Revision 4 Business Finance

Topic List 1. Internal Sources of Finance a. Retained earnings Advantages and disadvantages b. Increase working capital management efficiency 2. ivi!en! "olic# a. Factors influencing dividend policy b. !"eories of dividend policy Residual t"eory Irrelevancy t"eory by #$# $. )ird*in*t"e*"and +ignaling effect ,lientele effect Information asymmetry Exam Question Reference

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%lternative to &as' ivi!en!s a. +crip dividend b. +tock spilt c. +"are repurc"ase S'ort(term Finance a. .verdrafts b. +"ort*term loan c. !rade credit d. /ease finance

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Lon*(term Finance a. Reasons for seeking debt finance b. Factors affecting c"oice of debt finance

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c. !ypes of bonds +. ,enture &apital -,&. a. #eaning b. Interested in t"e types of business c. Factors to be considered by management to use 1, d. Factors to be considered by 1, w"en invest E0uit# Finance a. Reasons for e2uity finance b. +tock e3c"ange listing c. 4lacing d. Rig"ts issue

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e. 4ublic offer 1. Islamic Finance a. 6eneral principles b. Difference between Islamic finance and conventional finance c. ,oncept of interest 7Riba8 d. .t"er financial instruments !rade credit 7#uraba"a8 /ease finance 7I9ara8 :2uity finance 7#udaraba8 Debt finance 7+ukuk8 1enture capital 7#us"araka8 3earin* an! &apital Structure &onsi!erations a. 4roblems of "ig" level of gearing b. .perating gearing c. Financial gearing Ratio %nal#sis a. +"are"older wealt" ratios
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b. Debt "older ratios

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Finance for S5Es a. Financing problem for small businesses b. #easures to ease t"e financing problems c. Appropriate sources of finance for +#:s d. Impact of different sources of finance

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"art , Business Finance -un*11 Topics I. I!entif# an! iscuss S'ort(term Finance 1. .verdraft (. +"ort*term loan '. !rade credit . /ease finance II. Sources of an! Raisin* Lon*(term Finance ;. Identify and discuss long*term finance a. :2uity finance b. Debt finance c. /ease finance d. 1enture capital <. Identify and discuss met"ods of raising e2uity finance a. Rig"ts issue b. 4lacing c. 4ublic offer d. +tock e3c"ange listing III. Internal Sources of Finance an! ivi!en! "olic# %. Identify and discuss internal sources of finance a. Retained earnings b. =orking capital management efficiency 0. :3plain t"e relations"ip between dividend policy and financing decision &. Discuss t"e t"eoretical approac"es to5 and t"e practical influences on5 t"e dividend decision a. /egal constraints b. /i2uidity c. +"are"older e3pectations d. Alternatives to cas" dividends I,. 3earin* an! &apital Structure &onsi!erations 10. Identify and discuss t"e problem of "ig" levels of gearing 11. Assess t"e impact of sources of finance on financial position and financial risk using appropriate measures a. Ratio analysis b. ,as" flow forecasting c. :ffect on s"are"older wealt" ,. Finance for S5Es 1(. Describe t"e financing needs of small businessess 1'. Financing problem for small businesses a. Funding gap b. maturity gap c. Inade2uate security 1 . #easures to ease t"e financing problems of +#:s a. Responses of government departments b. Financial institutions 1;. Appropriate sources of finance for +#:s 1<. Impact of different sources of finanace for +#:s ,I. Raisin* s'ort an! lon* term finance t'rou*' Islamic financin* a. :3plain t"e ma9or difference between Islamic finance and t"e ot"er conventional finance b. :3plain t"e concept of interest 7riba8 and "ow returns are made by Islamic financial securities 7no calculations8 c. Identify $ briefly discuss a range of s"ort and long term Islamic financial instruments i. !rade credit 7muraba"a8 ii. /ease finance 7i9ara8 iii. :2uity finance 7mudaraba8 iv. Debt finance 7sukuk8 v. 1enture capital 7mus"araka8 Dec*10 -un*10 Dec*0& -un*0& Dec*00 -un*00 Dec*0% 4ilot

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Internal Sources of Finance

Retaine! earnin*s Retained earnings is surplus cas" t"at "as not been needed for operating costs5 interest payments5 ta3 liabilities5 asset replacement or cas" dividends. A company may "ave substantial retained profits in its statement of financial position but no cas" in t"e bank and will not t"erefore be able to finance investment from retained earnings. Advantages and disadvantages> %!vanta*es Retentions are a flexi6le source of finance? Does not involve a c'an*e in t'e pattern of s'are'ol!in*s an! no !ilution of control? @ave no issue costs. isa!vanta*es S'are'ol!ers may be sensitive to t'e loss of !ivi!en!s t"at will result from retention for re* investment5 rat"er t"an paying dividends. !"ere is an opportunit# cost in t"at if !ivi!en!s 7ere pai!5 t"e cas" received could be invested by s"are"olders to earn a return.

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Increase 7or8in* capital mana*ement efficienc# Internal source of finance can be t"e savin*s from more efficient mana*ement of trade receivables5 inventory5 cas" and trade payables. :fficient working capital management can re!uce 6an8 over!raft an! interest c'ar*es as well as increasin* cas' reserves.

