Sources of long term finance

Question 1

What is long term finance?

Answer 1

Long-term finance is typically defined as a type of financing that is obtained for a period of more than a year.

Some companies divide finance into three categories: less than one year as short term, one to five years as medium term and five years and longer as long term

Question 2

What type of long term finance must a company choose from?

Answer 2

In general, companies must choose between equity finance and debt finance.

Equity finance:

Equity finance refers to the finance
relating to the owners or equity shareholders of the company who jointly exercise ultimate control through their voting rights.

Equity finance is represented by the issued equity or ordinary share capital plus other components of equity (such as share premium and retained earnings).

Debt finance:

Debt finance is the main alternative to equity that involves the payment of interest. It can be used for both short-term and long-term purposes and may or may not be secured.

Question 3

What are the most common types of long term finance under equity:

Answer 3

most common types of long-term finance under equity and debt finance are:

1. equity or ordinary shares
2. retained earnings or internally generated funds
3. preference shares
4. debentures (bonds or loan stocks)
5. bank and institutional loans
6. leasing

etc.

Question 4

Equity or ordinary shares?

Answer 4

-Equity shares are permanent capital and a long-term source of finance.

• It is not returned to the shareholders in most circumstances other than in the event of liquidation.
• Shareholders are collectively referred to as the owners of the company.
• Ownership means that the equity shareholders bear the greatest risk.
• The equity shareholders receive dividends only after the payments of debts and dividends to preference shareholders have been made.
• To protect the interests of
  creditors, a company may declare a dividend only if it has sufficient profit available for the purpose.
• Authorised share capital is the maximum amount of share capital that a company may issue, as detailed in the company’s Memorandum of Association.
• The shares are issued in the UK at normal share value, either at this is generally £1, 50p, 25p, 10p or 5p.

The rights and voting powers of
shares and the differentials between the different classes of shares are listed in the company’s Articles of Association.

Question 5

Advantages of Equity or ordinary shares?

Answer 5

Advantages

1. Equity shareholders are paid the residual funds (in the form of dividends) or the leftover funds in the event of liquidation, after all other lenders and creditors are paid.
2. From an investor’s liquidity point of view, equity shares of a quoted company can be easily traded in the stock market.
3. A company which raises capital from issuing equity shares may provide a positive outlook for the company.
4. It delivers greater confidence amongst investors and creditors.

Question 6

Dis- advantages of Equity or ordinary shares?

Answer 6

Disadvantages

1. In return for accepting the risk of ownership, equity shares carry voting rights through which equity shareholders
   jointly control the company.
2. The equity shareholders have greater say in the management of the company, although managerial control may be
   limited.
3. The issue of additional equity shares may be unfavourable to the existing shareholders, as it will dilute their existing
   voting rights.
4. It may affect future dividends

Question 7

1. Raising of equity shares and selling price?

Answer 7

Quoted companies:

• Quoted companies can issue new shares and make rights issues.

Unquoted companies:

• However, an unquoted company can only raise its finance by rights issues and private placings due to its restricted access to the
  public.
• Statutory restrictions in the UK mean only public limited companies may offer shares to the general public.
• The order of preference for share issues is generally a rights issue, a placing and then an offer for sale to the general public. The next source is used as available funds are consumed.

Setting the price:

• Setting the price correctly is difficult.
• For a public issue, there is a danger of
  undersubscription if the price is set too high, unlike 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 at an attractive price.
• For unquoted companies, pricing is more complex as they cannot refer to an existing
  market price.

Question 8

2. Raising of equity shares? Public issue shares and placing

Answer 8

New shares: public issue

• inviting the public to apply for shares in a company at a fixed price or by
  tender based upon information contained in a prospectus.
• A public listing increases the marketability of the company’s shares to raise further equity finance.
• However, listing a company is a time-consuming process that incurs costs. Once listed, the company also has to face a
  higher level of regulation and public scrutiny.
• There is also a greater threat of dilution of control and takeover.

New shares: placing

• A company can use a placing to raise equity capital for the company by selling shares directly to third-party investors
  (usually a merchant bank).

