F2 1 Long-Term Finance

F2

Long term finance

F2

Finance is key to a business’s growth. If businesses lack the money to implement long-term plans
or projects, they may turn to long-term finance options.

Sources of finance

There are a number of sources of long-term finance, including capital markets and bank borrowing.

F2

Capital markets

Capital markets (or stock markets/exchanges) look at an entity’s capital as a purchasable

commodity. Each single portion of capital is a share, which when purchased gives the holder
ownership of that portion of the entity.

F2

Example

If a business is valued on a capital market at £100,000, a single share worth £10 would
equate to a 0.0001% ownership stake in the business.

Astranti

Roles of capital markets

 Primary function – Providing businesses with the opportunity to raise both debt and equity
finance

 Secondary function – Providing investors with the opportunity to trade with each other

Bank borrowings

Banks can provide both short-term (fewer than 12 months) and long-term (more than 12 months)
loans, without impacting an entity’s ownership. Both represent amounts which need to be paid
back with interest.
Key terminology regarding the status of companies

Astranti

Definition

Public company

Sells shares to the public and therefore is in part publicly owned.

Private company

Doesn’t sell shares to the public and therefore owned by private investors.

Limited company

Abbreviation of `limited liability’, meaning shareholders only risk the loss of their investment
in a particular company, not their personal assets.

Unlimited company

Investors have no safety net and may need to repay debts from their private assets/funds.

Listed company

A company that is listed/quoted/floated on a stock exchange.

Unlisted company

A company selling shares without being listed on a stock exchange.

F2

A number of combinations stem from these definitions

Listed Public Company Limited liability company selling shares publicly through a stock
market.

Unlisted Public Company Limited liability company selling shares to the public without
using a stock market.

Private Limited Company Limited company which doesn’t sell shares to the public.

Private Unlimited Unlimited company which doesn’t sell shares to the public.
Company
F2

Equity finance
F2

Equity investments are the buying and holding of shares on a stock market by individuals or firms.

There are two main ways by which an investor can make a return on an equity instrument:

 Dividends – Part of a company’s profits, which are paid to its shareholders

 Capital gains – Increases in the value of an investor’s shares over time

Ordinary shares (common stock)

These are the most common type of share.

F2

Ordinary shares

Dividends Not compulsory, so shareholders seek an increase in share

value to earn a return on investment.

Winding up/liquidation In the event of winding up, these shares are the lowest priority
and ordinary shareholders will be compensated last.

Voting rights Ordinary shares bestow holders with the right to vote in
shareholder meetings.

Risk The most risky investment in a company, with a high return

required as a result.

F2

Preference shares (preferred stock)

Provides its holder with a number of beneficial rights over holders of ordinary shares.
Preference shares

Dividends They carry a fixed dividend and companies are obliged to pay
dividends to preference shareholders before ordinary shareholders.

Winding up Higher priority than ordinary shares in the event of winding up,
however still subordinate to bonds or debt.

Voting rates No voting rights, so holders have no say on important company

issues.

Risk Lower risk, but usually more expensive than ordinary shares. More
likely, but smaller, returns.

Status More like bonds and are therefore considered to be hybrid

instruments, containing elements of both equity and debt.

F2

Four kinds of preference share

Cumulative preference Shares receiving a regular dividend from the issuing company.
shares Missing payments in any year must be made up in a
subsequent period.

Non-cumulative Similar to cumulative shares except no payment is received for

preference shares previous periods when a dividend was not received.

Participating preference Provides the shareholder with the opportunity to earn extra
shares dividends based on certain company targets being achieved.

Convertible preference Give the holder the right to convert the preference share to an
shares ordinary share at a later date

Debt finance
F2

Debt finance allows companies to raise finance without giving up ownership. Essentially, a
company is selling a promise to repay a fixed amount (with interest) at a later date.

F
 Definition

Security

A method for lenders to protect themselves from losing the money they have loaned, if the
recipient of the loan can’t repay their debts.

F2

There are two main kinds of security used for securing debt finance:

 Fixed charge – Secures debt against a specific asset, e.g. land, which the debtor would gain
ownership of if the loan is defaulted upon. This is the less risky option for the debtor

 Floating charge – Secures debt against general assets, e.g. inventory. This is the riskier
option for the debtors as there can be uncertainty surrounding what these assets may
include or their value

Debt covenants

Conditions or covenants used by lenders to protect themselves against default by the borrower.
Loans are made conditional on certain requirements.

F2

Types of debt covenants

Ratio limits Lenders may request that certain financial ratios remain at a
minimum level.

Dividend restrictions Limits the amount an entity can pay in dividends to

shareholders.

Financial reports Regular financial reports must be provided to the lender in

addition to the financial statements.

