Ebook Business finance Theory and practice (8E) Part 1

(BQ) Part 1 book Business finance Theory and practice has contents Introduction, a framework for financial decision making, financial (accounting) statements and their interpretation, investment appraisal methods, practical aspects of investment appraisal, risk in investment appraisal,...and other contents.

www.downloadslide.com Business Finance Business Finance Theory and Practice Eddie McLaney 8th Edition Now in its 8th edition, Business Finance is an essential introduction to financial decision making in businesses Taking a user’s perspective it explores the type of investments a business should make and how they should be financed, and successfully blends the theoretical, analytical and practical aspects of finance and investment This new edition of Business Finance has a real-world flavour, exploring the theories surrounding financial decision making and relating these theories to what happens in the real world Key Features l an extensive range of real-world examples l solid theoretical underpinning in an easily accessible form l excellent blend of theory and practice offering a comprehensive insight into the decision making process within finance and investment l exploration into, and explanation of, any divergence between theory and practice l comprehensive coverage of the latest international issues l improved pedagogy, including an accessible four-colour design l fully updated supplements for lecturers (featuring cases with solutions, progress tests, tutorial questions and powerpoints) and students (revision questions, multiple choice questions and weblinks) Eddie McLaney Eddie McLaney is Visiting Fellow in Accounting and Finance at the University of Plymouth Cover image © ALAMY CVR_MCLA7683_08_SE_CVR.indd www.pearson-books.com Eddie McLaney 8th Edition Business Finance is suitable for undergraduates in accounting and finance and for those on finance and financial management courses It is also appropriate for postgraduate students with an option in accounting and finance and will be highly useful for professional accounting students For additional material visit: www.pearsoned.co.uk/atrillmclaney Business Finance Theory and Practice 8th Edition 2/12/08 10:35:48 BUSF_A01.qxd 11/19/08 9:45 Page i www.downloadslide.com BUSINESS FINANCE Theory and Practice Visit the Business Finance, eighth edition, Companion Website at www.pearsoned.co.uk/atrillmclaney to find valuable student learning material including: ➔ Learning outcomes for each chapter ➔ Multiple choice questions to test your learning ➔ Extensive links to valuable resources on the web ➔ An online glossary to explain key terms BUSF_A01.qxd 11/19/08 9:45 Page ii www.downloadslide.com We work with leading authors to develop the strongest educational materials in business and finance, bringing cutting-edge thinking and best learning practice to a global market Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications that help readers to understand and apply their content, whether studying or at work To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.co.uk BUSF_A01.qxd 11/19/08 9:46 Page iii www.downloadslide.com Eighth Edition BUSINESS FINANCE Theory and Practice Eddie McLaney BUSF_A01.qxd 11/19/08 9:46 Page iv www.downloadslide.com Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 1986 Second edition published 1991 Third edition published 1994 Fourth edition published 1997 Fifth edition published 2000 Sixth edition published 2003 Seventh edition published 2006 Eighth edition published 2009 © © © © Macdonald & Evans Limited Published as Business Finance for Decision Makers by Pitman Publishing, a division of Longman Group UK Ltd Published as Business Finance for Decision Makers by Pitman Publishing, a division of Longman Group UK Ltd Pitman Publishing, a division of Pearson Professional Limited Pearson Education Ltd Pearson Education Ltd Pearson Education Ltd Pearson Education Ltd E J McLaney 1986, 1991 Longman Group UK Limited 1994 Pearson Professional Limited 1997 Pearson Education Limited 2000, 2009 The right of Eddie McLaney to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS All trademarks used herein are the property of their respective owners The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners ISBN: 978-0-273-71768-3 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data McLaney, E J Business finance : theory and practice / Eddie McLaney – 8th ed p cm Includes bibliographical references and index ISBN 978–0–273–71768–3 Business enterprises–Finance Business enterprises–Finance–Problems, exercises, etc Corporations–Finance Corporations–Finance–Problems, exercises, etc I Title HG4026.M388 2009 658.15–dc22 2008043421 10 11 10 09 Typeset in 9.5/13pt Palatino by 35 Printed and bound by Rotolito Lombarda, Italy The publisher’s policy is to use paper manufactured from sustainable forests BUSF_A01.qxd 11/19/08 9:46 Page v www.downloadslide.com Contents Guided tour of the book Preface Plan of the book xii xv xvii Part The business finance environment Introduction Objectives 1.1 The role of business finance 1.2 Risk and business finance 1.3 The relationship between business finance and accounting 1.4 The organisation of businesses – the limited company 1.5 Corporate governance and the role of directors 1.6 Long-term financing of companies 1.7 Liquidation 1.8 Derivatives 1.9 Private equity funds Summary Further reading Relevant websites Review questions 3 6 12 14 15 16 17 18 18 18 A framework for financial decision making 19 Objectives 2.1 Financial decision making 2.2 Business objectives 2.3 Conflicts of interest: shareholders versus managers – the ‘agency’ problem 2.4 Financing, investment and separation 2.5 Theory and practice Summary Further reading Review questions Problem Appendix: Formal derivation of the separation theorem 19 19 21 26 28 31 32 32 33 33 35 v BUSF_A01.qxd 11/19/08 9:46 Page vi www.downloadslide.com Contents Financial (accounting) statements and their interpretation Objectives 3.1 Introduction 3.2 The financial statements 3.3 Definitions and conventions of accounting 3.4 Problems with using accounting information for decision making 3.5 Creative accounting 3.6 Ratio analysis 3.7 Using accounting ratios to predict financial failure Summary Further reading Relevant websites Review questions Problems Appendix: Jackson plc’s income statement and balance sheet for 2007 41 41 41 42 46 49 50 53 66 67 68 68 68 69 75 Part Investment decisions Investment appraisal methods Objectives 4.1 Introduction 4.2 Net present value 4.3 Internal rate of return 4.4 Payback period 4.5 Accounting (unadjusted) rate of return 4.6 Investment appraisal methods used in practice Summary Further reading Review questions Problems Practical aspects of investment appraisal Objectives 5.1 Introduction 5.2 Cash flows or accounting flows? 