Sources Of Finance And Cost Of Capital Week 2

Front 1

Who investigates options available for financing business opportunities that require capital?

Back 1

The finance manager

Front 2

What are the two categories for sources of finance?

Back 2

Equity and debt

Front 3

What is critically important in the capital structure?

Back 3

The mix of debt and equity in order to find a balance using sufficient debt to take advantage of tax benefits

Front 4

What should an entity consider when picking a source of capital?

Back 4

Should use cheapest source

Front 5

Why is it better to use debt instead of funds from shareholders to fund capital?

Back 5

Funds from shareholders:

-more expensive source- funders expect high return because uncertainty on repayments is high (especially ordinary shares)

-you have to pay them a dividend; give them voting rights and ownership in return

Debtholders:

-funders expect low return because the uncertainty on repayments is less

-all you offer in return is interest that you pay above borrowed capital. Debtholders don’t get ownership and dont get voting rights

Front 6

Give to categories for long term capital

Back 6

-equity/ share capital

-long term debt

Front 7

Give examples of equity/ share capital

Back 7

-ordinary shares

-preference shares

-retained income

Front 8

Give examples of long term debt

Back 8

-bonds

-debentures

-long term loan

-mortgage bonds

-leases

Front 9

What are the different kinds of equity finance?

Back 9

-ordinary shares

-preference shares

-retained income

Front 10

What are the different types of debt finance?

Back 10

-bonds

-debentures

-long term loan

-mortgage bonds

-leases

Front 11

Discuss ordinary shares under the category of equity finance?

Back 11

effective owners and their shares give them rights to:

-attend shareholders meeting; elect board of directors; receive dividends; share surplus on asset when company liquidates

-they are ranked behind debtholders and preference shareholders when company liquidates

-take the highest risk to provide capital and expect a high return

Front 12

Where can ordinary shares be listed? And what is SA’s stock exchange?

Back 12

Shares may be listed on a Stock Exchange:

-primary market : first share issue to raise capital

-secondary market: matches investors who want to buy or sell

Johannesburg Stock Exchange

Front 13

How does a company get listed on the stock exchange?

Back 13

-process involves IPO : allows public to buy shares in company for first time

-the company issues a prospectus

-shares issued must be underwritten to ensure that all shares an entity plans to issue are purchased

(Underwriter agrees to purchase remaining shares not purchased by public)

Front 14

Explain preference shares under the category of equity financing

Back 14

-Preference shareholders have preference rights over ordinary shareholders with regards to receiving dividends

-they receive dividends before ordinary shareholders

-have preference on sharing of assets on liquidation

-dont have right to vote at shareholders meetings

-receive a fixed rate dividend in return

-the are ranked behind debt finance in event of liquidation:

Have a debt characteristic and thus referred to as hybrid instruments

Front 15

What are the different types of preference shares?

Back 15

Convertible preference shares

Cumulative preference shares

Participating preference shares

Redeemable preference shares

Front 16

Explain what convertible preference shares are under preference shares in equity finance?

Back 16

-preference shares that may be converted into ordinary shares in future

Front 17

What are cumulative preference shares?

Back 17

-dividends will accumulate when it is not paid when due

-shareholders may receive voting rights when dividend is in arrears

-ordinary dividend may not be paid until all outstanding dividends have been paid

Front 18

What are participating preference shares?

Back 18

-they receive fixed dividend and share in profits with the ordinary shareholders in a manner agreed between the parties

Front 19

What are redeemable preference shares?

Back 19

-shares are redeemed at some point in the future

- an entity that issues redeemable preference shares must ensure they have sufficient cash flow to repay these preference shares

Front 20

Explain what retained income is

Back 20

Accumulated profits that have been retained and not paid out as dividends

-it is the cheapest source of finance as retained profits are available immediately

-profits are retained for growth of company

-dividend decision has effect on share prices and shareholder wealth

-ordinary shareholders regard retained earnings as a share of their investment

Front 21

Why is long term debt cheaper than equity finance?

Back 21

-investors are guaranteed periodic interest payments and repayment of capital sum on maturity

Front 22

What are bonds?

Back 22

-refers to a number of non current debt instruments including debentures

-long term loan from public at fixed interest rate with specific repayment terms

-a fixed interest rate or coupon rate is paid until maturity

Front 23

What is a disadvantage of choosing bonds and debentures as capital finance?

