26Business f inance. Activity 26.1 (page 477)

26Business f inance Activity 26.1 (page 477) 1 Using the list of reasons why businesses require finance on page 476, identify: two business situations that are likely to need long-term finance (more than five years) [2] Expansion a business needs to purchase new fixed assets, e.g. an airline purchasing new aeroplanes. Research and development a pharmaceutical company, such as GSK, financing research into new treatments. two business situations that might require only short-term finance. [2] Building up stocks a business needs to increase purchases of stocks approaching a peak in seasonal demand. Paying bills a business needing to pay expenses such as rent for premises. In each case, explain your answer. [6] 2 Sheila and her friend Alison have decided to run their own mobile hairdressing business using the training they have received at college and the experience they both gained working for three years for a local hairdresser. Investigate, locally, the equipment and working stock they will need. From this, estimate the capital they will need to set up the business and survive the first year. Write a brief report on your findings. The report will need to identify: Capital equipment costs, including: transport, e.g. car hairdressing equipment such as scissors, brushes and combs, protective gowns mobile phone, computer equipment hairdryer. Working capital costs: hair products, e.g. shampoo and conditioners petrol. 1

Activity 26.2 (page 478): Directphone Ltd 1 Calculate the proposed increase in the working capital requirements of the business resulting from the expansion. [6] increase in stationery needs = 10% of $10,000 = $1,000. increase in debtors = 50,000 40,000 = $10,000. increase in cash reserves = 35,000 30,000 = $5,000. increase in creditors = 50,000 40,000 = $10,000. increase in working capital = increase in current assets increase in current liabilities = (1,000 + 10,000 + 5,000) 10,000 = $6,000 2 Outline two ways in which this increase in working capital might be financed. [4] Overdraft an overdraft is an external short-term source of finance that could be used to fund the increase in working capital needed. Although an overdraft is only temporary, it is possible for continued renewal of the agreement and it can become, in effect, an indefinite source of finance. The overdraft would provide immediate funds for increasing stocks of stationery. A bank loan this would provide an injection of cash into the business, but would have to be paid back according to the terms of the loan and would increase Directphone s expenses. Sale of shares this would provide a permanent source of finance to fund the increase in working capital. It would depend on whether existing shareholders were prepared to buy more shares in the business. Activity 26.3 (page 480): Internal finance 1 In each of the following cases, explain briefly why internal sources of finance might be unavailable or inadequate: a business needs to pay creditors after a period when it has made losses and the value of its assets have fallen [2] If losses have been made, then there may have been an outflow of cash to cover expenses which has not been matched by an inflow of cash from sales. If the value of assets has fallen, then it may be difficult to sell those assets to raise finance. the rapid expansion of a business, which requires expenditure several times greater than current profits [2] As profits are insufficient to cover the expenditure, the business may have to look toward external finance. As the business is expanding, it may not have unused assets which it can sell. the purchase of additional stocks by a retailer just before Christmas. [2] The firm may face seasonal demand for products and, therefore, be short of working capital before Christmas as a high proportion of sales may be made during the Christmas period. 2

Activity 26.4 (page 481): EIB loans 30m for aeronautics R and D 1 Do you agree that loan capital was the best source of finance for this company for this project? Justify your answer. [12] In considering sources of finance, it is usually considered advantageous to match the terms of the finance with the nature of the expenditure. Thus, as the capital is required for a long-term research and development project, it is appropriate to use a long-term source of finance. The product of the research and development should generate revenue to repay the loan in future years. Other relevant factors include: Interest rates are at an historical low due to the recession. This means that the cost of borrowing is low. Debt finance has the disadvantage of having to pay interest whatever the trading conditions. However, interest is an expense and, therefore, reduces taxable profits, whereas dividends paid to shareholders are not an expense. Suitability of loans depends partly on the gearing of the business. Raising finance through a share issue would be difficult because of volatility in the stock market. Shareholders are nervous of making investments because share prices may fall. An advantage of shareholder capital is that it does not have to be repaid it is permanent. Consequently, if the business is not profitable, it could choose to reduce dividends. However, attracting shareholders may be difficult because the benefits of R&D may be very long term and, consequently, shareholders will not benefit from increased dividends in the short term. Selling shares may dilute ownership of the business as new shareholders become part-owners of the business. Retained profits of the business may be insufficient to finance the project and the firm may be building its cash reserves to guard against potential problems as a result of the recession. Activity 26.5 (page 483): Indian companies take AIM 1 Why do you think the Indian companies decided to join AIM rather than the full Stock Exchange? [4] The companies can get some of the benefits of a full listing, such as access to international capital, but without the costs or controls of a full public listing. AIM has a more flexible regulatory system. AIM is a flexible market that does not stipulate minimum requirements for: company size track record the number of shares in public hands market capitalisation. 2 Peacocks decided to issue shares by prospectus to the general public. Why do you think this method of selling shares was selected? [4] 3

