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Summary FIN2603_Study Unit 07
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FIN2603_Study Unit 07
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FIN2603 – Finance for Non-Financial Managers (2023)Study Unit 07: Financing (PB: Chapter 7)
The goal of a firm should be to maximise its wealth. This can be achieved by earning the
maximum return from the assets of the firm and by keeping costs of capital as low as possible.
Trade credit - involves buying raw materials or goods on credit and paying the creditor after
30 or 60 days.
Bank overdraft - involves an arrangement with a bank to have a debit balance on the firm’s
cheque account up to a certain amount.
3. Long-term financing:
A firm can only finance its fixed assets by means of equity or long-term debt.
➢ The equity of a company listed on the securities exchange consists of ordinary share
capital.
➢ Long-term debt could take various forms - it could be debentures or bonds sold which only
pay interest every six months and repay the principal at maturity.
➢ Bonds - long-term debt instrument used by business and government to raise large sums of
money, generally from a diverse group of lenders - normally involve the financing of specific
assets that also serve as collateral.
➢ Debentures - loans made to a firm, usually for a predetermined period and at a
predetermined interest rate; used to finance any assets or activities of the firm without
pledging any assets as collateral - could be used to finance any assets or activities of the
firm.
➢ A mortgage loan -a loan backed by liens on land and buildings; the assets serve as collateral
and the instalments consist of interest and principal amounts to amortise the loan by the
time maturity is reached - requires monthly instalments over a 20- or 25-year period.
- Each instalment on a mortgage loan consists of 2 components - interest and
amortisation of part of the principal.
The mixture of debt and equity finance in the capital structure is also called gearing. A firm is said to be
highly geared when it obtains a substantial proportion of its finance from debt, be it short-term,
medium-term or long-term debt.
Characteristics of debt and equity:
When a firm borrows money, it usually gives first claim to creditors on the firm’s cash flow.
Equity holders are entitled only to the residual value, which is the portion left after the
creditors have been paid.
The value of this residual portion is the owner’s equity in the firm, which is the value of the
firm’s assets less the firm’s liabilities (debt):
Owners’ equity = total assets - liabilities
Lyana Petzer Page 1 of 6
, FIN2603 – Finance for Non-Financial Managers (2023)
The following factors distinguish debt from equity:
Maturity - refers to debt falling due.
• Short-term debt - debt that is scheduled to mature within one year.
• Medium- term debt - debt that matures from one to ten years.
• Long-term debt - debt that matures in a period exceeding ten years, usually debentures
or bonds sold, which only pay interest every six months and repay the principal back at
maturity.
Claims on income - 3 factors to consider:
1. Priority of the claim
- The claims of creditors come before the claims of owners. The firm must meet all
obligations to creditors first, and, in some instances, owners may not withdraw income if
these withdrawals. Residual owners - in a partnership, they are the general partners
in a company, they are the ordinary shareholders.
2. Certainty of the claim
- If the firm has promised to pay interest on debt, it must pay the interest (whatever the
level of earnings) or face legal action.
3. Amount of the claim
- Interest payments on debt are limited to a certain fixed amount. For example, the bank
receives 9,5% interest per annum, and no more, on its loan to the firm.
Claims on assets - auctioned when a firm gets into difficulty, especially when its assets are
being liquidated.
o Claims of creditors precede those of the owners.
o Claims of preference shareholders are usually superior to those of residual owners.
o Ordinary shareholders are last in line.
The right to a voice in management - Creditors have no direct voice in the management of a firm,
although they may place certain restrictions in the loan agreement on management's activities.
The tax benefit of paying interest - Interest paid is an expense item in a firm's statement of
financial performance. It reduces the earnings before tax (EBT) used in calculating the firm's tax
liability. The firm must adjust the interest rate paid on its loan as follows:
After tax cost of debt = interest rate X (1 - tax rate)
EXAMPLE
A firm uses a loan to finance part of its assets. The interest rate payable on the loan is 13.54% and the
firm is subject to a tax rate of 28%. The after-tax cost of debt is 9.75%, calculated as follows:
After tax cost of debt = 13.54% (1 – 0.28)
= 13.54 x 0.72
= 9.75%
Lyana Petzer Page 2 of 6
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