F3 – Financial Strategy CH4 – Financing – equity finance

Chapter 4
Financing – equity finance

Chapter learning objectives:

Lead Component Indicative syllabus content

B.3 Evaluate equity (a) Evaluate methods • Methods of flotation and implications for
finance. of flotation management and shareholders
(b) Discuss rights
• Rights issues, choice of discount rates and
issues
impact on shareholders
• Calculation of theoretical ex-rights price
(TERP) and yield adjusted TERP

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1. General introduction to financing

Sources of finance
Availability of a cash surplus:
If a company has a cash surplus available, it can afford to undertake new investment projects
without utilising external sources of finance.
External sources of finance:
1. The capital markets:
• New shares issue – acquiring a stock market listing for the first time
• Rights issue
• Issues of marketable debt
Note:
A company must be quoted on a recognised stock exchange to be able to raise finance
from the capital markets.
2. Bank borrowings:
• Long-term loans
• Short-term loans
• Revolving credit facilities
• Money market lines
3. Venture capital funds
• High-risk finance provided by specialised organisations.
• Providers demand significant equity participation in the company.
• May have an influence on the policy of the company.
4. Government and similar sources:
• The government may also provide grants and loans to startup companies.

Criteria for selecting sources of finance

The following factors should be considered:
• Cost
- Cost of equity capital:
§ The return that ordinary shareholders expect on their investments in the form of
dividends and share price growth.
§ There is no legal obligation to pay dividends to shareholders, but it must provide
a satisfactory return to support the share price.
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- Cost of debt:
§ Interest is the cost of debt.
§ An entity must pay interest at the current rate to the providers of debt capital.
§ The cost of interest is an allowable expense for tax purposes.
§ The cost of debt capital to a company is the interest cost less the tax relief on the
interest.
§ Providers of debt finance have lower risk than the providers of equity; this makes
it a cheaper source of finance than equity.
• Duration
- Equity capital is a permanent long-term source of finance.
- Debt finance is on fixed terms for a specific period, and the length of borrowing can
vary from very short-term (overdraft) to long-term loans, e.g. 5 years.
• Lending restrictions
- Security, e.g. collaterals may be required for debt finance.
- There may be debt covenants, which are clauses written into the debt agreement
that protect the lender's interests by requiring the borrower to satisfy certain criteria.
• Gearing level
- The ratio of debt to equity finance.
- High gearing is riskier than low gearing.
- High gearing involves the use of cheap debt finance.
- A high level of debt creates an obligation to meet interest payments and debt
principal repayment schedules.
- If these are not met, the company may end up in liquidation.
• Liquidity implications
• The currency of the cash flow
• The impact of different financing options on the financial statements
• Availability of finance
- The availability of debt finance is enhanced by a good credit rating and the
creditworthiness of a company.
- The more creditworthy the customer, the more likely that it will be easy to raise debt
finance.

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2. Equity finance – another name for shares or ownership

rights in a business
A fixed, identifiable unit of capital in an entity which normally has a fixed nominal value that
may be quite different from its market value (CIMA Official terminology, 2005)
Shareholders receive a return on their investments in shares in the form of dividends, and
also capital growth in the share price.

Ordinary shares Preference shares

• Pay dividends at the discretion of the • A form of equity that pays a fixed
entity’s directors. dividend, which is paid in preference to
ordinary shareholders’ dividends.

• Ordinary shareholders are the owners • On the winding-up of a company, the

of the company. preference shareholders are
subordinate to all of the debt holders
and creditors but receive their payout
before ordinary shareholders.

• Shareholders have a right to attend the • Preference share dividends are paid
annual general meetings and vote on out of post-tax profits; therefore, there
important matters. is no tax benefit to the company for
paying preference share dividends.

• On winding-up, the ordinary • The lack of tax relief on dividends on

shareholders are subordinates to all
other finance providers.
preference shares makes them
relatively unattractive to a company
compared with bank borrowing and
other forms of fixed-rate security such
as bonds.

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Capital Markets
Capital markets must fulfil both primary and secondary functions.

