SOURCES OF FINANCE (EQUITY)

There are two main sources of equity finance:

1) Internal funds (Retained earnings)

2) External funds (new issue of shares, rights issue etc)

INTERNAL FUNDS

The main source of internal funds comes from retained earnings. Firms set aside resources by retaining part of
their yearly earnings for future investment purposes.
WHY INTERNAL FINANCE?
It is often argued that internal funds are much more preferred to external funds because:
 Retained earnings are ready source of finance.
 There is no issue or transaction cost involve.
 There is no dilution of control.
 There is no public scrutiny of why the funds are needed and how they are to be used

EXTERNAL FUNDS
External funds are explained as under:
 Equity finance can be raised by selling ordinary shares to existing shareholders or new investors.
 These shares can be sold or bought in stock exchanges around the world.
 Ordinary shareholders are the ultimate bearers of risk in a company
 They therefore demand a higher return to compensate for the risk they bear.
 Ordinary shares have voting rights. They are the owners of business
 An ordinary share is normally issued at a price higher than the par value. The difference is called the share
premium.
 However, the issued price is not normally the same as the market price of a share and the share price
fluctuates on the basis of how stock markets assesses the future of the company.

WHY COMPANIES LIKE TO ISSUE SHARES AT STOCK EXCHANGE?

The process of issuing shares at stock exchange is called floatation.

The main reasons for floatation are:
 raising funds for current and future investments
 resolving liquidity shortages
 reducing debt levels
 using quoted shares in various ways, such as in a take-over bid

CONSEQUENCES OF FLOATATION

 Meeting investors’ expectations – it is evident that once a company is floated on a stock exchange, it will
be more heavily scrutinized by the public and especially existing investors.
 Costs of flotation – the process of flotation are a very expensive exercise for a company. It is often thought
that most companies would at some point in their life cycle have to consider flotation in the stock markets.
 Increased financial transparency and stock exchange’s requirements –Once a company is listed on a stock
exchange, the requirement for a high degree of transparency and reporting requirements might threaten
its continued listing.

WHY COMPANIES SEEK LISTING ON MORE THAN ONE STOCK EXCHANGE?

 Broaden the investor base

 Domestic stock exchange is too small Better understanding in the foreign market
 Raising awareness of the company (Chinese and Russian companies quoted on stock exchanges such as the
Hong Kong Stock Exchange and the London Stock Exchange).
ISSUING SHARES TO PUBLIC- (THE MECHANISM)

The mechanism of share issue is as follows:

 Initial public offer (IPO): This is when a firm issues shares to the public for the first time. It is a major
step for a firm to ‘go public’.
 Issuing process: Issuing process needs advisors. These advisers fall into the following categories:

 Sponsor: is the first advisor to the issuing firm. It can be an investment banker, stockbroker or
another professional. The sponsor (commonly known as the issuing house) will first examine and
assess if going public is the appropriate? The sponsor will also advise on the issue price and the
number of shares to be issued given the market conditions and the method and timing of the
equity issue.
 Under writers: Since it is difficult to estimate the precise demand of the new shares, an issuing
company will normally appoint an underwriter to underwrite any unsubscribed shares. If the price
set by the sponsor is too high, the demand will be less than supply and the issuing firm will be left
with unwanted shares. To ensure that this is not going to happen, a firm will pay the underwriters
a sum of money (acting like an insurance premium). In return, the underwriters will guarantee to
buy back any unwanted shares. The price of the unwanted shares that the underwriters will buy
back from the issuing firm will be lower than the original issue price to the public.
 Other professionals: Accountants and lawyers provide reports about the issuing firm’s financial
position and advise on legal matters relating to the equity issue.
 Other considerations: Issuing firm must consider the following also:
 Price stability – A newly floated firm should ensure that its share price is stable to give
investors additional confidence.
 Timing – Timing for new share issues is crucial to determine if the issue is going to be fully
subscribed. For e.g.The Industrial and Commercial Bank of China (ICBC) simultaneously floated
its shares on both the Hong Kong Stock Exchange and the Shanghai Stock Exchange. It was the
world’s largest IPO at that time. Due to the favourable market timing, the shares were heavily
over-subscribed and the share price ended up some 15% over the initial offer price by the end
of the first trading day.
 Initial returns –Companies which seek to float their shares for the first time might need to
consider underpricing their shares to attract investors.
 Long-term performance – A new IPO firm would need to prove itself to be a worthwhile
investment by showing solid and good long-term performance.

