FIN 540_ASU_ASSIGNMENT 2024_WEEK 6_LONG-TERM FUNDING SOURCES

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LONG-TERM FUNDING SOURCES

ARIZONA STATE UNIVERSITY

FIN 540 - ADVANCED FINANCIAL MANAGEMENT

WEEK 6

8.1 INTRODUCTION:

In the previous chapters we have seen that businesses obtain long-term financing either

from equity shareholders or from loans. Within each type of financing (equity or loan) there

are several sub-types. In fact, one method of financing (convertible loan notes) has both

equity and loan elements.

In this chapter we will discuss the various subtypes. Given that the financial objective

is to maximize shareholder wealth, we will consider each of them in the context of how they

will affect the interests of existing equity shareholders. We will also try to assess their

attractiveness to potential investors.

Primary capital market:

We will actually consider capital markets in their primary function, as new capital

markets. The primary capital market is not in one location. It is a rather nebulous market; in

fact, every point of contact between suppliers and users of capital is part of the primary capital

market. In the UK, this includes the London Stock Exchange (LSE) which, in addition to

being perhaps the most important part of the secondary market (i.e., the market for 'second-

hand' shares and debt securities), which is a more familiar role, is also a sector of the primary

market. However, the primary market also includes a large number of other institutions and

organizations. We will look at secondary capital markets in Chapter 9. An important source of

finance in modern Britain is grants provided by governments and the European Union. We

will therefore consider these extensively.

Factors that influence the decision to raise new funding:

From the point of view of existing businesses and shareholders, there are several

important factors relating to certain new sources of funding. These include:

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•

administrative and legal costs of raising funds;

•

financial service fees, such as interest payments;

•

the extent of the obligation to make interest or similar payments;

•

the extent of the obligation to repay the financing;

•

tax deduction for finance-related expenses; and

•

the impact of new funding on the level of business control by existing shareholders and

freedom of action.

For financing suppliers new to the business, the following may be important factors:

•

the rate of return that investors expect;

•

the amount of risk associated with the expected return;

•

potential liquidation of the investment either through direct payment by the business or

through the secondary market;

•

the investor's personal tax position with respect to the gains from his investment; and

•

The degree of control or influence over business affairs that an investor is likely to gain as

a consequence of an investment.

In this chapter we will assess each of the sources of finance under review, in the

context of these factors. We should note that matters relating to the suppliers of finance are of

more than just interest to the business's financial managers and existing shareholders. They

have a major influence on the attractiveness of a particular type of financing (as an

investment) and therefore on the likelihood of success of efforts to raise new funds in that

way.

Risk and return:

Both intuition and the results of several studies suggest that investors expect, and

actually earn, on average, higher returns if there is higher risk. The relationship appears as

depicted in Figure 8.1.

For businesses, the position is the opposite of that of investors: relatively risky sources

of finance (from the perspective of businesses) tend to be cheap in terms of servicing costs;

secured sources tend to be expensive. The rate of return required by secured lenders is

relatively low, but the existence of such loans is, as we shall see, a potential threat to

shareholder wealth. Equity investors expect high returns, but issuing additional common

shares is less likely to increase the risk borne by the original shareholders.

Expected (and actual) returns

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8.2 COMMON CAPITAL (EQUITY):

Equity finance is the most important source of finance in the UK corporate private

sector. Both in terms of cumulative financing arrangements and new capital raising, equity

financing tends to be the largest source. Equity seems to attract a large number of investors,

both private and institutional. (See Table 1.1 (on page 11), for the shareholdings of companies

listed on the LSE.) Equity financing dominates most corporate financing. Keep in mind that

most equity funding comes from businesses retaining profits (rather than paying it all out as

dividends), not from issuing new shares (Kay, 2012).

Nature of equity

Ordinary shareholders are the owners of the business and, through the voting rights

attached to their shares, they exercise complete control over the business. As owners of the

business, ordinary shareholders bear the greatest risk. If the business does not trade

successfully, common shareholders are the first to suffer from the lack of dividends and,

possibly, a decrease in the market value of their shares. If a company goes bankrupt

(liquidated), it is the ordinary shareholders who will be at the bottom of the pile with demands

for a return on their investment.

On the other hand, the fruits of business success principally benefit ordinary

shareholders; other participants-laborers, lenders, suppliers, and so on-tend to earn profits that

are unrelated to business success. So, once the claims of the other participants have been

satisfied, the remaining profits go to the ordinary shareholders. Face value

When a business is first established, decisions are made about how much equity

financing (the law requires there to be some) is to be raised and how many shares are to be

divided. If, for example, the decision is that Rp. 1 Billion needs to be raised, this could be two

shares of Rp. 500,000,000 par value (or face value) each, 1 million shares of Rp. 1,000 each,

200,000 shares of Rp. 5,000 each, or (more likely) 2 million shares of Rp. 500 each. Which of

these possibilities, or one of an almost infinite number of others, is decided upon, is a matter

of judgment for the backers of the business.

In making this decision, perhaps the main factor is marketability. Most investors

would not find a stock with a very large face value attractive, as this would make it difficult to

invest the right amount of money in the business. If the stock has a nominal value of Rp.

50,000, an investor who wants to invest Rp. 275,000 cannot do so. The choice is between five

or six stocks. If the stock has a face value of Rp. 10,000, the investor can come close to the

target of Rp. 275,000 (27 or 28 stocks). It seems to be believed that stocks with a large face

value are less marketable than stocks with a smaller face value. Of course, stocks with large

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denominations are very rare in practice. Only a few ordinary shares have a par value greater

than IDR 1,000 each, and most are smaller than this.

Once the company has invested its capital and started trading, the market value is

ordinary shares may move away from their nominal value, as a result of market forces.

Subsequent issues of ordinary shares will usually be priced by reference to the current market

price: that is, the company will seek to issue further ordinary shares at the highest price the

market can bear. In fact, face value ceases to matter once the business starts trading. This is

evidenced by the fact that, in the US, which has similar legal and corporate funding

arrangements to the UK, shares that have no par value (or no par value) are not unusual.

The decision regarding the face value is irrevocable; the business can further split or

consolidate the face value. For example, a business whose shares normally have a nominal

value of Rp. 1,000 each can divide them into shares of Rp. 500 each. In practice this is easy to

achieve. This splitting process culminates in each ordinary shareholder being sent a

replacement share certificate, which shows twice as many Rp. 500 shares as the previous

amount of Rp. 1,000. As we have seen, the purpose of such a move appears to be to lower the

unit price to make the shares more marketable.* Share splits in recent years have been

relatively few, reflecting the static nature of share prices; splits tend to be associated with

rising equity prices.

Investor ratio:

Some ratios are used by, or at least made available to, investors to measure some

aspect of a common stock's performance. For leading companies, these are published daily,

along with their share prices, by most of the more serious national newspapers. The three

main ratios (which were introduced in Chapter 3) are described below.