Functions of
Capital Markets

Primary Secondary
Functions Functions

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•To enable companies to raise new

finance (equity or debt)
Primary •To enable companies to
communicate with a large pool of
Function of a investors, making it easier to raise
finance.

Stock Market •In the UK, a company must be "plc"

before it is allowed to raise finance
through the stock market.

Secondary •To enable investors to sell their

investments to other investors

Function of a •A listed company's shares are

therefore more marketable than those

Stock Market
of an unlisted company, which makes
them more attractive to potential
investors.

Listed vs Private Companies

Public Limited Company (plc in the UK) Private Limited Company (Ltd in the UK)

• A Limited Liability Company may • Limited by shares

sell its shares to the public
• Shareholders with limited liability
• It can either be unlisted or listed on
• Its shares may not be offered to the general
a stock exchange
public
• Stringent compliance requirements
• A limited company may be private or public
• Disclosure requirements for a private limited
company are lighter
• Small companies are usually private limited
companies

Stock exchange listing

When an entity obtains a listing (or quotation) for its shares on a stock exchange, this is
referred to as floatation or an initial public offering (IPO).

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Advantages of a listing:
• The market will provide a more accurate valuation of the entity than had previously been
possible
• Realisation of paper profits and a mechanism for buying and selling the shares in the
future at will
• Raises profit for the entity that may have an impact on revenues and credibility with
suppliers and providers of long-term finance
• Raises capital for future investments
• Makes employee shares schemes more accessible
Disadvantages:
• Costly for small entities in terms of high floatation and underwriting costs
• The original owners lose some control into the hands of multiple shareholders
• Onerous reporting requirements
• Stringent stock exchange rules for obtaining a quotation

METHODS OF ISSUING NEW SHARES

Methods of
Issuing New
Shares

Initial Public
Offering (IPO)/ Placing Rights Issue
Floatation
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AN INITIAL PUBLIC OFFERING (IPO)/FLOATATION

• Shares are offered for sale to investors through an issuing house.
• The offer could be made at a fixed price set by the company or in a tender offer, where
investors are invited to tender for new shares issued at their own suggested price.
• All shares being offered are subsequently sold at the best price at which they would be
taken up.
• These offers may be of completely new shares, or they may derive from the transfer to
the public of some or all of the shares held privately.
• An issuing house, normally a merchant bank, acquires the shares and offers them to the
public at a fixed price.
• The offers are made in the form of a prospectus detailed in a newspaper, sometimes in
an abbreviated form.
• Buying new issues through the prospectus in the newspaper avoids dealing charges.
• Examples include:
- Government privatisation
- Privately held shares transferred to the public
• It is easier for prospective purchasers to form a judgement about such entities where
there is some track record, rather than an offer from a completely new entity.

Staging
Staging is the strategy of selling the shares immediately.
• Investors apply for new issues in the hope of selling immediately and reaping a quick
profit.
• For this to succeed, the number of shares purchased must be sufficiently high to cover
selling charges.
• For oversubscribed issues, the allocation may be scaled down, and the applicant may
receive only a small number of shares.

IPO lock-up period

• A contractual restriction that prevents insiders who are holding a company’s shares
before it goes public from selling the shares for a period usually lasting 90 to 180 days
after it goes public.
• Insiders include company founders, owners, managers, employees and venture
capitalists.
• The purpose of an IPO lock-up period is to prevent the market from being flooded with a
large number of shares, which would depress the share price.

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Tender offers
• An alternative to a fixed price offer.
• Subscribers tender for the shares at or above a minimum fixed price.
• Once all offers have been received from the prospective investors, the company sets a
strike price and allocates shares to all bidders who have offered the strike price or more.
• The strike price is set to make sure that the company raises the required amount of
finance from the share issue.
• Once the strike price has been set, all bidders who offered the strike price or more are
allocated shares, and they all pay the strike price irrespective of what their original bid
was.

Test Your Understanding 1: Tender Offer

Melt It Company needs to raise $50 million to invest in a new project. The company has asked
investors for tender offers, and the following offers have been received.

Maximum Price Offered No. of shares requested at this price

($ per share) (million)

3.00 6.00

3.50 5.00

4.00 4.20

4.50 3.50

What strike price should be set?

