This content provides a comprehensive overview of key financial executive roles and delves into specific debt financing instruments, challenges faced by SMEs in securing debt, and the decision-making process between debt and equity financing, concluding with a discussion on dividend policies.
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So remember
we've been talking about key roles, key
policies that senior executive will have
to take especially senior financial
executive or a financial advisor. We
said you have to be able to make good
financing decision. You need to make
good investment decision, dividend
policies, risk management, strategy,
financial planning, communicating those
planning to the key stakeholders and um
likewise being able to monitor and
control as you deem appropriate. So I've
been trying to do some revisions for you
on investment decision which we have
summarized earlier on using NPV to make
decisions and I told you core of those
discussions will come in the subsequent
syllabus. Yeah. on financing decision.
We said there are two key areas we'll be
looking at which is deciding whether to
finance using equity or to use uh debt.
And I did a quick review for you on
different types of how you can issue
equity as a form of financing and the
methods that not necessarily going to
provide financing for you. Now I want to
look at debt financing and here I'm
going to be starting with what is debt.
You know debt is other people's money.
That is just it. When you are borrowing
money from someone to be repaid back,
you have an obligation to pay back. And
there are different types of bonds that
can be issued, different types of debt.
The very common and easy one you
probably have heard of is a zero coupon bond.
Yeah. Zero coupon bond. Yeah. What does
this mean? This is a bond without
interest. Yeah. Zero interest.
And if there's no interest then you need
to find a way to compensate the buyers
the investors. And how do you compensate
them? So usually this is always sold at
a deep discount.
So which means usually it will be sold
less than $100. Remember every bond has
a par value of $100. Yeah.
And mostly when these bonds are sold at
zero coupon bond, they have to be sold
at less. So maybe like $65. So that by
the time the guy redeems at $100, at
least he's able to make like $35 profit
at the minimum. Yeah. On the face value
just like that. So that's zero coupon
bond is bond without interest. That's
all you need to know quickly about that.
Yeah. And you can also have a
convertible bond which you should be
very comfortable with now because you
even know how to do the valuation in
previous syllabus. So convertible bonds
are those bonds that have options for
conversion into equity. So they are
naturally debt but they carry an option.
So it's left for the buyers, the
investors to decide whether they will
rather collect redemption amount which
is at the expiration of the bond or they
will not collect the money but instead
collect shares and that is conversion to
equity. Yeah, very important. Um
something close to that which I'm going
to mention to you and explain is when
you have bonds u with warrants.
So because I know students always
confuse convertible bond with bonds with warrants.
Please pay attention to this. Yeah. So
this is different
from convertible bond. Convertible bond
is just a single instrument. Yeah. And
that single instrument can either be
redeemed with cash or as equity. But
when you are talking of bonds with
warrants, you're practically talking of
two instruments. So there are two
and those two instrument include normal bond
bond
which will be dealt with as a bond and
always as bond
plus the warrant
which is separate.
though they are included in the same
contract but is treated as a separate
instrument. Yeah. So this separate
warrant is like an option to buy
shares at a particular price.
So it's left for the buyers, the
investors to decide whether they want to
exercise this warrant or not. But
whether they decide to exercise the
warrant or not, it doesn't change the
fact that they still have a bond. And
that is why it is different from combat.
Convertible bond is just one instrument
that can be converted or not. But when
you have bonds with warrants, you have
bonds, you now have an addition, a
warrant, an option to buy shares. So if
the price makes sense, say if the excess
price is less than the market price,
definitely investor will exercise. But
if the exercise price is more than the
market price on the on that date of
exercise then definitely the warrant
will just expire and the buyer will not
exercise. So please take note of that.
Another type of bond you can have is uh
junk bond.
Yeah. And junk bond as you know is iris
bond. That's why they called junk bond.
It's high risk bond. Yeah. With risk of
default. You might not be able to get
your money back. However, they give high
return. Remember, they are the risk.
They are the reward. So, if you are
willing to take this kind of risk, you
are promised a very high return. But
guess what? They are so risky that you
might lose both the return and your
capital. So, you have to decide. And the
opposite to that is what you call the
Investment grade bond. And these are
very low risk, very good bonds issued by
good government or good companies,
stable enterprises. Yeah. So this one
definitely has low risk and if the risk
is low, you can expect that the return
will also be very low. So that's
investment grade bond. Also you need to
know this concept when we talk about the senior
subordinated bonds.
Yeah. Yeah.
What senior means is that upon liquidation,
liquidation,
if you hold a senior bond, it means that
you will receive
your principle and interest before
So you are senior to them. You will be
attended to before other holders. And if
you are holding a subordinated bond, it
means that you will not be attended to
until all other bond holders have been
attended to. So this is like the
opposite of senior, right? So this guy
is lower in the rank.
He's a subordinate.
But like you expect, if you're lower in
the rank, it means you have high risk.
whereas this guy has a low risk.
So good to know what that means. Another
type of bond that I'm going to be
talking about is the mezzanine
which you
definitely have heard about in FM meine
finance. When you talk about mezanine
of both debts
and equity. Yeah.