5.3 Do cash flows really occur at year ends? 5.4 Which cash flows? 5.5 Taxation 5.6 Inflation 5.7 An example of an investment appraisal 5.8 Capital rationing vi 79 79 79 80 87 94 97 99 104 105 106 106 111 111 111 112 115 116 117 120 121 126 BUSF_A01.qxd 11/19/08 9:46 Page vii www.downloadslide.com Contents 5.9 Replacement decisions 5.10 Routines for identifying, assessing, implementing and reviewing investment projects 5.11 Investment appraisal and strategic planning 5.12 Value-based management 5.13 Real options Summary Further reading Relevant website Review questions Problems Risk in investment appraisal Objectives 6.1 Introduction 6.2 Sensitivity analysis 6.3 Use of probabilities 6.4 Expected value 6.5 Systematic and specific risk 6.6 Utility theory 6.7 Attitudes to risk and expected value 6.8 Particular risks associated with making investments overseas 6.9 Some evidence on risk analysis in practice 6.10 Risk – the story so far Summary Further reading Review questions Problems Portfolio theory and its relevance to real investment decisions Objectives 7.1 The relevance of security prices 7.2 The expected value/variance (or mean/variance) criterion 7.3 Security investment and risk 7.4 Portfolio theory 7.5 Capital asset pricing model 7.6 CAPM: an example of beta estimation 7.7 Assumptions of CAPM 7.8 Tests of CAPM 7.9 CAPM – what went wrong? 7.10 How CAPM is used to derive discount rates for real investments 7.11 Use of CAPM in practice 130 132 135 137 143 144 146 146 146 147 153 153 153 154 159 162 165 166 169 174 174 174 175 176 177 177 184 184 184 186 187 189 198 200 202 202 203 204 205 vii BUSF_A01.qxd 11/19/08 9:46 Page viii www.downloadslide.com Contents 7.12 Arbitrage pricing model 7.13 Portfolio theory – where are we now? Summary Further reading Review questions Problems Appendix: Derivation of CAPM 205 206 208 209 209 210 211 Part Financing decisions Sources of long-term finance Objectives 8.1 Introduction 8.2 Ordinary (equity) capital 8.3 Methods of raising additional equity finance 8.4 Preference shares 8.5 Loan notes and debentures 8.6 Convertible loan notes 8.7 Warrants 8.8 Term loans 8.9 Asset-backed finance (securitisation) 8.10 Leasing 8.11 Grants from public funds 8.12 Conclusions on long-term finance Summary Further reading Relevant websites Review questions Problems The secondary capital market (the stock exchange) and its efficiency Objectives 9.1 Introduction 9.2 The London Stock Exchange 9.3 Capital market efficiency 9.4 Tests of capital market efficiency 9.5 The efficient market paradox 9.6 Conclusions on, and implications of, capital market efficiency Summary Further reading Review questions Problems viii 217 217 217 219 223 232 234 240 240 241 241 242 245 245 246 249 249 249 250 252 252 252 253 256 259 267 267 270 271 272 272 BUSF_A01.qxd 11/19/08 9:46 Page ix www.downloadslide.com Contents 10 Cost of capital estimations and the discount rate Objectives 10.1 Introduction 10.2 Cost of individual capital elements 10.3 Weighted average cost of capital ( WACC) 10.4 Practicality of using WACC as the discount rate 10.5 WACC values used in practice Summary Further reading Review questions Problems 11 Gearing, the cost of capital and shareholders’ wealth Objectives 11.1 Introduction 11.2 Is debt finance as cheap as it seems? 11.3 Business risk and financial risk 11.4 The traditional view 11.5 The Modigliani and Miller view of gearing 11.6 Other thoughts on the tax advantage of debt financing 11.7 Capital/financial gearing and operating gearing 11.8 Other practical issues relating to capital gearing 11.9 Evidence on gearing 11.10 Gearing and the cost of capital – conclusion 11.11 The trade-off theory 11.12 Pecking order theory 11.13 Likely determinants of capital gearing 11.14 Weighted average cost of capital revisited Summary Further reading Review questions Problems Appendix I: Proof of the MM cost of capital proposition (pre-tax) Appendix II: Proof of the MM cost of capital proposition (after tax) 12 The dividend decision Objectives 12.1 Introduction 12.2 Modigliani and Miller on dividends 12.3 The traditional view on dividends 12.4 Who is right about dividends? 12.5 Other factors 274 274 274 275 282 287 288 289 290 291 291 294 294 294 295 296 299 300 306 306 307 308 310 312 313 315 315 317 318 319 319 323 324 326 326 326 327 329 330 331 ix BUSF_C08.qxd 11/19/08 10:10 Page 237 www.downloadslide.com Loan notes and debentures Methods of issuing loan notes Loan notes can be issued in several ways, including direct issues to the public by newspaper advertisement and so on Quite often, businesses wishing to issue loan notes will approach an issuing house and ask it to try to place the issue with its clients, often institutional ones Factors for the business to consider on loan notes financing Issue costs Issue costs tend to be relatively low; they have been estimated at about 2.5 per cent of the value of the cash raised on a £2 million issue (Wilson Committee 1980) Lee, Lockhead, Ritter and Zhao (1996) found that, in the USA, issue costs of loan notes average per cent of funds raised Servicing costs Since loan notes represent a relatively low-risk investment to investors, expected returns tend to be low compared with those typically sought by equity holders Historically, this has been reflected in actual returns Obligation to pay interest Loan notes holders have the basic right under the law of contract to take action to enforce payment of interest and repayment of capital on the due dates, should they not be forthcoming In many cases, loan notes holders have the contractual right to take some more direct action (such as effective seizure of an asset on which their loan is secured), should the borrowing business default on payments This clear obligation to pay interest, with potentially dire results for defaulting, can make servicing the loan notes a considerable millstone around the neck of the borrowing business Obligation to redeem loan notes Irrespective of whether loan notes are issued as redeemable or not, it is always open to the business to buy its own loan notes, in