Price/earnings ratio (P/E):

Here the current price per share is expressed as a multiple of earnings per share (profit

for the year divided by the number of common shares issued by the company). The profit

figure used in the calculation of the ratio is the most recently reported year. A stock with a

large P/E is one that is highly valued based on its historical earnings levels, indicating the

market's confidence in the future of the business and its ability to grow.

Dividend yield (DY):

The dividend yield expresses the gross amount of dividends per share paid in the last

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year as a percentage of the current market price. It gives an idea of the rate of return that the

dividend represents. It can be compared to returns from other investments to try to value a

particular share. To the extent that, over a period, capital gains and losses may be as important

in terms of amount per share as dividends, DY is (at least) an incomplete measure of the

benefits of share ownership.

Dividend cover (DC):

Dividend cover expresses earnings per share, after previous claims have been satisfied,

as a multiple of the actual dividend per share paid out of those earnings. This gives some

indication as to the extent to which business profits are paid out as dividends and the extent to

which they are put back into the business.

Issues regarding the use of ratio:

Much of what we have discussed in this book, regarding the importance of risk, raises

questions regarding the merits of relying on the above ratios. It must be said, however, that

they are widely available to investors and are, therefore, likely to be used by them. We will

discuss issues relating to the choice of dividend rate in Chapter 12.

Factors that businesses need to consider in equity financing publishing costs:

Issuance costs vary widely according to the method used to raise new equity and the

amount raised, ranging from nothing at all (in the case of retained earnings) to around 4

percent of the new funding raised (Association of British Insurers, 2013). We will consider

this in more detail when dealing with the various methods in the following sections.

Service fee:

Shareholders expect relatively high returns in terms of capital appreciation and

dividends. Dividends represent an explicit cost. Capital appreciation occurs because profits

that are not distributed as dividends remain with shareholders, although shareholders must

wait until their shares are sold or the company is liquidated before they can convert retained

earnings into cash. Thus, one way or another, the entire profit will eventually be paid out to

shareholders. Over the period 1900 to 2014, the average real cost of equity financing

(ignoring inflation) in the UK was 5.3 percent (Dimson, Marsh, and Staunton, 2015).

Obligation to pay dividends:

The level of dividend payout is at the discretion of the directors and financial

managers. As we saw in 'Servicing costs' above, shareholders will eventually receive their

money, but they cannot directly insist on the payment of a certain amount of dividends in any

given year.

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Obligation to redeem investments:

There is no such obligation unless (or until) the business is liquidated. Therefore, and

to some extent due to dividend rate flexibility, funding provided by ordinary shareholders

does not usually impose a legally enforceable cash flow obligation on the business.

Tax deductible dividends:

Unlike the servicing of almost all other types of finance, dividends are not tax

deductible for calculating corporate tax liabilities. This tends to make dividends more

expensive than equivalent gross loan interest payments.

Effects on control and freedom of action

If new equity funding is raised other than from existing shareholders in the same

proportion as their initial investment, voting rights will shift to some extent, perhaps to a

significant extent, and it is possible that control of the business will shift as well. This is not

necessarily a feature of all equity financing raises. In fact, the most important way of raising

equity finance for most businesses, namely retained earnings (discussed below), can avoid this

problem.

Until recently, there were doubts as to whether this transfer of power actually

concerned ordinary shareholders, as they did not seem to exercise their voting rights in any

case. The annual general meetings of most companies are characterized by the absence of

most of those entitled to attend and vote. But in recent times, institutional investors have taken

a more active role as shareholders. Sometimes this means putting direct pressure on the board

of directors. Control is a factor that tends to be a constant concern of ordinary shareholders in

small businesses, a point we will discuss in Chapter 16. Factors for Potential Investors to

Consider in Equity Financing Rate of return

The rate of return on equity finance is expected to be higher than the rate of return

associated with 'safe' investments such as UK government securities. This has been the case

historically, with long-term annualized real returns on UK equities averaging around 5.3

percent per annum, as we saw above, in contrast to average real returns on government

securities of around 0.9 percent per annum. Compared to other types of securities, ordinary

shares on average provide the best hedge against inflation, although they are often incomplete.

Equity provides an opportunity to make an investment where the return is directly

linked to commercial success. Direct ownership of the assets of a business usually requires the

investor to spend time managing those assets. It also usually exposes the investor to unlimited

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liability. However, equity allows the delegation of day-to-day management to directors and

allows shareholders to protect their other assets.

Return risk:

Returns, whether in the form of capital gains or dividends, cannot be absolutely

guaranteed. Negative returns are very common in short periods, but historically, above-

average positive returns in other periods can offset this. In theory, an adverse trading period

for a particular business could cause the value of its common stock to drop to zero, with

shareholders losing the entire amount invested in the stock. Massive losses in the value of a

particular company's shares are not uncommon. For example, shares in supermarket retailer

Tesco plc fell from £Rp. 4,920 each on November 14, 2007 to just Rp. 1,470 on January 8,

2016 (a 70 percent drop). Even as recently as May 21, 2013, its share price reached IDR

3,850. This was due to a variety of factors. These include the accounting scandal that came to

light in 2015 (mentioned in Chapter 3) and the threat to Tesco's market share from German

discounters Lidl and Aldi.

Ease of liquidating investments:

Typically, when investors take part in a new equity issue of a business, they have no

particular thought as to whether the business will repay the investment. However, the average

investor will be reluctant to take up shares unless it is clear that there is an opportunity to

liquidate the investment by other means. This is where secondary capital markets come in. It

is clearly in a company's interest to regularly trade its shares on a recognized stock exchange

so that there is a facility to liquidate the investment.

Equity and personal tax:

In the UK, dividends are taxed as income in the hands of the shareholder, at marginal

rates of up to 45 percent (depending on the income level of the shareholder). This liability is

wholly (for those on low incomes) or partially offset by the income tax credit that

accompanies the receipt of dividends. Capital appreciation is subject to capital gains tax at a

rate of up to 28 percent.

Level of control:

Ordinary shares usually have voting rights. This puts the shareholder in a position,

perhaps acting in concert with other shareholders, to exert pressure on the company's senior

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management on any issue that concerns him or her.

8.3 ADDITIONAL EQUITY FUNDRAISING METHODS:

There are generally three ways to raise new equity financing. These are: retaining

profits rather than distributing them as dividends; issuing new shares to existing shareholders

(usually through a rights issue); and issuing new shares to the public. Evidence (Kay, 2012)

shows the clear dominance of retained earnings (profits) over other methods. In fact, for

businesses listed on the LSE, all new equity for almost all businesses comes from retained

earnings.

Retained earnings:

It may be surprising to mention retained earnings as a source of new equity funding.

However, profits do, of course, result in an increase in net funds. Keeping some or all of those

funds, rather than distributing them as dividends, is actually a way to raise funds. After all, if

the entire profit is paid out as dividends and then shareholders buy new shares in the same

business with their dividend money, the impact would be the same as holding those funds.

Free financial resources?

At first glance, retained earnings appear to be a source of service that costs nothing.

