Types and Sources of Finance

1.        Internal Sources of Finance

1.1       Retained earnings

1.1.1    Retained earnings is surplus cash that has not been needed for operating costs, interest payments, tax liabilities, asset replacement or cash dividends.
1.1.2    A company may have substantial retained profits in its statement of financial position but no cash in the bank and will not therefore be able to finance investment from retained earnings.
1.1.3    Advantages and disadvantages:

Advantages	Disadvantages
Retentions are a flexible source of finance; Does not involve a change in the pattern of shareholdings and no dilution of control; Have no issue costs.	Shareholders may be sensitive to the loss of dividends that will result from retention for re-investment, rather than paying dividends. There is an opportunity cost in that if dividends were paid, the cash received could be invested by shareholders to earn a return.

 

1.2       Increase working capital management efficiency

1.2.1    Internal source of finance can be the savings from more efficient management of trade receivables, inventory, cash and trade payables.
1.2.2    Efficient working capital management can reduce bank overdraft and interest charges as well as increasing cash reserves.

2.      Short-term Finance

2.1       Overdrafts

2.1.1    Most important sources of short-term finance and can arrange relatively quickly with the level of flexibility.
2.1.2    Solid core (or hard core) overdraft – means that the company is always in overdraft and become a long-term feature.
2.1.3    If the hard-core element of the overdraft appears to be becoming a long-term feature of the business, the bank might wish, after discussions with the company, to convert the hard core of the overdraft into a loan, thus giving formal recognition to its more permanent nature.
2.1.4    Otherwise annual reductions in the hard core of an overdraft would typically be a requirement of the bank.
2.1.5    Advantages and disadvantages

Advantages	Disadvantages
Flexible source of finance Only pay for what is used, so cheaper	Repayable on demand May require security, e.g. floating charges or personal guarantee Expose to the risk of an interest rates increase

 

2.2       Short-term loans

2.2.1    It is a loan for a fixed amount for a fixed period.
2.2.2    Advantages:

•             Borrower knows what he will be expected to pay back at regular intervals
•             Bank can also predict its future income with more certainty
•             Not repayable on demand

2.3       Trade credit

2.3.1    It’s a interest free short-term loan.
2.3.2    May have the following costs incurred if not settle when fall due:

•             Loss of early settlement discounts
•             Worsen the credit rating

3.       Leasing

3.1       Leasing is a contract between a lessor and a lessee for hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee.
3.2       Lessors include banks and insurance companies and the types of asset leased include office equipment, computers, commercial vehicles, aircraft, ships and buildings.

3.3       Leasing may have advantages for the lessee:

• The lessee may not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it. If so the lessee has to rent the asset to obtain use of it at all.
• Finance leasing may be cheaper than a bank loan.
• The lessee may find the tax relief available advantageous.

3.4       Operating leases have further advantages:

• The leased equipment does not have to be shown in the lessee's published statement of financial position, and so the lessee's statement shows no increase in its gearing ratio.
• The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out of date before the end of its expected life, the lessee does not have to keep on using it. The lessor will bear the risk of having to sell obsolete equipment second-hand.

4.      Debt Finance

4.1       Reasons for seeking debt finance

4.1.1    Reasons:

•             Shareholders are unwilling to contribute additional capital
•             Does not wish to involve outside shareholders
•             Lesser cost and easier availability
•             Tax relief on interest payments

4.2       Factors influencing choice of debt finance

4.2.1    Factors:

•             Gearing and financial risk – if already too high, not suitable to raise debt finance
•             Target capital structure – a company should seek to minimize its WACC. In practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than equity.
•             Availability of security – debt will usually need to be secured on assets by either a fixed charge or a floating charge.
•             Economic expectations – it is more easy to borrow money from bank in good economic conditions
•             Interest rate movements – expectations of interest rate movements will determine whether a company chooses to borrow at a fixed or floating rate
•             Duration – If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan should match the length of time that the asset will be generating revenues

4.3       Zero coupon bonds

4.3.1    Issued at a discount but no interest is paid.
4.3.2    Advantages for borrower:

•             No cash repayment until redemption date
•             Cost of redemption is known at the time of issue

4.4       Deep discount bonds

4.4.1    Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal value of the notes.

