Sources of funds
Financial Management (Correia – 9th
Ed.) - Chapters 13, 14 and 15.
Managerial Finance (MAF III Textbook)
– Chapter 7
Avani Sebastian
FNB 134A
avani.sebastian@wits.ac.za
2
LEARNING OUTCOMES
Learning Outcome
Level
Demonstrate knowledge of basic corporate funding arrangements, including
how measures in capital and money markets function
1
Evaluate possible sources of funding available to the organisation taking into
consideration its size and stage of development (e.g., crowd sourcing for startup businesses) and identify the most appropriate sources of funding to achieve
its business strategies and objectives, including value creation for stakeholders
3
Recommend appropriate funding arrangements after consideration of related
consequences, costs, benefits, implications for operational and future
financing decisions and tax, and other legal implications
3
Develop a financial proposal or financing plan that agrees with outcomes in the
organisation’s strategic objectives
3
Asset-specific finance: Lease vs. borrowing to buy
3
Source: SAICA’s Competency Framework: Updated on 17 February 2024
Denotes a Professional Value or Enabling Acumen per the SAICA
Competency Framework for the “CA of the Future”
3
Financial Markets
• What are the types of financial markets?
• Money Markets
• The money market is used mainly for short-term finance
• Because they deal in financial instruments with a life of less than three years
• It is operated by investment banks, commercial banks and finance houses
• Capital Markets
• The capital market is used mostly for raising long term finance – e.g. the JSE
• They are suitable for instruments with a life greater than three years e.g.
shares of a company listed on the JSE and long-term debentures
• Primary Markets
• For new issues of finance e.g. ___________________________________
• Secondary Market
• Not a source of finance but indicates marketability and value of securities
already issued. E.g.
• Formal Markets
• Highly regulated, specialised
• E.g. JSE, JSE Debt Market
• Over-the-counter (OTC) Markets
• Informal deals - there is a need for informal markets to allow parties to
innovate according to their needs (e.g. currency)
4
Financial Markets
• Spot and derivative market
• Spot : Instruments are traded at the agreed price immediately
• Derivative: Settlement is deferred (used to manage risk)
• Classification of markets: If you sold 1000 iOCO shares, this transaction
would have involved the following financial markets:
Business Acumen
5
Johannesburg Stock Exchange
• Formed to provide a marketplace for the trading of shares for the many mining
and financial companies formed after the discovery of gold
• Governed by the Financial Markets Act, 2012 and by its own rules and directives
• Since February 2002, all transactions on the JSE are traded and settled
electronically
• The main types of securities listed on the JSE are:
• Ordinary shares
• Preference shares
• Warrants
• Futures
• Options
• Why list?
6
Johannesburg Stock Exchange
• Why NOT list?
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Johannesburg Stock Exchange
• Listing Requirements
Business Acumen / Lifelong learning
https://www.businesslive.co.za/bd/companies/financial-services/2024-10-18-new-era-for-jse-in-biggest-shake-up/
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Johannesburg Stock Exchange
Critical thinking
Lifelong learning
https://www.businesslive.co.za/fm/opinion/boardroom-tails/2024-02-22-ann-crotty-company-governance-regulations-have-achieved-little/
https://cdn.ymaws.com/www.iodsa.co.za/resource/collection/7DAE15BF-07FA-4922-879E-6788368F5DB4/KingV_code.pdf
9
Alternative Exchange - AltX
• Market for small and medium sized companies. AltX is a division of the JSE.
• Listing requirements are less onerous
A2X Market
• Commenced trading in April 2017 with three listings
• By November 2018, companies such as Standard Bank, Growthpoint,
Sanlam, AVI were listed on the A2X
• Alternative place to transact
• A2X is only available for secondary listings – no IPOs
• Lower transaction costs
10
JSE Derivatives Market
• Market for trading of derivatives such as futures and options
• Futures Contracts
• Options
JSE Debt Market
• The market for the issue & listing of new corporate bonds
• Listing of debt securities issued by government, parastatals and large
companies.
