Sources of Long Term Finance

Sources of Long termFinance

CIMA

Shahin A. Shayan2004 - 2007

Topics

Shareholder’s funds Raising share capital – the stock market Debt finance Medium-term financing Financing of small businesses Fraud related to sources of finance

Shareholder’s Funds Ordinary Shares

An equity interest in a company can be said to represent ashare of the company’s assets and a share of any profitsearned on those assets after other claims have been met. Theequity shareholders are the owners of the business – theypurchase shares (commonly called ordinary shares), themoney is used by the company to buy assets, the assets areused to earn profits, and the assets and profits belong to theordinary shareholders. Ordinary shares are sometimesreferred to as the risk capital of a business; it is the ordinaryshareholders who take most of the risk in business

Nominal value – 10 pence Book value - 200 pence Market value – 500 pence

Shareholder’s Funds

Preferred and Deferred Ordinary Shares Preferred ordinary shares rank for a dividend at a

pre-agreed rate before the deferred ordinary shares.The dividend payable to the holders of deferredordinary shares on the other hand is not at a pre-agreed fixed rate. Sometimes preferred ordinaryshares are issued that entitle holders to the pre-agreed fixed dividend, and also to participate in afurther dividend with the deferred ordinaryshareholders.


Preference Shares Preference shares entitle their holder to a fixed rate

of dividend from the company each year. Thisdividend ranks for payment before other equityreturns and so the ordinary shareholders receive nodividend until the preference shareholders have beenpaid their fixed percentage. Preference shares carrypart-ownership of the company and allow dueparticipation in the profits of the business.


Reserves Reserves include share premiums, revaluation reserves

and retained profits. Regardless of how the reserve wascreated, it is included as part of the equity of thecompany. Retained profits are the most importantsource of finance for most businesses.

Raising Share Capital Investors may buy and sell shares, hoping to make a capital gain as the share price

rises. The capital gain will be realized when the share is sold to another investor at aprice higher than that originally paid. Shares may be traded in one of two markets,according to the size and status of the company concerned. The largest companies willbe traded on the Stock Exchange. The financial and other criteria necessary for acompany to receive a full Stock Exchange quotation (or listing) are stringent.Companies which do not satisfy these criteria may be traded through the AlternativeInvestments Market (AIM), where entry conditions are significantly easier. AlthoughAIM companies face similar regulations to fully listed companies, the entry proceduresand ongoing obligations are much less onerous. In particular, there are no criteriaconcerning the capitalization of the company or its trading history.

Investors may speculate by buying shares in a particular company or sector of themarket, believing that the value of those shares will rise shortly. Such a speculator isknown as a ‘bull’. Conversely, a ‘bear’ speculator is one who sells shares in the beliefthat their value is about to fall.

If the company were to fail altogether, the shares would be worthless, but theshareholder would not normally be required to use his or her own money to pay offthe company’s debts. Liability is said to be limited to the original investment.

Raising Share Capital New issues

Shares which come into circulation for the first time arecalled new issues (IPOs). This section will brieflyoutline the ways in which this happens. Offer for sale

These offers may be of completely new shares or they may derivefrom the transfer to the public of shares already held privately. Anissuing house, normally a merchant bank, acquires the shares and thenoffers them to the public at a fixed price. The offers are usually madein the form of a prospectus detailed in the Financial Times and othernewspapers, sometimes in an abbreviated form.

Some investors apply for new issues in the hope of sellingimmediately and reaping a quick profit. For this to succeed thenumber of shares purchased must be sufficiently high to cover sellingcharges. For over-subscribed issues, the allocation may be scaleddown and the applicant may receive only a small number of shares.

Raising Share Capital Offer for sale by tender

This method of issue is similar to that above, the only differencebeing that the shares are not issued at a fixed price. Subscribers musttender for the shares at, or above, a minimum fixed price. The sharesare allotted at the highest price at which they will all be taken up. Thisis known as the strike price.

