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Certified Finance SpecialistM M Fakhrul Islam

Email: fakhrul@bimsedu.com

Sources of Finance

1) Share capital (Equity)

2) Preference share

3) Long-term debt

4) Short term loan

5) Credit purchase

Long-term finance

Short-term finance

Considerable Factors:(a) the level of risk in the investment for the investor, and(b) the level of return the investor will require.

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Why do we need to study finance?

Almost half of all newventures fail becauseof poor financialmanagement

-Dun & Brandstreet

What is Finance?

Who needs money?Every one? you?Can you or a business survive

without cash? Why?So what is Finance? First, how to have money…

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Personal finance

Where does money for individuals (personal finance) come from:Our own money in pocket Borrows: from friends or credit cards Received from Government if entitled to some benefits Earned by doing something or sales of products and services

Business finance

Business finance: a business has the same source of money for individuals

Its own money

Borrows: from friends, colleagues, banks and lending institutions

Received from Government grants. Eg. new in deprived sectors

Earned by sales of products and services

From venture capitalists (seeking profit for spare funds)

From private individuals (Business Angels – often seen in entertainment sector)

Private companies

Microloans

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To obtain funding for a business project

Determine how much money is needed to start your company

Prove to your investor that your company requires the predetermined amount of money

Offer incentives, interest, or collateral for the investor’s contribution

Make arrangements to pay back the loan

Classifying businesses

Each type of business can have different ways to finance itself, so we

need to look at types of business ownerships

Sole trader – owned by one person

Partnership – owned by two or more and based on agreement among them

Limited company: owned by two or more but separate in law from people

who own and control

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Sources of Finance

Business Growth

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Internal Sources of Finance and Growth

‘Organic growth’ – growth generated through the development and expansion of the business itself. Can be achieved through: Generating increasing sales –

increasing revenue to impact on overall profit levels

Use of retained profit – used to reinvest in the business

Sale of assets – can be a double edged sword –reduces capacity?

Selling more goods and services to consumers is one way to grow the business.Title: Home Depot quarterly profit rises 53%. Copyright: Getty Images, available from Education Image Gallery

Business Growth

External Long TermShort Term 'Inorganic Growth‘

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Business Growth

External Long Term

SharesOrdinary Shares

Preference Shares

New share issues

Rights Issue

Bonus or Scrip Issue

LoansDebentures

Bank loans (mortgage)

Merchant or Investment Banks

Government/EUGrants

Business Growth

External

Short TermBank loansOverdraft facilitiesTrade creditFactoringInvoice discountingLeasing

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Business GrowthExternalShort Term

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money

Factoring allows company to raise finance based on the value of your outstanding invoices.

Factoring also gives company the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems.

Offers 80 – 85% of the total invoice value Company pays factoring fees

Business GrowthExternalShort Term

LEASING is a contract between the leasing company, the lessor, and the customer (the lessee). The leasing company buys and owns the asset that the lessee requires. The customer hires the asset from the leasing company and pays rental over a pre-determined period for the use of the asset. There are two types of leases:

1. Finance LeasesAn agreement where the lessor receives lease payments to cover its ownership costs. The lessee is responsible for maintenance, insurance, and taxes. Some finance leases are conditional sales or hire purchase agreements.

2. Operating LeasesThe lease will not run for the full life of the asset and the lessee will not be liable for its full value. The lessor or the original manufacturer or supplier will assume the residual risk. This type of lease is normally only used when the asset has a probable resale value, for instance, aircraft or vehicles.

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Business GrowthExternal

'Inorganic Growth'AcquisitionsMergerTakeover

External Sources of Finance

Long Term – may be paid back after many years or not at all!

Short Term – used to cover fluctuations in cash flow

‘Inorganic Growth’ –growth generated by acquisitionThe existence of capital markets enable firms to raise

long term loans and share capital.Title: Dow up on Wall Street. Copyright: Getty Images, available from Education Image Gallery

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Long term (Means?)

