1.

Introduction
PDE4232
Financial Management in
Engineering
Lecture 11
Financing a business
This presentation is based on the content of
Atrill & McLaney, 10th edition (2017)
Chapter 11 (pages 411 – 459)
1. Introduction
Learning outcomes

By the end of this unit, you should be able to:

 Identify the main sources of finance available to a

business and explain the advantages and disadvantages of
each

 Outline the ways in which share capital may be issued

 Explain the role and nature of the Stock Exchange

 Discuss the ways in which smaller businesses may raise

finance
2. Main objective of financing policy
 Aim to raise finance to maximise wealth of business +
owners
 Select sources of finance that combine cost + risk to
minimise overall cost of capital
 Recall: value of business = sum of the discounted future
cash flows it generates (This is one view)
 Discount rate here = the business’s overall cost of capital

 Minimise cost of capital  minimise discount rate

  maximise value of the business

3. Sources of finance
 Distinguish between internal and external
 Internal = not require more than agreement of directors
 Example of internal: retained earnings
 This doesn’t require explicit agreement of the shareholders
 Example of external: finance from issue of new shares
 This requires agreement of potential investors
 Also distinguish between long-term & short-term sources
 Roughly:
 Long-term = provide finance for  1 year
 Short-term = provide finance for  1 year
 Note: Sometimes short-term may become rather longer than
that
4. Internal sources of finance
5. Internal sources of long-term finance (1)
 Retained earnings - not distributed to shareholders (dividends)
 Most important source of new finance for UK businesses in terms
of the amount raised
 Not a “free” source of finance – opportunity cost to shareholders
 Even so, may be better than an issue of shares
 No issues costs
 Amount raised is certain

 Issue of new shares

 Substantial issue costs

 Success of the issue may be uncertain

 Possible dilution of control

5. Internal sources of long-term finance (2)
 Retaining earnings - probably an easier option
 No delay in receiving the funds
 Often less scrutiny
 BUT: timing and future level cannot not always be reliably
determined

 Retaining earnings is not a case of all or nothing

 E.g., larger businesses tend to pay out, as dividends, no more than
50% of their earnings
 Sometimes even profitable businesses may not pay out dividends.
 See Real World 11.1 Asos plc (p.414)
6. Internal sources of short-term finance (1)
 Major internal forms are:
 Tighter credit control
 Reducing levels of inventories
 Delaying payments to suppliers (Trade payables)
6. Internal sources of short-term finance (2)
 Tighter credit control
 Benefits – get sooner use of funds tied up in trade payables
 Potential costs – loss of customer goodwill
 Consider – needs of customers
 – credit policies of competitors
6. Internal sources of short-term finance (3)
 Reducing levels of inventories
 Take care to ensure enough for needs of the business
 - future production and sales demand

 Risk - lost customer goodwill

 - lost sales
 Need to look at why holding excessive inventories
 Poor buying?
 Slow moving
 Obsolete?
6. Internal sources of short-term finance (4)
 Delaying payment to suppliers (Trade payables)
 Suppliers are giving their customers interest-free “loans”
 Delaying payment of these “loans” may be beneficial.
 Beware: potential costs
 Agreed credit period
 Reputation as a slow payer

 Cash flow benefit of more efficient management of working

capital
 See Activity 11.3 (pages 415 – 6): Trader Ltd
6. Internal sources of short-term finance (5)
 Some further points

 “Short-term” = can be reversed at short notice

 Though changes likely to be maintained in the longer term

 For many businesses the funds invested in working capital

can be vast
 Not always necessary
 Scope for generating funds through more efficient
management of working capital (See Chapter 12)
7. External sources of finance
8. External sources of long-term finance (1)
 Major external sources are:
 Ordinary shares

 Preference shares

 Borrowing

 Finance leases (including sale-and-leaseback)

 Hire-purchase agreements

 Securitisation of assets
8. External sources of long-term finance (2)
 Ordinary shares
 The risk capital of the business
 The backbone of the business’s financial structure
 Dividend rate – not fixed
 And last in line for any payout, anyway
 Also last in line on company being wound up
 High risks here  shareholders expect high rate of return
 Potential returns “unlimited”
 Control the business through voting rights
 Elect directors and remove them from office

 Effective form of financing compared to borrowing

 Can avoid paying a dividend; can’t avoid paying interest
8. External sources of long-term finance (3)
 Preference shares
 Lower level of risk than ordinary shares
 Usually a fixed rate of dividend (provided profits available)
 Get any dividend before ordinary shareholders (Preference)
 On wind up of business: take preference over ordinary s/h
 Usually no voting rights
 No longer an important source of new finance
 Loan interest is allowable against tax; dividends are not

 As well, interest rates have been at low levels

8. External sources of long-term finance (4)
 Borrowings
 Lenders (E.g., banks) often seek some form of security
 E.g, fixed charge on particular assets
 Or floating charge (over whole of the business’s assets)
 Floating charge – gives managers greater flexibility
 Acceptable assets
 Non-perishable
 Easy to sell
 Of high and stable value
 Sometimes a personal guarantee may be required
 Loan covenants
 See RealWorld 11.2 (page 420)
9. Forms of borrowing (1)
 Among the most important forms are:
 Term loans
 Loan notes (loan stock)
 Eurobonds
 Convertible loan notes
 Mortgages
9. Forms of borrowing (2)
 Term loans
 Offered by banks and other financial institutions
 Can be tailored to the needs of the business
 Amount of loan, time period, repayment terms, interest rate –
all open to negotiation and agreement
 May be able to draw on loan facility as and when needed
 Interest advantage

 Tend to be cheap to set up (for the borrower)

