Sources of long-term finance Flashcards
What are the advantages of issuing equity shares from a company perspective?
- 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
- Dividend on equity shares is not a liability for the company. To protect the interest 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?
- Access to finance - 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 issue 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 flexibility for quoted companies for the amounts that can be 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 offer 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 are the limitations of PFI?
PFI schemes are controversial due to the wasteful spending built into the public sector procurement agreements that are part of PFI projects. There are many stories of flawed projects.
The biggest disadvantage is the high annual cost charged to the public sector for the project. The costs have been significantly larger than the annual cost of comparable projects. Many of the projects have run over budget. For example, the cost of private sector finance in the 2000s increased the overall debt cost of the UK government, indirectly costing taxpayers.
Since the asset ownership is transferred to the private sector, it may lead to a loss of control and accountability by the public sector. The ultimate risk of inflexibility and poor value for money with a project lies with the public sector. Repair or maintenance costs could also be higher. The administration cost spending on advisers and lawyers and the costs of the bidding process could cost millions.l,k
What is meant by a highly geared company?
Highly geared company has a high ratio of long-term debt to shareholders’ funds.
High 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 purpose, 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.
What are the problems of high gearing?
- Bankruptcy risk increases with increased gearing
- Agency costs and restrictive conditions imposed in the loan agreements constraint management’s freedom of action, such as restrictions on dividend levels or on the company’s ability to borrow
- After a certain level of gearing, companies will have no tax liability left against which to offset interest charges (tax exhaustion)
- companies may run out of suitable assets to offer as security against loans with high gearing
- gearing increases the cost of borrowing
- Directors have a natural tendency to be cautious about borrowing and related solvency issues,
