Ch 4

Question 1

External Sources of Finance

Answer 1

CAPITAL MARKETS

new share issues, rights issues, issues of marketable debt (e.g. bonds)

requires listing on recognized stock exchange

BANK BORROWINGS

l/t or s/t loans, including revolving credit facilities (RCFs) and money market lines

VENTURE CAPITAL FUNDS

high risk finance provided by specialists

challenge is that they often require significant equity participation and may also influence company policy

GOVERNMENT

or similar

Question 2

Criteria for Selecting Sources of Finance

Answer 2

COST of different sources

DURATION - how long required?

LENDING RESTRICTIONS - security, debt covenants

GEARING LEVEL (aka capital structure)

LIQUIDITY IMPLICATIONS - ability to service debt while leaving cash to meet interest and capital repayment obligations

CURRENCY of CF associated with new project

impact of different options on F/S, tax position, financial st/h of entity

AVAILABILITY - based on creditworthiness of borrow, willingness of lenders to extend credit (bank borrowings) / liquidity of capital markets (equity, bonds)

Question 3

Finance Criteria: Cost

Answer 3

Each source of finance has a different cost

Cost of debt capital to company = interest cost less tax relief on interest

Tax relief plus fact that debt providers are lower than equity providers => debt usually cheaper

Cost of equity capital = expected sh/g return = dividends and expectations of future dividends and share price growth

Although dividends not legally required, satisfactory return required to support share price - otherwise investors will not subscribe to new equity when org needs to raise new capital

Duration also relevant => l/t finance more expensive than s/t

Question 4

Finance Criteria: Duration

Answer 4

Equity is l/t “permanent” capital vs debt is fixed term (s/t overdraft to l/t)

Bank loans usually m/t 5-7 yrs, bonds can be much longer

L/T Assets should be financed by L/T funds; S/T assets by a mix of S/T and L/T

e.g. working cap funded by S/T A/P and overdraft, NCA funded by L/T finance

rule may be broken to access cheap S/T funds (especially A/P with no obvious cost) – but this involves risk

Question 5

Finance Criteria: Lending Restrictions

Answer 5

Security often required for debt finance - derived from existing assets or new assets to be acquired; land/buildings hold value and are easier for a lender to sell than plant/machinery

Debt covenants = clauses protecting lender’s interests by requiring borrower to satisfy criteria, e.g. interest cover must not <5, ratio of NCL to Equity not > 0.75:1

If covenants are not breached, lender is reassured that risk associated with borrow will not dramatically change

Question 6

Finance Criteria: Gearing

Answer 6

Ratio of debt to equity finance

High gearing = very risky

Although high gearing involves use of cheap debt finance, high debt creates obligation to meet interest payment and debt principal repayment schedules – failing which, liquidation

l/t funding should be happy balance of equity and m/t and l/t debt – thus benefiting from lower cost of debt finance without exposure to risks from excessive debt obligations

Question 7

Finance Criteria: Currency of CF associated with new project

Answer 7

If CF expected in foreign currency, entity may decide to raise finance in same currency to reduce risk of exchange rate mvmts – by matching project receipts with servicing costs of finance

Question 8

Finance Criteria: Impact of Different Finance Options on F/S, Tax Position, Financial St/h

Answer 8

Financial st/h (debt holders and sh/h) will use ratio analysis to assess org perf, thus F/S effect of any new financing must be considered by mgmt

e.g. raising debt will affect ROE, interest cover, gearing; will create tax-deductible interest payments thus impacting tax position

Existing financial st/h (debt holders and sh/h) will monitor performance closely, so mgmt must clearly explain rationale for any financing which impacts F/S or tax position

Question 9

Finance Criteria: Availability

Answer 9

small companies traditionally challenged in raising equity and l/t debt finance – many firms do not have an unlimited choice of funding arrangements

availability of debt enhanced by good credit rating

Question 10

Definition of share

Answer 10

a fixed identificable unit of capital in an entity which normally has a fixed nominal value, which may be quite different from its market value

shh receive returns from investment in shares in the form of dividends, and also capital growth in share price