TYPES OF SHARE ISSUES

Points of Public Issue and Rights issue Bonus issue
differences private placements
Definition The Issue of shares Issue of rights to The issue of shares
to the general existing to existing
public in stock shareholders that shareholders
exchange, entitles them to without any
institutions, or buy additional consideration from
private issue. shares directly them.
from the co as per
their existing
shareholding.
Objective Listing requirement, Increase in the Payment of
increase of subscribed capital dividend in form of
subscribed capital shares.
Cash Yes Yes No
involvement
Impact in equity Increases Increases Remain same
after issue
Issue Price Market value Below market Face value
value
Consideration Have to pay. Have to pay Free of cost
by investor
Utilization of Not done Not done Done
reserves
Paid up amount Full or part Full or part Full always
Change in Yes Yes No
EQUITY value
after issue

CUM- RIGHT PRICE AND EXRIGHT PRICE

 Cum rights price means accumulated of dividend.

 If the share price is cum right it means that buyer of share has the right
to receive dividends.
 In a rights issue, the share price before the right issue is called cum-rights
price.
 Ex- rights price means excluding dividend.
 If the share price is ex- right it means that the seller of share has the right
to receive dividends.
 In a rights issue, the share price after the right issue is called ex-rights
price.
 A share is described as cum rights when the buyer is entitled for current
rights and share is described as Ex Rights when the seller remains the
beneficiary.

Ex Rights + Rights = Cum rights

Cum rights - Rights = Ex rights 
Announcement of Ex-dividend date Payment of dividends
dividends made 31-1-2021 date 3-2-2021
1-1-2021
Shares get Cum- div Share gets Ex- div Payment of dividends
made
Buyer has the right to Seller has the right to Cash dividends received
receive dividends. No receive dividends. No by buyer if he bought
dividends to seller dividends to buyer shares up till 31-1-2021
and cash dividends goes
to seller if shares were
bought by buyer after 31-
1-2021

THE ROLE OF STOCK MARKETS

 Allow firms to raise funds and grow – stock markets enable companies to find investors to raise funds to
finance their investments.
 Allow investors to buy and sell stocks – well-organised stock markets enable investors to buy and sell
stocks whenever they want. A stock market is said to be liquid if investors can easily buy or sell their shares
at the prevailing market prices.
 Status and publicity – due to the heavy scrutiny by regulators and stock exchanges, companies which are
floated on well-organised stock exchanges are often regarded as more valuable.
 Mergers – one of the requirements for companies to be floated on stock exchanges is that they would need
to file quarterly financial information. This more regular reporting process helps companies to disseminate
financial information more readily to investors. It is argued that this makes companies’ financial status
more transparent and hence under-valued companies are easier to identify. This might encourage under-
valued companies to be take-over targets.
 Improve corporate behaviour – the heavy regulations and scrutiny by the markets are often seen as the
‘invisible hand’ which helps steer financial managers’ action to maximise shareholders’ wealth.

CHOOSING BETWEEN SOURCES OF EQUITY

When choosing between sources of equity finance, account must be taken of factors such as:
(1) the accessibility of the finance
(2) the amount of finance
(3) costs of the issue procedure
(4) pricing of the issue
(5) control
(6) dividend policy – using retained earnings could impact the share price Because of the relative issue costs and
the ease of organisation, the most important source of equity is retained earnings, then rights issues, then new
issues.

EXAMPLE 1
Babbel Co, which has an issued capital of 2 million shares, having a current market value of $2.70 each, makes an
issue of one right share for every two existing shares at a price of $2.10.
Required:
a) Calculate the TERP.
b) Calculate the value of right to obtain one right share
c) Calculate the value of right per existing shares.
d) Shareholder B had 1,000 shares in Babbel Co before the rights offer. Calculate
the effect on the net wealth of B of each of the following options:(1) Take up the shares.(2) Sell the rights.(3) Do
nothing.

ANSWER
a) Theoretical Ex right price
2 existing shares x $2.7 = $5.4
1 right share x $2.1 = $2.1
Total value $7.5
TERP = 7.5 / 3 = $2.50
b) Value of right to obtain one right share
Value of right =TERP - RI value = 2.5 – 2.1 = $0.4 per right share
c) Value of right per existing share
Value of right per existing share = 0.4 x1/2 = $0.2 per existing share

d) Net effect on shareholders wealth

Full take up of shares.