• Fixed rate and floating rate securities
• Zero coupon bonds
• Inflation linked bonds
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JSE Liquidity
• What does market liquidity mean?
• Why is market liquidity important?
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Methods of Obtaining a Listing
Public Offer
• Initial public offering
• Company is required to produce a pre-listing statement or prospectus
Introduction
• The firm already has the requisite number of public shareholders and capital
• No need to make an offer to the public
• Low cost option
Private Placement
• Ordinary shares are sold directly to a group of institutional investors
• Proportionate ownership may be diluted
• No underwriting and much quicker than rights issue or public offer
• No prospectus required
‘Back door” Listing
• Also known as a “reverse takeover”
• Private company acquires a listed company to bypass the IPO process.
• Private company’s shareholders receive a majority stake in the public company,
effectively taking control.
• Refer to Final Exam 2023 for an example
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Methods of Obtaining a Listing
Business Acumen
https://www.businesslive.co.za/bd/companies/retail-and-consumer/2025-01-07-stock-watch-pick-n-pay-scrambles-to-turn-the-corner-afterboxer-ipo/
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Rights Issues
•
•
•
Company raises capital by inviting existing shareholders to buy more shares in
the company
Proportionate ownership remains constant if all shareholders take up their
rights
Issue price at a discount to current listed price
Advantages of a rights issue:
• Cheaper than an offer for sale to the general public. Administration costs are
cheaper and the company does not normally require a prospectus. The
expenditure on marketing will also be reduced since the investors are familiar
with the company.
• If the shares are issued at a discount it is an attractive investment opportunity to t
he existing shareholders.
• The existing voting rights and therefore the control of the company – are
unaffected if all shareholders exercise their rights.
• In the case of a business organisation with excessive leverage, the capital raised
by a rights issue can be used to move the business closer to its target capital
structure.
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Rights Issues
•
Class Example
Co. has 90m shares in issue. The current price is R6 and
the company wishes to raise R50m. The Co. plans to issue
10m shares at R5.
What is value of the company after the rights issue?
What is the value of each right?
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Venture Capital & Private Equity
• Venture capital and private equity assist with launching and developing business
• Venture capital and private equity markets are less efficient than the public
markets
• Transaction costs are far higher
• There are a small number of buyers and sellers
• There are no reporting requirements – info is not freely available
• There are different investment objectives of venture capitalists and private
equity investors
• The risk of failure is higher than in formal markets
• Major private equity firms include;
• Brait
• Ethos
• Investec
• Consol Glass, Alexander Forbes and Edcon were private equity targets. These
companies were delisted. Consol and Alexander Forbes were later relisted.
Edcon was the largest private equity transaction valued at R25 billion at the time
and which has fallen on hard times
• Private equity firms will provide expertise and will organise financing and will
often increase the debt levels of firms
• Private Equity firms have a limited time horizon and will exit by listing or selling
the firm to another firm
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Industrial Development Corporation
• The IDC expects a meaningful contribution from the owner
• The owner must share the risk by funding 33% of total assets (40% if a new
business)
• The IDC considers loan finance which is equal to owner’s interest in the business
• Development is emphasized
• Empowerment related financial buy-ins or takeovers
IDC requires:
• Security
• Compliance with environmental requirements; and
• Reasonable financial contributions from owners
IDC does not cover replacement of existing sources of finance
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Business Partners
• Business Partners was formed to guide and promote entrepreneurship .
