Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 15 Short- and medium-term finance 405
■
Export factoring and invoice discounting
Export factoring is similar in essence to domestic factoring, with the added bonus that
the factor usually assumes the foreign exchange risk. If an export receivable is to be set-
tled on open account, rather than by DLOC or Bill of Exchange, the exporter can offer
the receivable to a factor in exchange for domestic currency, thus offering protection
against foreign exchange rate movements. The factor provides finance and also absorbs
credit risk. Export factoring may therefore be expensive.
Factors may have their own offices abroad where they can investigate directly the
credit status of firms’ clients locally, or may be a member of a network of independ-
ent factoring organisations. The largest of these is Factors Chain International (FCI),
founded in 1968. FCI now has around 90 member firms, in about 40 of the world’s
main commercial centres.
As with domestic factoring, recourse and non-recourse versions are available, the
latter being very convenient for export business, although more expensive. As well as
a charge for providing finance, the factor applies a service fee of between 0.5 per cent
and 2 per cent for running the sales ledger and collecting debts. In 2003, export invoice
discounting grew 25 per cent to million, while export factoring grew 17 per cent
to billion.£1.1
£2.8
SUMMARY
We have described a variety of short- and medium-term methods of financing compa-
ny operations: trade credit, bank lending, factoring and invoice discounting, money
market finance, HP and leasing. The key features of each source were examined, and
particular emphasis was given to leasing and HP, where the tax implications were
analysed. Several ways of financing foreign trade were also outlined.
Key points
■ Companies have access to significant amounts of trade credit through normal trad-
ing relationships.
■ Abuse of trade credit facilities can lead to severe liquidity problems.
■ Companies are using term loans more extensively, even though these are generally
more expensive than overdraft facilities.
■ The money market can offer significant amounts of credit through bill finance.
■ Hire purchase is often used by smaller, less creditworthy, companies to purchase
equipment. The asset becomes the property of the user upon completion of the con-
tract as scheduled. Users can exploit capital allowances in relation to assets acquired
via HP.
■ Leasing is a way of obtaining the use of an asset without incurring the initial ‘lump’
of capital outlay required for outright purchase.
■ Leases may be ‘job-specific’, contracts applicable for periods less than the lifespan
of assets (operating leases), or for periods coinciding with the asset’s expected life-
time (financial leases).
■ A lease contract normally involves a commitment to pay a series of fixed rental
charges, which qualify the lessee for tax relief. A finance lease is an alternative to
borrowing in order to purchase an asset, and the firm should expect its ability to
borrow to fall by an equivalent amount.
Continued
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406 Part IV Short-term financing and policies
Further reading
The classic works on leasing are by Clark (1978) and Tomkins et al. (1979). Rutterford (1992)
gives a more up-to-date treatment, while successive annual reports of the Finance and Leasing
Association will keep you abreast of developments. Drury and Braund (1990) survey UK practice.
See Bowman (1980) and Narayanaswamy (1994) for empirical work that supports the leasing–
debt equivalence view in the USA and the UK respectively, and Ang and Peterson (1984) for an
exception. Myers et al. (1976) develop the standard lease evaluation model on which the analy-
sis in the chapter is based. Jarvis et al. (2000) have conducted a historical appraisal of UK gov-
ernment policy in this area.
The Bank of England’s annually published Finance for Small Firms (2004) is a mine of informa-
tion on small-firm finance.
■ In the UK, if the ownership of a leased asset passes to the lessee, the tax breaks are
clawed back by the Inland Revenue.
■ SSAP 21 stipulates that leased assets acquired via finance leases must be included
among fixed assets on the firm’s Balance Sheet and that future rental obligations be
recorded as liabilities.
■ Evaluation of a lease, i.e. whether to lease or to borrow-to-buy, may be undertaken
in three equivalent ways:
1 by comparing the present values of the respective cash flow streams;
2 by assessing what equivalent loan could be raised with the same stream of pay-
ments entailed by the lease;
3 by comparing the effective rate of interest payable on the lease with the costs of
raising an equivalent loan.
■ Lease evaluation usually assumes that the asset is worth obtaining in its own right,
regardless of financing method, but an unattractive investment could be rendered
worth-while by leasing. To investigate this, a three-stage analysis should be under-
taken.
■ Even though financial criteria may point to a definite preference, consideration of
non-financial factors may reverse the lease or borrow-to-buy decision.
■ Banks perform a pivotal role in financing international trade.