the open market, and to cancel what it buys Thus loan notes offer a level of flexibility not so readily available with ordinary and preference shares On the other hand, if loan notes are issued as redeemable with a stated redemption date, which will usually be the case, the business is under a contractual obligation to redeem This could put the business into a difficult cash flow position as the due date for redemption approaches Tax deductibility of loan notes interest Interest is fully deductible from profit for corporation tax purposes This has tended in the past to make loan interest payments cheaper, pound for pound, than ordinary and preference share dividends This is a point that we shall return to in Chapter 11 Effect on control and on freedom of action The severity of the consequences of failing to meet interest payments and capital repayments can considerably limit the freedom of action of the business While control, in the sense of voting rights, is not usually involved with loan notes financing, the issuing of loan notes may well seriously erode control in the sense of being able to manage affairs without impediment 237 BUSF_C08.qxd 11/19/08 10:10 Page 238 www.downloadslide.com Chapter • Sources of long-term finance ‘ It is common for those who lend money to impose conditions or covenants on the business Failure to meet these covenants could, depending on the precise contract between the lenders and the business, give the lenders the right to immediate repayment of the loan Typical covenants include: l a restriction on dividend levels; l maintenance of a minimum current asset/current liability ratio; l a restriction on the right of the business to dispose of its non-current assets; and l a restriction on the level of financial (capital) gearing The Rank Group plc, the bingo (Mecca) and gaming (Blue Square) business, had to miss paying its normal dividend to shareholders in 2007 to avoid breaching its loan covenants In its 2007 annual report the rail maintenance business Jarvis plc said of a new loan that it had taken out: ‘The facilities are subject to certain financial covenants and events of default Breaches of financial covenants or events of default can be waived or consented to by the lenders but such waivers or consents may require the payment of fees and costs to the lenders.’ We shall go more fully in Chapter 11 into the effect on the position of the ordinary shareholders as borrowings increase Factors for the potential investor to consider on loan notes Level of returns The returns from loan notes tend to be low compared with those expected from equities and preference shares Riskiness of returns ‘ Example 8.4 238 Although the level of risk associated with default by the borrowing business tends to be low, the loan notes holder is usually exposed to another risk, namely interest rate risk This is the risk of capital losses caused by changes in the general level of interest rates An investor has £100 nominal value of perpetual (irredeemable) loan notes, which have a coupon rate (the rate that the borrowing business is contracted to pay on the nominal value of the notes) of per cent The prevailing interest rates and the level of risk attaching to the particular loan notes cause the capital market to seek a per cent return from them Since the loan notes’ return on their nominal value is per cent, the capital market would value the holding at £100 (the nominal value) If the general level of interest rates were to increase so that the capital market now sought a 7.5 per cent return from these loan notes, their value would fall to £80 (that is, the amount on which the per cent interest on £100 represents a 7.5 per cent return) Thus our loan notes holder would be poorer by £20 If the loan notes were not perpetual but redeemable at £100 at some date in the future, the price would probably not drop as low as £80 on the interest rate change The closer the redemption date, the smaller the fall; but irrespective of the redemption position some loss of value would occur Clearly, the investor would gain similarly from a general fall in prevailing interest rates, but a risk-averse investor (and most investors seem to be risk-averse) would be more concerned with the potential loss than with the potential gain BUSF_C08.qxd 11/19/08 10:10 Page 239 www.downloadslide.com Loan notes and debentures The relatively low interest rate risk associated with short-dated loan notes tends to mean that lower returns are available from them as compared with those from notes not due for redemption for some time Ease of liquidating the investment Businesses that wish to make public issues of loan notes must seek a capital market listing for them if they are to have any serious hopes of success Thus, publicly issued loan notes can be liquidated by sale in the market Loan notes and personal tax Interest is subject to income tax in the hands of individual loan notes holders Capital gains are also taxed Since all, or almost all, of the returns from loan notes are usually in the form of interest, capital gains tend not to be significant Degree of control Loan notes not give their holders any control over the business, except that which is necessary to enforce payment of their dues in the event of the business defaulting and to enforce any loan covenants Eurobonds ‘ Eurobonds are unsecured loan notes denominated in a currency other than the home currency of the business that made the issue They are foreign currency loans Businesses are prompted to make Eurobond issues to exploit the availability of loan finance in an overseas country Also, Eurobonds can offer innovative features making them more attractive, both to the lenders and to the issuing business This latter point arises from the fact that the bonds are traded in an unregulated market Despite their name, Eurobonds are not linked to Europe or the euro currency They are simply international bonds The airline business British Airways plc is an example of a UK business with a large Eurobond loan (£309 million), according to its 2007 annual report Interest rate swaps ‘ ‘ ‘ A business may have borrowed money where the contract specified a floating interest rate, that is, an interest rate that varies with the general level of interest rates in the economy It may have preferred a loan with a fixed interest rate but has been unable to negotiate such an arrangement Under these circumstances, it may be possible for the business to find another