CHAPTER 4 –SOURCES OF FINANCE
MARKETS
Primary Is a financial market in which new issues of security are sold by the issuer to initial buyers.
Secondary Is a market in which securities that have already been issued can be bought and sold.
Money Are markets for short-term capital.
Capital Are markets for medium-term to long-term capital.
Capital markets in the UK
1. The Stock Exchange
2. The ‘gilts’ or gilt-edged market
3. The Alternative Investment Market (AIM)
4. Over-the Counter (OTC) markets
5. Banks
PROVIDERS OF CAPITAL
The providers of capital include private individuals who buy stocks and shares directly on the Stock Exchange.
However, there are also the important types of institutional investor. These include:
▪ Pension funds
▪ Insurance companies
▪ Investment trust companies
▪ Unit trust companies
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SOURCES OF FINANCE
Source Key features
Equity (ordinary shares) - Carry votes Advantages:
- True owners of the company • Usually there is no obligation to pay
dividends
- Get paid dividends decided by the directors
• The capital does not have to be repaid
Disadvantages:
• High cost: direct costs of issue and the
return required to satisfy shareholders
• Unlike interest, dividends cannot be used
to reduce taxable profit
Preference shares - No votes Advantages:
- Fixed dividend • No need to pay dividend of profits are
poor
- Get money back before ordinary shareholders in
• Do not dilute control (usually no voting
the event of a winding up
rights)
• Unsecured, so preserve debt capacity
Disadvantages:
• Higher cost compared to debt due to tax
inefficiency
Debt - Usually secured Most are secured on assets such that lenders
are protected (in repayment terms) above
- Interest rates may be fixed or floating
unsecured creditors in a liquidation
-Company gets tax relief on interest payments
Debentures & Loan Most typical forms of debt in the UK. Usually fixed Covenants are written to ensure compliance
Stock interest rate borrowings with a set repayment date with the debt contract.
• Affirmative covenants (Dos)
• Negative (restrictive) covenants (Donts):
limits on
o Further debt issuance
o Dividend level
o Disposal of assets
o Certain financial ratios
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RAISING EQUITY FINANCE
Methods
Retained earnings Retaining earnings rather than paying ▪ By far the most important source
them out as dividends of equity, especially for young
growing businesses.
▪ Not costless: maybe no issue
costs but shareholders still
expect a return on the funds re-
invested.
Rights issues A secondary issue made to all existing ❑ Shareholders who subscribe to
shareholders, who are entitled to take the issue retain their
up new shares in proportion to their proportionate voting power.
present holdings. ❑ A rights offer usually allows
existing shareholders to acquire
shares in the business at a price
below the current market price.
❑ This means that entitlement to
participate in a rights offer can
sell their rights to other investors.
❑ Shareholders not wishing to take
up their rights may sell them on
the stock market or via the firm
making the rights issue, either to
other existing shareholders or
new shareholders. The buyer
then has the right to take up the
shares on the same basis as the
seller.
Public (new) issue To new shareholders, used at the time a
firm obtains a listing on the Stock
Exchange, or by large companies looking
to raise large amounts in a high profile (but
expensive) manner.
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RIGHTS ISSUES Popular in exams; combined with
Chapter 6 concepts.
Advantages Disadvantages
❑ The finance is guaranteed either from existing ❑ The fees of the underwriters and other issuing costs
shareholders or from the underwriters. may be expensive depending upon the underwriter’s
❑ There will be no change in the members of the perception of the success or otherwise of the rights
company or their relative voting powers provided the issue.
existing members subscribe for the shares. ❑ A rights issue forces the existing members to either
❑ If the stock market is rising, investors will be seeking subscribe for the shares or sell the rights; they may
to buy shares and therefore the rights issue should resent having to spend money to maintain their
be sold with relative ease. existing percentage holding in the company.
❑ The rights issue being equity finance will lower the ❑ Rights issues have to be made at a discount to
gearing ratio, thereby reducing the debt risk of the encourage their purchase, this usually reduces the
company. share price initially as there is a time-lag between
❑ They are far cheaper than a public share issue. raising the finance and generating the
Provided the issue is for less than 10% of the class corresponding increase in earnings.
of capital, there is no need for a prospectus,
although a brochure must still be made available.
