A business faces three major issues when selecting an appropriate finance source for a new project:
- Can the finance be raised from internal resources or will new finance have to be raised outside the business?
- If finance needs to be raised externally, should it be debt or equity?
- If external debt or equity is to be used, where should it be raised from and in which form?
By: Phoenix Lee/
Can the necessary finance source be provided internally?
In answering this question the company needs to consider several issues:
- How much cash is currently held? The company needs to consider the amount held in current cash balances and short-term investments, and how much of this will be needed to support existing operations. If spare cash exists, this is the most obvious finance source for the new project.
- If the required cash cannot be provided in this way then the company should consider its future cash flow. A cash budget can be prepared, but it is probably too detailed at this stage. A cash flow statement as shown in Example 1 would probably be more practical.
- If the company’s projected cash flow is not sufficient to fund the new project then it could consider tightening its control of working capital to improve its cash position.
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 source 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 companies have experienced major problems with this decision in recent years. Issues to be considered include:
- The cost of finance source. Debt finance is usually cheaper than equity finance. This is because debt finance is safer from a lender’s point of view. Interest has to be paid before dividend. In the event of liquidation, debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper to a taxpaying company. Arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible.
- The current capital gearing of the business. Although debt is attractive due to its cheap cost, its disadvantage is that interest has to be paid. If too much is borrowed then the company may not be able to meet interest and principal payments and liquidation may follow. The level of a company’s borrowings is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and companies must ensure this does not become too high. Comparisons with other companies in the industry or with the company’s recent history are useful here.
- Security available. Many lenders will require assets to be pledged as security against loans. Good quality assets such as land and buildings provide security for borrowing – intangible assets such as capitalised research and development expenditure usually do not. In the absence of good asset security, further borrowing may not be an option.
- Business risk. Business risk refers to the volatility of operating profit. Companies with highly volatile operating profit should avoid high levels of borrowing as they may find themselves in a position where operating profit falls and they cannot meet the interest bill. High-risk ventures are normally financed by equity finance, as there is no legal obligation to pay equity dividend.
- Operating gearing. Operating gearing refers to the proportion of a company’s operating costs that are fixed as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls by a larger percentage. Generally, it is a high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in many service industries where many operating costs are fixed.
- Dilution of earnings per share (EPS). Large issues of equity could lead to the dilution of EPS if profits from new investments are not immediate. This may upset shareholders and lead to falling share prices.
- Voting control. A large issue of shares to new investors could alter the voting control of a business. If the founding owners hold over 50% of the equity they may be reluctant to sell new shares to outside investors as their voting control at the AGM may be lost.
- The current state of equity markets. In a period of falling share prices many companies will be reluctant to sell new shares. They feel the price received will be too low. This will dilute the wealth of the existing owners. Note this does not apply to rights issues where shares are sold to the existing owners of the company. New issues of shares on the UK stock exchanges have been rare over the last few years due to the bear market. At the time of writing there is some evidence that the bear market is coming to an end.
After consideration of the above points the company will be in a position to decide between the use of debt or equity as a finance source. The last major decision is what type of finance source 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 equity finance source:
- For companies who already have shares in issue rights, issues are mandatory under company law. This means that any new shares have to be offered to existing shareholders in proportion to their existing holdings. This is to protect existing shareholders from the company selling shares to new investors at a low price and diluting the wealth of existing shareholders. This requirement may be overcome if existing shareholders are prepared to vote to ‘waive their pre-emption rights’.
- The current status of the company is important. Companies listed on the London International Stock Exchange or quoted on the Alternative Investment Market (AIM), can raise new equity finance by selling new shares on these markets by way of rights issues, offers for sale or placing. Other companies who lack access to the stock exchange find it more difficult to raise equity finance and may need to turn to venture capitalists if they require equity finance.
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.
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