As per ACCA 2.4 book

1. Sources of Finance
Maroof Hussain Sabri
Beenish Sarfraz

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. 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. 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. Long Term Finance
• Equity
• Long Term Loans
• Government Grants
Maroof Hussain, Beenish Sarfraz

6. Sources of Equity Finance
• Retained Profits
– No Transaction Costs
– Continual Source
– But
– Shareholders require return
Maroof Hussain, Beenish Sarfraz

7. Equity - Types of Share Capital
• Ordinary Shares
• Preference Shares
– Cumulative
– Non Cumulative
Maroof Hussain, Beenish Sarfraz

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. 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. 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. 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. 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. Rights Issue - Shareholders’ Options
• Take Up Rights
• Sell Rights
• Take up Part of Rights
• Take No Action
Maroof Hussain, Beenish Sarfraz

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. 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. 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. 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 www.bloomberg.co.uk
Maroof Hussain, Beenish Sarfraz

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
www.Bloomberg.co.uk
Maroof Hussain, Beenish Sarfraz

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. 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. 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. Equity Analysis
How investment analysts look at
shares

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. EQUITY ANALYSIS
• Basic principle :
if intrinsic value exceeds market value : BUY
if market value exceeds intrinsic value : SELL
Maroof Hussain, Beenish Sarfraz

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. 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. Significance of Beta
• Betas for companies shares are published on
www.Bloomberg.co.uk
– 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. 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. 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. 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. 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. 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. 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. 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. Thank you
Maroof Hussain, Beenish Sarfraz