4.5       Convertible loan notes

4.5.1    Give the holder the right to convert to other securities, normally ordinary shares, at a pre-determined price and time.
4.5.2    Attractions of convertible loan notes:

•             Issue at par normally has a lower coupon rate of interest than straight debt. This lower yield is the price the investor has to pay for the conversion rights.
•             Self-liquidating – provided that the conversion are pitched correctly and expected share price growth occurs, conversion will be an attractive choice for bond holders as it offers more wealth than redemption.
•             Increase debt capacity on conversion – gearing increases when convertible debt is issued, but if conversion occurs, the gearing will fall not only because the debt has been removed, but will fall even further because equity has replaced the debt.

4.5.3    The actual market price of convertible loan notes will depend on:

•             Price of straight debt
•             Current conversion value
•             Length of time before conversion may take place
•             Market expectation as to future equity returns and the risk associated with these returns

4.6       Subordinated loans (次級債務)

4.6.1    A subordinated loan is debt which ranks after other debts.
4.6.2    It has a lower priority in case of liquidation during bankruptcy, behind the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors.
4.6.3    Because subordinated debt is repayable after other debts have been paid, it is more risky for the lender of money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset.
4.6.4   In general, major shareholders and parent companies are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk.

4.7       Borrowing from commercial banks

4.7.1    Commercial banks make a wide variety of loans, from working capital loans for small businesses (with inventory and/or equipment as collateral) to unsecured bridging loans to support tender offers for acquisitions.
4.7.2    Regardless of the purpose of the loan, commercial banks generally make loans based on an analysis of the borrower’s overall financial condition.
4.7.3    There are a number of forms that bank credit arrangements can take:
(a)        Line of credit:

• Agreement to borrow up to a specified maximum during a year.
• Most bank lines of credit require the borrower to 're-represent and re-warrant' the condition of the company on a regular basis as required in the loan agreement.
• This action is required at each rollover of the loan and requires the management of the company to certify to the bank that nothing has changed in either the financial or operational condition of the company.
• Most lines of credit provide for borrowing at variable interest rates tied to some base rate, such as HIBOR. The rate paid on the loan is generally the rate base (sometimes the lender's cost of funds) plus some premium (the profit margin) required by the lender (for example, HIBOR + 1%).

(b)       Revolving credit agreement:

• A line of credit extended for a stated period of time (for example, three to five years) with no fixed repayment schedule.
• The borrower may draw down the line at any time or repay it in full without penalty.
• The borrower pays a commitment fee that secures the line of credit and commits the bank to lend as long as specified conditions are met.

(c)        Term loan:

• A loan with a fixed maturity, usually greater than one year, which is typically repaid in instalments of both interest and principal (amortised).

(d)       Bridging loan (過渡性貸款):

• Granted for a short period of time for a specific purpose, with both interest and principal paid at maturity and used either for a stop-gap funding purpose, or for leading to a more permanent lending structure such as a term loan.

(e)        Letter of credit:

• A commitment from a bank, or other financial institution, stating that the bank, under specified conditions, will make payment for a company's liability.
• It allows a substitution of the bank's credit rating for the purchaser's and is also known as 'credit enhancement'.
• Trade letters of credit are essentially linked to a specific transaction (or transactions) and serve as a means of financing and a guarantee of payment.
• Stand-by letter of credits (備用信用證) are essentially a backup form of credit for a company issuing general credit terms. This type of letter of credit indicates that a bank is willing to provide funding to the company in the event the commercial paper issue cannot be rolled over when it matures. It may be used for companies that are perceived as a potential credit risk by creditors. If the customer fails to pay, the supplier can draw on the letter of credit for payment.

