13. Capital structure and finance costs

Question 1

Capital finance can be loosely categorised into two groups. Explain them

Answer 1

Debt: legal liability to repay source of finance.

Equity: gives the provider rights to shares in residual assets of the business in return for finance. Riskier than debt; potential returns much higher.

Question 2

What are the three most common forms of financial capital?

Answer 2

• Ordinary shares
• Preferential share
• Loan notes

Question 3

Shares:

1. What is the main difference between an ordinary and preferential share?
2. How do we post shares?

Answer 3

1. Ordinary shares represent a single unit of equity ownership and voting rights whereas preferential shares are focused on returns on investment.
2. Dr Cash
   Cr Share capital
   Cr Share premium

Question 4

Ordinary shares:

1. Ordinary shares are shown under equity on which statement?
2. Dividends are shown on which statement?
3. Dividends are not shown on the SOPL because?

Answer 4

1. Statement of financial position
2. Statement of changes in equity
3. Because they are a distribution of profits, not a deduction

Question 5

Preference shares:

1. What are the two types of preference shares?
2. What is the main difference between them?
3. What effect does this have on positioning within the financial statements?

Answer 5

1. Redeemable and irredeemable
2. Redeemable shares are shares in which the initial investment is paid back - irredeemable it is not.
3. Thus, redeemable shares are treated as debt and irredeemable shares are treated as equity on the statement of financial position.

Question 6

Share capital terminology:

1. What is the nominal value?
2. What is the issue price?
3. What is the market value?

Answer 6

1. The minimum value of the share.
2. The price it is bought at.
3. The price at which shares are traded in the open market.

Question 7

Rights issues:

1. What is a rights issues?
2. What are two advantages?
3. What are two disadvantages?

Answer 7

1. A rights issue is when additional shares are offered to existing shareholders in proportion to the shares that they already own at a stated price (usually below market value).
2. • Likely successful as existing shareholders are the most likely customers.
     - Cheap method of obtaining finance
3. • Not certain
   • Potentially more expensive than debt

Question 8

Bonus issues:

1. What is a bonus issue?
2. What are two advantages?
3. What is the disadvantage?
4. How is a bonus issue posted?

Answer 8

1. A bonus issue is when shares are given out to existing shareholders in proportion to the shares that they already own - no cash is received for this.
2. • Reduces market value
   • Brought more into line with assets owned
3. • Admin costs
4. Dr Share premium, Cr Share capital

Question 9

Dividends:

1. What is a dividend?
2. How do you post a dividend?
3. What is important to remember when considering final dividends?

Answer 9

1. Returns on investments for shareholders based on amount per share owned.
2. Dr retained earnings, Cr bank
3. Final dividends have to be approved at annual general meeting (AGM) Thus, dividends cannot be recorded as liabilities at year end if not approved as no obligation to pay them.

Question 10

Loan notes:

1. How do you post a loan?
2. How do you post loan interest?

Answer 10

1. Dr cash, Cr non-current liability

2. Dr finance charges, Cr cash/payables

Question 11

How do you post redeemable preference shares?

Answer 11

Dr cash, Cr non-current liability

Question 12

Other reserves:

1. Other reserves consists of? (2)
2. Which statement are they included in?

Answer 12

1. Profits made and inflation in value of assets recognised

2. Statement of financial position.

Question 13

Income tax:

1. How do you post it (3)

Answer 13

1. Estimate liability
Dr tax (SOPL) Cr tax (SOFP)

2. Paid 
Dr tax (SOFP) Cr bank 

3. Any adjustments needed