However, a moment's reflection shows that this is not true. From an ordinary shareholder's

point of view, there is a clear opportunity cost, which is that if cash dividends are paid, then

the cash could be invested in an income-generating way. Since the obvious comparison is to

invest in equity with the same risk as the business under consideration, retained earnings

logically have a cost similar to that of the original common stock.

Bonus shares:

Just as businesses can and do make par value distributions, they can convert retained

earnings into ordinary shares, known as bonus shares, which are then distributed to existing

shareholders for free. This procedure is known as a bonus issue.

Example 8.1 The following is an abbreviated statement of financial position of a

company that has been trading for some period of time and still retains at least some of its

profits.

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No issuance fee:

Other ways to raise additional equity have explicit issuance costs that do not apply to

retained earnings.

Uncertain profits:

When the need to raise further funding has been identified, there is no guarantee that

profits large enough will be earned to meet the need. In contrast, when funds are generated

from profits, their existence is certain and their retention depends solely on management

decisions. This last point is in contrast to other methods of raising equity funding.

No dilution control

Retaining profits does not change the voting power of any holder

shares.

Equity issues for the public

Before we start considering equity issues in detail, it is worth distinguishing between

two types of equity issues. An initial public offering (IPO) is an initial public offering made

by a company that has just listed on the LSE and made its first significant issue of shares to

the public. A further issue made by a business, some time after its listing, is known as a

seasoned equity offering (SEO).

There are technically two ways to create a public issue:

•

A company issuing shares may sell its shares to an issuing institution, usually a merchant

bank that specializes in such work. The issuer then sells its shares to the public. This is

known as an offer for sale.

•

The issuing company sells its shares directly to the public. Often such businesses are

advised by a merchant bank on matters such as pricing the issue. Here the offer is known

as an offer by prospectus.

Regardless of which method is used, the general procedure is the same. Basically, the shares

are advertised in newspapers and/or elsewhere. The advertisement is required, by law and

LSE regulations, to provide a large amount of detailed information. The preparation is very

expensive, including reports from independent accountants and the like. The purpose of

including such voluminous and detailed information is to protect the public from the kind of

careless and, at times, fraudulent claims made by business management in the early days of

the LSE.

As shown in Table 8.1, public issues appeared to be popular among newly listed

companies until 2012. These public bond issues accounted for an average of over 40 percent

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of new equity financing for this group over the period 2006 to 2012, although there was

considerable variation from year to year. More recently however, placements, which we will

discuss in a moment, have dominated. One of the listed companies that recently had an IPO

was Worldpay Group plc, which raised IDR 2.4 trillion in October 2015. Worldpay is a

payment processing business. Public issues are always unpopular with seasoned businesses.

Placement

There is a variation in issuers selling their shares to the general public through

advertising. This is known as 'placing'. Here the issuer 'places' (i.e., sells) the shares to some

of its own clients, such as insurance companies and pension funds. These clients may include

existing shareholders.

This is still a public issue, but here 'public' does not have the usual meaning. The

advantage for businesses of raising equity finance through placements is that certain costs,

such as advertising (see above), can be saved. However, there is still a need to provide

extensive and expensive information on more traditional public issues. In February 2015, BT

Group plc's telecommunications business raised IDR 1 trillion through a placing. The equity

issued represented approximately 3 percent of the equity issued immediately following the

placement. The funds raised were used in part to fund the takeover of the mobile phone

business, EE Ltd (Orange etc.).

As we can see in Table 8.1, placements are an increasingly important means of issuing

new shares, both as IPOs and SEOs. During the period 2006 to 2012, placements played a

significant, but not dominant, role in IPOs, but since 2013, placements have become the most

important source of equity funds for newly listed companies. Public offerings have suffered

commensurate losses. Placements remain significant for experienced businesses. But in some

years, for experienced companies, placements no longer seem to be in line with human rights

issues (which we will discuss shortly). There is tremendous variation from year to year. The

issue of pricing to the public

The pricing of the issuance of ordinary shares to the public is very important to

existing shareholders. If the new shares are priced at a discount to the value of the old shares,

unless the existing shareholders take up at least the number of new shares so that they can

retain the same or a greater proportion of the number of shares they previously held. If the

new shares are priced at a discount to the value of the existing shares, unless the existing

shareholders take up at least a certain number of new shares so that they can retain an equal or

greater proportion of the number of shares they previously held, this will cause the new

shareholders to gain an advantage over the existing shareholders.

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As issuances to the public tend to occur when a company is significantly expanding its

equity base, it is unlikely that existing shareholders will be able to take up a sufficient number

of new shares to avoid sanctions for issuing at a discount.

There is evidence that IPO prices may be too low. Levis (2008) examined 1,735

separate IPOs conducted through the LSE over the period 1995 to 2006. The study looked at

performance (share price increase and dividends, if any) over the 12 months following the

new issue date. IPO stocks fared about 13 percent better than the average stock exchange

equity investment. In other words, an investor who did all IPOs between 1995 and 2006 and

held them for one year would have done 13 percent better than an investor who bought shares

in various other companies listed on the stock exchange and held them for 1 year. This does

not mean that all IPOs represent profitable one-year investments. It means that in such cases

IPO investors will experience fewer losses than other investors.

The valuation issue is how well the share issue price strikes a balance between

attracting the maximum amount of cash per share, on the one hand, and avoiding a very costly

failure to raise the required funds, after spending a large amount of money on promotion on

the other. There are two ways to address the pricing issue. One is to pledge the shares. For a

fee, the underwriter will guarantee to take the shares that are not bought by the public. This

ensures the success of the issue. The underwriter's fee or commission is set by them based on

how many shares they underwrite, the offering price, and of course, how confident the

underwriter is that it is likely that some shares will not be taken up by the public. In essence,

underwriters are insurance companies. Most issues that go to the public are underwritten.

Underwriting fees tend to be in the range of 4 percent of the capital raised.

The second way to address pricing issues is to open a share tender. This is similar to an

auction where shares are sold to the highest bidder, usually at a pre-determined reserve price

(i.e., prices below that price will not be accepted). When all bids have been received (the

closing date for bids has been reached), the company or issuer will assess what the highest

price for all shares can be issued. This is perhaps best explained with a simple example.

Share issues in a depressed market:

Some observers argue that it is unfair to sell new shares to the public when the general

capital market price, or that of a particular business, is depressed. This is because this would

allow outsiders to buy shares 'on the cheap' at the expense of existing shareholders. This

seems an illogical view given the evidence of capital market efficiency, which will be

reviewed in the next chapter. Such evidence strongly supports the hypothesis that the current

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market price of a stock is a consensus view of its value at that time. There is no reason to

believe that because it has recently fallen in value that it will increase, any more than it would

cause us to feel that it will either decline further in value or remain static.