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Chapter 15 Short- and medium-term finance 407
Questions with a
coloured number have solutions in Appendix B on page 707.
1 A supplier offers you the following trade credit terms: ‘3/15: net 45’.
If you delay payment until day 45, what effective annual interest rate are you paying for additional trade
credit?
2 A bank offers a client a choice between two financing options over a one-year period:
Option 1: a bullet loan for the full year of to be repaid at end year with interest fixed at 12 per cent
p.a.
Option 2: An overdraft, with a quoted rate of 14 per cent p.a, with interest charged quarterly on the average
balance.
The firm expects to need finance of in the first quarter, in quarter 2, in quarter
3 and only in the final quarter due to the seasonal nature of its business. (These are all quarterly aver-
ages).
Unused funds can be invested at 2 per cent per quarter. The bank will not charge interest on accumulated
quarterly interest charges.
(a) What advice would you give?
(b) What is the break-even rate on the overdraft, assuming the interest rate on the loan is fixed at 12 per cent?
3 A trader receives from a customer a Bill of Exchange set to mature in six months, and decides, after two
months, to sell it to a bank. The face value is and the bank discounts the Bill for
What effective annual interest rate is the trader paying to accelerate receipt of his money?
4 What is the monthly interest payment on the following HP contract?
■ Total purchase cost of
■ Down
■ Interest
■ Equal monthly payments over four years.
5 Haverah plc is a manufacturer and distributor of denim garments. It employs a highly aggressive working
capital policy, and uses no long-term borrowing. Highlights from its most recent accounts appear below:
£m
Sales 45.00
Purchases 20.00
Earnings before interest and tax 5.00
Interest payments 2.00
Shareholder funds (comprising issued
shares, par value 50 p, and reserves) 4.00
Debtors 2.50
Stocks 1.00
Trade creditors 6.00
Bank overdraft 5.00
Killinghall is a supplier of cloth to Haverah and accounts for 40 per cent of its purchases. It is most anxious
about Haverah’s policy of taking extended trade credit, so it offers Haverah the opportunity to pay for sup-
plies within 25 days in return for a discount on the invoiced value of 4 per cent.
Haverah is able to borrow on overdraft from its bank at 10 per cent. Tax on corporate profit is paid at 30
per cent.
£3 m
£1 m
rate 7.5 per cent
payment 15 per cent
equipment £100,000
£195,500.£200,000
£200,000
£500,000£500,000£400,000
£500,000
QUESTIONS
Continued
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Required
If Haverah made this arrangement with its supplier, what would be the effect on its working capital cycle and
key accounting measures such as interest cover, profit after tax, earnings per share, return on equity and gear-
ing? Should it accept the offer?
6 Raphael Ltd is a small engineering business which has annual credit sales of million. In recent years, the
company has experienced credit control problems. The average collection period for sales has risen to 50 days
even though the stated policy of the business is for payment to be made within 30 days. In addition, 1.5 per
cent of sales are written off as bad debts each year.
The company has recently been in talks with a factor who is prepared to make an advance to the company
equivalent to 80 per cent of debtors, based on the assumption that customers will, in future, adhere to a 30
day payment period. The interest rate for the advance will be 11 per cent per annum. The trade debtors are
currently financed through a bank overdraft which has an interest rate of 12 per cent per annum. The factor
will take over credit control procedures of the business and this will result in a saving to the business of
per annum. However, the factor will make a charge of 2 per cent of sales for this service. The use of
the factoring service is expected to eliminate the bad debts incurred by the business.
Raphael Ltd is also considering a change in policy towards payment of its suppliers. The company is given
credit terms which allow a 2.5 per cent discount providing the amount due is paid within 15 days. However,
Raphael Ltd has not taken advantage of the discount opportunity to date and has, instead, taken a 50 day pay-
ment period even though suppliers require payment within 40 days. The company is now considering the
payment of suppliers on the fifteenth day of the credit period in order to take advantage of the discount
opportunity.
Required
(a) Calculate the net cost of the factor agreement to the company and state whether or not the company
should take advantage of the opportunity to factor its trade debts.
(b) Explain the ways in which factoring differs from invoice discounting.
(c) Calculate the approximate annual percentage cost of forgoing trade discounts to suppliers and state what
additional financial information the company would need in order to decide whether or not it should
change its policy in favour of taking the discounts offered.
(d) Discuss any other factors which may be important when deciding whether or not it should change its pol-
icy in favour of taking the discounts offered.