($)
Wealth before RI
(1,000 shares x 2.7) 2,700
Wealth after RI
Existing shares = 1, 000
Right shares = 1,000 x ½ = 500.
Total shares = 1,500 3,750
Market value of shares= (1,500 x 2.5) (1,050)
Cash paid for right shares = (500 x 2.1) 2,700

Sell the rights

($)
Wealth before RI
(1,000 shares x 2.7) 2,700
Wealth after RI
Market value of shares= (1,000 x 2.5) 2,500
Cash from selling rights = (500 x 0.4) 200
2,700

Do nothing

($)
Wealth before RI
(1,000 shares x 2.7) 2,700
Wealth after RI
Market value of shares= (1,000 x 2.5) 2,500
2,500

Note
Total wealth in full take up or sell is same. But it is better to go with full take up because funds raised will be
invested in capital investment projects. So investor’s wealth is likely to increase more if he has 1,500 shares
rather than 1,000 only, plus the dilution of shareholding will not take place

EXAMPLE 2 (ASSIGNMENT)
TLC plc’s current share price is $10 each. There are 1m ordinary shares in issue. The company considers a one for
four rights issue at an issuing price of $8 per new share.
Required:
a) Calculate the TERP.
b) Calculate the value of right to obtain one right share
c) Calculate the value of right per existing shares.
d) Shareholder A has 100shares in TLC Co before the rights offer. Calculate the effect on the net wealth of B of
each of the following options:
(1) Take up the shares.(2) Sell the rights.(3) Do nothing.

ANSWER
a) Theoretical Ex right price

4 existing shares x $10 = $40.00

1 right share x $8 = $8.00
Total value $48.00
TERP = 48 / 5 = $9.60
b) Value of right to obtain one right share
Value of right =TERP - RI value = 9.6- 8 = $1.6 per right share
c) Value of right per existing share
Value of right per existing share = 1.6 x1/4 = $0.4 per existing share
d) Net effect on shareholders wealth
Full take up of shares.

($)
Wealth before RI
(100 shares x 10) 1,000
Wealth after RI
Existing shares = 100
Right shares = 1,000 x 1/4 = 25. 1,200
Total shares = 125 (200)
Market value of shares= (100 x 9.6) 1,000
Cash paid for right shares = (25 x 8)

Sell the rights

($)
Wealth before RI
(100 shares x 10) 1,000
Wealth after RI
Market value of shares= (100 x 9.6) 960
Cash from selling rights = (25 x 1.6) 40
1,000

Do nothing

($)
Wealth before RI
(100 shares x 10) 1,000
Wealth after RI
Market value of shares= (100 x 9.6) 960
960

EXAM TYPE QUESTIONS

Question 1
Supernova makes a public announcement that it will raise equity finance through a rights issue of new shares to
existing shareholders to finance a new project. The new project and the rights issue are announced
simultaneously. The project has an NPV of $10 million and requires an initial outlay of $20 million. The rights issue
shares will be priced at $2 each.
Assume that before making public the information about the new project or its financing, the firm had 20 million
shares with a market value of $3 per share. The market is semi-strong form efficient and there are no issuance
costs. When answering this question, state any additional assumptions you may need to make. Show your
calculations.
Required:
a) What is the value of a share in Supernova after the rights issue? (5 marks)

b) What is the value of a right to obtain one of the rights issue shares? Why should an outside investor be
unwilling to pay more? (3 marks)

Now assume you are an investor who holds $1 million cash and 5% of the shares of Supernova prior to the rights
issue.
c) Assume you exercise all of the rights offered to you. What is the change in your wealth after the rights issue,
compared to your wealth before the public announcement was made? (5 marks)

d)What will be the change in your wealth if you choose to buy half of the rights issue shares offered to you and
sell the rights to buy the other half?(5 marks)

e) What do your answers to parts c) and d) tell you about the relationship between rights issues, under-pricing,
and dilution of existing shareholders? How might this affect a firm’s equity issuance decision? (2 marks) [Total:
20 Marks]