Question 11

Ordinary shares vs Preference shares

Answer 11

ORDINARY SHARES

pay dividends at directors’ discretion

ordinary sh/h own company and have right to attend mtgs, vote on important matters

in winding-up, are subordinate to all other finance providers

PREFERENCE SHARES

form of equity paying a fixed dividend, paid in preference to ordinary sh dividends

winding-up => subordinate to debt holder, receive payout before ordinary sh/h

Question 12

Comparison of Preference Shares with Debt and with Ordinary Shares

Answer 12

Pref shares pay fixed proportion of share’s nominal value as annual dividend - thus often considered to behave as debt > ordinary shares

however, pref share dividends out of post-tax profits, thus no tax benefit (unlike interest on debt finance)

in certain cases, org can skip pref share dividends (e.g. insufficient distributable profits), whereas debt interest is an obligation (even if org cannot afford it)

lack of tax relief on dividends => relatively unattractive compared with bank borrowings or fixed-rate securities (bonds)

HOWEVER, some appeal to risk-averse investors looking for relatively reliable income stream

Question 13

Four types of preference shares

Answer 13

CUMULATIVE

dividends must be paid, unpaid are rolled into next year

NON-CUMULATIVE

no build up of missed payments

PARTICIPATING

fixed dividends plus extra earnings based on certain conditions (similar to ordinary shares)

CONVERTIBLE

can be exchanged for specified # of ordinary shares on given future date

note - some preference shares are redeemable, meaning holders will be repaid their capital at some future date (usually at par)

Question 14

Example - convertible preference shares

Answer 14

fixed-income securities, investor can choose to convert into set # of ordinary shares at specified point in time

fixed-income = steady income stream and some protection of investor capital

option to convert = opportunity to gain from rise in share price => attractive to participate in rise of hot growth companies while insulating against share privce drop

often used in context of Management Buyouts

Question 15

Functions of Capital Markets

Answer 15

PRIMARY

enable companies to raise new equity or debt finance - by providing access to large pool of potential investors

(in UK, company must be plc before allowed to raise finance from the public on stock market)

SECONDARY

enable investors to sell investments to other investors

thus, listed org’s shares more marketable than unlisted, thus more attractive to investors

Question 16

Private (Ltd) vs Public (plc) company

Answer 16

PRIVATE LIMITED COMPANY

sh/h with limited liability, shares not offered to public

sh/h liability limited to orignal capital invested (nominal + premium) - personal assets protected if org goes insolvent

PUBLIC LIMITED COMPANY

may sell shares to public

either unlisted, or listed on the stock exchange

Question 17

Advantages of a listing on stock exchange

Answer 17

once listed, mkt will provide more accurate entity valuation than previously possible

realization of paper profits and mechanism for buying/seeling shares at will in future

raise profile of entity => revenue impact, credibility with suppliers and l/t fin providers

raise capital for future investment

make employee share schemes more accessible

Question 18

Disadvantages of a listing on stock exchange

Answer 18

costly for small entity (flotation, underwriting costs, etc.)

making enough shares available to allow a market => loss of at least some control by original owners

more onerous reporting requiremenets

stringent stock exchange rules for obtaining a quotation

Question 19

Impact of Stock Exchange Listing on Key Stakeholders

Answer 19

SHAREHOLDERS benefit as shares become more marketable = listing improves company reputation, thus share price may rise

listing builds company reputation and profile => benefits EMPLOYEES and MANAGERS = listed orgs tend to be larger, less likely to fail => can afford to offer better pay, career progression

improved rep of listed company improves credit rating, thus reduces non-payment risk to SUPPLIERS and LENDERS; former may grant generous credit terms

Question 20

Two important capital markets in UK

Answer 20

STOCK EXCHANGE

market for larger companies

high entry costs, high scrutiny - but high profile thus very marketable shares

ALTERNATIVE INVESTMENT MARKET

smaller companies, lower associated costs, less stringent entry criteria

Question 21

Operation of Stock Exchanges

Answer 21

Prices of shares are determined by forces of supply and demand

a company doing well will attract investors => demand pushes up price

a company doing poorly will drive investors to sell shares => supply in the market drives down price