A. $3 per share
B. $3.5 per share
C. $4 per share
D. $4.5 per share

PLACING
• Placing is also called placement or private placement.
• It is a way to raise capital by selling securities to a relatively small number of selected
investors.
• Investors involved in private placements are usually large banks, mutual funds, insurance
companies and pension funds.

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• Private placement is the opposite of public issue, in which securities are made available
in the open market.
• Placement does not need to be registered or publically announced.
• This method is very popular, being cheaper and quicker to arrange.
• It does not lead to a very active market for the shares after floatation.
• Placement will lead to a dilution of shareholder control compared to an offer for sale.

Advisors to an IPO
Investment banks:
• Take the lead role in an IPO, handling:
- The appointment of the other specialists.
- Stock exchange requirements.
- Forms of any new capital to be made available.
- Arrangements for underwriting.
- Publishing the offer.
Stockbrokers:
• Provide advice on the various methods of obtaining a listing.
• May work with investment banks to identify institutional investors.
• Are involved with smaller issues and placings.
Institutional investors:
• Have little to no direct involvement other than as investors.
• Agree to buy a certain number of shares.
• Once the shares are in issue, institutional investors have a major influence on the
evaluation of and market for shares.

RIGHTS ISSUE
“The raising of new capital by giving existing shareholders the right to subscribe to new
shares in proportion to their current shareholding. These shares are usually issued at a
discount to market price.” (CIMA Official Terminology)
• This is where new shares are offered for sale to existing shareholders in proportion to the
size of their shareholdings.
• Rights issues are cheaper to organise than public issues.
• Rights issues are more expensive than placing.

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Pre-emption of rights:
“The rights to buy new shares ahead of outside investors are known as the pre-emption
rights of shareholders.”
• The purpose of pre-emption rights is to ensure that shareholder have an opportunity to
prevent their stake being diluted by new issues.
• These are protected by law.
• Can only be waived with the consent of shareholders.

Setting of the issue price

An issue price must be set that is:
• Low enough to secure the acceptance of shareholders, but
• Not too low, so as to avoid excessive dilution of the earnings per share.

Market price after issue

• After the announcement of a rights issue, there is a tendency for the share price to fall.
• The temporary fall is due to uncertainty about:
- Consequences of the issue
- Future profits and
- Future dividends.
• After the actual issue, the market price will normally fall again because:
- There are more shares in issue, and
- New shares were issued at a market price discount.
Cum rights:
When a rights issue is announced, all existing shareholders have the right to subscribe for
new shares, and so there are rights attached to the shares, and the shares are traded cum
rights.

Ex rights:
On the first day of dealings in the newly issued shares, the rights no longer exist, and the old
shares are now traded ex rights (without rights attached).

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Theoretical prices/values
• The theoretical ex-rights price is the theoretical price that the class of shares will trade at
on the first trading day after issue (theoretical price after the rights issue).
Calculated as follows:

("×$%&'()*+,- /()01)3 4--%1 5()01

TERP =
"36
The theoretical value of rights per share is calculated as:

(𝑇ℎ𝑒𝑜𝑟𝑒𝑡𝑖𝑐𝑎𝑙 𝐸𝑥 − 𝑟𝑖𝑔ℎ𝑡𝑠 𝑃𝑟𝑖𝑐𝑒) − 𝐼𝑠𝑠𝑢𝑒 𝑃𝑟𝑖𝑐𝑒

𝑁
N = no. of rights required to buy 1 share

Test Your Understanding 2 – TERP

Clover Company has 1 million $1 ordinary shares quoted at $5 per share ex div. It is considering a 1
for 5 rights issue at $3 per share.
Calculate the theoretical ex-rights price and value of the right per share.

Yield-adjusted ex-rights price

Calculation of the theoretical ex-rights price assumes that the additional funds raised will
generate a return at the same rate as existing funds. If an entity expects that the new funds
will earn a different return than is currently being earned on existing capital, a yield-adjusted
TERP should be calculated.