Prospectus issue In a prospectus issue, or public issue, a company offers its shares

direct to the general public. An issuing house may act as an agent, butthis type of issue will not be underwritten. This makes this type ofissue risky, and also very rare.

Raising Share Capital Placing

In this type of issue the shares are not offered to the public, but theissuing house will arrange for the shares to be issued to itsinstitutional clients (Private Placement). This method has become themost popular method of issue in the UK, being cheaper and quickerto arrange than most other methods.

Introduction Here, no new shares are issued, and the company is not seeking to

raise any new finance. The company may already be quoted onanother stock exchange, or else the ownership of the shares is alreadywidespread and the owners are now seeking a quotation for theirshares. The company becomes publicly quoted as a result of existingowners being willing to sell some of their holdings to generate a freemarket.

Raising Share Capital Investor ratios

Investors will wish to assess the performance of the shares they have invested in, overtime, against competing companies in the same sector, and against the market as awhole. There are a number of ratios which will be of specific interest to investors. Theuse of the market price of equity is an important component of this type of analysis. Market price per share

The market price per share (MPS) is the ex-dividend market price. Ex-dividendmeans that in buying a share today, the investor will not participate in theforthcoming dividend payment. Sometimes in an examination, the marketprice may be quoted cum-dividend which means ‘with dividend rights attached’.Here the investor will participate in the forthcoming dividend if purchasingthe share today. Arguably the investor will be willing to pay a higher price forthe share, knowing that a dividend payment is forthcoming in the near future.

The relationship between the cum-dividend price and the ex-dividend price isthen:

MPS (ex-dividend) = MPS (cum-dividend) – forthcoming dividend per share

Raising Share Capital Earnings per share

Earnings per share (EPS) is a company’s net profit attributable to ordinaryshareholders divided by the number of shares in issue.

A simple example of an EPS calculation is shown below. Example – Calculation of EPS

Earnings before interest and tax 525 £mInterest on debt 75Earnings after debt interest 450Tax payable 125Earnings after tax available for distribution 325 £mNumber of shares in issue = 175 millionEPS= £325m ÷ 175m = 186 pence per shareAn important point to remember is that EPS is an historical figureand can be manipulated by changes in accounting policies, mergersor acquisitions, etc.

Raising Share Capital

The price/earning ratio A common benchmark when analyzing different

companies is the use of the price/earnings ratio whichexpresses in a single figure the relationship between themarket price of a company’s shares and the earnings pershare.

It is calculated as:market price per share/earnings per share = mps/eps

Earnings yield (Short term yield) Earnings yield = eps/mps

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital Dividend payout rate

The cash effect of payment of dividends is measured by the dividendpayout rate.

Payout rate = dividend per share/earnings per sahre= dps/eps

The relationship between the above investors’ ratios is usually that acompany with a high P/E ratio has a low dividend payout ratio as thehigh growth company needs to retain more resources in the business.A more stable business would have a relatively low P/E ratio andhigher dividend payout ratio.

When analyzing financial statements from an investor’s point of viewit is important to identify the objectives of the investor. Does theinvestor require high capital growth with high risk, or a lower riskfixed dividend payment and low capital growth?

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital Dividend yield (Short term yield)

Dividend yield will indicate the return on capital investment, relative tomarket price.

Dividend yield = dividend per share/market price per share= dps/mps

Dividend cover Dividend cover measures the ability of the company to maintain the

existing level of dividend and is used in conjunction with the dividendyield.

Dividend cover = earnings per share/dividend per share= eps/dps

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital Exercise

Lilydale plc has 5,000,000 ordinary shares in issue. Its results for the year end areas follows.

£Profit before taxation 750,000Taxation 150,000Profit after taxation 600,000Ordinary dividend – proposed 150,000Retained profit 450,000

The market price per share is currently 83 pence cum-div.

Required; Calculate the following ratios:(i) Price/earnings(ii) Dividend payout(iii) Dividend yield(iv) Dividend cover.