THEORETICAL EX-RIGHTS PRICE
Example 1
A company has 100,000 shares with a current market price of £2 each.
It announces an increase in share capital to be achieved by a rights issue of one new share for every two existing
shares. The rights price is £1 per new share, thus raising £50,000 for investment in the new project.
Requirements
(a) Compute the theoretical ex-rights price (TERP)
(b) Calculate the value of the right to subscribe for each new share
(c) Calculate the value of the right to subscribe for each existing share
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(a) Calculation of TERP
(b) Value of rights offer (new share)
(c) Value of rights offer (existing share)
Impact of a rights issue on shareholder wealth
Shareholder’s choices in a rights issue
1. Investor takes up the rights issue
2. Investor sells the rights
3. Investor lets the rights offer lapse
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Example 2
Assume a shareholder owns 1,000 shares in the company whose share value was described above in Example 1.
Requirement:
Show the shareholder's position if:
(a) He takes up his rights
(b) He sells his rights for 662/3p per new share
(c) He does nothing.
Effect on shareholder’s wealth:
Before rights issue: Value of shares =
If he takes up the rights
Value of shares post-rights =
Cost of buying rights shares =
Comment:
If he sells the rights
Value of shares post-rights =
Sale of rights =
Comment:
If he does nothing
Value of shares post-rights =
Comment:
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Example 3 (Rights issue to finance a project)
The above company raises the £50,000 in order to take on a project with an expected NPV of
£25,000.
Summary of data
▪ Current market price is £2 per share
▪ 100,000 shares currently in issue
▪ A 1 for 2 rights issue at £1 will raise the £50,000
Requirement:
(a) What is the value of the company after the new project and the new issue?
(b) What is the ex-rights price per share and the value of the right?
(c) Assume a shareholder owns 1,000 shares. What is the effect on the shareholder’s wealth if he:
(i) takes up his rights
(ii) sells his rights
(iii) does nothing
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(c) Effect on shareholder’s wealth:
Before rights issue: 1 000 shares x £2 = £2 000
If he takes up the rights
Value of shares post-rights =
Cost of buying rights shares =
Comment:
If he sells the rights
Value of shares post-rights =
Sale of rights =
Comment:
If he does nothing
Value of shares post-rights =
Comment:
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Example 4 (Changing the terms)
The company in Example 1 raises the required £50,000 by issuing new shares on a one-for-one basis at
50p per new share.
Show what would happen to the shareholder's wealth (from the worked example) if he:
(a) Takes up his rights
(b) Sells his rights
MV of shares pre-rights =
Rights issue =
Project NPV =
TERP =
Value of rights:
Per new share: 1.375 – 0.50 = £0.875
(a) Takes up his rights
Value of shares post rights =
Cost of buying rights =
(b) Sells his rights
Value of shares post-rights =
Sale of rights =
Conclusion:
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Factors that may influence the actual share price following the rights issue:
1. The expectations of investors/the stock market regarding the company's future.
2. The level of take-up of the rights issue – if the issue was not fully taken up, for example, the share price
might fall.
3. Information regarding the use to which the proceeds will be put and the market's reaction to that information
– possibly being used to restructure finances in a way that affects the company's cost of capital; or being used
in a project with a positive net present value.
4. General stock market conditions/sentiment at the time of the issue, or conditions/sentiment within the
company's particular sector of the stock market.
5. The existence of specific information (positive or negative) regarding the company or its sector at the time
of the issue.
6. It is assumed that the details of any new investment/strategy are communicated to, and believed by, the
stock market, but if this is not the case then the share price will differ from the theoretical ex-rights price. In
other words, the degree of efficiency of the market could impact on the actual share price.
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CHAPTER 4 –SOURCES OF FINANCE
Bonds
A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the
funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states
and UK and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as
fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents.
Bond Basics: Learning the Language
▪ The borrower issues a …………………………
▪ The ………………value or ……………value of a bond is almost always £100
▪ The interest rate of the bond is called the …………………….
▪ The length of time until the principal amount of a bond must be repaid is the ……………………
▪ The ………………………purchases a bond.