Question 9

3. Rights issue and bonus share or script issue

Answer 9

New shares: rights issue

• A rights issue offers existing shareholders the right to buy new shares in proportion to their existing shareholdings.
• A rights issue enables shareholders to retain their existing share of voting rights.
• Shareholders also have an option to sell
  their rights on the stock market.
• For example, a one-for-four rights issue means that a shareholder is entitled to buy one new share for every four shares
  currently held. Usually the price at which the new shares are issued by way of rights issue are offered at a discount to the current share price (that is, less than the current share price).
• If shareholders don’t want to buy the shares, they can sell their rights in the market.

Bonus share or scrip issue:

-Bonus shares, also known as a scrip issues, are additional free shares given to the current shareholders based upon their existing number of shares.

-This is achieved by a transfer from one or more components of equity-to-equity share
capital and does not raise any funds for the company.

Question 10

Retained earnings?

Answer 10

Retained earnings are equity finance in the form of undistributed profits attributable to equity shareholders.

The proportion of the profits which is not distributed among the shareholders, but retained to be used in the growth of a
company, are reported as retained earnings.

Retained earnings are the most common and important source of finance, for both short-term and long-term purposes.

Use of retained earnings is also the most preferred method of financing over other sources of finance.

However, retained earnings are that element of profit not distributed, so they are not a cash amount. The cash generated in relation to these profits may have been spent – on a capital project, for example – and yet the retained earnings figure would remain on the statement of financial position.

Question 11

Advantages of Retained earnings?

Answer 11

Advantages

1. Since these are internally generated funds, they are the cheapest source of capital in that there are no issue costs.
   Companies save on expenses related to issuing shares or bonds such as marketing, publicity, printing and other
   administrative costs.
2. The cash is immediately available (if it has not already been spent).
3. There is no obligation on the part of the company to either pay interest or pay back the earnings.
4. The management have more flexibility to decide how or where this money can be used.
5. Retained earnings are part of equity. Therefore, the company is able to better face adverse conditions during depressions and economic downturns, thus building up its internally generated goodwill.
6. Shareholders may also benefit from the use of retained earnings as they may be able to receive dividends out of them representing profits not distributed from previous years, even if the company does not earn enough profit for that year, provided that the company has sufficient cash to pay a dividend.
7. Investors are also likely to view a company with sufficient retained earnings as favourable, thus appreciating its share value.
8. The existing shareholders may profit from the rise in share prices

Question 12

Dis-advantages of Retained earnings?

Answer 12

Disadvantages

1. Internally generated funds may not be sufficient for financing purposes – especially in new companies that require a
   lot of investment.
2. The investment requirements might not match the availability and the timing of the funds. A company runs the risk of
   missing company opportunities
3. The excessive ‘ploughing back’ of profits or accumulated retained earnings may result in overcapitalisation.
4. Excessive savings may be misused against the interest of the shareholders.
5. The money is not made available to those in the company who can use it. Devoting too much profit to growth may
   starve the company of the cash it needs to fund ongoing operations

Question 13

What factors should you consider when choosing between sources of finance?

Answer 13

What factors should you consider when choosing between sources of finance?

1. Access to finance
2. Control
3. Amount of finance
4. Cost of raising finance
5. Pricing the issue

Question 14

What factors should you consider when choosing between sources of finance? and explain each?

Answer 14

1. 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.

2. 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.
3. 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.

4. 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.

5. 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.

Question 15

What are Preference shares ?

Answer 15

Preference shares

Preference shares are shares which carry preferential rights over equity shares on profits available for distribution (in the form of dividends) and on the leftover funds in the event of liquidation.

Although legally equity, they may be treated as debt rather than equity for accounting purposes as they carry a fixed rate of dividend, unlike equity shares where the dividend can fluctuate.

From an investor’s point of view, investment in these shares is safer as they get regular dividends and have lower risk.

However, preference shareholders do not have a say/voting rights in the management of the company.

Question 16

What are the types of preference shares you can obtain?

Answer 16

What are the types of preference shares you can obtain?

