Sources of Finance

Key Learning Points

 Sources of long-term finance

 Sources of equity finance

 Sources of debt finance

 Debt finance vs. equity finance (advantages and disadvantages)

Sources of long-term finance

SOURCES OF LONG – TERM FINANCE

PREFERENCE OTHER
EQUITY SHARE DEBT SOURCES
FINANCE FINANCE FINANCE OF
FINANCE
Equity Finance

 What do you need to know? : -

• Definition of equity finance

• Types of equity finance

i. Retained earnings

ii. Rights issues (see associated lecture)

iii. Issue of new shares to new investors

Equity Finance

 Equity capital is the ordinary share capital in the business

 This is finance raised from the company’s ordinary shareholders

 Ordinary shares give the holder the right to vote on major decisions and
effectively give ownership in a business

 The ordinary shareholder therefore ‘owns’ any profits generated in the

business after interest and tax has been paid
Types of Equity Finance

 Three main types of equity finance: -

• Retained earnings
• A rights issue of shares
• A new issues of shares to new investors

1. Retained Earnings

This is where directors of the company decide to retain and reinvest

profits that are generated rather than distribute profits as dividends.

This is the simplest form of equity finance and it avoids incurring the
issue costs associated with a rights issue or an issue of new shares.
Types of Equity Finance
2. Rights Issue (more of this in the next lecture)

The existing shareholders are offered the right to buy new shares in
proportion to their existing shareholding.

A shareholder who is offered the right to buy new shares in the company
has three options available:

i. To take up the rights

ii. To sell the rights to another investor
iii. To allow the rights to lapse

3. Issue of new shares to new investors

This is where the directors of the company offer new shares to new
investors. There are three main ways in which this can be done:

i. An offer for sale

ii. An offer for sale by tender
iii. A placing
 Issue of new shares to new investors

i. An offer for sale

This is often made when a company first obtains a listing on a stock

exchange. When a company first obtains a listing on a stock exchange this
is often called an IPO (Initial Public Offering).

The company and its advisors set an issue price and then invite the investing
public to buy the new shares issued at that price.

ii. An offer for sale by tender

Rather than set an issue price, in this case a minimum price for the shares is
set and investors are invited to bid for the shares at or above this price.

After all the bids have been received an issue price is the set.

This is particularly useful as a method of issuing new shares when there is

difficulty in determining an appropriate issue price.
 Issue of new shares to new investors

iii. A placing

New shares are sold or ‘placed’ by a merchant bank directly with an

institutional investor or a number of institutional investors e.g. a large
pension fund.

This has the advantage of ensuring that the issue will be successful before it
even takes place.
Preference Share Finance

Preference share capital offers an investor a fixed dividend each year which is a
percentage of the nominal value of the capital.

Key characteristics of preference share capital: -

• An investor receives a fixed dividend each year

• A preference share holder cannot benefit if the company profits grow

• A company does not have to pay the fixed dividend in a year when
performance is poor

• The ability of a company to delay or defer a dividend in a bad year makes this
a more risky form of investment than debt capital

• Dividends paid to preference share holders are a distribution from post-tax

earnings, like dividends to ordinary shareholders
Debt Finance

Debt finance is where an investor receives a guaranteed return each year on the
capital invested, normally in the form of interest payments.

A company must pay interest to the providers of debt finance before paying
dividends to preference and ordinary shareholders.

The interest payable is tax allowable from a company’s point of view.

The main types of debt finance to be aware of: -

i. Bank term loan

ii. A straight bond
iii. Zero coupon or deep discounted bond
iv. Unsecured bond (mezzanine finance)
v. Convertible bond
vi. Straight bond with warrants attached
vii. Leasing
Other sources of finance
Small company financing: -

Financing possibilities for smaller unquoted companies are significantly more

limited than those available to large quoted companies.

Main financing possibilities for small companies: -

1. Bank term loan / overdraft

This is a prime source of financing for small companies. Often small

companies use over draft facilities as medium to long-term financing

2. Retained earnings

Many small companies rely on using retained earnings for financing rather
than paying a dividend

3. Business angels and venture capital funding

Smaller private companies with ambitious growth plans can raise new
finance from business angels or venture capital funding
Business Angels and Venture Capital Funding
Venture Capital Funding

Venture capital organisations specialise in providing capital to high potential

growth, but riskier, private companies e.g. high technology or research and
development companies.

In order to obtain a high return they will normally demand a significant equity
stake in return for finance.

A venture capital company will normally look for an EXIT ROUTE from the
investment.
Business Angels

The term business angel refers to a wealthy individual, or group of individuals,

who are willing to invest in smaller businesses.

Like venture capital organisations they would normally take a significant equity
stake. Business angels tend, however, to be prepared to invest at an earlier
stage than venture capital organisations, and are often prepared to invest for a
longer period of time.
Debt vs. Equity Financing

The advantages of using debt finance over equity: -

• Debt interest is tax allowable whereas dividends are not

• Debt does not carry votes thus by issuing debt the control of the company is
not affected

• Debt finance is fairly quick to arrange

• Debt finance has little in the way of issue costs making debt cheaper for the
company to issue than equity

• As debt is cheaper it may have a more beneficial impact on earnings to equity

shareholders than a fresh equity issue
 Debt vs. Equity Financing

The disadvantages of debt finance: -

There are two key problems with using debt as a source of finance

Firstly is that providers of debt finance may wish to protect their interests by
imposing restrictions on the company: -

• Secured assets may not be disposed of without the debt holders permission
• Further raising of debt finance is prohibited
• Debt holders may have power of veto over new investment opportunities if
they consider them too risky

Secondly, companies with a high level of debt finance in their capital structure run a
higher risk of insolvency than companies that do not i.e. high gearing!!...

This is because interest must be paid but dividends can be passed (i.e. not paid) by
directors.
Debt vs. Equity Financing

Benefits of equity shares as a source of funds: -

• No fixed charges i.e. dividends do not have to be paid

• No fixed maturity date

• Increases the creditworthiness of the firm

• Access to wide source of investors

• The opportunity for the owners of the business to realise part or all of their
investment

• Enhanced status for the company

• Reduces your gearing level

Debt vs. Equity Financing

Disadvantages of equity shares: -

• Issuing ordinary shares extends voting rights of shareholders

• Costs of underwriting and distributing new issues are high

• Overall cost of capital may be raised if there is a lot of equity finance

• Dividends are not tax deductible, like interest payments

• Public scrutiny and accountability

• Possibility of takeover bids

• Increased costs of company reporting

• Outside pressure on directors of the company (profits & dividends)

Key Learning Points

 Sources of long-term finance

 Sources of equity finance

 Sources of debt finance

 Debt finance vs. equity finance (advantages and disadvantages)

Sources of Finance