(Certified Diploma, June 1996)
7 Amalgamated Effluents plc, a chemical company currently in legal difficulties over its pollution record, is con-
sidering a proposal to acquire new equipment to improve waste generation. The equipment would cost
and have a working life of four years. At the end of Year 4, the disposal value of the equipment is
expected to be The machine is expected to generate incremental cash flows of for each of the
four years.
Amalgamated can acquire the equipment in two ways:
(a) Outright purchase via a four-year bank loan at a pre-tax interest cost of 7 per cent.
(b) A financial lease with rentals of at the end of each of the four years.
Amalgamated is presently ungeared. Its shareholders seek a return of 10 per cent after allowing for all
taxes. Corporation Tax is paid at 30 per cent with no tax delay. If the equipment is purchased, a 25 per cent
writing-down allowance (reducing balance) is available.
Required
Should Amalgamated acquire the equipment and, if so, how should it be financed?
£70,000
£200,000£50,000.
£500,000
£18,000
£2.4
408 Part IV Short-term financing and policies
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Financial managers face two key decisions: which assets to invest in and how to finance them?
Earlier in the book, we discussed strategic investment decisions, and we examined short-term
finance in Part IV.
Also in Part IV, there was strong emphasis on the ‘Golden Rule’ of financing – that long-term assets
should be financed by long-term sources of finance (although we did encounter alternative stances).
It is now appropriate to look at methods of financing long-term investments, i.e. long-term sources
of finance. This is done in Chapter 16.
Choices between alternative forms of finance essentially reduce to choices between different mixes
of borrowing and equity capital in the firm’s capital structure. We therefore examine, in Chapter 17,
the factors that determine a firm’s dividend policy – a decision to distribute higher dividends has
implications for the debt/equity mix, but there are important constraints on dividend policy.
In Chapters 18 and 19, we examine how the use of borrowed funds can affect the value of the
company and the return required on new investments. Chapter 18 presents the ‘traditional’ view on
these issues, while Chapter 19 presents the ‘modern’ theory of capital structure, which emphasises
the essential underlying relationships. We will also discover how borrowing affects the Beta coeffi-
cient, and how to tackle cases of investment evaluation where a firm alters its gearing and its
(systematic) risk. We extend the analysis to cover interactions between investment and financing
decisions and develop a decision rule – the adjusted present value – to handle complex interactions.
In Chapter 20, we examine mergers and takeovers – why they occur, how they are financed, and the
effects they have on organisational structure and shareholder wealth. Other forms of restructuring
are also considered.
Chapter 16 Long-term finance 411
Chapter 17 Returning value to shareholders: the dividend decision 447
Chapter 18 Capital structure and the required return 478
Chapter 19 Does capital structure really matter? 512
Chapter 20 Acquisitions and restructuring 541
STRATEGIC FINANCIAL DECISIONS
Part
V
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Long-term finance
16
Learning objectives
After reading this chapter, you should understand the following:
■ The key characteristics of the main forms of long-term finance.
■ The benefits and drawbacks of each capital form.
■ The factors that influence the choice between the various forms.
Search engine trouble
Successful start-ups that grow and prosper usually
aspire to a stock exchange floatation, partly to enable
the founders to realise some of their investment, and
partly to raise new capital for further expansion.
The Initial Public Offering (IPO) by Google, founded
by Sergey Brin (in his bedroom) and Larry Page in
August 2004, was one of the most interesting and con-
troversial flotations in recent years for several reasons:
■ Google is one of the few dotcom firms with a sus-
tainable and profitable business model.
■ This was one of the largest technology issues ever, in
a sector where firms are notoriously difficult to value.
■ The founders attempted to minimise the financial
pickings of the Wall Street establishment. They tried
to moderate likely first-day excess demand in a
complex Dutch auction process that favoured small
investors, and was designed to slash investment
banks fees by over 50 per cent (2.8 per cent instead
of 7 per cent).
■ Google made a number of highly publicised errors
in the run-up to the floatation. Notable among
these gaffes were failure to register shares award-
ed to employees (called ‘googlers’), and giving an
interview to Playboy magazine that appeared to
breach the rules of the Securities and Exchange
Commission, the US stock market regulator,
regarding promotion of a company’s shares in the
lead-up to an IPO.
■ In addition, it was reticent in its prospectus about
the intended use (‘general corporate purposes’) of
the cash to be raised but, bizarrely, promised ‘not
to be evil’.
■ On the day it announced the target price range, its
operating system all but crashed, overloaded by
the MyDoom internet virus.
