ACCA paper f9 financial management study materials F9FM session09 d08

SESSION 09 – DEBT FINANCE OVERVIEW Objective To appreciate the options available to a company for long, medium and short-term debt finance DEBT FINANCE LONG-TERM FINANCE Preference shares Debentures Deep discount bonds Zero coupon bonds Tax relief on interest MEDIUM-TERM FINANCE Bank loans Leasing Sale and leaseback Mortgage loans SHORT-TERM FINANCE Bank overdraft Trade credit Bills of exchange Commercial paper OTHER SOURCES Grants Loan guarantee scheme Business angels CONVERTIBLES AND WARRANTS Convertibles Effect on EPS of convertible debt Warrants 0901 SESSION 09 – DEBT FINANCE LONG-TERM FINANCE 1.1 Preference shares Definition Shares with a fixed rate of dividend having a prior claim on profits available for distribution Whilst legally equity, they are often treated as debt as they are similar in nature to debt 1.1.1 Features Shares which have a fixed percentage dividend payable before ordinary dividend The dividend is only payable if there are sufficient distributable profits However if the shares are cumulative preference shares the right of dividend is carried forward Any arrears of dividend are then payable before ordinary dividends As with ordinary dividends, preference dividends are not deductible for corporate tax purposes – they are a distribution of profit rather than an expense On liquidation of the company, preference shareholders rank before ordinary shareholders 1.1.2 Advantages No voting rights; therefore no dilution of control Compared to the issue of debt: Dividends not have to be paid if profits are poor; Not secured on company assets; Non-payment of dividend does not give holders the right to appoint a liquidator 1.1.3 Disadvantages Dividends are not tax deductible (unlike interest on debt) To attract investors the company needs to pay a higher return to compensate for additional risk compared to debt 0902 SESSION 09 – DEBT FINANCE 1.2 Debentures Definition A written acknowledgement of a debt, usually given under the company’s seal, containing provisions for payment of interest and repayment of principal The debt may be secured on some or all of the company’s assets Type Security and voting rights Secured debentures Can be secured on one or more specific assets - a “fixed charge” e.g over property Or a “floating charge” can be offered over a class of assets e.g over net current assets (working capital) Unsecured debentures No security Holders have the same rights as ordinary creditors No voting rights On default the assets are sold and debt repaid No voting rights Income A fixed annual amount, usually expressed as a % of nominal value A fixed annual amount, usually expressed as a % of nominal value Amount of capital A fixed amount per unit of loan stock or debenture A fixed amount per unit of loan stock or debenture In the UK debentures are usually issued with a face value of £100 They can then be traded on the bond market and reach a market price Hence, if a debenture is said to be selling at a premium of £15%, this means that a debenture with a face value of £100 is currently selling for £115 This indicates that the rate of interest on this debenture is attractive when compared with current market rates, creating demand for the debenture and a rise in price In the US the face value of each debenture is usually $1000 Note – the terms “debenture”, “loan stock” and “bond” all basically refer to the same thing i.e a written acknowledgement of a company’s debt which can then be traded Also “face value” can also be referred to as “par value” of “nominal value” 0903 SESSION 09 – DEBT FINANCE 1.3 Deep discount bonds Definition Loan stock issued at a large discount to nominal value − redeemable at par on maturity Investors receive large capital gain on redemption, but low rate of interest during term of the loan Cash flow advantage to the borrower – useful for financing projects which produce weak cash flows in early years Illustration A five year $1000 3% Bond issued at $800 would generate the following cash inflows/(outflows) for the issuing company: Issue price Interest t0 800 t1 t2 t3 t4 t5 (30) (30) (30) (30) (30) Redemption 1.4 (1000) Zero coupon bonds Definition Bonds issued at a discount to face value and which pay zero annual interest No interest is paid Investors gain from the difference between issue and redemption price Advantages to borrowers: No cash payout until maturity; Cost of redemption known at time of issue 1.5 Tax relief on debt interest Interest expense is tax deductible and therefore reduces corporate tax payments Regarding the tax system the Issue of debt is preferable to the issue of shares as dividends are not allowable for tax 0904 SESSION 09 – DEBT FINANCE Illustration Profit before tax Interest Corporation tax 30% CoA 100 − _ 100 (30) _ 70 CoB 100 (10) _ 90 (27) _ 63 $7 difference Effective cost of debt in CoB Interest Less Tax relief 10 (3) _ $7 _ After-tax cost of debt = Pre-tax cost of debt × (1 – Tax rate) The fact that interest on debt is tax allowable is referred to as the “tax shield” CONVERTIBLES AND WARRANTS 2.1 Convertibles Definition Bonds or preference shares that can be converted into ordinary shares Pay fixed interest or dividend until converted They may be: converted into ordinary shares; on a pre-determined date; at a pre-determined rate; at the option of the holder Conversion ratio may change during the period of convertibility − to stimulate early conversion 0905 SESSION 09 – DEBT FINANCE Advantages to investors − a relatively low risk investment with the opportunity to make high returns upon converting to ordinary shares Advantages to issuing company − can offer a lower rate of interest than on “straight” debentures 2.2 Effect on EPS (Earnings Per Share) of convertible debt Convertible debentures require a “fully diluted” EPS to be calculated to indicate what EPS might be if debt is converted into equity Method Increase earnings by the loan interest saved, net of tax Increase the number of shares due to conversion Recalculate EPS 2.3 Warrants Definition A right given to an investor to subscribe cash for new shares at a future date at a fixed price − the exercise price Warrants are sometimes attached to loan stock, to make the loan