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ivi!en! "olic#
Factors influencin* !ivi!en! polic# !"e nee! to remain profit to maintain its operating capability unc"anged ivi!en! restraints imposed 6# loan a*reements Effect of inflation 5aintain or re!uce t'e *earin* level 5aintain li0ui!it# position A dividends are a cas" payment5 if a company "as

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not enoug" cas"5 dividends cannot be paid !"e nee! to repa# !e6t in t"e near future !"e ease of raisin* extra finance A small company may find it "ard to raise e3ternal finance5 so it rely more "eavily on retained earnings. !"e si*nalin* effect of dividends to s"are"olders and t"e financial markets in general.

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T'eories of !ivi!en! polic# Resi!ual t'eor#> 9nl# 7'en t'e investment opportunities are ex'auste! s"ould !ivi!en!s 6e pai!. Irrelevanc# t'eor# 7by #$#8> 5iller an! 5o!i*liani s"owed t"at5 in a perfect capital mar8et5 t"e value of a compan# !epen!e! on its investment !ecision alone5 and not on its !ivi!en! or financin* !ecisions. In suc" a market5 a c'an*e in !ivi!en! polic# 7oul! not affect its s'are price or its market capitalisation. !"ey s"owed t"at t"e value of a compan# 7as maximise! if it investe! in all pro:ects 7it' a positive net present value 7its optimal investment sc"edule8. !"e compan# coul! pa# an# level of !ivi!en! and if it "ad insufficient finance5 ma8e up t'e s'ortfall 6# issuin* ne7 e0uit# . +ince investors 'a! perfect information5 t"ey were in!ifferent 6et7een !ivi!en!s an! capital *ains. S'are'ol!ers w"o were un'app# 7it' t'e level of !ivi!en! declared by a company could gain a B"ome*made dividendC by sellin* some of t'eir s'ares. !"is was possi6le since t"ere are no transaction costs in a perfect capital mar8et. Bir!(in(t'e('an!>
Investors prefer certain !ivi!en!s no7 rat"er t"an uncertain capital gains in t"e future.

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Si*nalin* effect> Increase in !ivi!en!s would si*nal *reater confi!ence in t"e future by managers and would lea! investors to increase t'eir estimate of future earnin*s an! cause a rise in t'e s'are price. It implies t"at dividend policy is relevant. ,ompanies s"ould attempt to adopt a stable 7or rising8 dividend payout to maintain investorsC confidence. &lientele effect;
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S'are'ol!ers are attracte! to particular companies as a result of 6ein* satisfie! 6# t'eir !ivi!en! policies.
!"e existence of t'is !ivi!en! clientele implies t"at t"e s'are price ma# c'an*e if t'ere is a c'an*e in t'e !ivi!en! polic# of t"e company5 as s'are'ol!ers sell t'eir s'ares in order to reinvest in anot'er compan# 7it' a more satisfactor# !ivi!en! polic#.

In a perfect capital mar8et5 t"e existence of !ivi!en! clienteles is irrelevant5 since substituting one company for anot"er will not incur any transaction costs. Real(7orl! capital mar8ets are not perfect< perfect information is t'erefore not availa6le< it is possible for information as#mmetr# to exist between s"are"olders and t"e managers of a company. ivi!en! announcements may *ive ne7 information to s'are'ol!ers and as a result5 in a semi*strong form efficient market5 s'are prices ma# c'an*e.

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Information as#mmetr#;

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%lternative to &as' ivi!en!s

Scrip !ivi!en! -or 6onus issue or capitali=ation issue. Is a dividend paid by t"e issue of additional company s"ares5 rat"er t"an by cas". +crip dividend will be made w"en a company prefers to retain funds wit"in t"e business but consider t"at t"ey must maintain a certain amount of dividend. Advantages of scrip dividends> "reserve cas' position Investors can o6tain tax a!vanta*es if dividends are in t"e terms of s"ares ecrease t'e compan#>s *earin* and so en'ance its 6orro7in* capacit# Disadvantage of scrip dividends> It affects in future years5 because t"e number of s"ares in issue "as increased5 t"e total cas' !ivi!en! 7ill increase5 assuming t"e dividend per s"are is maintained or increased. Stoc8 split A stock split occurs w"ere5 for e3ample5 eac" ordinary s"are of D1 eac" is spilt into two s"ares of ;0c eac". It can create c'eaper s'ares 7it' *reater mar8eta6ilit#. In general5 t"e mar8et price of s'are ma# 6enefit after stock spilt because investors
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may "ave t"e anticipation of stron* future *ro7t' in earnin*s an! !ivi!en!s. !"e !ifference 6et7een a stoc8 spilt an! a scrip issue is t"at a scrip issue coverts e0uit# reserves into s'are capital5 w"ereas a stoc8 spilt leaves reserves unaffecte!. S'are repurc'ase For a smaller compan# wit" few s"are"olders5 t"e reason for 6u#in* 6ac8 t"e companyCs own s"ares may be t"at t"ere is no imme!iate 7illin* purc'aser at a time 7'en a s'are'ol!er 7is'es to sell s'ares. For a pu6lic compan#5 s"are repurc"ase could provide a way of 7it'!ra7in* from t'e s'are mar8et an! *oin* private. )enefits and drawbacks> %!vanta*es ?se of surplus cas'5 w"ic" may be a !ea! asset. Increase E"S Increase in *earin* Rea!:ust t'e compan#>s e0uit# 6ase to more appropriate level "revent a ta8eover :nable a 2uoted company to *o private isa!vanta*es @ar! to arrive at a price Admit t"at t"e compan# cannot ma8e 6etter use of fun!s S'are'ol!ers may suffer from being ta3ed on a capital *ain