F2

Types of debt finance

Debt finance is mainly obtained from banks and capital markets.

 Bank finance

Bank loans • Provide specific amounts for a set time period, at either
variable (changes with the market) or fixed (doesn’t
change) interest rates

• Can be secured or unsecured (more expensive as higher

risk)

• Loans are simple, easy to arrange and flexible

• Bank facility allowing the withdrawal of funds up to an

Revolving credit facilities agreed credit limit
(RCFs)
• Flexible financing option, minimising interest payments
as interest is only paid on the amount borrowed

Capital market finance

Debentures (bonds, loan • A medium to long-term instrument used by large companies

stock, notes)
• Evidence a company has to repay a specific amount with
interest

• May be secured on company assets

• Offered via the bond market and are freely transferable by the
holder

Convertible debentures  Debentures which can be converted into equity shares of the
issuing company

 Convertibility is attractive to buyers, though it often results in

lower interest rates
 Definition

Face value (Par/Nominal value)

The price paid for debt instruments by investors.

Coupon

The interest paid by a company on a debenture or bond.

Redemption date (Maturity date)

The date by which a company has to repay their investors.

F2

Yield to maturity for a redeemable debt

A method of calculating a debt instrument’s yield, based on the difference between the current
purchase price and the redeemable value. It also takes into consideration the time value of money.
The return or yield is expressed as an annual percentage rate.

F2

Yield to maturity for redeemable debt

NPVa
IRR = A+ x (B - A)
NPVa – NPVb

A = the first discount rate

B = the second discount rate
NPVa = the net present value using discount rate A
NPVb = the net present value using discount rate B

Astranti

Example

Yield to maturity

 NPVa = £127.50
  NPVb = £50.30

 A = 12%

 B = 18%

NPVa
IRR = A+ x (B – A)
NPVa – NPVb

127.5
IRR = 12 + x (18 – 12)
127.5 - (- 50.3)

Yield to maturity = 16.3%

Astranti

Yield to maturity for irredeemable debt

( )
Annual interest
X 100%
Current purchase price of debt

Astranti

Example

Yield to maturity for irredeemable debt

• Bond has a face value of £1,000 and a coupon rate of 10%

• Current purchase price is £800

Annual interest
( Current purchase price of debt
) X 100%

£100 (£1,000 x 0.1)

( £800
) X 100% = 12.5%

F2
Bond markets

The capital or bond markets are the source of long-term debt finance for stock exchange listed
entities. Like the stock market, the bond market has a primary and secondary market.

Bond market

Primary market Where new bonds are issued

Secondary market Where bondholders can buy and sell bonds previously held

The most common process for issuing bonds is through underwriting, using the following process:

Underwriting process

 One or more securities firms or banks form a syndicate

 The book runner is the lead underwriter

 The lead underwriter advises the bond issuer about the timing and price of the bond
issue

 The syndicate re-sells the bonds to investors, either as a bond placement, e.g. sold to
specific investors, or using the bond market to sell to a wider range of investors

 The underwriter effectively takes the risk of being unable to sell on the issue to end
investors, as they will have to buy any unsold shares

Issuing bonds physically in the bond market requires:

 Listing on a recognised exchange (listed entities will already have done this)

 Filing documentation to allow admission to trading

 The appointment of a market maker

W
 Definition

Market maker

A dealer in securities or other assets who agrees to buy or sell at specified prices at all times.
This ensures that the bonds have quoted buy and sell prices throughout the day to allow
them to be traded.

Other long term finance

Astranti

Sale-and-leaseback and warrants are two other examples of long-term finance. Established
companies with significant assets may lack cash and can therefore benefit from these options.

Astranti

Sale and leaseback and warrants

Sale and leaseback Selling non-current assets and leasing them back. A drawback
of this option is that any potential capital gains on leased
assets are forgone.

Warrants Securities entitling the holder to buy underlying stock at fixed

prices. Can be attached to bonds or preference shares
encouraging uptake and allowing the issuer to pay lower
interest rates or dividends.

Astranti

And finally...
Astranti

Stop!

By this stage you should know:

 How companies are classified in relation to their relationship with capital markets

 The characteristics of different share types

 The difference between a fixed and a floating charge

  How to differentiate between debentures and convertible debentures

 How to calculate yield to maturity for redeemable debt

 The formula for calculating the yield to maturity of irredeemable debt

 The definition of a market maker

 Alternative methods of long-term finance

Got it?

If not, go back and re-read the study text before moving on.

Astranti

Question Time

It's now time to practise questions.

If you've signed up for our practice questions or are on our fully inclusive course, here's a direct link
to questions for this chapter:

If you want to sign up for our practise questions here's where you will find more details: