STUDY GUIDE E2: SOURCES OF AND RAISING, LONG-

TERM FINANCE
 Get through Intro
Long-term finance is obtained for long-term assets. Its volume is likely to be higher than the volume of short-
term finance. The amount is locked up for longer time hence the risks for the investors are higher. As a result, it
is relatively difficult, compared to short-term finance, to obtain long-term finance.

Students will need to identify the sources of long-term finance that will enable a company to fulfill its objectives.
In the future, it may be necessary to advise client on issues such as whether to opt for equity finance or debt
finance. If debt finance is chosen, further issues such as whether to go for loan stock or for convertible
debentures may arise.

This Study Guide examines these interesting and challenging issues.

 Learning Outcomes
a) Identify and discuss the range of long-term sources of finance available to businesses, including:
i. Equity finance
ii. debt finance
iii. lease finance
iv. venture capital
b) Identify and discuss methods of raising equity finance, including
i. rights issue
ii. placing
iii. public offer
iv. stock exchange listing
 Case Study
In April 20X9, Tollcross Ltd, a real estate investor group based in San Francisco, engaged Inspiration Co, to seek
an equity partner and gaming operator that would enable it to develop a $51.0 million casino/hotel property in
San Francisco. The two companies became involved in the early stages of the development process and
contributed to the partnership creation, capital structure formulation, development process and approval
process.
➢ In July 20X9, Tollcross Ltd signed a term sheet with jackpot Casinos Ltd. Under the terms of the agreement,
Jackpot contributed $3.5 million cash and Tollcross Ltd contributed its real estate assets towards JC Tollcross
LLC, a joint venture entity newly-formed for the development of the casino resort.
➢ In August 20X9, in order to finance the development and contraction of the project, Inspiration began to
canvas the capital markets to raise approximately $33.5 million of equipment and construction debt
financing.
➢ In September 20X9, management meetings with a short list of debt investors were organized by inspiration.
In November, Tollcross received its first proposal for construction financing which, after lengthy
negotiations, resulted in a signed term sheet in January 20Y0. The term sheet provided for $27.8 million of
construction financing, non-recourse to all parties.
➢ The $14.2 million equity financing transaction closed in January 20Y0. The $32.0 million debt financing
closed in December 20Y0.
➢ Jackpot Casino and Hotel opened to the public in August 20Y0 with 535 slot machines, 10 games tables and
32 hotel rooms.

The above case study shows how long term finance was obtained through the issue of debt as well as equity. In
this Study Guide we discuss the nature of these long term sources of finance and how they are raised.
i. Identify and discuss the range of long-term sources of finance available to businesses,
including:(2)
i. Equity finance
ii. debt finance
iii. lease finance
iv. venture capital
[Learning Outcome a]
Long-term finance is used as a source for long-term assets such as:
1. Non-current assets
2. Expansion of facilities
3. Large scale construction projects
4. Permanent current assets
Diagram 1: Sources of long-term finance

Sources
of finance
There are different sources available for these long-term funds. The following are the major sources available to
companies:
1.1 Equity finance
Equity finance is the money raised by issuing ordinary shares to investors. It may take different forms such as a
rights issue, placing, public offer, stock exchange listing etc. These forms of raising equity finance are covered in
Section 2 of this Study Guide. In this section, we look into the general features of equity finance.
1. Ordinary shares normally have a value. This was traditionally printed on the actual face of the share
certificates; therefore they came to be called ‘face value’ shares. This value may be expressed in different
denominations e.g. $1 or $0.25. Some countries have made it legally compulsory to mention the nominal
value. However, Sri Lankan Companies Act does not talk about a face value or a nominal value
2. The market value of a share has no relationship to the nominal value. The market value is determined by
the market forces and keeps fluctuating while the nominal value is fixed.
3. The issue price, i.e. the money that a company gets on freshly-issued shares, can be different from the
nominal value. The laws of some countries prohibit the issue of shares for an amount below the nominal
value. The issue price can be, and often is, more than the nominal value. The excess of issue price above
nominal value is known as known as share premium. Company law normally stipulates strict controls on the
utilization of share premium amounts.

Example
Shares of $1 each are issued at a price of $1.50 each.$1 per share is appropriated towards capital and $0.50
towards share premium.

4. Equity holders are effectively the owners of the company; however, they are not involved in the day-to-
day running of the business. They control the company’s affairs by selecting a board of directors (at the
annual general meetings), who are responsible for the day-to-day running of the company. According to
company law, certain decisions are to be made or ratified by shareholders and not by the board.
5. Equity finance is available for an indefinite period; there is no fixed repayment date.
6. Equity holders bear the entire risk of a business and, in return, are entitled to the entire retained profit or
loss, however distribution of said profits in the form of dividends is purely at the discretion of the directors.
Payment of dividends is not obligatory.
7. Ordinary shares are usually listed on the stock exchange where they can be freely bought and sold. The
investors realize the gains accrued on the shares by selling them on the stock market at the appropriate
time. Subject to the provisions of company law, a company can even buy its own shares and cancel them.
8. Seemingly, there is no fixed cost of equity finance. However, this is not true; equity finance also has a cost.
This issue is analyzed in Study Guide F2 of this subject.
9. Equity or ordinary shares can also be deferred shares in the sense that the dividend on them is deferred
until the time profits rise above a certain minimum.
10. Shares may be issued:
➢ In order to raise cash
➢ To take over another company
➢ To float a company’s shares on the stock market
11. Equity shareholders expect a higher return on investment. In this context, a business needs to support
higher growth rates of around 20%, in order to attract equity funding.

1.2 Debt finance

Long-term debt finance is finance obtained through borrowing and has a fixed interest payable on it. This
interest is a tax-deductible expenditure. It is a contrast to equity finance which has no fixed interest or dividend
attached to it. The dividend paid is not a tax-deductible expenditure; it is actually an appropriation of post-tax
profits to the shareholders, being the owners.
Interest on debt is payable whether adequate profits are available or no. This is unlike a dividend which is purely
discretionary. If a company goes into liquidation, debt will be paid first, before anything is paid to equity holders.
The exact ranking for repayment of debt will depend upon the kind of security the lenders hold. What equity
holders get after liquidation depends upon the assets leftover after paying all the creditors. In this way debt
carries a lower risk for investors as compared to equity.
Debt finance, even when it is long-term, still has to be repaid on the stipulated dates. The company has to plan
for these repayments.

Types of debt finance

1. Loan stock and debentures

2. Deep discount and zero coupon bonds
3. Institutional debt and bank finance
4. Eurobonds
5. Convertible bonds and warrants

1. Loan stock and debentures

a) Nominal or par value

Loan stock or debentures have a par value that signifies a debt owed by a company to the loan stock holder.

b) Market value
Loan stock or debentures can be bought or sold on the capital market. The market value may be different from
the par value. This is because the market value depends upon market forces and interest rate expectations.

c) Interest or coupon rate

The interest or coupon rate is specified. Interest, at the specified rate, is paid every year or every six months and
is calculated on the par value. Usually the interest rate is fixed; however, it may also be floating related to the
current market interest rate. It may be linked to some benchmark rate such as LIBOR (London interbank offered
rate).
A floating rate is suitable for investors who want returns consistent with market conditions or investors who
want to be protected against unanticipated inflation. It may be remembered (refer to Study Guide D4) that the
expected inflation rate is built into the fixed nominal interest rate.

d) Security
Although the words loan stock and debentures are used interchangeable, a debenture is usually taken to mean a
secured bond, and loan stock is taken to mean an unsecured bond. A debenture trust deed will usually contain
all the terms and conditions related to the securities and the procedures. Generally, investors would expect
higher returns on unsecured loan stock, compared to secured debentures because of the higher risk factor.
Debentures may have a fixed or floating charge on the assets. A fixed charge may be on specific assets such as
land and buildings. The specified assets cannot be sold while the loan is outstanding. A floating charge is a
charge on a class of assets, such as inventory, receivables or machinery. Sale of some assets of the class is
permitted. When a default arises, such as a default in payment of interest, a floating charge crystallizes into a
fixed charge on the specific class of asset.

e) Ratings
Bond rating is carried out by organizations such as Standard and Poor’s and Moody’s Investors Services. It
measures the risk related to a bond regarding the protection of interest payments and repayments of principal,
in the present as well as in the future.
These rating agencies base their conclusions on a detailed analysis of the company’s financial position, the
expected conditions of the economy and the expected financial performance of the company. Institutional
investors invest only in the bonds with the minimum required rating such as investment grade.
f) Redemption
The term redemption means repayment of a debenture or loan stock or any other security. Usually these
securities are redeemable after a certain period. This period varies from 10 to 30 years. Sometimes, the
redemption terms allow a time span of a few years. This allows flexibility to the company when planning cash
flows.

Example
10% Debenture 20X8/Y0 indicates that redemption may be done anytime between a specific date in 20X8 to a
specific date in 20Y0.

There may be irredeemable or undated debentures or loan stock. Although the company is not under obligation
to redeem these, it may elect to do so.

Arranging the money

Redemption calls for careful financial planning since it puts substantial demand on the cash flows of a company.
Some companies arrange for a sinking fund where a fixed amount is invested annually. This amount along with
cumulative interest generates money that will be sufficient to meet the redemption demands.
A company may also issue a fresh loan in order to raise money to redeem the earlier loan. This enables the
company to maintain the capital structure and the related ratios.
If a debenture issue has a call option, the company has a right (option) but not an obligation to redeem the
debentures before maturity.

g) Restrictive terms and conditions

Terms of issue may contain some restrictive conditions where the investors can restrict the actions of the
managers of the issuing company that may increase the risk borne by the investors. Such restrictions may take
the form of:
i. Restrictions on additional debt
ii. Target ratios such as current ratio, debt equity ratio or gearing ratio.
Breach of any conditions may lead to disposal of assets. However, in practice this issue is usually resolved
through negotiations.

2. Deep discount and zero coupon bonds

Deep discount bonds

Deep discount bonds are that are issued at a large or ‘deep’ discount and are redeemable at par or at a
premium.
a) Income and costs
These bonds offer a higher income to investors by way of capital gains.

Capital gains = Maturity value – Issue price

On the other hand the regular interest rate is lower. This is best suited for investors who prefer a higher income
by way of capital gains and lower income by way of interest.
The borrower can, however, deduct notional interest costs each year when calculating its profits.

b) Taxation
Investors who prefer to get more income by way of capital gains normally do so for taxation purpose. In many
countries, concessional tax treatment is given to capital gains.
The borrower charges a notional amount as interest every year. Depending upon the local taxation laws, this
cost is likely to be allowed as tax-deductible expenditure.
 Example
A company issued $4m of loan stock in 20X9, each having a nominal value of $100, at a price of $50 each,
redeemable at a premium of $5m each. The annual interest is only 5% as against the ruling market rate of 10%.
This is a deep discount bond.

Deep discount bonds have a benefit of lower cash flows towards servicing. However, cash flows at the time of
redemption will be heavy. These bonds are suitable for projects that are expected to give lower returns in the
initial years and higher returns later on.

Zero coupon bonds

When the concept of higher capital gains and lower interest is stretched to such an extent that the entire
income is offered only as a discount, and the interest rate is zero, the bonds are called ‘zero coupon bonds’
Investors will not get any inflows from the bonds before maturity. If they need cash, they will have to sell the
bonds at the ruling market price. The market price will depend upon the remaining term of the bonds and the
ruling market interest rates.

3. Institutional debt and bank finance

Banks and financial institutions provide for long-term loans.

a) Interest and fees

Interest rate may be fixed or fixable. Usually, the rate is tied up to the bank’s base lending rate. A loan
processing fee or an arrangement fee is charged at the time the loan is processed. A commitment charge is
frequently levied for the loan that is sanctioned but not utilized.

b) Securities
The loans are secured against the assets of the borrower. The charge may be fixed or floating. A fixed charge is
attached to specific assets that cannot be sold without the permission of the lender. A floating charge is a charge
on a class of assets that are allowed to be bought or sold individually, until the time there is no default on the
loan.
Small enterprises face problems in raising finance because they do not have appropriate securities. Some
governments provide facilities such as the Loan Guarantee Scheme, which is operated by the UK government. It
enables small enterprises to obtain bank finance without offering security.

c) Repayment
A borrower has to make a periodic payment towards the repayment of the principal and interest. The pattern is
mutually agreed depending upon the needs of the borrower and the policies of the lender. Often, a combined
fixed installment is worked out, consisting of the principal as well as the interest, e.g. equated monthly
installments (EMIs).

d) Securitization
Long-term loans are not usually sold by lenders. However, if there is a legal and institutional framework
available, lenders can securitize the loan and sell in the securitized debt market.
4. Eurobonds
Eurobonds are bonds that are denominated in a currency different from that of the country in which they are
issued. They are outside the control of the country in whose currency they are denominated.

Example
Bonds denominated in Australian dollars issued in Japan, by an Australian company. These bonds, although
issued in Australian dollars, are outside the control of Australia.
Eurobonds have the following features

a) They are usually sold in different countries at a time. They are suitable for large companies and
governments.
b) The usual term of Eurobonds is 5 to 15 years. They are suitable for financing long-term investments.
c) Eurobonds are ‘bearer’ securities. Bearers of the bonds are entitled to the amount specified. This provides
anonymity to the investors, which is an attraction, especially for tax purposes. These bonds, although
unsecured can be issued only if the credit ratings are excellent. Therefore, they are reasonably safe.
However, in spite of being bearer securities, their liquidity on the secondary market is found to be relatively
limited.
d) Usually the interest rates are lower, compared to the rates on domestic bonds. This is perhaps due to the
fact that the Eurobond market is not as tightly regulated as the domestic bond markets.

5. Convertible bonds and warrants

Convertible bonds

Definition
Convertible bonds are fixed interest debt securities, which the holder can choose to convert into ordinary shares
of the company. This conversion takes place at a predetermined rate and on a predetermined date.

If conversion does not take place, the bonds will run their full life and be redeemed on maturity.

Conversion rate
The conversion rate is expressed as a conversion ratio, i.e. the number of ordinary shares to be issued in
exchange for one bond, or a part of it. Alternatively, the conversion rate is also expressed as conversions price
i.e. the price of one ordinary share that will be appropriated from the nominal value of the convertible bond.
Conversion terms may vary over time.

Example
A company issues convertible bonds of $100 each. The conversion rate may be specified as:
a) Five ordinary shares to be obtained from one bond; or
b) Each $20 of the face value of a bond will be converted into one ordinary share: or
c) If varying conversion terms are to be specified, five ordinary shares to be obtained from one bond on 1 April
20X9 and four ordinary shares to be obtained from one bond on 1 April 20Y5.

Conversion value
The conversion value is the market value of shares expected to be issued on conversion of one bond.

Conversion premium

The conversion premium is the difference between the market price of the convertible bond and its conversion
value. In other words, it is the difference between the market price of the convertible bond and the market price
of the shares into which the bond is expected to be converted.

Conversion premium = Market price of the convertible bond – Its conversion value

Example
The market value of a convertible bond is $14. It is convertible into 3 ordinary shares. Market value of one
ordinary share is $4.
Conversion premium = $14 – (3 x $4) = $2
Features of conversion premium

a) General
a) As the conversion date approaches, the market price of a convertible bond and its conversion value tend to
be equal. In other words, the conversion premium will be negligible.
b) Initially the conversion value is lower than the market value of the bond.
c) The conversion premium is proportional to the time remaining before conversion. It is highest at the
beginning and decreases so that, just before conversion, it is negligible. It is expected that the price of
ordinary shares will increases over the period and gradually reduce the conversion premium.

b) Company
a) A company will look for the greatest possible conversion premium. This will enable it to stipulate the lowest
possible number of equity shares to be issued on conversion. Investors will accept this high premium only if
they believe in the growth potential of the company and its share price.
b) Due to the presence of a conversion right, the rate of interest on convertible debentures is lower than for
ordinary or straight debentures. This makes it attractive to companies.
Rights premium
The difference between the market price of a convertible bond and the price of straight bonds with similar
terms excluding conversion is called a rights premium. Conversion into ordinary shares is a valuable right and
causes the value of convertible bonds to be higher than the value of ordinary bonds.

Test Yourself 1
Consider an 11% convertible bond, redeemable at par in six years time that can be converted into 35 ordinary
shares at any time in the next three years. Currently the bond is trading ex-interest (buying the bond does not
confer the right to receive the next interest payment) at $145.20 and the current ordinary share price is $3.55.
The ex-interest market value of ordinary bonds of a similar risk class and maturity is $129.70.
Required:
Calculate the current conversion value, current conversion premium and the rights premium.