▪ The ……………………. issues a bond.
Loan stock and debentures
• Loan stock and debentures are long-term bonds or debt securities with a par value, which is usually (in the UK) ₤100
and a market price determined by buying and selling in the bond markets.
• The interest rate (coupon) is based on the par value and is usually paid once or twice a year. E.g. a fixed interest 10%
debenture will pay the holder ₤10 per year in interest, although this might be in the form of ₤5 paid twice each year.
• Interest is an allowable deduction in calculating taxable profit and so the effective cost to a company of servicing debt
is lower than the interest (or coupon) rate. E.g. on a fixed interest 10% debenture with corporation tax at 30%, the
servicing cost is reduced to 7% per year.
• While the terms debenture and loan stock can be used interchangeably, since a debenture is simply a written
acknowledgment of indebtedness, a debenture is usually taken to signify a bond that is secured by a trust deed against
corporate assets, whereas loan stock is usually taken to refer to an unsecured bond.
• The debenture may be secured against assets of the company by either a fixed or a floating charge.
• A fixed charge will be on specified assets and the assets cannot be disposed of while the debt is outstanding: if the
assets are land & buildings, the debenture is called a mortgage debenture.
• A floating charge will be on a class of assets, such as current assets, and so disposal of some assets is permitted. In
the event of default, for example non-payment of interest, a floating charge will crystallize into a fixed charge on the
specified class of assets.
• Major risk in investing in loan capital – business defaults in interest payments/capital payments.
• To protect themselves, lenders seek some form of security by pledging assets (fixed or floating charge).
• Assets pledged – normally be non-perishable, capable of being sold easily, fairly high in value relative to their size.
• Lenders seek further protection using loan covenants - obligations/restrictions on the business that form part of the loan
contract.
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CHAPTER 4 –SOURCES OF FINANCE
Purchasing a bond
Amount Coupon rate = 6% Yield
Face Value Interest =
Discount Interest =
Premium Interest =
Life of a bond
Year Cash flows
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Types of bonds
Government bonds. The government bond sector is a broad category that includes ‘sovereign’ debt, which is
issued and backed by a central government. U.K. Gilts, U.S. Treasuries, German Bunds, Japanese Government
Bonds (JGBs) and French OATs are all examples of sovereign government bonds.
Sovereign bonds issued by these major industrialised countries are generally considered to have very low default
risk and are among the safest investments available. However, it should be noted that guarantees on government
bonds tend to relate to the timely repayment of interest and do not eliminate market risk. Also, shares of a portfolio
of government bonds are not guaranteed.
Local Government Bonds. Local governments borrow to finance a variety of projects, from bridges to schools,
as well as general operations. The market for local government bonds is well established in the U.S., where these
bonds are known as "municipal bonds," and European local government bond issuance has grown significantly in
recent years.
Corporate bonds. Corporations borrow money in the bond market to expand operations or fund new business
ventures. Corporate bonds fall into two broad categories: investment-grade and speculative-grade (also
known as high-yield or ‘junk’) bonds.
Zero coupon bonds. Are bonds that are issued at a discount to their redemption value, but no interest is paid on
them. All the returns to investors will be in the form of capital appreciation. The investor gains from the difference
between the issue price and the redemption value. The general attractions of zero coupon bonds to the issuing
company are similar to those of deep discount bonds. However, these advantages must be weighed against the
high cost of redemption compared with the amount of finance raised.
Deep discount bonds. Are loan stock issued at a price which is at a large discount to the nominal value of the
stock, and which will be redeemable at par (or above par) when they eventually mature. This will be attractive to
investors who prefer to receive a higher proportion of their return in the form of capital gains (the difference
between the issue price and the redemption value), as opposed to interest income. The lower servicing cost
of deep discount bonds may be attractive if cash flow problems are being experienced or are anticipated, eg. if the
cash raised by the new issue is to be used in an investment project whose returns are expected to be low in its
initial years.
Eurobonds (‘International bonds’). Eurobonds are a form of long-term loans. Eurobonds are issued by listed
companies and other large organizations, and the finance is raised on an international basis. They are issued in
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CHAPTER 4 –SOURCES OF FINANCE
a currency that is different from the currency in which the business raising the funds is based. Thus, for example,
a UK business may issue a eurobond that is denominated in US dollars.