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S'ort(term Finance
9ver!rafts 5ost important sources of s'ort(term finance and can arran*e relativel# 0uic8l# wit" t"e level of flexi6ilit#. Soli! core -or 'ar! core. over!raft A means t"at t"e company is al7a#s in over!raft and become a lon*(term feature. Advantages and disadvantages %!vanta*es Fle3ible source of finance .nly pay for w"at is used5 so isa!vanta*es Repayable on demand #ay re2uire security5 e.g. floating

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c"arges or personal guarantee :3pose to t"e risk of an interest rates increase

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S'ort(term loans It is a loan for a fi3ed amount for a fi3ed period. Advantages> Borro7er 8no7s 7'at "e will be e3pected to pa# 6ac8 at regular intervals Ban8 can also pre!ict its future income wit" more certainty Aot repa#a6le on !eman! Tra!e cre!it ItCs a interest free s"ort*term loan. #ay "ave t"e following costs incurred if not settle w"en fall due> /oss of early settlement discounts =orsen t"e credit rating Leasin* Details refer to Revision (5 point <.1

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e6t Finance
Reasons for see8in* !e6t finance Reasons> +"are"olders are unwilling to contribute additional capital Does not wis" to involve outside s"are"olders /esser cost and easier availability !a3 relief on interest payments Factors influencin* c'oice of !e6t finance Factors> 3earin* an! financial ris8 A if already too "ig"5 not suitable to raise debt

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finance Tar*et capital structure A a company s"ould seek to minimiEe its =A,,. In practical terms t"is can be ac"ieved by "aving some debt in its capital structure5 since debt is relatively c"eaper t"an e2uity. %vaila6ilit# of securit# A debt will usually need to be secured on assets by eit"er a fi3ed c"arge or a floating c"arge. Economic expectations A it is more easy to borrow money from bank in good economic conditions Interest rate movements A e3pectations of interest rate movements will determine w"et"er a company c"ooses to borrow at a fi3ed or floating rate uration A If loan finance is soug"t to buy a particular asset to generate revenues for t"e business5 t"e lengt" of t"e loan s"ould matc" t"e lengt" of time t"at t"e asset will be generating revenues

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Bero coupon 6on!s Issued at a discount but no interest is paid. Advantages for borrower> Ao cas' repa#ment until redemption date &ost of re!emption is 8no7n at t"e time of issue eep !iscount 6on!s Deep discount bonds are loan notes issued at a price w"ic" is at a lar*e !iscount to t"e nominal value of t"e notes. &onverti6le loan notes

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6ive t"e "older t"e rig"t to convert to ot"er securities5 normally ordinary s"ares5 at a pre*determined price and time. ;. .' Issue at par normally "as a lo7er coupon rate of interest t'an strai*'t !e6t. !"is lo7er #iel! is t"e price t"e investor "as to pay for t'e conversion ri*'ts. ;. . !"e actual market price of convertible loan notes will depend on> 4rice of straig"t debt ,urrent conversion value /engt" of time before conversion may take place #arket e3pectation as to future e2uity returns and t"e risk associated wit" t"ese returns
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,enture &apital
#eaning> /ong*term capital offered by specialist institutions Aim at small and medium*siEe businesses t"at "ave a fairly "ig" level of risk In general5 interested in a business wit" good profit and growt" prospects 1enture capitalist may be interested in t"e following types of business> Business start(ups 3ro7t' capital A business "as already passed t"e start*up p"ase and is seeking capital for furt"er e3pansion 5ana*ement ac0uisitions A provide capital for managers t"at wis" to take over an e3isting business S'are purc'ases A provide to "elp finance t"e buy*out of a part*owner of a business Business recoveries A "elp turn round t"e fortunes of a business t"at is currently e3periencing difficulties Factors to 6e consi!ere! 6# mana*ement w"en using venture capital finance ="et"er t"e management can meet t"e 'i*' returns tar*et by venture capitalists 1enture capitalists may re0uest to 'ave a representative on t"e board of directors 1enture capitalists often re2uest to 'ave internal an! sensitive information of t"e company suc" as forecasts and ot"er financial information 1enture capitalist will e3pect to receive an e0uit# sta8e and will often sell t"is stake later. !"e directors s"ould know t"at t"e business may be sold to anot"er business or investors5 so t"ey may loss t'e control or even t'eir :o6. Factors to be considered by venture capitalist w"en assessing an investment Financial performance !"e mar8et for t'e pro!ucts or services A for e3ample5 t"e degree of competition5 t"e t"reat of substitutes5 t"e bargaining power of suppliers5 t"e barriers to market entry5 etc. 97ner investment A t"e venture capitalist will e3pect t"e owners to demonstrate t"eir belief in t"e venture in a tangible way
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!"e 0ualit# of mana*ement Ris8 A it involves t"e types of risk t"at will be encountered by t"e business Business operations A t"e nature and comple3ity of internal business operations will be e3amined Exit route A t"e venture capitalist will normally identify a possible e3it route and time frame before entering into t"e investment