Loans (Represent creditors to the company – not owners) Bank loans and mortgages – suitable for small to medium sized firms where

property or some other asset acts as security for the loan

A mortgage loan is a loan secured by real property Merchant or Investment Banks – act on behalf of clients to organise and

underwrite raising finance Government/EU – may offer loans in certain circumstances

Grants

Shares (Shareholders are part owners of a company only in PLC’s)New Share Issues – arranged by investment banks.

Short Term

Bank loans – necessity of paying interest on the payment, repayment periods from 1 year upwards but generally no longer than 5 or 10 years at most

Overdraft facilities – the right to be able to withdraw funds you do not currently have

Provides flexibility for a firm

Interest only paid on the amount overdrawn

Overdraft limit – the maximum amount allowed to be drawn - the firm does not have to use all of this limit

Trade credit – Careful management of trade credit can help ease cash flow –usually between 28 and 90 days to pay

Factoring – the sale of debt to a specialist firm who secures payment and charges a commission for the service.

Leasing – provides the opportunity to secure the use of capital without ownership –effectively a hire agreement

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'Inorganic Growth'

Acquisitions The necessity of financing

external inorganic growth Merger:

firms agree to join together – both may retain some form of identity

Takeover:One firm secures

control of the other, the firm taken over may lose its identity

The merged entity, which will operate under the brand name of Robi, will be 70 percent-owned by Axiata Group. Bharti Airtel will have 25 percent stakes in the new company. Japan's NTT DOCOMO in Robi will be diluted to 5 percent from 8.41 percent now

Business Angels

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Business Angels

Individuals looking for investment opportunitiesGenerally small sums up to £100,000Could be an individual or a small groupGenerally have some say in the running of the

company

Venture Capital

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Venture Capital

Pooling of capital in the form of limited companies –Venture Capital Companies

Looking for investment opportunities in fast growing businesses or businesses with highly rated prospects

May also buy out firms in administration who are going concerns

May also provide advice, contacts and experience In the UK, venture capitalists have invested £50 billion

since 1983

Reasons for share listing

i. Access to a wider pool of finance.ii. Improved marketability of sharesiii. Transfer of capital to other usesiv.Enhancement of the company image.v. Facilitation of growth by acquisition.

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Rights issue Offer to existing shareholders at existing proportion, at a lower price than

market Pre-emption rights This is a choice of shareholders

Take up

Renounce

Take partial

Do nothing at all

‘Cum rights’ Theoretical ex rights price

Rights Issue and EPS

Seagull can achieve a profit after tax of 20% on the capital employed. At present its capital structure is as follows.

$ 2,000,000 ordinary shares of $1 each 2,000,000 Retained earnings 1,000,000

3,000,000 The directors propose to raise an additional $1,260,000 from a rights issue. The current market price is $1.80.

(a) Calculate the number of shares that must be issued if the rights price is: $1.60; $1.50; $1.40; $1.20. (b) Calculate the dilution in earnings per share (EPS) in each case.

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Preference shares

not equity

P. shareholders are not owners of the company

Shareholders are entitled to a dividend before any dividend to equity holders

Types of preference shares(a) cumulative

(b) participating

(c) redeemable, or

(d) convertible

Cost of Capital

Two aspects Cost of funds Expected return by investors

Three elements Risk free rate of return Premium for business risk Premium for financial risk

Cost of Equity Cost of Debt Weighted Average Cost of Capital (WACC)

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Cost of Equity Dividend valuation model

r = D1/ P 0

Where, r = the shareholders' cost of capital D1= the annual dividend per share, starting at Year 1 to be received

perpetuallyP0 = Current Share Price

Dividend growth model (also known as Gordon's growth model )

D1 = D0 (1 + g) g = the annual growth rate in dividends, expressed as a proportion (e.g. 4% = 0.04)

Cost of Debt

Interest on debt capital is an allowable deduction

After-tax cost of irredeemable debt capital

where: Kd = cost of debt capital

I = annual interest payment

P0 = current market price of the debt capital ex interest (that is, after payment of the current interest)

t = Rate of tax

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Weighted Average Cost of Capital (WACC)

where: Keg is the cost of equity

Kd = Cost of debt

E = Market value of equity in the firm is the market value of debt in the firm