4.8       Rating system

4.8.1    Not all the companies have the same risk. There is a bond-rating system, which helps investors distinguish a company’s credit risk. Below is the Fitch and Standard & Poor’s bond rating scales.

Fitch/S&P	Grade	Risk
AAA	Investment	Highest quality
AA	Investment	High quality
A	Investment	Strong
BBB	Investment	Medium grade
BB, B	Junk	Speculative
CCC/CC/C	Junk	Highly speculative
D	Junk	In default

4.8.2    If the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because they are so risky they have to offer much higher yields than other debt. This brings up an important point: not all bonds are inherently safer than shares.
4.8.3    The minimum investment grade rating is BBB. Institutional investors may not like such a low rating. Indeed some will not invest below an A rating.

 

5.      Venture Capital

5.1       Meaning:

•             Long-term capital offered by specialist institutions
•             Aim at small and medium-size businesses that have a fairly high level of risk
•             In general, interested in a business with good profit and growth prospects

5.2       Venture capitalist may be interested in the following types of business:

•             Business start-ups
•             Growth capital – business has already passed the start-up phase and is seeking capital for further expansion
•             Management acquisitions – provide capital for managers that wish to take over an existing business
•             Share purchases – provide to help finance the buy-out of a part-owner of a business
•             Business recoveries – help turn round the fortunes of a business that is currently experiencing difficulties

5.3       Factors to be considered by management when using venture capital finance

•             Whether the management can meet the high returns target by venture capitalists
•             Venture capitalists may request to have a representative on the board of directors
•             Venture capitalists often request to have internal and sensitive information of the company such as forecasts and other financial information
•             Venture capitalist will expect to receive an equity stake and will often sell this stake later. The directors should know that the business may be sold to another business or investors, so they may loss the control or even their job.

5.4       Factors to be considered by venture capitalist when assessing an investment

•             Financial performance
•             The market for the products or services – for example, the degree of competition, the threat of substitutes, the bargaining power of suppliers, the barriers to market entry, etc.
•             Owner investment – the venture capitalist will expect the owners to demonstrate their belief in the venture in a tangible way
•             The quality of management
•             Risk – it involves the types of risk that will be encountered by the business
•             Business operations – the nature and complexity of internal business operations will be examined
•             Exit route – the venture capitalist will normally identify a possible exit route and time frame before entering into the investment

Question 1 – Venture capital Venture capital is an important source of capital for some businesses. Required: (a)     Explain what is meant by the term ‘venture capital’ and identify the main types of business ventures that are likely to be an attractive investment for a venture capitalist.                                                                                                                            (7 marks) (b)     Outline the main issues that the board of directors of a company should take into account when considering the use of venture capital finance.                                         (4 marks) (c)     Discuss the main factors that a venture capitalist will consider when assessing an investment proposal.                                                                                           (9 marks) (Total 20 marks)

6.      Equity Finance

6.1       Internally-generated funds

6.1.1    It comprises of:

•             Retained earnings
•             Non-cash charges against profits (e.g. depreciation)

6.2       Advantages and disadvantages for equity finance:

6.2.1    Advantages:

• Decrease gearing and so decrease financial risk
• Not require security
• Lower interest payment if replace the debt

6.2.2    Disadvantages:

• May dilute the ownership and control of existing shareholders (rights issue may not only if they take up their rights)
• Higher costs than debts
• May not be able to obtain the fundings from existing shareholders

 

6.3       Stock exchange listing

6.3.1    A stock exchange is a market place that is designed to bring together providers of capital and companies seeking to raise capital. It acts as both a primary market and a secondary market for securities.
6.3.2    Primary market – facilitates the issue of new shares and debentures by public companies. (IPO)
6.3.3    Secondary market – facilitates the purchase and sale of ‘second-hand’ securities. A stock exchange enables investors to transfer their investments easily and quickly.
6.3.4    Companies may incur the following costs when issuing shares:

