BRUNEL UNIVERSITY LONDON

Department of Economics and Finance

EC2024A LECTURE

Sources of Long-term Finance : Equity Finance

Reading: Recommended:
Hillier Chapter 7 (only Sections 7.2 & 7.3) & Chapter 14
Supplementary:
Arnold Chap 6
Pike and Neale Chap16
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(1) DISTINCTION BETWEEN DEBT AND EQUITY FINANCE

Equity finance: Capital paid into or kept in the business by shareholders -

the owners of the firm. It is long term capital and carries the greatest risk
and attracts the highest returns.

Debt finance: Money invested in the business by third parties, usually for a
shorter period of time than equity and carrying a lower risk and lower
return.
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(2)TYPES OF COMPANY FINANCE

Table 1 Sources of new finance for U.K. companies

-----------------------------------------------------------------------------------------------------
Retained Ordinary Debentures & Bank and
Profits Shares Preference other Total
Shares Borrowings Finance
(%) (%) (%) (%) (£bn)
-----------------------------------------------------------------------------------------------------
t-4 64 10 5 21 51.4
t-3 56 18 5 21 75.0
t-2 49 5 4 42 90.4
t-1 44 2 6 48 86.8
t 51 4 5 40 68.0

Average
t-4 to t 53 8 5 34
-----------------------------------------------------------------------------------------------------
Source: Financial Statistics

Finance can be generated both 'internally' and 'externally.'

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(3) MAIN FACTORS TO CONSIDER WHEN RAISING FINANCE

(i) Risk

(ii) Ownership

(iii) Duration

(iv) Debt Capacity

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(4) EQUITY FINANCE

Equity finance represents a stake in the ownership of the firm.

(5) ORDINARY SHARES

Ordinary share capital is the main source of equity finance.

An equity interest in a company represents a 'share' of the company's assets

and a share of any profits earned on those assets 'after other claims have
been met.' Thus, shareholders are the owners of the business.

The shareholders have no power to ask the company to return their original
stake. To regain the money invested they must either find a buyer for their
shares on the stock market at the going market price, or force the company
into liquidation.

Shareholders carry full rights to participate in the business on matters

concerning the company through voting in the general meeting.
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They are entitled to payment of a 'dividend' out of profits and repayment of

capital in the event of liquidation 'only after all other claims have been
satisfied.'

Thus, equity shareholders are the last to have their claims met by the
company; all other interests - employees, creditors, and holders of
debentures (bonds) - come before them.

Therefore, the ordinary shareholders bear the greatest risk, but also enjoy
the benefits of corporate success in the form of higher dividends and/or
capital gains - but only after all other interests have been settled.

To compensate them for bearing this risk, shareholders expect a higher rate
of return than that on more secure forms of investment.
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(6) PREFERENCE SHARES

Preference shares are really hybrid securities, falling between equity and
debt (debentures).

Their debt feature arises because they usually entitle their holder to a fixed
rate of dividend from the company each year in the event of profits being
earned. Like ordinary shares, in a bad year, no profits  no dividend
(although it can be paid out of accumulated reserves.)

Preference shares usually carry no voting rights, except in the event of

liquidation.

They have preferential rights over ordinary shareholders regarding

dividends and ultimate repayment of capital  preference shareholders
receive their fixed percentage dividend before ordinary shareholders.

Preference shareholders are part-owners of the company since they

participate in the appropriation of the profits of the business.
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This is unlike debenture (debt) holders whose interest payments must be

met irrespective of whether the company has made a profit or not.

Thus, debenture holders cannot be regarded as part-owners of the company

and because of this they are treated differently for tax purposes.

Debenture interest is a tax-deductible expense and therefore reduces the

company's tax bill.

Preference dividends are not tax deductible since the tax is paid on the
profits figure before the preference dividends have been deducted.

Thus, on the face of it, it appears that for a company raising LTF, it is
cheaper to use debentures (i.e. debt finance/borrowing) than preference
shares (i.e. equity finance.)
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Preference dividends may be termed cumulative - in which case the

shareholders right to a dividend is carried forward in the event of profits
being insufficient in any one period - or non-cumulative.

With participating preference shares the dividend payment does not have to
be fixed but is instead linked to corporate performance, much like ordinary
shares.

Companies can issue ordinary or preference shares that are redeemable at

the option of the company or the shareholder within the terms of the
Articles of Association (the company's internal regulations) and the
Companies Act.

