Sources of finance

For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for the success of the business. It is important, therefore, that you understand the various sources of finance open to a business and are able to assess how appropriate these sources are in relation to the needs of the business.

Short-term and Medium-term Finances

(Arnold, 2005) Usually finance which is payable within a year is short term finance; where as that due for a year to seven years is regarded as medium term finance. Quite often several short term and medium-term finances are discussed below.

The royal Bank of Scotland has the following long-term and short-term finances: -

Long Term Finance

Long term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance. Long-term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

It is important to remember that in most cases, a firm will not use just one source of finance but a number of sources. There might be a dominant source of funds but when you are raising hundreds of millions of pounds it is unlikely to come from just one source.

The Royal Bank of Scotland sources of finance

Long term sources of finances such as (source (RBS, 2009)): -

Equity

Preference shares; (Pike and Neale, 2006) unlike ordinary shares, Preference shares are entitled to specific percentage of dividend. These dividends are distributed before to the ordinary shares. However these dividends are announced only if distributable profits are available. However, unpaid dividends on Cumulative preference shares are carried forward and must be paid before the ordinary share holders are paid.

There are three further types of preference shares such as; participating preference shares, convertible preference shares and redeemable preference shares. The preference share holders have no voting rights.

Ordinary shares, the ordinary shares of the Royal Bank of Scotland are shares of a quoted company since it is listed in the official listings of London Stock Exchange.

Scrip Issues

A scrip issue, also referred to as a capitalization, or a bonus issue, involves the conversion of reserves onto capital, causing a fall in the reserves. Shareholders receive additional shares in proportion to their holding.

Unlike right issues no additional funds are raised, the share holders do not pay for the issues. This would result in the decrease of the market value for a short period, since this would attract the potential investors. The reserves used might be from the credit balance in the profit and loss account or from reserves particularly marked for the payment of shares. The Group's share price had been trading for some time at a price which was high relative to the average share price of companies trading on the London Stock Exchange.

(RBS, 2009)The directors believed that many shareholders prefer to deal in shares with a lower price per share, which is more in line with the stock market as a whole. Therefore, in March 2007 the directors proposed to adjust the level of the price per share by issuing, by way of a bonus issue, two new ordinary shares for every one ordinary share held by shareholders.

The Bonus Issue was approved by shareholders at the Annual General Meeting on 25 April 2007 and took effect on 8 May 2007. It has had the effect of lowering the price per share, aligning them closer with the average share prices for FTSE 100 companies and other banking stocks.

Debt

Securities; in 2007 RBS issued $1,600,000,000 Fixed Rate/Floating Rate Preferred Capital Securities (RBS, 2009). Here Floating Rate means the securities are offered for a fixed interest rate. The security documentation of RBS is shown in appendix 3.

Debentures

Debentures are loans that are usually secured and are said to have either fixed or floating charges with them. A secured debenture is one that is specifically tied to the financing of a particular asset such as a building or a machine, fixed rate of interest based on nominal value. Then, just like a mortgage for a private house, the debenture holder has a legal interest in that asset and the company cannot dispose of it unless the debenture holder agrees. If the debenture is for land and/or buildings it can be called a mortgage debenture.

Debenture holders have the right to receive their interest payments before any dividend is payable to shareholders and, most importantly, even if a company makes a loss, it still has to pay its interest charges. Failure to pay (default) likely to trigger legal action, including liquidation orders.

Unsecured Loan Stock; Not secured on assets, but effectively secured on firm's earning power, thus more risky, and lower ranking for payment;

Deep-Discount Bonds/Subordinated Loan Stock; Sold at a price well below nominal value. Attractive to investors that prefer capital appreciation to interest income. Extreme case is the Zero-Coupon Bond;

Asset-backed Securities (ABSs); Securitization of a long-term income stream e.g. income from licensing a copyright, into a tradable bond;

Convertibles; Start life as debentures, then convertible into ordinary shares, often on favorable terms

Short term finances like (source (RBS, 2009), shown in appendix 1 ): -

Bank credit; in which includes Overdrafts and Term loans to customers; Banks often offers a variety of credit facilities varying from short-term, medium-term and long term loans. Generally the interest rate gradually increases with the term of advance. Two main types of bank credit are corporate overdraft and term loans.

Overdraft

Overdraft is the most common type of finance offered by banks. This facility specifies maximum amount that the firm can draw upon either or through direct cash withdrawals or in payments by cheque to third parties.

Term Loans

Term loans are loans for a year or greater than a year. Interest is payable on the amount overdrawn rather than the full amount as in the case of a term loan. Term loans are for periods of greater than one year with interest being payable at a variable or fixed rate. Grace periods for term loans are where no interest is payable for a set period. Balloon and bullet loans are also available.

Mortgages like commercial mortgage and personal mortgage. Here commercial mortgages are related to business and personal mortgages means residential mortgages. A mortgage is a form of secured loan lacing the tittle deeds of freehold or long leasehold property with a lender as security for a cash loan

Asset Finance

Invoice Finance i.e. Factoring involves raising immediate cash based on the security of the company's debtors, thus accelerating payment from customers. Factor offers three main services like:

Sales administration: - a factor assumes various functions of sales ledger administration, ranging from recording sales details to sending out invoice and remainders and collecting payments.

Credit protection: - the factor may provide a credit evaluation service for clients, analysing customer characteristics before deciding on their creditworthiness.

Provision of finance: - a factor will also provide funds to a client, based on a proportion, of approved invoices

The advantages of factoring are; Obtain cash to gain benefits of cash discounts for prompt payment; Sales growth results in cash growth; less attention to chasing customers for payment; and bad debts can be protected.

Commercial paper; Offering promissory notes to financial institutions, however commercial paper is confined to largest firms with the highest credit ratings. Those companies should be listed on the London Stock Exchange.

Apart from the above mentioned sources of finance there are other types of short-term and long-term finances as follows

Short and medium-term finances

Trade Credit

Trade credit is short-term finance that is obtained from suppliers of both goods and services over the period between the delivery of the goods and the settlement of the account by the recipient of the goods.