• Focus on small business
• It will invest up to R25m depending on the owner’s contribution, risk and
collateral
• Loans over 5-10 years and interest rate linked to prime rate
• Equity participation
Public Enterprises
• Public Investment Corporation
• Increased profile / active shareholder
• Assets under management > R1.4 trillion
• Financing of BEE transactions
• Financing between R20m and R2bn
• National Empowerment Fund (NEF)
• Sefa & Khula Enterprise Finance
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EQUITY RELATED INSTRUMENTS
• Ordinary shares
• Retained Earnings
• Preference Shares
• Preference shares promise a fixed dividend
• Preference dividends are not deductible
Participating Preference shares
Have a fixed dividend and share in the remaining profits of the company
Redeemable Preference shares
The company has the option or obligation to redeem them at a specific price on
a particular date
Convertible Preference shares
The holder has the right to exchange them for ordinary shares or securities on
prearranged terms
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DEBT RELATED INSTRUMENTS
•
•
•
Medium-term finance = between 1 and 3 years and 5 and 10 years is longterm finance
Classification of Debt :
•
Fixed Interest : Debt with a fixed rate of interest for the term of the issue
e.g. debentures
•
Variable interest : Interest that fluctuates according to market forcese.g. mortgage bonds
•
Secured debt
•
Unsecured debt
Loan of R8m at 11% repayable in instalments or by a single payment at end of
the term. What are the cash flows?
• Corporate Bonds and Debentures
• Main terms of bond, debenture and note issues are: repayment conditions,
interest rate, and security over certain assets
• Mortgage Bonds and Loans
• A mortgage bond is a long-term loan secured over the fixed property of the
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company
Credit Ratings
• Standard & Poor /
Moody’s – provide
independent ratings
of the risk of bond
issues
• Source: S&P Website
(https://www.spglob
al.com/ratings/en/pr
oductsbenefits/products/cr
edit-ratings)
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Inflation-linked Bonds
• Offer investors a hedge against inflation
•How does an inflation-linked bond work?
•Bond pays a fixed real coupon rate
•The nominal amount (principal) and the coupon increase with inflation.
•Example:
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Hybrid Instruments
• Hybrids – a combination of debt and equity
•What criteria is used in the classification of a hybrid instrument as either debt or
equity?
•Equity has a residual right
•Debt has a contractual right
•Payments for the use of debt are tax deductible
•Debt tends to have a finite life but the life of equity tends to be the life of the firm
•Equity holders have control of the firm, while debt holders do not
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Debt vs. Equity
Relationship between debt and equity = capital structure. There is always a trade-off
between risk and return. The use of debt increases risk and return.
•
Positive and Negative Leverage (Risk vs Return):
•When the company is earning more than the interest charged – the profits are
•
•
levered so that the return on shareholders’ funds is higher than the return on
assets
•When the return on assets is lower than the interest charge, then the reverse is
true. Negative leverage results in the return to shareholders being lower than
the return on assets.
Tax Deductibility
• Interest charge on debt is usually tax-deductible. Dividends are not taxdeductible
Cost of Debt
•
The cost of debt is usually less than the cost of equity. Why?
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Debt vs. Equity
Commitment
• Interest payments on debt must be met whether there are profits or not
Capital Repayment
• Debt usually requires a capital repayment
Capital Structure
• A limited amount of debt can be raised before the market re-evaluates the firm’s
risk profile – this is reflected in the cost of capital
• Raising debt reduces the firm’s flexibility for raising future debt finance
Control
Dilution of Control due to the issue of more shares or due to loan covenants:
• The issue of equity dilutes control
• Raising finance through debt may mean restrictions or covenants are imposed as
a condition of the loan
• Restrictive covenants could limit the company’s ability to pay dividends , dispose
of assets and raise additional borrowings. The company may be required to
maintain specified working capital ratios.
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Advantages and disadvantages of debt compared to equity
Advantages of debt finance
• Debt is generally a cheaper form of finance as the investor bears lower
risk
• Interest is normally tax deductible, reducing the effective cost to the
company
• Issue costs of debt are usually lower than that of shares
• Debt has no immediate impact on the control structure of the company
• Using debt finance does not affect the denominator of the organisations
performance measures of earnings and dividends per share. However,
interest may impact the profitability of the company, which could affect
the numerator.
Disadvantages of using debt finance
• Interest has to be paid, regardless of profitability. Capital also has to be
repaid in terms of an agreed repayment schedule. This could impact
negatively on the company’s cash flow and might even lead to
bankruptcy.
• Shareholders are likely to demand a higher return due to increased risk.
