d08

1 LONG-TERM FINANCE 1.1 Preference shares Definition Shares with a fixed rate of dividend having a prior claim on profits available for distribution.. 1.1.1 Features Ü Shares which ha

OVERVIEW

Objective

Ü To appreciate the options available to a company for long, medium and short-term debt finance

LONG-TERM

Ü Preference shares

Ü Debentures

Ü Deep discount bonds

Ü Zero coupon bonds

Ü Tax relief on interest

MEDIUM-TERM FINANCE

Ü Bank loans

Ü Leasing

Ü Sale and leaseback

Ü Mortgage loans

Ü Bank overdraft

Ü Trade credit

Ü Bills of exchange

Ü Commercial paper

Ü Grants

Ü Loan guarantee

scheme

Ü Business angels

CONVERTIBLES

AND WARRANTS

Ü Convertibles

Ü Effect on EPS of convertible debt

Ü Warrants

DEBT FINANCE

1 LONG-TERM FINANCE

1.1 Preference shares

Definition

Shares with a fixed rate of dividend having a prior claim on profits available

for distribution

Whilst legally equity, they are often treated as debt as they are similar in nature to debt

1.1.1 Features

Ü Shares which have a fixed percentage dividend payable before ordinary dividend

Ü The dividend is only payable if there are sufficient distributable profits However if the

shares are cumulative preference shares the right of dividend is carried forward Any

arrears of dividend are then payable before ordinary dividends

Ü As with ordinary dividends, preference dividends are not deductible for corporate tax purposes – they are a distribution of profit rather than an expense

Ü On liquidation of the company, preference shareholders rank before ordinary

shareholders

1.1.2 Advantages

X No voting rights; therefore no dilution of control

X Compared to the issue of debt:

̌ Dividends do not have to be paid if profits are poor;

̌ Not secured on company assets;

̌ Non-payment of dividend does not give holders the right to appoint a liquidator

1.1.3 Disadvantages

W Dividends are not tax deductible (unlike interest on debt)

W To attract investors the company needs to pay a higher return to compensate for additional risk compared to debt

1.2 Debentures

Definition

A written acknowledgement of a debt, usually given under the company’s seal,

containing provisions for payment of interest and repayment of principal The

debt may be secured on some or all of the company’s assets

Type Secured debentures Unsecured debentures

Security and

voting rights Ü Can be secured on one or more

specific assets - a “fixed charge” e.g

over property

Ü Or a “floating charge” can be offered over a class of assets e.g over net current assets (working capital)

Ü On default the assets are sold and debt repaid

Ü No voting rights

Ü No security

Ü Holders have the same rights as ordinary creditors

Ü No voting rights

Income Ü A fixed annual amount, usually

expressed as a % of nominal value Ü A fixed annual amount, usually expressed as a % of nominal value

Amount of

capital

Ü A fixed amount per unit of loan stock

or debenture Ü A fixed amount per unit of loan stock or debenture

In the UK debentures are usually issued with a face value of £100 They can then be traded

on the bond market and reach a market price Hence, if a debenture is said to be selling at a

premium of £15%, this means that a debenture with a face value of £100 is currently selling

for £115 This indicates that the rate of interest on this debenture is attractive when

compared with current market rates, creating demand for the debenture and a rise in price

In the US the face value of each debenture is usually $1000

Note – the terms “debenture”, “loan stock” and “bond” all basically refer to the same thing

i.e a written acknowledgement of a company’s debt which can then be traded Also “face

value” can also be referred to as “par value” of “nominal value”

1.3 Deep discount bonds

Definition

Loan stock issued at a large discount to nominal value − redeemable at par on

maturity

Ü Investors receive large capital gain on redemption, but low rate of interest during term

of the loan

Ü Cash flow advantage to the borrower – useful for financing projects which produce weak cash flows in early years

Illustration 1

A five year $1000 3% Bond issued at $800 would generate the following cash

inflows/(outflows) for the issuing company:

t 0 t 1 t 2 t 3 t 4 t 5

1.4 Zero coupon bonds

Definition

Bonds issued at a discount to face value and which pay zero annual interest

Ü No interest is paid

Ü Investors gain from the difference between issue and redemption price

Ü Advantages to borrowers:

̌ No cash payout until maturity;

̌ Cost of redemption known at time of issue

1.5 Tax relief on debt interest

Ü Interest expense is tax deductible and therefore reduces corporate tax payments

Ü Regarding the tax system the Issue of debt is preferable to the issue of shares as

dividends are not allowable for tax

Illustration 2

CoA CoB

_ _

100 90

_ _

Effective cost of debt in CoB

_

$7 _

$7 difference

Ü After-tax cost of debt = Pre-tax cost of debt × (1 – Tax rate)

Ü The fact that interest on debt is tax allowable is referred to as the “tax shield”

2.1 Convertibles

Definition

Bonds or preference shares that can be converted into ordinary shares

Ü Pay fixed interest or dividend until converted

Ü They may be:

̌ converted into ordinary shares;

̌ on a pre-determined date;

̌ at a pre-determined rate;

̌ at the option of the holder

Ü Conversion ratio may change during the period of convertibility − to stimulate early conversion

Ü Advantages to investors − a relatively low risk investment with the opportunity to make high returns upon converting to ordinary shares

Ü Advantages to issuing company − can offer a lower rate of interest than on “straight” debentures

2.2 Effect on EPS (Earnings Per Share) of convertible debt

Convertible debentures require a “fully diluted” EPS to be calculated to indicate what EPS might be if debt is converted into equity