Trade credit acts as both a source and use of finance because it can be received and as well as offered. Debtors represent the currently unpaid element of credit sales. While the extension of credit is accepted practice in most industries, credit is essentially an unproductive asset which both ties up scare financial resources and is exposed to the risk of default, particularly when the credit period taken by customers is lengthy. Trade credit is a normal part of trading relationships and is therefore called 'spontaneous finance' (Pike and Neale, 2006).

In determining the appropriate level of creditors for a corporation it is important to pay particular attention to the financial analysis ratio:

Creditor days = trade creditors/credit purchases *365

Bill Finance

A bill is a commitment to pay a specific sum at a specified point in time. Bills are traded on the money market, which specialises in providing funds repayable over periods of less than one year. There are three main types:

Bills of Exchange

Buyer promises to pay at some future date. Then the supplier either holds the bill until maturity or sells it on the market at a discount. The terms of the bill usually include imlicit interest charges, although no interest as such is paid.

Bank bills or acceptance credits

Bank agrees to accept bills up to an agreed limit at some time in the future (30, 60, 90 180 days); Customer pays the discount and bank fee. Some of the advantages are; the interest rate is relatively low. Unlike traditional bills of exchange, they are not limited to specific transactions.

Commercial paper

Offering promissory notes to financial institutions, however commercial paper is confined to largest firms with the highest credit ratings. Those companies should be listed on the London Stock Exchange.

Hire Purchase

Hire Purchase (HP) or Asset Purchase (AP) is where the company which eventually own the asset after making an initial deposit and regular interval payments. It is most similar to a finance lease. The hire charge contains two elements; an interest charge to reflect the borrowing of the capital involved; and a capital repayment element.

As with both types of leases the two main advantages are the avoidance of a major initial outlay and the immediate availability of the asset. As with both types of leases if the company fails to fulfil the payment schedule the HP provider can repossess the asset.

Leasing

Leasing is a commercial arrangement whereby the owner of the equipment conveys the right to use equipment in turn for payment by the equipment user of a specified rental over pre-agreed period. Leasing is a distinctive method of finance because it involves important interactions between the investment and financing decisions.

Finance Lease (FL)

Transfers the risks and rewards of ownership to the lessee; Period of the lease usually matches the expected asset life. Financial Lease borne by lessee unlike the operating lease.

Operating Lease (OL)

Lessee rents the equipment often for specific tasks. Operating Lease is for a specific task over a short time period. OL can be easily terminated and it is borne by lessor. OL typically more expensive and disclosed in footnotes and therefore off-balance sheet financing.

Long-term finances

Right Issues

The term right issue is applied to the system of issuing shares to existing shareholders, usually at a discount from the market price, in order to raise further capital from existing shareholders. When offering shares in a right issue, the company sends an explanatory letter to each shareholder detailing the price, accompanied by a provisional allotment letter indicating the number of shares to which the member is entitled to subscribe.

The rights of shareholders to buy rights are known as pre-emptive rights. if shareholders do not take up the rights or sell them, the company must, under Stock Exchange rules, sell them for the shareholder who get the rights value. If small amounts are involved the benefit go to the company.

Share Splits

A share split is the splitting of existing shares available into smaller shares. For e.g. each ordinary share of 50p is split into two 25p shares, in order improve the company's shares. It is a way to express that the company is intending growth in EPS and dividends per share, and for this reason the resulting market price of split share a is higher than the simple split price would be.

Bonds

A bond is a long term contract in which the bondholders lend money to a company. In return the company promises to pay the bond owners a series of interest payments known as coupons, until the bond matures. At maturity the bond holder receives specified principal sum call par (nominal value) of the bond the time of maturity is usually between 7 to 30 years.

  • Foreign bonds - domestic issues by non-residents, denominated in the local currency
    • e.g. issue in London in GBP by a US firm
  • International bonds or Eurobonds - securities issued by borrowers in a location outside that of their domestic currency
    • e.g. US firm borrows in USD in London

Floating Rate Notes (FRNs) - Eurobonds that pay a floating rate of interest.

IPO's and Capital Markets

Capital market

Capital market deals with long dated securities such as shares and loan stock. The London Stock Exchange is one of the best known institutions in the capital market. There are also other capital markets like bond market and Eurobond market.

The London Stock Exchange is comprised of two different stock markets: the Main Market and the Alternative Investment Market (AIM). The Main Market is solely for established high-performance companies, and the listing requirements are strict. Approximately 1,800 of the LSE's company listings trade on the Main Market, and the total market capitalization is over 3,500 billion. The Alternative Investment Market on the other hand trades in small-caps, or new enterprises with high growth potential. Over 1,060 companies list on this market, with a total capitalization of 37 billion (ADVFN, 2009).

The financial markets provide mechanisms through mechanisms which the corporate financial manager has access to wide range of sources of finance and statements. Capital markets function in two ways:

Primary market: providing new capital for business and other activities, usually in the form of shares to new existing share holders (equity), or loans.

Secondary market: trading existing securities, thus enabling share or bond holders to dispose their holdings when they wish. An active secondary market is a necessary condition for an effective primary market, as no investor wants to feel 'locked in' to an investment that cannot be realized when desired (Pike and Neale, 2006).

London stock exchange also functions both as a primary and secondary market. The primary and secondary markets are shown in the below figure 2.1 shown below

The stock exchange discharges its responsibility by:

  • Vetting new applicants for membership
  • Monitoring members' compliance with its rules
  • Providing services to aid trading and settlement of members' business
  • Supervising settlement activity and management of settlement risk
  • Investigating suspected abuse of its market.

The Royal Bank of Scotland has been listed on the London Stock Exchange on official Listings. he following figure shows various facts like fluctuations of share price for a day and a week respectively also the volume of shares, earnings per share, dividend yield and symbol of Royal Bank of Scotland related to London Stock Exchange: -

RBS Quote(London exchange)

IPO

QUOTE DRIVEN SYSTEM

A price system on a stock exchange in which prices are generated by dealers' and market makers' quotes before market forces come into play and prices are determined by the interaction of supply and demand. The London Stock Exchange's dealing system, as well as of those manyover-the-counter markets, has quote-driven systems (qfinance.com, 2009).

