Chapter 5 Financing – Equity finance By the end of this session you should be able to: evaluate the financing requirements of an entity and recommend a strategy for meeting those requirements (in particular, evaluate and compare alternative methods of raising equity finance) and answer questions relating to these areas.

Chapter 5

Chapter 5 1 The financing decision 1.1 Debt or equity finance The financing decision has already been identified as one of the three key decisions of financial strategy (along with the investment decision and the dividend decision). The key decision is whether to use equity or debt finance. Consider: cost of the different sources of finance (kd < ke) duration – for how long is finance required? lending restrictions – for example security and debt covenants gearing level (also called capital structure) liquidity implications – the ability of the business to service the new debt, allocating sufficient cash resources to meet interest and capital repayment obligations the currency of the cash flows associated with the new project impact of different financing options on the financial statements, tax position and financial stakeholders of the entity availability – availability of finance depends on the creditworthiness of the borrower and also the willingness of lenders to extend credit (for bank borrowings) or liquidity of the capital markets (for equity and bonds).

Chapter 5 2 Sources of equity finance 2.1 Terminology Ordinary shares Dividends paid at the discretion of the company's directors. Ordinary shareholders are the owners of the company, attend meetings and vote on any important matters. Subordinate to all other finance providers on a winding up. Preference shares A form of equity that pays a fixed dividend, paid before ordinary share dividends. On a winding up, preference shareholders are subordinate to debt holders and creditors, but receive their pay-out before ordinary shareholders.

Chapter 5 Rights issue of shares Ordinary shares Dividends paid at the discretion of the company's directors. Ordinary shareholders are the owners of the company, attend meetings and vote on any important matters. Subordinate to all other finance providers on a winding up. Rights issue of shares New shares are issued to existing shareholders in proportion to their existing shareholdings. Rights issues are simple to arrange and do not alter control, but are not always suitable for raising large amounts of finance. New issue of shares Only a quoted company can issue shares to ‘the market’. Issues can be placings or IPOs (Initial Public Offerings).

Chapter 5 2.2 Capital markets Stock market Ordinary shares Dividends paid at the discretion of the company's directors. Ordinary shareholders are the owners of the company, attend meetings and vote on any important matters. Subordinate to all other finance providers on a winding up. Stock market A place where LARGE companies can become ‘listed’ or ‘quoted’. New shares can be issued into the market, and existing shares can be traded. Stringent criteria are applied to quoted companies, but the company’s profile is raised by being quoted. Alternative Investment Market (AIM) A stock exchange for smaller companies. More straightforward admission requirements than the main stock exchange.

Chapter 5 3 More details on rights issues 3.1 Theoretical ex rights prices (TERP)

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 5 Key point The wealth of a shareholder will always increase by his share of the project NPV, as long as he either takes up his rights, or sells them. Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Now try TYU questions 1, 3 and 7 from Chapter 5

Chapter 5 3.2 Yield adjusted theoretical ex rights prices

Chapter 5 OT Questions You should now be able to answer all the TYU questions from Chapter 5 in the Study Text and questions 78, 94 to 104 inclusive and 117 from the Exam Practice Kit For further reading, visit Chapter 5 from the Study Text.