CORPORATE FINANCE
SOURCES OF FINANCE
After studying this Chapter , you should be able to:
 Discuss the various sources of short term and long term
finance
 Explain different methods of issuing shares
 Describe the different factors that influence the use of debt
finance
 Evaluate and discuss the suitable financing decisions
In your own words, What do you understand the
phrase; Sources of Finance and why is it so
important in the business world?
 Financing decision is one of the main components of corporate
financial management that has an effect on the objective of
maximize shareholder wealth.
 When considering this area, the main objective is to identify the
cost-effective sources of finance.
 There are two main Sources of finance (Business finance)
a) Debt Finance
b) Equity Finance
 Business finance is then subdividend into;
a) Short term sources of finance
b) Long term sources of Finance
Factors to consider when seeking finance
 Duration: - for how long is the finance required?
 Duration depends on the reason and amount of funds needed. No-one would take out a
25 year mortgage to finance the purchase of a personal computer or would buy a house
with a bank overdraft.
 Businesses apply the same principles of matching the purpose of finance with the
source of finance.
 Cost: - In general, businesses look for the cheapest source of finance, even though this is
not always easy. The easiest way to compare the cost of finance is to express the annual
payment to lenders or investors as a percentage of the amount of finance provided.
 Interest on a loan can be expressed in percentage terms. So can the rate of return to
shareholders.
 Return on investment in shares =Dividend per share, share price change since the start
of year. The rate of return expected by shareholders becomes the cost to the business
of using this form of finance.
 Repayment: - what level is acceptable?
 A business should not get into a position where all of its profits are
being swallowed up in interest payments.
 There is a real danger of borrowing too much. The same applies to
individuals.
 If all of the company’s profits are being used to repay loan interest, the
company runs the risk of closure because it would eventually have no
working capital.
 It is like an individual using up all his salary to pay his salary advances
and staff loans. He would have nothing left to finance his home
operations.
CLASS DISCUSSION
What is the difference between Short term and Long term
Finance? Give an example of each and explain why it is a short
term or long term Finance
The main Difference between Short term and Long term Finance
 Short term finances have maturities of less than one year and usually
used for working capital requirements for day to day operations of a
business.
 long-term finance on the other hand have maturities longer than one
year and are usually financed Capital investments (Expenditures) i.e
purchases a special machine that will reduce operating costs over, say, the
next five years.
 The main sources of short term sources of finance includes;
i. Bank overdraft
ii. Short term loan
iii. Trade credit
iv. Lease finance
v. Letters of Credits
vi. Invoice discounting
 The main sources of long term sources of finance Includes
i. Equity finance
ii. Preference Shares
iii. Debt finance
iv. Lease finance
v. Venture capital
(I) EQUITY FINANCE
This is finance which is provided by the ordinary shareholders.
 It comprises of share capital and retained earnings. Retained earnings are
simply undistributed profit.
 The level of retained earnings in a business depends on the company’s level
of profitability and the associated dividend policy.
 Assuming the business is profitable, the dividend a company pays out
reduces the retained earnings and/finance available for business activities
and vice versa.
 Share capital can be raised through the following methods;
a) Placing or placement or selective marketing
b) Public offer
c) Rights issues
a) A Placing -is an arrangement whereby not all shares are issued to the public, but a
sponsoring market maker arranges most of the shares to be bought by a small
number of investors such as pension funds and insurance companies.
b) Public offer - is a direct sale to the general public. This can be an offer for sale
particularly an Initial Public Offer (IPO) or a sale by tender. Under an IPO or offer
for sale, the shares are advertised at a fixed price and the general public is invited to
buy or subscribe for the shares at this price. In case of sale by tender, the general
public is invited to bid for shares.
c) Rights issue –this is an offer of additional shares to existing shareholders at a
discount to the current market price and in proportion to their current shareholding.
The discount offered causes the theoretical ex-rights price (TERP) to be lower than
pre-rights issue price.
Practice Question for Rights issue
Chasuko Enterprises Limited’s capital structure comprises of 8 million K0.25 ordinary
shares. Current ordinary share price is K4·50 .The business is considering raising
additional finance using a 1- for – 4 rights issues of shares at a 20% discount to the
current share price. The extra finance is required in order to support the replacement of
worn out assets.
Required:
Assuming the rights issue takes place and ignoring the proposed use of the funds raised
and issue costs, calculate:
a) The rights issue price per share;
b) The cash raised;
c) The theoretical ex rights price per share; and
d) The market capitalization of PC co.’s shares post rights issue
PREFERENCE SHARES
 Preference shares have a fixed percentage dividend before any dividend is paid to
the ordinary shareholders.
 As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the
right to an unpaid dividend is carried forward to later years.
 The arrears of dividend on cumulative preference shares must be paid before any
dividend is paid to the ordinary shareholders.
 From the company's point of view, preference shares are advantageous in that:
 Dividends do not have to be paid in a year in which profits are poor, while this is
not the case with interest payments on long term debt (loans or debentures);
 Since they do not carry voting rights, preference shares avoid diluting the control
of existing shareholders while an issue of equity shares would not;
 Unless they are redeemable, issuing preference shares will lower the company's
gearing. Redeemable preference shares are normally treated as debt when gearing
is calculated;
 The issue of preference shares does not restrict the company's borrowing power,
at least in the sense that preference share capital is not secured against assets in
the business; and
 The non-payment of dividend does not give the preference shareholders the right
to appoint a receiver, a right which is normally given to debenture holders.
 However, dividend payments on preference shares are not tax deductible in the way
that interest payments on debt are.
 Furthermore, for preference shares to be attractive to investors, the level of
payment needs to be higher than for interest on debt to compensate for the
additional risks.