INITIAL PUBLIC OFFERING

REASONS FOR FLOATATION/QUOTATION:

  • Enables owners' to realise a portion of their equity stake;
  • Enables sale of more shares to generate funds;
  • Provides a market for owners to realise assets in future
  • Widens shareholder base with a greater ability to raise equity in future;
  • Allows firm to set up bonus schemes to reward staff in shares;
  • Makes acquisitions easier if can offer own shares;
  • Image/Prestige - higher profile may generate sales.

The issuing process for the official listings involves various stages as shown in figure 2.3 below exh-10-5a

Methods of Issuing Shares

One way in which a firm can expand is to issue additional equity usually on the main stock market or secondary market, either by a quoted company issuing additional shares or by an unquoted company obtaining a quotation. There different approaches a firm can issue shares;

Placing

This method is often used for a company wishing to be floated for the first time and to issue a small issue, or by a quoted company wishing to rise additional finance. It involves securities acquisition by a market so that they can be purchased by a small number of investors.

Offer by Sale

This method is popular with companies being floated for the first time and undertaking a large issue, example; an unquoted company may sell some of its existing shares on the market. An unquoted company can also issue new shares and market all shares. The selling of existing shares provides a wider market for finance in a company and allows shareholders a chance to sell their shares. A company will only receive additional funds if new shares are issued.

Sale by Tender

This method is occasionally used for large first time issue but it is lee common then offers for sale because of uncertainties as to the amount of finance which will be raised and it may give the impression that the issuing house is unable to set a price for the shares. An issue by tender has become a more common method of share issue in recent years. The issuing house invites members of the public to subscribe by tender, i.e. to state at which price they will take the security offered; sometimes there is a minimum price below which tenders will not be accepted.

Right issue

The term right issue is applied to the system of issuing shares to existing shareholders, usually at a discount from the market price, in order to raise further capital from existing shareholders. When offering shares in a right issue, the company sends an explanatory letter to each shareholder detailing the price, accompanied by a provisional allotment letter indicating the number of shares to which the member is entitled to subscribe.

The rights of shareholders to buy rights are known as pre-emptive rights. if shareholders do not take up the rights or sell them, the company must, under Stock Exchange rules, sell them for the shareholder who get the rights value. If small amounts are involved the benefit go to the company.

On 22 April 2008, the Royal Bank of Scotland (RBS) announced a rights issue to raise £12 billion (net of expenses) to increase its capital base, the largest ever rights issue in Europe (practicallaw, 2008)

The following figure is the share prices of RBS on London Stock Exchange and New York stock Exchange in the month December 2009.

Current Share Price

The EMH is the extent to which market prices fully reflect (Pike and Neale, 2006) available information (historical and current).

  • The measure of efficiency is seen in the extent and speed with which the market reflects new information in the price.
  • There is no role for fundamental or technical analysis where there is a weak form of EMH.

Weak Form

Current share prices reflect all information contained in past price movements. If this level of efficiency holds, there is no value trying to predict future price movements by analysing trends in past price movements

Semi-strong Form

Current market prices reflect all publicly available information. In other words, there is no benefit in analysing existing information, such as that given in published accounts, dividends and profits.

Strong Form

Current prices reflect all relevant information whether held publicly or privately. The market price reflects the true value of share based on the underlying future cash flows.

COST OF CAPITAL

"The cost of capital is the rate of return that a company has to offer finance providers to include them to buy and hold financial security. This rate is determined by the returns offered on alternative securities with the same risk" (Arnold, 2005). Using cost of capital at appropriate discount rate is important, if it is too high investments would constrain. As a result the firms would not grow also the shareholders could miss value enhancing opportunities.

The Required Rate of Return

(Arnold, 2005) The capital provided to large firms includes many forms. The main forms are Equity and Debt. When a provider chose to provide funds to a firm in the form of debt, he deliberately attempts to reduce the risk, by imposing covenants or requiring collateral. The required rate of return of investors will be determined by the opportunity cost forgone of investors, and the risk they are required to bear. If the opportunity cost is greater than projected return, the risk of investing in a company is generally considered to be high.

Cost of Equity

The requirements and expectations of shareholders must be considered must be considered when looking at the cost of equity. The effect changes in earnings and dividends may have on the share price must also be considered.

Dividend Yield or Dividend Valuation

The dividend valuation model may appear to be a rather naïve and incomplete model of share price behavior. It implies that share prices are only determined by the expected future level of dividends and the systematic risk of future dividend flow 6.

The return composed of two elements: the dividend and the capital gain (or loss) on the share price. The dividend valuation model appears to be ignoring this second element of return-the capital gain.

However, the dividend valuation model does not ignore the idea of capital gains and losses on the share price. Instead, what the model implies is that what causes a capital gain (or loss) is changed expectations as to the future level (or riskiness) of the expected dividends.

Model

If we assume the future expected dividend flow will remain at a constant level for all future time periods (i.e. a level in perpetuity), then the equation for cost of equity would be

Ke = De/Se

Where, Ke = cost of equity,

De=current dividend payable,

Se=current share price.

Dividend Growth Model

This assumption is about the future pattern of share's dividends is not that they are constant, but that they grow at constant annual rate, in perpetuity. The calculations in panel show how this 'dividend growth' model can be derived as 11:

Po=do (1+g)/(r-g) which is also written as Se=De (1+g)/(Ke-g)

Where, Po or Se= the current ex dividend market,

De or do= the current dividend,

g= the expected annual growth in dividends,

r or Ke= the shareholder's return on shares.\

The Cost of Retained Earnings

The cost of Retained Earnings is one of the most important sources of corporate long-term investment capital is retained earnings - i.e. that part of net cash flow generated by a company's past investment projects which, at the time it arises, is retained within the firm rather than being distributed to the shareholders as a part of the dividend flow. Because retained earnings arise from sources internal to the company, rather than externally, there is a temptation to believe that this source of capital is somehow 'costless'.

Retained Earnings belong to the ordinary shareholders of a company and so the cost of retained earnings, or the minimum expected return that their use in investment projects should generate, is exactly the same as the expected return required by shareholders on new equity: the cost of equity capital.