Factors to Consider with Respect to Equity Issues to the Public

Issuance cost

Publishing costs are substantial, estimated at around 4 percent of the proceeds of an

IDR 200 billion issue in the UK and around 7 percent in the US (Association of British

Insurers, 2013). Most issuance costs are fixed, regardless of the size of the issue, so the costs

can be proportionally higher, based on the percentage of funds raised, for small issues.

In addition to the explicit costs of an IPO, there are additional costs. In order to attract

a sufficient number of investors for the IPO to be successful, it is usually necessary to offer

the shares at a discount to the price at which they would normally be expected to trade. This is

because the issue is likely to be large enough to have an adverse impact on the price. The

London Stock Exchange (2006) estimates this IPO discount to be between 10 and 15 percent.

At these cost levels, the impact on the cost of equity is substantial. We saw earlier that

the average cost of equity during the twentieth century averaged about 5.3 percent per year.

This translates to IDR 5,300 for every IDR 100,000 of equity. If the explicit issuance cost is,

say, Rp. 4,000, and the additional IPO discount is Rp. 10,000, then the net proceeds are only

Rp. 86,000. So the effective cost of equity is Rp. 5,300/Rp. 86,000, or 6.2 percent. This may

explain the small number of public issues, especially if there are other alternatives. Public

issues are more likely to occur when rights issue and retained earnings options are not

available.

Uncertainty of public issues:

The relative certainty of success associated with human rights issues does not exist for

issues that are made public. As we have discussed, the use of underwriters and/or issuance by

tender can to some extent address this issue, but at a cost.

Pricing issues are very important:

If the interests of ordinary shareholders are to be protected, the question of price is one

of great importance. Issuance by tender can, to some extent, address this issue. Capital market

efficiency suggests that a 'winning' tender offer will provide a rational and fair price for the

issue.

Control dilution:

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Clearly, dilution of control for existing shareholders will occur if there are public-

facing issues. This may be the price that the original shareholders have to pay to gain access

to additional equity funding when rights issuance and retained earnings are not possible.

Notes on the place of public issues in fundraising for business:

Evidence (Kay, 2012) shows that funds raised through public issues, by UK companies

listed on the LSE, are rarely used for business expansion. Most businesses are able to raise all

the funding they need for expansion from retained earnings. Where there is a public issue, this

is usually because the company has gone public and the shares issued are not issued by the

company itself, but by a major shareholder wishing to realize all or, usually part, of its

investment. . Overseas businesses listed on the LSE tend to use public issues to raise funds for

expansion.

Rights issue:

A rights issue is an offer to ordinary shareholders to subscribe for additional shares, in

cash, at a price that is usually well below the current market price of the existing shares. In

February 2016, Chemring Group plc conducted a rights issue to raise IDR 81 billion.

Chemring is a global business that provides a range of advanced technology products and

services to the aerospace, defense and security markets. The shares were offered to existing

shareholders on the basis of four new shares for every nine shares already held at a price of

IDR 940, which represents a 47 percent discount to the share price immediately prior to the

issue. Approximately 96 percent of the shares offered to shareholders were subscribed for,

with the remainder left to the underwriters to handle. The new funds are partly needed to

reduce the business's borrowings.

Human rights issues have generally been an important method of raising new equity

funding in the UK over recent years. Table 8.1 shows that they accounted for around 40

percent of SEOs on average between 2006 and 2015. For businesses that do not have a season,

there is really no option to do a rights issue as such businesses typically do not have a season

has a large enough shareholder base to conduct a rights issue.

The law requires, under normal circumstances, that any issue of New equity must first

be offered to existing shareholders in proportion to their respective shareholdings; that is, it

must be a rights issue. However, shareholders can waive this 'pre-emptive right' and some

companies require their shareholders to agree to this. The existence of pre-emptive rights is

sometimes seen as limiting the board of directors' ability to utilize other sources of equity

funding.

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Once the company has decided on the amount of funding it needs and set a price, it

simply offers shares to existing shareholders. The number of new shares each shareholder is

entitled to take up depends on the number of shares already held.

If the shareholder does not wish to take up these rights, they can be sold to someone

who does (regardless of whether the buyer is an existing shareholder or not). Usually the

rights can be sold on the stock market. The buyer acquires the same rights to take up the

shares as the shareholder to whom they were originally granted.

Example 8.3 A company has 4 million ordinary shares worth £1,000 whose current

market price is £1,800 per share. It wishes to raise Rp. 1.2 Billion through the issue of

restricted shares at a price of £1.50 per share. The number of shares to be issued is 800,000

(i.e., £1.2 million/£1.50). Therefore, this offering will be offered on a 1-for-5 basis to existing

ordinary shareholders. For example, a shareholder who owns 200 shares will be given the

right to purchase 40 additional shares. In Example 8.3, the value of the company's entire

equity immediately before the rights issue is IDR 7.2 Billion (4 million * IDR 1.80).

Immediately after this issue, this amount will increase by Rp. 1.2 Billion (the amount of new

money raised). The total equity value should be Rp. 8.4 Billion (4 million + 800,000 = 4.8

million shares) or Rp. 1.750 per share (Rp. 8.4 Billion/4.8 Billion).

This is the price at which the shares should trade immediately after the rights issue,

assuming all other things remain the same. So, the value of the right to buy one share is likely

to be IDR 250, which is the difference between the rights issue price and the ex-rights price.

Market forces tend to ensure that this is generally true, because, otherwise, it means that either

there is a possibility of making an abnormal profit by buying the rights on the one hand, or

there is no one willing to buy them on the other.

Companies typically price rights issues at between 30 and 40 percent below the

theoretical ex-rights share price (Association of British Insurers, 2013). As mentioned above,

Chemring Group plc's rights issue was discounted by 47 percent from the share price at the

time the company announced its intention to make a rights issue and 38.2 percent from the

theoretical ex-rights price. As we have already seen, doing this should not be favorable to

shareholders. However, since letting the rights lapse would be detrimental to the shareholders,

a rights issue at a discounted price puts pressure on them to either go through with the issue or

sell the rights. Either way, this is likely to lead to a successful rights issue in that all the shares

are taken up and the desired amount of money is raised.

Another reason for pricing a rights issue at a discount is to try to ensure that any

possible decline in the market price of the issued shares, between the date of the

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announcement of the rights issue (and the rights issue price) and the date of the rights issue,

still leaves the rights issue price below the market price. If, on the issue date, the shares are

cheaper to buy on the stock market than to take up the rights, then the issue is almost certain

to fail.

Factors to Consider in Relation to Human Rights Issues.

Rights issues are a relatively inexpensive way to raise equity funding

It is estimated that the cost of issuance is on average 2.5 to 3 percent of the funds

raised (Association of British Insurers, 2013). Note that most of these issue costs are fixed,

meaning that they are the same regardless of the amount of funds raised from the issue. As a

result, the cost (as a proportion of the value of funds raised) will be greater for small issues

and less for large issues.

The pricing issue is not an important factor:

As we have seen, shareholders who sell or take up their rights are in roughly the same

position in terms of wealth, regardless of the issue price.