Question 1 1enture capital is an important source of capital for some businesses. Re0uire!; 7a8 :3plain w"at is meant by t"e term Bventure capitalC and identify t"e main types of business ventures t"at are likely to be an attractive investment for a venture capitalist. 7% marks8 .utline t"e main issues t"at t"e board of directors of a company s"ould take into account w"en considering t"e use of venture capital finance. 7 marks8 Discuss t"e main factors t"at a venture capitalist will consider w"en assessing an investment proposal. 7& marks8 7!otal (0 marks8

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E0uit# Finance
Internall#(*enerate! fun!s It comprises of> Retained earnings Fon*cas" c"arges against profits 7e.g. depreciation8 %!vanta*es an! !isa!vanta*es for e0uit# finance; Advantages> Decrease gearing and so decrease financial risk Fot re2uire security /ower interest payment if replace t"e debt Disadvantages> #ay dilute t"e owners"ip and control of e3isting s"are"olders 7rig"ts issue

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may not only if t"ey take up t"eir rig"ts8 @ig"er costs t"an debts #ay not be able to obtain t"e fundings from e3isting s"are"olders

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Stoc8 exc'an*e listin*

A stock e3c"ange is a market place t"at is designed to bring toget"er providers of capital and companies seeking to raise capital. It acts as bot" a primary market and a secondary market for securities. %.(.( "rimar# mar8et A facilitates t"e issue of new s"ares and debentures by public companies. %.(.' Secon!ar# mar8et A facilitates t"e purc"ase and sale of Bsecond*"andC securities. A stock e3c"ange enables investors to transfer t"eir investments easily and 2uickly. %.(. %!vanta*es of listing> S'are transfera6ilit# A s"ares can be transferred easily and so encourage investment S'are price A s"ares listed in e3c"ange s"ould be priced more efficiently t"an non*listed company5 w"ic" give investors confidence w"en buying or selling s"ares &ompan# profile A "elp t"e company in establis"ing new contracts or in developing business opportunities Business com6inations A stock e3c"ange can facilitate takeovers and mergers %.(.; isa!vanta*es of listing> @i*' flotation costs A e.g. underwriting fees5 professional fees5 etc. Re*ulator# costs A t"e cost of maintaining a stock e3c"ange listing can be "ig"5 e5g. must "ave non*e3ecutive directors5 audit committee5 etc. &ontrol A e3isting s"are"olders may suffer loss of control Investors expectations A it may put pressure on t"e directors to produce gains over t"e s"ort term Ta8eover tar*et A a listed company is muc" more vulnerable to a takeover t"an an unlisted company Question 2 A well*functioning stock e3c"ange is an essential re2uirement of a well*functioning private enterprise system.

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Re0uire!; 7a8 7b8 )riefly e3plain t"e nature and purpose of a stock e3c"ange. 7 marks8 Discuss t"e possible advantages and disadvantages for a company of obtaining a listing on a stock e3c"ange. 71< marks8 7!otal (0 marks8 "lacin*

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Aot all offere! to t'e pu6lic but sell to a smaller num6er of investors5 usually institutional investors suc" as pension funds and insurance companies. %.'.( %!vanta*es of placing> 4lacing is muc" c'eaper 4lacing is likely to be 0uic8er ecrease *earin* 4lacing is likely to involve less !isclosure of information Aot re0uire securit# w"en compared wit" debt finance %.'.' isa!vanta*e of placing> ilute o7ners'ip an! control A institutional s"are"olders may "ave control of t"e company /.4 %. .1 Ri*'ts issue

It is an offer to existin* s'are'ol!ers enabling t"em to 6u# more s'ares5 usually at a price lo7er t'an t'e current mar8et price. %. .( %!vanta*es of a rig"ts issue> &'eaper t"an I4.s and no prospectus #ore 6eneficial to existin* s'are'ol!ers because of t"e pre*emptive rig"ts Relative votin* ri*'ts are unaffecte! if s"are"olders all take up t"eir rig"ts Re!uce *earin* Ao securit# re2uired %. .' Gnderstand t"e calculation of t'eoretical ex(ri*'ts price %. . %ctions to s"are"olders for rig"ts issue> !ake up all t"e rig"ts A no effect on control and wealt" !ake up part of t"e rig"ts A dilute control but no effect on wealt" Do not"ing A may affect bot". @owever5 some +tock :3c"ange rules state t"at if new securities are not taken up5 t"ey s"ould be sold by t"e company to new

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subscribers for t"e benefits of t"e s"are"olders w"o were entitled to t"e rig"ts. %. .; Actual market price after a rig"ts issue> ?nc'an*e! A if t"e e3pected returns of t"e additional funds are t"e same wit" t"e e3isting funds Fall A if t"e e3pected returns of t"e additional funds are lower t"an t"e e3isting funds Rise A if t"e e3pected returns of t"e additional funds are "ig"er t"an t"e e3isting funds Question $ S'are price calculation< ri*'ts issue< semi(stron* form< e0uit# finance an! !e6t finance !@4 ,o is planning to buy ,RH ,o5 a company in t"e same business sector5 and is considering paying cas" for t"e s"ares of t"e company. !"e cas" would be raised by !@4 ,o t"roug" a 1 for ' rig"ts issue at a (0I discount to its current s"are price. !"e purc"ase price of t"e 1 million issued s"ares of ,RH ,o would be e2ual to t"e rig"ts issue funds raised5 less issue costs of D'(05000. :arnings per s"are of ,RH ,o at t"e time of ac2uisition would be J0c per s"are. As a result of ac2uiring ,RH ,o5 !@4 ,o e3pects to gain annual after*ta3 savings of D&<5000. !@4 ,o maintains a payout ratio of ;0I and earnings per s"are are currently < c per s"are. Dividend growt" of ;I per year is e3pected for t"e foreseeable future and t"e company "as a cost of e2uity of 1(I per year. Information from !@4 ,oCs statement of financial position>