Advantages of convertible bonds to companies

a) Convertible bonds serve a company as delayed equity: a company can delay the issue of equity or ordinary
shares and the resultant reduction in earnings per share. Similarly, if the directors feel that the company’s
share price is depressed and it is not an opportune time to issue new ordinary shares immediately, it may
issue convertible bonds.
b) The interest payable on the bonds is tax deductible. This may decrease the overall cost of capital.
c) Since interest payments are fixed, financial planning becomes easier.
d) Convertible bonds are expected to be self-liquidating. This means that cash is not needed to redeem them.
e) As stated earlier, these bonds usually carry a lower interest rate.

Disadvantages of convertible bonds to companies

a) On conversion there will be a reduction in earnings per share.

b) On conversion there may be a reduction in the control of existing shareholders.

c) Before conversion, gearing will be increased, thereby affecting the risk profile of the company.
Advantages of convertible to investors
a) A convertible bond offers the unique combination of fixed interest plus lower risk in the beginning, and the
possibility of higher gains in the long run.
b) Investors get an opportunity to participate in the growth of a company.
c) It is possible for them to evaluate the performance of a company and then decide whether to opt for a
conversion.
Warrants

Definition
The right to buy new ordinary shares in a company at a future date, at the exercise price (a fixed, predetermined
price) is known as a warrant.

Usually warrants are issued along with loan stock, in order to make the loan stock attractive. For this reason
they are also known as equity sweeteners.
Intrinsic or theoretical value of warrants is calculated as:
(Current ordinary share price – Exercise price) x Number of shares obtained for each warrant

Example
Zyco issues warrants that entitle a holder to purchase 3 ordinary shares at a price of $5.50. The price of ordinary
shares on the market is $6.00. The theoretical value of the warrants is:
(Current ordinary share price – Exercise price) x Number of shares obtained for each warrant
= ($6.00 - $5.50) x 3 = $1.50
The actual market price of the warrant may be equal to or higher or lower than the theoretical price, depending
upon the investors’ expectations about the future of the company.
In the above example, if the actual warrant price is $1.75, the warrant conversion premium is $0.25 ($1.75 -
$1.50).

Warrant conversion premium or time value

The difference between the actual market price of a warrant and its intrinsic or theoretical value is known as
warrant conversion premium or time value.
Gearing effect of warrants
The effect of changes in the price of shares on the value of warrants is proportionately higher. This is known as a
gearing effect.

Example
Continuing with the example of Zyco
If the share price increases to $7.50, the increase in the share price is $7.50 - $6.00 = 1.50. In percentage terms,
the increase is $1.50/$6.00 x 100 = 25%. The revised warrant price is ($7.50 - $5.50) x 3 = $6.00. The increase in
the warrant price is $6.00 - $1.50 = $4.50. In percentage terms, the increase is ($4.50/$1.50) x 100 = 300%.
Overall, the share price increased by 25%, whereas the warrant price increased by 300%. This is called a gearing
effect.

Advantages of warrants for the investor

a) A potential for a higher percentage of profits due to the gearing effect discussed above.
b) Low initial investment. In the example of Zyco, above an investor has to invest $1.50 for a warrant that
entitles him to 3 shares in the future. To purchase 3 shares, he would have to spend $6 x 3 = $18 today.
c) Due to lower investment, the risk of loss of investment is also lower.
Advantages of warrants for the company
a) Lower interest rate on loan stock, due to the attraction of warrants.
b) Even when security for the loan stock is insufficient or not available, it may be possible to issue them
because of the warrants.
c) In the future, when the warrants are exercised, they will lead to an actual cash inflow. This is not the case
for convertible bonds.

1.7 Lease finance

In Study Guide D6, the issue of lease finance was analyzed in detail when we considered lease vs. buy decisions.
Lease finance also serves the purpose of long-term financing. If a company wants to borrow in order to purchase
an asset in its own name, it has to provide assets as a security for the borrowing. If it lacks good assets, it may
not be able to borrow.
The title of the assets does not pass to the user in the case of leases. As a result, the asset can be repossessed by
the lessor if there is a default in the payment from the lessee. In this way, the leased asset itself serves as a
security. Hence it is possible to acquire assets on lease even when there are no suitable assets to offer as a
security, other than leased assets. This factor has made lease financing popular, especially with smaller
companies.

Advantages of leasing
1. The lessor earns a reasonable income by way of leases and gets capital allowances for the assets when
calculating tax, in the case of an operating lease.
2. Since the total amount has been paid to the supplier in the beginning, he avoids the hassle of collection.
3. The lessee can obtain an asset even when he lacks the security to obtain a bank loan. Finance leasing may be
cheaper than ordinary bank finance.
4. In the case of an operating lease, the lessee does not bear the risk of obsolescence. The lessor will have to
sell the obsolete second-hand equipment.

Benefits of leasing
Leasing can be beneficial only if the financial benefits can be shared by both the lessor as well as the lessee.
Financial benefits may accrue on account of one or more of the following:
1. Different possibilities for availing capital allowances: some companies may be tax exhausted, in the sense;
they are not in a position to utilize capital allowances. In this case it makes sense to let some other party
claim the allowance and share the benefits indirectly, for example, by reducing the lease premium.
2. Different tax structures: large and small companies may have different tax structures.
3. Different costs of capital: the cost of equity and debt funds for a large leasing company may be lower than
the cost of capital for a small company trying to raise finance from the market. Small companies may find
lease finance cheaper.

1.4 Venture capital financing

Venture capital, as the name indicates, is capital put in by investors in a relatively more risky business. The
investors take the risk knowingly, with an expectation of higher returns and/or a stake in the ownership of the
company. The risk may be due to the fact that the business is new, the product is based on a new technology
that has not yet been marketed, or a business is struggling for some other reasons.

The growth of many firms in Silicon Valley was financed by venture capitalists. The concept of venture capital
has been used successfully by venture capitalists in industrialized countries, especially in the US and the UK.
 Example
A polypropylene technology has been introduced to an African country. There are worldwide success stories.
However, it has not been tested in the country, therefore banks and financial institutions are not willing to
finance projects involving this technology.
The promoters approach a venture capital company, VC Inc. VC feels that there are prospects of good returns
and the risk is worth taking. They agree to finance the project.

The different stages VC finance may be involved in are:

1. Early stage financing
a) This may take the form of seed capital representing an investment in applied research.
b) It may also be used for a start-up, where commercial manufacturing has to commence. Finance for product
development and initial marketing may be provided by VCs, in connection with a product or service that is
being commercialized for the first time.

2. Second round financing

When a business has been in operation for some time but has still not become profitable, VCs may infuse
additional capital when the promoters are unable to do this. VC finance at this stage may be of a higher amount
but for a shorter period, compared to early stage financing.

3. Later stage financing

a) When a business is established and has shown profits for some time, but is still not in a position to raise
money from capital markets, VCs may provide the finance.
b) Finance may be provided for management buyouts.
c) VCs provide turnaround finance if good management is available to turn a company around i.e make it
profitable.

Exit router for venture capitalists

After the purpose of VC finance has been fulfilled, venture capitalists want to withdraw their investments and
the accrued gains. If the finance was in the form of equity, they can do so by selling their holdings either on the
stock market or directly to interested parties, such as promoter and employees. If the finance was in the form of
a loan, they will obtain repayments.

1.5 Preference shares

Preference shares have certain common characteristics with equity finance while their other features are similar
to debt finance.

Preference shareholders get a preference over ordinary shareholders so far as payment of dividends or
repayment of capital is concerned. However, they rank below debt holders. Preference dividends cannot be paid
unless interest on debt has been paid. Similarly, repayment of preference shares is not possible until debt
holders debts have been paid off fully. As a result, preference shares are less risky than ordinary shares but
more risky than debt. On the other hand, they are more expensive than debt and less expensive than equity.

Types of preference shares

➢ Cumulative preference shares

➢ Non-cumulative preference shares
➢ Participating preference shares
➢ Non-participating preference shares
1. Cumulative and non-cumulative
When profits for a particular period are insufficient to distribute dividends, in the case of cumulative preference
shares, the right to receive a dividend for that year is carried forward to the next year. Non-cumulative
preference shares do not provide that right. If a dividend is not paid for a particular year due to insufficiency of
profits, the dividend for that year is lost.
2. Participating and non-participating
When preference shareholders are entitled to participate in profit over and above the stipulated minimum, in
addition to getting their fixed dividend in the case of a company making excess profits, these shares are called
participating preference shares. If they do not have such a right and receive only the fixed dividend the shares
are known as non-participating.
Advantages of preference shares to a company
1. If the shares are non-cumulative the company does not have to pay a dividend if the profits are insufficient.
However, to compensate for this, shareholders expect a higher rate of dividend.
2. Since preference shareholders do not have voting rights, ownership and control is not diluted.
3. Preference shares are not secured. This means that assets are free to be offered as a security for debt.
4. Non-payment of preference dividend does not lead to liquidation proceedings.
Disadvantages of preference shares to a company
The main disadvantage for a company is that, unlike interest on debt dividend on preference shares, although a
fixed payment is not tax-deductible. This increases the already exiting cost disadvantage of preference shares.