•             Underwriting costs (see below)
•             Stock market listing fee (the initial charge) for the new securities
•             Fees of the issuing house, solicitors, auditors and public relations consultant
•             Charges for printing and distributing the prospectus
•             Advertising in national newspapers

6.3.5    Advantages of listing:

•             Share transferability – shares can be transferred easily and so encourage investment
•             Share price – shares listed in exchange should be priced more efficiently than non-listed company, which give investors confidence when buying or selling shares
•             Company profile – help the company in establishing new contracts or in developing business opportunities
•             Business combinations – stock exchange can facilitate takeovers and mergers

6.3.6    Disadvantages of listing:

•             High flotation costs – e.g. underwriting fees, professional fees, etc.
•             Regulatory costs – the cost of maintaining a stock exchange listing can be high, e,g. must have non-executive directors, audit committee, etc.
•             Control – existing shareholders may suffer loss of control
•             Investors expectations – it may put pressure on the directors to produce gains over the short term
•             Takeover target – a listed company is much more vulnerable to a takeover than an unlisted company

 

 

Question 2 – Stock exchange listing A well-functioning stock exchange is an essential requirement of a well-functioning private enterprise system. Required: (a)     Briefly explain the nature and purpose of a stock exchange.                             (4 marks) (b)     Discuss the possible advantages and disadvantages for a company of obtaining a listing on a stock exchange.                                                                                         (16 marks) (Total 20 marks)

6.4       Placing

6.4.1    Not all offered to the public but sell to a smaller number of investors, usually institutional investors such as pension funds and insurance companies.
6.4.2    Advantages of placing:

•             When compared with IPO:
• Placing is much cheaper
• Placing is likely to be quicker than IPO
• Placing is likely to involve less disclosure of information when compared with IPO
• When compared with debt financing:
• Not require security when compared with debt finance
• Not need to redeem

6.4.3    Disadvantage of placing:

•             Dilute ownership and control – institutional shareholders may have control of the company
•             Dividends are not tax-deductible like interest payments.

6.5       Rights issue

6.5.1    It is an offer to existing shareholders enabling them to buy more shares, usually at a price lower than the current market price.
6.5.2    Advantages of a rights issue:

•             Cheaper than IPOs and no prospectus
•             More beneficial to existing shareholders because of the pre-emptive rights
•             Relative voting rights are unaffected if shareholders all take up their rights
•             Reduce gearing
•             No security required

6.5.3    Understand the calculation of theoretical ex-rights price
6.5.4    Actions to shareholders for rights issue:

•             Take up all the rights – no effect on control and wealth
•             Take up part of the rights – dilute control but no effect on wealth
•             Do nothing – may affect both. However, some Stock Exchange rules state that if new securities are not taken up, they should be sold by the company to new subscribers for the benefits of the shareholders who were entitled to the rights.

6.5.5    Actual market price after a rights issue:

•             Unchanged – if the expected returns of the additional funds are the same with the existing funds
•             Fall – if the expected returns of the additional funds are lower than the existing funds
•             Rise – if the expected returns of the additional funds are higher than the existing funds

