Financing Equity Finance

Chapter 4

1. External funds can be raised from =

a) The capital markets (must be quoted/listed)

b) Bank borrowings
c) Venture capital funds (demand significant equity
participation)
d) Government and similar sources

2. Criteria for selecting source of finance=

a) Cost of different sources of finance:

Debt is cheaper because it is tax deductible.

b) Duration:

Equity capital is long term permanent capital, normal rule:

long term assets should be financed by long term funds,
short term assets such as inventories, receivables should
normally be financed by a mixture of short term and long-
term funds, could be broken to gain cheap access to funds,
particularly short-term payables.

c) Lending restrictions:

Debt covenants
d) Gearing level:

Interest has to be paid, a satisfactory distinction between

long term ad short term finance needs to be found.

e) Liquidity implications

f) Currency of cash flows associated with the new project:

If currency of cash flow is expected to be in foreign currency,

the entity may decide to raise finance in that same currency
i.e. matching concept.

g) Impact of different financing options, tax positions:

Impact of new financing should always be considered on the

financial statements of the business, raising debt finance is
tax deductible so tax position is also impacted.

h) Availability:

Availability is enhanced if entity has a good credit rating

3. Preference share dividends are paid out of post-tax profits, so
the company has no tax benefit as compared to debt interest.

Different types=

a) Cumulative

b) Non-cumulative

c) Participating preference shares:

Give holder fixed dividends plus extra earnings if certain

conditions are met by the company.

d) Convertible preference shares:

Fixed income securities which the investor can choose to

turn into certain number of ordinary shares after a
predetermined time. Particularly for hot growth companies
while being insulated to a drop I share price. Often used in
management buy outs MBO’S concept. If trading price is
higher than nominal value/no. of shares to exchange only
then shares would be converted.
4. Capital markets= must fulfill both primary and secondary
conditions.

a) Primary function:

Enable companies to raise new finances. In the UK company

must be PLC before it is allowed to raise finance from the
public stock market.

b) Secondary function=

Enable investors to sell their investments to other investors.

5. Private limited company:

Shares may not be offered to public. Limited by shares means

that the company has shareholders and that the liability of the
shareholders to the creditors of the company is limited to the
capital originally invested. Private limited disclosures are lighter
and may not be listed and shares not given to public. Most
companies, particularly smaller are private.

6. Public limited company:

Sells shares to the public. Can be listed or unlisted

7. Advantages of listing, disadvantages: Read from Book.

8. UK capital markets= the full stock exchange and the AIM.

9. Methods of issuing shares=

A) An IPO or Flotation=

Shares are offered through an issuing house, could be a set

price or a tender price suggested by the investors. All shares
are sold at the best price at which they would be taken up.

Completely new shares of turning private company to public,

an issuing house or a merchant bank generally acquires the
shares and then offers them to the public at a fixed price.
Buying new issues through the prospectus in the
newspapers avoids the dealing charges at times.

a) Stagging=

Some investors apply to new share issues mainly with the

hope of selling immediately and reaping a quick profit. For
this to succeed the number of shares purchased must be
high enough to cover the selling charges.

b) An IPO lock up period=

Contractual agreement that prevents insiders from selling

the shares for a period usually lasting 90 to 180 days after
the company goes public. Insiders include founders,
owners, managers, employees and venture capitalists.
Purpose is to prevent the market from being flooded with
a large number of shares depressing the share price. Can
 have a significant if investors sell their investment
because they own a large percentage.

c) Tender offers=

Alternative to a fixed price offer. Subscribers tender for

the shares or above a minimum fixed price. Once all offers
are received from prospective investors the company sets
a strike price and allocates shares to all bidders who have
offered the strike price or more. Strike price is set to
make sure company raises the required amount of
finance form the share issue.

B) Placings=

Also called private placements, is the sale of securities to a

relatively small number of select investors as a way of raising
capital. Usually large banks, mutual funds, insurance
companies and pension funds. Cheaper and quicker and
does not have to be announced.

C) Private equity=

Equity capital that is not quoted on a public exchange.

Investors make investments directly in private companies or
conduct buyouts of public companies that result in the
delisting of a public entity, Investors who can commit large
sums of money for a long term until there is an IPO or
company is sold to make a profit.
10. Advisors to an IPO

X) Investment banks usually take a lead role in an IPO

and will advise on= appointment of other specialists
such as lawyers, stock exchange requirements, forms
of any new capital to be made available, number of
shares to be issued and issue price, arrangements for
underwriting, publishing the offer.

Y) Stockbrokers

Z) Institutional investors.

D) Rights issue=

Prevent stake from dilution. Price would never be higher

than MPS and never lower than Nominal value, discount is
normally 20%. Underwriting avoids the possibility that the
entity will not sell all of the shares and thus will receive less
funds that it expects. They are usually financial institutions
such as merchant banks. It returns for a fee they agree to
buy any shares that are not subscribed for in the issue. Issue
price decided first and then number of shares, 2$ and 4$
example in text.

11. TERP= (n*cum rights price) + issue price/ N+1

12. Value of rights per share= (TERP-issue price)/N where

N= number of rights required to buy 1 share.
13. NPV given in question= TERP+ (NPV/no of total
shares).

14. If new funds are expected to earn a different return than

is currently being earned on the existing capital then a yield-
adjusted TERP must be calculated.

15. Yield adjusted TERP= {cum rights price*N/(N+1)} +

{(issue price/N+1) * yn/yo)}

a) Yo= yield on old capital

b) Yn= yield on new capital

16. If new funds are expected to earn a return above the

rate generated by the existing funds there will be less dilution
of the market price than suggested in the original TERP
calculation.

If NPV of new project given yield adjusted TERP will be=

(original company market capitalization +NPV of the project+
rights issue proceeds)/ New total number of shares.
17. Courses of action open to a shareholder=

A) DO nothing=

After deducting an expense and offer price balance would be

sent to shareholder. This cash would partially or fully
compensate the shareholder for the reduction in value. The
shareholders percentage of shareholding would reduce.

B) Sell rights=

Would sell at (TERP-offer price). Shareholders percentage

share of the entity would reduce.

C) Fully subscribe for the new shares=

Shareholders percentage share of the entity will be

maintained.

D) Sell some rights to buy some new shares=

Sell rights some rights to finance purchase of shares in the

same company so investor does not have to commit more
funds to the entity. Value of the investment will be
maintained but shareholders percentage share of the entity
will be reduced.