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital Solution to exercise

Earnings per share = profit after tax/ number of shares= 600000/5000000 = 12p

Dividend per share = ordinary dividens/number of shares= 150000/5000000 = 3p

Mps(cum-div) 83p less dps 3p

Mps(ex-div) 80p

(i) Price earnings = 80/12 = mps/eps = 6.7(ii) Dividend payout = 3/12 = dps/eps = 25%(iii) Dividend yield = 3/80 = dps/mps = 3.75%(iv) Dividend cover = 12/3 = eps/dps = 4

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital Book value per share

From a capital point of view the balance sheet may be used incomputing ratios for the investor.

The book value per share indicates the asset backing of the investment;“shareholder’s funds/number of equity shares in issue “

However this must be interpreted with care.1. The valuation of the balance sheet may be based on historical cost values.

Other valuations of assets may be more informative.2. The ratio may be irrelevant in service based businesses where the major

asset is the quality of staff and other intangibles which may not beincluded in the balance sheet.

eps

mps

shareperearnings

shareperpricemarket

eps

mps

shareperearnings

shareperpricemarket

Raising Share Capital

Rights issuesIn a rights issue, the company sets out to raiseadditional funds from its existing shareholders. It doesthis by giving them the opportunity to purchaseadditional shares. These shares are normally offered at aprice lower than the current share price quoted,otherwise shareholders will not be prepared to buy,since they could have purchased more shares at theexisting price anyway.

Raising Share Capital Selection of an issue price

In theory there is no upper limit to an issue price but in practice it would never be set higherthan the prevailing market price (MPS) of the shares, otherwise shareholders will not beprepared to buy as they could have purchased more shares at the existing market priceanyway. Indeed, the issue price is normally set at a discount on MPS. This discount is usuallyin the region of 20 per cent. In theory, there is no lower limit to an issue price but in practiceit can never be lower than the nominal value of the shares. Subject to these practicallimitations, any price may be selected within these values. However as the issue price selectedis reduced, the quantity of shares which has to be issued to raise a required sum will beincreased.

Selection of an issue quantityIt is normal for the issue price to be selected first and then the quantity of shares to beissued becomes a passive decision. The effect of the additional shares on earnings per share,dividend per share and dividend cover should be considered (dilution effect). The selectedadditional issue quantity will then be related to the existing share quantity for the issue termsto be calculated. The proportion is normally stated in its simplest form e.g. 1 for 4, meaningthat shareholders may subscribe to purchase one new share for every four they currentlyhold.

Raising Share Capital Terms of an issue

Once the issue price and share quantity have been selected by the company, theterms of the rights issue can then be announced. For example, Lauchlan plc has 2million £1 ordinary shares in issue with a current MPS of £5. It decides to raise £2million by means of a rights issue at £4 per share. Since 500,000 additional shareswill now have to be issued, the terms of the rights issue may be summarised as ‘1for 4 at £4’.

The theoretical ex-rights price (TERP)Assuming this rights issue is taken up by the existing shareholders, the marketprice of the shares will readjust to a value above that of the rights issue but belowthe original market price. Using the data above for Lauchlan plc, the followingTERP calculation results.

P1 ‘new’ share at 400p = 4004 ‘old’ shares at 500p = 2,0005 2,400pTERP = 2400/5 = 480p

Raising Share Capital Value of a right

The value of a right is the theoretical gain a shareholder can make fromtaking up their rights. The value of a right will be the difference between thetheoretical ex-rights price and the issue price of the shares. In the exampleabove, the value of a right is calculated as:

TERP = 480pIssue price = 400pValue of the right = 80p per ‘new’ share = (80 ÷ 4) = 20p per ‘old’ share.

Shareholder optionsA shareholder receiving notification of a rights issue from a company has anumber of options available. Consider the position of a shareholder inLauchlan plc owning 1,200 shares and, then, being offered 300 shares at £4each.