They are bearer bonds (i.e. the owner of the bond is not registered and the holder of the bond certificate is regarded
as the owner) and interest is normally paid (without deduction of tax) on an annual basis. Eurobonds are part of
an emerging international capital market and they are not subject to regulations imposed by authorities in particular
countries. This may explain, in part, the fact that the cost of servicing eurobonds is usually lower than the cost of
similar domestic bonds.
There is a market for eurobonds that has been created by a number of financial institutions throughout the world.
Eurobonds are usually issued to large banks and other financial institutions, which may either retain them as an
investment or sell them to their clients.
Foreign bonds. These are domestic issues by non-residents, e.g. an issue of stock by a US company in London
(a ‘bulldog’), or in Tokyo (a ‘samurai’) or in Australia (a ‘kangaroo”). Such bonds are domestic bonds in the local
currency – only the issuer is foreign. If British Airways makes a bond issue in New York, this is a ‘yankee’ bond.
The Netherlands allows foreigners to issue ‘Rembrandt ‘bonds and in Spain ‘Matador’ bonds are traded.
Hybrids
1. Convertible bonds
2. Loan stock with Warrants
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Convertible bonds Advantages of convertibles
• Issues costs. Issue costs are lower for loan stock
• A convertible bond begins life as a form of
than for equity.
debt, but carries the right, at the holder’s
option, to convert into ordinary shares at some • Interest. Because investors are given the option of
specified date in the future and on specified converting into shares, they are likely to accept a
terms e.g. how many new ordinary shares can lower coupon rate of interest than on loan
be obtained on conversion per unit of stock without conversion rights, since they are
convertible stock. accepting the low risk of default in return for being
• If they are not converted, they are redeemed at able to gain the benefits of future equity. This means
a date, which is usually several years after the that the company can use greater amounts of loan
conversion date. finance than it can with straight loan finance and
• The interest on a convertible bond is less than higher interest costs. In addition, conversion rights
that on an unconvertible bond (also called an mean that the company is not committed indefinitely
ordinary, vanilla or straight bond) due to the to paying interest.
value to the investor of the conversion rights. • Interest and dividends. Interest on loan stock is
• Interest on the loan (whilst it is a loan) is tax- tax-deductible, unlike dividends per share.
deductible. • Earnings per share. There is no immediate
• Convertible loan stock can be issued more
dilution in earnings and dividends per share.
cheaply than a straight loan because it offers
• Control. There is no immediate change in the
an equity incentive.
structure of control, though this will change over
• Companies perceived as relatively high risk
time as conversion rights are exercised.
can attract loan finance by offering the
• Conversion. If conversion is expected to take place,
possibility of participating in future growth.
the company does not have to put funds aside for
• The bonds can also be traded on the Stock
future redemption i.e. it is self-liquidating.
Exchange.
• Convertibles offer the benefits of both equity • Fewer restrictive covenants. Investors don’t ask for
and loan stock, thereby attracting additional a high level of security, impose strong operating
investors. restrictions on managers, and insist on strict financial
• If all goes as planned, the conversion to equity ratio boundaries.
will occur, reducing the gearing ratio (but also
lowering the EPS).
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Briefly compare the following three types of debt and their
Warrants
effect on the company's gearing.
• convertible debt
• A warrant is the right to buy new ordinary
• loan stock with warrants
shares in a company at a future date at a • redeemable debentures
fixed, pre-determined price, known as the
exercise price.
Convertible debt instruments are fixed return securities,
• Warrants are usually issued as part of a
either secured or unsecured, which may be converted, at the
package with loan stock as an equity
option of the holder, into ordinary shares in the same
sweetener, a phrase, which signifies that
company. The conversion rights have value when the market
attaching warrants to the bond issue can price of shares rises above the conversion price. Convertible
make it more attractive to investors. debt helps the issuing company to encourage investors with
• The investor benefits from a relatively the possibility of sharing in long-term profits and can also
safe (but low) income on the bond if the mean that redemption costs are avoided if the debt is
converted to equity.
firm performs in a mediocre fashion, but if
the firm does very well and the share price Loan stock with warrants are loan stocks which cannot
rises significantly the investor will themselves be converted into equity but give the holder the
participate in some of the extra returns right to subscribe at fixed future dates for ordinary shares at
through the ‘sweetener’ or ‘equity kicker’ a predetermined price. The subscription rights are known as
provided by the warrant. warrants.