 For the investor, preference shares are less attractive than loan stock because:
 They cannot be secured on the company's assets; and
 The dividend yield traditionally offered on preference dividends has been much
too low to provide an attractive investment compared with the interest yields on
loan stock in view of the additional risk involved.
(II). DEBT FINANCE
 Debt finance is finance that is raised through borrowing.
 This can take the form of bank loan or tradable securities like bonds or loan notes.
 Bank loans are term loan that are liquidated through amortization.
 Debt finance may be secured or unsecured. Interest payable on borrowed funds may be
fixed or index-linked (floating).
 The amount of debt finance in the firm’s capital structure is referred to as capital
gearing. Therefore, gearing (financial risk) rises with an increase in borrowed funds.
 Factors that might influence the choice of debt finance include.
a) Fixed or floating interest rate
b) Availability of specific forms of debt finance
c) Duration or life of the loan
d) Security and covenants imposed by the lender
e) Capital gearing; the current level of long term debt in the business and their
maturity dates
EFFECTS OF BORROWING
 Suppose our company is financed entirely by ordinary shares (equity). What would be
the effects of issuing some debt capital? The main advantage of borrowing is that debt
has a cheaper direct cost than equity. There are two distinct reasons for this:
i. Debt is less risky to the investor than equity (low risk results in a low required return);
and
ii. Interest payments are allowable against corporate taxation, whereas dividends are not.
 However, borrowing has two distinct disadvantages.
 Firstly it causes shareholders to suffer increased volatility of earnings. This is known
as financial leverage.
 For example, if a firm is financed entirely by equity, a 10% reduction in operating
earnings will result in a 10% reduction in earnings per share. But if the firm is
financed by debt as well as equity, a 10% reduction in operating earnings causes a
greater reduction in earnings per share than 10%, because debt interest does not
reduce in line with operating earnings.
The increased volatility to shareholders’ returns resulting from financial
leverage causes shareholders to demand a higher rate of return in
compensation.
In other words, any borrowing at all will cause the cost of equity capital to
rise, off-setting the cheap direct cost of debt.
 The second disadvantage of borrowing is that if the company borrows
too much, it increases its bankruptcy risks. At reasonable levels of gearing
this effect will be imperceptible, but it becomes significant for highly
geared companies and results in a range of risks and costs which have the
effect of increasing the company’s cost of capital.
Below is a table summarizing the advantages and disadvantages of debt financing
Two advantages and two disadvantages of borrowing
Advantages
Disadvantages
 Cheap direct cost because debt is less
 Financial leverage causes shareholders to
risky to the investor
increase their cost of capital
 Cheap direct cost because interest is a tax  Bankruptcy risks if borrowings are too
deductible expense.
high.
(III). LEASE FINANCE
 A leasing agreement is between two parties – a lessor and a lessee. A financier
(the lessor) purchases the asset and provides it for use by the company (the
lessee).
 The lessee makes payments to the lessor for the use of the asset.
 There are two forms of leases – finance leases and operating leases.
 Finance leases are leases in which the lessor (the owner) will expect to recoup the
whole (or most) of his cost of performing the contract during the initial period of
rental, referred to as the basic lease period (or primary term).
 At the end of the period the asset is generally leased for a further period for a
peppercorn rent or sold by the lessor to the lessee.
 The servicing and maintenance of the asset is the lessee's responsibility. Finance leases
are reported on the face of the statement of financial position (Balance sheet) of the
lessee.
(IV) VENTURE CAPITAL
 Venture capital is private equity from high worth individuals in form of
venture capital funds.
 These individuals would want to invest cash in return for shares in private
companies.
 Most SMEs will not be big enough for venture capital finance. The following
are ventures that might be invested:
a) Business start-ups: When someone has already put resources and time to
start a business, the venture capitalist might provide more finance.
b) Business development: Venture capitalists might be willing to provide
development capital for a company which wants to invest in new products
or market.
c) Management Buyout: A management buyout is the purchase of all or
parts of the business from the owners by management.
TYPICAL EXAM QUESTIONS
QUESTION ONE
The management of Chasuko Enterprises Limited are considering
investing in a new Production machine. The company has proposed to
either borrow the necessary funds from its bank at 9% and purchase
the Machinery or enter into a finance lease involving five annual year
end payments of K2.4m. The new Machinery costs K10m and would
attract capital allowances at 20% on straight line basis over its five year
life for its owners. Company tax is 35% payable in the year of the
relevant profits. As a financial manager of Chasuko Enterprises Ltd,
you have been asked by management to advise on the possible ways on
how the company can finance the purchase of new Machinery.
Required:
a) Write the Report to management explaining to them on the
possible ways on how the purchase of new machinery can be
financed, giving merits and demerits of each of the suggested
financing options
b) Calculate and advise the management on which of the two
proposed options, (borrowing or leasing), is financially more
advantageous for the company and why.
QUESTION TWO
(a)Twadya Limited a food Manufacturing company in Lusaka needs to raise
ZMW4 million to pay for its food processing equipment. The company has
proposed to raise the funds through the rights of 1 for 4. The company
currently has 2 million shares priced at K10 each. Ignore issuing costs.
Required:
(i) Calculate the No. of new shares to be issued and rights issue price in order
to raise the required funds of ZMW4 Million
(ii)What will be the share price after the rights issue?
(5 marks)
(4 marks)
(iii)The market capitalization of Twadya Limited’s shares after rights issue
(4 marks)
(a)Debt finance is another source of long term capital for
companies.
(i)Explain any three types of debt Finance that are available to
companies.
(6 marks)
In relation to a company sourcing capital, describe three benefits
of using equity finance.
(6 marks)
THE END