Module 7 and 8

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Module 7 and 8

• Short Term and Long Term Financing (chapter 9,10
  and 11)

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Learning Objectives

• By the end of this section you should be able to
• understand short-term sources of finance
• understand long-term sources of finance

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Financial Policy maturity matching principle

• Permanent investments (investments more than one
  year) long term financing
• Temporary investment (investments less than one
  year) short term financing

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Short-term Financing

• Short-term financing is defined as debt due for
  repayment within a period of 12 months.
• The major short-term borrowing choices available
  to Australian companies are
• trade credit (account payable)
• Bank overdraft
• factoring
• money market sources
• Interbank deposit (cash rate)(Overnight loan)
• issuing short-term marketable debt securities
  such as promissory notes and bills of exchange

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Borrowing From Banks and Other Financial
Institutions

• Bank Overdraft
• An overdraft permits a company to run its current
  (cheque) account into deficit up to an agreed
  limit.
• The cost of a bank overdraft includes the
  interest cost (currently about 9.85 p.a.) and
  fees.
• The interest rate charged is usually at a margin
  above an indicator rate, published regularly by
  the bank, and only on the amount by which the
  account is overdrawn.

6
Money Markets Sources

• The money market is an active market in which
  large sums of money may be lent and borrowed for
  short periods.
• Because of the large sums involved, nearly all
  participants are large and well-known entities.
• Most banks act as dealers in the market.
• Interest rates in the money market are determined
  by market forces.

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Money Markets Resources (cont.)

• Overnight loan
• Funds lent in the money market on the basis that
  either party can terminate the loan by giving
  notice by 11 a.m. on the following day. Also
  known as 11 a.m. money.
• Interbank overnight interest rate (cash rate) is
  a better indicator of conditions in short term
  money market.
• 24-hour loans funds lent in the money market,
  where the loan may be terminated or renegotiated
  after 7 days on 24 hours notice.

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Money Markets Resources (cont.)

• Short-Term Marketable Debt
• Companies can obtain short-term debt funding by
  issuing (selling) securities such as promissory
  notes and commercial bills (bills of exchange).
• The securities are a promise to pay a sum of
  money on a future date

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Short-Term Marketable Debt Promissory Notes

• A promise to pay a stated sum of money (such as
  500000) on a stated future date (such as a date
  90 days hence).
• Issuer of the note----borrower, the only party
  with an obligation to pay the face value at
  maturity, so also known as one-name paper or
  commercial paper.
• Discounter
• Purchaser of a short-term debt security such as
  a promissory note or a bill of exchange.

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Short-Term Marketable Debt Promissory Notes

• Face Value
• Sum promised to be paid in the future on the debt
  security.
• Credit risk of a promissory note depends on the
  credit standing of the issuer.
• Only large, reputable companies with a high
  credit rating and government entities are able to
  raise funds by issuing promissory notes, for
  example, Shell Australia, BHP Finance, Australian
  Wheat Board.

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Short-Term Marketable Debt Commercial Bills
(Bills of Exchange)

• CB are the means by which amounts of 100,000 or
  more can be borrowed for periods normally ranging
  from 90 to 180 days.
• CB is a bill of exchange issued by a borrower
  (the drawer) which directs another person ( the
  acceptor or drawee), usually a bank, to pay a
  stated sum of money on maturity of the bill to a
  specified person or to bearer (the payee or
  discounter).

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Source Perison et al. (2006), Business Finance,
McGraw Hill.
13
Bills of Exchange (cont.)

• The face value is paid to whoever holds the bill
  on the maturity date.
• The discounter has the choice of either holding
  the bill until maturity, when payment will be
  received from the acceptor, or selling
  (rediscounting) the bill. However, if the bill is
  sold, the seller normally endorses the bill at
  the time of sale.
• Endorsement acceptance by the seller of a bill
  in the secondary market, of responsibility to pay
  the face value if there is default by the
  acceptor, drawer and earlier endorsers.

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Bills of Exchange (cont.)

• Normal process of repayment

Source Perison et al. (2006), Business Finance,
McGraw Hill.
15
Source Wilson et al. (2007), Financial
Management, 5th edn, Pearson, Australia
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Bills of Exchange (cont.)

• Bank Bills
• Bill of exchange that has been accepted or
  endorsed by a bank.
• Non-bank Bills
• Any bill of exchange that has been neither
  accepted nor endorsed by a bank but from the
  other institutions.