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Re0uire!; 7a8 7b8 ,alculate t"e current e3 dividend s"are price of !@4 ,o and t"e current market capitalisation of !@4 ,o using t"e dividend growt" model. 7 marks8 Assuming t"e rig"ts issue takes place and ignoring t"e proposed use of t"e funds raised5 calculate> 7i8 t"e rig"ts issue price per s"are? 7ii8 t"e cas" raised? 7iii8 t"e t"eoretical e3 rig"ts price per s"are? and 7iv8 t"e market capitalisation of !@4 ,o. 7; marks8 Gsing t"e priceKearnings ratio met"od5 calculate t"e s"are price and market capitalisation of ,RH ,o before t"e ac2uisition. 7' marks8 Assuming a semi*strong form efficient capital market5 calculate and comment on t"e post ac2uisition market capitalisation of !@4 ,o in t"e following circumstances> 7i8 !@4 ,o does not announce t"e e3pected annual after*ta3 savings? and 7ii8 t"e e3pected after*ta3 savings are made public. 7; marks8 Discuss t"e factors t"at !@4 ,o s"ould consider5 in its circumstances5 in c"oosing between e2uity finance and debt finance as a source of finance from w"ic" to make a cas" offer for ,RH ,o. 70 marks8 7(; marks8 7A,,A F& Financial #anagement -une (000 Q(8

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Question 4 Ri*'ts Issue !irwen plc is a medium*siEed manufacturing company w"ic" is considering a 1 for ; rig"ts issue at a 1;I discount to t"e current market price of L J00 per s"are. Issue costs are e3pected to be L((05000 and t"ese costs will be paid out of t"e funds raised. It is proposed t"at t"e rig"ts issue funds raised will be used to redeem some of t"e e3isting debentures at par. Financial information relating to !irwen plc is as follows>

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Re0uire!; 7a8 Ignoring issue costs and any use t"at may be made of t"e funds raised by t"e rig"ts issue5 calculate> 7i8 t"e t"eoretical e3 rig"ts price per s"are? 7ii8 t"e value of rig"ts per e3isting s"are. 7' marks8 ="at alternative actions are open to t"e owner of 15000 s"ares in !irwen plc as regards t"e rig"ts issueM Determine t"e effect of eac" of t"ese actions on t"e wealt" of t"e investor. 7< marks8 ,alculate t"e current earnings per s"are and t"e revised earnings per s"are if t"e rig"ts issue funds are used to redeem some of t"e e3isting debentures. 7< marks8 :valuate w"et"er t"e proposal to redeem some of t"e debentures would increase t"e wealt" of t"e s"are"olders of !irwen plc. Assume t"at t"e priceKearnings ratio of !irwen plc remains constant. 7' marks8

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Discuss t"e reasons w"y a rig"ts issue could be an attractive source of finance for !irwen plc. Nour discussion s"ould include an evaluation of t"e effect of t"e rig"ts issue on t"e debtKe2uity ratio and interest cover. 7% marks8 7!otal (; marks8 7A,,A (. Financial #anagement and ,ontrol December (00 Q'8

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Islamic Finance
3eneral principles

0.1.1 !"e following are t"e main principles of Islamic finance> All investments must be made according to t"e rules of S'aria' 7Islamic /aw8. Ao transaction must be carrie! out for *oo!s t'at are not 'alal 7 )5 e.g. alco"ol5 gambling5 drugs5 etc. !"e ris8 relating to a transaction must 6e s'are!. !"e entities investing funds and t"e entities managing t"e funds s"are t"e business risk in return for a s"are in profit. !"e following are pro'i6ite!> Riba5 i.e. payment or receipt of interest #asir5 i.e. speculation or gambling 6a"arar5 i.e. uncertainty regarding t"e sub9ect of sale or t"e terms of t"e contract. A person must not trade in t"ings t"at t"ey do not own. 1.2 ifferences 6et7een Islamic an! conventional finance

0.(.1 Differences> Islamic finance Religious principles Debt capital &onventional finance Ad"eres to t"e principles of Does not follow rules of any Islam religion Receipt and payment of Fo pro"ibition interest is pro"ibited. securities. @ence5 debt securities cannot be issued. on debt

@ybrid securities +peculation

,annot be issued because Fo pro"ibition. !"ey are t"ey are part debt. used to raise capital. Is not allowed Is allowed

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@alal goods

.nly supports businesses in !rading in all types of "alal goods. goods is allowed as long t"ey do not violate any applicable law. Allowed Fot re2uired

!rading in none3istent 1oid goods .wners"ip of t"e Re2uired sub9ect of t"e trade 4ossession of sub9ect of sale +ale at future date ,onditional sale

t"e 4"ysical or constructive Fot re2uired possession is re2uired 4ro"ibited Allowed Allowed only w"en t"e Allowed. Fre2uently used in condition according to t"e real estate transactions. usage of trade is recogniEed as a part of t"e transaction

Question ) 7a8 /ist t"e main principles of Islamic finance. 7b8 )riefly e3plain t"e differences between Islamic and conventional finance. 1.$ Ri6a -Interest.

