Long Term Finance Part 3

Front 1

What is debt finance

Back 1

A loan of funds to the business without conferring ownership rights

Front 2

What are the key features of debt financing arising from an arm’s length transaction

Back 2

Interest is paid out of pre-tax profits as an expense of the business

Carries the risk of DEFAULT if interest and principal payments are not met.

Front 3

What type of ‘charge’ or security can be offered against which the funds are advanced.

Back 3

FIXED CHARGE – debt is secured against a specific asset. Eg Land and building.

Preferred, in the event of liquidation, it put the lender at the front of the queue of creditors.

FLOATING CHARGE – Debt is secured against underlying assets that are subject to changes in quantity or value. Eg. Inventory.

This form of security is not very strong, again it confers a measure of security on liquidations as the lender is first in line as a “preferred creditors”.

IN THE EVENT OF DEFAULT, THE LENDER WILL BE ABLE TO TAKE ASSETS IN EXCHANGE FOF THE AMOUNT OWING.

Front 4

How are covenants used in debt finance?

Back 4

Means of limiting risk to the lender is to RESTRICT the actions of the directors through the means of covenants.

These are specific REQUIREMENT or LIMITATIONS laid down as a CONDITION of taking on debt financing.

Front 5

What type of covenants are there

Back 5

DIVIDEND RESTRICTIONS – limitations on the level of dividends a company is permitted to pay. Prevent excessive dividend payments which may seriously weaken the company’s cash flow and place the lender at greater risk.

FINANCIAL RATIOS – specify level below which certain ratios may not fall. Debt to net asset ratio, current ratio.

FINANCIAL REPORTS – Regular accounts and financial reports to be provided to the lender to monitor progress.

ISSUE OF FURTHER DEBT – the amount and type of debt that can be issued may be restricted.

Front 6

Bank finance – Discuss Revolving Credit Facilities (RCFs)

Back 6

Borrow may withdraw or use funds up to a pre-approved credit limit.

The amount of available credit increases or decreases, as funds are borrowed and then repaid

Borrower makes payments based only on the amount they actually used or withdrawn, plus interest

Borrower may repay the borrowing over time or in full at any time

RCFs are very FLEXIBLE debt financing options

Enable a company to minimize interest payments because the amount of funds borrowed fluctuates over time and is never more than the company needs.

Front 7

Debt Finance – Capital Markets – What is a bond

Back 7

Is a debt security, issuer owes the holder a debt and depending on the terms is obliged to pay interest (coupon).

Is like a loan.Issuer is the borrower and holder is the lender and more commonly referred to as the investor.

Coupon is the interest.

Bonds provide the borrower with external funds to satisfy long—term funding requirement.

What is the difference bonds and shares?

Bonds and shares are both securities which can be traded in the capital markets,

But the major difference is that shareholders have an equity stake in the company and bondholders have a creditor stake in the company.

Front 8

Bank finance – Discuss Money Market borrowings

Back 8

Money Market consists of financial institutions and dealers in money or credit who wish either to borrow or lend.

Money Market consists of financial institutions and dealers in money or credit who wish either to borrow or lend.

Used by participants as a means for borrowing and lending in the short term, from several days to just under a year.Core of the money market consists on INTERBANK lending. Banks borrowing from and lending to each other.

Core of the money market consists on INTERBANK lending. Banks borrowing from and lending to each other.

Front 9

What opportunities does issuing debt in the capital market provides entities with

Back 9

Enables an entity to borrow a large amount of finance from potentially a wide range of potential investors.

Front 10

Discuss the three main groups of the bond market

Back 10

ISSUERS – sell bonds in the capital market to fund the operations of their organization. Mainly governments, bank and corporations.

UNDERWRITER – made up of investment bank and other financial institutions that help the issuer to sell the bond in the market. A lot of work needs to be done to prepare the offering, eg creating a prospectus and other legal documents.

Underwriters necessary for corporate debt market because there are more risks associated with this type of debt. Underwriter sometimes using “bond placement” place bonds with specific investors or they can attempt to sell the bonds more widely in the market.

PURCHASERS – Investor or individual.

Front 11

Can an entity used retained income to finance new investment projects?

Back 11

No, the level of retained earnings reflects the amount of profit accumulated over the entity life.

An entity can only use internal sources of finance to fund new projects if it has enough in hand.

Front 12

What is Sale and Leaseback

Back 12

Selling good quality fixed assets (high street buildings) and leasing them back over many years (25+)

Funds are released without any loss of use of assets.

Any potential capital gain on assets is forgone

Popular for retail organizations.

Front 13

What is debt with warrants attached?

Back 13

Warrant is an OPTION to buy shares at a specified point in the future for a specified (EXERCISE) price

Warrants are often issued with a bond a sweetener to encourage investors to purchase the bonds

Warrant offers a potential capital gain where the share price may rise above the exercise price.

Holder has the OPTION to buy the share on the exercise date

But can also choose to sell the warrant before that date.

Front 14

What is convertible debt

Back 14

Similar to debt with warrants attached except option to convert to shares cannot be detached and traded separately.

With convertible debt, the debt itself is converted into shares at a predetermined price at a date or range of dates in the future.

Potential capital gain over and above the return from the repayment of the debt.

If the value of share is greater than value of the debt on the exercise date, then conversion should be made by the investor and if share value is lower than the debt value, the investor should retain the debt to maturity

Front 15

What is venture capital

Back 15

Finance provided to young, unquoted profit-making entities to help them to expand.

Usually provided in the form of equity finance, but may be a mixture of equity and debt.

Venture capitalist usually accept low levels of dividends and expect to make most of their returns as capital gains on exit.

Exit routes may be IPO or flotation, venture capitalist will sell his stake in the company on the stock market.

Front 16

What is Business angels

Back 16

Are similar to venture capitalists.Venture capitalists rarely invest in small businesses, on the grounds that monitoring progress is uneconomic.Business angels are wealthy investors who provide equity finance to small business.