Sources Of Finance


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Sources Of Finance

  1. 1. Sources of Finance Maroof Hussain Sabri Beenish Sarfraz
  2. 2. Contents • Requirement for Finance & Time Horizon • Long Term Finance • Equity Finance – Types of Share – Share Issues • Shareholders View Of Shares – Shareholders’ Ratios – Growth – Equity Analysis Maroof Hussain, Beenish Sarfraz
  3. 3. Requirement for Finance • Long Term Finance (> 7 Years)  To buy a whole business  To finance purchase of a long term asset  Land Buildings Machinery  To finance core working capital  Inventories, • Medium Term Finance (1 to 7 Years)  To finance medium term assets  Computers, cars etc  Core working capital which will eventually be financed from retained profits • Short Term Finance (< 1 Year)  To finance seasonal variations in working capital  Special arrangements for types of working capital  Financing debtors  Supplier credit arrangements Maroof Hussain, Beenish Sarfraz
  4. 4. Criteria For Choice of Finance • Cost After Tax Cost • Duration Long Term Assets  Long Term Funds Working Capital • Part Long Term • Part Short term • Term Structure of Interest Rates • Gearing  Financial Risk • Accessibility Small Company v. Large plc Maroof Hussain, Beenish Sarfraz
  5. 5. Long Term Finance • Equity • Long Term Loans • Government Grants Maroof Hussain, Beenish Sarfraz
  6. 6. Sources of Equity Finance • Retained Profits – No Transaction Costs – Continual Source – But – Shareholders require return Maroof Hussain, Beenish Sarfraz
  7. 7. Equity - Types of Share Capital • Ordinary Shares • Preference Shares – Cumulative – Non Cumulative Maroof Hussain, Beenish Sarfraz
  8. 8. External Share Issues • Unquoted Company ▫ Sources  Private negotiation  Enterprise Investment Scheme  Investors  Individuals, Merchant Banks, Venture Capital • Quoted Company ▫ Finance with new issue  LSE or AIM placing, Offer for Sale (by Tender)  Investors  Public, Pension Funds etc ▫ Finance with Rights Issue  Existing Shareholders Maroof Hussain, Beenish Sarfraz
  9. 9. Stock Exchange Listing • Offer for sale by Prospectus ▫ Fixed Price ▫ Prospectus Contents • Offer for sale by Tender • No fixed price ▫ Potential shareholders bid • Placing ▫ Small issues ▫ Bankers identify potential shareholders • Intermediaries ▫ Brokers allocate to clients • Introduction ▫ Where Public already holds 25% of Shares Maroof Hussain, Beenish Sarfraz
  10. 10. Advisers for New Share Issues • Issuing Houses – 50 to 60 members of Issuing Houses Association – Fees Charged • Investment Banks – Underwriting – Marketing – Pricing of Offers • Fees are significant cost – Can be 5 – 10%, with minimum Maroof Hussain, Beenish Sarfraz
  11. 11. Rights Issues • Offered to Existing Shareholders • Usually at Significant discount to Market Price to reflect – Dilution of Value of One Share – Incentive for shareholders to take up new shares Maroof Hussain, Beenish Sarfraz
  12. 12. Ex Rights Price and Value of Rights Rights Value Model £0.00 Current Share Price £3.25 Rights Issue 1 for 4 Rights issue price £2.25 Value of shares after Rights issue £2.60 Value of Rights £0.35 Maroof Hussain, Beenish Sarfraz
  13. 13. Rights Issue - Shareholders’ Options • Take Up Rights • Sell Rights • Take up Part of Rights • Take No Action Maroof Hussain, Beenish Sarfraz
  14. 14. Other Common Share actions • Bonus Issues – Capitalising Reserves • Scrip Dividends – Take dividends in shares • Share Splits – Mathematically no impact on Share price – But increased liquidity of shares may attract smaller investors Maroof Hussain, Beenish Sarfraz
  15. 15. Choice of Source of Equity Finance • Ability of Company to Raise external finance – Small Company v Large Company • Amount of Finance Required – Limited possibility of Rights Issue for Private Company • Costs and Complexity • Pricing of New Issue • Control of Company • Tax • Dividend Policy Maroof Hussain, Beenish Sarfraz
  16. 16. Ratios For Investors • Earnings per Share – Growth – Net Profit after tax divided by no of shares in issue – Required to be stated in accounts • Dividend per Share – Growth • Dividend Yield – Dividends divided by current share price • Dividend Cover – Profit after tax divided by value of dividends Maroof Hussain, Beenish Sarfraz
  17. 17. Shares As an Investment • Dividend yield: – Dividend per share /Market price per share – Dividend yield shows the percentage of a share’s market value returned as dividends to shareholders each period. – Dividend Yields are published in “Quality” Newspapers and on Maroof Hussain, Beenish Sarfraz
  18. 18. Shares As an Investment Price/earnings ratio:Market price per share of common stock/Earnings per share ◦ It is the ratio of market price per share to earnings per share. If a company is profitable a high price earnings ratio will say that the market has confidence in a company Health warning ◦ It may be a high ratio because of exceptional losses in the current year P/E Ratios and dividend cover are published in the F.T. and Sunday Times. Also available from Maroof Hussain, Beenish Sarfraz
  19. 19. Ratios For Investors • Total Shareholder Return – Returns come from Income & Share Price Growth – Some Companies Publish TSR in accounts and compare it to what they consider to be their peer group – “Shares Magazine” has a list of the top 500 0 011 P PPDiv TSR −+ = Maroof Hussain, Beenish Sarfraz
