Long term financial management, sources of finance and funding methods

Welcome to Your Journey into Long-Term Finance!

Hello there! Welcome to one of the most important chapters in your HKICPA QP Business Finance module. Think of this chapter as the "Architect’s Blueprint" for a company. Just like a person needs to decide whether to buy a house using their savings or a bank mortgage, a company must decide how to fund its big dreams and long-term projects.

In this section, we will explore where the money comes from (Sources of Finance) and how managers decide which bucket of money to dip into (Funding Methods). Don’t worry if the terms seem a bit "corporate" at first—we’ll break them down using everyday examples that make sense. Let’s get started!

1. The Big Picture: Equity vs. Debt

At the highest level, a company has two main ways to get long-term cash: Equity (selling a piece of the pie) or Debt (borrowing the pie and paying it back with interest).

Equity Finance (The Owners' Money)

Equity is money raised from the owners of the business. The most common form is Ordinary Shares.

Key Characteristics:
- No fixed repayment date (it’s permanent).
- No legal obligation to pay dividends (only if the company has profit and wants to).
- Shareholders have voting rights and "own" the company.

Debt Finance (The Borrowed Money)

Debt is money borrowed from external lenders like banks or bondholders.

Key Characteristics:
- Must be repaid at a specific date (Maturity).
- Interest must be paid regardless of profit levels.
- Lenders do not own the company but often have "security" (collateral) over assets.

Quick Review: The Risk-Return Trade-off

From a company's perspective, Debt is usually cheaper because interest is tax-deductible, but it is riskier because you must pay it back. Equity is safer (no mandatory payments), but it is more expensive because shareholders take the most risk and expect higher returns.

2. Internal Sources of Finance: The "Hidden" Treasure

Before asking outsiders for money, smart companies look inside first. The most important internal source is Retained Earnings.

Retained Earnings: This is simply the profit the company has kept instead of paying out as dividends.
Analogy: Imagine you earn $10,000. You spend $7,000 on bills and fun. The $3,000 left in your savings account is your "retained earnings" to buy a new laptop later.

Common Mistake to Avoid: Many students think Retained Earnings are "free." They aren't! Shareholders expect the company to earn a return on that kept money at least equal to what they could get elsewhere. This is called the Cost of Equity.

3. External Equity: Raising New Capital

When a company needs a lot of cash for a big expansion, it might issue new shares. Here are the methods you need to know:

A. Rights Issue

This is an offer to existing shareholders to buy new shares at a discount to the current market price. It is "fair" because it gives current owners the first chance to keep their percentage of ownership.

The Calculation you need to know: Theoretical Ex-Rights Price (TERP)
The TERP is the expected market price of a share after the rights issue has taken place.

\( TERP = \frac{(N \times P) + (n \times p)}{N + n} \)

Where:
\( N \) = Number of existing shares
\( P \) = Current market price
\( n \) = Number of new shares offered
\( p \) = Subscription price (the discounted price)

B. Initial Public Offering (IPO)

When a private company goes "public" for the first time on the Hong Kong Stock Exchange (HKEX). It’s exciting but very expensive due to legal fees, underwriting, and strict HKEX regulations.

C. Placing

Shares are sold directly to a few large institutional investors (like pension funds). It’s faster and cheaper than a public offer but can annoy small shareholders because they are left out.

4. Long-Term Debt Finance: Borrowing for the Long Haul

If a company doesn't want to give up ownership, it borrows. Here are the common tools:

A. Bank Loans

Simple and flexible. Usually involves a fixed or floating interest rate (often linked to HIBOR - Hong Kong Interbank Offered Rate).

B. Bonds (Debentures)

The company issues "IOUs" to the public or institutions. The company pays a fixed Coupon (interest) and repays the Principal (face value) at the end.

C. Convertible Bonds

These are the "hybrids." They start as debt (paying interest), but the holder has the option to convert them into equity shares at a later date.
Why use them? They usually have a lower interest rate because the investor gets the added "bonus" of potentially becoming a shareholder if the stock price goes up.

Did you know?

Companies love Convertible Bonds when their stock price is currently low but they expect it to rise. It’s like getting cheap debt now and selling shares at a premium later!

5. Other Funding Methods: Leasing

Sometimes you don't need to own the asset; you just need to use it. This is where Leasing comes in.

- Finance Lease: You basically own the asset for its whole life. It appears on your Balance Sheet as an asset and a liability.
- Operating Lease: Like a short-term rental. (Note: Under accounting standards like HKFRS 16, most leases now appear on the balance sheet, but the economic logic remains different from buying).

6. How to Choose? The "Pecking Order Theory"

Don't worry if you're confused about which source to pick. Finance experts often follow the Pecking Order Theory. It suggests companies follow a specific "path of least resistance":

1. Internal Funds: Use Retained Earnings first (no paperwork, no bossy lenders).
2. Debt: If internal funds run out, borrow money (interest is tax-deductible).
3. New Equity: As a last resort, issue new shares (most expensive and signals that the stock might be overvalued).

Mnemonic to Remember: "I Do Everything" (I-D-E)
Internal -> Debt -> Equity

7. Key Factors Influencing the Decision

When an exam question asks you to evaluate a funding method, consider these 4 C's:

1. Cost: Is it expensive (Equity) or cheap (Debt)?
2. Control: Will the current owners lose their voting power? (Equity does, Debt doesn't).
3. Cash Flow: Can we afford the interest payments every month? (Debt requirement).
4. Covenants: Are there "strings attached"? (Banks often set rules on how you run the business).

Summary & Key Takeaways

- Equity is permanent and safe but expensive; Debt is cheap due to tax benefits but increases financial risk (Gearing).
- Rights Issues allow existing shareholders to buy more shares at a discount; TERP is the weighted average price after the issue.
- Retained Earnings should always be the first choice according to the Pecking Order Theory.
- Convertible Bonds offer a middle ground with lower interest rates and a future option to become equity.

You've made it through the basics of long-term funding! Keep practicing those TERP calculations, and remember: finance is all about balancing the cost of the money with the risk of not being able to pay it back. You've got this!