The issue of human rights is quite definite:

In practice, rights issues rarely fail. This is an important factor as many of the issue

costs are paid upfront and lost if the issue fails.

Existing shareholders are forced to increase or liquidate some of their shareholdings.

For shareholders who are given the right to take additional shares, doing nothing is not a

reasonable option. To preserve their wealth, they would either have to take the shares, then

increase their investment in the business, or sell their rights, essentially liquidating part of

their investment. None of these may be attractive to some shareholders. This may cause the

shares of companies that frequently conduct rights issues to become unpopular, adversely

affecting their market value.

Of course, it is always open to any shareholder to sell some of their rights in order to

obtain sufficient cash to take up the rest. This still requires action on the part of the

shareholder. In practice, existing shareholders hold most of the rights (estimated to be around

90 percent).

Control dilution:

Dilution of control need not occur through a rights issue as existing shareholders are

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given the opportunity, which is usually accepted, to retain the same voting rights after the

rights issue as before.

Some shareholders may not have the funds for a rights issue:

This can be particularly problematic for companies whose shares are not listed on a

recognized stock exchange, as it may be difficult to sell their rights to third parties.

Alternative Investment Market:

Small businesses may not want to submit to the rigors, and the accompanying costs, of

obtaining a full listing on the LSE for their shares. For such businesses, the LSE provides a

separate market where shares can be traded. This is the Alternative Investment Market (AIM),

which tends to cater to businesses whose shares have a total market value of around £50

million, although many are much larger or smaller than this.

The fact that the securities of a particular company are traded on AIM should warn

potential investors that the requirements for obtaining, and maintaining, a full listing have not

been met, even though less stringent requirements have been met. This means that those

securities represent a more precarious investment than a similar business that has a full listing.

AIM has been seen as a step towards businesses obtaining a full listing. Recently however,

some fully listed businesses have switched their listing to AIM. The aim is clearly to save the

larger annual fees of being fully listed and, perhaps, to avoid the cost and inconvenience of

meeting the more stringent requirements of a full listing. AIM is discussed in more detail, in

the context of small businesses, in Chapter 16.

8.4 PREFERENT SHARES:

Preference shares are the risk-bearing part of business ownership, but preference

shareholders are usually entitled to the first share (of a predetermined size) of any dividends

paid. Preferred shares are usually cumulative. This means that if preferred stock dividends are

not fully satisfied in a given year, then common stockholders are not entitled to dividends in

the following year until the preferred stock dividends have been renewed. Because of their

favorable treatment of dividends, preferred stocks carry less risk, from an investor's

perspective, than common stocks. Therefore, investors' expectations of preferred stock returns

are lower than those of common stock investors in the same business. Historically, preferred

stocks have been a significant source of corporate funding. More recently, they seem to have

fallen out of favor and tend to be overlooked as a new source of funding. However, many

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businesses were partially financed by preferred shares issued a few years ago. One company

that currently issues preferred shares is Rolls-Royce Holdings plc, an engine manufacturer.

This is offers common shareholders the opportunity to receive preferred shares in lieu of

dividends, at an equivalent value.

Face value:

Preferred shares have a par value, but as with common shares, the size is usually not

very important. However, preference dividends are usually expressed as a percentage of the

face value (although they need not be).

Investor ratio:

Dividend yield and dividend coverage are important ratios for preferred shareholders.

Dividends are usually the most important part of the preferred stock yield, so their effective

interest rate and security are important.

Factors for Businesses to Consider Regarding Preferred Stock Financing

Issuance cost

Issuance costs are similar to costs associated with raising new equity funding and also

vary based on the method used.

Service fee

The cost of servicing tends to be lower compared to common stock, as preferred stock

presents less risk to the holder.

Obligation to pay dividends:

Preferred shares do not impose a legal obligation on the business to pay dividends.

However, they impose an obligation to satisfy preference dividends before any dividends can

be paid to ordinary shareholders. If the preference shares are cumulative, arrears of unpaid

preference dividends must also be repaid before ordinary shareholders can participate in

dividends. In practice, while there is no legal obligation, businesses seem reluctant to skip

paying preference dividends.

Obligation to redeem preferred shares:

Some preferred shares are expressly issued as redeemable. If this is the case,

businesses should be aware of the need to finance this redemption. Not all preferred shares are

redeemable and, if they are not, they are in the same position as common shares. If preferred

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shareholders cannot demand redemption, this type of financing is relatively safe from the

point of view of common shareholders.

Tax deductible preferred stock dividends:

The UK tax system does not distinguish between ordinary dividends and preference

dividends, so preference dividends, like ordinary share dividends, are not deductible from

profits for corporation tax purposes.

Effects on control and freedom of action:

Typically, preferred shares do not impose many restrictions on common shareholders.

Many preferred shares give their holders the right to vote only if their dividends are in arrears.

Generally, preferred shareholders do not have voting rights.

Factors to be Considered by Prospective Investors Regarding Preferred Stock

Ownership

Rate of return

The rate of return to preferred shareholders tends to be low, well below the rate of

return on equity in the same business. The return also tends to be entirely in the form of

dividends as preferred shares typically do not experience significant changes in value.

Return risk

Typically, this risk lies between the risk inherent in common stocks and debt

securities. This is mainly because preference dividends have priority over ordinary dividends.

Ease of liquidating investments

If the preference shares can be redeemed and/or traded on the capital market,

liquidation is possible. Failure of at least one of these will usually discourage investors from

taking up a preference share issue.

Preference shares and personal tax

Dividends are taxed as income.

Level of control

Unless dividends are in arrears, preferred shareholders usually have no voting rights

and therefore no real power.

Preferred share capital increase method

The methods used to increase preferred share capital are more or less the same

as those available to ordinary shares, including the issuance of bonuses to ordinary

shareholders generated from retained earnings. In practice, the issuance of preference shares

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appears to be the most popular method of issuing preference shares.

8.5 DEBENTURES AND DEBT SECURITIES:

Many businesses borrow by issuing securities with a fixed rate of interest payable

based on the face value or par value of the security (known as the coupon rate) and a

predetermined redemption date. Such securities are known as loan notes, debentures, bonds,

or loan stock. They are usually issued for a term of between 10 to 25 years, although some are

issued for terms beyond that range. Indeed, perpetual loan notes (no redemption date) do exist.

The popularity of debentures, as a means to raise long-term funds, seems to fluctuate

drastically from year to year. Many businesses obtain a capital market listing for their loan

notes, so that potential lenders can purchase a portion of the business' loan from the previous

lender. The new owner of the debenture, from the date of its acquisition, will receive interest

payments as well as capital payments if the debenture is held until the redemption date.

Letters of credit attract all types of investors who seek returns with relatively low risk.

Institutional investors are particularly interested in them, especially institutions that require

regular cash receipts to meet recurring payment obligations, such as pension funds. Like most

types of loans, most loan notes are secured, either on specific assets of the lending business or

on assets in general. For example, the aviation business of International Airlines Group plc

(British Airways, Aer Lingus and Iberia), according to its annual report in 2014, has pledged

€1,169 million of the value (cost) of its aircraft as collateral for a loan.