Peacocks was seeking to raise a substantial amount of capital. A share issue by prospectus, although expensive, advertises the company to the public and, therefore, will appeal to a broad cross-section of investors. Thus, it is more likely that the share issue will successfully attract sufficient investors. 3 What did the managing director of Peacocks mean when he said that there were advantages in selling shares to repay debt? What are the advantages of repaying debts? [6] Debts have to be serviced, that is interest paid on borrowing. Thus, if Peacocks repays the debt, it will reduce the firm s interest burden. Interest is an expense and it, therefore, reduces profits. Further, interest payments must be made or the business could be forced into insolvency. At a time of economic uncertainty, it will be beneficial to reduce a firm s exposure to debt interest. Shareholders provide permanent capital, and, although over time dividends have to be paid, it is possible for a business to declare no dividend in difficult trading times. 4 Why do you think Incitec Pivot decided to use a rights issue of shares to raise capital? [4] A rights issue is a cheaper way of raising capital than a public issue by prospectus because Incitec does not have to incur the expense of advertising the shares to the public. Further, a rights issue does not broaden share ownership in the business. Although the shares are offered at a 40% discount, this does not represent a cost to the business, simply an incentive to existing shareholders to purchase more shares. 5 Evaluate whether a shareholder in Incitec Pivot would be advised to buy the rights issue of shares being offered. [8] Relevant issues include: A 40% discount is being offered A$2.50 instead of the quoted price of A$4.17. Thus, there is a substantial margin for a return to be made. The rights issue, by increasing the number of shares, will lead to a decrease in the listed share price. This will reduce the capital gain that could be made. Incitec has tripled its profits over the last year. This is partly a result of a recent takeover. This could suggest that the firm is being effectively managed. Fertiliser prices are volatile, so the increase in profits could be short term. As Incitec intends to repay debt this will reduce the interest payments and help boost profits further. Evaluation may consider: Decision may be influenced by consideration of the likely share price in the future being above A$2.50. This depends on many factors, including the state of the economy. With volatile share prices around the world, Incitec are offering a substantial discount to make the rights issue a success; that is, there is probably an expectation that share prices will dip. However, the 40% discount offers the potential for a quick profit if the market responds favourably to Incitec s decision to reduce its debt burden. 4

Activity 26.6 (page 486): Sources of finance 1 Copy the following table and complete it by ticking the appropriate boxes alongside each source of finance. [9] Sources of finance Sale of shares to the public Longterm finance Mediumterm finance Shortterm finance Available to unincorporated businesses Available to private limited companies Available to public limited companies Sale of debentures Leasing Debt factoring Loans from family Take on partners Rights issue of shares Ten-year bank loan Bank overdraft Activity 26.7 (page 488): Going exclusive with ice cream 1 What is meant by a venture capitalist? [3] A venture capitalist is an organisation that specialises in lending money to, or purchasing shares in, businesses that find it difficult to raise money from other sources. They specialise in high-risk investments that have the potential for good profit. 2 Outline the benefits for Omah and Sara in preparing a detailed business plan for their new proposal. [8] Business plans provide a number of benefits including: Planning for the future reduces the risk of failure. The plan provides focus and direction for the ice-cream bar. It will force Omah and Sara to consider all relevant aspects of running the business. A plan helps test the viability of the business proposal through financial forecasts. 5