Question 22

Three most commonly used methods of issuing new shares

Answer 22

Initial Public Offering

Placing

Rights Issue

Question 23

Initial Public Offering

Answer 23

offering may be completely new shares, or shares transfering from private to public ownership

issuing house, normally merchant bank, acquires shares and offers to public

offer either at fixed price set by company, or in tender whereby investors suggest their own price (with subsequent sale at best price offered)

offers usually made as a prospectus in newspapers, sometimes abbreviated - buying through the prospectus avoids dealing costs

examples of IPOs also include gov’t privatizations and privately held shares transferred to public

easier for investors to judge entities with track record > new entity

Question 24

Placing

Answer 24

sale of securities to relatively small number of selected investors - usually large banks, mutual funds, insurance companies, pension funds

placement not publicly announced or registered; detailed fin information often not disclosed and need for prospectus waived

average investor only made aware of the placement after it has occurred

popular = cheaper and quicker to arrange than most other methods => HOWEVER does not lead to very actrive market for shares after flotation

Question 25

Stagging

Answer 25

a strategy whereby investors apply for new issues in hope of selling immediately and reaping quick profit

depends on # of shares purchased being high enough to cover selling charges; ovrersubscribed issues may scale down allocations / applicant receives only a small # of shares

often successful as companies typically price new issues conservatively to ensure uptake and raise req’d finance - often leading to immediate post-issue price increase

notable successes of stags (especially in privatization issues) - but also cases where initial dealing price has been substantially below offer price

Question 26

IPO Lock-Up Period

Answer 26

contractual restriction stopping insiders who currently hold shares from selling them for 90 or 180 days after company goes public

insiders = founders, owners, mgrs, emp’ees, venture capitalists

intent = avoid flooding market with large number of shares post-issue, which would depress share price

insider selling activities can have strong impact on share price as their % holdings are relatively large

Question 27

Tender Offer

Answer 27

subscribed tender for shares at or above minimum fixed price

company sets a “strike” price and allocates shares to bidders who met or exceeded it - ensuring req’d amount of finance raised

everyone pays the strike price irrespective of original bid

keep in mind = company does not want to issue more shares than it has to, to ensure dilution of sh/h holdings is minimized

Question 28

Private Equity

Answer 28

equity capital not quoted on a public exchange = investors and funds investing directly into private companies or conducting buyouts of public ones (resulting in delisting of public equity)

capital for private equity raised from retail/institutional investors, used to fund new tech, expand working cap, make acquisitions, or strengthen a B/S

majority of private equity = instutitional and accredited investors who can commit large sums of money for long time periods - they often demand long holding periods to allow turnaround of distressed company or “liquidity event” (IPO, sale to a public company)

steady growth of market since 1970s

many firms conduct leveraged buyouts (LBOs) - issuing large amounts of debt to fund a large purchase - in the hope of improving fin results/prospects and reselling or cashing out via IPO

Question 29

Advisors to an IPO

Answer 29

INVESTMENT BANKS

take the lead and advise on appointing other specialists, stock exch reqs, forms of new cap to be made available, # of shares and price, underwriting arrangements, offer publication

STOCKBROKERS

advise on various methods of HOW to obtain listing - usually involved with smaller issues and placings

INSTITUTIONAL INVESTORS

agree to buy a certain # of shares, used by entity to give indication of likely uptake and accepted offer price - major influence on evaluation and market for shares once they are in issue

Question 30

Definition of Rights Issue

Answer 30

raising of new capital by giving existing sh/h right to subscribe to new shares in proprtion to current holdings, usually issued at discount to mkt price

cheaper to organize but may be more expensive than placing

price must be low enough to secure acceptance of sh/h, but not so low that EPS dilution becomes excessive - often 20% discount - however, bigger discounts mean more shares req’d to raise req’d capital

“Pre-emption” rights = ensuring sh/h have opportunity to prevent dilution of their STAKE

Question 31

Underwriting a rights share issue

Answer 31

avoids possibility that entity will not sell all shares it is issuing / receives less funds than expected

underwritings usually fin institutions e.g. merchant banks

agree to buy unsubscribed shares for a fee - they collect fee irrespective of whether they need to take up shares or not

underwriting costs could be avoided through deeper discounts

Question 32

Selecting issue quantity - rights issue

Answer 32

price usually selected first, quantity then becomes passive decision

effect of new shares on EPS, div/share and divdend cover should be considered

additional issue qty then related to existing share qty and expressed in simplest form, e.g. 1 for 4

offers are limited to ratios like this to avoid flooding the market with new shares and bringing share price down to discounted rate

