Chapter 1 – Long term finance
Financing capital projects = sources of long term finance & cost of long-term finance.
SOURCES OF LONG TERM FINANCE
Finance that will be held or settled over a period greater than 12 months from issue date. These
sources of finance may not be required if a large cash surplus is readily available to invest in certain
projects. If not, then the following external sources will be used:
The capital markets new share issue (listing on stock market for first time), rights issue to
existing shareholders, or issues of marketable debt. These capital markets can only be used
if company is listed on a recognised stock exchange.
Banks and finance houses borrowings from banks through long or short term loans like
bank facilities (revolving credit facilities RCFs, and money market lines).
Government and other similar sources grants.
Equity VS Debt Finance
EQUITY FINANCE
Shares a fixed identifiable unit of capital in an entity with a fixed nominal value, what may be
quite different to its market value. Shareholders receive dividends in return for their investment in
shares, and also capital growth in the share price.
Ordinary shares or equity shares – these are held by the owners of the company; they have the
right to attend meetings and vote on important matters. They are subordinates to all other finance
providers (receive payment last after all other monies owed are settled).
Preference shares a fixed proportion of share’s nominal value paid in the form of dividends in
preference to (before) ordinary share dividends. These are also paid after all other debt holders and
creditors but are settled before ordinary shareholders. More similar to debt finance due to the fixed
annual returns, but dissimilar in that amounts due are based on post-tax profits, unlike debt finance
where there is a tax benefit of due to interest payments being based on pre-tax profits.
ALSO, there are certain instances where the company will not be required to pay its preference
share dividends (when insufficient distributable profits have been earned), unlike debt interest,
which is an obligation to pay every year regardless of profits. Lack of tax relief therefore makes
preference shares seem less appealing, compared with bank borrowings. Whereas less risky
investors might favour preference shares if they are looking for a more reliable income stream.
Four types of preference shares:
1. Cumulative – dividends must be rolled forward if company has insufficient funds one year,
the dividend is cumulative.
2. Non-cumulative – missed dividends do not have to be paid later.
3. Participating – fixed dividends plus extra earnings available for performance levels.
4. Convertible – can be exchanged for a specified number of ordinary shares in future.
ALSO, some preference shares can be redeemable, where shareholders will be repaid their capital at
a pre-determined future date (usually at par value).
Convertible preference shares fixed income securities that offer a steady income stream and
protection of capital (if redeemable), with the option to gain from a rise in share price by converting
,to ordinary shares instead. Attractive to investors that want to participate in rise of hot growth
companies, whilst also not being adversely affected if ordinary share price growth is not as expected.
These convertible shares may be offered as a ratio of 1:3 for example, for every 1 preference share,
the holder can convert to 3 ordinary shares.
CAPITAL MARKETS
Shares in a listed or quoted company will be traded on a capital market. Capital markets must fulfil
primary and secondary functions.
Primary this function of a stock market is to help companies raise new finance (equity or debt).
Through the stock market, a company can communicate with a large pool of investors, making it
easier to raise finance rather than communicating with investors individually. In UK, company must
be PLC before raising finance from public on stock market.
Secondary this function of a stock market is to help investors sell their investments to other
investors. A listed company’s shares are more marketable than shares of an unlisted company,
meaning they are more attractive to investors.
Private limited company limited by shares which means that the liability of the shareholders is
limited to the capital they originally invested – nominal value of shares and any premium paid in
return for issue of shares by company. This principle therefore protects shareholders personal assets
if company was to become insolvent, limited to funds invested in the firm. LTD disclosure
requirements are lighter, which means that shares may not be offered to the general public. Most
companies are LTD, particularly small companies.
Public limited company limited liability that may sell shares to public. Can either be listed on stock
exchange, or unlisted. Identified by PLC title after organisation name.
Stock exchange listing
When an entity lists or quotes for its shares on a stock exchange, this is referred to as a FLOTATION,
or an Initial Public Offering (IPO). Provides benefits because market will represent an accurate
valuation of entity than prior, creates opportunity for buying and selling shares in future at will,
raises profile of company which may impact revenues, increase credibility with suppliers and long-
term providers of finance. Can now raise capital for future investment. Also, makes employee share
schemes more accessible.
HOWEVER, can be costly for a small entity (flotation, underwriting costs etc), loss of control by
making shares available to other investors, reporting requirements are heavy, stock exchange rules
for obtaining a quotation can be strict.
Two main capital markets in UK the full Stock Exchange – a market for larger companies, where
entry costs are high, scrutiny is high, but profile is very high, so shares are highly marketable & the
Alternative Investment Market (AIM) – for smaller companies, with lower associated costs and less
stringent entry criteria.
Prices of shares are determined by the forces of supply and demand. If a company performs well,
shares become more attractive, creating demand for the shares which drives up the price of the
shares (due to more capital investments). On the other hand, if a company is underperforming,
current investors will try to sell those shares, creating supply in the market, which drives down the
share price (due to less capital being invested).