Alternatively, the lender may only have guarantees provided by

contractual law to an unsecured creditor to carry out interest or principal payments if its

business defaults. Whether or not a loan note is secured determines where the loan note

holder's payment queue will stand in the event of liquidation of the lending business. As it is

usually impractical for individual loan note holders to monitor their security at all times,

trustees are often appointed by businesses to do this for them. Businesses will readily do this

so the issue will attract lenders.

Loan note (bond) rating:

Where debt securities are listed on the LSE, they tend to be rated by three independent

ratings agencies, Moody's, Standard and Poor's and Fitch Ratings, all of which are commercial

financial services providers. The rating indicates the assessor's judgment on the quality of the

debt securities in terms of the commercial and financial prospects of the business issuing the

debt securities. The rating considers various matters from the perspective of potential

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investors. Therefore, the ability of the company in question to pay interest and redeem the

loan notes, in full, on the contractual date, is a key factor. Raters constantly review their bond

ratings and change them as circumstances change. Businesses with high ratings will find it

relatively easy to borrow and/or can borrow more cheaply. All of these raters rate the loan

notes into one of a number of classes. Table 8.2 shows the Standard and Poor classifications.

Standard and Poor's sees the line of demarcation between BBB and BB loans as an important

one. BBB and higher are seen as 'investment grade' loans and generally represent safe

investments. BB and below are considered risky and speculative. BB and below are often

called junk bonds.

In December 2015, Moody's cut the credit rating of the world's third largest mining

company, Glencore plc, to one notch above junk status. Moody's justified its reassessment by

identifying falling market prices for mined minerals. Rating agencies came under heavy

criticism for failing to identify the risks inherent in sub-prime loans around 2008, a point we

will come to shortly when we discuss securitization. This raised doubts about the reliability of

their ratings.

Investor ratio:

Since profitability is not of direct interest to bondholders, ratios relating to the

effective interest rate (yield) are likely to be of more concern to them.

Two ratios that tend to be widely reported in the media are:

•

Flat yield. This is simply gross interest receivable expressed as a percentage of the current

market value of the relevant loan amount.

•

Redemption proceeds. If, as is usually the case, the debentures are redeemable, the

effective gain from holding the debentures may include some capital gains or even losses.

(A capital loss will arise if the current market price is above the redemption value. This

tends to happen if the prevailing interest rate is below the coupon rate of the debentures.)

The gross redemption yield (r) will be given by the following expression:

𝑛

Current market value = ∑𝐼/(1 + 𝑟)𝑡 + RV/(1 + 𝑟)𝑛

𝑡=1

where I is the annual gross interest payment, RV is the redemption value and n is the

remaining life (in years) of the bond. Using the annual net (tax) interest payment as I in the

expression will give the net redemption yield. This, in essence, is the IRR of the debenture,

taking into account the current market price, interest payments over the remaining life of the

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debenture and the amount to be received at the time of redemption. An example calculation

involving this equation is given in Chapter 10.

Loan note issuance method:

Loan notes can be issued in a number of ways, including being issued directly to the

public through advertisements in newspapers and so on. Often, A company looking to issue a

loan note will approach the issuing institution and ask it to try to convey the issue to its

clients, often institutional clients.

Factors that businesses need to consider regarding financing through loan notes

Issuance cost

Issuance costs tend to be relatively low; probably less than 2 percent of the cash value

collected from an issue of IDR 2 Billion.

Service fee:

Since loan notes represent a relatively low-risk investment for investors, the expected

rate of return tends to be lower than that typically sought by shareholders. Historically, this

has been reflected in actual returns. As we have seen, the average return on UK equity from

1900 to 2014 was 5.3 percent per year. In contrast, this was only 1.6 percent for corporate

loan notes (or bonds) (Dimson, Marsh and Staunton, 2015). Obligation to pay interest

Debenture holders have a basic right under contract law to take action to enforce the

payment of interest and repayment of capital on the due date, if such payments are not made.

In many cases, debenture holders have contractual rights to take more direct action (such as

the effective seizure of assets that collateralize their loans) if the borrowing company defaults

on its debts. A clear obligation to pay interest, with potentially devastating consequences in

the event of default, can make debt repayment a heavy burden on the borrowing business.

Obligation to redeem loan notes:

Regardless of whether a loan note is issued as redeemable or not, a business is always

open to buying its own loan notes, on the open market, and canceling what it bought. As such,

loan notes offer a level of flexibility that is not available with common and preferred stock.

On the other hand, if the loan notes are issued as redeemable debentures with a predetermined

redemption date, which is usually the case, the company has a contractual obligation to

redeem them. This can put the business in a difficult cash flow position as the repayment due

date approaches.

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Tax deduction for interest on loan notes:

Interest is fully deductible from profits for corporate tax purposes. This tends to make

loan interest payments cheaper, pound for pound, than dividends on ordinary and preference

shares. This is a point we will return to in Chapter 11.

Effects on control and freedom of action:

The severity of the consequences of failing to meet interest payments and capital

repayments can severely limit a company's freedom of action. Although control, in the sense

of voting rights, is not usually associated with debt financing, the issuance of debt securities

can be very restrictive. Debt can seriously erode control in the sense that the company is able

to manage its affairs without a hitch.

It is common for those who lend money to impose conditions

or covenants on its business. Failure to fulfill these requirements, depending on the exact

contract between the lender and the company, may entitle the lender to repay the loan

immediately.

Typical agreements include:

•

Restrictions on dividend rates;

•

Maintenance of a minimum current assets/current liabilities ratio;

•

Restrictions on the company's right to dispose of its non-current assets; and

•

Restrictions on funding (capital) levels.

Babcock International Group plc, an engineering business, under the covenants associated

with its loans, was required to keep its annual operating profit, before depreciation, at least

four times its annual loan interest liability. While this was not the case with Babcock, there are

many businesses that are forced to act in ways that they would not normally choose, to avoid

the problems that can result from covenant breaches. In Chapter 11, we will explore in more

depth the impact on the position of ordinary shareholders when borrowings increase.

Factors to be Considered by Prospective Investors in Loan Notes Rate of Return:

Returns on debt securities tend to be low compared to those on other debt securities.

expected from equity and preferred shares.

Return risk:

While the level of risk associated with default by borrowing businesses tends to be

low, bondholders are usually exposed to another risk, namely interest rate risk. This is the risk

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of capital loss caused by changes in the general level of interest rates.

Example 8.4 An investor has £100 face value of a perpetual (non-redeemable)

debenture, which has a coupon rate (the rate of interest payable by the borrowing company on

the face value of the debenture) of 6 percent. The prevailing interest rate and the level of risk

attached to a particular bond cause the capital market to seek a 6 percent return on the bond.

Since the return on the loan note at face value is 6 percent, the capital market will value the

holding at Rp. 100,000 (face value).

