Sources of Finance
It was explained in week 1 that this week’s lectures will focus primarily on institutions that provide finance. Finance has been defined by Chadwick and Kirkby (1995, p 38) in their book Financial Management (first edition, publisher Routledge) as a “system of costs and risks”. As we will see throughout the course, the notion of risk from an investor’s point of view is related to whether there is the accrual of the financial returns that are anticipated from the investment. The inversion of this from a company’s point of view is whether that company will be able to meet any costs associated with acquiring investment funds from an investor. To maximise its chances of doing so, a company is, thus, likely to want to minimise both the costs of finance and any obligations that are associated with acquiring those funds. Yet for companies to function, they will require some long-term finance to be invested. It is possible to sub-divide the sources of long-term finance available to a company into internal sources, external sources that carry few or no financial liabilities and external sources that carry financial liabilities. Internal sources of finance include investment of retained profits, surplus current assets and underutilized fixed assets. These methods carry few if any direct new financial obligations and risks. Grants – as distinct from loans – from governmental bodies are the main external source of funds that carry few if any financial liabilities.
The main sources of finance for many companies are external sources of funds that carry financial liabilities. These may be sub-divided into two. Firstly, there are non-marketable debt such as bank loans and marketable debt such as corporate bonds. All other things being equal, debt finance should be cheaper for a corporation than the other main form of long-term finance, equity. This is because debt finances tends to come with a definite obligation that the principal sum borrowed will be a definite date and generally interest payments or their equivalent will often have to be paid at definite points in time. If the payments are not made on the specified dates, then the lender may take legal action to recover the debt, which could ultimately result in the corporation being declared bankrupt. This gives the investor a certain degree of protection while creating risks for the corporation. By contrast, the second main source of long-term finance, which involves the issuing of shares, results in the shareholder sharing in the corporation’s ownership. The consequence is that the investor takes on the risk because there is no guarantee that s/he will get their money back. Moreover, as they have been give a share in the company for their investment, they cannot get their money back other than by selling to an alternative shareholder. For this reason, shareholders may expect to receive greater returns than debt-holders. This week’s lectures aim to consider equity and debt as sources of finance for companies, paying particular attention to the institutions from which they are raised and the stages in a company’s life cycle to which they may be best suited, as well as considering basic methods of assessing their costs and valuing different assets. Thus, the objectives of this week are below:
By the end of this week’s lectures, you will be able to:
- define equity as a source of finance
- explain how a company may raise equity capital, including raising venture capital, selling shares more widely and making rights issues - outline the process of a rights issue of shares
- calculate the theoretical price of a share following a rights issue - discuss critically the use of rights issues as a means of raising finance - outline differences between ordinary and preference shares - define debt as a source of finance
- outline various types of debt...