The plan enables a review of the business s progress in meeting targets. The bank will not lend money without a detailed plan. Without further capital, Omah and Sara cannot start the ice-cream bar. 3 Discuss what further work on the business plan the bank manager might have been requesting Omah and Sara to undertake. [8] Further market research Omah and Sara had only asked friends and work colleagues. More detailed break-down of start-up and working capital required about $50,000 is a little vague. Cash-flow forecasts should be provided. Projected income statement should be provided. Clarifying the short- and long-term goals of the business Omah and Sara appear to have differing expectations of the business. 4 To what extent would a bank loan be preferable to venture capital to finance this new business start-up? [10] Venture capital may be more expensive because it is typically taken because banks are unwilling to lend money. Sara and Omah will retain control of the business if they secure a bank loan. If venture capital is used, the venture capitalist may wish to take an equity stake in the business. This would mean that Sara and Omah do not control the business by themselves the venture capitalist may also exert some control over the direction of the business. Sara wants to be her own boss. If a venture capitalist supports the start-up, there is more likely to be interference in the direction of the business. If an equity stake is given, then the venture capitalist will take a dividend from the business indefinitely, whereas a bank loan has a fixed repayment date and interest payments stop once the loan is repaid. Venture capitalists will charge substantial arrangement fees for their investment. The extent to which a loan is preferred will depend, in part, on the form in which venture capital is being offered. If the venture capital is in return for a stake in the business and, therefore, a share of future profits, Sara and Omah are likely to prefer a bank loan. 5 Evaluate two factors that might determine the success of this new venture. [8] Many factors could be considered including: Securing sufficient financing to fund the start-up many businesses fail in their first year as a result of being underfinanced. Sara and Omah have estimated that they need $80,000 will this be enough? Competition are there established franchises in the same city? State of the economy as the product is high-priced and a luxury, if there is a downturn in the economy, demand may fall substantially. Friends and colleagues felt that the suggested price of $2 per standard cone was high do you agree? 6

Activity 26.8 answer provided on Student s CD-ROM. Activity 26.9 (page 489): Telkonet raises $3.5m by sale of debentures 1 Explain the terms: convertible debentures [2] A debenture is a long-term bond. If it is convertible, then after a period of time the debenture can be converted into shares and, therefore, the borrower never has to pay the debenture back. working capital. [2] In accounting terms, this is the difference between current assets and current liabilities. Working capital is the day-to-day finance required for running the business. 2 Explain the benefits to both companies of raising finance through sale of debentures rather than either selling shares or taking a long-term bank loan with variable interest rates. [10] This approach offers a number of benefits: Interest is fixed. This will help Telkonet and CuraGen plan cash flows in the future, whereas a variable-rate bank loan may result in substantial changes in interest payments. The success of a share issue will depend, in part, on the stability of the stock market. Telkonet is trying to raise finance at a time when stock markets are suffering from falling share prices. The interest paid on debentures is an expense and thus reduces taxable profit. Issuing shares will result in dividend payments; however, dividends are not treated as an expense. For CuraGen, the advantage of issuing a convertible debenture is that it will reduce interest payments. Lower interest is offered because the debenture holder will be further rewarded, after seven years, when the debenture is converted into stock. Revision case study 1 (page 490): Sharma Taxis needs finance as it expands 1 Identify the stages of this business s development where additional finance was required. [4] start-up growth to purchase additional vehicles and a small garage growth and diversification into road haulage expansion through takeover of taxi business 7

2 At each of the stages you have identified, explain what type of finance was needed. [4] start-up long-term finance (owner s savings) required to purchase vehicle growth long-term finance (capital from a new partner) for purchase of further fixed assets diversification long-term finance (equity finance) to purchase fixed assets and short-term finance to boost working capital and offer business clients credit expansion long-term finance (retained profits and further equity finance) 3 In your opinion, how could the increase in spare parts and debtors of the business have been financed? [4] A number of options could have been available including: trade credit for spare parts overdraft facility to provide funding for spare parts and debtors. As the increase in spare parts and debtors requires an increase in working capital over the long term, Sharma Taxis might also consider a longer-term injection of capital into the business through, for example, a bank loan. 4 Examine the decision by the directors to float the company on the AIM. [8] This is cheaper than a full stock market listing and the AIM is less regulated. It gives access to international capital rather than depending on existing shareholders. It will dilute ownership of the business and will reduce the control of the original partners. Equity finance is permanent and never has to be repaid. It avoids debt finance with the associated risk of operational profits being insufficient to cover interest payments. Using debt finance has the advantage of there being no loss of control and interest being an expense that reduces tax paid. 5 If the company were to expand further, evaluate the case for and against financing this expansion with a long-term loan. [10] For: Interest is an expense to the business and, therefore, reduces taxable profits. It avoids further dilution of ownership of the business. Against: Interest payments have to be paid, whereas dividends do not. Interest rates can change, leading to a potentially costly increase in interest payments. Evaluation may consider: The amount required. The current and future level of interest rates. The extent to which the owners want to retain control of the business. 8