Question 3 – Share price calculation, rights issue, semi-strong form, equity finance and debt finance THP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash for the shares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20% discount to its current share price. The purchase price of the 1 million issued shares of CRX Co would be equal to the rights issue funds raised, less issue costs of $320,000. Earnings per share of CRX Co at the time of acquisition would be 44·8c per share. As a result of acquiring CRX Co, THP Co expects to gain annual after-tax savings of $96,000. THP Co maintains a payout ratio of 50% and earnings per share are currently 64c per share. Dividend growth of 5% per year is expected for the foreseeable future and the company has a cost of equity of 12% per year. Information from THP Co’s statement of financial position: Equity and liabilities $000 Shares ($1 par value) 3,000 Reserves 4,300   7,300 Non-current liabilities   8% loan notes 5,000 Current liabilities 2,200 Total equity and liabilities 14,500 Required: (a)     Calculate the current ex dividend share price of THP Co and the current market capitalisation of THP Co using the dividend growth model.                              (4 marks) (b)     Assuming the rights issue takes place and ignoring the proposed use of the funds raised, calculate: (i)      the rights issue price per share; (ii)     the cash raised; (iii)    the theoretical ex rights price per share; and (iv)    the market capitalisation of THP Co.                                                         (5 marks) (c)     Using the price/earnings ratio method, calculate the share price and market capitalisation of CRX Co before the acquisition.                                               (3 marks) (d)     Assuming a semi-strong form efficient capital market, calculate and comment on the post acquisition market capitalisation of THP Co in the following circumstances: (i)      THP Co does not announce the expected annual after-tax savings; and (ii)     the expected after-tax savings are made public.                                        (5 marks) (e)     Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity finance and debt finance as a source of finance from which to make a cash offer for CRX Co.                                                                                       (8 marks) (25 marks)

 

7.       Gearing

7.1       Operating gearing

7.1.1    The measure of the extent to which a firm’s operating costs are fixed. It affects the level of business risk.
7.1.2    High proportion of fixed costs, high operating gearing.
7.1.3    Ways of measurement:

1.	Fixed costs	or
	Variables costs

2.	Fixed costs	or
	Total costs

3.	% change in EBIT (or PBIT)	or
	% change in turnover

4.	Contribution	or
	PBIT or EBIT

7.2       Financial gearing

7.2.1    Is the amount of debt finance a company uses relative to its equity finance.
7.2.2    The greater the level of debt, the higher the financial risk, so the higher is the shareholders’ required return.
7.2.3    Financial gearing ratios:

1.	Equity gearing =	Preference share capital + long-term debt
		Ordinary share capital + reserve

2.	Total or capital  gearing =	Preference share capital + long-term debt
		Total long-term capital

3.	Interest gearing =	Debt interest
		PBIT

 

Question 5 – Operating Gearing and Financial Gearing Jack Ltd plans to raise $5 million in order to expand its existing chain of retail outlets. It can raise the finance by issuing 10% loan stock redeemable in ten years’ time, or by a rights issue at $4.00 per share. The current financial statements of Jack Ltd are as follows: Income statement for the year   $000 Sales revenue 50,000 Cost of sales 30,000 Gross profit 20,000 Administration costs 14,000 Profit before interest and tax 6,000 Interest 300 Profit before tax 5,700 Taxation at 30% 1,710 Profit after tax 3,990 Changes in equity   $000 Dividends 2,394 Net change in equity (retained profits) 1,596 Statement of financial position   $000 Net non-current assets 20,100 Net current assets 4,960   25,060     Ordinary shares, par value 25 cents 2,500 Retained profit 20,060 12% loan stock (redeemable in six years) 2,500   25,060 The expansion of business is expected to increase sales revenue by 12% in the first year. Variable cost of sales makes up 85% of cost of sales. Administration costs will increase by 5% due to new staff appointments. Jack Ltd has a policy of paying out 60% of profit after tax as dividends and has no overdraft. Required: (a)     For each financing proposal, prepare the forecast income statement after one additional year of operation.                                                                                                (5 marks) (b)     Evaluate and comment on the effects of each financing proposal on the following: (i)      Financial gearing; (ii)     Operational gearing; (iii)    Interest cover; (iv)    Earnings per share. (12 marks) (c)     Discuss the dangers to a company of a high level of gearing, including in your answer an explanation of the following terms: (i)      Business risk; (ii)     Financial risk. (8 marks) (25 marks)

 

8.      Shareholder Wealth Ratios

8.1       Earnings per share (EPS)

8.1.1    In general, the higher the EPS, the higher the shareholders wealth

 

EPS =	Profit after tax and preference dividends
	Weighted average number of shares

8.2       Price-earnings ratio (P/E ratio)

8.2.1    A high P/E ratio indicates strong market confidence in the future profit growth of the company.

P/E Ratio =	Market price per share
	EPS

8.3       Dividend cover

8.3.1    The higher the cover, the better the ability to maintain dividends.

Dividend cover =	EPS
	DPS

8.4       Dividend yield

8.4.1    Is the rate of return a shareholder is expecting on an investment in shares, so the higher the dividend yield is better.
8.4.2    The yield will be influenced by the dividend policy, a company which has traditionally paid high dividends will be popular with some investors and this will reflected in its share price.

