Syllabus A. Role Of The Senior Financial Adviser A2. Financial strategy formulation

A2b. Sources of Finance 4 / 9

Syllabus A2b)

Recommend the optimum capital mix and structure within a specified business context and capital asset structure.

Sources of Finance

Operating Leases

This is a useful source of finance for the following reasons:

  1. Protection against obsolescence

    Since it can be cancelled at short notice without financial penalty. 

    The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business. 

    This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms and servicing cover

  2. Less commitment than a loan

    There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided
    Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.

  3. Cheaper than a loan

    By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition that borrowing.

  4. Off balance sheet finance

    Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet.

Debt v Equity

These are the things you need to think about when asked about raising finance - so just put all these in your answer and link them to the scenario. Job done.

  • Gearing and financial risk

    Equity finance will decrease gearing and financial risk, while debt finance will increase them

  • Target capital structure

    The aim is to minimise weighted average cost of capital (WACC).

    In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress)

  • Availability of security

    Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets).

  • Economic expectations

    If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead.

  • Control issues

    A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.

Rights Issues

A 1 for 2 at $4 (MV $6) right issue means….

The current shareholders are being offered 1 share for $4, for every 2 they already own. 

(The market value of those they already own are currently $6)

  • Calculation of TERP (Theoretical ex- rights price) 

    The current shareholders will, after the rights issue, hold:
    1 @ $4 = $4
    2 @ $6 =$12

    So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

  • Effect on EPS

    Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for them

    To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue

    Eg Using the above illustration
    EPS x 5.33 / 6

  • Effect on shareholders wealth

    There is no effect on shareholders wealth after a rights issue. 

    This is because, although the share price has fallen, they have proportionately more shares

    Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up the right

The factors considered when reducing the amount of debt by issuing equity :

As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs.

Companies with high levels of financial distress would find it more costly to contract with their stakeholders. 

For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms.

  1. Less financial distress may therefore reduce the costs of contracting with stakeholders.

  2. Having greater equity would also increase the company’s debt capacity. 

    This may enable the company to raise additional finance

  3. On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield.

  4. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.