business with exactly the opposite problem, that is, with a fixed rate loan but a preference for a floating rate loan Having identified one another, each of the businesses might agree to service the loan of the other In practice they would probably make contact first and then issue the loan notes or undertake the borrowing in some other form Interest rate swaps have practical relevance because different businesses have different credit ratings One may be able to negotiate a floating rate loan at a reasonable rate, but not a fixed rate one The other business may find itself in the opposite position Swaps are another example of a derivative The supermarket business Tesco plc uses interest rate swaps to limit its exposure to interest rate risk In its 2007 annual report, the business says that its policy is to have about 40 per cent of its long-term borrowings on fixed rates 239 BUSF_C08.qxd 11/19/08 10:10 Page 240 www.downloadslide.com Chapter • Sources of long-term finance 8.6 Convertible loan notes ‘ Convertible loan notes are securities that bear all of the features of loan notes, which we have just discussed, except that at a pre-stated date they may be converted by the holders, at their discretion, into ordinary shares of the same business The conversion rate is usually expressed as so many ordinary shares in exchange for £100 nominal value of loan notes If there are any splits or bonus issues of ordinary shares during the life of the loan notes, the conversion rights are usually adjusted to take account of them Convertible loan notes are an example of a financial derivative The UK oil exploration business Premier Oil plc made a convertible bond issue in June 2007 The issue raised funds of £127 million The bonds have a coupon rate of 2.875 per cent p.a and are convertible at the rate of £15.82 per share In other words, the bondholders will be able to convert £15.82 worth of bonds (at nominal value) for one of the business’s ordinary shares Convertible issues have not been popular over recent years, though a number of businesses are partially financed by them Since convertibles are a hybrid of loan notes and equities, the factors important both to the issuing business and to potential investors will basically be those that we have already considered However, a couple of features of convertibles are worth mentioning Issue costs The fact that loan notes are cheaper to issue than are equities means that convertibles may be a cheap way to issue ordinary shares, particularly where the business is keen to have some loan finance in any case Borrowings are self-liquidating There is no need for the business to find cash to redeem the loan notes since they are redeemed with ordinary shares This does not, of course, make them free Issuing shares to redeem loan notes represents an opportunity cost to the business and its existing shareholders Convertible loan notes tend to be used to raise finance where investors prefer to have the security of loan notes, with the option to convert to equity should the business perform well 8.7 Warrants ‘ Warrants are, in effect, options granted by the business that entitle the holder to sub- scribe for a specified quantity of ordinary shares, for a specified price at, or after, a specified time – usually several years following their issue The business would usually issue the warrants in one of two ways: l sell them, in which case it would derive a cash inflow; or l attach them to a loan notes issue as a ‘sweetener’ or incentive to investors to take up the loan notes Where a business attaches the warrants to loan notes, which is probably the most common means of issuing them, the arrangement very much resembles a convertible, 240 BUSF_C08.qxd 11/19/08 10:10 Page 241 www.downloadslide.com Asset-backed finance (securitisation) except that the loan notes continue after the warrant has been used to subscribe for shares Thus the loan notes, unlike convertible loan notes, are not self-liquidating Like convertible loan notes, warrants are financial derivatives In most ways, warrants so resemble convertibles that the important factors are much the same 8.8 Term loans ‘ Term loans are negotiated between the borrowing business and a financial institution such as a clearing bank, an insurance business or a merchant bank This sort of finance is extremely important, perhaps accounting for as much as 25 per cent of new finance raised by businesses other than through retained profits In many ways, term loans are like loan notes in that security is usually given to the lender and loans are made for up to 20 years They differ from loan notes in that they are not usually transferred from lender to lender in the way that loan notes typically are They are not traded in the capital market Some term loans are repayable in instalments so that each monthly or annual payment consists of part interest, part capital repayment, in a similar manner to mortgage loan payments made by private house purchasers under repayment mortgages Term loans tend to be very cheap to negotiate, that is, issue costs are very low since the borrowing business deals with only one lender (at least in respect of each loan) and there is room for much more flexibility in the conditions of the loan than is usually possible with an issue of loan notes The cheapness and flexibility of term loans make them very popular with businesses of all sizes For most businesses, finance raised through term loans vastly outweighs the amounts raised through loan notes Term loans, usually granted by banks, represent a very major source of medium to long-term finance Clearly, term loans so closely resemble loan notes that, with the exception of the points concerning transferability and the possible spreading of capital repayment, the factors affecting both borrower and lender are much the same as those that we reviewed in respect of loan notes 8.9 Asset-backed finance (securitisation) ‘ Where a business has expectations of a stream of future positive cash flows, it effectively owns an asset, the value of which is the (discounted) present value of those cash flows It is possible to turn this asset into a security and sell it to an investor and so raise funds; this is known as securitisation An example of such streams of cash flows is monthly repayments made by those who have borrowed money to buy their homes from a mortgage lender This had become a popular thing for US mortgage lenders to during the early years of the 2000s