Question 33

Market Price after rights issue

Answer 33

immediately after announcement of rights issue, share prices tend to fall:

uncertainty about consequences of issue, future prodits, future dividends

after issue has taken place, price will fall again:

adverse EPS impact of more shares, new shares issued at discount to market price

Question 34

Cum rights vs Ex rights

Answer 34

CUM RIGHTS

rights of all existing sh/h to subscribe to new shares when rights issue is announced

EX RIGHTS

lit. “without rights attached”

rights no longer exist on first day of dealings in newly issued shares

Question 35

Theoretical “Ex Rights” Price and “Value of Rights”

Answer 35

TERP

theoretical price that the class of shares will trade at on first trading day after issue

[(N x cum rights price) + Issue Price] / N + 1

N = number of rights to buy one share

e.g. 1 for 4 issue at $4, MPS/CRP $5 TERP = 24/5 = $4.80

Theoretical Value of Rights per share

(TERP - Issue Price) / N

e.g. 4.80/4 = $0.20 per share sold

Question 36

Yield-Adjusted Ex-Rights Price

Answer 36

TERP calculation assumes that addnl funds will generate return at same rate as existing funds

if entity expects (and market agrees) new funds will earn different return than currently being earned on existing capital, “yield adjusted” TERP should be used

[CRP * N/(N+1)] + (Issue price / N+1) * ( Y_n / Y₀ )

N = # of rights req’d to buy one share

Y_n = yield of new capital

Y₀ = yield of old capital

e.g. CRP $5, issue price $4, 1 for 4 issue, existing ROR 12%, new ROR 15%

[5*(4/5)] + (4/5)*(15%/12%) ] = 4 + 1 = $5

aka 1 new shares @ $4 * (15%/12%), plus 4 old shares @ $5 = $25 for five shares = $5 per share

if new funds are expected to earn ROR above that of existing unds, mkt price dilution will be lower than suggested by original TERP calc

Question 37

TERP and Yield-Adjusted TERP example for project appraisal/NPV

Answer 37

company has 1m $1 shares at $4.5 ex div, is considering 1 for 5 rights issue @ $4.2/share

TERP

[(5*4.5) + 4.2] / 5+1 = 26.7/6 = $4.45

assume funds will be used to finance project with NPV of $300k - TERP if project is undertaken?

NPV = gain in sh/h wealth if project is undertaken (assuming an efficient market)

Total # of shares = 1m existing + (1/5)*1m rights = 1.2m

TERP after rights issue and after project = 4.45 + (300k/1.2m) = $4.70/share

read as starting TERP plus project NPV divided into new # of shares

If using a yield adjusted TERP:

(original company market capitalization + NPV + rights issue proceeds) / New # number of shares

Question 38

Courses of action open to a sh/h in a right issue scenario

Answer 38

e.g. CRP $5, issue price $4, TERP $4.80, 1 for 4 issue offered, currently own 1,200 shares

DO NOTHING

MV of investment = $6k (5*1,200) falling to $5.76k (4.8*1,200)

unaccepted shares would typically be offered to market for best price available; company would deduct selling expenses and issue price of $4, anything left would be sent to sh/h and may partially or fully compensate red’n in MV

% share in entity would reduce

SELL THE RIGHTS

sell the right to buy shares @ $4 to another investor - who would not expect to pay more than $0.80 (TERP less $4 issue price).

seller might receive 300 shares * 0.8 = $240 less any dealing costs

% share in entity would reduce

FULLY SUBSCRIBE TO NEW SHARES

pay entity 1,200 for 300 new shares

thus own 1,500 valued at $7.2k (using TERP)

% share would be maintained

SELL SOME RIGHTS AND BUY SOME SHARES

sh/h may be unable/unwilling to invest more in the entity

may decide to sell sufficient # of rights to purchase the balance

e.g. 5 rights sold at 80 cents each = cash raised to purchase one new share at $4

thus shareholder could sell 250 rights, purchase 50 (300 total), and maintain total investment at 6,000 (from 1,200*5 to 1,250*4.8)

but % share of entity would be reduced

Question 39

IMPLICATIONS OF A RIGHTS ISSUE

Answer 39

SH/H PERSPECTIVE

gives option of buying shares at preferential price

gives option of withdrawing cash by selling rights

gives ability to maintain existing voting position by exercising rights

COMPANY PERSPECTIVE

simple and cheap

usually fully subscribed thus successful

often provides favorable publicity