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Long-term Financing

• Major sources of long-term financing
• Equity securities
• Debt securities
• Hybrid securities

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Equity Finance

• Limited companies
• Equity raised via the issue of ordinary and
  preference shares to shareholders
• Limited companies
• Ordinary shareholders
• No prima facie right to a dividend unless
  declared

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Equities---Ordinary Shares

• Ordinary share features
• Par value represents its unit value as described
  by a companys authorised capital. Ex I million
  ordinary shares of 1each.
• Ownership shareholders are part-owners of the
  company.
• Limited liability but without priority for
  dividends or in bankruptcy.
• Permanent capital an issue of ordinary shares
  represents an irredeemable source of funds. The
  company is prohibited from buying back these
  shares.
• Company flotations

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Shareholders Rights

• The right to share proportionally in dividends
  paid.
• The right to share proportionally in assets
  remaining after liabilities have been paid in
  liquidation.
• The right to elect the directors and to vote on
  important shareholder matters (one share one
  vote).
• The right to share proportionally in any new
  shares sold (pre-emptive right).

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Flotation New Issues

• Flotation is the initial offering of securities
  to the public (Initial Public Offering, IPO).
• Reasons for a private company may be floated?
• e.g,
• convert from a private company to a public
  company for the first time.
• form a new public company
• privatise a public organisation

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Secondary Issues

• When additional equity funds are needed and
  sought from the market, two methods can be chosen
  in terms of the costs.
• Private placementssecurities are offered and
  sold to a limited number of investors who are
  often the current major investors in the
  business.
• Rights issuesissue of shares made to all
  existing shareholders, who are entitled to take
  up the new shares in proportion to their present
  holdings.

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Rights Issues Basic Concepts

• Rights Issues
• Issue of ordinary shares to existing
  shareholders.
• Allows current shareholders to avoid the dilution
  that can occur with a new share issue.
• Rights are given to the shareholders
  specifying
• number of shares that can be purchased
• purchase price
• time frame.
• Shareholders can either exercise their rights or
  sell them. They neither win nor lose either way.

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Processes of Issuing Securities to the Public

• Analyse funding needs and how they can be met.
• Approval from board of directors for a public
  issue.
• Outside expert opinions sought for support of
  issue.
• Pricing, time-tabling, prospectus prepared,
  marketing.
• Prospectus filed with ASIC and ASX.

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Processes of Issuing Securities to the Public

• Underwriting agreement executed.
• Prospectus registered.
• Public announcement of offering.
• Funds received.
• Shares allotted, holdings registered.
• Shares listed for trading on ASX.

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Underwriting

• The underwriter undertakes to guarantee that the
  share issue is fully subscribed and to purchase
  any unsold shares.
• Firm underwriting
• A guarantee that funds will be made available to
  a company at a specific time on agreed terms and
  conditions.
• Best efforts underwriting
• Underwriter must use best efforts to sell the
  securities at the agreed offering rate.

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Underwriting

• Role of underwriter
• pricing the issue
• marketing the issue
• engaging sub-underwriters
• placing the shortfall
• Sub-underwriter
• A group of underwriters formed to reduce the risk
  and to help to sell an issue.

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Underwriting Fees

• The underwriters fee is a reflection of the
• size of the issue
• issue price
• general market conditions
• market attitude towards shares
• time period required for underwriting.
• Fees also include brokerage and management fees.

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The Cost of Issuing Securities
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Advantage and Disadvantage of Using Equity
Securities as a Source of Financing
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Other sources of equity fund

• Private equity security issued to investors are
  not publicly traded (venture capital)
• Internal finance retained earnings
• But it will be affected by dividend policy of
  the company.

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Debt Securities

• An obligation to pay a specific amount of money
  to another party.
• Corporations try to create debt securities that
  are really equity to get the tax benefits of debt
  and the bankruptcy benefits of equity.
• Interest on debt is fully tax deductible, so the
  distinction is important for tax purposes.

