University of Portsmouth

Department of Accounting and Finance

Business Finance

Sources of Long Term Finance 1

 • Issues Concerning Types of
Sources of Long Term Financing
Finance 1
• Equity Financing:

Methods of Raising Equity

Finance

Retained profit

Bonus Issues

Rights Issues
 Introduction
We have discussed that there are three important
elements of Business Finance.
• These are Investment, Financing and the
Dividend decision.
• We have be looking at techniques that assist us in
determining which projects to invest in (the
investment decision) now we will turn our
attention to the financing issue.
• This may concern the financing of an individual
project or the company as a whole.
Issues Concerning Types of Financing
• We have previously discussed that businesses
raise their financing from equity shareholders
or from borrowing.
• We will now look at each of these in more
detail giving consideration to both the
objective of the company (shareholder wealth
maximisation) and the relative attractiveness
of the different types of financing to the
investor themselves.
 The company must consider the following factors
when determining their source of financing:

• The administrative and legal costs of raising the finance;

• The cost of servicing the finance e.g. paying interest or

dividends;

• The level of obligation to make interest or similar payments;

• The tax deductibility of the cost related to the finance;

• The effect of the new finance on the level of control of the

business by it’s existing shareholders.
The supplier of the finance (investor) will need
to consider the following factors:
• The level of return that is expected by the investors;

• The level of risk that is attached to the returns;

• The potential for liquidating the investment;

• The personal tax position of the investor;

• The degree of control that the investor will acquire in

the business.
 • Equity share capital is the
company's issued share
Equity Financing capital less capital which
carries preferential rights.

• Equity financing is the largest

source of raising capital.
Equities attract a wide range
of investors both private and
institutional.
• Note that In recent years
there has been a trend
towards loan financing.
 Equity Financing
• The ordinary shareholders are the owners of
the business who through their voting rights
attaching to their shares exercise ultimate
control over it.
• As the owners of the business they bear the
greatest risk.
 • If the business is trading
Equity Financing
unsuccessfully the ordinary
shareholders are the first to
suffer in terms of lack of
dividends and probably a
fall in the market value of
their shares.
• However if the business
does well then the ordinary
shareholders will share in
that success.
Methods of Raising Equity Finance
There are three ways of raising new equity
finance:
• These are retaining profits (rather than paying
them out as a dividend);
• Making issues of new shares to existing
shareholders; and
• Making new issues of shares to the public.
 Retained profit
• Retained profits are a very important source
of finance accounting for about half of the
long term finance raised by companies over
recent years.
• At first consideration retained profits may
seem like a source of funds that requires
nothing to service. There is an opportunity
cost of this type of financing.
 • Factors to considering is
using retained profit as a
Retained profit source of finance:

• There are no issue costs;

• The source of funds are
certain;
• There is no dilution of
control.
 Bonus shares

• In much the same way that businesses split

the nominal value of shares they can convert
retained profits into ordinary shares.

• They distribute these to ordinary shareholders

free of charge, these are known as Bonus
Shares.
Example 1 Bonus Shares Company X
Example 1 Bonus Shares Company X
 Bonus Issue
• The economic effect of the bonus issue should
be zero. If the shares of company X was
previously priced at £1.80 before the bonus
issue then after the bonus issue the price
should be £1.20 (£1.80 x 2/3).
• If there are no economic consequences why
do companies make bonus issues?
 Bonus Issue
• Possibly bonus issues are intended to transmit
information, they maybe thought to indicate
confidence on the part of management of the
investments they have made.
• Another possible reason is it reduces the unit
price of the shares to a more marketable size.
 Rights Issues

• The following definition have been provided by the

Chartered Institute for Management Accountants
(CIMA):

A Rights issue is the raising of new capital by giving

existing shareholders the right to subscribe to new
shares and debentures in proportion to their current
holdings. These shares are usually issued at a discount
to the market price. A shareholder not wishing to take
up a rights issue may sell the rights.
 Rights Issues

The advantages to rights issues are as follows:

• Rights issues are cheaper than offers for sale * to the general public.
• This is partly because no prospectus is required but also because the
administration is simpler and the underwriting ** costs are less.

