Business Finance & the Capital Market

A market for funds is subject to the same sort of forces as are to be found in operation in other markets. The price of funds reacts to the usual laws of supply and demand. Within the broad framework there are separate ‘markets’ for different types of securities: long-term, short-term, gilt-edged, ordinary shares etc., and hence separate rates of return for such securities. The price of securities (and consequently the rate of return to funds) does not simply depend on the flow of new savings compared with the level of investment in capital projects, but on speculative movements reflecting the public’s varying preferences for holding cash rather than securities.

This chapter is principally concerned with the finance of a new and developing business. The risks associated with business affairs, and, in particular, new ventures, are discussed, and some indication is given of the problems of calculating the initial capital of a new business. Finally, various short- and long-term methods of raising funds are considered. The possibility of raising capital by taking a partner is seen to involve several serious disadvantages.

In this chapter we initially explain why the limited company is such a popular organisation and the steps that have to be taken to convert a business into a company. There then follows an examination of how to attract the financial support of a larger section of the community and finally we consider the different forms in which this support could be given.

In previous chapters we have discussed how business organisations are formed and how their initial capital requirements can be assessed. We have also examined some of the sources of short- and long-term capital which could be tapped by the new or expanding business.

So far in this section on business capitalisation the way in which we have discussed the various topics has been determined very broadly by the organisation’s size and stage of development. We have progressed from a sole trader and partnership to a limited company and discussed how the latter may obtain finance from outside the ambit of the family and friends and what form this finance should take. In this chapter it is our intention to discuss the financial sources and facilities available to the more established company. Fairly obviously such companies can use the bank, tradecredit and hire-purchase facilities discussed in Chapter 2 as being suitable for the new business, but the established company can also benefit from sources of finance made available only to those companies with a successful record. To some extent this has already been explained in connection with long-term finance, i.e. access to the capital market via the Stock Exchange. In the following pages we discuss other sources including the principal specialist finance corporations. Finally, part of this chapter is reserved for discussing the finance of a special situation or industry, i.e. death duties, agriculture and shipbuilding.

Our final chapter in this section will be concerned with the finance of exports. We think we are justified in devoting a separate chapter to this because of the special factors involved. These are mainly the extra risks incurred when trading internationally in a world of frequent political disturbance and also the longer credit which may have to be granted because of the lack of wealth in some of the developing countries. Export trade involves the same procedures as internal trade (i.e. enquiries into customer’s credit-standing and possibly sales only on cash-on-delivery terms) but these procedures are applied in a way which accommodates the circumstances, and the terminology is often different.

An explanation of the meaning of funds and the internal flow of funds in business leads on to a discussion of the relationship of profitability, sound finance and the flow of funds. The need to plan ahead calls for some system of budgetary control, and the operation of such a system is described in outline. The chapter concludes with an account of the forward-looking finance budget and the backward-looking sources and uses of funds statement, with examples of each.

The normal accounting profit may not be synonymous with the real profit. There are different methods of depreciation and valuation of stocks, and the figure for profit will vary according to which of these methods are used. Conventional methods of depreciation and valuation tend to over-state profit in times of rising prices, and understate it in times of falling prices. The inclusion of overhead costs in the valuation of closing stocks of work-in-progress for a particular year will lead to a higher figure for profit than would be the case if these are excluded. The method of taxation affects business behaviour and the level of investment.

In Chapter 11 we discuss some of the reasons which motivate expansion. It is fair to say that management would not undertake expansion if it thought that the cost of this — both initial and annual — would exceed the additional income or revenue arising. What is much more likely is that the prospect of larger revenues, both in absolute terms and relative to the size of capital earning these returns (an increase in the ratio of profits to capital employed), is the stimulant for expanding the size of their organisation. This chapter is concerned with the techniques management use to choose between capital projects which are competing for limited capital resources and to decide whether a capital project is undertaken or not. The factors which control the administration of our capital budget have been discussed elsewhere, particularly in Chapter 7.

This final chapter in the section concerned with financial control examines the way in which the profit an organisation makes is allocated to the various competing claims. This allocation is made by the directors, and although it might appear a formality, because all profits after paying dividends on earlier ranking capital belong to the ordinary-share holder, in practice it is rather more complicated. The ordinary-share holder never does get his full due immediately, be it because of Government policy, or directors building up the company over which they hold power, or any of the other diverse reasons discussed hereafter.

In tracing the various motivating forces underlying expansion, the first possibility to be considered is that of organisation and planning leading to the economies of large-scale enterprise. Other possibilities followed up are mergers, for the purpose of establishing greater control over the sources of raw materials and markets, or for gaining the advantages of diversification, or simply to eliminate competition. The evolution of the industrial leviathans is then considered. The chapter concludes with a brief comment on the desirability of a favourable economic environment.

Take-over bids make the financial headlines some time during nearly every week of the year and many of the reports are compelling reading for people interested in industry and finance. This is particularly so as many of the companies are known to everyone. We have already noted how the British motor industry has regrouped its forces to counter the spread of the Detroit octopus. The trend has followed in the less glamorous component manufacturing world where, for example, Birfields (propeller shaft manufacturers) have been absorbed by the giant Guest, Keen and Nettlefolds group.

We have described some of the effects of taxation on businesses in various parts of this book without actually describing the calculations and rules which have to be applied before the tax liability is ascertained. The detail has been reserved for this chapter where we examine the spectrum of taxation borne by businesses and in particular the taxes introduced in the mid-sixties. In addition to explaining how the various taxes work we also look to the reasons for their introduction, the influence on capital market operations, and how other countries’ business taxation compares with our own.

It is seen that although total savings for 1966 amounted to over £7,000 million, less than a third of this represented savings within the personal sector. During 1965 only about £700 million had been used for the net acquisition of financial assets by this sector (the remaining personal saving being in the form of increased expenditure on such items as housing and stocks of goods). However, whereas the savings of Government, public corporations and companies are generally applied directly to capital expenditure, personal savings applied to the acquisition of financial assets are channelled through the market. Some of the financial intermediaries which mobilise these savings, particularly those which channel funds to business, are briefly reviewed. An increased tendency for persons to invest indirectly through financial intermediaries rather than directly in securities is noted.

Factors affecting the market for securities are reviewed, special attention being given to economic forces and Government controls. In the light of this discussion the possibilities for forecasting future trends in market prices are considered. The chapter is concluded with an account of the role of the Stock Exchange and a summary of some of the more important procedures.

Savers’ investment policies vary according to their circumstances and responsibilities. An explanation of the methods of calculating yields leads to a comparison of high- and low-yielding shares. A brief review of the system of personal taxation is related to the effect of tax on the choice of securities. The chapter concludes with a review of the more popular forms of security.

Two aspects of the market for funds, namely the demand for capital from new and existing business concerns and the supply of savings available to business, have received our main attention in this book.