Preference shares can be convertible, in that they can be converted into

ordinary shares at some future date.
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(7) THE EQUITY MARKET

The U.K's stock exchange is based in London : The London Stock

Exchange. It is one of the largest stock exchanges in the world.

(a) The Primary Market - this is where companies raise finance for the first
time, i.e. where new issues occur and companies get their market quotation.

An initial public offering (IPO) is a process that private companies undergo

to offer shares of their business to the public in a new share issuance.

Industry giants, such as Google and Meta (formerly Facebook), raised

billions in capital through IPOs.

(b) The Secondary Market - this is where shares that are already quoted
are traded and investors can buy or sell shares at the going market price.

N.B. In this market no funds go to the firms in question.

It is typical for companies to use equity financing several times as they

become mature businesses.

A seasoned equity offering (SEO) is where a company already listed on a

stock exchange simply decides to release additional stocks.
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(8) SOURCES OF EQUITY FINANCING

(a) Individual investors e.g., friends, family members, members of the public.

Usually invest small amount → more of them are needed to raise the
required amount. Can have relevsnt industry experience, skills to
contribute.

When a company is initially formed it will, by definition, have equity

financing provided by the founders.

(b) Angel Investors. Welathy individuals or groups often investing large

amounts, usually at the early stages of a company’s development, in the
expectation of large returns.

(c) Venture Capitalists. Individuals or firms that make substantial

investments in companies having very high growth prospects.

Often enter at early stage and exit at IPO stage so as to make large
profits.

Usually ask for a majority or noteworthy share of the ownership and

may insist on significant involvement in the management (Management
Buyouts) to protect their investment.

(d) Crowdfunding. Individual investors invest small amounts via an online

platform (e.g., Kickstarter, Indigogo and GoFundMe).
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(9) METHODS OF RAISING EQUITY FINANCE:

ISSUING NEW SHARES

In broad terms, equity finance can be raised in two ways : the private
placement of stock (method C below) and public stock offerings (methods
A, B and D).

Below I highlight four methods that are available (there are many more)

(A) Offer for Sale,

(B) Public Issue,

(C) Private Placing,

(D) Offer for Sale by Tender.

(A) Offer for Sale

Most common method.

Issuing company offers its shares to an Issuing House which in turn offers
them to the general public.

Problem: ‘What is the correct issue price that equates demand to supply
and ensures no capital losses?’

To overcome undersubscription, the Issuing House normally unserwrites

the issue.

The fee charged is normally 1-2% of the value of the issue – although it can
vary.

The fee can be viewed as the risk premium paid for insuring oneself against
undersubscription.
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(B) Public Issue

The offer is being made by the issuing company to the public.

Normally used for ‘large’ issues by well-known companies.

(C) Private Placing

Instead of being 'offered for sale' to the general public, this time the shares
are privately placed, i.e. sold privately to clients and to market dealers.

Cheaper than an offer for sale.

Tends to be for smaller placings.

(D) Tender Offer

Minimum price for the shares is set by the issuer and investors are invited
to bid (submit tenders) for shares at or above this level.

Shares are then allotted to successful bidders at the highest price which
ensures that all the shares are taken up - the 'striking price.'

Avoids the uncertainty and risks associated with setting an issue price but,
is the most expensive method.

Tends to be used for companies with unique characteristics coming to the

market for the first time, e.g. privatised utilities.
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(10) METHODS OF RAISING FINANCE FOR ALREADY QUOTED

COMPANIES.

(A) Rights Issues

New shares are offered to existing shareholders in return for capital.

Shareholders are granted the right to subscribe to shares in proportion to

their existing holdings e.g. one new share for every one held  they
maintain their current voting control.

Other advantages of rights issues:

(a) Cheaper than public share issues

(b) Can be made at the discretion of directors without the consent of

shareholders or the Stock Exchange.

(c) They rarely fail. Shares are offered at adiscount (20%) to existing
shareholders so it is not sensible to not ‘take up your rights.’
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(B) Scrip Dividends

Company issues new equity shares to its existing shareholders instead of

directly paying out a cash dividend.

Advantage: Preserves liquidity as no cash leaves the firm.

So long as the number of shares issued are not too large and the cash saved
is reinvested to yield a satisfactory rate of return, the share price should not
fall.