• Warrants can be separated from the
The difference between a loan stock with warrants and
underlying loan stock, however, and convertible debt is that, with a warrant, the loan stock itself
traded in their own right, both before and is not converted into equity, but bond holders make a cash
during the specified exercise period. payment to acquire the shares and retain their loan stock.
• The buyer of loan stock with warrants This means that the loan stock will continue in existence until
it is redeemed.
attached can therefore reduce the
investment cost by selling the warrants.
Redeemable debentures offer a fixed return, and the
• Unlike convertible bonds, warrants lead company must pay cash to redeem the debentures on the
to the subscription of a small amount of maturity date.
additional equity funds in the future,
Impact on gearing
provided that satisfactory share price
growth is achieved and the warrants are All three forms of debt will increase gearing by the same
exercised. amount when the debt is issued, but long-term gearing should
be less under convertible debt on the assumption that debt
holders wish to convert their debt. This is because debt will
be replaced by equity upon conversion. Assuming the same
level of interest with warrants gearing will be higher because
the new equity will exist alongside the loan stock.
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EFFICIENT MARKET HYPOTHESIS
Capital markets, efficiency and fair prices
Investors in capital markets want to be sure that the prices they pay for securities, such as ordinary shares and bonds, are fair
prices. In order for security prices to be fair, the capital markets must be able to process relevant information quickly and
accurately. Relevant information is anything that could affect security prices e.g. previous movements in security prices, newly-
released company financial statements, changes in interest rates or details of sales of their own company’s shares by company
directors. We say that a capital market is efficient when we are confident that security prices are fair. A capital market can be
efficient when share prices in general are falling (a bear market) or rising (a bull market).
Forms of efficiency
WEAK FORM ▪ Refers to a market where share prices fully and fairly reflect all past information.
EFFICIENCY
▪ In such a market, it is not possible to make abnormal gains by studying past share price
movements.
▪ Research has shown that capital markets are weak form efficient and that share prices
appear to follow a ‘random walk’, the random changes in share prices resulting from the
unpredictable arrival of favourable and unfavourable information on the market.
SEMI-STRONG FORM ▪ Refers to a market where share prices fully and fairly reflect all publicly available
EFFICIENCY
information in addition to all past information.
▪ In such a market it is not possible to make abnormal gains by studying publicly available
information such as the financial press, company financial statements and records of past
share price movements.
▪ Research has shown that well-developed capital markets such as the London Stock
Exchange and the New York Stock Exchange are semi-strong form efficient.
STRONG FORM ▪ Refers to a market where share prices fully and fairly reflect not only all publicly available
EFFICIENCY
information and all past information, but also all private information (insider information)
as well.
▪ In such a market, it is not possible to make abnormal gains by studying any kind of
information.
▪ Since it is always possible to make abnormal gains by using insider information (even if
governments have made this illegal), even well-developed capital markets cannot be
described as strong form efficient.
▪ However, investors and analysts are often accurate in their estimates of what is happening
inside companies and financial management theory considers well-developed capital
markets to be highly efficient.
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Anomalies in the behaviour of share prices
▪ Calendar effects
▪ Size anomalies
▪ Value effects
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BEHAVIOURAL FINANCE
Behavioural finance questions the validity of the EMH and share price movements occur due to investors’ irrational
behaviour explained as follows:
Overconfidence Miscalculation of probabilities Cognitive dissonance
Investors tend to overestimate their trading Investors attach too low a probability to likely Investor has a long-held belief and will
abilities; leading to them making bad outcomes and too high a probability to unlikely continue to hold it even if evidence completely
investments; likely to overestimate the outcomes. Example: stock market bubbles such contradicts this belief leading to investors
accuracy of their forecasts; be surprised by, for as the ‘dotcom’ bubble as investors holding shares that they believe will increase in
example earnings announcements, because overestimated the potential of the internet value when the evidence overwhelmingly
their predictions were overambitious; start-ups and their ability to dominate their suggests otherwise.
