Equity Financing

Equity financing involves funding through issue of ordinary shares.

Stock Exchange Listing

Advantages

To Existing shareholders
 Can sell their shares more easily
 Increased marketability of shares that may result in increased value
 Readily available market values (no valuation problem for business)

To the company
 Easy access to new funds
 Better credit standing as a listed entity
 Perceived risk reduction may result in lower cost of capital
 Listed entity status may result in or support generation of new business

Disadvantages
 Additional cost to company
 Compulsory regulatory compliance
 Dilution of control (of existing owners)
 Public scrutiny of company operations, results and profits

Methods of issuing new shares

 Right issue
 Offer for sale at a fixed price
 Offer for sale by tender
 Placing

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Q1: ABC limited is a listed entity and has 100,000 shares outstanding. Current market price of its one
share is Rs. 15.50 ex-dividend. Its board of directors is planning to announce 20% right issue (that is
1 right share for every 5 shares held) at a Price of Rs. 12.50.

Required:
1) Calculate theoretical ex-right share price after announcement of right issue.
2) Calculate the amount of gain or loss of Mr. Ahmed who holds 5,000 shares in ABC limited) in
respect of each of the following independent situations:
a) Mr. Ahmed exercises all rights
b) Mr. Ahmed sold all the rights in the market
c) Mr. Ahmed sold 60% rights in the market and exercised remaining rights
d) Mr. Ahmed did not do anything and all the rights lapsed

Note:
𝐶𝑢𝑚 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = 𝐸𝑥 − 𝑑𝑖𝑣 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑜𝑐𝑒 + 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑎𝑏𝑜𝑢𝑡 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑

Q2: Flower limited has 100,000 Rs. 10 ordinary shares quoted at Rs. 45 ex-dividend. It is considering a 1
for 5 rights issue at Rs. 42 per share. The raised funds will be used to finance a new investment
project that has an expected NPV of Rs. 300,000.

Required: Calculate the theoretical ex-right share price if the project is undertaken.

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Cost of Equity (Ordinary Shares)
1) Dividend Valuation Model (DVM)
2) Capital Asset Pricing Model (CAPM)
3) Bond-yield premium method

1) Dividend Valuation Model (DVM)

 Constant dividend (without any growth)

𝑑
𝐾 =
𝑃

𝐾 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑑 = 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑒𝑥 − 𝑑𝑖𝑣 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑜𝑐𝑒

 Dividend with constant growth

𝑑
𝐾 = + 𝑔
𝑃

𝑊ℎ𝑒𝑟𝑒: 𝑑 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 𝑠 𝑡𝑖𝑚𝑒 ; 𝑑 = 𝑑 (1 + 𝑔)

 Computing growth

1) Averaging method

𝑑
𝑔= −1
𝑑

𝑊ℎ𝑒𝑟𝑒: 𝑑 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 ; 𝑑 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝒏 𝑦𝑒𝑎𝑟 𝑎𝑔𝑜

2) Gordon's growth model

𝑔 = 𝑟𝑏

𝑊ℎ𝑒𝑟𝑒: 𝑟 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 ; 𝑏 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜

 Dividend with multiple growth rates

Compute individual cash flows and apply constant growth model when it is applicable.

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Assumptions of Gordon's growth model
 The entity must be all equity financed
 Retained profits are the only source of additional investment
 A constant proportion of each year's earnings is retained fro reinvestment
 Projects finance from retained earnings earn a constant rate of return

Approximation Model for Three-Phase Growth (H model)

 The entity must be all equity financed

𝐷
𝐾 = [(1 + 𝑔 ) + 𝐻(𝑔 𝑔 )] + 𝑔
𝑃
𝑊ℎ𝑒𝑟𝑒:

𝐷 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑔 = 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑓𝑖𝑛𝑎𝑙 𝑝ℎ𝑎𝑠𝑒

𝐴+𝐵
𝐻= , 𝑤ℎ𝑒𝑟𝑒 𝐴 𝑖𝑠 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑖𝑛 𝑝ℎ𝑎𝑠𝑒 1 𝑎𝑛𝑑 𝐵 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑝ℎ𝑎𝑠𝑒 2
2

𝑔 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑝ℎ𝑎𝑠𝑒 1

Cost of Preference Share

𝑑
𝐾 =
𝑃

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Q3: Compute the required element (identified in bold Italic font) in each of the following independent
situations: (most examples from study text)

1) Share price of an ordinary share is Rs. 20 ex-dividend. A dividend of Rs. 1.6 has just been paid
and there expected to be no growth in dividends in foreseeable future. Compute Cost of equity.

2) Share price of an ordinary share is Rs. 40. A dividend of Rs. 3.0 is about to be paid. There is
expected to be no growth in dividends in foreseeable future. Compute Cost of equity.

3) The cost of equity is 12%. The dividend just paid is Rs. 4.0 and there expected to be no growth in
dividends in foreseeable future. Compute Share price.

4) Share price of an ordinary share is Rs. 25 ex-dividend. A dividend of Rs. 1.75 has just been paid
and the expected growth in dividends is 5% pa for foreseeable future. Compute Cost of equity.

5) Share price of an ordinary share is Rs. 50. A dividend of Rs. 4.25 is about to be paid. There is
expected to be growth of 3% in dividends in foreseeable future. Compute Cost of equity.