Revision case study 2 (page 491): easyjet takes off to 342p share price 1 easyjet s sale of shares to the public raised 195 million. What did management intend to spend this capital on? [4] The capital was needed to purchase new aircraft to enable easyjet to expand its operations over the subsequent four-year period. easyjet wanted to more than double the size of its fleet of aircraft. 2 Explain possible reasons why Stelios, the founder and chairman, chose to go public with easyjet rather than take out loan finance. [8] Equity finance is permanent and does not have to be repaid. Loans would increase the gearing of easyjet. The more highly geared a business is, the greater the risk taken. easyjet was seeking to raise nearly 200 million 25% of the total share capital of the business. This would have had a substantial impact on gearing if it had been borrowed. Debt has to be serviced, that is interest paid. A good example of the impact of this is Liverpool FC. When the football club was purchased by its current owners, they borrowed the money to fund the acquisition. As a consequence, Liverpool now has to use its operational profits to pay interest. In 2009, as a result of the 350 million debt, the club s parent company made a loss of over $42 million with interest payments accounting for over 36 million of the loss. The timing of the share issue was beneficial as the stock market was performing well and, therefore, it was likely that the share issue would be successful. 3 Explain why Stelios might be reluctant to sell a further 63 million shares in easyjet to raise additional capital. [4] Stelios and his brother and sister will wish to retain control of the business. They currently control 75% of the shares; if another 63 million shares were issued, their stake in the business would fall to around 60%. Profits would be shared among more shareholders and, therefore, the dividend received by Stelios would, potentially, be reduced. 4 Use the internet to research: easyjet s current share price. Comment on whether buying the company s shares has been a good investment since 2000. easyjet s latest profit figures ( www.easyjet.com). How are the profits of a business such as this likely to be affected by world economic growth or recession? [8] Have easyjet s shares been a good investment since 2000? Current share price is 399 pence (January 2010). As the share price has risen since 2000 shareholders will make a capital gain if they sell their shares. However, share prices fluctuate considerably and the price of easyjet shares has been below the original offer price of 310 pence at various points during the 9

last ten years. For example, in 2009 easyjet s share price fluctuated from a low of 262p in July to a high of 411p in November. Shares are not purchased just for a possible capital gain; they also provide dividend payments. The level of dividends paid out over the years should be taken into account in assessing whether easyjet shares have been a good investment. Latest profit figures: Profits for the year ended September 30th 2009 easyjet made an underlying pre-tax profit of 43.7 million. The profits of easyjet will not be affected as much as airlines such as British Airways that depend more on business and first-class passengers. As easyjet is a low-cost carrier it has seen passenger numbers continue to grow as households focus more on value for money in their purchasing decisions. Essay 1 a Outline the main sources of long-term external finance available to a limited company. [10] Long-term external finance Loans Venture capital Commercial mortgage Debentures Share capital Commentary Business repays the capital borrowed with the addition of interest. For a fixed-rate loan, repayments are known in advance. Fixed rates provide certainty of repayment amounts. Variable-rate loans change as interest rates go up or down. Collateral may be required. These are a form of debt finance. This may be in the form of a loan or in return for an equity stake. Venture capitalists specialise in high-risk ventures that offer potentially high returns. This is similar to a long-term loan. It is used to purchase property. The property acts as security for the lender. This is a form of debt finance. These are long-term bonds issued by companies. They can be for as long as 25 years. They usually have a fixed rate of interest. They can be secured to company assets. These are a form of debt finance. All limited companies have share capital when formed. Further shares can be issued up to the authorised share capital. Shares cannot be sold publicly if it is a private limited company. This is a form of equity finance. Share capital is permanent and is never repaid (unless the business is wound up). Dividends paid to ordinary shareholders are at the discretion of the board. 10

b Explain why a business might be reluctant to finance long-term expansion plans with a long-term loan. [15] A long-term loan is a form of debt finance and requires interest to be paid. Interest is an expense to the business so, although it reduces the taxable profit of a business, it has to be paid whatever the trading conditions. Therefore, increasing the level of debt finance carries more risk than securing equity finance. A business needs to consider its ability to cover interest payments from its revenues and after other expenses have been paid. If a business has a low interest-cover ratio, it might be unwise to borrow more, as interest payments will increase and it may be some time before expansion generates the cash inflows to pay the interest. Gearing is also an important factor. A business with a high debt-to-equity ratio is at much greater risk of defaulting on its loan repayments. Further borrowing will increase that risk. In contrast, equity finance does not have to be repaid, and, if trading conditions are poor, directors can choose not to declare a dividend. Interest rates can increase over time, resulting in a significant increase in loan repayments. Loans may have to be secured against the assets of the business, putting those assets at risk in the event of defaulting on repayments. Further reading Consider the case of Liverpool Football club; see: http://www.timesonline.co.uk/tol/sport/football/premier_league/liverpool/ article6433469.ece 11