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WHY DO COMPANIES BORROW?

WHY DO COMPANIES BORROW?. Temporary cash flow problems Low interest rates Tax advantages Gearing issues. CAPITAL GEARING. A measurement of risk Compares long-term debt with equity Important to distinguish between debt and equity

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WHY DO COMPANIES BORROW?

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  1. WHY DO COMPANIES BORROW? • Temporary cash flow problems • Low interest rates • Tax advantages • Gearing issues

  2. CAPITAL GEARING • A measurement of risk • Compares long-term debt with equity • Important to distinguish between debt and equity • Preference capital included as long-term debt due to fixed return • Debt may include bank overdraft

  3. IAS 32 IAS 39 and IFRS 7FINANCIAL INSTRUMENTS • To provide a clear analysis of capital instruments into debt and equity • Fair allocation of costs relating to capital instruments • To provide relevant information on the nature and amount of sources of finance

  4. FINANCIAL INSTRUMENTS All instruments issued by reporting entities which are a means of raising finance - including shares, debentures, loans, options and warrants that give the holder the right to subscribe for or obtain capital instruments.

  5. FINANCE COSTS The difference between the net proceeds of an instrument and the total amount of the payments that the issuer may be required to make in respect of the instrument

  6. HYBRIDFINANCIAL INSTRUMENTS • Contain an element of equity as well as debt • Convertible securities • Classify as debt • Do not split unless constituent parts can be transferred, cancelled, or redeemed independently of each other

  7. CATEGORISATION OF FINANCIAL INSTRUMENTS Type of instrument Analysed between Shareholders’ funds Equity interests Non-equity interests Liabilities Convertible Non-convertible Minority interest Equity interests Non-equity interests

  8. BALANCE SHEET TREATMENT OF DEBT INSTRUMENTS • Initial carrying value should be net proceeds received on issue less any issue costs • Subsequent balance sheet values will be increased by finance costs attributable to the period less any payments made in the period • Accrued finance costs payable in subsequent periods may be treated as accrued expenses

  9. INCOME STATEMENT TREATMENTOF DEBT INSTRUMENTS • Finance costs are calculated as the total payments to be made over the period of the debt less the initial carrying value • Finance costs to be allocated over the life of the debt at a constant annual rate of interest based on the outstanding carrying value • Profit or loss on early settlement to be charged to profit and loss immediately

  10. TYPES OF FINANCIAL INSTRUMENT • Auction market preferred shares (AMPS) • Participating preference shares • Perpetual debt • Repackaged perpetual debt • Stepped interest bonds • Deep discount bonds • Index-linked loans • Subordinated debt • Convertible loan stock • Derivatives

  11. TYPES OF DERIVATIVE INSTRUMENTS • interest rate and currency swaps • cap and floor contracts • forward sales contracts whose final price is indexed on a fluctuating variable • indexed floating rate debt instruments • foreign currency denominated commercial contracts • indexed call options • share warrants • conversion options • hedging instrument

  12. REPORTING DEBT CAPITAL A £1m debenture is issued on 31 December 2000 Debenture issued at a discount of 10% Coupon rate is 5% Interest is paid annually on 31 December Debenture will be redeemed at par on 31 December 2005

  13. ANALYSIS OF CASH FLOWS 31 December 2000 900,000 31 December 2001 ( 50,000) 31 December 2002 ( 50,000) 31 December 2003 ( 50,000) 31 December 2004 ( 50,000) 31 December 2005 (1,050,000) Internal rate of return (IRR) is 7.47%

  14. REPORTING THE DEBENTURE Amount raised 31.12.2000 900,000 Interest to 31.12.2001 at 7.47% 67,227 Payment on 31.12.2001 ( 50,000) Balance at 31.12.2001 917,227 Interest to 31.12.2002 at 7.47% 68,514 Payment on 31.12.2002 ( 50,000) Balance at 31.12.2002 935,741 Interest to 31.12.2003 at 7.47% 69,897 Payment on 31.12.2003 ( 50,000) Balance at 31.12.2003 955,638

  15. REPORTING THE DEBENTURE Balance at 31.12.2003 955,638 Interest to 31.12.2004 at 7.47% 71,382 Payment on 31.12.2004 ( 50,000) Balance at 31.12.2004 977,020 Interest to 31.12.2005 at 7.47% 72,980 Payment on 31.12.2005 (1,050,000) Balance at 31.12.2005 Nil

  16. INCOME STATEMENT EXTRACTS Year to 31.12.2001 - interest 67,227 Year to 31.12.2002 - interest 68,514 Year to 31.12.2003 - interest 69,897 Year to 31.12.2004 - interest 71,382 Year to 31.12.2005 - interest 72,980

  17. BALANCE SHEET EXTRACTS Liability at 31.12.2001 917,227 Liability at 31.12.2002 935,741 Liability at 31.12.2003 955,638 Liability at 31.12.2004 977,020 Liability at 31.12.2005 Nil

  18. SHARE PREMIUM ACCOUNT Issue costs and discounts must be charged to income statements but can subsequently be taken to the share premium account by means of a transfer through reserves

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