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Types of Long-term Debt Security

• Marketable long-term debt Debentures and
  unsecured notes
• Long-term loans

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Types of Long-term Debt

• Marketable long-term debt
• Debenturessecured debt are sold through public
  offer in a similar manner to equity and offer
  assets as security (issued amounts of at least
  1,000 to 10,000)
• Unsecured notes (corporate bonds) long-term, fix
  interest debt security with coupon payments every
  6 months, issued by non-government entities in
  amounts of at least 500000 per investor..
• Corporate bonds require high credit ratings

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Types of Long-term Debt

• Main differences between corporate bonds and
  debentures are that corporate bonds
• are usually issued as unsecured notes
• have less restrictive trust deeds
• are placed privately with institutional investors
• do not need a prospectus, if placed with
  institutional investors

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Long-Term Loans

• Australian companies obtain long-term debt
  finance largely by loans, rather than by issuing
  their own debt securities.
• Loans
• variable rate loans
• fixed rate term loans
• mortgage loans
• Foreign bond
• Eurobond

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Long-Term Loans (cont.)

• Variable Rate Loans
• Borrowers are charged an interest rate that is
  variable at the banks discretion.
• Consists of a base rate that is published weekly,
  plus a credit margin that varies between
  borrowers.
• Fixed Rate Term Loans
• Pay an agreed fixed interest rate for a period of
  at least 1 year
• Interest rate can be fixed from 5 to 10 years.
• Mortgage Loans
• Borrower pledges property as security for a loan.

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Types of Long-term Debt

• Foreign bond- bond issued outside the borrowers
  country and denominated in the currency of the
  country in which it is issued
• Ex bonds denominated in US dollars and issued in
  the US domestic market
• Eurobondsunsecured fixed-interest borrowings
  with maturity of five to ten years, denominated
  in a currency of a country other than its country
  of issue.
• Ex An Australian dollar Eurobond is a debt
  security denominated in Australian dollars but
  issued outside Australia with a view to
  attracting non Australian investor.

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Advantage and Disadvantage of Using Long-term
Debt as a Source of Financing
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Hybrids of Debt and Equity Finance

• Preference shares
• Convertible notes

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Preference shares

• A form of equity financing with characteristics
  of debt securities.
• Normally holders have no voting rights.
• Normally entitled to receive a specified fixed
  return out of a firms net profit.
• Rank ahead of ordinary shares with respect to
  dividend payments, and usually with respect to
  claims on assets in the event of a liquidation.

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Preference shares

• Cumulative or non-cumulative
• A company that issues cumulative preference
  shares is required to pay any accumulated
  preference dividends before a distribution may be
  made to ordinary shareholders.
• Non-cumulative preference shares do not oblige
  the company to pay any past accumulation of
  unpaid preference dividends.

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Preference shares

• Redeemable, irredeemable, converting or
  convertible
• Redeemable preference shares are similar to
  debentures, giving them the same status as
  lenders.
• Irredeemable preference shares are similar to
  ordinary shares.
• Converting preference shares automatically
  convert to ordinary shares at some specified time
  in the future.
• Convertible preference shares can be converted to
  ordinary shares at the option of the holder.

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Preference shares

• Participating or non-participating
• A company may issue participating preference
  shares that allow the holders to share in any
  profit earned in excess of a certain amount.
• These participating preference shareholders can
  obtain a dividend in excess of the preference
  dividend rate.
• Non-participating preference shareholders are not
  entitled to a dividend in excess of the stated
  dividend rate.

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Preference Shares

• Most preference shares issued are cumulative,
  irredeemable and non-participating

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Reasons for Issuing Preference Shares

• Redeemable preference shares can be used to
  enhance the balance sheet by increasing the
  equity base.
• As subordinate debt, they can be included in a
  banks capital base.
• They can be used to avoid the threat of
  bankruptcy that exists for debt.
• Companies unable to take advantage of the tax
  deductibility of debt favour preference shares.
• A means of raising equity without surrendering
  control.

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Hybrids of Debt and Equity Finance Convertible
Notes

• Convertible Note
• A convertible note is a debt instrument issued
  for a fixed term at a stated interest rate, which
  gives the holder the right to convert the note
  into ordinary shares at specified future dates.
• If the holder choose not to exercise the right to
  convert, the security will be redeemed at
  maturity.
• Notes are usually issued at an interest that is
  lower than that offered on straight debt
  instruments. Why?
• Have terms up to 10 years
• Can be listed on the ASX for trade
• e.g10-year 8 per cent convertible notes with a
  face value of 10 that maturity can be converted
  to shares at a conversion ratio of one to one.

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Advantage and Disadvantage of Using Hybrid
Securities as a Source of Financing
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