0.'.1 #eaning> #eans e3cess5 increase or addition It is pro"ibited under Islamic laws because it refers to any e3cess compensation wit"out due consideration 0.'.( :ffect on Islamic finance Interest cannot 6e c'ar*e! +o use profit s'arin* or fee 6ase! approac' for obtaining returns on t"e funds provided 1.4 5ara6a'a -Tra!e cre!it.

0. .1 #eaning> A contract of sale between a financer and its client for financing t"e ac2uisition of assets by t"e client. !"e price consists of t"e cost of t"e asset and premium 7profit margin agreed

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between t"e financer and its client8. !"ere are two ways for t"e repayment> Deferred payment Repayment in instalments 0. .( +teps involved in #uraba"a +tep 1> an agreement is signed between t"e financer and its client t"at from time to time t"e financer will sell assets5 t"e client will re2uire and purc"ase t"em. !"e assets will be sold at a premium to t"e client. !"e margin of premium and repayment sc"edule will be mentioned in t"e agreement. +tep (> w"en t"e client re2uires an asset5 t"e financer will appoint t"e client as its agent to purc"ase t"e asset. +tep '> t"e client will buy t"e asset as t"e financerCs agent and will take possession of t"e asset. +tep > t"e client will inform t"e financer t"at t"e asset "as been purc"ased by it as t"e financerCs agent. !"e client will immediately give an offer to t"e financer to buy t"e asset. +tep ;> t"e financer will accept t"e clientCs offer and will sell t"e asset at a premium to t"e client. !"e client will pay for t"e asset as determined according to t"e agreement signed in step 1.

1.)

I:ara -Lease finance.

0.;.1 #eaning>
&%

Is a lease contract t"at allows an entity to obtain an asset on lease for a specific time and cost /essor ac2uires an asset and leases it out for a rental fee Rental fee consists of t"e capital cost of t"e asset and t"e profit margin of t"e lessor

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5u!ara6a -E0uit# finance.

0.<.1 #eaning> Is an arrangement in w"ic" one entity provides t"e capital 7financer8 and anot"er entity provides e3pertise and management 7entrepreneur8 !"e profits from t"e business are s'are! in pre(!etermine! ratio w"ereas t"e losses are 6orne 6# t'e financer ,losely resem6les t'e partners'ips in conventional finance5 t"e financer is e2uivalent to a sleepin*C!ormant partner in a partners"ip 0.<.( #udaraba is commonl# use! for investment of fun!s . !"e investors give t"e money to an Islamic bank and t"e bank c"arges a management fee for managing t"e money. 1./ Su8u8 - e6t finance. - )

0.%.1 #eaning> #eans certificates !"e certificates represent t"e owners"ip of> Debts Assets 4ro9ects Investments5 etc. 0.%.( Features> Asset*backed securities Fo interest is paid @ave an active secondary market :ntitle for a s"are in t"e revenues earned from t"e sukuk assets .btain proportional beneficial owners"ip in t"e underlying assets +"are from t"e realiEation proceeds of t"e sukuk assets 1.1 5us'ara8a -,enture capital.

0.0.1 #eaning>
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)usiness relations"ip establis"ed under a contract wit" mutual consent of all t"e parties involved t"at s"aring of profits and losses +imilar to partners"ip 0.0.( Features> %ll partners must 'ave capital contri6ution w"ic" can be monetary or non* monetary @ave a ri*'t to participate in t"e business "rofits are s'are! in an a*ree! ratio Losses are s'are! in t"e ratio of capital investe! Question + 7a8 )riefly e3plain t"e meaning of t"e word BribaC and its effect on Islamic finance. 7b8 )riefly e3plain Bi9araC. 7c8 /ist t"e feature of sukuk. 7d8 :3plain mura"aba.

2.
2.1

3earin*
9peratin* *earin*

&.1.1 !"e measure of t"e extent to 7'ic' a firm>s operatin* costs are fixe! . It affects t"e level of 6usiness ris8. &.1.( @i*' proportion of fixe! costs< 'i*' operatin* *earin*. &.1.' =ays of measurement>

1.

Fi3ed costs 1ariables costs

or

(.

Fi3ed costs !otal costs

or

'.

I c"ange in :)I! 7or 4)I!8 I c"ange in turnover

or

,ontribution 4)I! or :)I!

or

&&

2.2

Financial *earin*

&.(.1 Is t"e amount of !e6t finance a company uses relative to its e0uit# finance. &.(.( !"e *reater t'e level of !e6t5 t"e 'i*'er t'e financial ris85 so t"e 'i*'er is t'e s'are'ol!ers> re0uire! return. &.(.' Financial gearing ratios> 1. :2uity gearing O 4reference s"are capital P long*term debt .rdinary s"are capital P reserve (. !otal or capital gearing O Interest gearing O 4reference s"are capital P long*term debt !otal long*term capital Debt interest 4)I! Question / -ack /td plans to raise D; million in order to e3pand its e3isting c"ain of retail outlets. It can raise t"e finance by issuing 10I loan stock redeemable in ten yearsC time5 or by a rig"ts issue at D .00 per s"are. !"e current financial statements of -ack /td are as follows> Income statement for t'e #ear +ales revenue ,ost of sales 6ross profit Administration costs 4rofit before interest and ta3 Interest 4rofit before ta3 !a3ation at '0I 4rofit after ta3 D000 ;05000 '05000 (05000 1 5000 <5000 '00 ;5%00 15%10 '5&&0