Overconfidence leads investors to think they market segments.
can beat the market.
Availability bias
Ambiguity aversion
Individuals pay particular attention to one fact
Self-attribution bias
Investors afraid of areas that they do not have or event because it is freshest or most
Investors will attribute their successes to their much information; instead prefer the familiar, prominent in their mind. The bigger picture is
own skills; failures caused by bad luck rather which they believe they know well. Example: ignored, although likely to be based on sound
than themselves. investors avoid overseas shares when, probabilities rather than the emotion attached
rationally, international diversification brings to the one fact or event.
benefits to the investor.
Representativeness
Conservatism
Judgements based too heavily on a Positive feedback and extrapolative
representative observation and don’t take into Investors naturally conservative and resistant
expectations
account numerous other factors, such as to changing an opinion. Hence, if profits turn
statistical evidence; some investors think that Positive feedback investors buy shares after out to be higher than expected, they will
past performance can be used to indicate their prices have risen and sell them after prices underreact and not adjust subsequent profits
future performance, when in reality the link is fall. They build extrapolative expectations expectations. This means that one profits
generally a poor one. about the share prices, expecting prices to announcement surprise is followed by another.
continue rising (or falling).
Some informed traders use this behavioural Overall
Narrow framing tendency to their advantage by joining in and
pushing rising prices higher and then selling at Despite these behavioural tendencies,
Investors unable to look at the broader picture.
a profit before the price falls. This creates investors tend to be viewed as flawed
For example, an investor can focus on the price
instability in the market and means the share rational thinkers rather than as completely
movement of a single share instead of looking
price has diverged from its realistic value. This irrational. These investors attempt to be
at the whole portfolio; investors may worry
behaviour can create stock market bubbles. rational, but have limitations in their memory,
about short-term performance when their goal
emotion and cognitive function which lead
is to fund long-term retirement savings;
them to repeat mistakes.
looking at the broader picture, can be seen that
in the long run, a well-diversified portfolio
should grow in value, despite some short-term
fluctuations.
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Debt or Equity finance? – A checklist to use in questions
1. Cost
- Debt is usually cheaper than equity finance.
- The issue costs of debt are also lower than for equity.
2. Gearing
- Gearing can be measured as D/E or D/(D+E) – MVs if possible.
- Too much debt can cause financial distress.
- Too much equity can dilute EPS and control.
3. Control
- An issue of shares may change the balance of control.
4. Security
- Debt is usually secured against the assets of the company
5. Cash flow
- Try to match finance flows with project flows – e.g. match lifetimes.
- If cash flows are uncertain, then equity may be better - dividends may be cut.
6. Availability
- Further debt may be restricted by agreements (covenants) in existing loans.
- Could shareholders afford a rights issue of the size suggested?
- Difficult to issue equity if unquoted
7. Exit routes
- No exit route may make finance unattractive to investor.
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Debt funds Equity funds
Relationship
Claim on liquidation
Rate of return
Nature of returns
Tax effect
Maturity of funds
Voting rights
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FACTORS TO CONSIDER WHEN CHOOSING FINANCE
Cost Debt finance is cheaper
Cash flows If a business can generate regular cash flows, it would be better to borrow
Risk If a business is experiencing poor trading cash flows (business risk) then the company should
not consider borrowing (borrowing increases financial risk)
Security Debt finance is usually secured. Long-term debt is secured against NCA. If security available is
insufficient, the business will have to pay higher interest rate.
Availability of finance Debt finance is more easily available than equity finance.
Maturity Finance raised should follow ‘matching principle’. Long-term finance for long-term investments
and vice versa.
Control Dilution of ownership and control occurs when new equity finance is raised.
Provided existing shareholders subscribe to a rights issue, there’s no dilution of O&C.
Debt finance has no ownership issues although control can be imposed through covenants.
Yield curve The business must consider the yield curve when raising debt finance. The yield curve is a
graphical representation of the term structure of interest rates.
Also refer to STUDY Manual page 278 for The Examining Team's guide to answering financing questions.
Use the mnemonic 'FAT PRICE'.
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