Financial Decision Making-4

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MN7029 – Financial Decision Making

3.3 Financing a business (continued)

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This Photo by Unknown Author is licensed under CC BY-SA

What sources or types of finance are available to a company?

Insert footer / references if needed

Reminder from last week – what can the students remember about sources/types of finance?

Figure 6.1 The major external sources of finance

A reminder

What might a bank consider before lending money to a company?

Question for class – what would a bank look at in a potential loan?

Bank lending

Attitude of lenders influenced by:

Cash-generating ability

Security for the loan

Profitability

Fixed cost commitments

Lender will look at the profitability of the company, cash flows and whether there is any security available for the loan.

What can banks do to reduce risk?

Loan covenants may deal with such matters as:

Other borrowings

Dividend payments

Financial statements

Liquidity

Requiring security (fixed or floating charge on assets)

Including covenants in the loan contract

Lenders may reduce the risk of lending by

Examples of how bank reduce risk. They can take a security over a specific asset or assets in general (floating) like a mortgage, or they can put covenants into the loan agreement. Covenants tend to put restrictions on how a company will behave in order to protect the bank’s interests e.g. they need to provide the financial statements to the bank immediately after year end or they need to keep liquidity at a certain level, or they have restrictions on the dividend payments that can be made. If a company breaks covenants the bank can ask for the loan to be repaid immediately.

Figure 6.3 Factors influencing the attitude of owners towards borrowing

These are some of the factors that can influence how the company feels about borrowing as a source of finance. It tends to have a lower return requirement than more risky equity finance and means that the existing owners do not need to give up ownership of the company (dilution of shareholdings). It can also be flexible (often loans have a draw down facility so that company’s only need to take the loan when they need it) and having a third party involved can encourage better financial discipline in the company. However, the company needs to be aware of how much capacity they have to take on extra debt – is the company already very highly geared and therefore lenders may be less disposed to lending more money due to risk?

Figure 6.1 The major external sources of finance

There are other external sources of finance that a company can tap into. The next is finance leases, HP and securitisation

Figure 6.5 Benefits of finance leasing

If a company for example wants to buy a fixed asset it could take out a loan and buy the asset. A finance lease on the other hand is where the financial institution buys the asset and rents it to the company, so the company never owns it. Often this can be easier than arranging a loan, it improves the company cash flows as the cost of the machine is spread across it’s life rather than all paid out to acquire the machine, and it gives flexibility e.g. if the company wants to upgrade to a better machine they don’t have to go through the bother of selling the original.

Figure 6.6 The hire purchase process

HP is very similar – the financial institution buys the machine and the customer makes regular payments to the financial institution over the life of the asset. However, generally an HP agreements has a clause such that the company ends up owning the asset after a final payment is made.

Figure 6.7 The securitisation process

Securitisation is where a company creates a special purpose vehicle (SPV) which is usually a trust or a company, bundles up some assets and transfers them into the SPV and then issues bonds from the SPV to third parties. The assets in the SPV generate income which is then used to pay the interest on the bonds. It is a way generating capital from a bundle of assets and can be sued for example with a bunch of intangible assets such as licenses or IP. However this is similar to what happened during the financial crisis in 2008 when banks were bundling up bad mortgages and then selling bonds off the back of these bundles.

Figure 6.1 The major external sources of finance

We can also consider short term external finance. A bank overdraft is fairly self explanatory – it is a short term loan which can be very flexible but may also be more expansive than properly arranging a loan facility with the bank. Bills of exchange are short term IOUs.

Figure 6.8 The factoring process

Debt factoring is particularly popular with small businesses. Where a company supplies goods to customers on credit, it can enter into an arrangement with a financial institution or factor. The factor is responsible for invoicing the customer and pays 80% of the value of the invoice to the company immediately. Therefore the company does not need to wait until the credit period is up to get payment from customers. The factor then chases the customer for payment and when they pay the factor transfer the remaining 20% to the company less its factoring fees. This can be really useful for small companies who do not have a debt chasing department as it takes away all of that administrative work. However, it may also to signal to customers that the company is short of funding.

