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Definition of call option contract
Chapter 7 - Sources of finance Chapter objectives Structure of the chapter Sources of funds Ordinary equity shares Loan stock Retained earnings Bank lending Leasing Hire purchase Government assistance Venture capital Franchising Key terms Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement - new machinery or the construction of a new building or depot. The development of new products can be enormously costly and here again capital may be required.
Normally, such developments are financed internally, whereas capital for the acquisition of machinery may come from external sources. In this day and age of tight liquidity, many organisations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion.
Interest rates can vary from organisation to organisation and also according to purpose. Chapter objectives This chapter is intended to provide: Structure of the chapter This final chapter starts by looking at the various forms of "shares" as a means to raise new capital and retained earnings as another source.
However, whilst these may be "traditional" ways of raising funds, they are by no means the only ones. There are many more sources available to companies who do not wish to become "public" by means of share issues. These alternatives include bank borrowing, government assistance, venture capital and franchising. All have their own advantages and disadvantages and degrees of risk attached.
Sources of funds A company might raise new funds from the following sources: Ordinary equity shares Ordinary shares are issued to the owners of a company. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares. Deferred ordinary shares are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount.
Voting rights might also differ from those attached to other ordinary shares. Ordinary shareholders put funds into their company: Simply retaining profits, instead of paying them out in the form of dividends, offers an important, simple low-cost source of finance, although this method may not provide enough funds, for example, if the firm is seeking to grow.
A new issue of shares might be made in a variety of different circumstances: If it issues ordinary shares for cash, should the shares be issued pro rata to existing shareholders, so that control or ownership of the company is not affected?
If, for example, a company with , ordinary shares in issue decides to issue 50, new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead? In the example above, the 50, shares would be issued as a one-in-four rights issue, by offering shareholders one new share for every four shares they currently hold.
New shares issues A company seeking to obtain additional equity funds may be: The methods by which an unquoted company can obtain a quotation on the stock market are: An offer for sale is a means of selling the shares of a company to the public. All the shares in the company, not just the new ones, would then become marketable. When this occurs, the company is not raising any new funds, but just providing a wider market for its existing shares all of which would become marketable , and giving existing shareholders the chance to cash in some or all of their investment in their company.
When companies 'go public' for the first time, a 'large' issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately. Rights issues A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.
For example, a rights issue on a one-for-four basis at c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a price of c per new share. A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.
Preference shares Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years.
The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders. From the company's point of view, preference shares are advantageous in that: Redeemable preference shares are normally treated as debt when gearing is calculated.
However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks.
For the investor, preference shares are less attractive than loan stock because: Loan stock Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate.
Holders of loan stock are therefore long-term creditors of the company. Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. The rate quoted is the gross rate, before tax. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.
Debentures with a floating rate of interest These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile. Security Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.
The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset. The redemption of loan stock Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years.
At the end of this period, they will "mature" and become redeemable at par or possibly at a value above par. Most redeemable stocks have an earliest and latest redemption date. The issuing company can choose the date. The decision by a company when to redeem a debt will depend on: There is no guarantee that a company will be able to raise a new loan to pay off a maturing debt, and one item to look for in a company's balance sheet is the redemption date of current loans, to establish how much new finance is likely to be needed by the company, and when.
Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified period.
Most organisations owning property which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of the value of the property. As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax. Retained earnings For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend.
The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.
From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit which will only be taxed when shares are sold than receive current income, then finance through retained earnings would be preferred to other methods.
A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors such as banks to pay generous dividends, nor over-generous salaries to owner-directors.
Bank lending Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. Short term lending may be in the form of: Interest is charged at a variable rate on the amount by which the company is overdrawn from day to day; b a short-term loan, for up to three years. Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower.
A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate. Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate.
A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS. A The amount of the loan. The customer must state exactly how much he wants to borrow.
The banker must verify, as far as he is able to do so, that the amount required to make the proposed investment has been estimated correctly. R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments? T What would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans are now quite common. S Does the loan require security?
If so, is the proposed security adequate? Leasing A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental.
Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment.