Chapter 9 Flashcards
Preference shares
shares with a fixed rate of dividend which have a prior claim on profits available for distribution.
Features of preference shares
The shares have a fixed percentage dividend payable before ordinary dividends. This preference share dividend is expressed as a percentage of the share’s nominal value.
The dividend is only payable if there are sufficient distributable profits. If the shares are cumulative, however, the right to receive dividends which were not paid is carried forward (i.e. cumulative preference dividends). Any arrears of dividend are then payable before ordinary dividends.
As for ordinary dividends, preference dividends are not deductible for corporate tax purposes. The preference dividends are considered a distribution of profit rather than an expense.
On liquidation of the company, preference shareholders rank before ordinary shareholders and after debt holders.
A participating preference share is a type of preference share that gives the holder the right to receive an additional dividend (if certain conditions are met) in addition to a fixed percentage of the share’s nominal value.
Advantages of preference shares
No voting rights; therefore no dilution of control.
Compared to the issue of debt:
preferred dividends do not have to be paid in any specific year, especially if profits are poor;
preferred shares are not secured on company assets; and
non-payment of dividend does not give holders the right to appoint a liquidator.
Disadvantages of preference shares
Preferred dividends are not tax deductible (unlike interest on debt which is a tax allowable expense). Preference shares are a relatively rare source of finance in practice because of this.
To attract investors to buy preferred shares, the company needs to pay a higher return to compensate for the additional risk compared to debt.
Bond
a negotiable security evidencing a debt governed by a contract which specifies, for example, the coupon rate, repayment schedule, security (if any), principal value, seniority (if subordinate to other debt) and other covenants.
How may bonds be secured
a fixed charge over a specified asset (e.g. a specific building) which cannot therefore be sold unless the debt is repaid; or
a floating charge over a class of asset which changes (e.g. inventory). On default, the floating charge “crystallises” as a fixed charge, and the asset class can no longer be traded until the debt is repaid.
Deep discount loan note
loan notes issued at a large discount to nominal value (i.e. issued well below nominal value) and redeemable at nominal value on maturity.
How do investors in deep discount loan notes gain wealth
Investors in deep discount loan notes receive a large capital gain on redemption, but are paid a low coupon during the term of the loan.
Zero coupon loan notes
loan notes issued at a discount to nominal value and which pay no coupon.
Advantages of deep discount loan notes
The issuing company pays no interest and the only cash payout is at the loan note’s maturity.
Return to investors is wholly in the form of a capital gain (the difference between issue and redemption price).
Why is the issue of debt preferred over issue of shares
Interest expense is tax deductible and therefore reduces corporation tax payments.
Convertibles
loan notes or preference shares which can be converted into a pre-determined number of ordinary shares
Advantages of convertibles
For investors, they are a relatively low-risk investment with the opportunity to make high returns on conversion to ordinary shares.
For the issuer, they can offer a lower coupon/dividend rate than would have to be paid on a non-convertible (straight) loan notes/preference shares (because the conversion option has value).
For younger companies, investors may not want to risk investing in equity but may be prepared to invest in less risky loan notes. If the company does well, investors can opt to convert and benefit from capital growth, or otherwise keep the safe loan notes.
Warrants
the investor’s right, but not the obligation, to purchase new shares at a future date at a fixed price. This fixed price is also called the exercise or subscription price.
Benefits of warrants
Are sometimes attached to loan notes, to make the loan notes more attractive.
Are an option to buy shares.
May be separated from the underlying debt so the holder of the warrants may sell them rather than keep them (i.e. they are traded independently).
Advantages of warrants
When initially attached to the loan note, the coupon rate on the loan note will be lower than for comparable straight debt. This is because the investor has the additional benefit of the potential purchase of equity shares at an attractive price.
They may make an issue of unsecured debt possible when the company’s assets are inadequate to secure the debt.
They are a way of issuing equity (albeit with a delay) without the usual negative signal associated with an equity issue.
Advantages of bank loan
As the loan is for a fixed term, there is no risk of early recall