6) The cost of equity is 12%. The dividend just paid is Rs. 4.0 and the expected growth rate in
dividends is 4% pa for foreseeable future. Compute Share price.

7) Share price of an ordinary share is Rs. 50. A dividend of Rs. 4.0 is about to be paid. Dividend
after one year is expected to be Rs. 4.20 and the future dividends are expected to be in same
direction. Compute Cost of equity.

8) Kashmir limited paid a dividend of Rs. 3.0 per share four years ago, and the current dividend just
paid is Rs 4.40. The current share price is Rs. 100 ex-dividend. Compute Cost of equity.

9) A company paid a dividend of Rs. 0.80 per share eight years ago and the current dividend is Rs.
1.3. The current share price is Rs. 27.6. Compute Cost of equity.

10) The ordinary shares of a company are quoted at Rs. 70 cum-dividend. A dividend of Rs. 5.0 is just
about to be paid. The company earns return of 12% and each year pays out 70% of its profits as
dividends. Compute Cost of equity.

11) ABC limited paid a dividend of Rs. 2.0 this year. Dividend expected to grow at 14% for next 5
years then at 11% for further five years and thereafter growth is expected to continue at 7%.
Current market price per share is Rs. 40. Compute Cost of equity.

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12) Current earning of the company is Rs. 3.0 while the cost of equity is 15%. Earnings growth and
dividend payouts are as follows:

Phase EPS Growth DP ratio

1 - 4 years 25% 20%

5 - 8 years 15% 26%, 32%, 38%, 44%

Year 9 and beyond 8% 50%

At the end of year 8, P/E ratio is expected to be 10 times.

Compute market price per share.

Reference material
Issuing Securities - chapter 19
Financial Management & Policy - 12th edition
James C. Van Horne

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 Debt Financing

Debt financing has following two key features:

 Its cost (that is interest) is paid out of pretax earnings and is recognized as admissible expense
by tax authorities (that is it attracts tax-shield or tax savings).

 It carries a risk of default (for non-payment of interest and/or principal)

Security Charges
 Fixed charge
 Floating charge

Covenants - are specific requirements or limitations laid down as a condition of taking on debt
financing. They may include:
 Dividend restrictions
 Maintaining key financial ratios
 Submission of regular financial and/or other reports to loan providers
 A nominee director or representative of loan provider on board of company
 Restrictions over issuance of further debt

Types of debt
Two general sources from which funds can be raised:
 Bank Finance
 Trade Investments (that is issuing debt securities in the market)
Trade investments include:
1) Debentures
2) Unsecured loans
3) Mezzanine finance
4) Euro bonds

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Advantages and disadvantages of using debt

Advantages
1) Low cost as compare to equity
2) Tax benefits
3) Ownership stake is not diluted

Disadvantages
1) Need to have quality assets for security
2) Bring more volatility (that is risk) to the return of shareholders
3) Most debt need to be redeemed

Yield to Maturity (YTM)

It is effective average annual percentage return to the investor relative to the current market value of
the bond.
 Irredeemable debt
𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑌𝑇𝑀 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

𝐼𝑛 𝑵𝒐 𝑻𝒂𝒙 𝒘𝒐𝒓𝒍𝒅: 𝑌𝑇𝑀 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑐𝑜𝑚𝑝𝑎𝑛𝑦

𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑰
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑟𝑟𝑒𝑑𝑒𝑒𝑚𝑎𝑏𝑙𝑒 𝑑𝑒𝑏𝑡 = 𝑂𝑅 𝑲𝒅 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑫𝑴𝑽

𝐼𝑛 𝑾𝒐𝒓𝒍𝒅 𝒘𝒊𝒕𝒉 𝑻𝒂𝒙: 𝑌𝑇𝑀 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟 ≠ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑐𝑜𝑚𝑝𝑎𝑛𝑦

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑟𝑟𝑒𝑑𝑒𝑒𝑚𝑎𝑏𝑙𝑒 𝑑𝑒𝑏𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐼 (1 − 𝑡)
𝐾 =
𝐷

𝐾 = 𝐾 (1 − 𝑡)

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 Redeemable debt

Q: Globe limited has some 7% coupon Rs. 100 nominal value bonds in issue that redeemable
after 5 years at 10% premium. The current market value of the bond is Rs. 98.
Required:
1) Calculate the YTM of this bond for an investor.
2) Calculate cost of this debt to the company if corporate tax rate is 30%.

 Foreign currency based redeemable debt

Q: Globe limited (a Pakistan based company) issued $100, 5% coupon bonds at par,
redeemable in 5 years at $110. Current exchange rate is Rs. 100 per US $. While over five
years US $ is expected to strengthen by 3% per annum against the Rs.
Required: Calculate the cost of this debt to the company if corporate tax rate is 35%.
Note: Any excess payments in respect of exchange rate differences are tax allowable.

 Cost of Convertible debt

Q: Globe limited has Rs. 100 debenture which is redeemable at 5% premium in 5 years time.
Alternatively, this debenture is convertible (at the option of holder) into 10 shares at the
time of redemption. Interest rate on debenture is 8%. Corporate tax rate is 30%. Current
market price per share is Rs. 8.60, while current market price of debenture is Rs. 103.
Required: Calculate the cost of this debt to the company if:
1) Expected growth rate in share price is 3% pa.
2) Expected growth rate in share price is 6% pa.

Reference material
Chapters 20 and 21
Financial Management & Policy - 12th edition
James C. Van Horne

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