Here the monthly repayments were ‘securitised’ and sold to many of the major banks, particularly in the US Unfortunately, many of the mortgage loans were made to people on low incomes who were not good credit risks (sub-prime loans) When the borrowers started to default on their obligations, it was realised that the securities, now owned by the banks, were worth much less than the banks had paid the mortgage lenders for them This led to the so-called ‘sub-prime’ crisis that triggered the major worldwide economic problems being experienced at the time of writing 241 BUSF_C08.qxd 11/19/08 10:10 Page 242 www.downloadslide.com Chapter • Sources of long-term finance There is no particular reason for asset-backed finance and securitisation to be a problem and it is no doubt unfortunate that the practice may be linked with the subprime difficulties It is a perfectly legitimate and practical way for a business to raise finance 8.10 Leasing It may seem strange to see leasing referred to as a source of long-term finance, but in fact it is very similar to secured lending Leases may be divided into two types: l Operating leases It is often possible to hire an asset, say an item of plant, that is perhaps required only occasionally, rather than purchasing it Usually, the owner carries out any maintenance necessary The decision whether to buy the asset or to lease it will perhaps be affected by financing considerations Basically, though, it is an operating decision, which would be made according to which approach would be cheaper l Finance leases Here the potential user identifies an asset in which it wishes to invest, negotiates price, delivery and so on, and then seeks a supplier of finance to buy it Having arranged for the asset to be purchased, the user leases it from the purchaser Naturally, the lease payments will need to be sufficient to justify the owner’s expenditure, in terms both of capital repayment and of interest The nature of finance leasing ‘ 242 It is finance leases that concern us here since they are effectively term loans with capital repayable by instalments This is an important source of finance, which has been estimated to provide as much as 20 per cent of the total finance for new capital expenditure by businesses over recent years (Drury and Braund 1990) In the past, finance leasing has been believed to be popular with users partly because, while it is tantamount to borrowing, neither the asset nor the obligation to the owner appeared on the balance sheet of the user business Those trying to assess the business’s financial position could overlook such a source of off balance sheet finance However, accounting regulations have now put leasing on the balance sheet Businesses are now required to show both the leased assets and the capital value of the obligation to the owner on the face of the balance sheet Another feature of finance leasing, which was apparently a major reason for the growth in its popularity during the late 1970s and early 1980s in the UK, was its considerable tax efficiency in some circumstances Lease payments are fully deductible for corporation tax purposes by the borrowing business This includes the capital portion of the payment Until 1984, the capital cost of items of plant attracted 100 per cent first-year capital allowance in their year of acquisition As far as the borrowing business was concerned, leasing rather than buying a non-current asset would deny it the opportunity to claim the first-year allowance On the other hand, leasing would still enable the business to claim 100 per cent of the cost of the asset, but over its life, rather than in the first year In many cases, however, even where businesses were to buy the asset by raising finance from, say, a term loan, profits were insufficient for the full benefit to be gained BUSF_C08.qxd 11/19/08 10:10 Page 243 www.downloadslide.com Leasing from the large first-year allowance This was particularly true where recession restricted profitability With leasing, the right to claim capital allowance passed to the ‘lender’ If the profits from leasing and other activities were such as to put the ‘lender’ in a position to take full advantage of them, some of this advantage could be passed on to the ‘borrower’ in lower lease payments Thus the ‘borrower’ could give up some of the advantage of the first-year allowance in exchange for a lower lease charge Evidence on leasing The advent in the mid 1980s of lower corporation tax rates and the abolition of the 100 per cent first-year tax capital allowance greatly reduced the benefit of finance leasing This, taken together with the requirement for the ‘borrower’ business to disclose in its annual accounts the extent of its indulgence in this source of finance, seemed likely to reduce the level of use of finance leasing In fact, far from decreasing in popularity since the accounting and tax changes of the mid 1980s, finance leasing has expanded massively in popularity since the late 1980s The reasons for this fact are not obvious Drury and Braund (1990) conducted a survey of UK businesses of various sizes on the reasons why they frequently prefer to acquire assets on finance leases rather than buying them There were two principal reasons given for the popularity of leasing The first was that the interest rate implied in leasing contracts was lower than the rate that the businesses would have to pay to raise finance to buy the assets themselves The other main reason given was that they believed it still to be more tax efficient to lease rather than to buy, despite the changes in the tax treatment of non-current assets British Airways plc, according to its 2007 annual report, leases a significant part (29 per cent of balance sheet value) of its fleet of aircraft Although in some cases one or both of the principal reasons given in the Drury and Braund survey could be valid, for the majority of businesses this seems unlikely to be so Drury and Braund discovered one factor that could cast some light on the subject This was an alarmingly high incidence of mishandling of the analysis of the decision whether to lease, on the one hand, or to borrow and purchase, on the other Even among larger, and presumably more financially sophisticated, businesses, about 30 per cent were taking an incorrect approach to the analysis such as to bias the results in favour of a decision to lease Although it would be unreasonable to conclude that the continued popularity of finance