Raising Share Capital Shareholder options – cont…

Option 1 – Do nothing. In this situation, the market value of the investment could be expected to fall by£240 from £6,000 to £5,760 (1,200 @ £4.80). The company would normally reserve the right to sell any‘unaccepted’ shares for the best price available in the market. After having deducted any expenses and, ofcourse, £4 per share, the balance would be sent to the shareholder. This cash balance could fully or partiallycompensate the shareholder for the reduction in market value. The shareholder’s percentage share of thecompany will reduce.

Option 2 – Sell the rights. In this situation, the shareholder decides to sell the right to buy the shares at £4each to another investor. A rational investor would not be expected to pay more than 80p per share(TERP – £4) for such a right. The existing shareholder might receive £240 (300 @ 80p) less any dealingcosts incurred. The shareholder’s percentage share of the company will be reduced.

Option 3 – Fully subscribe. In this situation, the shareholder will have to increase the value of theshareholding by paying the company £1,200 for the 300 new shares. The shareholder will then own 1,500shares which, using TERP, will be valued at £7,200. The shareholder’s percentage share of the companywill be maintained.

Option 4 – Sell some to buy some. In this situation, the shareholder may be unable or unwilling to investmore funds in the company. Since the rights can normally be sold in the market, the shareholder could sellsufficient of the rights to purchase the balance. In the Lauchlan plc example, each block of 5 rights sold at80p raises sufficient cash to purchase one new share at £4. The shareholder could sell 250 @ 80p to raise£200 which would be sufficient to purchase 50 @ £4. The value of the investment will be maintained at£6,000 but the shareholder’s percentage share of the company will be reduced.

Raising Share Capital Yield adjusted ex-rights price

The calculations of theoretical ex-rights price above assume that the additional funds raised will generate areturn at the same rate as existing funds. If a company expects (and the market agrees) that the new fundswill earn a different return than is currently being earned on the existing capital then a ‘yield-adjusted’ TERPshould be calculated.Using the figures for Lauchlan plc and assuming:

The rate of return (yield) on the new funds = 15% The rate of return on the existing funds = 12%

The yield adjusted ex-rights price becomes:P

1 ‘new’ share at 400p x 15/12 = 5004 ‘old’ shares at 500p x 2,0005 2,500p

TERP = 500p

Notice that if the new funds are expected to earn a return above the rate generated by existing funds, therewill be less dilution of the market price than suggested by the original TERP calculation.


Molson plc has a paid-up ordinary share capital of £2,000,000 representedby 4 million shares of 50p each. Earnings after tax in the most recent yearwere £750,000 of which £250,000 was distributed as dividend. The currentprice/earnings ratio of these shares, as reported in the financial press, is 8.

The company is planning a major investment which will cost £2,025,000and is expected to produce additional after-tax earnings over the foreseeablefuture at the rate of 15 percent on the amount invested. The existing rate oninvestments are 12.5 percent (1/PE ratio).

The necessary finance is to be raised by a rights issue to the existingshareholders at a price 25 per cent below the current market price of thecompany’s shares.


(a) You are required to calculate:

(i) the current market price of the shares already in issue;(ii) the price at which the rights issue will be made;(iii) the number of new shares that will be issued;(iv) the price at which the shares of the company should theoretically bequoted on completion of the rights issue (ie the ‘ex-rights price’), ignoringincidental costs and assuming that the market accepts the company’sforecast of incremental earnings.

(b) It has been said that, provided the required amount of money is raisedand that the market is made aware of the earning power of the newinvestment, the financial position of existing shareholders should be thesame whether or not they decide to subscribe for the rights they are offered.You are required to illustrate and comment on this statement.(7 marks)


(a) (i) Current market price of shares already in issue:Earnings per share = 750000/4000000 = 18.75pP/E ratio = mps/eps = 8Market price per share = 8 x 18.75p

= £1.50(ii) Price at which rights issue will be made:

£1.50 x 75% = £1.125(iii) Number of new shares that will be issued:

2025000/1.125 = 1.8 million(iv) Ex-rights price is:

1.50*(4000000/5800000) + (1.125*(1800000/5800000)*(15%/12.5%) =£1.034 + £0.419 = £1.453

* The price earnings ratio is given as 8. This would imply an earnings yield of (1 ÷ 8) =12.5%. This is assumed to be the yield or rate of return on existing funds.