Example
Debt finance has a market rate of 9%. Preference shares may have a higher expected rate of say 11% due to the
risk elements discussed above. Interest on debt finance is tax deductible.
For a company paying tax at 30%, the net interest cost is 9% -( 30% of 9%) = 9 – 2.7 = 6.3%, whereas the cost of
preference shares is 11%.

SAMMURY

equity finance money raised by issue of shares

loan stock and debentures

deep discount bonds and zero

coupon bonds
Debt finance institutional debt and bank
finance
institutional debt and bank
finance
convertible bonds and warrant
Lease finance
title to the asset does not pass in
Long-term sources of finance
lease finance

preference over ordinary

shareholders in payment of dividend
Preference shares preference over ordinary shareholders
in repayment of dividend
source of finance in case of
start-up companies
venture capital
involves high investment risk

generates above average profits in

future
Choosing between debt and equity

In practice, most businesses use a combination of debt and equity financing.

If the company has too much debt, it may overextend its ability to service it and can therefore be vulnerable to
business downturns and changes in interest rates. On the other hand too much equity dilutes the ownership
interest of existing shareholders.
The choice between debt and equity depends on the type of business, its age , and a number of other factors.
The following five key issues should be taken into consideration while choosing between debt and equity.

1. Risk
Risk refers to uncertainty in the business environment. The directors have to see the effects of fluctuations in
the economy on the company. If the company is sensitive to uncertain environments, the risk has to be
confirmed with regard to the company’s investment opportunities.
If the environment is uncertain and changing rapidly, equity would be a better option. This is because equity
investors may demand dividends or a portion of annual profits. On the other hand, if the company opts for debt
it will have to meet scheduled interest and principal payments regardless of the cash flow position. Although
loan terms can be negotiated to build in flexibility, ultimately the money must be paid back.

2. Cost
When a company is paying tax, debt is likely to be cheaper. This is because when paying tax, the company will be
able to take advantage of the tax shield on debt interest.
In addition, the cost of debt finance will be known in advance, as the capital element will be fixed and a fixed
rate of interest can be negotiated. This will be helpful for tax planning.
Equity is likely to be more expensive as the risk of shareholders is greater than the risk of lenders.

3. Ownership and control

Equity differs from debt in that it represents a permanent ownership stake in the company. When you finance
with equity, you are giving up a portion of your ownership interest in and control of, the company in exchange
for cash.
Major injections of capital by new shareholders can dilute the ownership and control exercised by the present
owners. Smaller family firms may prefer to take on debt in order to retain control.
On the other hand debt carries no voting rights, so the only diminution in control is imposed by the
incorporation of restrictive covenants in the loan agreement.

4. Duration
Finance raised should correspond with the use for which it is raised. If an investment is not expected to produce
profits in the early years, then equity may be preferred. However, if profits are expected from the outset then
debt may be suitable.
Similarly, it would be unwise to raise long-term debt if the investment has a short-term life span.

5. Gearing effect
With regard to debt capacity, a company’s existing gearing levels will have an impact on the perceptions (and
pricing) of potential lenders, as will the type of industry in which it operates, the nature and quality of any
security the firm can offer and the variability of its expected cash flows.
The use of debt finance also imparts a ‘gearing effect’ to shareholder profit, where an increase in the activity
and sales revenue of a given proportion will have a more than proportional impact.
The use of debt is therefore excellent when companies expand, but the reverse applies in adverse trading
conditions. The use of debt therefore can have dire consequences in a recession.
The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors.
Accordingly, a business is limited as to the amount of debt it can carry.
The decision for choosing between debt and equity also has an impact on reported profits and ratios such as
earnings per share, gearing, interest cover and dividend cover.

2. Identify and discuss methods of raising equity finance, including:(2)

i. rights issue
ii. placing
iii. public offer
iv. stock exchange listing
[Learning Outcome b]
1.2 Rights issue
Company law protects the rights of existing shareholders. It provides that any new issue of shares shall first be
offered to the existing shareholders in the ratio of their shareholdings. This preserves the existing pattern of
shareholding and control. A share issue protecting the rights of existing shareholders in this manner is called a
rights issue.

Example
A company issues rights shares on a one for three bases at $4.50. This means that the existing shareholders will
be entitled to one new share at a price of $4.50, for each 3 shares held by them.

Advantages of a rights issue

1. A rights issue involves lower costs as compared to an issue to the general public.
2. Existing shareholders are benefited in two ways:
a) Their shareholding proportion is protected, if they purchase the shares.
b) They get shares at a price lower than the market value.
3. Finance can be used to reduce gearing.

Disadvantage of a rights issue

The amount that can be raised by a rights issue is limited, when compared to a public issue. This is because the
resources available with the existing shareholders are likely to be limited.

Pricing of a rights issue

A rights issue is normally priced at a discount (of approximately 15 to 20%) on the existing market price, in order
to make the shares attractive to shareholders. This is done to provide for the variations occurring in the market
price of shares, until the time of actual issue. This makes the rights attached to the shares a valuable
commodity. However, company law usually does not permit an issue below nominal value.

Deep discount rights issue

When a company issues rights shares at a deep discount (substantial discount) to the existing market price, it
may be able to save on underwriting costs since the success of the issue would be guaranteed.

Example
The issue may be made at half of the market price.

However, a company would be under pressure to maintain the dividend rate and hence the cost of capital would
increase.

Ordinary shareholders get an offer of rights which they can exercise by buying new shares. Alternatively, they
can transfer the rights to buy shares to other investors for a consideration.
Cum-rights and ex-rights price

The rights attached to the shares are valid for a limited period. The list of shareholders is closed, as of a certain
date. Only the shareholders registered on that date are eligible to the rights issue. If the purchase of shares
entitles the buyer to the attached rights, the price on the stock market is said to be the cum-rights price. It is
higher than the price of a share without a right. After the period is over, the right is extinguished and the price of
share becomes ex-rights (i.e. it is reduced)

Theoretical ex rights price

The theoretical ex rights price is the weighted average of the cum rights price and the rights issue price.

It is calculated as:
Fair value of all outstanding shares before the exercise of rights + Total amount received from exercise of rights
=
Number of shares outstanding before exercise + Number of shares issued in the exercise

(Source: IAS 33 Earnings per share)

Example
Warnock Plc issued 3.5 million ordinary shares with a face value of $1.00. They are currently trading at $4.40 per
share. It decides to raise new equity funds, offering its existing shareholders the right to subscribe for one new
share at $2.50 each, for every five shares already held. Find out the theoretical ex-rights price.
Cum rights price $4.40
New issue price $2.50
Number of old shares 3.50 million
Number of new shares 0.7 million
Total number of shares 4.20 million

Therefore,
Theoretical ex-rights price, Pe
Fair value of all outstanding shares before the exercise of rights + Total amount received from exercise of rights
=
Number of shares outstanding before exercise + Number of shares issued in the exercise

(No. of old shares × Cum rights price) + (No. of new shares × New issue shares)
=
No. of new shares + No. of old shares
(3.50 × $4.40) + (0.70 × $2.50)
=
3.50 + 0.70

$15.40 + $1.75
=
4.2

$17.15
=
4.2
= $4.08

Value of rights

As seen earlier the rights have a value that can be detached from the shares and sold in the market. Rights are
bought and sold routinely and quotations are available in the market. The value of rights is calculated as:

Value of rights = Theoretical ex rights price – Rights issue price

The value of rights is the maximum price that a buyer is prepared to pay.
 Example
Continuing the example of Warnock Plc
The value of rights attached to 5 Warnock shares is $4.083 - $2.50 = $1.583. This is the amount the investor
could be prepared to pay in exchange for the rights attached to the five shares, as he could the pay $2.50 for a
lot of 5 shares which would be worth $4.01 on the equity market.
The value of rights can also be expressed as ‘per exiting share’ = $1.583/5 = $0.317 per exiting share.

