KCB Notes - Sources of long term finance

Question 1

What are the 3 main sources of long term finance?

Answer 1

Equity Capital
Preference Share Capital
Debt Capital

Question 2

What are the different way a company can issue equity?

Answer 2

Companies can issue shares in the following ways:
1. Market issue (public or private)
2. Rights issue
3. Bonus or SCRIP issue

Question 3

Retained earnings are the most common source of finance. What are the disadvantages and advantages or using retained earnings for financing investments?

Answer 3

Advantages
1. No issue costs
2. Available within the company (no loss of control by issuing shares)
3. No obligation to pay interest or repay
4. Flexibility
5. Reduces the risk of being taken over

Disadvantages
1. May not be sufficient is the investment is large
2. Investment may not match the timing and availability
3. If not used properly, the retained profit may incur an opportunity costs
4. Too much of retained earnings may result in over-capitalisation
5. Large amount of retained earnings may attract hostile takeover bids

Question 4

What are the 2 methods of issuing new shares?

Answer 4

1. Public issue of shares - shares are issued to the public by inviting the public to apply for the shares at a fixed price or by tender.
2. Placing - Shares are sold directly to pre-selected investors.

Question 5

Describe what “rights issue” are in connection to shares and some advantages and disadvantages.

Answer 5

Rights issue is offering new shares to existing shareholders in the proportion to their current shareholdings. Share holders have the option of not participating in the rights issue or sell their rights separately.​

Rights issues are usually made at a discount price to the market price. ​

The advantages of rights issue are ​

1. It maintains existing control. ​
2. It is cheaper compared to a full market issue.​

The disadvantages are ​

1. The share price may fall on the announcement of a rights issue. ​
2. The EPS may suffer high dilution​

Question 6

Describe what “preference shares” are and list what types of preference share are available.

Answer 6

Preference Shares carry preferential rights over equity shares on profits available for distribution and usually on the leftover funds in case of a liquidation.​

They usually earn a fixed amount as dividend in priority to ordinary dividend. ​

There are many types of Preference Shares:​

• Cumulative and Non-cumulative Preference Shares​
• Redeemable and Irredeemable Preference Shares
• Participating and Non Participating Preference Shares
• Convertible and Non Convertible

Question 7

Explain the differences between Cumulative and Non-Cumulative Preference Shares.

Answer 7

Cumulative Preference Shares-​
If the preference dividend is not paid in a particular year it is carried ​
over to the next year and paid before any equity dividend is paid.​

Non-Cumulative Preference Share - not carried forward.

Question 8

Explain the differences between Redeemable and Irredeemable Preference Shares,

Answer 8

Redeemable preference shares are those shares which can be purchased back (redeemed) by the company within the lifetime of the company, subject to the terms of the issue. These shares can be redeemed at a future date and the investment amount returned to the owner. ​

Irredeemable preference shares are not redeemable or paid back except when the company goes into liquidation.

Question 9

Explain the differences between participating and non - participating preference shares.

Answer 9

Participating preference shares are entitled to a fixed rate of dividend and a share in surplus profits which remain after dividend has been paid to equity shareholders. The surplus profits are distributed in a certain agreed ratio between the participating preference shareholders and equity shareholders. ​

Non-participating preference shares are entitled to only the fixed rate of dividend​

Question 10

Explain the differences between convertible and non-convertible preference shares.

Answer 10

The holder of convertible preference shares enjoys the right to convert the preference shares into equity shares at a future date.​

This gives the investor the benefit of receiving a regular fixed dividend. Also an option to convert the preference shares to equity shares. ​

The holder of non-convertible preference shares does not enjoy this right

Question 11

List the advantages to the company when issuing preference shares.

Answer 11

Unlike fixed interest for debt financing, dividends are only payable if there are sufficient distributable profits available for the purpose.​

There is no loss of control, as preference shares do not carry voting rights. ​

Unlike debt, dividends do not have to be paid if there are not enough profits. ​

The right to dividend for that year is lost except for cumulative preference shares (the right to dividend is carried forward). ​

• Unlike debt, the shares are not secured on the company’s assets.

Question 12

List the disadvantages to the company when issuing preference shares.

Answer 12

Unlike debt interest, dividends are not tax allowable. The use of preference shares is quite rare nowadays given the tax advantages of debt. ​

Preference shares pay a higher rate of interest than debt because of the extra risk for shareholders.​

On liquidation of a company, preference shares rank before equity or ordinary shareholders

Question 13

Long term debt is made up of what?

Answer 13

Bonds
Debentures
Loan Stock

Question 14

What are Bonds and what are the key features?

Answer 14

A bond is a general term for various types of long-term loans to companies, including loan stock and debentures. ​

Bonds are used by companies, governments and semi-governmental bodies to raise money and finance a variety of projects and activities. ​

Owners of bonds are accounted for as creditors of the issuing company.​

They may issue bonds directly to investors instead of obtaining loans from a bank. ​

The company issues a bond with a fixed interest rate (coupon rate) and the duration of the loan, which must be repaid at the maturity date. ​

The issue price of a bond is typically set at par, usually £100 ($1,000 in the US) face value per individual bond. ​

The actual market price depends upon the expected yield and the performance of the company compared to the market environment at the time​

Question 15

What are Debentures and what are the key features?