Dividend yield =	Gross DPS	x 100%
	Market price per share

 

9.       Debt Holder Ratios

9.1       Interest cover

9.1.1    Is a measure of the adequacy of a company’s profits relative to its interest payments on its debt. In general, a high level of interest cover is good.

Interest cover =	PBIT
	Debt interest

9.2       Interest yield

9.2.1    The interest yield is the interest rate expressed as a percentage of the market price.
9.2.2    It is a measure of return on investment for the debt holder.

Interest yield =	Interest rate
	Market value of debt

10.     Finance for SMEs

10.1     Financing problem for small businesses

10.1.1  Funding gap:

• A funding gap is the difference between the money required to begin or continue operations, and the money currently accessible.
• Funding gaps are common in very young companies, who may underestimate the amount of capital needed to sustain production until a workable cash flow has been established.

10.1.2  Maturity gap:

• It is particularly difficult for SMEs to obtain medium term loans due to a mismatching of the maturity of assets and liabilities.
• Longer term loans are easier to obtain than medium term loans as longer loans can be secured with mortgages against property.

10.1.3  Inadequate security:

• A common problem is often that the banks will be unwilling to increase loan funding without an increase in security given (which the owners may be unwilling or unable to give), or an increase in equity funding (which may be difficult to obtain).

10.2     Potential sources of financing for SMEs

10.2.1  Potential sources of financing include the following:

• Owner financing
• Overdraft financing
• Bank loans
• Trade credit
• Equity finance
• Business angel financing
• Venture capital
• Leasing
• Factoring

Question 6 – SME sources of finance problems (a)      Discuss the difficulties that may be experienced by a small company which is seeking to obtain additional funding to finance an expansion of business operations. (8 marks) (b)      Explain why very Small to Medium-size Enterprises (SMEs) might face problems in obtaining appropriate sources of finance. In your answer pay particular attention to problems and issues associated with: (i)      uncertainty concerning the business; (ii)     assets available to offer as collateral or security; and (iii)    potential sources of finance for very new SMEs excluding sources from capital markets. (12 marks)

 

Additional Examination Style Questions

Question 7 – Rights issue, share price valuation and agency problem
Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand its existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price of Dartig Co is $2·50 per share and the rights issue price will be at a 20% discount to this. The finance director of Dartig Co expects that the expansion of existing business will allow the average growth rate of earnings per share over the last four years to be maintained into the foreseeable future.

The earnings per share and dividends paid by Dartig over the last four years are as follows:

	2003	2004	2005	2006	2007
Earnings per share (cents)	27.7	29.0	29.0	30.2	32.4
Dividend per share (cents)	12.8	13.5	13.5	14.5	15.0

Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recent years. Ignore issue costs.

Required:

(a)     Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion.                                                                                                                              (3 marks)
(b)     Calculate the expected share price following the proposed business expansion using the price/earnings ratio method.                                                                                                         (3 marks)
(c)     Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rights issue, and evaluate the expected effect on the wealth of the shareholders of Dartig Co. (5 marks)
(d)     Using the information provided, calculate the ex div share price predicted by the dividend growth model and discuss briefly why this share price differs from the current market price of Dartig Co.           (6 marks)
(e)     At a recent board meeting of Dartig Co, a non-executive director suggested that the company’s remuneration committee should consider scrapping the company’s current share option scheme, since executive directors could be rewarded by the scheme even when they did not perform well. A second non-executive director disagreed, saying the problem was that even when directors acted in ways which decreased the agency problem, they might not be rewarded by the share option scheme if the stock market were in decline.