Concerned that sentiment was turning against it,
Google, having set its original price range between
$108 and $135, was forced to cut this back to $85 a
few days before the float, as well as reducing the num-
ber of shares on offer from 25.7 million to 19.6 million.
On the launch day, Google shares closed at an 18 per
cent premium, suggesting a successful issue but also
implying that Google’s maladroitness had depressed
the issue price, thus reducing the proceeds of the issue
from a hoped-for $3.5 billion to less than $2 billion.
Nevertheless, founders Brin and Page each banked
around $40 million as the payoff for their entrepre-
neurship, and their remaining stakes were now valued
at $3 billion each.
Source: Several articles in the Financial Times during July and
August 2004.
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412 Part V Strategic financial decisions
16.1 INTRODUCTION
The next four chapters analyse the factors that determine a firm’s long-term financing
decisions. Before we can do this, it is important to present the main sources of finance
and their essential characteristics. With an understanding of the pros and cons of dif-
ferent financial instruments, the reader will more fully appreciate the choices open to
companies and the pressures that drive their choices.
The basic distinction in long-term financing is that between debt and equity, or,
more accurately, between the various forms of debt and the various forms of equity. In
recent years, the demarcation line between debt and equity has become increasingly
blurred by the development of ’hybrid’ forms of finance, such as warrants and con-
vertibles, as companies and their advisers have sought to exploit the advantages of
each form of capital without incurring all the disadvantages.
In 1994, the UK accounting authorities issued a standard, FRS4 Capital Instruments,
designed to clarify these differences and to offer guidance to companies in construct-
ing and presenting their Balance Sheets. FRS4 divides capital instruments into debt
and shareholder funds. Debt is any instrument that creates a liability, including the
right to demand cash or shares at some future date. Shareholder funds are instruments
that are not debt. These are split into equity and non-equity interests: broadly, ordinary
shares and preference shares respectively.
This distinction continues to apply under International Financial Reporting Standards.
hybrid
A security that combines fea-
tures of both equity and debt
16.2 GUIDING LIGHTS: CORPORATE AIMS AND CORPORATE FINANCE
Strategists often divide companies into two categories: niche and global. A niche com-
pany sells high-quality products at a price that offers healthy profits. Such companies
exist by exploiting a product differentiation advantage. A global company is able to
compete in world markets with leading international firms by exploiting its own prod-
ucts at a competitive cost of production. Global companies thus combine product and
cost advantages.
Not all companies aspire to global status; some are run by the proprietor to provide
a livelihood for his or her family. Such proprietorial companies rarely offer sufficient
potential to interest outside investors. Conversely, the entrepreneurial company has
high growth potential and is driven by the desire of the owners to generate substan-
tial wealth – in crude terms, to be ‘seriously rich’.
Yet the predominant motive of many entrepreneurs is not money but the creative
urge, the desire to build a thriving company, often for dynastic purposes. However, for
the owners of such companies to realise their full potential, most of them eventually
have to offer a share of the action to external participants, thus relinquishing a degree
of control. Selling shares of equity involves releasing voting rights (it is possible to
issue non-voting shares, but the Stock Exchange bans these for companies seeking a
listing), and exposing the company’s operations to outside scrutiny. Issuing debt usu-
ally involves some form of restrictive covenant over company financial policy, such as
limits on subsequent borrowing and on dividend policy.
We now examine a short case to give a flavour of the strategic dimension of long-
term financing.
■ Mitre Ltd: strategic financing issues
Mitre is a young, rapidly growing company, operating in the highly competitive com-
puter software market. Its directors are the five founder members, all former employ-
ees of a giant US-owned computer manufacturer. All five found that ‘working for a
master’ inhibited their creative energies. The company was set up on a shoestring,
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Chapter 16 Long-term finance 413
using the personal financial resources of the founders, supplemented by small inputs
of capital from trusting close friends and relatives. After two years of struggle in rent-
ed premises, without paying its owners a salary, it managed to show an operating prof-
it, on the basis of which it persuaded the local bank to extend overdraft facilities.
In subsequent years, Mitre has financed its operations through ploughing back the
bulk of its profits, by further borrowing from the bank and by taking as much trade
credit as possible from suppliers. It expects further rapid growth in the next few years,
but is most concerned to avoid the problems of overtrading. It is, therefore, seeking to
obtain long-term funding to support this growth.
Choosing the financing mix of short- and long-term debt and equity that best meets
the investment requirements of a business is a key element of strategic financial man-
agement. Four issues need to be addressed.