leasing is based on wholesale mishandling of the decision data, it remains far from clear as to why leasing is so popular To lease or not to lease – a financing decision When a business is considering the acquisition of an asset, it should estimate the cash flows that are expected to arise from its ownership These should then be discounted at a rate that reflects the level of risk associated with those cash flows If the NPV is positive the asset should be acquired; if negative it should not, at least from a financial viewpoint Whether the asset should be financed by a finance lease or by some other means is a completely separate decision The first is an investment decision, the second a financing one 243 BUSF_C08.qxd 11/19/08 10:10 Page 244 www.downloadslide.com Chapter • Sources of long-term finance Only by coincidence will the appropriate discount rate be equal to the rate inherent in the finance lease This latter rate will tend to reflect the relatively risk-free nature of lease financing from the lender’s point of view To the user of the asset, the level of risk is likely to be rather greater than that borne by the lender It would therefore be illogical to discount the cash flows from the asset at the rate implicit in the finance lease We shall consider more fully in Chapter 11 the importance of separating the investment and the financing decision Finance leasing is so similar in practical effect to secured borrowing that the factors that both ‘borrower’ and ‘lender’ need to consider are much the same in respect of each of them Sale and leaseback ‘ Sale and leaseback is a variation on a finance lease Where a business needs finance, and has a suitable asset, it can sell the asset to a financier, with a leaseback deal as part of the sale contract Thus the business retains the use of the asset yet gains additional funds Again this is very similar to a secured loan Land and buildings are often the subject of sale and leaseback deals Recently, several major UK businesses have sold off freehold properties in this way Numerous UK supermarkets and public house and hotel chains have sold and leased back some of their freehold properties over recent years This is now a significant source of finance for many businesses Tesco plc sold 21 of its freehold properties to raise £500 million in March 2007 Surprising subjects of sale and leaseback deals are professional footballers The playing contracts of several English Premier League footballers are owned by the leasing arm of Barclays Bank plc, rather than by the club concerned Perhaps the best-known player to whom this applied was Rio Ferdinand, the England defender, who was leased from Barclays Bank by Leeds United when he played for that club (Fletcher 2002) Hire purchase ‘ Hire purchase is a form of credit used to acquire a non-current (fixed) asset Under the terms of a hire purchase (HP) agreement the buyer pays for the asset by instalments over an agreed period Normally, the customer will pay an initial deposit (down payment) and then make instalment payments at regular intervals (perhaps monthly) until the balance outstanding has been paid The buyer will usually take possession of the asset after payment of the initial deposit, although legal ownership of the asset will not be transferred until the final instalment has been paid Hire purchase agreements will often involve three parties: l the supplier l the buyer l a financial institution Although the supplier will deliver the asset to the customer, the financial institution will buy the asset from the supplier and then enter into a hire purchase agreement with the buyer This intermediary role played by the financial institution enables the supplier to receive immediate payment for the asset but allows the customer a period of extended credit 244 BUSF_C08.qxd 11/19/08 10:10 Page 245 www.downloadslide.com Conclusions on long-term finance British Airways plc uses HP arrangements At 31 March 2007, 31 per cent of the airline’s planes (by balance sheet value) were being acquired through HP HP agreements are similar to finance leases in so far as they allow a customer to obtain immediate possession of the asset without paying its full cost Under the terms of an HP agreement, however, the customer will eventually become the legal owner of the asset, whereas under the terms of a finance lease, ownership will stay with the lessor Although HP may be regarded as a form of finance more used by smaller businesses, it is widely used by large ones, as we have seen with British Airways 8.11 Grants from public funds In the UK there are many different grants or sources of finance that are given at little or no direct cost to businesses The bulk of such finance emanates either from UK government sources or from the European Union Each of the grants is formulated to encourage businesses to act in a particular way Examples of such action include: l investment in new plant; l development of the microelectronics industry; l training and retraining staff; l energy conservation; and l research and development Many of the grants available apply only, or particularly, to businesses located in specified parts of the UK Since there are so many different schemes, and since they tend to alter quite frequently, it is probably not worth our looking at any individual ones here It must be emphasised, however, that the amounts that individual businesses may claim can be highly significant, and that every effort should be made by financial managers to familiarise themselves with the grants available and how to claim them The Department of Trade and Industry will provide information on most sources of grant finance (See the section on relevant websites at the end of this chapter.) Local authorities, particularly county councils, tend to produce guides to grants available in their own areas 8.12 Conclusions on long-term finance The apparent existence of an efficient capital market, coupled with the evidence on the relationship between risk and expected return, suggests that businesses are unlikely to be advantaged significantly by selecting one type of finance rather than another An increase in equity financing, which does not expose existing ordinary shareholders to increased risk, tends to be expensive Secured loan finance, which does expose them to increased risk, tends to be cheap This suggests that there is no advantage or disadvantage to existing ordinary shareholders in raising further finance in one way rather