(b) This statement can be illustrated as follows:For every 20 shares held the rights issue means another nine shares. At least in theory, theselling price of the right to purchase one share will be £1.453 less £1.125, ie £0.328.A shareholder with 20 shares taking up the rights:

£Market value of 29 shares at £1.453 each 42.137Less: Cost of taking up rights of nine new shares at £1.125 each 10.125

32.012

A shareholder with 20 shares selling the rights:£

Market value of 20 shares after rights issue at £1.453 each 29.060Add: Sale of nine rights at £0.328 each 2.952

32.012

The above, however, assumes no transaction costs. Furthermore, the market may read aparticular message into the rights issue which would affect the above calculations.

Raising Share Capital Share splits and bonus issues

These are shares issued without payment to holders ofexisting ordinary shares. They are issued because theprice of the existing shares has become unwieldy.Bonus issues are at the initiative of the companydirectors, with the subsequent approval of theshareholders. Obviously these additional shares arenormally accepted by the shareholders, but they are notgetting something for nothing even though they arecalled bonus shares. This is because if all otherthings are unchanged, the value of the companyremains unaltered.

Debt finance Debentures

The Companies Acts define ‘debenture’ as including debenture stock and bonds. It is quite common for theexpressions debenture and bond to be used interchangeably. Company debentures can also be referred to as‘loan stock’.

Secured or unsecuredDebentures and debenture stock can be secured or unsecured.The debentures can be secured by a charge upon the whole or a specific part of a company’s assets, or they can be securedby a floating charge upon the assets of the company.

Deep discounted bondDeep discounted bonds are debt instruments which are issued at a price well below their nominal value. At the eventualredemption date they will be redeemed at their nominal (par) value. For example, a company might raise £5,000,000 byissuing deep discounted bonds in 1999 at a price of £60 per £100 nominal which will be redeemed at par in 2010. The deepdiscounting means that the interest rate on the bond will be much lower than current market rates. This will give a cashflow benefit to the issuing company as interest payments will be low throughout the life of the bond. Investors will beprepared to sacrifice interest for the capital gain on redemption they can lock into. This may be appealing to investors whowould prefer capital gains to income.

Zero coupon bondsThe lower the issue price of a bond in relation to its nominal value, the greater the potential for a capital gain onredemption. The interest rate can therefore be reduced until we reach a stage where no interest is paid on the bond at allduring its life. This is referred to as a zero coupon bond. With a zero coupon bond, all of the investor’s return is wrappedup in a capital gain on redemption.

Debt Finance Debt yields

The rate of return, or yield, on debentures, loan stocks and bonds is measuredin two different ways.

Interest yieldInterest yield = (Gross interest/Market value) x 100%

Example;A 6 per cent debenture with a current market value of £90 per £100 nominalwould have an interest yield of:

(6/90) x 100% = 6.7% gross, or pre tax

Yield to maturity (redemption yield)The yield to maturity (or redemption) is the effective yield on a redeemablesecurity, taking into account any gain or loss due to the fact that it was purchasedat a price different from the redemption value.

Debt Finance Exercise

You are asked to put a price on a bond with a coupon rate of 8 per cent. It will repay its face value of £100 at the end of fifteen years. Other similar bondshave a yield to maturity (YTM) of 12 per cent.

Solution to exercise 2.3;

The price of the bond is:£8 x (annuity factor for t = 15, r = 12) + £100 x (discount factor for t = 15, r = 12)= (£8 x 6.811) + (£100 x 0.1827) = £72.76.

What we are doing here is adding the NPV of fifteen years of interest payments to the present value of the sum receivable on redemption.We can turn this example round to calculate the YTM. If the price of the bond is known to be £78.40, what is the yield to redemption? This is basically aninternal rate of return calculation and the answer is approximately 11 per cent.The calculation is as follows.