Required:

Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducing the agency problem in a stock-market listed company such as Dartig Co.          (8 marks)
(25 marks)

Question 8 – Shareholders’ wealth maximization, rights issue and merits of equity financing
JJG Co is planning to raise $15 million of new finance for a major expansion of existing business and is considering a rights issue, a placing or an issue of bonds. The corporate objectives of JJG Co, as stated in its Annual Report, are to maximise the wealth of its shareholders and to achieve continuous growth in earnings per share. Recent financial information on JJG Co is as follows:

	2008	2007	2006	2005
Turnover ($m)	28.0	24.0	19.1	16.8
Profit before interest and tax ($m)	9.8	8.5	7.5	6.8
Earnings ($m)	5.5	4.7	4.1	3.6
Dividends ($m)	2.2	1.9	1.6	1.6
Ordinary shares ($m)	5.5	5.5	5.5	5.5
Reserves ($m)	13.7	10.4	7.6	5.1
8% Bonds, redeemable 2015 ($m)	20	20	20	20
Share price ($)	8.64	5.74	3.35	2.67

The par value of the shares of JJG Co is $1·00 per share. The general level of inflation has averaged 4% per year in the period under consideration. The bonds of JJG Co are currently trading at their par value of $100. The following values for the business sector of JJG Co are available:

Average return on capital employed	25%
Average return on shareholders’ funds	20%
Average interest coverage ratio	20 times
Average debt/equity ratio (market value analysis)	50%
Return predicted by the capital asset pricing model	14%

Required:

(a)     Evaluate the financial performance of JJG Co, and analyse and discuss the extent to which the company has achieved its stated corporate objectives of:
(i)      maximising the wealth of its shareholders;
(ii)     achieving continuous growth in earnings per share.
Note: up to 7 marks are available for financial analysis.
(12 marks)
(b)     If the new finance is raised via a rights issue at $7·50 per share and the major expansion of business has not yet begun, calculate and comment on the effect of the rights issue on:
(i)      the share price of JJG Co;
(ii)     the earnings per share of the company; and
(iii)    the debt/equity ratio.
(6 marks)
(c)     Analyse and discuss the relative merits of a rights issue, a placing and an issue of bonds as ways of raising the finance for the expansion.                                                                               (7 marks)
(Total 25 marks)

 

Question 9 – Financing methods and efficient market hypothesis
The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listed company, which wishes to raise $200m in cash in order to acquire a competitor.

Assets	$m	$m	$m
Non-current assets			300
Current assets			211
Total assets			511
Equity and liabilities
Share capital		100
Retained earnings		121
Total equity			221
Non-current liabilities
Long-term borrowings		100
Current liabilities
Trade payables	30
Short-term borrowings	160
		190
Total liabilities			290
Total equity and liabilities			511

The recent performance of Nugfer Co in profitability terms is as follows:

Year ending 30 November	2007	2008	2009	2010
	$m	$m	$m	$m
Revenue	122.6	127.3	156.6	189.3
Operating profit	41.7	43.3	50.1	56.7
Finance charges (interest)	6.0	6.2	12.5	18.8
Profit before tax	35.7	37.1	37.6	37.9
Profit after tax	25.0	26.0	26.3	26.5

Notes:
1.      The long-term borrowings are 6% bonds that are repayable in 2012
2.      The short-term borrowings consist of an overdraft at an annual interest rate of 8%
3.      The current assets do not include any cash deposits
4.      Nugfer Co has not paid any dividends in the last four years
5.      The number of ordinary shares issued by the company has not changed in recent years
6.      The target company has no debt finance and its forecast profit before interest and tax for 2011 is $28 million

Required:

(a)     Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation with both analysis and critical discussion.                                                         (15 marks)
(b)     Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds. (4 marks)
(c)     Identify and describe the three forms of efficiency that may be found in a capital market.
(6 marks)
(Total 25 marks)