MSIN0168: Managerial Finance for Decision Makers
Topic 1: Financing Methods and Objectives
Stakeholder Problem: Business objectives represent the vaguely related, conflicting,
contradictory and complementary interests of a coalition of parties that are affected by the
firm's existence.
Principal - Agent Problem (shareholder vs management)
How can the principal control the agent?
o Goal congruency
o Manager’s objectives vs shareholders objectives
Agency costs: the difference between the return expected from an efficient agency contract
and the actual return, given that managers may act more in their own interest than in the
interest of shareholders.
Company Financing
Equity – Ordinary Shares
Advantages: reduces gearing (reduces percentage of debt through the issue of shares), no
interest charge against the profit, no repayment obligation, leaves debt finance capacity still
available, no restrictive covenants by lenders
Disadvantages: higher cost than debt, no tax shield - cannot set dividend payments as an
expense against profits
Forms of equity finance: Retained earnings/profit, belongs to shareholders, easily available,
no issue cost, no dilution of ownership
Share Issues
Advantages: raises a large amount of capital
Disadvantages: advertising, prospectus is issued, underwriting arranged, dilution of
ownership and earnings spread over more shareholders, if not fully subscribed - bad
publicity
Different forms of share issues:
• Public issue/IPO: shares sold directly to the public, using the advice of a merchant
bank
• Offer for sale: popular method, sell shares to tissue house for a fee, issue house sells
shares to the public
• Sale by tender: costly method/unliked by small investors, set a minimum reserve
price and ask for potential shareholders to bid for shares at the minimum price or
higher
• Placing: shares sold privately to a few institutional investors - reduces costs, no
uncertainty, small amounts of capital, low price offered, large blocks of shares to
individual institutions may make the company vulnerable to takeover
, • Rights Issues: can only be used when additional shares are to be issued, existing
shareholders have the right to buy new shares in the company at a discount on the
current market price, or they can sell the rights - the company would still use
underwriters to give the market confidence in the issue
o BUT, Shareholders may take the opportunity to diversify rather than increase
their shareholding in the company, insufficient funds
o Advantages: no need to advertise or issue a prospectus - cheap, pricing issue
is not as important, dilution of ownership is limited to the extent that the
rights are sold to outsiders, success rate is very high
• Scrip Issues (bonus issues, capitalisation issues): the issue of shares free of charge to
existing shareholders out of company's reserves, no new funds are raised, all that
happens it that shareholders' funds in the balance sheet are rearranged - part of the
reserves become issued share capital
o Instead of paying a cash dividend the company issues new shares to the
shareholders - the company is retaining the profits for investment
• Stock Splits: share numbers are increased by splitting their value
o E.g. £1 share split into ten 10p shares, no capital is raised, makes the shares
more marketable, value of your holding is unchanged, just increasing the
number of shares to increase the marketability of the shares
Debt Financing
Advantages of short-term finance:
• Speed: long-term lenders require more information, and the process takes more
time than with short-term finance
• Flexibility: short-term debt can be repaid when required with no penalty for early
payment.
• Costs: interest rates lower than long-term debt. No issue cost.
• No restriction clauses on debt financing
Disadvantages of short-term debt:
• Risk: interest rates may change within period of loan
• Liquidity: there must be sufficient funds to make interest payments when due
Long-term financing
• Term loans from financial institutions: interest payments made over period of loan,
full repayment at end of loan period
• Company issues debentures/bonds in the capital market: interest payments made
over period of load, full repayment at end of loan period, these creditors gain legal
precedence over shareholders and may insist on a fixed or floating charge on
company assets as security
Advantages of debt financing:
- Lower issue cost and lower cost of capital
- Tax shield
- No dilution of ownership
Disadvantages of debt financing:
, - Gearing increases
- Fixed interest rates
- Principal paid at end of loan period (potential liquidity problem)
- Restrictive covenants
- Loan may be secured on assets
As gearing increases, risk increases. If interest rates decrease, you may want to secure a new
loan, you may be paying higher rates than the market standard.