Cost of Debt Capital

Costofdebt capitalis associated with the amount of interest that is paid on currently outstanding debts. In the broadest sense, this can apply to all types of interest, including interest charges that are associated with revolving charge accounts. Most commonly,costofdebtcapitalis understood to be the interest that is paid on bank loans, bond options, and similar types of financial transactions. There are debentures can be either redeemable or irredeemable. It is important to know the type of debenture a firm has in issue when calculating its cost of capital.

The cost of debt is generally determined by the following factors (Arnold, 2005).

  • The prevailing interest rates
  • The risk of default
  • The benefits derived from interest being tax deductable.

Irredeemable debt

The formula for calculating irredeemable debt is

Kd = I(1-t)/ Sd

Where: Kd = cost of debt capital

I = annual interest payment

Sd = current market price of debt capital

T = the rate of corporation tax applicable

Taxation is considered because the interest can be offset against taxation, which will lower its nominal rate, and thus its cost. The higher the rate of corporation tax payable by the company, the lower will be the after- tax cost of debt capital. Thus the cost of debt capital is much lower than the cost of preference shares with the same coupon rate and market value as the debentures because of the availability of tax relief on debt.

Cost of Preference Shares

Preference shares are similar to redeemable fixed debt capital, in that the holders receive an annual preference 'dividend' which expressed as a fixed percentage of their nominal value. This annual dividend, unlike normal debt interest, is not an allowable expense against corporation tax.

However, other than for this, calculating the cost of preference capital is virtually identical to the calculation of the cost of debt. The formula for calculating cost of preference shares is:

Kp = Dp/Sp

Where, Kp= cost of preference shares,

Dp= fixed dividend based on the nominal value of the shares,

Sp= market price of preference shares.

Redeemable debt

Redeemable debt means the debt will be paid on a particular date. Here IRR is calculated to obtain necessary cash flows. The IRR is calculated using discount factors for the appropriate coat of capital. Here the longer the period to maturity the lower will be the overall cost of capital.

The weighted average cost of capital

The organization makes financial decisions based upon all of its sources of finance rather than in mere isolation. Therefore it becomes important to calculate the WACC -based upon the gearing relationship. We need to calculate the weighted average cost of capital to establish the minimum return needed on an investment within the firm, that will produce enough to satiny the lenders and shareholders (Arnold, 2005). Investments which offer a return in excess of WACC will increase the market value of company's equity, reflecting the increase in expected future earnings and dividends arising as a result of the project. The formula for WACC is: -

WACC = Ke * We + Kd * Wd

Where: Ke = cost of equity

We = weighted equity

Kd = cost of debt

Wd = weighted debt.

Financial distress constrains gearing

There are number of reasons for increasing in gearing and to obtain a lower WACC value, the most important of which is the increasing risk to the finance providers of financial distress and ultimately liquidation.

As gearing increases the profitability of equity investors decreases receiving a poor return. So they demand higher expected returns to compensate. At first, the risk premium rises slowly, but at higher gearing levels it increases to fast that it more than offsets the benefit of increasing debt in the capital structure. This is shown in figure number----- in which the WACC at lower levels of debt is primarily influenced by increasing the debt proportion in the capital structure, and at higher levels by the rising cost of equity. X is the value of the form firm it wants to operate, it is maximum value of the company

Working capital

Introduction

Working capital refers to the resources of the firm that are used to conduct operations- to do the day-to-day "work" that makes the business successful. The management of working capital is one of the most important areas in determining whether a firm will be successful. The effective management of working capital requires both medium-term planning and immediate reactions to change in forecasts and conditions (Hampton and Wagner, 1989).

(Hampton and Wagner, 1989) the term working capital refers to current assets of the firm-those items that can be converted into cash within the next year. Net working capital is defined as the difference between the current assets and current liabilities. Liquidity may be viewed as the near cash resources (current assets) available to pay near tem bills (current liabilities). Inventories are the two most important components of current assets.

Current assets-current liabilities = Net working capital

According to the balance sheet of RBS at June 30, 2009 (RBS, 2009)

Total assets of RBS = 1,644,445 m pounds

Total liabilities = 1,586,656 m pounds

Total Assets - Total Liabilities = 1,644,445 m pounds - 1,586,656 m pounds

57789m pounds = Working Capital

Here the working capital of Royal Bank of Scotland is positive. Positive working capital means that the company is able topayoff its short-term liabilities.Negativeworking capital means that a company currently is unable tomeetits short-term liabilities withits current assets (cash, accounts receivable andinventory).

A firm's working capital may be viewed as having two components

  1. Permanent working capital this category represents cash, receivables, and inventories required on a continuing basis over the entire year.
  2. Variable working capital this category reflects additional current assets needed at peak periods during the operating year. Additional inventory may be needed to support higher sales during the selling season. Receivables must increase once the goods have been sold.

Circulating nature of current assets

Working Capital Ratios

(Hampton and Wagner, 1989) The firm's level of working -capital bears a relationship to a variety of operating and financial activities. Without adequate working capital, the firm's primary lines of business may be paralyzed. With excess working capital the firm is bearing unneeded costs. There are three essential ratios involved in assessing the working capital of a public sector organisation:

Current Ratio The current ratio is used as a measure of the pool of liquid funds available to pay near term obligations. A lower ratio is an indicator that a firm may not be able to pay bills on time. A high ratio means excessive amount of current assets, a failure to properly utilize the firm's resources.

Current Ratio = Current Assets

Current Liabilities

According to the balance sheet of RBS at June 30, 2009

Current ratio = Current Assets

Current Liabilities

= 1,644,445 m pounds/1,586,656 m pounds

= 1.036

The current ratio of RBS is just higher than 1. This figure should be always higher than 1 if not it shows that a company is technically insolvent.

Acid Test and Quick Ratio the acid test and the quick ratio are used to measure the most liquid assets against current obligations. It shows the ability of the firm to pay its bills without relying on the sale of inventories and collection of the resulting receivables.