,The role of advisors in a share issue
Investment banks usually take a lead role in share issues and will advise on the appointment of
other specialists (i.e., lawyers), stock exchange requirements, forms of any new capital to be made
available, number of shares to be issued and the issue price, arrangements for underwriting, and
publishing the offer.
Stockbrokers provide advice on various methods for obtaining a listing on the stock exchange. May
work alongside investment banks on identifying institutional investors, but usually involved in
smaller share issues and placings.
Institutional investors are investors from large organisation or institutions (i.e., pension funds). Have
little direct involvement other than as investors, agreeing to buy a certain number of shares. They
may also be used to provide an indication of the likely take up and acceptable offer price for the
shares. Once the shares are in issue, institutional investors have a major influence on evaluation and
the market for the shares.
Registrars to an issue will complete administrative duties like collecting and processing applications
from potential investors, monitoring payments made to and from investors and providing advice to
stock exchanges, investors and issuing entities regarding share issues.
Public and Investor relations will work with entity to ensure transparency of communications
regarding the share issue, and are informative and understandable by investors. If successful, they
can improve the uptake of share issue and increase market value of issued shares.
Reporting accountants will provide advice regarding impact on financial statements of share issues.
Will consider wider impact of economic decisions upon the economic decisions of the users of the
financial statements caused by the potential share issues e.g., implications on loan covenants.
Underwriters are financial institutions that help corporations raising finance by taking on risk of new
issue and promoting the new share issue to third party investors. They retain part of the proceeds
from raising finance in return for bearing the risk.
METHODS OF ISSUING NEW SHARES
Three most common methods of issuing new shares are an IPO (or flotation), a placing and a right
issue. IPO is suitable for first time listing on a stock market, whereas placings and rights issues are
relevant to entities that are already listed on stock exchange and require further financing.
IPO’s may be of new shares or offered to public from existing private shares. Shares are offered for
sales to investors through an issuing house, which can be made at a fixed price set by the company,
or via a tender offer, when investors can suggest their own price, and shares would be sold at best
price offered.
Tender offer is alternative to fixed price offer, where subscribers tender for the shares equal to or
above a minimum fixed price. Once all offers have been received, the company sets a “strike price”
and allocates shares to all bidders who have met or exceeded the strike price, and they all pay the
strike price irrespective of their original bid (tender offer). The strike price ensures that the company
raises required amount of finance from the share issue.
EXAMPLE – highest price would be accepted that can meet required finance. Keep going down list of
offers until share price offered multiplied by number of shares requested at that price or higher
would provide the level of finance, then all investors will be offered at the strike price.
, PLACING Shares are placed directly with certain investors (normally institutions) on a pre-
arranged basis. Shares are not offered to public in this instance, issuing house will arrange for shares
to be issued to its institutional clients. Cheaper and quicker to arrange, but may not lead to an active
market for these shares after flotation.
RIGHT ISSUES New shares offered to existing shareholders only, in proportion to the size of their
current shareholdings – giving the shareholders “pre-emption rights”. Usually offered at a
discounted price to current market value, low enough to secure acceptance but not too low to avoid
excessive dilution of EPS. This prevents their stake being diluted by new share issues. Cheaper than a
public share issue. Offers so many shares for however many held (i.e 1 new share for every 4 held).
When setting an issue price for the rights issue, this would not be higher than MPS (market price),
tends to be discounted in the region of 20%. Can never be lower than nominal value of the shares.
Value is reduced so number of shares issued will increase to make-up the required capital.
Market price after issue – share prices tend to fall after announcing the share issue, due to
uncertainty of consequences from the issue, future profits and future dividends, and also again at
the actual share issue because there are more shares in issue and new shares will be at discounted
price.
Cum rights price (CRP) price offered before the rights issue VS Ex rights price market price of
shares after rights issue has occurred.
Can calculated the TERP THEORETICAL ex-rights price, which is what the share price should be
after the rights price has taken place
TERP = (No. of shares to be held to be receive rights issue x cum price) + issue price
N (“ “) + 1
Numerator – issue price would be (No. of new shares to be issued x issue price), which is just 1 new
share so is same as using just issue price.
Denominator is the total of shares that will be held, existing shares plus new shares from issue.
Shareholders option to buy shares at a better price, option to withdraw cash by selling their
rights, and able to maintain existing voting position by exercising the rights.
Company simple and cheaper, usually successful (fully subscribed) and often provides favourable
publicity.
DEBT FINANCE
Loan of funds to a business without conferring ownership rights, creating an obligation to repay
funds and interest. Interest is paid out of pre-tax profits as an expense, and it carries risk of default if
payments are not made.
Lenders may require some security (collateral) over assets to be seized if payments are not made.
FIXED CHARGE would be secured against a specific asset like land or buildings, lender being a priority
to be repaid if defaulted. FLOATING CHARGE is secured against underlying assets subject to changes
in quantity or value (like inventory, or trade receivables), still providing preferred status for
repayment.