Back 23

-they are secured against immovable property

If borrower defaults on a repayment, then funder may sell the company’s assets to raise funds needed to fullfil loan

-bonds and debentures are ranked first in event of liquidation

Front 24

Discuss mortgage bonds under the category of debt finance?

Back 24

-a non current loan is usually secured against the property of an entity and generally incurs interest at a variable rate

Front 25

Discuss long term loans?

Back 25

-loan agreement with other parties, normally financial institutions

*secured or not secured

*terms of payment (interest rate; time; etc)

Front 26

What is leasing?

Back 26

-agreement between lessor and lessee

-lessor gives right to lessee to use an asset for specific period of time in return for lease payments

-its considered as a medium debt but as the same financial risk as any other form of borrowing

Front 27

Why does leasing not appear on the statement of financial position?

Back 27

-the asset is used by the company but it is not owned or purchased by the company

Front 28

What are 3 sources of short term finance?

Back 28

-trade creditors (accounts payable)

-bank overdrafts

-account receivable factoring

Front 29

What is trade creditors?

Back 29

-purchases made on credit from supplier

-trade credit finances purchase of inventory

-comes with credit terms and often seem to be without cost

Supplier benefits from ability to sell more goods

Customer benefits from delayed settlement

Front 30

What are bank overdrafts?

Back 30

-finance is available immediately

Bank allows entity to withdraw more money from its bank account than it actually has (balance goes below zero)

-gets arranged with the bank and an overdraft rate is negotiated

Front 31

What is a common error in bank overdrafts?

Back 31

Entities start to depend on overdraft financing on a permanent basis

Front 32

What does account receivable factoring mean?

Back 32

Handing over accounts receivable to a third party for collection in return for a substantial portion of debts due

Front 33

What is the benefit of accounts receivable factoring?

Back 33

-company receives cash upfront. Company saves on administration fees as this process is handed to 3rd party

Front 34

What is the disadvantage of accounts receivable factoring?

Back 34

The bad debts are still the responsibility of the business, not of 3rd partay

So business are still exposed to risk

Front 35

What does investors offer and what do they want in return?

Back 35

Investors offer a scare resouce which is capital. It is a cost that a business incurs when raising debt and equity capital when raising capital to fund its operations

Front 36

Define cost of capital

Back 36

Price paid by an entity to gain access to capital, usually in the form of interest or dividends

Front 37

Define capital

Back 37

Funds that an entity needs to finance its assets and operations

Front 38

How does a company raise capital?

Back 38

By issuing equity and debt capital

Front 39

Discuss return on investment

Back 39

-users of capital must not misuse capital so that they earn sufficient income to meet investor’s expected return needs

-management needs to know break even point in order to plan and budget financially so that they meet investor’s expected returns

-if a company performs more than investor’s required return, their wealth increases and added value accrues to shareholders

-if companies do not meet investor’s required returns, then they will be unable to attract future capital and will not grow and expand

Front 40

Which providers of capital carry the biggest risk?

Back 40

Shareholders

Front 41

Why do shareholders carry the biggest risk as providers of capital?

Back 41

If company does not perform well, all other providers of capital are paid before shareholders

Thus incentive to invest in shares are driven by expectation of returns that re higher than those that will accrue to debt holders

Front 42

What are the expectations of long term lenders?

Back 42

-secured and unsecured loans will each have their own prescribed interest rate that depends on perceived risk of loan and interest rate ruling at time of issue

Front 43

What are the expectations of short term lenders?

Back 43

-short term financing like bank overdraft also cost interest

-average amount of short term financing during year will also incur finance charge

Front 44

Discuss the cost of capital

Back 44

-source of finance has a price that is quoted as a rate of return

-entity must aim to achieve a return in excess of its cost of capital to meet required return rates

Front 45

Should an entity borrow long term or short term?

Back 45

long term assets should be financed with long term debt

-why? Benefits from assets will be received over long period of time

short term assets should be financed with short term debt

-why? finance available at lower rate

Front 46

What are the three components of cost of capital?

Back 46

-cost of ordinary shareholders’ equity

-cost of preference shareholders’ equity

-cost of debt

Front 47

How is the cost of capital expressed?

Back 47

As percentage rate