Types and sources of long-term funds

Question 1

What is the definition of a Share?

Answer 1

A fixed identifiable unit of capital in an entity which normally has a fixed nominal value, which may be quite different from its market value.

Question 2

What are the characteristics of Ordinary Shares?

Answer 2

• Are issued to owners of a company
• Ordinary shareholders have rights as a result of their ownership of the shares.
• Shareholders can attend company general meetings and can vote on important company matters such as:
  ~ appointment and re-election of directors
  ~approving takeover bid for another company
  ~ appointment of external auditors
  ~ approving company’s remuneration policy for senior executives
• Entitled to receive share of any agreed dividend
• Will receive a share of any assets remaining after liquidation
• Can participate in any new issue of shares

Question 3

What are the advantages of ordinary shares as source of finance?

Answer 3

• No obligation to repay the funds raised through an ordinary share issue
• Amount and timing of a dividend payments is flexible

Question 4

What are the disadvantages of ordinary shares?

Answer 4

• Cost of equity finance is typically higher than cost of debt finance because:
  ~ admin costs of issuing shares are expensive
  ~ to investors, shares are riskier than debt so shareholders expect a higher return
  ~ dividends paid are not tax deductible whereas interest payments can be used to reduce company’s taxable profits.
  ~ issuing new shares will typically dilute the control of original shareholders

Question 5

What are the characteristics of Preference Shares?

Answer 5

• Have a face value
• Have no voting rights
• Also receive dividends
• Dividends are paid before ordinary dividends
• In event of liquidation, they receive their share of remaining assets after all debt-holders and creditors but BEFORE ordinary shareholders
• May have conditions attached to them
• Participating preference shares = give holder fixed dividends plus extra earnings based on certain conditions
• Convertible preference shares = can be exchanged for a specified number of ordinary shares at a given future

Question 6

What are the 3 ways to represent preference shares?

Answer 6

• Depends on whether they meet the Conceptual Framework’s definition of a liability (present obligation of an entity to transfer economic benefits as a result of past events.
  1.) Cumulative irredeemable preference shares contain an obligation to pay dividends and are therefore treated as a liability
  2.) Redeemable preference shares contain an obligation to repay the principal so are also treated as a liability
  3.) Non-cumulative irredeemable preference shares are treated as equity because they do not contain an obligation.

Question 7

What are the advantages of Preference shares as a finance source?

Answer 7

• Preference shareholders do not have voting rights, share issue does not dilute control of ordinary shareholders
• Cost to company cheaper than ordinary shares because preference shareholders are exposed to lower risk and expect lower return
• Where company is not permitted to obtain additional debt finance, issuing of preference shares may be a possible alternative.

Question 8

What are the disadvantages of preference shares?

Answer 8

• Payment of preference shares is MANDATORY where distributable funds are available
• Cost of preference shares is still more expensive than debt
• Preference shares paid is NOT TAX-DEDUCTABLE

Question 9

Name the characteristics of Long-term debt:

Answer 9

• Providers of debt finance are not owners of business
• Entity has obligation to pay interest to debt-holders and to repay the principal
• On liquidation, debt-holders would have priority access to assets of the entity before any shareholders. Less risk than ordinary shareholders, expected return on debt is lower than return on shares
• Cost of debt is cheaper because interest is tax deductible
• If entity has little or no existing debt finance, it may be easier to raise a debt finance rather than equity finance, particularly if the company is unquoted

Question 10

What are the characteristics of Bank Loans (Long-term debt finance)?

Answer 10

• Will be for a fixed amount
• Interest rate may be fixed, variable, or capped (bank guarantees a maximum rate of interest)
• Repayment of structure will be put in place
• Bank may require security for the loan
• Loan covenant may be set by the bank

Question 11

What are the 2 examples of debt covenants (loan covenants)?

Answer 11

1.) Positive covenants:
- maintaining certain levels of particular financial ratios
- ratios such as debt to equity, debt to net assets,interest cover and net working capital
2.) Negative covenants
- limit the borrower’s behaviour
- Examples include not being allowed to borrow from another lender or limitations on level of dividends a company is permitted to pay

Question 12

What is a conventional bond?

Answer 12

A debt instrument, offering a fixed interest over a fixed period of time, and normally with a fixed redemption value. Can be issued by governments or companies (corporate bonds).

Question 13

What is a Convertible Bond?

Answer 13

-Convertible bonds give the holders the right (but not obligation) to convert their bonds at a specified future date into new equity shares of the company at a conversion rate that is also specified when bonds are issued.
- Convertible bonds issued at par normally have a lower coupon rate of interest than conventional fixed rate bonds because the convertible bondholders have the potential additional benefit of the value of shares on conversion being higher than redemption value of the bond. Very attractive for a company.

Question 14

What are the 2 different securities offered for bonds and bank loans?