 Conditions can be quite flexible
 Therefore, popular
9. Forms of borrowing (3)
 Loan notes (Loan stock)
 Generally issued by larger Stock Exchange listed companies
 Individual investor can take up a slice of the larger loan
 Sometimes these smaller slices can be traded on the SE
 Flexibility  Can make loan notes an attractive investment
 Sometimes known as debentures
 May be redeemable or irredeemable
 Irredeemable = no specified maturity date)

 Called bonds in the USA

 See Real World 11.3 Manchester United (page 422)
9. Forms of borrowing (4)
 Eurobonds
 Unsecured loan notes
 In a different currency from that of the business issuing them
 Finance raised internationally
 Often denominated in US$, and also in other major currencies
 Bearer bonds – owner of the bond is not registered
 Interest normally paid without deduction of tax
 Part of an international capital market not restricted by local
regulations
 Lower servicing costs than similar domestic bonds
 UK borrowings in non-£ currencies expanded in recent years
 Access to a wider pool of potential investors  successful issue
9. Forms of borrowing (5)
 Convertible loan notes (Convertible bonds)
 Give investors the right to convert into ordinary shares
 at a specified price and at a given future date (range of dates)
 This specified price is called the exercise price
 It will normally be higher than market price of the ord shares at
the time of issue of the loan notes
 Investor/lender  Investor/shareholder
 No obligation to convert
 Business point of view
 If business successful lenders will convert – no cash outlay by bus.
 Possibility of offering lower interest rate
 Some dilution of control for existing shareholders
9. Forms of borrowing (6)
 Mortgages
 Form of loan that is secured on an asset
 Asset is typically land and property
 Range of lenders:
 Banks
 Insurance businesses
 Pension funds

 May be over a long period (20 years or more)

9. Forms of borrowing (7)
 Interest rates
 Floating or fixed
 Floating = rises and falls with market rates of interest
 May be a condition of a maximum or a minimum rate

 MV of floating loan notes likely to be fairly stable over time

 Fixed = no change in interest payments with the rises and falls of

the market rates of interest
  Value of the loan notes falls when interest rates rise

  Rises when interest rates fall

 See Activity 11.10 (page 425)

 Which is better for a business that wants to borrow?

9. Forms of borrowing (8)
 Finance leases
 If business needs a particular asset:
 Buy direct from a supplier (Pay full capital cost)

 Other options:
 Have a bank buy it. Bank then leases asset to the business
 Lease it from the supplier/manufacturer
 Equivalent to taking out a loan

 Finance lease: legal ownership remains with the lessor

 Operating lease: ownership remains with the business
 : is often short term
9. Forms of borrowing (9)
 Sale and leaseback
 Business raises finance by selling asset to financial institution
 Agreement to lease the asset back to the business
 Lease rental paid = allowable expense of the business
 Can be used to help a business to focus on its core areas of
competence
 E.g.: Hotel businesses – become hotel operators rather than a
combination of hotel operators and owners
9. Forms of borrowing (10)
 Hire purchase
 A form of credit used to buy an asset
 HP agreement:
 Customer pays for the asset in instalments
 Normally an initial deposit
 Instalment payments at regular intervals (Monthly?)
 Customer takes possession of the asset at initial deposit
 Legal ownership transfers only after final instalment paid
 Often three parties : Supplier/Customer/A financial institution
9. Forms of borrowing (11)
 Securitisation
 Bundle together illiquid financial or physical assets
 Illiquid = not readily able to be sold

 Aim: to provide financial backing for an issue of bonds

 Much more popular in the US than in, say, the EU

 Securitisation and the financial crisis

 Serious US problem of misuse
 Led to so-called “sub-prime” crisis of 2008
10. External sources of short-term finance
 Major sources are:
 Bank overdrafts
Negative balance on bank account.
Relatively inexpensive to arrange
Interest rates – credit-worthiness
Repayable on demand
 Debt factoring
Outsourcing trade receivables management
Factor may make advance to the business (80%?)
Usually paid immediately after goods supplied

 Invoice discounting
A short-period (60/90 days) loan based on a
proportion of face value of credit sales outstanding
(75 – 80%)
11. Long-term versus short-term borrowing
 Factors to take into account
 Matching
 Type of borrowing with the nature of the assets held
 Non-current <-- -> current

 Flexibility
 Perhaps to postpone a commitment to long-term borrowing

 Refunding risk
 Short-term to be renewed more frequently
 Problems if business in difficulty

 Interest rates
 Higher for long-term
 Arrangement fees?
12. Gearing and the financing decision
 Financial gearing
 Business is financed, in part, by borrowing
 Level of gearing often an important in assessing risk
 as well as returns to shareholders

 Example 11.1 Blue plc (pages 436 – 438)

+ Activities 11.14, 11.15
13. Raising long-term finance
 Share issues
 Rights issues Issue of new shares to existing shareholders

 Offers for sale and public issues

Offer for sale: Shares sold to an issuing house
IH sells on to potential investors
Sales proceeds certain
Public issue: Shares sold direct by the business
to the public
 Private placings Shares placed with selected investors

 Bonus issues Is not a means of raising finance

Is merely converting one part of equity (reserves)
into another part (shares)
14. Role of the Stock Exchange
 Is an important primary and secondary capital market for
businesses Enable businesses Enable investors to
to raise new sell their securities
finance easily

 Advantages of a listing
 Secondary market role: cited as an example of an efficient
capital market

 Disadvantages of a listing
 Strict rules
 Close scrutiny by analysts
 Pressure to perform well over the short term
 Huge costs of obtaining and retaining a listing
OTHER
 Alternative investment market (AIM) (page 446)

 Small business funding (page 447)

 Venture capital

 Government assistance

 Islamic finance