Assignment 1 – Sources of Finance
1. What are the gearing implications of (i) equity and (ii) loan financing for the current and future shareholders?
Raven Construction PLC has Share Capital of £400,000 and total long-term debts of £800,000 giving it a debt to equity ratio of 2:1. Therefore, Raven Construction PLC is said to be Highly Geared as it currently has £2 of debt for every £1 of equity. This is calculated from the following equation:
Long-term DebtCurrent Equity =Gearing Ratio
i. Equity Financing – This is the process of raising capital through the sales of shares and refers to an ownership in Raven PLC. The purchase of shares is a simple way of introducing permanent ...view middle of the document...
Raven is looking to generate finance for new land and buildings and additional plant and machinery. As a High Geared business the potential to borrow more money from the bank is reduced. Raven must also consider that it may have its debts recalled in the near future with limited warning from the bank. If the bank agreed long-term borrowing then the Gear Ratio would increase potentially exacerbating the issues raised above. Mortgages and long-term bank loans could offer Raven the option to borrow money over a long period, secure it against company assets and repay the loan on a monthly basis. Venture capital firms may provide loan capital as they are prepared to take more risk the banks. The conditions for the loan will be more stringent and will require a very detailed business plan before anything is agreed. The final Loan Capital option available to Raven PLC is a Debenture. It offers a fixed period loan secured against company assets that requires interest payments honoured over the life of the loan before the loan is repaid in full on the agreed date. The debenture does not represent any form of company ownership so not diluting the current shareholders stake in Raven. This option will require the company to turn a substantial profit to ensure the loan can be honoured in full on the agreed date.
The short-term finance options available to Raven PLC include short-term bank loans, overdrafts and hire purchasing. A short-term loan is a simple agreement that requires monthly payments repaid to the bank until the value of the loan and interest has been repaid; the loan will be secured against company assets. Overdrafts provide a lower interest rate than a short-term bank loan and could therefore be cheaper than a loan. It is a flexible loan that could be used by Raven when required. Hire purchasing allows a company to immediately use the hired items without having to raise the full amount of cash required for a purchase. The finance is usually provided by a finance company that will repossess the items if payments are not maintained. The interest rates are also usually higher than that of a bank due to the greater risk the finance company faces. Another option available is leasing. Leasing is a very popular option to companies as they pay for the use of the assets but do not own them. It offers a company a good way of maintaining up to date equipment without purchasing assets that may depreciate very quickly. An additional advantage to leasing assets is to include it as a trading expense, reducing the companies tax liability.
Raven PLC could also generate funds through the careful management of payments in and out of the company. A customer may be encouraged to pay their invoices off earlier if a discount is offered for early payments giving more working capital available for investments whilst improving company-customer relationships. Conversely, Raven may wish to delay the payment of its own bills until...