Quick Asset Ratio = Current Assets - Inventory

Current Liabilities

Quick ratio removes those items which cannot easily and quickly be converted into cash at their full value i.e. stock

Acid Test Ratio= Cash + Deposits + Investments

Current Liabilities

Acid test ratio is the amount of cash which firm has to service its current liabilities. Companies with poor acid test ratios need to have standby overdraft facilities in order to ensure that the short term need to service payments of current liabilities can be met.

Cash conversion cycle

(Arnold, 2005)The working capital cycle can be seen as the length of time between acquisition of raw materials and other inputs and the inflow of cash from the sale of goods. This is shown in the figure number-----, includes a number of intermediate stages.

The cash conversion cycle considers the time between the firms outlay on inputs and the recipt of money from the sale of goods. In terms of manufacturing firm it is the average time raw materials remain in stock, plus the time taken to produce the company's output, plus the length of time finished goods stay within the company as a form of inventory, plus the time taken for debtors to pay, less the credit period granted by suppliers. The cash conversion cycle can be summarized as the stock-conversion period plus the debtor-conversion period less the credit period grated by suppliers this is shown in the figure number---

Overtrading

Over trading is quite commonly occurred for growing companies, and occurs when a business over extends itself by having insufficient capital to match increases in turnover. Increasing turnover results in higher stock which in turn results in debtor levels which will needed to be funded. Another case is when a company needs to repay its loan when it has insufficient funds. Whilst there will be some corresponding growth in creditors, sustaining growth on trade credit alone is unlikely to be successful in the longer term.

Cash Management

"Cash" is something that is very important to the firm. Cash is of different forms such as, notes, coins and bank balance accounts giving immediate access, which is mostly invested in short-term bank deposits. Despite the seemingly low returns, there are several good reasons why firms hold cash and marketable securities (Scherr, 1989). Some of them are

Day to Day Transactions: - Day to Day cash inflows and outflows do not match perfectly; cash serves as a buffer to ensure that transactions occur at the appropriate time. Cash balances are particularly important where the patterns of cash inflows and outflows differ greatly (Pike and Neale, 2006).

Precautionary Balances: - The Treasury of RBS said that it would inject a further £25.5 billion of taxpayers' funds into RBS to prop up the lender along with a new £8 billion pot of reserves intended for emergencies only (business/industry sectors/banking_and_finance, 2009). These balances are contingency balances since cash flows often unpredictable. Precautionary balances are required to cater for unpredicted cash flows.

Speculative Balances: - cash allows the business to be highly flexible and to exploit wealth creating opportunities more easily. Large cash balances are common among acquisitive companies where a cash alternative to takeover bid is required

Cash and Near-Cash as Hedges: - emergencies may arise for which the firm needs immediate cash. The firm must hedge against the possibility of the unexpected needs. Several types of hedges are possible. Example, the firm can arrange to be able to borrow from its bank on short notice should funds suddenly needed (Scherr, 1989).

There are several number reasons cash-management problems occur such as overtrading, growth, inflation, payment delays, bad debts and seasonal trading.

The remedies to deal with short-term cash shortage are; accelerating cash inflows from debtors, postponing cash outlays; Accelerating cash inflows from debtors; Postponing cash outflows by delaying payment to creditors; Postponing capital expenditure Reversing past investment decisions; Rescheduling loan repayments.

Cash Ratio

The ratio ofa company's totalcashand cash equivalentsto its current liabilities.Thecashratio is most commonly used as a measure of company liquidity. It can therefore determine if, and how quickly, the companycan repayits short-term debt. A strong cash ratio is useful to creditors when deciding how much debt, if any,they would be willing to extend to the asking party.

  • Cash Holding = Cash
  • Current Assets

  • Cash Turnover = Turnover
  • Average Cash Balance

Float

A float is the time lost between a payer making a payment and a beneficiary receiving value

The Cost of the Float is:

= Principle amount due x no of days x cost of funds 360 or 365

Any delay in the process of converting inventory to receipt of payment results in a float cost; similarly, any delay in making payments will also give rise to float but this time to our advantage.

The Miller-Orr Model

(Miller, 1966) Miller and Daniel developed a cash balance model to deal with cash inflows and out flows and outflows that fluctuate randomly from day to day. The Miller-Orr model includes both inflows and outflows in it. The model assumes that the distribution of net cash cash flows is normally distributed.

The model operates in terms of upper limit (H) and lower limit (L), and Return Point or Target Cash Balance (Z). Under the model, the organisation allows the cash balance to fluctuate between the upper control limit and the lower control limit, as long as the cash balance is between (H) and (L) the firm makes no transactions. Making a purchase and sale of marketable assets only when one of these limits is reached. The assumption made here is that the net cash flows are normally distributed with a zero value of mean and a standard deviation.

When the firm's cash limit fluctuates at random and touches the upper limit (H), the firm buys sufficient marketable securities to come back to a normal level of cash balance i.e. the return point (Z). Similarly, when the firm's cash flows wander and touch the lower limit (L), it sells sufficient marketable securities to bring the cash balance back to the normal level i.e. the return point (Z).

The Miller-Orr model depends on trading costs and opportunity costs. The cost per transaction of buying and selling marketable securities, F, is assumed to be fixed. The percentage opportunity cost per period of holding cash, K, is the daily interest rate on marketable securities.

Given L, which is set by the firm, the Miller-Orr model solves for Z and H

(Rose et al. 2002) To use the Miller-Orr model, the manager must do four things:

  1. Set the lower control limit for the cash balance.
  2. Estimate the standard deviation of daily cash flows.
  3. Determine the interest rate.
  4. Estimate the trading costs of buying and selling securities.

The Baumal Model

Baumol's cash management model helps in determining a firm's optimum cash balance under certainty. As per the model, cash and inventory management problems are one and the same. The Baumol model is possibly the simplest and most stripped down sensible model for determining the optimal cash position. Its chief weakness is that it assumes discrete, certain cash flows (Rose, 2002).