Yeah.
And definitely this is very risky. As
you can see this type of bond that is
already having equity component will be
very risky and that is why they are the
lowest ranked debt. In fact after measine
measine
you go straight to equity. You know
equity is definitely riskier than debt.
So this measine finance is just like in
the middle. So very risky and uh is an
abid instrument of debt and equity component.
component.
Also good to understand the concept of
euro bonds.
I've heard students saying euro bonds
are bonds that are issued in Europe.
Please that is not correct.
It doesn't have anything to do with Europe.
Europe.
The euro bonds is just signifying
foreign. So in case what we are saying
is that these are bonds that are not
issued in the local currency. So that's
simple way to put it.
So they are not issued in the local currency.
So take for instance if you are talking
of Euro dollar bond. Yeah. Euro dollar bond.
This is a dollar bond. So which means
you cannot issue this in the US. So
means that Euro dollar bond will be bond
that is issued outside
It cannot be issued in the US. If you
have Euro pound bond cannot be issued in
the UK.
Euroen bond cannot be issued in Japan.
Right? So
the word euro just mean it's foreign.
So the currency of the bond will always
come and that currency will determine
where the bond cannot be issued not
where it is issued. Please take note
quickly let's talk about finance.
Yeah because usually they struggle to
get debt finance. So it's a common point
of reference. Remember your exams even
if there are big chunk of questions and
big chunk of marks allotted there will
still be small little questions that
will have two marks one mark three marks
which you need to put together to pass
your exam. So you can be asked why do
you think will struggle to get
financing? Yeah. And the major reason is
Because they are small companies
definitely they are considered to be
high risk. And if they are high risk the
cost of debts
will be very high. So they might not
even be able to afford it. Yeah. So
affordability might be a problem.
Likewise, because they are small company
to get debt, you most likely need
collateral. So, they might struggle to
get security or what you call the collateral
collateral
and that might make
debt finance companies not to be able to
provide them with those money. Likewise,
they are just coming up. They don't have
track record. So, credibility might be a problem.
They might struggle with credibility.
Yeah. And that might also be attributed
to the fact that their financial statement
statement
is not transparent
because most of them are private. They
don't even get audited by big four
auditors and dead providers might not be
comfortable with that. Yeah. So this struggle
struggle
creates a problem for them and that
And what is funding gap? Funding gap is
a situation whereby the amount required
the money that they want
is less
than the amount provided
or available. So they have a gap they
are not able to get the amount that they
need. Please take note this is different
from maturity gap. Don't confuse funding
gap with maturity gap. In maturity gap
what you are saying is that there is a mismatch.
There's a mismatch of asset
and liability maturity.
maturity.
So take for instance
you have a liability
that needs to be paid in 10 years time
whereas the asset that you have is
account receivable there is a mismatch
because the money would have come
whereas the liability is still in the
future. So either you use the money in a
different way before you even due for
payment or you're not able to use the
money properly for a long-term
investment and make more money since you
don't have obligation immediately or you
probably even have OD as a liability and
your asset is in a real estate long-term
then that will be a problem because your
OD will be due immediately or very soon
whereas you won't find cash to be able
to pay because your cash is tied into a
long-term investment. So that's a
maturity gap which is also common
withmemes. Yeah, it's another
problemmemes have. So please take note
the difference between the funding gap
and maturity gap. But when you have a
problem whereby thesemesmemes are not
able to get money they struggle what are
the solutions where do they get money
from? So you expect them to get money
from business a angels which are
individuals. Please take note these are individuals
individuals
that provide monies to organizations.
Yeah. With the intention that the
organization gets better and they're
able to make return from that money that
has been provided. Business agents are
different from venture capital which is
another source of money for small
companies especially startups. So
venture capitals are institutions that
is how they are majorly different from
business engines. These are
institutions. They are companies. Yeah.
They always look for promising
companies, small companies that are
struggling but with a lot of prospect
that if they acquire those small
companies, they turn it around then they
can sell it once you start getting
better. Also government can
supportmemes. Yeah. Government support
very important. Yes.
Bank loans as well might come handy.
Yeah. even overdraft. Yes. And also some
of them also go for leasing. Yeah. Yeah.
Remember when you're talking of leasing,
you can have an operating lease, you can
have a finance lease. Operating lease is
when you don't have rights to buy at the
end of the term of the lease, which
means significant risk and reward still
lie with the owner of the asset. Whereas
when you have a finance list, the signal
risk and reward sit with the lei which
is the person using the asset and most
likely the lei will have the option to
buy the asset at the end of the term of
the lease. So depending on what the
company wants, the amount of cash flows
they have, we will determine which
approach they want to use whether it's
operating lease or financing lease.
Yeah, very important. But generally
speaking, should a company finance with
debt or with equity?
Debt or equity? Which one should a
company finance with? We've looked at
debt. We've looked at equity. There are
various factors that a company will
always consider which you need to know.