Assume two discount rates as for an IRR interpolation, between which the required percentage is likely to fall. Let us say, in this case, 10 per centand 14 per cent. Then the equations are:

t = 15; r = 10, so £8 x 7.606 + £100 x 0.239 = £84.75t = 15; r = 14, so £8 x 6.142 + £100 x 0.140 = £63.14

Then, by interpolation, bearing in mind that r = 10 is closer to £78.40 than is r = 14, so that the required rate must be nearer 10, then:Redemption yield = 10% + ((84.75-78.40)/(84.75-63.14) x 4%

= 10% + 1.17% 11%

A connected issue which is often misunderstood is the relationship of face value to market value and coupon rate (on debt) to rate of return.When a bond or debenture, or any fixed-interest debt is issued, it carries a ‘coupon’ rate. This is the interest rate which is payable on the face, or nominal,value of the debt. Unlike shares, which are rarely issued at their nominal value, debt is frequently issued at par, usually £100 payable for £100 nominal of thebond. At the time of issue the interest rate will be fixed according to interest rates available in the market at that time for bonds of similar maturity. Thecredit rating of the company will also have an impact on the rate of interest demanded by the market.

Debt Finance

ConvertiblesConvertibles are hybrids between equity and debt finance. Theyoffer investors a fixed return but also give the investor the rightto convert into the underlying ordinary shares of the company atfixed terms. Exercise

Oldham plc has in issue convertible loan stock with a coupon rate of 10per cent. Each £100 nominal is convertible into 20 ordinary shares. Themarket price of the convertible is £108, while the current ordinary shareprice is 480p.Calculate (i) the conversion premium and (ii) the conversion value.

Debt Finance Solution to exercise

The conversion terms are: £100 loan stock = 20 ordinary shares. This is known as the conversion ratio.The conversion terms could also be expressed as: £5 loan stock = one ordinary share.

(i) The conversion premium measures how much more expensive it is to buy the convertible loan stock than the underlyingordinary share.

The cost of buying £5 loan stock is:£5 x (108/100) = £5.40

compared to the cost of buying one ordinary share, £4.80.

The conversion premium is therefore:((5.40-4.80)/4.80)= 12.5%

In this case, it is more expensive to purchase the loan stock and convert, than to purchase one ordinary share directly.

(ii) The conversion value is calculated as the market value of ordinary shares that is equivalent to one unit of the convertible.

Conversion value = conversion ratio x MPS (ordinary shares)= 20 x £4.80 = £96

Note that from this calculation of conversion value, the conversion premium may also be stated as:((108-96)/96) = 12.5%

Debt Finance Warrants

Warrants are options to buy shares in the company at a given price withina given period. They can be traded on the market and are sometimesissued with loan stock as a ‘sweetener’.

Share warrants issued in conjunction with a debt security will put theholder in an overall position which is very similar to that of a convertibleholder. Thus it follows that the holder has both debt and equity interestin the issuing firm. However, it may be argued that investors will findwarrants more attractive than a convertible since they can sell warrantsseparately, whereas the conversion option is an integral part ofconvertible securities.

The warrant, like the conversion option, will enable the coupon rate to bereduced on the debt instrument. The amount of this reduction willdepend upon the value of the warrant.

Medium Term Financing

The distinction between short, medium and long termfinance is not well defined but, as a guide, short-term isup to one year, medium-term is from one to five years,and long-term is from five years upwards.

The major sources of medium term financing in recentyears have been either term loans or leasing. Mostmedium-term finance is used by small businesses, as aresult of the problems they face in raising capital.

Medium Term Financing Term loans

Term loans are offered by the high street banks and are usually arranged forperiods in excess of one year.