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&'an*es in e0uit# Dividends Fet c"ange in e2uity 7retained profits8 Statement of financial position Fet non*current assets Fet current assets D000 (05100 5&<0 (;50<0 .rdinary s"ares5 par value (; cents Retained profit 1(I loan stock 7redeemable in si3 years8 (5;00 (050<0 (5;00 (;50<0 !"e e3pansion of business is e3pected to increase sales revenue by 1(I in t"e first year. 1ariable cost of sales makes up 0;I of cost of sales. Administration costs will increase by ;I due to new staff appointments. -ack /td "as a policy of paying out <0I of profit after ta3 as dividends and "as no overdraft. Re0uire!; 7a8 7b8 For eac" financing proposal5 prepare t"e forecast income statement after one additional year of operation. 7; marks8 :valuate and comment on t"e effects of eac" financing proposal on t"e following> 7i8 Financial gearing? 7ii8 .perational gearing? 7iii8 Interest cover? 7iv8 :arnings per s"are. 71( marks8 Discuss t"e dangers to a company of a "ig" level of gearing5 including in your answer an e3planation of t"e following terms> 7i8 )usiness risk? 7ii8 Financial risk. 70 marks8 7(; marks8 D000 (5'& 15;&<

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14.
14.1

S'are'ol!er Dealt' Ratios

Earnin*s per s'are -E"S.

10.1.1 In general5 t"e "ig"er t"e :4+5 t"e "ig"er t"e s"are"olders wealt"

:4+ O

4rofit after ta3 and preference dividends =eig"ted average number of s"ares

14.2

"rice(earnin*s ratio -"CE ratio.

10.(.1 A 'i*' "CE ratio indicates stron* mar8et confi!ence in t'e future profit *ro7t' of t"e company. 4K: Ratio O #arket price per s"are :4+ 14.$ ivi!en! cover

10.'.1 !"e 'i*'er t'e cover5 t"e 6etter t'e a6ilit# to maintain !ivi!en!s. Dividend cover O :4+ D4+ 14.4 ivi!en! #iel!

10. .1 Is t"e rate of return a s'are'ol!er is expectin* on an investment in s"ares5 so t"e 'i*'er t'e !ivi!en! #iel! is 6etter. 10. .( !"e #iel! 7ill 6e influence! 6# t'e !ivi!en! polic# 5 a company w"ic" "as traditionally paid "ig" dividends will be popular wit" some investors and t"is will reflected in its s"are price. Dividend yield O 6ross D4+ #arket price per s"are 3 100I

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11.
11.1

e6t @ol!er Ratios

Interest cover

11.1.1 Is a measure of t'e a!e0uac# of a compan#>s profits relative to its interest pa#ments on its debt. In general5 a 'i*' level of interest cover is *oo!.

Interest cover O

4)I! Debt interest

11.2

Interest #iel!

11.(.1 !"e interest yield is t"e interest rate e3pressed as a percentage of t"e market price. 11.(.( It is a measure of return on investment for t"e debt "older. Interest yield O Interest rate #arket value of debt

12.
12.1

Finance for S5Es

Financin* pro6lem for small 6usinesses

1(.1.1 Fun!in* *ap; A funding gap is t"e !ifference 6et7een t'e mone# re0uire! to begin or continue operations5 an! t'e mone# currentl# accessi6le. Funding gaps are common in ver# #oun* companies5 w"o may un!erestimate t'e amount of capital nee!e! to sustain pro!uction until a workable cas" flow "as been establis"ed. 1(.1.( 5aturit# *ap; It is particularly !ifficult for +#:s to o6tain me!ium term loans !ue to a mismatc'in* of t'e maturit# of assets an! lia6ilities. /onger term loans are easier to obtain t"an medium term loans as longer loans can be secured wit" mortgages against property. 1(.1.' Ina!e0uate securit#; A common problem is often t"at t"e 6an8s 7ill 6e un7illin* to increase loan

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fun!in* 7it'out an increase in securit# *iven 7w"ic" t"e owners may be unwilling or unable to give85 or an increase in e2uity funding 7w"ic" may be difficult to obtain8. 12.2 "otential sources of financin* for S5Es

1(.(.1 4otential sources of financing include t"e following> .wner financing .verdraft financing )ank loans !rade credit :2uity finance )usiness angel financing 1enture capital /easing Factoring Question 1 S5E sources of finance pro6lems 7a8 Discuss t"e difficulties t"at may be e3perienced by a small company w"ic" is seeking to obtain additional funding to finance an e3pansion of business operations. 70 marks8 7A,,A (. Financial #anagement and ,ontrol -une (00< Q(7c88 7b8 :3plain w"y very +mall to #edium*siEe :nterprises 7+#:s8 mig"t face problems in obtaining appropriate sources of finance. In your answer pay particular attention to problems and issues associated wit"> 7i8 uncertainty concerning t"e business? 7ii8 assets available to offer as collateral or security? and 7iii8 potential sources of finance for very new +#:s e3cluding sources from capital markets. 71( marks8

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%!!itional Examination St#le Questions