1. Cumulative and non-cumulative
2. Redeemable and irredeemable
3. Participating and non-participating
4. Convertible and non-convertible

Question 17

Explain each of the following preference shares:

1. Cumulative and non-cumulative
2. Redeemable and irredeemable
3. Participating and non-participating
4. Convertible and non-convertible

Answer 17

1. Cumulative and non-cumulative

A cumulative preference share accrues or accumulates its annual fixed rate dividend in the following year if it cannot be
paid in any year.

If dividends are not paid due to insufficient distributable profits (usually denoted by retained earnings), the right to dividend for that year is carried forward to the next year and paid before any dividend is paid to equity shares.

In case of non-cumulative preference shares, the right to dividend for that year is lost.

Normally preference shares are considered cumulative unless specifically mentioned otherwise.

2. Redeemable and irredeemable

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.

3. Participating and non-participating

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.

4. Convertible and non-convertible
   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 as well as an option to gain further benefit by converting the preference shares to equity shares.

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

Question 18

Advantages of preference shares?

Answer 18

Advantages

1. Unlike fixed interest for debt financing, dividends are only payable if there are sufficient distributable profits available
   for the purpose.
2. There is no loss of control, as preference shares do not carry voting rights.
3. 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).

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

Question 19

What are Debentures?

Answer 19

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 20

What are the types of debentures

Answer 20

Redeemable and irredeemable

Debentures can be either redeemable or irredeemable.

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

Debentures which are never repaid are irredeemable (also known as perpetual
debentures).

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.

Question 21

Advantages of debentures?

Answer 21

Advantages of debentures?

1. 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.

2. They have a fixed repayment date.
3. Unlike dividends, the interest paid is tax allowable, reducing the net cost to the company.
4. Unlike shares, there are no restrictions contained in company law regarding the terms of issue of debentures.
5. 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

Disadvantage of debentures?

Answer 22

Disadvantage of debentures?

1. 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.

2. 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.

3. 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

Sale and leaseback?

Answer 23

A sale and leaseback arrangement (sometimes only called leaseback) is a structured transaction in which the owner
(a company raising finance) sells an asset to another party (the buyer or lessor), while maintaining the legal rights to use the asset (‘lease back’) from the buyer or lessor.

Sale and leaseback arrangements usually work in the following way:

A company sells its asset (such as a building) to an investment company.

The purchasing company (lessor) acts like the landlord of the property and the selling company becomes the lessee, renting the building which it previously owned.

The rent is usually reviewed every few years.

There is a risk that the lessor will have the right to rent the property to another company if the original lessee is unable to pay rent for the property.

Properties that are rising in value, are well maintained and have a potential for increase in rental revenue are preferred in this type of arrangement.

The main advantage of this method of financing is that the company can raise more money than from a normal mortgage
arrangement.

Question 24

Advantages of Leasing?

Answer 24

Advantages of Leasing?

1. 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.

2. While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense. A company should o invest in good quality assets.
3. Leasing expense or lease payments are considered as operating expenses and are tax deductible.
4. Lease expenses usually remain constant for over the asset’s life or lease tenure, or grow in line with inflation. This helps in planning expense or cash outflow when undertaking a budgeting exercise.
5. At the end of the leasing period, the lessee holds the right to buy the property and terminate the leasing contract, thus providing flexibility to business.

Question 25

Dis-advantages of Leasing?

Answer 25

Dis-advantages of Leasing?

1. At the end of the leasing period, the lessee does not become the owner of the asset despite paying a significant amount of money towards the asset over the years.
2. The lessee remains responsible for the maintenance and proper operation of the asset being leased.
3. If paying lease payments towards a land, the lessee cannot benefit from any appreciation in the value of the land.

The long-term lease agreement also remains a burden on the business, as the agreement is locked and the expenses for several years are fixed.

4. Although a lease does not appear on the statement of financial position of a company, investors still consider long-term lease as debt and adjust their valuation of a business to include leases.
5. Given that investors treat long-term leases as debt, it might become difficult for a business to access capital markets
   and raise further loans or other forms of debt from the market.