Chapter 12 - Test your knowledge Flashcards
What are the advantages of issuing equity shares from a company
perspective?
The advantages of issuing equity shares are as follows.
- Equity shares are permanent capital and a long-term source of finance.
- Normally, the capital raised is not required to be paid back during the
lifetime of the company, other than in the event of liquidation - The dividend on equity shares is not a liability for the company. To protect
the interests of creditors, a company may declare a dividend only if it has
sufficient profit available for the purpose.
A company that raises capital with equity shares gives a positive outlook of the company, providing greater confidence to investors and creditors
How can companies raise finance from a rights issue?
Companies can raise finance by making a rights issue that offers existing
shareholders the right to buy new shares in proportion to their existing shareholdings.
Rights issues enables shareholders to retain their existing share of
voting rights.
What factors should you consider when choosing between sources of
finance?
The main factors to consider when choosing between sources of finance are
summarised below.
- Access to finance:
the ability of a company to raise equity finance is
dependent on its access to the investors. Quoted companies can issue both
new shares and make rights issues.
However, unquoted companies can
only raise finance by rights issues and private placings due to its restricted access to public. There are also statutory restrictions: in the UK, only public limited companies may offer shares to the general public.
- Control:
Raising funds through internally-generated funds and rights issues results in no change to shareholder control. However, if diversification of control is desired, then an issue to the public will be preferred.
- Amount of finance:
the amount of finance that can be raised by a rights issue is limited and dependent on the amounts that can be raised from the existing shareholders.
There is more flexibly for quoted companies for
the amounts that can raised from the general public that opens up the full financial resources of the market.
- Cost of raising finance:
flotations incur significant costs in management
and administrative time and may not be a viable option for smaller companies.
Use of internally generated funds is the cheapest and simplest
method. For shares, public offers are the most expensive, following by
placings and then by rights issues.
- Pricing the issue:
setting the price correctly is the most difficult area for all shares.
For public issues, there is a danger of undersubscription if it is
set too high, unlike a placing which is pre-agreed and negotiated to be attractive enough to the subscribing institutions. A rights issue bypasses the price problem since the shares are offered to existing shareholders.
For unquoted companies, pricing is more complex as they cannot refer to no
existing market prices.
Why would investors be interested in preference shares with warrants
attached?
Warrants attached to a preference share are attractive to investors because they offering the potential to earn a profit in the future.
Warrants are rights given to lenders allowing them to buy new shares in a company at a future date at a fixed price (the exercise price).
If the current share price is higher than the exercise price, then the warrant holder has a potential to make a profit by getting the shares at a cheaper exercise price in the future.
How can purchasing assets via leases assist in managing a company’s
cash levels?
The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over several years, hence saving the burden of one-time
significant cash payment to purchase an asset outright.
This helps a business to
maintain a steady cash-flow profile.
What is meant by a highly geared company?
A highly geared company has a high ratio of long-term debt to shareholders’
funds. A high level of gearing implies a higher obligation for the business in paying interest when using debt financing.
It has a higher risk of insolvency than
equity financing. While dividends on ordinary share capital need only be paid when there are sufficient distributable profits, the interest on debt is payable
regardless of the operating profit of a company.
A review of the gearing ratio is key in the funding decisions made by financial managers and investors. It affects risk, returns and controls associated with
equity capital. Investors may require a higher return to compensate for the higher risk associated with the higher gearing.
According to the control
principle, debt may also be preferred over equity to minimise possible risk of loss of control.
When might investors and other stakeholders prefer gearing and
why?
Other stakeholders who have an interest in the profitability and stability of the company, including employees, customers and particularly creditors, will also be interested in the level of gearing.
Since debt capital is cheaper than equity capital, debt financing should minimise the cost of capital and maximise the earnings per share.
The interest on debt is deductible for income tax purposes, making debt capital cheaper, whereas no such deductions are allowed for dividends.
Debt should be used to the extent that it does not threaten the solvency of the firm.