There are certain assumptions that are made in the model:

  1. The organisation is able to forecast its cash requirements with certainty and receive a specific amount at regular intervals.
  2. The organisation's cash payments occur uniformly over a period of time.
  3. The opportunity cost of holding cash is known and does not change over time.
  4. The organisation will incur the same transaction cost whenever it converts securities to cash.

Q = maximum cash balance

Q/2 = average cash balance

B = transaction costs for selling securities or arranging a loan

N = total amount of new cash needed for the period under consideration

C = the holding cost of cash opportunity cost

The total cost line consists of the following:

Debtors Management

Introduction

Trade Credit

Trade credit acts as both a source and use of finance because it can be received and as well as offered. Debtors represent the currently unpaid element of credit sales. While the extension of credit is accepted practice in most industries, credit is essentially an unproductive asset which both ties up scare financial resources and is exposed to the risk of default, particularly when the credit period taken by customers is lengthy (Pike and Neale, 2006).

There are four main reasons for providing trade credit:

Investment and Marketing: Trade credit should be viewed as an investment forming part of sales package. Many companies lose their customers demanding cash on delivery. Investing in trade credit also involves risks if the company is exposed to the possibility that the debt will not be paid on time or at all.

Industry and Competitive pressures: it is difficult for firms to offer credit terms that are less generous than their competitors.

Finance: certain companies have the competitive advantage of offering credits more cheaply than their competitors which reflects their offering generous credit to customers who experience greater difficulties in raising finance.

Efficiency: customers would not be able to find out the quality of the product they have ordered to delivery until it has been thoroughly inspected. Trade credit is therefore is a convenient means for separating the delivery of goods from the payment of deliveries.

Royal bank of Scotland offers credit to its customers through credit cards differing by type, the following are credit cards offered by RBS

Royal Bank of Scotland Cards: Major Types & Their Features

Platinum

  • APR of 16.9%
  • Daily cash advances worth £ 750
  • Balance transfer rate of 0%, for the first 13 months
  • 0% purchase rate, for the first three months

Classic

  • A low purchase rate of 8.9% for the first eight months
  • Daily cash advances worth £300
  • No annual fee
  • Minimum credit limit of £300

Student

  • No annual fee
  • 18.9 % APR
  • Minimum credit limit of £500

Private

  • Typical APR of 14.9%
  • Introductory purchase rate of 8.9%
  • Minimum credit limit of £5000
  • Inaugural balance transfer rate for three months is 8.9% p.a.

There is always a risk for banks if the customer delays his or her payment or they don't pay at all. In this case the banks offer cash discounts to minimize the risk to make life easy for customers to make payments on time. Cash discounts; Firms often have bad debts i.e. customers account remains unpaid for long term, which implies the great risk, that it will never be paid. But the cost of financing late payments is often greater than the cost of bad debts. "Cash discounts are financial inducements for customers to pay accounts promptly" (Pike and Neale, 2006)

The cost of cash discount = Discount %/( 100-discount %) * 365/ (final date - discount period)

Credit Management Process

The aims of credit management process are: -

  • To safeguard the firm's investment in debtors
  • To maximize operational cash flows by assessing customer credit risk, agreeing approximate terms and collecting payments in accordance with these terms (Pike and Neale 2006).

Effective debtor control policy requires careful consideration of the following:

Credit Period

The main factors influencing the period of credit granted to customers are:

The Normal Terms of Trade for the Industry: it difficult to operate a trade credit policy by a company whose policies life is less compared to the normal expected life, unless it has another competitive advantage like quality.

The Importance of Trade Credit as Marketing Tool: the more vital the perception of credit as a marketing tool, the longer the likely period of credit offered.

The Individual Credit Ratings of customers: certain firms operate regular credit terms for good quality customers and specific credit terms for higher risk customers.

Credit Standards

Credit assessment should involve:

Prior experience with the particular customer. The credit extended and payment experience in the past would be as useful guide, but the past experience with customer might be the time when the customer was not experiencing financial difficulty.

Analysis of the customer's profit and loss accounts also the credit reports. Credit reports include:

  1. Bank references
  2. Trade references
  3. Credit Bureau Reports: these repots relate to the period and amount granted to the customer.

Many small firms fail to chase their late payers with a degree of urgency, since their credit management systems are not up to the task. In evaluating the customer credit worthiness, it is useful to remember the five Cs of credit. They are: -

Capacity: - the capacity of the customer to repay the may within required period, assessing this from the past payment record of the customer.

Character: - the effort of customer to repay the payment. Bank references would be helpful.

Capital: - financial health of the customer. Financial accounts and credit agency reports will help here.

Collateral: - requirement of security in return for extending credit facilities.

Conditions: - offers made by competitors and terms for the industry.

Credit Collection Policy

A good credit collection policy is one in which procedures are clearly defined and customers know the rules. Debtors who are expecting financial difficulties will always try to delay payment to companies with poor or relaxed collection procedures. The suppliers who insist on payment in accordance with agreed terms, and who is prepared to cut off suppliers or take action to recover overdue debts, is most likely to be paid in full and on time.

The figure below shows the debt collection cycle, starting with the customer order and ending with the cash received. The pace of the payments often results in variation in working capital required. Late payments would affect the whole supply chain especially if it is a major customer. Penalties; Post dated cheques; Legal process; Internal process; Stop supply required are some of the methods firms use to alarm their customers in case delay or bad debts.

Debtor as Security

The Royal Bank of Scotland in order reduce the risk of bad bets it follows techniques like factoring, services -invoice discountingandfactoringinclude built-in credit reference checks and credit limit analysis to all your customers. This simple step can often avoid bad debts in the first place. RBS offers invoice discounting to businesses with well-established credit control and sales ledger systems only.

Firms try to reduce the effects of the bad debts by mainly two methods; firstly Assignment of debts (invoice discounting) with invoice discounting the risk of default on the trade debtors pledged remains with the borrower. Secondly factoring the factor bears the loss in the event of a bad debt. Factors provide a wide range of services, the most common of which are as follows: -

  1. Advancing cash against invoices;
  2. Insurance against bad debts;
  3. Administration of the credit control functions.