Answer 14

1.) Fixed charge =
- security relates to specific asset/group of assets
- company cannot dispose of assets without providing substitute/consent of lender
2.) Floating charge=
- Security relates to certain group of assets which will be constantly changing
- Company can dispose of assets until default takes place
- In event of default the lender appoints a receiver rather than laying claim to assets

Question 15

What are Capital Markets?

Answer 15

Markets for trading in medium-to long-term finance, in form of financial instruments such as equities and corporate bonds.
- In UK the principal capital markets are main market (stock exchange listing), and second tier Alternative Investment Market (AIM).

Question 16

What are the Primary and Secondary functions that capital markets must fulfill?

Answer 16

1.) Primary =
- Purpose: to enable companies to raise new finance by issuing new shares or bonds
- In UK, company must be publicly listed company to be allowed to raise finance from public on capital market
2.) Secondary =
- Purpose = to enable investors to sell their investments to other investors
- Marketability of securities is an important feature of capital markets because investors are more willing to buy shares if they know they can sell them easily

Question 17

What are the 6 advantages of seeking a Stock Market Listing?

Answer 17

1.) Improved marketability
2.) Enhanced public image
3.) Original owners realising holding
4.) Original owners selling holding to obtain funds for other projects
5.) Easier to seek growth by acquisition
6.) Access to wider pool of finance

Question 18

What are the 3 disadvantages of Stock Market Listing?

Answer 18

1.) Significant public regulation,accountability and scrutiny.
2.) Wider circle of investors with more exacting requirements will hold shares
3.) Additional costs involved in making share issues,including brokerage commissions and underwriting fees.

Question 19

What are the 3 ways that an unlisted company can obtain a listing on the stock market?

Answer 19

1.) Initial public offering (IPO)
2.) Placing
3.) Introduction

Question 20

What is a Market Maker?

Answer 20

Company or individual that undertakes to buy and sell securities at specified prices

Question 21

The choice between IPO and Placing?

Answer 21

• Placings are much cheaper. Approaching institutional investors privately is much cheaper way of obtaining finance. IPO will involve underwriting costs and costs of advertising the share issue to the public.
• Placings are quicker
• Placings are likely to involve less disclosure of info.
• Most shares will be placed with a relatively small number of shareholders, means that most shares are unlikely to be available for trading after flotation, and institutional shareholders will have control of the company.

Question 22

What is a Rights Issue?

Answer 22

Is an issue of raising of new capital by giving existing shareholders the right to subscribe new shares in proportion to their current holdings. These shares are usually issued at discount to market place.

Question 23

What is the main characteristic of a Rights issue?

Answer 23

The issue price must be set low enough to secure acceptance of shareholders but not so low that earnings per share is excessively diluted.
Cheaper than public shares but still have underwriting costs.

Question 24

What are the possible courses of action open to existing shareholders regarding the rights issue?

Answer 24

-Buy the new shares
- Sell their right to buy the shares
- Sell enough rights to finance their share purchases
- Do nothing

Question 25

What are the 3 main groups in the Bond market?

Answer 25

1.) Issuers - Sell bonds in capital markets to raise finance. Commonly governments, banks and corporations
2.) Underwriters - Help issuer to sell bonds in market. Consist of investment banks, other financial institutions. Used for corporate debt market because risks are higher.
3.) Purchasers - Buy bonds to hold as an investment. Buyers include the government, banks,corporations as well as any other investor including individuals.

Question 26

What is a Sponsor?

Answer 26

Typically an investment bank or large accounting firm, acts as lead advisor in an IPO on the market.

Question 27

What are the Sponsor’s 4 functions?

Answer 27

1.) Project managing the IPO process
2.) Co-ordinating the due diligence and drafting of the prospectus
3.) Ensuring compliance with applicable rules
4.) Developing the investment case, valuation and offer structure
- For listings of AIM, the role of sponsor is fulfilled by nominated advisor(nomad)

Question 28

What is a Bookrunner?

Answer 28

Main underwriter of a syndicate (group of underwriters) for new share and debt issues. It is usually a financial institution, such as investment bank.

Question 29

What does a Bookrunner usually do?

Answer 29

• Raises finance from investors on behalf of company
• Helps to determine the appropriate pricing for the shares of debt
• Guarantees to buy unsold shares or debt itself if it is unable to find enough investors

Question 30

What is the Reporting Accountant?

Answer 30

Reviews and reports on company’s readiness for listing

Question 31

What are the responsibilities of the reporting accountant?

Answer 31

• Financial reporting procedures
• Financial historical records
• Working capital
  -Other information - any additional info provided in prospectus, such as profit forecasts and proforma financial information.

Question 32

What does a Lawyer typically do in an IPO?

Answer 32

• Performs legal due diligence
• Drafts the prospectus
• Provides legal opinions

Question 33

What is a Financial public relations firm?

Answer 33

Company obtaining a listing may appoint a financial PR firm to develop an appropriate communication strategy pre-IPO and post-IPO.