Risk
How uncertain is the environment in which the business operates? How sensitive is it
to turbulence in the economy? Mitre Ltd would probably be viewed by potential
investors as having relatively high risk, particularly if the existing level of borrowing
was high. Such a company will probably have a relatively inflexible cost structure, at
least in the short term. As most of its costs will be fixed (unless it subcontracts work), it
exhibits a high level of operating gearing.
Ownership
A major injection of equity capital by financiers would dilute the control currently exer-
cised by the founder members/directors. The desire to retain control of the company’s
activities may well make them prefer to borrow.
Duration
The finance should match the use to which it is put. If, for example, Mitre Ltd required
finance for an investment in which no returns were anticipated in the early years, it
might be desirable to raise capital that has little, if any, further drain on cash flow in
these years. Conversely, it would be unwise for Mitre Ltd to raise long-term finance if
the projects to be funded have a relatively short life. This could result in the business
being over-capitalised, and unable to generate returns sufficient to service and repay
the finance.
Debt capacity
If Mitre Ltd has a low level of borrowing at present, it has a greater capacity to raise
debt than a similar firm with a higher borrowing level. However, debt capacity is not
just a function of current borrowing levels, but also depends on factors such as the type
of industry, and the security that the company can offer. An important benefit of bor-
rowing is that the interest paid attracts tax relief and, hence, lowers effective financing
charges, although this advantage can only be exploited when the company is profitable.
operating gearing
The proportion of fixed costs in
the firm’s structure operating
cost
16.3 HOW COMPANIES RAISE FINANCE IN PRACTICE
The financial manager can raise long-term funds internally, from the company’s cash
flow, or externally, via the capital market – the market for funds of more than a year to
maturity. This exists to channel finance from persons and organisations with temporary
cash surpluses to those with, or expecting to have, cash deficits. A critical intermediary
function is provided by the major institutions such as pension funds, insurance compa-
nies and various types of bank. These collect relatively small savings and channel them
to companies and other organisations seeking capital. As a result, the institutions are
now the major holders of securities, both debt and equity, issued by companies.
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414 Part V Strategic financial decisions
The record of business financing patterns over the past 50 years or so shows sever-
al clear features:
■ The majority of funds comes from internal sources – retained earnings and depre-
ciation provisions (more strictly, cash flow), depending on company profitability
and dividend policies.
■ Bank borrowing plays a major role but is highly volatile, even negative in some
years as firms repay debt. Firms tend to use bank finance as a buffer – borrowing
heavily when interest rates are low and repaying when rates rise.
■ Sales of shares on the New Issue Market are relatively unimportant, although many
firms try to exploit high and rising stock markets by making rights issues.
■ Long-term debt issues are also small contributors, as are preference share issues.
We now consider the main forms of raising long-term finance to cast some light on
these trends. In Chapters 18 and 19, we will examine several theories that attempt to
explain firms’ long-term financing decisions.
16.4 SHAREHOLDERS’ FUNDS
Authorised and issued share capital
The accounts for Scottish Power plc (www.scottishpower.com) as at March 31 2004
showed:
Authorised £m
3,000,000,000 ordinary shares of 50p each 1,500.0
Allotted, called up and fully paid
1,859,538,923 ordinary shares of 50p each 929.8
Scottish Power thus has scope to issue about a further 1.14 billion shares without seeking
amendment to its Articles. Notice that share capital is recorded in the accounts at par value.
Self-assessment activity 16.1
What impact might the events of 11 September 2001 have on corporate financing decisions?
(Answer in Appendix A at the back of the book)
■ Ordinary shares
Share ownership lies at the heart of modern capitalism. By purchasing a portion or
‘share’ of the ownership of a firm, an investor becomes a shareholder with some degree
of control over a company. A share is therefore a ‘piece of the action’ in a company.
When a company is formed, its Articles of Association will specify how many ordi-
nary shares it is authorised to issue. This maximum can be varied only with the agree-
ment of ordinary shareholders. Meanwhile, the issued share capital is the cornerstone
of a company’s capital structure. Ordinary shareholders carry full rights to participate
in the business through voting in general meetings. They are entitled to payment of a
dividend out of profits and ultimately, repayment of capital in the event of liquidation,
but only after all other claims have been met. As owners of the company, the ordinary
shareholders bear the greatest risk, but also enjoy the fruits of corporate success in the
form of higher dividends and/or capital gains.
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