than another One method may increase expected returns of existing ordinary shareholders but it is also likely to increase their risk commensurately 245 BUSF_C08.qxd 11/19/08 10:10 Page 246 www.downloadslide.com Chapter • Sources of long-term finance However, the situation in real life is probably not quite as suggested by Figure 8.1 (page 219) There are anomalies in the primary capital market that can mean that using one form of financing rather than another can be to the advantage of equity holders For example, loan finance attracts tax relief in a way that equity finance does not Convertibles are probably a cheaper way of issuing ordinary shares than is a direct offer of equities to the public These points and those that will be discussed in the context of the gearing and dividend debates later in the book explain why we find that businesses seem to devote much effort to deciding on the most appropriate means of raising long-term finance Perhaps we could generally conclude that businesses should assess all possible methods of raising long-term finance They should look for anomalies like the ones mentioned above and then seek to exploit them as far as is practical, given the particular circumstances of the business Summary Risk and return are key issues in financing l To the business (that is, the shareholders) sources that are cheap in terms of servicing costs (for example, loans) tend to be risky; those that are less risky (for example, equities) tend to be expensive l To the provider of finance, risk and reward are positively linked, that is, high returns mean high risk, and vice versa Ordinary shares 246 l The owners’ (shareholders’) stake in the business l The largest element of business financing, much of it from retained profits l Risky for the shareholders, low risk for the business; high levels of return expected by investors, expensive for the business l Typically no legal or contractual obligation on the business either to pay dividends or to redeem the shares l Dividends are not tax deductible to the business, but are taxable in the hands of shareholders l Retained profits can be slow and uncertain, but no issue costs l Issues to the public: l Relatively rare in the life of the typical business l The IPO premium is a significant cost to the issuing business l Significant issue costs, perhaps 11 per cent of funds raised, though there are economies of scale l Placings of shares now an important approach to issuing shares l Pricing is an important issue l Not always successful, though underwriter (in effect, insurer) may be used l Control may shift from the original to the new shareholders BUSF_C08.qxd 11/19/08 10:10 Page 247 www.downloadslide.com Summary l l Rights issue = issue to existing shareholders at a discount on the current market value Shares offered pro rata to existing holdings l Issue costs about per cent of funds raised, but there are economies of scale l Issue price is not a big problem l Tend to be successful l Control stays in the same hands if existing shareholders take up their entitlement l Rights can be sold by a shareholder who does not want to take them up l Rights issues seem to be losing their popularity in favour of placings Shares easy to liquidate if listed on a stock exchange; otherwise could be very difficult Preference shares l Shares that have a right to the first part of any dividend paid, up to a maximum level l Relatively little used in recent years l Relatively low risk for the shareholders, some risk to the ordinary shareholders since preference shareholders are usually entitled to any backlog of dividends as well as that for the current year before an ordinary share dividend can be paid l Relatively low cost to the business and low returns to the preference shareholder l Ratios used by preference investors are dividend yield and dividend cover l Typically no legal or contractual obligation on the business to pay dividends, but sometimes there is an enforceable one to redeem the shares l Dividends are not tax deductible to the business, but are taxable in the hands of shareholders l Issue methods and costs similar to those of equities l Shares easy to liquidate if listed on a stock exchange; otherwise could be very difficult Loan notes and debentures l Long-term borrowings, with contractual interest payments and typically redemption payments as well, though some loans are perpetual l Typically an important source of finance l Usually very low risk for the lenders, high risk for the business; low levels of return expected by investors, cheap for the business l Interest is tax deductible to the business (makes them seem even cheaper), and taxable in the hands of lenders l Issued to the public through advertising or investment intermediaries, like stockbrokers, costing up to about 2.5 per cent of the funds raised l The existence of loan finance can severely restrict a business’s freedom of action ‘ 247 BUSF_C08.qxd 11/19/08 10:10 Page 248 www.downloadslide.com Chapter • Sources of long-term finance l Loan notes easy to liquidate if listed on a stock exchange; otherwise could be difficult l Loan covenants (or restrictions) likely to be involved Convertible loan notes l Loan notes that entitle the holders to convert to ordinary shares on or after a particular date at a particular rate of conversion l Not a very important source of finance in recent years l Tend to be used where investors prefer the certainty of a loan, with the option to convert should the equities perform well – it is an option to convert, not an obligation l Loans are self-liquidating; they not require a cash outflow from the business l The relatively low issue costs of loan notes means that, ultimately, convertibles are a cheap way of issuing equities l Other factors similar to those of loans before conversion and equities afterwards Warrants l Options sold by, or attached to loan notes issued by, the business They entitle the holder to subscribe for new shares issued by the business at a specified price at, or after, a certain date Term loans l Loans negotiated between the business and financial institutions, for example a clearing bank l Very important source of finance for businesses of all sizes l Cheap to negotiate – very low issue costs l Usually able to be negotiated to suit the borrower business’s precise needs l Most aspects of term loans are the same as loan notes Asset-backed finance (securitisation) l Raising funds by selling the rights to future cash