If the general interest rate is increased so that the capital market now seeks a 7.5

percent return on this loan note, its value will drop to Rp. 80,000 (i.e., the sum of 6 percent

interest on Rp. 100,000 representing a 7.5 percent return). Thus the holder of our loan note

will become poorer by Rp. 20,000.

If the loan note is not perpetual but redeemable at Rp.

100,000 at some point in the future, the price may not drop to IDR.

80,000 due to interest rate changes. The closer the redemption date, the smaller the loss; but

regardless of the redemption position, there will be a loss of value. He explained, While

investors would benefit equally from a general decline in interest rates, risk-averse investors

(and most investors seem to be risk-averse) will be more concerned with potential losses than

potential gains.

The relatively low interest rate risk associated with short-term debt securities tends to

mean that the returns available from such debt securities are lower compared to debt securities

that are not yet due for redemption within a certain period of time.

Ease of liquidating investments:

Businesses that want to issue loan notes to the public must seek listing in the capital

market if they want to have any serious hope of success. Publicly issued loan notes can be

liquidated by being sold in the market.

Personal loan and tax records:

Interest is subject to income tax in the hands of individual loan note holders. Capital

gains are also taxed. Since all, or almost all, of the gains from debt securities are usually in the

form of interest, capital gains tend to be insignificant. Level of control

Loan notes do not give their holders any control over the business, unless it is

necessary to enforce payment of their dues if the business defaults and to enforce any loan

agreement.

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Eurobond:

Eurobonds are unsecured loan notes denominated in a currency other than the home

currency of the company issuing them. They are foreign currency loans. Businesses are

encouraged to issue Eurobonds to capitalize on the availability of financing loans abroad. In

addition, Eurobonds can offer innovative features that make them more attractive, both to

lenders and to the issuing business. This last point arises from the fact that the bonds are

traded on an unregulated market. Despite the name, Eurobonds are not related to Europe or

the euro currency. They are simply international bonds. Aviation business International

Airlines Group plc is an example of an LSE business with a large Eurobond loan, according to

its 2014 annual report.

Interest rate swap:

A business may borrow money if its contract stipulates a floating interest rate, i.e. an

interest rate that varies according to the general level of interest rates in the economy. They

may prefer a loan with a fixed interest rate but are unable to negotiate such an arrangement.

Under these circumstances, it may seek out other businesses that have the opposite problem,

with fixed-rate loans but preferring floating-rate loans. After identifying each other, the

businesses may agree to repay each other's loans. In practice they may make contact first and

then issue a loan note or borrow in some other form.

Interest rate swaps have practical relevance because different businesses have different

credit ratings. One may be able to negotiate a floating rate loan at a reasonable interest rate,

but not at a fixed rate. Another business may be in the opposite position. Swaps are another

example of derivatives. Tesco plc's supermarket business uses interest rate swaps to limit its

exposure to interest rate risk. In its 2015 annual report, the company said that its policy is to

place around 40 percent of its long-term borrowings at fixed rates.

8.6 CONVERTIBLE LOAN NOTES:

A convertible loan note is a security that has all the features of the loan notes we just

discussed, except that on a predetermined date, it can be converted by the holder, at its

discretion, into common shares of the same business. The conversion rate is usually expressed

in terms of the number of common shares in exchange for the loan note's face value of Rp.

100,000. If there is a split or bonus issue of common shares during the life of the loan note,

the conversion right is usually adjusted to take this into account. Convertible loan notes are

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another example of a financial derivative.

J Sainsbury plc, a UK supermarket, has borrowed IDR 450 billion through convertible

bonds. The bonds have an annual interest rate of 1.25 percent, but are convertible into fully

paid Sainsbury's ordinary shares. They can be converted anytime until November 21, 2019 at

a price of IDR 3,530 per share. The conversion price is about 36 percent above the share price

on the bond issue date (November 2014), but below the share price in the past. Convertible

issues have not been popular in recent years, although a number of businesses are partly

financed by such issues. Since convertible bonds are a hybrid of debt and equity securities, the

factors important to the issuing business and potential investors are essentially the factors we

have already considered. However, there are some features of convertibles that are worth

mentioning.

Issuance cost

The fact that loan notes are cheaper to issue compared to equity means that convertible

bonds may be an economical way to issue ordinary shares, especially if a business is looking

to obtain a certain amount of loan financing in any case.

Loans are self-liquidating

Businesses don't need to find cash to redeem loan notes because they are redeemed

with common shares. Of course, this does not make them free. Issuing shares to redeem loan

notes is an opportunity cost to the business and existing shareholders. Convertible loan notes

tend to be used to raise funds where investors prefer to have the loan note as collateral, with

the option to convert to equity if the business does well.

8.7 WARRANT:

Basically, warrants are options granted by a company that entitle the holder to

subscribe for a certain number of common shares, at a certain price, at, or after, a certain time

- usually several years after issuance.

Companies usually issue warrants in one of two ways:

•

Sell it, resulting in a cash inflow; or

•

Attach it to the issuance of loan notes as a 'sweetener' or incentive for investors to take out

the loan notes.

If a company attaches warrants to a loan letter, which may be

is the most common way to issue them, the arrangement is very similar to convertible

debentures, except that the loan notes continue after the warrant is used to subscribe for

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shares. This means that the warrant holder must pay cash for the relevant shares, rather than

exchanging the loan notes for the shares. Therefore, a debenture, unlike a convertible

debenture, cannot liquidate itself. Like convertible debentures, warrants are financial

derivatives. In many ways, warrants are so similar to convertible bonds that the importance

factors are almost the same.

8.8 TERM LOAN:

Term loans are negotiated between the lending business and a financial institution such

as a clearing bank, insurance business, or merchant bank. This kind of financing is very

important, accounting for perhaps 25 percent of new funding a business obtains other than

through retained earnings.

In many ways, term loans are like loan notes where collateral is usually given to the

lender and the loan is given for up to a period of 20 years. They differ from loan notes in that

they are usually not transferred from lender to lender as loan notes usually are. They are not

traded on the capital market. Some term loans are repaid in installments so that each monthly

or annual payment consists of part interest, part capital repayment, in a similar way to

mortgage loan repayments made by private home buyers through mortgage repayments. Term

loans tend to be very cheap to negotiate, i.e. their issuance costs are very low because the

lending business deals with only one lender (at least for each loan) and there is room for more

flexibility in the terms of the loan than would normally be possible with the issuance of debt

securities.

The cheapness and flexibility of term loans make them extremely popular among

businesses of all sizes. For most businesses, the funding obtained through term loans far

exceeds the amount obtained through loan notes. Term loans are a major source of medium

and long-term funding. Obviously, term loans are very similar to debt securities so, with the

exception of points regarding issuance costs, transferability and the possibility of deployment,

term loans are very similar to debt securities capital repayment, the factors that affect

borrowers and lenders are almost the same as the factors we reviewed in this article. of the

loan note.