* An offer for sale is a means of selling share to the public at large based
on information held in a prospectus.

** Underwriters are financial institutions which agree (in exchange for a

fee) to buy any unsubscribed shares at the issue price.
 Rights Issues

• Rights issues are more beneficial to existing

shareholders than issues to the general public.
New shares issued at a discount to the market
price to make them more attractive to investors.

• Relative voting rights are unchanged as long as all

the investors take up their rights.

• The finance raised may be used to reduce gearing

by paying off long term debt.
 Example 2 Rights Issue - Seagull PLC
Seagull PLC At present it’s capital structure is as follows:
£
200,000 ordinary shares of £1 each 200,000
Retained earnings 100,000
Total 300,000

• Seagull can achieve a 20% profit after tax on capital employed.

• The directors propose to raise an additional £126,000 from a rights issue.
• The current market price is £1.80.

1. Calculate the number of shares that must be issued if the price is:
A. £1.60
B. £1.50
C. £1.40
D.£1.20

2. Calculate the dilution in Earnings per Share (EPS) in each case.

Example 2 Rights Issue - Seagull PLC
 Example 2 Rights Issue - Seagull PLC

• Earnings before the rights issue are £300,000 x

20% = £60,000

• This gives an earnings per share of

£60,000/200,000 shares = 30p

• The earnings after the rights issue will be

(£300,000 + £126,000) x 20% = £85,200
Example 2 Rights Issue - Seagull PLC
 Rights Issue
• After a rights issue has been made the market
price of the shares will normally fall. This is
because there are more shares in issue and
the rights issue was made at a discounted
price. It is therefore possible to calculate a
theoretical ex-rights price (a price after the
rights issue has been made).
 Rights Issue
• The formula of theoretical ex-rights price:

• (1 / N+1) x ((N x cum rights price) + issue price)

• Where N is the number of shares required to buy

1 new share.

• Cum rights price is the market price of the share

before the rights issue.
 Example 3 Rights Issue - Company Y

• Company Y has £4m ordinary £1 shares whose market value is

£1.80 each.

• It wishes to raise a further £1.2m of capital via a rights issue.

• The rights issue has been priced at a value that it is hoped will be
attractive to investors at £1.50 per share.

• The number of shares to be issued therefore will be £1.2m/£1.50 =

800,000 shares

• These will be offered to existing shareholders on a 1 to 5 basis i.e.

4000,000/800,000 = 5

• What will be the ex rights price per share?

Example 3 Rights Issue - Company Y
 Example 3 Rights Issue - Company Y
Using the formula:

(1 / N+1) x ((N x cum rights price) + issue price)

(1 / 5+1) x ((5 x £1.80) + £1.50)

= £1.75
 Example 3 Rights Issue continued
• A shareholder has 3 options under a right
issue. Let’s illustrate this by assuming a
shareholder with 100 shares.
• The Rights issue price is £1.50 giving 800,000
new shares.
• Under this scheme he will be entitled to 20
shares i.e. 4,000,000 / 800,000 = 5 (5 to 1).
 Example 3 Rights Issue continued
• Option 1 Purchase the rights issue.
• He will pay 20 x £1.50 = £30.

• Before the rights issue his share holding was worth:

100 shares x £1.80 = £180

• After the rights issue his share holding is worth:

120 shares x £1.75 = £210
Less paid for rights issue 30
Total £180

• Conclusion he is no better or worse off after the rights issue

 Example 3 Rights Issue continued
• Option 2 Sell the right

• He could sell the right for:

£1.75 - £1.50 = 0.25 x 20 shares = £5

• His share holding after the rights issue will be

100 shares x £1.75 £175
Plus cash 5
Total £180

• Conclusion he is no better or worse off after selling the right.

 Example 3 Rights Issue continued
• Option 3 Do nothing
• His share holding after the rights issue will be
100 shares x £1.75 £175

• Conclusion, a loss of £5
Further Reading
• Business Finance Theory
and Practice - Eddie
McLaney Chapter 8