flows in the form of a security Finance leases l An arrangement where a financial institution buys an asset which it leases to the user for a substantial proportion of the asset’s life l Quite an important source of finance l In effect this is a loan secured on the asset concerned, and the factors relating to loan finance apply to finance leases Sale and leaseback 248 l An arrangement with a financial institution that it will buy an asset already owned by the business and lease it back l Quite an important source of finance BUSF_C08.qxd 11/19/08 10:10 Page 249 www.downloadslide.com Review questions l This too is quite like a loan secured on the asset concerned and the factors relating to loan finance also apply to finance leases Hire purchase l An arrangement for purchasing an asset by instalments, where possession passes to the buyer immediately, but the legal ownership does not pass until the last instalment is paid Grants from public funds l Mainly from government or EU l Intended to encourage businesses to act in a particular way l Schemes change frequently Further reading Arnold (2005) and Brealey, Myers and Allen (2007) give full treatment, from both a theoretical and practical perspective, of corporate financing Relevant websites The site for the London Stock Exchange contains a lot of information and statistics about the exchange www.londonstockexchange.com The sites of Moody’s and Standard and Poor’s are, respectively: www.moodys.com www.standardandpoors.com The site for the Department of Trade and Industry gives information about grants www.dti.gov.uk REVIEW QUESTIONS Suggested answers to 8.1 From the point of view of the borrowing business, loan capital tends to be cheap but review questions appear risky In what sense is it risky? in Appendix 8.2 Why are retained profits not a free source of finance? 8.3 If retained profits are not a free source of finance, why are they nonetheless such a popular source of finance? 8.4 Loan notes, listed on the stock market, have a ‘coupon’ rate (interest rate specified in the contract between the business and the lenders) of 10 per cent Does this necessarily mean that the current pre-tax cost of the loan notes is 10 per cent? 8.5 What factors tend to affect the market value of particular convertible loan notes? (Note that the answer to this question is not really provided in the chapter A combination of background knowledge and common sense should enable you to come up with some relevant points, however.) 8.6 In what way can it be said that finance leasing is a source of long-term finance? 249 BUSF_C08.qxd 11/19/08 10:10 Page 250 www.downloadslide.com Chapter • Sources of long-term finance PROBLEMS Sample answers to problems marked with an asterisk appear in Appendix (Problems 8.1 to 8.3 are basic-level problems, whereas problems 8.4 and 8.5 are more advanced and may contain some practical complications.) 8.1* Many businesses issue loan notes, which carry the right for holders to convert them into ordinary shares in the same business at a later date Why might a business choose to issue convertible loan notes rather than make an issue of equity in the first place? 8.2* Most businesses, particularly larger ones, have outstanding claims (financial obligations) of a wide variety of types from a wide variety of claimants at any given moment Why is there this diversity? 8.3 Polecat plc has 18 million £0.50 ordinary shares in issue The current stock market value of these is £1.70 per share The directors have decided to make a one-for-three rights issue at £1.25 each Julie owns 3,000 Polecat ordinary shares Assuming that the rights issue will be the only influence on the share price: (a) What, in theory, will be the ex-rights price of the shares (that is, the price of the shares once the rights issue has taken place)? (b) For how much, in theory, could Julie sell the ‘right’ to buy one share? (c) Will it matter to Julie if she allows the rights to lapse (that is, she does nothing)? 8.4* Memphis plc has 20 million £0.10 ordinary shares in issue On June the stock market closing price of the shares was £1.20 Early on the morning of June, the business publicly announced that it had just secured a new contract to build some hospitals in the Middle East To the business, the contract had a net present value of £4 million On June the business announced its intention to raise the necessary money to finance the work, totalling £10 million, through a rights issue priced at £0.80 per share Assuming that the events described above were the only influence on the share price, for how much, in theory, could a shareholder sell the right to buy one of the new shares? 8.5 The management of Memphis plc (Problem 8.4) is reconsidering its decision on the rights issue price It is now contemplating an issue price of £1 per new share One of its concerns is the effect that the issue price will have on the wealth of its existing shareholders You have been asked to advise Calculate the effect on the wealth of a person who owns 200 shares in Memphis plc before the rights issue, assuming in turn a rights issue price of £0.80 and £1.00 In each case make your calculations on the basis both that the shareholder takes up the rights, and that the shareholder sells the rights Taking account of all of the factors, what would you advise Memphis plc to about the rights issue price? 250 BUSF_C08.qxd 11/19/08 10:10 Page 251 www.downloadslide.com Problems ‘ There are sets of multiple-choice questions and missing-word questions available on the website These specifically cover the material contained in this chapter These can be attempted and graded (with feedback) online There is also an additional problem, with solution, that relates to the material covered in this chapter Go to www.pearsoned.co.uk/atrillmclaney and follow the links 251 ... real investments 7 .11 Use of CAPM in practice 13 0 13 2 13 5 13 7 14 3 14 4 14 6 14 6 14 6 14 7 15 3 15 3 15 3 15 4 15 9 16 2 16 5 16 6 16 9 17 4 17 4 17 4 17 5 17 6 17 7 17 7 18 4 18 4 18 4 18 6 18 7 18 9 19 8 200 202 202 203... 79 79 80 87 94 97 99 10 4 10 5 10 6 10 6 11 1 11 1 11 1 11 2 11 5 11 6 11 7 12 0 12 1 12 6 BUSF_A 01. qxd 11 /19 /08 9:46 Page vii www.downloadslide.com Contents 5.9 Replacement decisions 5 .10 Routines for identifying,... Evidence on gearing 11 .10 Gearing and the cost of capital – conclusion 11 .11 The trade-off theory 11 .12 Pecking order theory 11 .13 Likely determinants of capital gearing 11 .14 Weighted average