The effect of various options on the shareholders’ wealth and proportion of equity holding
Sr. Effect on the wealth of Effect on shareholding
Option
No. shareholders proportion
1 Exercise the rights No effect No effect
2 Renounce and sell all the No effect Will be reduced, since the
rights purchaser of rights will exercise
them and apply for shares
3 Renounce and sell part of the No effect Will be reduced to the extent of
rights, and exercise the the renounced part
remaining
Will be reduced, unless the stock
exchange rules make it mandatory
4 DO nothing for the company to sell them to new Will be reduced
subscribers, for the benefit of the
shareholders who were entitled to
the rights

Example
Using data from the example of Warnock, above calculate the effect on the shareholders wealth if he holds 500
shares and:
➢ sells 40% of rights and exercises the remaining 60%
➢ sells all the rights
➢ does nothing
1. If the shareholder sells 40% of the rights and exercises the balance
$ $
a) The value of shares cum right and the additional investment
Value after announcement rights cum rights (500 x $4.40) 2,200
Additional investment (1/5 x 500 x 60% x $2.50) 150 2,350

b) Sale proceeds of rights (500 x 40% x $0.3167) 63

Market value of 560 shares ex rights (@$4.0833) 2,287 2,350
There is no effect on the shareholder’s wealth.
2. If the shareholder sells all the rights
$ $
a) Cum rights price of 500 shares (500 x $4.40) 2,200

b) Sale proceeds of rights (500 x $0.3167) 158

Market value of 500 shares ex rights (@$4.0833) 2,042 2,200

There is no effect on the shareholder’s wealth.

3. If the shareholder does nothing
$ $
a) Cum rights price of 500 shares (500 x $4.40) 2,200

b) Market value of 500 shares ex rights (@$4.0833) (2,042)

Loss in wealth 158
The shareholder’s wealth decreases by $158.
The actual market price after a rights issue depends upon the expected rate of earning on the new funds:
1. If the rate of earning on new funds is expected to be the same as that on old funds, the actual market price
is likely to be the same as the theoretical ex rights price.

Example
The current market value of one share of Distribute Ltd is $10. The current rate of earning is 15%. The company
decided to raise new funds through rights issue. The rate of earning expected on the new fund is 15%. Hence,
the actual market price of the share after the rights issue will be $10.

2. If the rate of earnings on new funds is expected to be higher than that on old funds, the actual market price
is likely to be higher than the theoretical ex rights price.

Example
Continuing the example of Distribute Ltd
Assume that the rate of earning expected on the new fund is 20%. In such a case, the actual market price of the
share after rights issue will be more than $10.

3. If the rate of earnings on new funds is expected to be lower than on old funds, the actual market price is
likely to be lower than the theoretical ex rights price.

Example
Continuing the example of Distribute Ltd
Assume that the rate of earning expected on the new fund is 10%. In such a case, that actual market price after
rights issue will be less than $10.

See the income-based share valuation models covered in Study Guide G2.
Effect of the rights issue price on the EPS
Depending upon how the issue price or rights shares compares with the capital employed per share before the
issue, the EPS will be affected as follows:
1. If the rights issue price is the same as the capital employed per share before the issue, the EPS will not be
affected.
2. If the rights issue price higher than the capital employed per share before the issue, the EPS will increase.
3. If the rights issue price is lower than the capital employed per share before the issue, the EPS will be
decreased (diluted)

Example
Disperse Inc has 10,000 outstanding shares. The capital employed by the company is $200,000. Hence, the
capital employed per share is $20 ($200,000/10,000).
The company has decided to make a rights issue to raise $50,000. The rate of return on capital employed is 10%.
The current earning of the company is $20,000 and the current EPS is $2 ($20,000/10,000).
The total earning of the company after the rights issue will be $25,000 (($200,000 + $50,000) x 10%).
i. If the company issues shares at $20 then the company will have to issue 2,500 shares. In such a case the
total outstanding shares of the company would be 12,500 shares. The new EPS of the company would be $2.
ii. If the company issued shares at $25 then the company will have issue 2,000 shares. In such a case the total
outstanding shares of the company would be 12,000 shares. The new EPS of the company would be $2.08.
iii. If the company issued shares at $10 then the company will have issue 5,000 shares. In such a case the total
outstanding shares of the company would be 15,000 shares. The new EPS of the company would be $1.67.

Test Yourself 1
Ashely Plc can achieve a profit after tax of 22% on the capital employed. The present capital structure is as
follows:

$
275,000 ordinary shares of $1 each 275,000
Retained earnings 125,000
It is proposed by the directors to raise an additional $155,000 from a rights issue. The current market price is
$2.20.

Required:
1. Calculate the number of shares that must be issued if the rights price is $1.90, $1.80, $1.60, $1.40.
2. Calculate what the diluted EPS will be in each case.

2.2 Placing

An issue of equity shares is ‘placed’ by the company to a number of institutional investors. This is done through
a broker, before the issue takes place. The general public is not approached. This is a low risk and low cost way
of issuing shares. Generally the issue is underwritten. In this way a company’s shares are distributed to the
institutional investors. This is also known as a private placement.
This method is suitable for smaller issue sizes. The costs of these issues such as advertisement, marketing and
underwriting are not justified by the issue size. In fact, there may be some statutory limits on the maximum
amount that can be raised from an issue.
Placing issues dominate the Alternative Investment Market, which is an alternative to a stock exchange and is
suitable for smaller issues.
2.3 Public offer

Definition
A public offer refers to the process in which a company offers its shares for sale to the public. A public offer
allows the public to become involved in the company and also to gain a perception of its value.

Different types of Public offers

1. Offer for sale at a fixed price

Shares are offered at a fixed price to the public. The price is determined by the company in consultation with the
sponsor and the broker who also helps to manage the issue.

The issue price is decided in such a manner that it is attractive to the shareholders, as it is lower than the market
price. At the same time it is not so low that it increases the number of shares and dilutes the EPS by a high
margin.

The issue is underwritten so that the company can be confident of the success of the issue. The underwriters
subscribe to the shares that are not taken up by the public.
2. Offer for sale by tender

A minimum price is decided. The public is invited to bid for the shares at a price that is equal to or above this
level. After the offers have been received, a ‘striking price’ is determined. A striking price is that ensures that all
the shares on offer are sold.

3. Intermediaries offer

Intermediaries such as members of the London Stock Exchange initially purchase all the shares. Subsequently,
these intermediaries pass on the shares to their clients. This ensures that the shares of the company are widely
distributed. This method is quicker and cheaper compared to offering the shares for sale at a fixed price. Offers
for sale are generally for much larger amounts than the placing.

2.4 Stock exchange listing

What is stock exchange listing?

A stock exchange listing means getting shares or other securities included in an official list that lists the
securities which are permitted to be traded on the stock exchange. It is granted by the stock exchange. In some
places, there may be a separate listing authority to grant the listing.

There are certain requirements that a company must comply with to obtain and keep a listing.

Example
1. A commitment to abide by the regulations contained in the rule book (known as the purple book in the UK).
2. Publication of a prospectus containing forecasts and other information to enable investors to make proper
decisions.
3. Fulfillment of minimum market capitalization norms.
4. Submission of audited published accounts.
5. Ensuring that a certain minimum proportion is held by the public, before trading in shares can begin.

Why do companies seek listing?

There are numerous advantages to getting a company’s shares listed on a stock exchange.
1. Access to finance
Once a company is listed on the stock exchange, it is subject to the rules and regulations of the exchange and is
generally subject to a public scrutiny. There is more accountability and improved corporate governance. This
improves the image and credibility of the company.
a) Institutional investors are ready to put large amounts of money into the equity of a listed company on a
long-term basis.
b) Since the company’s risk profile is lowered, it is possible for it to obtain debt at a lower cost of capital.
c) Listing enables the company to access the wider pool of finance from the general public.
d) Listing provides easy marketability and liquidity to the company’s shares. As a result, more investors, both
institutional as well as retail are attracted to the company’s shares.

2. Better image

Generally, the image of the company improves. This is beneficial in its dealings with various parties. The
negotiating power of the company may increase in its dealings with suppliers.

3. Releasing capital for other uses

Promoters or venture capitalists may be interested in withdrawing their capital partially or fully. Listing provides
them with an opportunity of doing so.
4. Possibilities of acquisition and growth

Listed companies are better placed to make offers to the shareholders of a target company than unlisted
companies.