stock more attractive Warrants are basically share options The holder of the warrants may sell them rather than keep them Advantages to issuing company The warrants themselves not involve the payment of any interest or dividends When they are initially attached to loan stock, the interest rate on the loan stock will be lower than for comparable straight debt This due to the additional benefit for the investor of potential equity shares at an attractive price May make an issue of unsecured loan stock possible where no adequate security exists 0906 SESSION 09 – DEBT FINANCE MEDIUM-TERM FINANCE 3.1 Bank loans 3.1.1 Advantages The loan will be for a fixed term: no risk of early recall; Interest rate may be fixed 3.1.2 Disadvantages Inflexible; May require security, May require “covenants” – restrictions on the company e.g limits on dividend payments, limits on further borrowing 3.2 Leasing 3.2.1 Advantages Many willing providers; Remains off-balance sheet if an operating lease; Matches finance to the asset ; Very flexible packages available, some of which include maintenance 3.2.2 Disadvantage Can be costly 3.3 Sale and leaseback Property is sold to an institution, such as a pension fund, and then leased back to the company 3.3.1 Advantages Releases significant funds; May improve ratios such as ROCE (Return on Capital Employed) 3.3.2 Disadvantages No longer own property and hence cannot participate in any future increase in value; Risk of lease payments increasing 0907 SESSION 09 – DEBT FINANCE 3.4 Mortgage loan — a loan secured on property 3.4.1 Advantages Given the security, the loan will attract a lower interest rate than other debt; Institutions will be willing to lend over a longer term; Still participate in the growth in value of the property 3.4.2 Disadvantage Default may result in a key asset being liquidated SHORT-TERM FINANCE 4.1 Bank overdraft 4.1.1 Advantages Flexible; Provides instant finance 4.1.2 Disadvantages Repayable on call, unless the bank offers a “revolving line of credit” High and variable interest rate 4.2 Trade credit 4.2.1 Advantages Generally cheap; Flexible 4.2.2 Disadvantages May lose settlement (quick payment) discounts; May lose suppliers’ goodwill 0908 SESSION 09 – DEBT FINANCE 4.3 Bills of exchange Definition An acknowledgement of a debt to be paid at some time in the future e.g by a customer Such a bill may then be ”discounted” i.e sold to a third party for a % of face value 4.3.1 Advantages Improves cash flow Flexible 4.3.2 Disadvantages Fees Illustration X sells $2m worth of goods to Y X writes out (“draws”) a bill of exchange for $2m payable in months (say) which it sends to Y Y signs the bill to acknowledge the debt and returns it to X X can hold on to the bill for months until Y pays the debtor sell it at a discount e.g at 98%of face value The buyer of the bill then receives the $2m and makes a gain 4.4 Commercial Paper Definition Commercial paper is short-term (usually less than 270 days) unsecured debt issued by high quality companies The paper can then be traded by investors on the bond markets 4.4.1 Advantages Large sums can be raised and relatively cheaply No security required 4.4.2 Disadvantages Only available to large companies with very good credit ratings 0909 SESSION 09 – DEBT FINANCE OTHER SOURCES Commentary The following are particularly suitable for small and medium sized enterprises (SME’s) which are of particular interest to the examiner as they often have difficulty finding debt finance Such difficulties may be caused by”asymmetry of information” – where banks fear making loans to companies which are not well known and without published credit ratings 5.1 Grants Depending upon the location and nature of the business local, regional, national or European grant assistance may be available 5.2 Loan guarantee scheme Just as small/medium sized companies find it hard to raise equity, they can also find it hard to raise debt, due to their high perceived risk The Loan Guarantee Scheme is a UK government-backed scheme where, for a fee, a substantial proportion of the loan may be guaranteed Hence potential providers of that loan are willing to lend, as most of their risk has been eliminated 5.3 Business angels Business angels are rich individuals who are prepared to invest money in small companies if they see high potential for growth Such angels are often retired businesspeople who became wealthy as entrepreneurs in the high-tech sector They may also give useful advice as well as finance and may even be able to use their contacts to obtain new business for the companies they invest in 0910 SESSION 09 – DEBT FINANCE Key points Preference shares are in substance debt as they pay a fixed committed dividend in priority to any ordinary dividend They also rank ahead of ordinary shareholders upon liquidation (although after “real” debt such as bank loans and debentures) Preference shareholders therefore face lower risk than ordinary shareholders and require lower returns However banks and bondholders take even lower risks, as they rank ahead of preference shareholders upon bankruptcy, and their debts may be secured by fixed or floating charge over assets Providers of loans therefore require lower returns than other providers of finance Hence loans are the least expensive source of finance for a company, particularly if the effect of the tax system is introduced (loan interest is a tax allowable expense, unlike dividends.) Unfortunately debt also has a dark side – too much debt may increase the risks faced by shareholders to unacceptable levels FOCUS You should now be able to: explain the features of preference shares and the reasons for their issue; explain the features of different types of long-term straight debt and the reasons for their issue; explain the features of convertible debt and warrants and the reasons for their issue; assess the effect on EPS of conversion and option rights; suggest appropriate sources of debt finance for SME’s e.g leasing, loan guarantee scheme, and business angels 0911 SESSION 09 – DEBT FINANCE 0912 ... and makes a gain 4.4 Commercial Paper Definition Commercial paper is short-term (usually less than 270 days) unsecured debt issued by high quality companies The paper can then be traded by investors