The first one is the tax benefit might
be a factor. If you consider the tax
benefit definitely a company will go for
debt because the interest on debt is tax
tax deductible. Unfortunately for equity
dividend is paid out of profit after tax
and even the dividend is even taxed
again. So if you're tax conscious and
sensitive you're probably going to be
interested in debt. Yeah. Likewise cost
of capital
is a big problem and big factor. Yeah,
generally debt is cheaper. So if you are
also looking at cost, you might be
looking for debt. Also, if you are
considering dilution effect, you don't
want dilution. Also, this will make you
to go for debt because with debt, the
owners remains the owners. There is no
to repay or maybe you call it risk.
Yeah. And this you need to understand
depending on the perspective you're
looking at. So if you're looking at
company that is looking for fund. Yeah.
I want to look for fund which means I'm
not asking should I sell shares or
should I just go and borrow. If I'm
looking for less risky, definitely
equity is less risky for the company
because there's no obligation to pay
back equity. Whereas if you go and do
your financing with debt for the
company, it's a pressure. It's high risk
for them. Gearing. That's what you're
talking about here. This will increase
your gearing if you take that. So
companies rather take equity if they are
risk adverse because for equity even if
they fold up tomorrow they don't have
any obligation to pay any shareholders
whereas if they have used debt they must
pay and sell their asset right
unfortunately this is different for
investor for investor they will prefer
debt because for them debt is less risky
because they know that their money is
guaranteed so it's opposite
depending on the perspective that you're
looking at it from. So please I need you
to understand that so you're able to
explain like I said in this paper
application of knowledge is what you
need. You don't have to memorize
anything. Yeah. Another factor you can
think about is a transaction cost. Yeah.
So when you want to collect debt or you
want to issue equity
there are transaction costs that are
involved and usually it is more when you
are issuing equity than when you are
trying to get debt.
Likewise, covenants.
Yeah, for debt most times covenants are
attached to it. Either you have a
minimum positive cash you must have or
you have a minimum profit you must make.
You know, you're just going to have some
covenant some restrictions.
Yeah. And if those restrictions are too
much, you might not be able to get money
from debt. You might decide to go for
equity. And likewise availability.
availability.
Yeah. And you can remember when we talk
about pecking order.
Yeah. Right. Return earnings are usually available.
available.
Then you can go to bank loans or go
issue bonds or the most difficult ones
to issue is the shares. Right? So all of
that might influence your decision as to
whether you want to issue debt or you
want to issue equity as a form of financing.
financing.
That is a quick one on debts. And uh the
final one on those key policy decision
is the dividend policy. Yeah, was a
quick refresher on dividend policy. And
for dividend policy, remember you have
invested, you've made money. What you
are asking now is how much should we share?
share?
Yeah. And uh when
can we share this profit? That's what
you are saying. And there are two school
of thought to this. The first one is a
residual policy which you can use.
When you are talking of residual policy,
you are saying that when you make this
profit, you must first of all invest
then after. So you invest first
then after share the remnant.
That's why it's called residual. Share
Yeah. Which is the residual. The
residue. The remaining amount after you
have done all the available good
investment that is residual. So that is
what you have to do if you're using
residual policy. errors. There's M&M
that says there's also a relevance policy
policy
by Eminem. And what this one is saying
is that shareholders can make money from
share cap share capital gains. So that
is by selling their shares and making
profit or from dividend.
And for shareholders, they don't care
where the money is coming from. They
just want to make money. That's why it's
called irrelevance. That whether you
share dividend or not, it is not
relevant. If you share dividend, we are
happy. If you don't share dividend, we
believe that you're going to invest the
money. And when you invest the money,
you're even going to make more profit.
So the share price will go up and we can
sell our shares and make some capital
gains. That is just money. So money is
money. That's what relevant story is
talking about. Wherever is coming from
does not matter. Once legitimate money,
we're fine. So and when we so this
decide when we will pay
right but how much if we decide want to
and when you're talking of how much you
can you can have a constant payout
which means a company has a policy that
says whatever we make that we want to
distribute it's going to be 30%.
Yeah. of profit after tax. A company can
have that policy. So which means when
they make $100, they will share 30. When
they make $200, they will share 60.
So it's about 30% of profit after tax.
That is constant payout. So they have a
constant rate that they used to pay out.
Or they can just have a stable dividend
policy. So which ones they just saying
that let's stay stable.
Yeah. because we don't know some days
might be good some years might be bad.
So if they sell we stay stable you
discover that there's going to be slow
growth of dividend so they practically
just paying dividend around the same
amount $1 per share 1.1 $1 per share
1.102 102 per share you know like that
every year so there's not so much
increase but at the same time they are
consistent with payment of dividend and
you can even have a company that will
say I want to do a constant dividend
which is difficult because you don't
know how much you will make or which
year you will not make profit so
constant dividend is saying the same
amount that's what is saying $1 every
year this is very rare this is the very
common approach that most company
use. So that's the
information you need to grab about the
dividend policy. In next video I'll be
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