Disadvantages of listing shares on the stock market

1. Increased public scrutiny of the company

The general public, financial analysts and potential investors will scrutinize the company’s reports closely before
taking decisions.
2. Possibility of dilution of control
If the company performs poorly, it may be a target for a corporate takeover. Dissatisfied shareholders may sell
their shares to a bidding company.
3. Increased costs
There are costs for initially obtaining the listing as well as subsequently retaining the listing. Initially, lawyer’s
fees, listing fees, sponsor’s fees, reporting accountant’s fees and similar expenses need to be met. Thereafter,,
annually, increased costs of reporting detailed financial data are to be incurred, as compared to unlisted
companies.
Stock exchange introduction
A stock exchange introduction indicates that a quotation is made available to the exiting shares of a company
without any new issue of shares. In other words, the existing shares of a company can start trading on the stock
exchange. The stock exchange listing is granted if the exchange finds that the shares in a large company are
already widely-held and a market for the shares exists.
2.5 Alterations in the capital structure of a company without raising new equity funds
1. Scrip issue or bonus issue
This involves converting the reserves exiting in a company’s SOFP into additional shares and issuing them to the
existing shareholders in proportion to their share holdings. This is only an accounting entry that does not involve
any funds generation i.e. no cash is raised.

Example
Existing share capital is $1m represented by 1m shares of $1 each. Reserves are $3m. A 1:2 bonus issue is made.
For every two share held, one new share is issued. The total bonus amount is $0.5m. This amount will be added
to the share capital and reduced from the reserves. A total of 500,000 shares will be issued to the existing
shareholders. This is beneficial for shareholders as it allows them to increase their shareholding at no additional
cost.

2. Share split
The nominal value of shares is split into shares of a smaller denomination. At the same time, the number of
shares is increased so as to keep the SOFP value of share capital unchanged.

Example
A company has an issued share capital of $5m represented by 500,000 shares of $10 each. Each share of $10 is
split into 10 shares of $1 each. In this case, the share capital will still be $5m, but represented by 5m shares
(500,000 x 10) of $1 each.

The logic behind share split: The following theories are forward by researchers:
a) Ease of trading due to smaller nominal value. This improves marketability of shares.
b) Positive effect on the shareholders’ wealth. This may be due to the fact that the share split decision is seen
as a positive signal by investors regarding the future outlook of the company.
However, these reasons are yet to be conclusively proven.
3. Scrip Dividends
Shares are issued as a partial or total alternative to cash for discharging the dividend responsibilities of a
company. Share capital is increased and the retained earnings are reduced. As far as accounting is concerned,
this is similar to a bonus issue. This option allows ordinary shareholders to increase their shareholdings without
incurring dealing costs.
Diagram 2: Alterations in the capital structure without raising new finance

Alterations in the capital structure without

raising new finance

Scrip issue / Share split

Bonus issue Scrip dividends

Tax impact
For taxpaying shareholders, it makes no difference whether they accept cash or scrip’s as a dividend. However,
for non tax-paying shareholders, it makes a difference. In the case of cash dividends, the shareholders can
reclaim the tax paid by the company. This is not possible in the case of scrip dividends.
2.6 Share repurchases
This is an outflow, rather than an inflow of finance. Provided that the procedures and limits stipulated by local
company law are followed, a company can repurchase its own shares. Payments for these purchases can be
made only out of divisible profits. To ensure that the share capital is not reduced so as to endanger the security
available to the creditors and other shareholders, repurchases are strictly regulated.
The law normally stipulates the maximum limits up to which shares can be repurchased, such as, 25% of paid up
equity capital and reserves.
Reasons behind the repurchase of shares:
1. Value of the remaining shares will increase.
2. Return on capital employed will increase.
3. Earnings per share will increase.

Example
Jubilant Inc has 10,000 shares outstanding. The shares are trading at $1.00 on the stock exchange. The company
employs $50,000 as capital and $2,000 as reserves. The company expects $5,000 as net profit for the current
financial year.
Here,
The return on capital employed is 9.61% (($5000/$52,000) x 100).
The earnings per share is $0.50 ($5,000/10,000).
The company decides to buy 2,000 of its outstanding shares.
Now,
The number of outstanding shares are 8,000 (10,000 – 2,000).
The return on capital employed is 10% (($5000/$50,000) x 100).
The earnings per share is $0.63 ($5,000/8,000).
An increase in earnings per share will result in an increase in the market value of the remaining shares.
2.7 Relative advantages of debt and equity

1. Advantages of debt financing

a) There is no need for an owner to give up any ownership of future profits of his business. The lender has no
control in how the business is managed. He is only concerned with repayment of the loan.
b) Borrowed money will help in obtaining business assets, it will enable business profits to remain in the
company, or ensure that the profits are used to pay a return to the owners of the company.
c) Interest paid on the loan is generally tax deductible.

2. Disadvantages of debt financing

a) The company must have sufficient cash flows to repay its loans.
b) Generally, cash profits are used to pay back the loans. If the business has a lot of debt, it may end up with a
profit, but not have any cash to show for it.
c) Having to dealing with the lenders and their criteria to obtain the loan.
d) The riskier the loan is, the higher the interest rate will be.
e) Most lenders will require small business loans to be co-signed or guaranteed by the owner(s) of the
business.
f) Loans usually require collateral for them to be secured. If the loan cannot be repaid, the lender has the right
to seize the collateral.
g) Too much debt may impair the credit rating and the ability to raise money in the future.

Equity is money that is received in exchanged for a share of ownership in the business.

3. Advantages of equity financing

a) Equity contributions do not have to be paid back even if the company goes bankrupt.
b) The business assets do not have to be pledged as collateral to obtain equity investments.
c) Business with sufficient equity will look better to lenders, investors and so on.
d) The business will have more cash available because it will not have to make debt payments.

4. Disadvantages of equity financing

a) The company has to relinquish ownership and a share of the business’s profits to other equity investors.
b) Other owners may have different ideas on how the business should be run.
c) Dividend payments to investors in companies are not tax deductible.

Debt-to-Equity Ratio

A company’s debt-to-equity ratio is the business’s total debt divided by the business’s total equity. Lenders and
potential investors will look at this figure to determine if a business is operating efficiently. If the debt-to-equity
ratio is too high (i.e. the business is carrying too much debt) lenders will view the business as high risk and the
owners may have trouble obtaining new financing. Also, if a business has too little equity, lenders may question
how committed the owners are to the business.

A debt-to-equity ratio that is too low usually indicates that the business is not using its cash and profits
effectively to obtain business assets. This may discourage investors because it will mean that less profits are
distributed to them.

Lenders generally consider an acceptable debt-to-equity ratio to be anything lower than 3:1. If your ratio is
higher than 3:1, a lender may consider your business too risky to lend money. However, the industry you
operate in will be taken into consideration. Businesses in certain industries (such as real estate and banking)
operate with ratios significantly higher than 3:1.
 SAMMURY purchase additional shares on
the company

invitation to existing shareholders

rights issue
new share issue offered to
institutional investors
company

not open to general public

placing
company offers its shares for
Methods of raising equity finance
sale to general public
public offer
means getting shares or other
securities included in an official
list of securities which are
permitted to be traded on the
stock exchange
stock exchange listing

Answers to Test Yourself

Answer to TY 1p
$20.95/35 shares
Current conversion value = 35 x 3.55 = $124.25
Current conversion premium = $145.20 - $124.25 = $20.95 or 60c per share.
Current rights premium = $145.20 - $129.70 = $15.50 or 44c per share.

$15.50/35 shares
Answer to TY 2
The earnings at present are 22% of $400,000 = $88,000
This gives an EPS of 32c.
The earnings after the rights issue will be 22% of $555,000 = $122,100
Rights No. of new shares Total Shares EPS ($122,100/Total Dilution
price ($155,000/rights (275,000 + No. of No. of shares) (cents)
$ Price) New shares) (cents)
1.9 81,579 356,579 34.2 2.2
1.8 86,111 361,111 33.8 1.8
1.6 96,875 371,875 32.8 0.8
1.4 110,714 385,714 31.7 (0.3)

It is necessary to understand that, at a high rights price, the EPS increases, and does not get diluted.
The breakeven point or zero dilution occurs when the rights price is equal to the employed share capital i.e.
400,000/275,000 = $1.45

Quick Quiz
1. What are the uses to which long-term finance is put?
2. If lower returns on capital invested are expected compared to the interest rates on debt finance, the
easy way out is to opt for equity finance, since there is no fixed dividend. True or false?
3. What is the difference between deep discount bonds and zero coupon bonds?
4. The market value of a convertible bond is $24. It is convertible into 5 ordinary shares. The market value
of one ordinary share is $4. What is the conversion premium?
5. The current ordinary share price is $9. A warrant attached to the share entitles the holder to purchase 4
shares at $7 each. Find out the theoretical value of the warrants.
6. What is a stock exchange introduction?
7. A company making a relatively small issue of shares worth $1m has two options: either placing or a public
offer. Which one would you recommend and why?