Debt factoring

Two types

Recourse factoring – where the business assumes responsibility for bad debts

Non-recourse factoring – where the factor assumes responsibility for bad debts

Debt factoring can also be recourse – so if the debt factor does not get paid by the customer they can reclaim the money from the original company or non recourse where the debt factor bears the risk of an unpaid invoice – this is obviously preferable to the company but tends to be more expensive.

Invoice discounting

Charges are lower

It is confidential

Invoice discounting is often preferred to debt factoring because:

Control over all aspects of customer relationship is retained

Invoice discounting is similar but the factor does not take over responsibility for issuing the invoice and chasing the debt – that remains with the original company, but the debt factor advances the money to the original company. This can be used when companies want to maintain control over their debt chasing

Long-term versus short-term borrowing

Considerations

Flexibility

Refunding risk

Matching borrowing with assets held

Interest rates

Companies clearly have a choice between different methods of funding, some of which are long term and some short term. In deciding which is the most appropriate they might consider matching to borrowing with the asset – e.g. if it is for a long term capital investment project it might be best to look at a long term loan, rather than a bank overdraft. However if it is for a short term boost in stock they might go for a short term method such as bank overdraft. Short term finance can often be more flexible – the ability to repay an overdraft which you cannot necessarily do with a loan until it becomes due. Refunding risk occurs if a lender calls back the loan before maturity and the borrower cannot find a loan with a similar rate of interest and interest rates themselves might determine whether to do for short or long term, or equity v debt

Figure 6.10 Short-term and long-term financing requirements

A typical; example of how short and long term financing might look might be to have a level of long term finance that covers both fixed assets and the permanent level of current assets e.g, the amount of stock that usually needs to be held. Short term finance is then used to finance any fluctuations in current assets.

Figure 6.11 The major internal sources of finance

We have looked so far only at external finance. However there are ways of generating finance without needing to go to third parties. On a short term basis reducing stock, collecting receivables and extending the period for trade payables will provide some financing. Ona long term kevel companies can choose to re-invest retained profits, however, always considering the impact of reinvestment on shareholder wealth.

Pecking order theory and long-term financing

Retained profits will be used to finance the business if possible

Where retained profits are insufficient, or unavailable, loan capital will be used

Where loan capital is insufficient, or unavailable, share capital will be used

One final theory about how business use finance is Pecking order Theory. This states that businesses when requiring finding will first use retained profits as they are quick and easy to access, the loan capital as it is again relatively quick and more certain and finally share capital as this is the hardest and most costly to raise.

The funding journey

In the next section e are going to look specially at funding for start up and early stage companies and where they might go to raise finance.

Start ups

How does a start up raise initial funding – can you guess from the pictures. Answers clockwise from top left:

Friend and family

Seed money/venture capital

Bank loans

Grants or government incentives

Crowdfunding

Business angels

Figure 7.5 Long-term finance for smaller businesses

Business angels

Financing smaller businesses

Crowdfunding

Government

Alternative investment market

Venture capital

Hotel Chocolat (Video) https://www.youtube.com/watch?v=TOcxf7kL8VQ

Video about how Hotel Chocolat raised initial funding – in particular I like to discuss with the class the innovation behind the Chocolate Bond and how they effectively self financed market research through the Chocolate club. You don’t need to watch the whole video – I generally stop it around 3:52.

Private equity – types of investment

Expansion capital

Venture capital

Replacement capital

Buy-out and buy-in capital

Rescue capital

One course of funding for early stage, particularly tech companies is private equity. Private Equity refers to funds put together by financial institutions and generally funded by High Net Worth Individuals who invest in private companies. Private Equity covers a lot of different capital at different stages, but the most relevant for small companies is venture capital. This is private investment in early stage businesses who have the potential to grow. It can range from hundreds of thousands to millions and the fund will take a reasonable large slide of shares for the funding as it tends to be high risk. As businesses grow there are other forms of private equity available e.g expansion if the company is trying to grow or expand into a new jurisdiction, replacement capital where one fund buys out another, buy out capital which is provided if a management team want to buy the company from the existing owners or rescue capital for businesses in trouble.