("×$%&'()*+,- /()01) (4--%1 /()01) ×

Yield-Adjusted TERP: +[ Yn/Yo]
"36 "36

Yo = yield on old capital

Yn = yield on new capital

Test Your Understanding 3 – Yield-Adjusted TERP

Clover Company has 1 million $1 ordinary shares quoted at $5 per share ex div. It is considering a 1
for 5 rights issue at $3 per share.
Assuming the rate of return (yield) on the new funds = 20%
The rate of return on the existing funds = 15%
Please calculate the yield-adjusted TERP.

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Courses of action open to the shareholders

Possible actions for shareholders are:
1. Do nothing.
2. Renounce the rights and sell the rights in the market.
3. Exercise the rights (i.e. buy all the shares at the rights price).
4. Renounce part of the rights and take up the remainder.

Test Your Understanding 4 – Courses of action

Clover Company has 1 million $1 ordinary shares quoted at $5 per share ex div. It is considering a 1
for 5 rights issue at $3 per share.
If the shareholder owns 1500 shares worth $5 per share, in the 1 for 5 right issues he will be offered
300 shares at $3 per share.
Please discuss all 4 possible courses of action.

3. Solutions to Test Your Understanding

Test Your Understanding 1: Tender Offer

Correct option: A

Maximum Price Offered No. of shares requested

Finance generated ($)
($ per share) at this price (million)
3 6 18
3.5 5 17.5
4 4.2 16.8
4.5 3.5 15.75

The strike price will be set at the highest possible level that generates the required amount of finance.
At a price of $4.50 per share:
At this price, only 3.50 million shares will be issued, raising finance of $15.75 million, which is
insufficient.
At a price of $4 per share:
At $4 or more, i.e. $4.5 per share, 7.7 million (3.5 + 4.2) shares will be offered, accumulating finance
of $30.80 million, i.e. ($4 x7.7m), which is again not sufficient.

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At a price of $3.5 per share:

At $3.5 per share or more, we have 5 million + 4.2 million + 3.5 million shares, raising finance of $44.45
million, e.g. ($3.5 x 12.7 million), which is still insufficient to meet the demand.
At $3 per share or more, we have 18.7 million shares (3.5 + 4.2 + 5 + 6), raising finance of $56.1 million
($3 x 18.7m), which is finally sufficient to meet the demand.
Therefore, the strike price is $3 per share.

Test Your Understanding 2 – TERP

("×$%&'()*+,- /()01)3 4--%1 5()01 (K×K)3 L
TERP = "36
= M

TERP = $4.67 per share

Value of right = $4.67 - $3.00 = $1.67 per share

Test Your Understanding 3 – Yield-adjusted TERP

Yield-adjusted TERP = (5×5)/6 +[3/6×(20/15)]
Yield-adjusted TERP = [4.17 + 0.67]
Yield-adjusted TERP = $4.84 per share

Test Your Understanding 4 – Courses of action

Option 1 – Do nothing:
In this situation:
Market value of shares = 1,500@$5 per share = $7,500 (A)
("×$%&'()*+,- /()01)3 4--%1 5()01 (K×K)3 L
"36
= M

TERP = $4.67 per share

Market value of shares will fall from:
Market value of shares = 1,500@$5 per share = $7,500 (A)
Market value of shares = 1,500@$4.67 per share = $7,005 (B)
Fall = A – B = $495

Option 2: Sell the rights

In this situation, the shareholder will decide to sell the right to buy the shares at $3 per share to
another investor.
A rational investor would not be expected to pay more than (TERP – Issue price), i.e. ($4.67 - $3.00)
= $1.67 per share for such a right.
The existing shareholder will receive = $1.67 per share for 300 shares = $501
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The shareholder’s percentage share of the entity would be reduced.

Option 3: Fully subscribe to the new shares:

In this situation, the shareholder will have to increase the value of the shareholding by paying the
entity $900 (300 shares @ $3 per share).
The shareholder will then own 1800 shares that will be valued at $8,406 using $4.67 per share (TERP).

Option 4 – Sell some rights to buy some new shares

In this situation, the shareholder may be unable or unwilling to invest more funds in the entity. Since
the rights can normally be sold in the market, the shareholder could sell sufficient of the rights to
purchase the balance.
300 rights could be sold for $1.67 per share = $501

4. Chapter summary

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