LeasingUsually lease vs. buy decisions are influenced by the taxation structure in aneconomy. The distinguishing feature of a lease is that one party (the lessee)obtains the use of an asset for a period of time, whereas the legal ownershipof the asset remains with the other party (the lessor). The leasing agreementdoes not give the lessee the right to final ownership.Leasing is common in aircraft, vehicles, plant and machinery, computers andother office equipment. (example of borrow & purchase vs. lease p. 59)

Finance leases Sale and leaseback Operating leases

Medium Term Financing Finance lease

Finance leases are similar to term loans The terms of the lease extends over the full useful life of the asset The asset is purchased by the leasing company and financed by a bank The leasing company arranges a lease contract with the lessee At the end of the contract the sale proceeds of the asset are shared between the lessor and lessee or if the lessee

wants it can continue the contract The lessee has used the leasing company as a financing vehicle to use the asset

Sale and leaseback Sale of an asset to a company and leasing it back again for a set time It is useful when you have an appreciating asset It is a form of financing or raising funds since you are selling and asset and still using it

Operating lease Operating lease are similar to a contract to use an asset; good for assets with rapid change in technology The terms of the lease does not extend over the full useful life of the asset The asset usually belongs to the manufacturer of a product that wants to create a better selling conditions The leasing company is the manufacturer which arranges a lease contract with the lessee At the end of the contract the manufacturer can lease the product to other lessee’s The leasing company usually incurs the maintenance and other servicing expenses The lessee has used the leasing company as a financing vehicle to use the asset

Financing of Small Businesses

Lending to small businesses used to be seen as anattractive part of any bank’s portfolio. The rate ofinterest was good and the client was likely to need otherservices on which the banks could make money. Fromtime to time, however, attention is drawn to thedifficulties small businesses have in obtaining thefinance to support their growth strategies, at anythingless than penal rates of interest (several percentagepoints higher than that at which large businesses canborrow) and the additional charges they face (e.g.manager’s time attending a lunch hosted by the client!).

Financing of Small Businesses Among the explanations given for this situation are that:

the costs of monitoring such loans are high or even prohibitive, in whichcase the risk is greater, i.e. the investment has more of the characteristicsof equity than lending

the banks themselves are involved in a competitive struggle for existenceand have gone through difficult times, incurring substantial bad debtsduring recessions and in the emergence from recessions, exacerbatedrecently by the unprecedented fall in the values of properties used assecurity

(consequently?) the regulators attach a higher risk weighting to corporateloans when assessing capital adequacy, with the result that banks arepredisposed towards property and government loans

some of those other services are being provided by ‘niche’ players whoare able to specialize and therefore offer better terms than the full-rangebanks

Financing of Small Businesses Venture Capital

Venture capital is the name given to equity finance provided to young, unquoted businesses tohelp them to expand.

Business ‘Angels’To judge from deals reported, venture capital funds are rarely interested in investing less than£250,000 on the grounds that monitoring progress is uneconomic. Below this level, companiesmay think in terms of business ‘angels’ (a term borrowed from show business), i.e. privateindividuals (e.g. big-company directors/managers who have retired with ‘golden handshakes’),usually with time and expertise available as well as cash and hence looking for a local, hands-oninvolvement. They may come together in syndicates, led by an ‘archangel’.

Government assistanceThe UK government has introduced a number of schemes to help businesses, many of which aretargeted at small and medium sized enterprises.

The Enterprise Initiative Scheme Venture capital investment trusts Regional Selective Assistance (RSA)

Fraud related to sources of finance Wages fraud

Dead men (or women) on the payroll Overcasting the payroll Fraudulent overtime Stealing unclaimed wages

Misappropriation of cash takings Variations in overall ratios like gross profit percentage Cash register

Teeming (taking out) and lading (putting back) Fraudulent payments (inflating expenses…) Management fraud (improve profits….) Advance fee fraud (pay fee for a loan, Nigerian cases….) Pyramid schemes (top of the pyramid benefits, it collapses soon) Ponzi schemes

A pyramid like investment structure; one needs to bring in new investors High interest payments are paid to previous investors

Sources of Long Term Finance

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