Answer 15

Debentures are the most common form of long-term loan used by large companies. A debenture is a written acknowledgement of a debt, most commonly used by large companies to borrow money at a fixed rate of interest. ​

Debentures are written in a legal agreement or contract called ‘indenture’, which acknowledges the long-term debt raised by a company. ​

Debentures can be traded on a stock exchange, normally in units. They carry a fixed rate of interest expressed as a percentage of nominal value.​

These loans are repayable on a fixed date and pay a fixed rate of interest. ​

A company makes these interest payments prior to paying out dividends to its shareholders

Question 16

What is Loan Stock and what are the key features?

Answer 16

Loan stock refers to shares of common or preferred stock that are used as collateral to secure a loan from another party. ​

The loan is provided at a fixed interest rate, much like a standard loan and can be secured or unsecured. ​

Loan stock is valued higher if the company is publicly traded and unrestricted, since these loan stock shares can be easier to sell if the borrower is unable to repay the loan.​

Lenders will have control of the shares’ loan stock until the borrower pays off the loan. Once the loan term expires, the shares would be returned to the borrower, as they are no longer needed as collateral.​

Question 17

Long Term Debt Capital may be unsecured or secured. Provide some information in connection with this.

Answer 17

Secured and unsecured Bonds or debentures are either unsecured or secured against collateral. ​

Secured debts or debenture holders have first charge on the assets that are used as security if the company goes into liquidation. ​

A company with a fixed charge debenture is restricted from selling the assets used as security until the loan is repaid in full. ​

With a floating charge, it is free to dispose of its assets in the ordinary course of business. ​

Unsecured debentures are backed only by the reputation and trust of the issuer.​

Question 18

Government debentures and bonds are considered as risk free - explain why.

Answer 18

Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. ​

Private and government institutions frequently issue this type of bond to secure capital. ​

Some examples of a government debentures would be government-issued Treasury bonds (T-bond) or Treasury bills (T-bill). ​

They are generally considered risk free because governments are assumed not to default on payments. ​

Unsecured debentures do not have this benefit and charge a higher rate of interest to compensate the risk​

Question 19

As well as preference shares, debentures can also be redeemable or irredeemable. Provide further information in connection to this.

Answer 19

Debentures can be either redeemable or irredeemable.​

Redeemable debentures are debentures which the company has issued for a limited period of time.​

Redeemable debentures are usually repaid at their nominal value (at par) but may be issued as repayable at a premium on nominal value.​

They are repayable at a fixed date (or during a fixed period) in the future. ​

Debentures which are never repaid are irredeemable (also known as perpetual debentures). They are rare nowadays. ​

Question 20

As well as preference shares, debentures can be convertible and non-convertible. Provide further information in connection with this.

Answer 20

Convertible debentures or convertible loan stock have the option to convert into equity shares at a future time and in a ratio decided by the company when issued. ​

Non-convertible debentures cannot be converted into equity shares.​

Convertible debentures carry a lower interest rate compared to non-convertible debentures. ​

Question 21

List the advantages of issuing Debentures to the Company.

Answer 21

These loans are repayable on a fixed date and pay a fixed rate of interest. ​

The interest paid is usually less than the dividend paid to shareholders, as debentures are considered less risky than shares by investors. ​

Debentures are advantageous to the issuer because they have a fixed repayment date. ​

Unlike dividends, the interest paid is tax allowable, reducing the net cost to the company. ​

Unlike shares, there are no restrictions contained in company law regarding the terms of issue of debentures. ​

Debenture holders typically have no right to vote or have a voice in the management. ​

They are preferred as a source of finance if any dilution of control is not desirable​.

Question 22

List the disadvantages of issuing Debentures to the Company.

Answer 22

Debenture holders are creditors of a company. Secured debenture holders have first charge on the assets that are used as security if the company goes into liquidation. ​

Debenture holders receive interest payments regardless of the amount of profit or loss at the stipulated time. The interest payments are due prior to paying out dividends to shareholders. ​

The risk for an investor of investing in debentures and other loans is less than the risk of investing in shares but there is still a risk of default. ​

The higher the amount of debt finance, the higher the debt or gearing ratio. This may make the company more volatile and could lead to insolvency.​

Question 23

In relation to loan stock, what is conversion ratio, conversion price and conversion premium and what is the formulas?

Answer 23

the conversion ratio ( this is the number (or ratio) of equity shares received at the time of conversion for each loan stock) ​
Formula = amount of convertible shares / nominal value of loan stock

• the conversion price ( this is the price per share at which loan stock can be converted into equity shares) ​
  Formula = nominal value / no. of convertible shares
• the conversion premium ( this is the amount that would be yielded if loan stock is converted into equity shares)​
  Formula = Conversion price - share price at the time of issue.