Business Finance: Medium -term Business Finance

TOPIC FOUR

 

Medium -term Business Finance

 

Debt Finance

 

Debt finance is a fixed return finance as the cost (interest) is fixed on the par value (face value of debt).  It is ideal to use if there’s a strong equity base.  It is raised from external sources to qualifying companies and is available in limited quantities.  It is limited to:

 

1. i) Value of security.
2. ii) Liquidity situation in a given country. It is ideal for companies where gearing allows them to raise more debt and thus gearing level.

 

Classification of Debt Finance

 

1. Loan finance – this is a common type of debt and is available in different terms usually short term. Medium term loans vary from 2 – 5 years.  Long-term loans vary from 6 years and above

 

The terms are relative and depend on the borrower.  This finance is used on the basis of matching approach i.e. matching the economic life of the project to the term of the loan.  It is prudent to use short-term loans for short-term ventures i.e. if a venture is to last 4 years generating returns, it is prudent to raise a loan of 4 years maturity period.

 

Conditions under Which Loans Are Ideal

 

• When the company’s gearing level is low (the level of outstanding loans is low.
• The company’s future cash flows (inflows and their stability) must be assured. The company must be able to repay the principal and the interest.
• Economic conditions prevailing. The company must have a long-term forecast of the prevailing economic condition.  Boom conditions are ideal for debt.
• When the company’s market share guarantees stable sales.
• When the company’s anticipated future expansion programs, justify such borrowing.

Requirements for Raising Loan

 

• History of the company and its subsidiaries.
• Names, ages, and qualifications of the company’s directors.
• The names of major shareholders – 51% plus i.e. owner who must give consent.
• Nature of the products and product lines.
• Publicity of the product.
• Nature of the loan – either secured, floating or unsecured.
• Cash flow forecast.

 

Reasons Why Commercial Banks Prefer To Lend Short Term Loans

 

• Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardize planning e.g. political and economic factors.
• Commercial banks are limited by the Central Bank of Kenya in their long term lending due to liquidity considerations.
• Short-term loans are profitable. This is because interest is high as in overdrafts.
• Long term finance loses value with time due to inflation.
• Cost of finance – in the long term, the cost of finance may increase and yet they cannot pass such a cost to borrowers since the interest rate is fixed.
• Commercial banks do credit analysis that is limited to short term situations.
• Usually security market favours short term loans because there are very few long term securities and as such commercial banks prefer to lend short term due to security problems.

 

Advantages of Using Debt Finance

 

• Interest on debt is a tax allowable expense and as such it is reduced by the tax allowance.

 

Example

 

Interest = 10% tax rate = 30%

The effective cost of debt (interest) = Interest rate(1 – T)

= 10%(1-0.30)

= 7%

Consider companies A and B

 

Company                      A                      B

          Sh.’000’        Sh.’000’

10% debt                   1,000              –

Equity                                       –                    1,000

1,000              1,000

 

The tax rate is 30% and earnings before interest and tax amount to Ksh.400,000.  All earnings are paid out as dividends.  Compute payable by each firm.

                        Company                                              A                 B

                                                         Sh.’000’      Sh.’000’

EBIT                                                     400               400

Less interest 10% x 1,000               (100)                 – 

EBT                                                    300                 400

Less tax @ 30%                                (90)             (120)

Dividends payable                           210               280

 

Company A saves tax equal to Sh.30, 000 (120,000 – 90,000) since interest charges are tax allowable and reduce taxable income.

 

• The cost of debt is fixed regardless of profits made and as such under conditions of high profits the cost of debt will be lower.
• It does not call for a lot of formalities to raise and as such its ideal for urgent ventures
• It is usually self-sustaining in that the asset acquired is used to pay for its cost i.e. leaving the company with the value of the asset.
• In case of long-term debt, amount of loan declines with time and repayments reduce its burden to the borrower.
• Debt finance does not influence the company’s decision since lenders don’t participate at the AGM.

 

 

 

 

 

Disadvantages

• It is a conditional finance i.e. it is not invested without the approval of lender.
• Debt finance, if used in excess may interrupt the companies decision making process when gearing level is high, creditors will demand a say in the company i.e. and demand representation in the BOD.
• It is dangerous to use in a recession as such a condition may force the company into receivership through lack of funds to service the loan.
• It calls for securities which are highly negotiable or marketable thus limiting its availability.
• It is only available for specific ventures and for a short term, which reduces its investment in strategic ventures.
• The use of debt finance may lower the value of a share if used excessively. It increases financial risk and required rate of return by shareholders thus reduce the value of shares.

 

Differences between Debt Finance and Ordinary Share Capital (Equity Finance)

 

	Ordinary share capital		Debt
a) b) c) d) e) f) g) h) i)	It is a permanent finance Return paid when available Dividends are not tax allowable Unsecured finance Carry voting rights Reduces gearing ratio No legal obligation to pay Has a residue claim Owners’ money	a) b) c) d) e) f) g) h) i)	It is refundable (redeemable) It is fixed return capital Interest on debt is a tax allowable expense Secured finance No voting right Increases gearing ratio A legal obligation to pay Carries a superior claim Creditors finance.

 

Similarities between Preference and Equity Finance

 

1. Both may be permanent if preference share capital is irredeemable (convertible).
2. Both are naked or unsecured finances.
3. Both are traded at the stock exchange
4. Both are raised by public limited companies only
5. Both carry residue claims after debt.
6. Both dividends are not legal obligations for the company to pay.

Differences between Preference and Equity Finance

 

	Ordinary share capital		Preference share capital
a) b) c) d) e) f)	Has a residue claim both on assets and profit Carries voting rights Reduces the gearing ratio Variable dividends hence grow over time Permanent finance Easily transferable.	a) b) c) d) e) f)	Has a superior claim No voting rights Increases the gearing ratio Fixed dividends hence no growth Usually redeemable Not easily transferable

 

Similarities between Debt and Preference Share Capital

 

1. Both have fixed returns.
2. Both will increase the company’s gearing ratio.
3. Both are usually redeemable.
4. Both do not have voting rights.
5. Both may force the company into receivership
6. Both have superior claims over and above owners.
7. Both are external finances.
8. There is no growth with time.

 

Differences between Preference Share Capital and Debt

 

	DEBT		PREFERENCE SHARE CAPITAL
a) b) c) d) e)	Interest is tax allowable Interest is a legal obligation Debt finance is always secured Debt finance is a pre-conditional Has a superior claim	a) b) c) d) e)	Dividends are not tax allowable Dividends are not a legal obligation Preference is not secured finance Is not conditional finance Has a residue claim (after debt)

 

 

 

 

 

Why It May Be Difficult For Small Companies To Raise Debt Finance In Kenya (Say Jua Kali Companies)

 

• Lack of security
• Ignorance of finances available
• Most of them are risky businesses as there are no feasibility studies done (chances of failure have been put to 80%).
• Their size being small tends to make them UNKNOWN i.e. they are not a significant competitor to the big companies.
• Cost of finance may be high – their market share may not allow them to secure debt.
• Small loans are expensive to extend by bank i.e. administration costs are very high.
• Lack of business principles that are sound and difficult in evaluating their performance.

 

Solutions to the Above Problems

 

• There should be diversification of securities e.g. to accept guarantees.
• Education of such businessmen on sound business principles.
• The government should set up a special fund to assist the jua kali businessmen.
• Encourage formation of co-operative societies.
• To request bankers to follow up the use of these loans.