Dividend Policy

Introduction

(Ross, 2002) "The term dividend is usually refers to a cash distribution of earnings". If a distribution is made from current or accumulated earnings it is called distribution rather than dividend. However if the distribution of made from accumulated earnings and capital it is called dividend. (Pike and Neale, 2006) Usually most quoted companies pay dividend twice a year, an interim or 'taster' followed by the main dividend at the end of the year. This is determined at the Annual group meeting, advised by financial advisors for approval of shareholders. This process determines the percentage of post profits to paid as dividends and what percentage to retain.

These dividends are specified on particular day called Record Day, the shares are traded Cum-dividend, where purchasers will be entitled to receive the dividend. The share would be then quoted ex-dividend, after appearing on the share register the Record Day.

Standard Method of Cash Dividend Payment

The decision whether or not to pay dividend lies in the hands of board of directors. Once they announces a particular date to pay the dividends, it becomes a liability of the firm and cannot be easily rescinded by the corporation. The amount of dividends to be paid would be expressed as dividend per share, as a percentage of the dividend yield, or as a percentage of earnings per share. There are specific dates when these dividends are paid, shown in the following figure:

The dividend dates of Royal Bank of Scotland from the year 2005 to 2007 are shown clearly below:-

Cash Dividends

(Ross et al, 2002) The most common type of dividend is in the form of cash. Public companies usually pay regular cash dividends four times a year. Sometimes firms will pay a regular cash dividend and an extra cash dividend. Paying a cash dividend reduces the corporate cash and retained earnings, except in the cash of a liquidating dividend.

Alternative to Cash Dividends

Another type of dividend is paid out in shares of stock. This dividend is referred to as stock dividend. It is true dividend, because no cash leaves the firm. Rather, a stock dividend increases the number of shares outstanding. When a firm declares a stock split, it increases the number of shares outstanding. Because each share is now entitled to a smaller percentage of the firm's cash flow, the stock price should fall (Ross et al. 2002).

Share Repurchases

Instead of paying cash dividends, a firm can rid itself of excess cash by repurchasing shares of its own stock. Share repurchase has become an important way of distributing earnings to share holders (Dunsby, 1994). The repurchase of stock is a potentially useful adjunct to dividend policy, when tax avoidance is important. Some of factors that influence share repurchases are: -

Targeted Repurchase

Companies adapt this type of repurchase for several reasons. Sometimes a single stockholder buys a large amount of stock for less price than that I a tender offer. The legal fees in a targeted repurchase may also be lower than those in a more typical buy back. Though targeted repurchases executed for these reasons are in the interest of the remaining shareholders, the shares of large stockholders are often repurchased to avoid a takeover unfavorable to management (Ross et al. 2002).

Repurchase as Investment

Many companies buy back stock because they believe that a stock repurchase is their best investment. This happens when the company believes that the stock price is temporarily depressed. Here, it thought that a) investment opportunities in nonfinancial assets are few, and b) the firm's own stock price should rise with the passage of time (Ross et al. 2002).

Strategic Dimension

Formulating corporate strategy requires specification of clear objectives and delineation of the strategic options contributing to the achievement of these objects. Although maximization of shareholder wealth may be paramount aim, there may be various routes to it the main alternatives for the listed company are short and long term debt capital, new share issues and internal financing.

(Pike and Neale, 2006) Companies sometimes may exceed the capital borrowing capital than the capital required to support the selected strategic option, necessitating the use of additional equity funding. There the firm faces the choice between retention earnings, i.e. restricting the dividend payout, or paying out high dividends but then clawing back capital through subsequent right issues. Retention may offend investors reliant on dividend income, resulting in share sales and lower share price conflicting the aim of wealth maximization.

Alternatively, the dividend payment plus right issue policy falling market. To this extent the dividend decision is strategic, since all ill judged financial decision could subvert the overall strategic aim.

Legal acts

The profit available for dividends is also influenced by legal acts like Companies Act 1985; states that companies are restricted to accumulated realised profits. However, public companies are further restricted to realise profits less unrealised losses. Furthermore, bond holders may insist on prevent large dividends being declared.

PASSIVE THEORY

Residual dividend policy

Residual dividend policy is used by companies, which finance new projects through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the project capital needs are met. This equity is also known as residual equity. Companies which follow the policy of residual dividend should maintain a balanced debt/equity ratio. If a certain amount of money is left after all forms of business expenses then the corporate houses distribute that money among its shareholders as dividends.

The companies that follow a residual dividend policy pay dividends only if other satisfactory opportunities and sources of investment of funds are not available.

The main advantage of a residual dividend policy is that it reduces the issues of new stocks and flotation costs. The drawback of this policy mainly lies in the facts that such a policy does not have any specific target clients. Moreover, it involves the risk of variable dividends. This policy helps to set a target payout. Before opting for the policy of residual dividend, the earnings that need to be retained to back up the capital budget have to be calculated. Then, the earnings that are left can be paid out in the form of dividends to the shareholders. Thus, the issue of new equities gets considerably reduced and this in turn leads to reduction in signalling and flotation costs. The amount payable as dividend fluctuates heavily if this policy is practiced. When the total value of productive investments is in excess of the total value of retained earnings and sustainable debt, the companies feel the urge to exploit the opportunities thus created to postpone a few investment schemes.

The MEI relates to the IRR of available projects. Hence the optimal investment level will be at point X where Ke = MEI. If the company has net cash flows of Eo then it will pay dividends of X-Eo,If the company has net cash flows of E1 then it will require investment of E1-X and pay no dividend.

The residual dividend policy is more suitable for the government concerns because they mainly aim for creation of value and maximization of wealth and therefore they have to make use of every value added investment opportunity that comes on their way. A little change in the basic postulates of the policy usually occurs when it is applied to the government sector because it takes into its purview the government's liking for dividends rather than capital gains.

ASSEERTIVE THEORY

Dividend Irrelevance Theory

The most comprehensive argument for the irrelevance of dividends is by Modigliani and Miller. They assert that, given the investment decision of the firm, the dividend-payout ratio is a mere detail. It does not affect the wealth of shareholders. MM argue that the value of the firm is determined by the earning power of the firm's assets or its investment policy and that the manner in which the earnings stream is split between dividends and retained earnings does not affect this value.