Method

Ü Increase earnings by the loan interest saved, net of tax

Ü Increase the number of shares due to conversion

Ü Recalculate EPS

2.3 Warrants

Definition

A right given to an investor to subscribe cash for new shares at a future date at

a fixed price − the exercise price

Ü Warrants are sometimes attached to loan stock, to make the loan stock more attractive

Ü Warrants are basically share options

Ü The holder of the warrants may sell them rather than keep them

Advantages to issuing company

X The warrants themselves do not involve the payment of any interest or dividends

X When they are initially attached to loan stock, the interest rate on the loan stock will be lower than for comparable straight debt This due to the additional benefit for the investor of potential equity shares at an attractive price

X May make an issue of unsecured loan stock possible where no adequate security exists

3 MEDIUM-TERM FINANCE

3.1 Bank loans

3.1.1 Advantages

X The loan will be for a fixed term: no risk of early recall;

X Interest rate may be fixed

3.1.2 Disadvantages

W Inflexible;

W May require security,

W May require “covenants” – restrictions on the company e.g limits on dividend

payments, limits on further borrowing

3.2 Leasing

3.2.1 Advantages

X Many willing providers;

X Remains off-balance sheet if an operating lease;

X Matches finance to the asset ;

X Very flexible packages available, some of which include maintenance

3.2.2 Disadvantage

W Can be costly

3.3 Sale and leaseback

Property is sold to an institution, such as a pension fund, and then leased back to the

company

3.3.1 Advantages

X Releases significant funds;

X May improve ratios such as ROCE (Return on Capital Employed)

3.3.2 Disadvantages

W No longer own property and hence cannot participate in any future increase in value;

W Risk of lease payments increasing

3.4 Mortgage loan — a loan secured on property

3.4.1 Advantages

X Given the security, the loan will attract a lower interest rate than other debt;

X Institutions will be willing to lend over a longer term;

X Still participate in the growth in value of the property

3.4.2 Disadvantage

W Default may result in a key asset being liquidated

4.1 Bank overdraft

4.1.1 Advantages

X Flexible;

X Provides instant finance

4.1.2 Disadvantages

W Repayable on call, unless the bank offers a “revolving line of credit”

W High and variable interest rate

4.2 Trade credit

4.2.1 Advantages

X Generally cheap;

X Flexible

4.2.2 Disadvantages

W May lose settlement (quick payment) discounts;

W May lose suppliers’ goodwill

4.3 Bills of exchange

Definition

An acknowledgement of a debt to be paid at some time in the future e.g by a

customer Such a bill may then be ”discounted” i.e sold to a third party for a %

of face value

4.3.1 Advantages

X Improves cash flow

X Flexible

4.3.2 Disadvantages

W Fees

Illustration 3

X sells $2m worth of goods to Y X writes out (“draws”) a bill of exchange for

$2m payable in 2 months (say) which it sends to Y Y signs the bill to

acknowledge the debt and returns it to X

X can hold on to the bill for 2 months until Y pays the debtor sell it at a

discount e.g at 98%of face value The buyer of the bill then receives the $2m

and makes a gain

4.4 Commercial Paper

Definition

Commercial paper is short-term (usually less than 270 days) unsecured debt

issued by high quality companies The paper can then be traded by investors

on the bond markets

4.4.1 Advantages

X Large sums can be raised and relatively cheaply

X No security required

4.4.2 Disadvantages

W Only available to large companies with very good credit ratings

5 OTHER SOURCES

Commentary

The following are particularly suitable for small and medium sized enterprises (SME’s)

which are of particular interest to the examiner as they often have difficulty finding

debt finance Such difficulties may be caused by”asymmetry of information” – where

banks fear making loans to companies which are not well known and without published

credit ratings

5.1 Grants

Depending upon the location and nature of the business local, regional, national or

European grant assistance may be available

5.2 Loan guarantee scheme

Just as small/medium sized companies find it hard to raise equity, they can also find it hard

to raise debt, due to their high perceived risk The Loan Guarantee Scheme is a UK

government-backed scheme where, for a fee, a substantial proportion of the loan may be guaranteed Hence potential providers of that loan are willing to lend, as most of their risk has been eliminated

5.3 Business angels

Business angels are rich individuals who are prepared to invest money in small companies if they see high potential for growth

Such angels are often retired businesspeople who became wealthy as entrepreneurs in the high-tech sector

They may also give useful advice as well as finance and may even be able to use their

contacts to obtain new business for the companies they invest in

Key points

ÐPreference shares are in substance debt as they pay a fixed committed

dividend in priority to any ordinary dividend They also rank ahead of

ordinary shareholders upon liquidation (although after “real” debt such as

bank loans and debentures)

ÐPreference shareholders therefore face lower risk than ordinary

shareholders and require lower returns

ÐHowever banks and bondholders take even lower risks, as they rank

ahead of preference shareholders upon bankruptcy, and their debts may

be secured by fixed or floating charge over assets Providers of loans

therefore require lower returns than other providers of finance

ÐHence loans are the least expensive source of finance for a company,

particularly if the effect of the tax system is introduced (loan interest is a

tax allowable expense, unlike dividends.)

ÐUnfortunately debt also has a dark side – too much debt may increase the

risks faced by shareholders to unacceptable levels

FOCUS

You should now be able to:

Ü explain the features of preference shares and the reasons for their issue;

Ü explain the features of different types of long-term straight debt and the reasons for their issue;

Ü explain the features of convertible debt and warrants and the reasons for their issue;

Ü assess the effect on EPS of conversion and option rights;

Ü suggest appropriate sources of debt finance for SME’s e.g leasing, loan guarantee scheme, and business angels