This is a flier prepared by PwC to help companies understand what Venture capital firms are looking for when they consider an investment.

Problems of smaller businesses in raising finance

Lack of financial management skills

Lack of knowledge concerning the availability of finance

Inability to meet assessment criteria of lenders

Bureaucratic screening processes

Inability to provide security

To sum up, some of the issues around smaller businesses raising capital – there is generally a lack of time and specific finance skills to understand where and how to raise capital as it can take a lot of time to secure a venture capital investment or a bank loan. Small business, particularly tech companies do not tend to have fixed assets they can offer as security and may not have much of track record or prior financial statements to convince lenders or inventors and for years many banks had quite bureaucratic screening processes which put small companies at a disadvantage.

Figure 7.9: External financing of small businesses (2017/18)

Bank loan/ commercial mortgage

Credit cards

Loans from other third parties

Grants

Invoice finance

Bank overdraft

Leasing or hire purchase

Loans/equity from directors, family, friends

Per cent

Source: British Business Bank 2017/18 (2018), ‘Small business finance markets (February)'. Figure B.16, p. 25, Used with permission.

Overall, small businesses tend to rely on credit cards and bank overdrafts to get the business operational, but for those who have the potential for growth, seed funding, crowd funding or business angels may be available.

Cost of Capital

In the next section we are going to look at the cost of the capital we have been discussing in the financing section.

What is cost of capital?

The cost to the business to of the finance needed.

Businesses tend to be financed through a mixture of equity (shareholder funds) or debt (bonds or borrowings from a bank, financial institution).

Shareholders will only invest if the business is likely to generate the return required by them. This is linked to the risk they perceive in the business and the opportunity cost of investing elsewhere. Therefore the cost of equity is the shareholders required return.

Banks or financial institutions require return in the form of interest on borrowings

The combined cost of these required returns is a company’s Cost of Capital

Video

Investopedia Cost of Capital explained

https://www.investopedia.com/terms/c/costofcapital.asp

Why do we need to know cost of capital?

It indicates the return required by shareholders and banks in order to provide funding

The cost of capital is therefore used as the discount rate for NPV;

If understated, may accept projects which decrease shareholder wealth;

If overstated may reject projects that would increase wealth.

What is cost of capital? Ultimately it is the cost of all the company’s funding, both debt and equity as all types of funding carries a cost. However, it can be easier to think about it from the other angle – it is the return that a company needs to generate in order to satisfy the requirements of its debt and equity funders. If it cannot generate this return then they will not provide the funding to the company, therefore it doesn’t represent a cost in cash terms, but a return that the company needs to achieve

Practically speaking the cost of capital is the discount rate we use when we are calculating the Net present Value of a project. If we get it wrong we might make an incorrect decision. If we pick a rate that is too low we may go ahead with project that do not achieve the required return and therefore decrease shareholder value. If we get it too high we may reject projects that would otherwise have been wealth enhancing.

So far you have been given the discount rate or cost of capital but now we are going ton work out how to calculate it ourselves. The steps we take are to look at each form of long term capital, work out the cost of that particular type of capita and then calculate an overall cost for the business.

Steps to calculate cost of capital

Identify each form of long term capital

Deduce the cost of each form of capital

Determine value of each form of long term capital;

Calculate an overall cost of capital.

The steps we take are to look at each form of long term capital, work out the cost of that particular type of capita and then calculate an overall cost for the business.

Cost of capital

The major forms of external long-term capital

Ordinary shares

Loan capital

Retained earnings

In addition an important form of internal long-term capital is:

These are the 3 types of capital which we can calculate the cost of capital on. Next week we will look at how you deduce the cost of capital for each of these elements of long term finance

Financial Decision Making-4

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