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Deciding on the best financing option
• The aim of the financing decision is to decide on the best financing option for a
proposed investment. In choosing this, several factors have to be considered:
• Financing possibilities – what are the available options, including asset-specific
finance (e.g. leasing)
• Capital structure – does the business have capacity for more debt? How close is
the business to its optimal (or target) capital structure?
• Cost considerations – which viable financing option is the most cost effective?
• Impact – what is the impact of each viable choice in finance on the business? E.g.
the impact on control, and the impact of debt covenants)
• Level of business risk – If cash inflows from the asset being financed are
uncertain then equity is safer.
• Matching – is there a proper match between expected investment cash inflows
and finance cash outflows?
• Security – advantages and disadvantages of offering assets for security
• Signalling effects – A company usually only raises debt finance if they are certain
they can cope with the additional financial risk
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Deciding on the best financing option
• The aim of the financing decision is to decide on the best financing option for a
proposed investment. In choosing this, several factors have to be considered:
• Financing possibilities – what are the available options, including asset-specific
finance (e.g. leasing)
• Capital structure – does the business have capacity for more debt? How close is
the business to its optimal (or target) capital structure?
• Cost considerations – which viable financing option is the most cost effective?
• Impact – what is the impact of each viable choice in finance on the business? E.g.
the impact on control, and the impact of debt covenants)
• Level of business risk – If cash inflows from the asset being financed are
uncertain then equity is safer.
• Matching – is there a proper match between expected investment cash inflows
and finance cash outflows?
• Security – advantages and disadvantages of offering assets for security
• Signalling effects – A company usually only raises debt finance if they are certain
they can cope with the additional financial risk
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ASSET SPECIFIC FINANCING - LEASING
• Since the default assumption in making an investment decision is that the firm
would take ownership and enjoy the associated tax benefits of wear and tear, the
decision to lease (where the firm does not obtain legal ownership) cannot be
directly compared to a decision to finance the asset using, for example, a loan
(where the firm obtains direct ownership).
• Where finance is asset specific, there will be a link between the investment
decision and the financing decision.
• The evaluation is as follows:
• Calculate the NPV.
• Calculate the NPC of each alternative.
• Calculate the net advantage of the asset specific finance by deducting the NPC
of asset specific finance from the NPC of borrowing.
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ASSET SPECIFIC FINANCING - LEASING
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Evaluating the leasing decision
• Lease vs. borrow & purchase
• Leasing is an alternative to borrowing
• Evaluation of leasing usually takes place once the investment decision has been
made.
• Evaluation = comparison of PV of lease cash flows to PV of borrow and purchase
cash flows
• What is the appropriate discount rate?
• Investment decisions – use the firm’s WACC to evaluate the project’s cash
flows
• Leasing is a financing decision – the correct discount rate is the incremental
after-tax cost of debt.
• Principle = financing cash flows are discounted at the after-tax cost of debt.
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Evaluating the leasing decision - NPC
• The after-tax cash flows for each finance alternative are discounted at Kd(1-t) to
arrive at a NPC.
• Assessed losses will defer tax shields.
• Compare the NPC of leasing against borrowing to purchase.
• Choose the lowest NPC alternative.
• Class Example
Cost of plant: R500 000. Loan at interest rate of 9.7222% or plant can
be leased at R125 000 per year, payable annually in advance.
Lease includes maintenance but if purchased, repairs will amount to
R25 000 per year. Residual value is R70 000.
Before tax cost of debt is 9.7222% and WACC is 12%.
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Evaluating the leasing decision - NPC
• What is the NPC of the lease option?
• What is the NPC of the borrow and purchase option?
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Evaluating the leasing decision - NAL
• An incremental analysis
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ASSET SPECIFIC FINANCING - LEASING
• What are the benefits of leasing?
• Changing technology
• Tax advantages
• Obtaining 100% debt financing
• Operating flexibility
• Coping with uncertain demand
• Specialisation effects on maintenance, residual values and purchase costs
• Standardisation of contracts
• Fewer restrictions
• Off-balance sheet financing if contract does not meet definition of a lease
• Avoidance of capital expenditure controls and budgetary constraints
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END
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