Question 2 Dartig ,o is a stock*market listed company t"at manufactures consumer products and it is planning to e3pand its e3isting business. !"e investment cost of D; million will be met by a 1 for rig"ts issue. !"e current s"are price of Dartig ,o is D(J;0 per s"are and t"e rig"ts issue price will be at a (0I discount to t"is. !"e finance director of Dartig ,o e3pects t"at t"e e3pansion of e3isting business will allow t"e average growt" rate of earnings per s"are over t"e last four years to be maintained into t"e foreseeable future. !"e earnings per s"are and dividends paid by Dartig over t"e last four years are as follows>

Dartig ,o "as a cost of e2uity of 10I. !"e priceKearnings ratio of Dartig ,o "as been appro3imately constant in recent years. Ignore issue costs. Re0uire!; 7a8 7b8 7c8 ,alculate t"e t"eoretical e3 rig"ts price per s"are prior to investing in t"e proposed business e3pansion. 7' marks8 ,alculate t"e e3pected s"are price following t"e proposed business e3pansion using t"e priceKearnings ratio met"od. 7' marks8 Discuss w"et"er t"e proposed business e3pansion is an acceptable use of t"e finance raised by t"e rig"ts issue5 and evaluate t"e e3pected effect on t"e wealt" of t"e s"are"olders of Dartig ,o. 7; marks8 Gsing t"e information provided5 calculate t"e e3 div s"are price predicted by t"e dividend growt" model and discuss briefly w"y t"is s"are price differs from t"e current market price of Dartig ,o. 7< marks8 At a recent board meeting of Dartig ,o5 a non*e3ecutive director suggested t"at t"e companyCs remuneration committee s"ould consider scrapping t"e companyCs current s"are option sc"eme5 since e3ecutive directors could be rewarded by t"e sc"eme even w"en t"ey did not perform well. A second non*e3ecutive director disagreed5 saying t"e problem was t"at even w"en directors acted in ways w"ic" decreased t"e agency problem5 t"ey mig"t not be rewarded by t"e s"are option sc"eme if t"e stock market were in decline.
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7d8

7e8

Re0uire!; :3plain t"e nature of t"e agency problem and discuss t"e use of s"are option sc"emes as a way of reducing t"e agency problem in a stock*market listed company suc" as Dartig ,o. 70 marks8 7(; marks8 7A,,A F& Financial #anagement December (000 Q18 Question 14 --6 ,o is planning to raise D1; million of new finance for a ma9or e3pansion of e3isting business and is considering a rig"ts issue5 a placing or an issue of bonds. !"e corporate ob9ectives of --6 ,o5 as stated in its Annual Report5 are to ma3imise t"e wealt" of its s"are"olders and to ac"ieve continuous growt" in earnings per s"are. Recent financial information on --6 ,o is as follows>

!"e par value of t"e s"ares of --6 ,o is D1J00 per s"are. !"e general level of inflation "as averaged I per year in t"e period under consideration. !"e bonds of --6 ,o are currently trading at t"eir par value of D100. !"e following values for t"e business sector of --6 ,o are available>

10%

Re0uire!; 7a8 :valuate t"e financial performance of --6 ,o5 and analyse and discuss t"e e3tent to w"ic" t"e company "as ac"ieved its stated corporate ob9ectives of> 7i8 ma3imising t"e wealt" of its s"are"olders? 7ii8 ac"ieving continuous growt" in earnings per s"are. Fote> up to % marks are available for financial analysis. 71( marks8 If t"e new finance is raised via a rig"ts issue at D%J;0 per s"are and t"e ma9or e3pansion of business "as not yet begun5 calculate and comment on t"e effect of t"e rig"ts issue on> 7i8 t"e s"are price of --6 ,o? 7ii8 t"e earnings per s"are of t"e company? and 7iii8 t"e debtKe2uity ratio. 7< marks8 Analyse and discuss t"e relative merits of a rig"ts issue5 a placing and an issue of bonds as ways of raising t"e finance for t"e e3pansion. 7% marks8 7!otal (; marks8 7A,,A F& Financial #anagement -une (00& Q 8

7b8

7c8

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Question 11 !"e following financial position statement as at '0 Fovember (010 refers to Fugfer ,o5 a stock e3c"ange*listed company5 w"ic" wis"es to raise D(00m in cas" in order to ac2uire a competitor.

!"e recent performance of Fugfer ,o in profitability terms is as follows>

Fotes> 1. !"e long*term borrowings are <I bonds t"at are repayable in (01(
10&

(. '. . ;. <.

!"e s"ort*term borrowings consist of an overdraft at an annual interest rate of 0I !"e current assets do not include any cas" deposits Fugfer ,o "as not paid any dividends in t"e last four years !"e number of ordinary s"ares issued by t"e company "as not c"anged in recent years !"e target company "as no debt finance and its forecast profit before interest and ta3 for (011 is D(0 million

Re0uire!; 7a8 7b8 7c8 :valuate suitable met"ods of raising t"e D(00 million re2uired by Fugfer ,o5 supporting your evaluation wit" bot" analysis and critical discussion. 71; marks8 )riefly e3plain t"e factors t"at will influence t"e rate of interest c"arged on a new issue of bonds. 7 marks8 Identify and describe t"e t"ree forms of efficiency t"at may be found in a capital market. 7< marks8 7(; marks8 7A,,A F& Financial #anagement December (010 Q(8

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