Answers to Quick Quiz

1. Long-term finance is used for the following purposes:

➢ purchase on non-current assets
➢ expansion of facilities
➢ large scale construction projects
➢ purchase of permanent current assets
2. True
3. Deep discount bonds are bonds that are issued at a large or ‘deep’ discount and are redeemable at par or at
a premium. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead,
investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will
be worth when it “matures” or becomes due.
4. Conversion premium = $24 – (5 x $4) = $4
5. Theoretical value of warrants = (Current ordinary share price – Exercise price) x Number of shares
obtained for each warrant = ($9.00 - $7.00) x 4 = $8.00
6. A stock exchange introduction indicates that the company can now start trading its existing shares on the
stock exchange, without any new issue of shares. The stock exchange listing is granted if the exchange finds
that the shares in a large company are already widely-held (usually 25% of shares publicly held) and a
market for the shares exists.
7. The best option for the company for making an issue worth $1m would be to choose the placing option
because this method is suitable for smaller issue sizes. For small issues, the costs of issue such as
advertisement, marketing and underwriting are not justified by the issue size.

Self Examination Questions

Question 1
A company wants to raise long-term finance. It has a debt equity ratio of 2:1. Advise the company on:
a) General advantages and disadvantages of equity and debt financing.
b) Given the debt equity ratio, what are the options the company can consider?

Question 2

Lambert Co issued 8% convertible debentures. The conversion is due in 3 years. One debenture of $100 is
presently quoted at $130. Each debenture will be converted into 25 ordinary shares. The market price of a share
is $5.00. Stephen is considering buying the debentures in Lambert Co. He targets a 10% compounded rate of
return over the next three years. The recent trend shows that an 8% growth can be expected in the price of
ordinary shares.

Advise Stephen whether or not he should the buy debentures.

Question 3

A company provides you the following details

20X7 20X8 20X9

$ $ $
Profit attributable to ordinary equity holders of the parent entity 2,200 3,000 3,600

Shares outstanding before rights issue: 1000 shares

Rights issue
One new share for each four outstanding shares (250 new shares in total)
Exercise price: $10.00
Date of rights issue: 1 January 20X8
Last date to exercise rights: 1 March 20X8
Market price of one ordinary share immediately before exercise on 1 March 20X8: $22.00
Reporting date: 31 December
Required:
Calculate the EPS for the years 20X7 to 20X9.
Question 4
Kylie Fashions is a large retail chain. It provides fashion garments for the UK market. After extensive research, it
was concluded that Kylie Fashions has a wide scope to establish their business in China. In order to expand the
business, the directors of the company decided to enter into the Chinese market.
In order to raise sufficient finance for the proposed expansion, the directors decided to make a right issue. The
current share price is $16 per share. The company makes a right issue of 1 for 3 at $12 per share.
Calculate:
a) The ex-rights market value
b) The value of right
c) Wealth of Ms.Julie if she takes up half the rights and sells the other half on the 1200 shares held by her.

Question 5

Discuss the factors that need to be considered while making the financing decision between debt and equity.

Question 6

Describe the circumstances in which a business might seek venture capital finance.

Question 7

Briefly explain why convertibles might be an attractive source of finance for companies.

Question 8

Glorious Plc is a Scottish manufacturer of golf clubs. The company has decided to purchase an existing golf club
manufacturer in the State of Florida, USA. The purchase will cost an agreed $60 million for noncurrent assets
and equipment, and in addition $2 million of working capital will be needed. No additional external funding for
the proposed US subsidiary is expected to be needed for at least five years, and sales from the subsidiary would
be exclusively to the US market. Glorious has no other foreign subsidiaries and the company’s managers are
considering how to finance the US investment. Glorious’s bank has advised that taking into account Glorious’s
credit rating, the following alternatives might be possible, with finance available up to the amount shown:

i. A one for five rights issue, at a price of 300 pence per share. Underwriting and other costs are expected to
be 3% of the gross amount raised.
ii. Five year Sterling 6% fixed rate secured bank term loan of up to £40 million, initial arrangement fee 2%.
No currency swaps are available other than those shown. Currency swaps would involve swapping the principal
at the current spot exchange rate, with the reversal of the swap at the same rate at the swap maturity date
$US LIBOR is currently 3%.
Spot One year forward
$/£ 1.8059 – 1.9082 1.8256 – 1.8286
Glorious’s current SOFP is summarized below:
Particulars £m £m
Non-current assets 117.8
Investments 8.1
Current assets 98.1
Creditors: amounts falling due within one year
Loans and other borrowings (38.0)
Other creditors (48.6)
137.4
Creditors: amounts falling due after more than one
Year
Medium and long-term bank loans 30.0
8% Bond 20X9 (par value £100) 18.0 48.0
Capital and reserves
Ordinary shares (25 pence par value) 20.0
Reserves 69.4
137.4

Glorious’s current dividend per share is approximately 5% per year. The company’s current share price is 320
pence.
Interest payments on debt financing may be assumed to be made annually at the end of the year. Corporate tax
in the UK, USA is at a rate of 30%. Issue costs and fees such as swap fees are not tax allowable.
Required:
Discuss and evaluate the two sources of finance, and provide a reasoned recommendation of which source
Glorious should use.
Answers to Self Examination Questions
Answer to SEQ 1
a) The advantages as well as the disadvantages of debt and equity financing are listed as follows:
Advantages of debt financing
1. There is no need for an owner to give up any ownership or future profits of his business. The lender has no
control in how the business is managed. They are only concerned with the payment of the loan.
2. Borrowed money will help in obtaining business assets, it will allow us to keep the business profits in the
company or use the profits to pay a return to the owners of the company.
3. Interest paid on the loan is generally tax deductible.

Disadvantages of debt financing

1. The company must have sufficient cash flows to repay its loans.
2. Generally, cash profits are used to pay back the loans. If the business has a lot of debt, it may end up with a
profit but not have any cash to show for it.
3. Dealing with the lenders and their criteria to obtain the loan.
4. The riskier the loan, the higher the interest rate will be.
5. Most lenders will require small business loans to be co-signed or guaranteed by the owner(s) of the
business.
6. Loans usually require collateral to secure them. If the loan cannot be repaid, the lender has a right to seize
collateral.
7. Too much debt may impair the credit rating and ability to raise money in the future.
Advantages of equity financing
1. Equity contributions do not have to be paid back even if the company goes bankrupt.
2. The business assets do not have to be pledged as collateral to obtain equity investments.
3. Businesses with sufficient equity will look better to lenders, investors and the IRS.
4. The business will have more cash available because it will not have to make debt payments.

Disadvantages of equity financing

1. The company has to relinquish ownership and a share of the business’s profits to other equity investors.
2. Other owners may have different ideas on how the business should operate.
3. Dividend payments to investors in companies are not tax deductible.
b) The debt equity ratio acceptable to investors varies according to the economy and the industry. Depending
upon the company’s financing strategy and the current debt ratio; the company can afford to increase its
debt finance if its ROCE is higher than the rate of interest it offers on its debt finance. In this way the
company can increase the returns per share.