The bases of criticisms of MM's model are its following assumptions

  1. Perfect capital markets in which all investors are rational. Information available to all at no cost, instantaneous transactions without cost, infinitely divisible securities, and no investor large enough to affect the market price of a security.
  2. An absence of flotation costs on securities issued by the firm.
  3. A world of no taxes.
  4. A given investment policy for the firm, not subject to change.
  5. Perfect certainty by every investor as to future investments and profits of the firm.(Van Horne, J C (1989))

Bird-in-hand/ Dividend Relevancy Theory

Gordon and Lintner refer to this as the "Bird in hand theory" another name for dividend relevance. Contrary to the irrelevance proponents, Gordon and Linter suggested stockholders prefer current dividends and that a positive relationship exists between dividends and market value. Fundamental to this theory is the "bird-in-hand" argument which suggests that investors are generally risk-averse and attach less risk to current as opposed to future dividends or capital gains. This is because current dividends are less risky; investors will lower their required return- thus boosting stock prices.

There are several arguments that support the idea that the level of dividend will have an effect on the value of the firm-the dividend relevancy theory.

  • The effects that different tax rates have on investors' preferences.
  • Market imperfections mean that a positive NPV project will not be automatically reflected in the firms share price, but its effects will be shown over time, whereas a reported dividend has a much quicker impact on the share price.
  • Empirical evidence shows that investors prefer a constant dividend policy with either constant dividends or dividends growing at a constant rate helping them plan their finances.
  • If capital rationing exists then it may be cheaper for the firm to retain its earnings and pay a lower level of dividend.
  • Uncertainty as to the future means that shareholders may prefer a certain dividend to an uncertain capital gain.

INFLUENCES ON DIVIDENDS

Growth: Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or for future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.

Liquidity of Funds: Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend.

Taxation: the taxation of dividends and capital gains on shares is likely to influence the preference of share holders for receiving cash either in the form of a regular payment from the company or by selling shares. If shareholders are taxed more heavily on dividends that on capital gains they are more likely to favor shares which pay lower dividends.

Valuation Methods

Valuation of assets, shares and companies is need for several reasons like, to assess the impact of financial to value decisions, to value IPO floatation's; to value privatizations; to value acquisition candidates; to value break-up situations and divestments; to value MBOs and MBIs. For quoted companies' share values can always be found from market prices on stock exchange, it may be necessary to calculate another valuation for a quoted company's share in the process of a takeover bid.

Unquoted companies do not have market price for their shares, and may have to estimate the value for them in the following situations:

  • The shares are to be sold;
  • The shares are to be valued for capital gains tax;
  • The shares are to be used as collateral or a charge;
  • To shares may become quoted.

Methods of Shares and Company Valuation

Accounting Rate of Return

The ARR method uses the following formula to calculate the value of the shares:

Value = Estimated future profits/Required return on capital employed

The required rate of return used is the accounting rate of return here. It may be necessary to adjust the estimated future profit figures for expected changes resulting from the takeover, such as economies of scale achieved to rationalization, in order to use this method to value a takeover bid.

P: E Ratio

(Pike and Neale, 2006) A P:E ratio measures the price that the market attaches to each 1 pound of company earnings, and thus superficially is a sort of payback period. The P:E ratio varie directly with the share price, but it also drives from the share price. The ratio should be for particular share categories and individual companies, and look for disparities between sector and companies. This method calculates the value of a company's shares by using the following formula.

Market value per share = Earnings per Share * P/E ratio;

Where P/E = price per share/ Earnings per Share.

ANNUAL STOCK VALUATION

The p:e ratio of RBS has been decreasing over the years from 2006 to 2008. High P/E ratio indicates the good growth potential of the company. P/E ratios rely on accounting profits rather than the expected cash flows which confer value on any time. The report suggest that the RBS growth has been diminished over the last four years.

Net Asset Valuation

Net asset value of company is equal to the net tangible asset of company attributable to those shares is the basis of this method of calculating share values. Intangible assets are only included in the calculation if they have a recognizable market value. To calculate the values of a share simply divide the value of assets attributable to a class of shares by the number of shares in the class. NAV, when based on reliable accounting data, only really offers a guide to the lower limit of owners' equity, but even so, form of adjustment is often required. This may be an easy method to calculate, but in practice it has quite few problems such as:

Problems with Net Asset Valuation (NAV):

  • Fixed Asset values usually based on historic cost
  • Is the stock valuation accurate?
  • Can all the debtors be collected?
  • Are there any off-balance sheet liabilities?
  • Are the accounts reliable?

NAV may provide a useful reference point; it is unlikely to be a reliable guide to valuation. This is largely because it neglects the capacity of the assets to generate earnings.

Dividend Yield Method

This model assumes the future expected dividend flow will remain at a constant level for all future time periods (i.e. a level in perpetuity), then the value of company's share can be calculated as:

Market Value = Dividend/Estimated (or yield) return on shares %

Dividend Growth Model

This assumption is about the future pattern of share's dividends is not that they are constant, but that they grow at constant annual rate, in perpetuity. The calculations in panel show how this 'dividend growth' model can be derived as:

Share value = do (1+g)/(r-g)

Where, do= the current dividend,

g= the expected annual growth in dividends,

The market value of ordinary shares represents the sum of the expected future dividend flows, to infinity, discounted to present value.

Predict future flow of cash from operations = Profit after Tax, plus Depreciation and adjusted for known investment needs

DCF Approach

Valuation methods imply we should rely on discounted cash flow approach. Since, it is rational to attach value to future cash proceeds rather than to accounting earnings, which are based on numerous accounting techniques, including the deduction of non cash charge of depreciation. Given that depreciation is not a cash item.

The Discounted Cash flow Method is used when a company intends to purchase another's assets and invest in improvements in order to increase future profits. Most companies need investment funds for growth purpose as well as for replacement. The value of growing companies depends not only on the earning power of their assets, but also on their growth potential. To obtain an accurate we should assess total ongoing investment needs and set these against anticipated revenue and operating cost flows; otherwise we might over value the company (Pike and Neale, 2003).

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