Major Sources of Financing Solutions to Chapter Review Questions

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1 Chapter 2: Major Sources of Financing Solutions to Chapter Review Questions 1. Debt finance available in Australia: Trade Credit Bank Overdraft Trade Bills Promissory Notes Commercial Bills Inter-Company Loans Factoring of Trade Debtors Debentures Unsecured Notes (Bonds) 2. Trade credit is important in trade and commerce for ease of transactions. It is readily available after appropriate credit checks and is interest free. It is linked to the level of acquisitions so that the level of financing grows automatically with the epansion of a business. 3. ( a ) A bank overdraft is a facility which allows the entity to overdraw its current (bank) account. The firm and bank negotiate an upper limit on the overdraft. Once a company has been granted an overdraft it has complete discretion as to the use of the account. An overdraft is subject to a periodic review by the bank. The interest calculation on a bank overdraft is calculated on the daily balance, and debited either quarterly or half yearly to the account. The Overdraft facility is on a call basis. The bank may at any time withdraw the facility, requiring payment of the loan. Although the overdraft facility is viewed as short-term debt the practise frequently is to roll over the debt, and it is sometimes viewed as a long-term or permanent feature of total finance. ( b ) Trading Banks are a most important provider of finance. They provide short or medium term finance on the basis of overdrafts and fully drawn advances. Commercial Bills are also within the services of trading banks. 3

2 4. The appropriate mi of or weighing of alternative sources will depend on consideration of: cost availability timing fleibility collateral current encumbrances on assets impact on funding mi/risk profile of company. 5. Facto rs that will affect the negotiations with the bank: The bargaining power/position of the company. Current and future financial position and probability of the firm. A lender will require cash budget and financial reports. Security for the overdraft. The lending capacity of the bank. Current economic climate/interest rates 6. Stretching is etending trading credit beyond the trading terms, that is postponing payment. For eample, if the terms are net 30 days, and the purchaser takes in ecess of this time to pay, stretching occurs. There is a cost to the supplier and the recipient of the credit should take care not to affect the credit rating of the organisation. Stretching accounts payable where a discount is involved will cost the purchaser the amount of the cash discount. 7. ( a ) = 12.23% ( b ) = 18.43% ( c ) = 11.12% ( d ) = 12.29% ( e ) = 6.11% 8. ( a ) The adoption of this policy will favourably affect the cost of accounts receivable. The cost of carrying small accounts receivable will be lessened, though there may be a decline in sales. ( b ) There would be an increase in accounts receivable and potentially with customers who would not have availed themselves of credit previously. There would be an increased cost in financing the accounts receivable. 4

3 ( c ) This should reduce accounts receivable but the costs of discount will increase the cost of receivable financing. 9. ( a ) If prompt payment discounts are foregone, there is an implicit cost. If a firm continually delays payment beyond the net period, additional costs are incurred including reputational factors which may increase the cost of funding in the future. ( b ) A supplier, after assessing the risk involved in advancing trade credit, will determine, the upper limit of the credit. In assessing the risk the supplier may use: ( i ) Financial statements from the customer; ( ii ) Trade enquires/credit bureau and computerised data banks; ( iii ) Credit reports, frequently provided by mercantile agencies; ( iv ) Credit ratings including the material available from Dun and Bradstreet s reports. 10. ( a ) If prompt payment discounts are foregone, there is an implicit interest cost. ( b ) A supplier after assessing the risk involved in advancing trade credit will determine, based on enquires the upper limit of credit. In assessing the risk the supplier may use: 1. Financial Statements from the customer 2. Trade enquires/credit bureaus and computerised data banks. 3. Credit reports, frequently provided by mercantile agencies. 4. Credit ratings including the material available from Dun and Bradstreet reports. 11. Factoring involves the sale or assignment of accounts receivable. Assignment is characterised by the fact that the lender has not only a lien on the receivable but also has recourse to the seller of the debt. Assigning accounts receivable is a quick method of obtaining credit, but is an epensive source of finance. Advantages: Quick access to funds, effectively immediate payment for the sale of goods and a reduction of accounts receivable. Ability to re-invest funds into the company which can allow faster growth Disadvantages: Can be very costly, should only be used for new fast growing company s who may not be able access other financing options. Factoring is often regarded as a last resort method of finance and may in some cases damage a company s reputation. 5

4 12. Trade credit or bank overdraft 13. A return to ordinary shareholders is made up of two components: Dividends Capital gains which arise due to and increase in the market price of the shares over time. 14. ( a ) Equity is where a company sells of small portions of the firm, known as shares. Holders of shares become part-owners of the company. ( b ) Debt is the sale of debentures, bills, or other debt products which give the holders contractually fied interest payments during the life of the products. 15. Yes. Share options can be used by a firm that epects additional future finance. Share options, when they are eercised provide additional equity funds to a firm at maturity date. 16. Ordinary shareholders are the owners of the company and have ultimate control over the firm s activities. Ordinary shareholders have limited liability, that is, their liability in the case of insolvency is the amount of unpaid calls. All major companies in Australia today have issued shares. In the case of winding up ordinary shareholders have a residual claim on the assets after secured and unsecured creditors and preference shareholders. Ordinary shareholders represent a perpetual claim having no maturity date, and are only entitled to a return in the form of dividends. Ordinary shares can be freely traded (bought and sold) on the Australian Securities echange (ASX). Their value or market price will fluctuate based on the forces of supply and demand. 17. A company s only internal source of equity funds is retained earnings. The major difference between retained earnings and other sources of equity finance is that there are no initial issue costs. 18. The drawer is the party who draws up or issues the draft, usually the borrower of funds. The draft states that it will be paid by the acceptor. The drawer has secondary liability on the bill, after the acceptor. 6

5 The acceptor is the party who undertakes to meet the payment of the bill and incurs primary liability on the bill. The discounter or payee is the party to whom the bill is to be paid to on the due date. The payee is the initial lender of the funds and has a choice of holding the bill to maturity or trading it on a discount basis. 19. Any company with idle cash may lend in the inter-company market. This may be at call, 24 hours or for a fied period. Only a small number of companies borrow on the inter-company market. The loans are frequently unsecured, restricting borrowers to only companies with high credit ratings. 20. A promissory note is:... an unconditional promise in writing, signed by the maker, (borrower) agreeing to pay, on demand or at a fied or determinable future time, a sum certain in money, to or to the order of a specified person, or to bearer. Although promissory notes are bills of echange, there are a number of features which distinguish them. Promissory notes do not require endorsement, and therefore holders acquire no liability. Also the borrowing company s name. Put simply the borrower promises to pay the bearer of the note. 21. The ordinary shareholders are the residual owners of a firm. Collectively they own the company and carry the risks associated with ownership. All major companies are formed as companies limited by shares. This means if liquidation occurs and the creditors cannot be fully satisfied from the proceeds of the assets, the liability of the shareholders is limited to the amount unpaid on the shares. Shareholders who s shares are fully paid incur no further liability to contribute if liquidation occurs. In the event of a surplus on liquidation shareholders would receive any sum remaining in proportion to the capital subscribed. 22. Preference Shares Ordinary Shares Preference as to dividend payment Have voting rights Preference as to return of capital More Popular v s preference shares Usually set percentage interest rate 23. Fleible line of approved credit Only pay interest on funds borrowed 24. Debentures are always secured by either a floating charge over specific assets or a floating charge over all or part of a firm s assets. Unsecured notes have no security at all. Because of the additional risk associated with an investment in unsecured notes the return to investors is higher. 7

6 25. 3 Mortgage 5 Creditors 1 Preference Shares 2 Ordinary Shares 4 Deferred Shares 8

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