This article considers the practical issues facing a business when selecting appropriate sources of finance. It does not consider the theoretical aspects of such decisions (Modigliani and Miller), nor does it provide detailed descriptions of various sources of finance. These are well covered in manuals and textbooks.
A business faces three major issues when selecting an appropriate source of finance for a new project:
Can the necessary finance be provided from internal sources?
In answering this question the company needs to consider several issues:
Pressurising debtors for early settlement, running down stock levels and lengthening the payment period to creditors could increase cash resources. Note however, there are dangers in such tactics. For example, lost customer/supplier goodwill and production stoppages due to running out of stock etc.
If the necessary finance cannot be provided internally then the company has to consider raising finance externally.
The debt or equity decision
Here a company needs to consider how much it should borrow. This is a very important decision and several British companies have experienced major problems with this decision in recent years, eg Marconi, British Telecom and NTL. Issues to be considered include:
After consideration of the above points the company will be in a position to decide between the use of debt or equity finance. The last major decision is what type of finance should be used and where should it be raised?
A detailed consideration of the different sources of equity finance is beyond the scope of this article and students are recommended to consult their textbooks or manuals for more detailed coverage. However, here are a few general points on the subject:
Debt finance comes in many different forms. Students will find detailed descriptions in their textbooks and manuals. The major considerations in raising new debt finance are detailed below.
The duration of the loan
Generally, short-term borrowing (loans for less than one year) is cheaper than longer-term borrowing (loans for more than one year). This is because many lenders equate time with risk. The longer they lend for, the more risk is involved as more things can go wrong. Hence they charge a higher interest rate on longer-term lending than on short-term lending. However, short-term borrowing has a major disadvantage - renewal risk. Short-term loans have to be regularly renewed and the company carries the risk that lenders may refuse to extend further credit. This risk is at its highest on overdraft borrowing where the bank can call in the overdraft ‘on demand’. With long-term borrowing, as long as the borrower does not breach the debt covenants involved, the finance is assured for the duration of the loan.
In choosing between short-term and long-term borrowing, the firm should consider the textbook rule of thumb for prudent financing: ‘finance short-term investments with short-term funds and long-term investments with long-term funds’. Simply, this means use cheap short-term borrowing where it is safe to do so (investments that are short-term in nature and hence renewal risk is not a problem) but use long-term finance for long-lived investments.
Fixed v floating-rate borrowing
Many lenders offer the borrower the choice between a fixed rate of interest and one that floats (ie varies) with the general level of interest rates. Fixed-rate borrowing has the attraction of certainty (you know what interest rate you are going to pay) but on average is more expensive. This is because lenders see themselves as taking more risk on fixed-rate lending as they may lose out if interest rates increase. Generally, floating (variable) rate borrowing is cheaper, but it carries more risk to the borrower as interest payable may increase if interest rates rise. If a firm is already highly geared it may consider the risks of floating-rate borrowing too high.
The status of the company
Some types of debt finance are only available to large listed companies. Small companies are usually restricted to short-term borrowing. If long-term debt finance is available it is usually in the form of leasing, sale and leaseback, hire purchase or mortgage loans on property.
Currency of borrowing
It is important to remember that if a company borrows in a foreign currency it has to repay the loan and the interest in that currency. Currency fluctuations may add to the cost of the loan and increase the risk involved.
Borrowing money often entails certain obligations for the borrower over and above repaying the interest and principal. These are referred to as covenants. These include restrictions on the use of assets financed by the loan, restrictions on dividend payments and restrictions on further borrowing. Such covenants restrict the flexibility of the borrower and should be carefully considered before borrowing money.
It is not possible to recommend an ideal source of finance for any project. What is important is that students appreciate the advantages and disadvantages of different financing methods and can provide reasoned advice to businesses.
ABC plc needs $100m over the coming year to finance an expansion of the business. Accounting statements for the last financial year are given below.
|Cost of sales*||(180)|
|Pre tax profit||90|
|Profit after tax||66|
|* This includes depreciation of $16m|
|Balance sheet as at 30 June 20X3|
|Non-current assets (net)||100|
|Land and buildings||100|
|Fixtures and fittings||400|
|Liabilities falling due in less than one year:|
|Total assets less current liabilities||766|
|15% debentures 2015 - 2018||(200)|
|Issued share capital||200|
Without the expansion sales turnover, cost of sales (excluding depreciation), dividends and working capital requirements are expected to grow by 10% in the coming year. The corporation tax bill is expected to be $120m. Tax and dividends are paid nine months after the year end.
Required: Calculate ABC’s expected net cash flow for the year ending 30 June 20X4 without the new investment. Comment on the amount of external financing required for the proposed expansion. (Note: a statement in FRS 1 format is not required).
Net cash flow year ending 30 June 20X4
|Turnover (300m x 1.10)||330.0|
|Cost of sales (180m - 16m) x 1.10||(180.4)|
|Tax paid (last year’s bill)||(24.0)|
|Increase in stock (120m x 0.1)||(12.0)|
|Increase in debtors (200m x 0.1)||(20.0)|
|Increase in creditors (170m x 0.1)||17.0|
|Net cash flow||40.6|
Cash flow from operations is expected to be $40.6m in the coming year. If the remaining $59.4m is financed from the cash balance of $80m, then the firm will have no need to raise external finance to finance the proposed expansion.