ANSWER

a)
Company value before RI = (20m shares x $3) = $60m
Right issue (10m shares x $2) = $20m
NPV from project = $10m
Total value after RI and project = $90m
Share price after RI and project = 90/30 = $3 per share

b)
Share exchange ratio is 10/ 20 = ½ = 1 right share for existing 2 shares
Value of right =TERP – RI value = $3 - $2= $1 per right share
Outside investor will be not be interested in the company because share value before and after RI remains same
(i.e. $3 per share)

c)

($m)
Wealth before RI
Cash in hand 1
20m x 5% = 1m shares x $3 3
Total 4
Wealth after RI
Existing shares = 1m shares x $3 3
Right shares = 1m shares x 1/2 = 0.5m right shares x $3 1.5
Cash paid for right shares = 0.5m right shares x $2 = $1m (It is
(0)
paid out of the available $1m cash. So net cash = 0)
4.5
Total

Total increase of $0.5m wealth after RI

d)
 ($m)
Wealth before RI
Cash in hand 1
20m x 5% = 1m shares x $3 3
Total 4
Wealth after RI
Existing shares = 1m shares x $3 3
Right shares = 1m shares x 1/2 = 0.5m x 50% = 0.25m right
0.75
shares x $3
Cash paid for right shares = 0.25m right shares x $2 = $0.5m (It is 0.5
paid out of the available $1m cash. So net cash = 1- 0.5 = 0.5) 0.25
Sell the rights = 0.5m x 50% = 0.25m rights x $1 4.5
Total
Total increase of $0.5m wealth after RI

e) Your wealth does not depend on whether you buy the rights issue, however underpriced, as you can sell your
rights. It may thus make sense for companies to price right issues at a high discount as this makes it more likely
that the rights issue succeeds. But its better either to exercise rights & buy shares or sell rights. If you do nothing
then your wealth will remain same before or after RI. (i.e. $3m in shares + $1m in cash = $4m)

Question 2

The firm XYZ makes a public announcement that it will raise equity finance through a rights issue of new shares to
existing shareholders to finance a new project with a net present value of £9.8 million and an investment cost of
£25.2 million. There will be 15 million rights issue shares, priced at £1.68 each.
Assume that before making public the information about the new project or its financing, the firm had 30 million
shares with a market value of £1.95 per share. The market is semi-strong form efficient and there are no issue
costs.

(a) What is the value of a share in XYZ after the rights issue? (5 marks)

(b) What is the value of a right to obtain one of the rights issue shares? (3 marks)

(c) You are an investor who owns 1% of the shares of XYZ. You are offered 1% of the rights issue shares.

(i) Assume you buy all of the rights issue shares offered to you. What is the change in your wealth after the rights
issue, compared to the value of your shareholding before the public announcement was made? (5 marks)

(ii) What will be the change in your wealth, assuming you choose to buy half of the rights issue shares offered to
you and sell the rights to buy the other half? Is this different to your answer in (i)? Why /why not? (5 marks)

(iii) What will be the change in your wealth if you choose not to buy any rights issue shares or sell any of your
rights? (2 marks)

Answer

a)
Company value before RI = (30m shares x $1.95) = $58.5m
Right issue (15m shares x $1.68) = $25.2m
NPV from project = $9.8m
Total value after RI and project = $93.5m
Share price after RI and project = 93.5/45 = $2.08 per share
b)
Share exchange ratio is 15/ 30 = 1 /2 = 1 right share for existing 2 shares
Value of right =TERP - RI value = $2.08 - $1.68 = $0.40 per right share

C (i)
 ($m)
Wealth before RI
30m x 1% =0.3m shares x $1.95 0.585
Total 0.585
Wealth after RI
Existing shares = 0.3m shares x $2.08 0.624
Right shares = 0.3m shares x 1/2 = 0.15m right shares x $2.08 0.312
Cash paid for right shares = 0.15m right shares x $1.68 (0.252)
Total 0.684

Total increase of $0.099m wealth after RI

C (ii)

($m)
Wealth before RI
30m x 1% =0.3m shares x $1.95 0.585
Total 0.585
Wealth after RI
Existing shares = 0.3m shares x $2.08 0.624
Right shares = 0.3m shares x 1/2 = 0.15m x 50% = 0.075m right
0.156
shares x $2.08
(0.126)
Cash paid for right shares = 0.15m right shares x $1.68
0.03
Sell the rights = 0.15m x 50% = 0.075m rights x $0.4
0.684
Total

Total increase of $0.099m wealth after RI

Your wealth does not depend on whether you buy the rights issue, however underpriced, as you can sell your
rights. It may thus make sense for companies to price right issues at a high discount as this makes it more likely
that the rights issue succeeds.