  20. 20. Growth analysis • Investors are interested in a company’s growth potential so that they can predict and value future cash flows. • Creditors are interested in a company’s growth potential so that they can assess the company’s ability to pay future obligations of interest and principal repayment. Maroof Hussain, Beenish Sarfraz
  21. 21. Sustainable Growth• Sustainable growth is the growth rate the company is expected to maintain in the future. • Sustainable growth, g, is estimated as: – g = (Earnings retention rate) X (Return on equity) – Example • Profit after tax £1500 • Dividends £500 • Retention rate = 66.67% • Return on Equity 15% • Sustainable Growth = 10% • Look for consistency in retentions rate and Dividend Cover Maroof Hussain, Beenish Sarfraz
  22. 22. Equity Analysis How investment analysts look at shares
  23. 23. EQUITY ANALYSIS Intrinsic value of a share = Present value of the expected future earnings or dividends of the company Three variables in the valuation model are : future cash flows timing of cash flows appropriate discount rate Maroof Hussain, Beenish Sarfraz
  24. 24. EQUITY ANALYSIS • Basic principle : if intrinsic value exceeds market value : BUY if market value exceeds intrinsic value : SELL Maroof Hussain, Beenish Sarfraz
  25. 25. EQUITY ANALYSISConstant growth  P= D1  r-g  P Share Price  D1 expected dividends  r minimum rate of return  g constant growth rate of dividends  Maroof Hussain, Beenish Sarfraz
  26. 26. Required Rate of Return Determined by the risk of an investment and available returns in the market Determined by: ◦ The real risk-free rate of return, Usually the rate for short term government finance (Treasury bills) currently 5.3% ◦ A risk premium to compensate for the uncertainty of returns  Sources of uncertainty, and therefore risk premiums, vary by the type of investment ◦ Historically in the UK the average risk premium for the stock market has been 5% ◦ But all shares do not move in line with the market ◦ The relative risk for an individual firm in comparison to the market is called Beta. Maroof Hussain, Beenish Sarfraz
  27. 27. Significance of Beta • Betas for companies shares are published on – A company with a high beta (over 1.0) will rise more than the market when the market is going up and will fall more than the market when the market is going down – A company with a beta of 1.0 will go up and down exactly as the market does – A company with a beta of less than 1.0 will go up less than the market when the market is going up and will go down less than the market when the market is going down Maroof Hussain, Beenish Sarfraz
  28. 28. Rate of return using betas • Return on equity should be Risk Free rate + risk premium for share • Required Return on equity = 5.3% + 5% X β • Example – β = 1.7 – Required return on equity 4% + 5% X 1.7 = 12.5% Maroof Hussain, Beenish Sarfraz
  29. 29. EQUITY ANALYSIS • Example : • If a stock is expected to pay a dividend of £0.30 next year, has a long term growth rate of 12% and a 15% rate of return is required, then it is worth, • P = .30 = £10.00 ______ • .15-.12 Maroof Hussain, Beenish Sarfraz
  30. 30. EQUITY ANALYSIS Advantages : Simple Empirical studies show that models are able to distinguish undervalued from overvalued stocks Disadvantages : Only applies to dividend paying stocks Appropriate discount rate is difficult to ascertain Estimates of g and r may be in error Small changes in r and g produce large differences in valuation Maroof Hussain, Beenish Sarfraz
  31. 31. EQUITY ANALYSIS • Price /Earnings • Considerations : – historical growth rate in earnings, relative to the industry’s average – forecast earnings – instability of earnings (risk) – financial leverage (risk) – competitive position, management ability, economic conditions. Maroof Hussain, Beenish Sarfraz
  32. 32. EQUITY ANALYSIS  Intrinsic value =Earnings per share (EPS) x equivalent P/E ratio,  EPS = Net profit / no. of shares  The equivalent P/E ratio is often based on industry/sector average P/E, modified by the analyst’s assessment of the company’s leadership position and circumstances.  A low P/E compared to the sector’s average suggests that if the market were to value the company similarly to other companies in the sector, the P/E would be much higher. This implies that the intrinsic value of the stock should also be higher.  However, stocks with low P/E may not necessarily perform in the long run because it could be that investors don’t have much interest in the stock. Maroof Hussain, Beenish Sarfraz
  33. 33. EQUITY ANALYSIS • Market value added approach – The book value of a stock – = – Shareholders’ funds – Total number of outstanding ordinary shares • Stocks with low Price to Book ratio relative to the industry’s average have historically outperformed stocks with high Price to Book ratio in the UK. • But a high market to book ratio also signifies investor confidenceMaroof Hussain, Beenish Sarfraz
  34. 34. EQUITY ANALYSIS • Market value added approach • Disadvantages : – Based on historical accounting data and may not truly reflect the current values of the company’s assets. – Does not take into consideration the quality of the company’s assets. – Does not reflect any contingent liabilities/off balance sheet items that may have been incurred. – Most analysts now used P/adjusted book value to price in expected events and their effect on the book value of the company. Maroof Hussain, Beenish Sarfraz
  35. 35. Thank you Maroof Hussain, Beenish Sarfraz