Answer to SEQ 2

The value of one debenture is $130. That is the outflow today. Stephen would receive $8 interest per annum. If
we discount these figures @10% we would get the net present value of these cash flows.
The present value of cash flow is as follows:
Year Cash flow Discount factor Present value
@10%
0 (130) 1.000 (130)
1 8 0.909 7.27
2 8 0.826 6.61
3 8 0.751 6.01
(110.11)

Now, let us calculate the money value of the shares after 3 years, and check if their present value exceeds the
present value of the net outflow above.
$
The current market price of 25 shares = 25 x $5 125.00
The money value after three years would be: = $125 x 1.083 157.46
The present value of this amount @10% discount factor = $157.46 x 0.751 118.25
Since the present value of the proceeds on conversion is
Higher, Stephen should buy the debentures. His gain is = $118.25 - $110 8.25

Answer to SEQ 3
Calculation of theoretical ex-rights value per share
Fair value of all outstanding shares before the exercise of rights + Total amount received from exercise of rights
=
Number of shares outstanding before exercise + Number of shares issued in the exercise

($22.00 x 1,000 shares) + ($10.00 x 250 shares)

=
1,000 shares + 250 shares
$22,000 + $2,500
=
1,250 shares
$24,500
=
1,250
Theoretical ex-rights value per share = $19.60
Calculation of adjustment factor

Fair value per share before exercise of rights $22.00

= = 1.12
Theorecitcal ex − rights value per share $19.60
Calculation of basic earnings per share

20X7 20X8 20X9

$ $ $
20X7 basic EPS as originally reported
$2,200
=
1,000 shares 2.20
20X7 basic EPS restated for rights issue
$2,200
=
1,000 shares x 1.12 1.96
20X8 basic EPS including effects of rights issue

$3,000
=
(1,000 x 1.12 x 2/12) + (1,250 x 10/12)

$3,000
=
186.67 + 1041.67

$3,000
= 2.44
1,228.34
20X9 basic EPS
$3,600 2.88
=
1,250 shares

Answer to SEQ 4
a)
Shares Value
$
Current holdings 3 48
Rights 1 12
4 60

New market value

60
=
4
= $ 15 per share
b) Value of rights
$
Market value 15
Cost 12
3

c) Wealth of Ms Julie if she takes up half the rights and sell the other half on the 1200 shares held by her:
Current wealth = Number of shares x price per share
= 1,200 x $16
= $19,200
New wealth
Number of shares 1,200
Shares under rights issue 1/3 400
Total 1,600

$ $
Value of shares after rights issue 21,000
= 1,200 + (1/2 x 400) x $15
= 1,400 x $15
Sale of half rights
= 200 x 3 600
Cost of rights
= 200 x 12 (2,400) (1,800)
New net wealth 19,200

Answer to SEQ 5
The following key issues should be taken into consideration while choosing between debt and equity.
➢ Risk
Risk refers to the uncertainty in the business environment. The directors have to see the effects of fluctuations
in the economy on the company. If the company is sensitive to the uncertain environment, the risk has to be
confirmed with regard to the company’s investment opportunities.
If the environment is uncertain and fluctuating, the equity option would be better than debt. This is because
equity investors may demand dividends or a portion of the annual profits. On the other hand, the company will
have to meet the scheduled interest and principal payments regardless of the cash flow position. Although loan
terms can be negotiated to build in flexibility, ultimately the money must be paid back.
➢ Cost
When the company is paying tax, debt is likely to be cheaper. This is because when paying tax, the company will
be able to take advantage of the tax shield on debt interest.
In addition, the cost of debt finance will be known in advance, as the capital element will be fixed and a fixed
rate of interest can be negotiated. This will be helpful for tax planning.
Equity is likely to be more expensive as the risk of shareholders is greater than the risk of lenders.
➢ Ownership and control
Equity differs from debt in that it represents a permanent ownership stake in the company. When you finance
with equity, you are giving up a portion of your ownership interest in, and control of the company, in exchange
for cash.
Major injections of capital by new shareholders can dilute the ownership and control exercised by the present
owners. Smaller family firms may prefer to take on debt, in order to retain control.
On the other hand, debt carries no voting rights, so the only diminution in control is imposed by the
incorporation of restrictive covenants in the loan agreement.
➢ Duration
Finance raised should correspond to the use to which it is put. If the investment is not expected to produce
profits in the early years, then equity may be preferred. However, if profits are expected from the outset then
debt may be suitable.
Similarly, it would be unwise to raise long-term debt if the life span of the investment is short-term.
➢ Gearing effect
With regard to debt capacity, a company’s existing gearing levels will impact the perceptions (and pricing)
potential lenders, as will the type of industry in which it operates, the nature and quality of any security the
borrower can offer and the variability of its expected cash flows.
Use of debt finance also imparts a ‘gearing effect’ to the shareholder profits, under which an increase in active
and sales revenue of a given proportion will have a more than proportional impact.
The use of debt is therefore excellent when companies expand, but the reverse applies in adverse trading
conditions. The use of debt, therefore, can have dire consequences in a recession.

Answer to SEQ 6
Venture capital, as the name indicates is capital put in by investors in a relatively more risky business. The
investors take the risk knowingly with an expectation of higher returns and/or a stake in the ownership of a
company. The risk may be due to the fact that the business is new, or the product is based on a new technology
that has not yet been marketed or that a business is struggling for some other reason.
The following are the circumstances where a business will need venture capital finance:
➢ Future expansion
➢ Research and development
➢ Business combinations
➢ Starting up the company

Answer to SEQ 7
The company can benefit from many advantages by financing through convertible debentures:

➢ Raising low cost capital

One of the advantages of issuing convertible debentures is that they can provide immediate finance at lower
costs since the conversion option effectively reduces the interest rates payable. By raising finance from this
source, a company can use the lower cost of capital during the initial stage of investment when its effect is not
fully reflected in the earnings.

➢ Represent attractive investment

The primary purpose of issuing convertible debentures is to make the issue attractive enough so that it is fully
subscribed. Convertible represent attractive investments to investors since they are effectively debt risks for
future equity benefits. Hence, finance is raised relatively easily.

➢ Deferred equity financing

By issuing a convertible debenture, the company can defer the equity financing i.e. the company sells ordinary
shares in the future.

➢ Cash flow
If the investors are ready to convert their debentures, the company can avoid cash flow problems associated
with the repayment of debentures, if any. If the company’s assumptions regarding the conversion of debentures
turn out to be true, then the company need not establish a large sinking fund to redeem the debentures.

➢ Higher gearing levels

Convertibles allow for lower gearing levels than would otherwise be the case with straight debt (interest costs
are potentially lower with convertibles).
Answer to SEQ 8
Since the subsidiary would generate dollar cash flows, it would be rational to finance the acquisition in dollars in
order to achieve a ‘natural’ foreign exchange hedge. The repayment of principal and servicing of interest would
be made from dollar cash flows generated by the subsidiary.
The company would need $60 million for noncurrent assets and $2 million for working capital, which requires
total financing of $62 million. This translates to £34.33 million at the current spot exchange rate of 1.8059.
Since a major proportion of the borrowing is for the purpose of acquiring long-term noncurrent assets, it would
not be appropriate to finance these with short-term funds. Short-term finance, such as dollar commercial paper,
should ideally be obtained for financing the working capital requirement.
Rights issue
An equity issue involves high risk for the investors as compared to debt finance and does not offer tax relief to
the company on dividend payments. Also equity finance is an expensive source of finance. The current cost of
equity can be estimated using the dividend growth model as follows.
D0 (1 + g)
Ke = +g
P0
Where,
D0 = Current dividend
P0 = Current ex dividend market price of the share
g = Expected future growth rate of dividends

Therefore,
24(1.05)
Ke = + 0.05 = 0.1288 or 12.88%
320

Since the rights issue price below the current market price, the cost of capital could increase consequent to the
rights issue.
The proposed rights issue would entail issue of 16 million (80m/5) new shares at 300 pence each. This translates
into a total of £48 million which after deducting the issue costs of 3% results in a net amount of £46.56 million
being raised from the issue. This would be higher than the funds that are needed (£34.33 million).

£34.33 x 103/100 = £35.36/3.0 = 12m

Therefore the company should approximately issue 12 million new shares to finance the US subsidiary.
However, rights issue would involve currency risks and a longer lead time compared to other sources of finance.
Fixed rate loan
Since the fixed rate secured bank term loan is up to £40 million, it would be sufficient to meet the entire
borrowing requirements of the company. Since the initial fees are 2%, the company will have to raise
approximately £35.03 million (£34.33m/0.98).
The post tax Sterling cost of £35.03 million can be estimated as follows:

£35.03 x 2% issue costs £35.03 x 6% interest

2.102(1 − 0.3) 2.102(1 − 0.3) 2.102(1 − 0.3) 35.03

35.03 = 0.7006 + d
+ d 2
…+ d 5
+
1(1 + k ) (1 + k ) (1 + k ) (1 + k d )5
Using trial and error and assuming 5% as the interest rate

5% interest £m 2.102 x (1-0.3)

PV annuity 1.471 x 4.329 (Cumulative PVF) 6.368
PV 35.03 x 0.784 (PVF for year 5) 27.464
Fee (35.03 x 0.02) 0.701
34.533

Since the calculated figure is close to the principal amount of £35.03m, it can be concluded that Sterling after tax
cost of debt is marginally above 5%. However, currency risk would still remain in the fixed rate loan option.
Conclusion
Glorious could potentially use both the sources of borrowing for financing the investment. The company could
consider financing some part of the investment through the rights issue if it does not want to increase its
existing gearing ratio.