C (iii)
Value before RI = 0.3 shares x 1.68 = $0.585m
Value after RI = 0.3m shares x 2.08 = $0.624m
There will be an increase in wealth of only $0.039m if investor does nothing with the RI. So it’s better to either
exercise rights or sell rights

QUESTION 3

Orion plc is an all equity company with 240 million shares issued and a current share price of 560p. Having just
received and reviewed its preliminary results for the year ended 31 March 2015, the directors have decided to
invest heavily in new technology. This will require immediate long-term financing of £112 million. The funds
can be raised by one of two ways, either by a one-for-six rights issue at a deep discounted price of £2.8 per share,
or take out a 15 year debenture for the same amount. The debenture will cost £15 million (gross) in interest each
year. If the rights issue option is taken the Price Earnings (PE) ratio is expected to remain at 14 times, while
if the debenture issue option is taken the PE ratio is predicted to decline to 13 times.
For the year to 31 March 2016 the company predicts a substantial growth in operating profits (pre-interest and tax)
to £180 million based on the benefits of the new investment and the improving trading conditions. Operating profit
before interest and tax for the year ended 31 March 2015 was £120 million. The Finance Director is optimistic that
the profit trend is an upwards one of around 10% pa. The company does not intend to make dividend payments
during the year.
Assume a corporation tax rate of 20%.
Required:
(a) Assuming a rights issue of shares is made, calculate
i. the theoretical ex-rights price of an ordinary share in Orion plc;
ii. the theoretical value of the rights for each original ordinary share. (5 marks)
(b) Estimate the price of an ordinary share in Orion plc on 31 March 2016 assuming:
i. a rights issue was made during the year; (4 marks)
ii. a debenture issue was made. (4 marks)
(c) Calculate the breakeven operating (pre-interest and tax) profit for a shareholder to be indifferent between the
two methods of raising the required long-term capital. (6 marks)
(d) Discuss your results from (a) to (c) above and explain how critical, in your view, the pricing of a rights issue is
likely to be. Finally in the light of the information given, results obtained, and the discussions you have provided
make a recommendation to the directors of Orion plc as to which method they should use to raise the required long-
term capital. (6 marks)

Answer
a (i)
6 existing shares x £5.6= £33.60
1 right share x £2.8 = £2.8
Total value = £36.4
TERP = 36.4/ 7 = £5.20

a (ii)
Value of right per existing share = 5.2 – 2.8 = 2.40 x 1/6 = £0.40
(or) = 5.6 – 2.8 = 2.80/7 = £0.40

b (i) (ii)

Details Share price if RI is made (£m ) Share price if debentures were

issued (£m)
EBIT 180 180
Interest - (All equity firm) (15) given
EBT 180 165
PER 14 13
Total value before tax (EBT x PER) 2520 2145
Tax (20%) (504) (429)
Total value after tax 2016 1716
Existing shares (in millions) 240 240
Right shares (in millions) 240 x 1/6 40 0
Total shares (in millions) 280 240
Share price 7.20 7.15

c)
If X represents EBIT, the value of the old shareholders’ equity at the end of the year assuming that a right issue
was made during the year is = 14X * (1 – T) * 6/7. If debenture issue was made, the equivalent payoff is
(X-15)*13* (1 – T). Now the old shareholders are hence indifferent when:
14X * (1 – T) * 6/7 = (X-15)*13* (1 – T)
Solving for X
X = £195m

d)
Right issue (Benefits)
1) Shares are offered at a discounted price.
2) No dilution of control if rights are exercised.
3) Company can save some costs (e.g. underwriter fee, advertisement etc.).
Right issue (Limitations)
1) Control gets diluted if rights are not taken up.
2) Sometimes RI is viewed as negative market sentiment. People think company is struggling to run operations
smoothly.
Debt issue (Benefits)
1) Large wealth accumulation.
2) Interest cost is tax deductible
3) Utilizing available equity elsewhere. (I.e. in well diversified portfolios).
Right issue (Limitations)
1) Increase in financial risk of business.
2) Legislative risk (change in tax laws, regulatory framework etc.).
3) Low dividends for shareholders.