8.9 ASSET-BACKED FINANCING (SECURITIZATION):

If a business has an expectation of a stream of positive cash flows in the future, then it

effectively owns an asset, the value of which is the present (discounted) value of those cash

flows. It is possible to convert this asset into securities and sell them to investors to raise

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funds. This is known as securitization. An example of such a cash flow stream is the monthly

payments made by those who borrow money to buy a house from a mortgage lender.

Securitization became a popular practice of US mortgage lenders in the early 2000s. Here the

monthly payments were 'securitized' and sold to many large banks, especially in the US.

Unfortunately, many of these mortgage loans were made to low-income people who were not

good credit risks (sub-prime loans). When borrowers started defaulting, it was realized that

the securities, now owned by the banks, were worth much less than the payments the banks

were making to the mortgage lenders. This led to the so-called 'sub-prime' crisis that triggered

major economic problems around the world that are still being experienced at the time of

writing. It might fairly have been claimed that sub-prime securities would not have been so

easy to sell to banks if many of them had not been given the top rating (AAA) by credit rating

agencies. These ratings were given even though the underlying mortgage loans were

subprime.

There is no particular reason why asset-backed financing and securitization are a

problem and it is unfortunate that this practice may be linked to the sub-prime difficulties. It is

a legitimate and practical way for businesses to raise funds. Arsenal (Arsenal Football Club

plc) securitized its gate receipts from the Arsenal Emirates Stadium, their headquarters, and

issued floating rate notes whose returns to investors were based on those receipts. In July

2015, these bonds were rated BBB by Fitch Ratings.

8.10 RENTAL:

It may seem strange to see leasing referred to as a source of long-term financing, but it

is actually very similar to a secured loan.

Rent can be divided into two types:

•

Operating lease. It is often possible to lease an asset, such as a factory unit that may only

be needed occasionally, rather than buying it. Typically, the owner undertakes any

necessary maintenance. The decision whether to buy the asset or lease it may be

influenced by funding considerations. But essentially, it is an operational decision, which

will be made on the basis of which approach is cheaper.

•

Finance lease. Here the prospective user identifies the asset he wants to invest in, and

negotiates the price, delivery, and so on. Then find a financing supplier to purchase the

asset. After arranging for the asset to be purchased, the user leases it from the buyer. Of

course, the lease payments must be sufficient to justify the owner's expenses, both in terms

of capital and interest payments.

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Nature of finance lease

It is finance leases that concern us here as they are term loans with capital repayable in

installments. It is an important source of funding, having provided around 25 percent of the

total funding for new capital expenditure by UK businesses over recent years (Finance and

Leasing Association, 2015).

No-frills airline operator easyJet plc uses finance leases to fund part of its aircraft fleet,

according to its 2015 annual report. As of September 30, 2015, out of 241 aircraft, 163 were

directly owned, 11 were subject to finance leases and 67 were operating leases. Over the

years, some of the important benefits associated with finance leases have disappeared.

Changes in tax laws have made this form of funding no longer tax efficient, and changes in

accounting disclosure requirements mean that this form of 'borrowing' can no longer be

hidden from investors. Despite this, the popularity of finance leases continues. Therefore,

there must be other reasons for businesses to adopt this form of financing. These reasons

include the following:

•

Ease of borrowing. Leases can be obtained more easily than other forms of long-term

financing. Lenders usually require some form of security and a favorable track record

before making advances in a business. However, lessors may be willing to lease assets to a

new business with no track record and use the leased assets as collateral for the amount

owed.

•

Fees. A lease agreement can be offered at a reasonable cost. As the leased asset is used as

collateral, standard lease arrangements can be applied and detailed credit checks on the

lessee may not be required. This can reduce administrative costs for the lessor and, thus,

assist in providing competitive lease rentals.

•

Flexibility. Leasing can help provide flexibility when there are rapid changes in

technology. If an option to cancel can be included in the lease, the company may be able

to exercise this option and invest in new technologies as they become available. This will

help businesses avoid the risk of obsolescence. However, avoiding this risk will come at a

cost to the lessee, as the risk is passed on to the lessor.

•

Cash flow. Leasing, rather than purchasing an asset outright, means that large cash

outflows can be avoided. The lease option allows cash outflows to be smoothed over the

life of the asset. In some cases, it may be possible to arrange for low lease payments to be

made in the early years of the asset's life, when cash inflows may be low, and increase over

time as assets generate positive cash flows.

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To lease or not to lease - funding decisions:

When a business is considering the acquisition of an asset, it should estimate the cash

flows expected to arise from its ownership. These should then be discounted at a rate that

reflects the level of risk associated with those cash flows. If the NPV is positive then the asset

should be acquired; if it is negative, it should not be, at least from a financial point of view.

Whether the asset should be financed through a finance lease or by other means is an entirely

separate decision. The former is an investment decision, the latter a financing decision. It is

only by chance that the appropriate discount rate will be the same as the rate inherent in a

finance lease. The latter rate tends to reflect the relatively low-risk nature of finance lease

financing from the lender's point of view. For the asset user, the level of risk is likely to be

greater than the risk borne by the lender. Therefore, it is not logical to discount the cash flows

coming from the asset at the rate implied in the finance lease. We will discuss more fully in

Chapter 11 the importance of separating investment and financing decisions. Finance leases

have very similar practical effects to secured loans so the factors that 'borrowers' and 'lenders'

need to consider are almost the same in relation to each of them.

Sold and leased back:

Sale and leaseback is a variation of a finance lease. If a business needs funding, and

has a suitable asset, it can sell the asset to the financier, with a leaseback agreement as part of

the sale contract. By doing so, the business retains the use of the asset but obtains additional

funding. Again this is very similar to a secured loan. Land and buildings are often the subject

of sale and leaseback transactions. Recently, several large businesses in the UK have sold

freehold properties in this way. Many supermarkets and public house chains and hotels in the

UK have sold and leased back some of their freehold properties over the past few years. This

is now a significant source of finance for many businesses. According to its 2015 annual

report, Wm Morrison Supermarkets plc is in the process of selling and leasing back some of

its properties, but with the aim of retaining 80 percent of its properties on a freehold basis.

Installment purchase method:

Lease purchase is a form of credit used to acquire non-current (fixed) assets. Under the

terms of the hire purchase agreement (HP), the buyer pays for the asset in installments over an

agreed period of time. Typically, the customer will pay an initial deposit (down payment) and

then make periodic installment payments (possibly monthly) until the outstanding balance has

been paid off. The buyer will usually take ownership of the asset upon payment of the initial

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deposit, although legal ownership of the asset will not be transferred until the last installment

has been paid. Lease purchase agreements often involve three parties:

•

Suppliers,

•

Buyer, and

•

Financial institutions.

While the supplier will deliver the asset to the customer, the financial institution will purchase

the asset from the supplier and then enter into a lease purchase agreement with the buyer. This

intermediary role played by the financial institution allows the supplier to receive immediate

payment for the asset but also provides the customer with an extended credit term. HP

agreements are similar to finance leases insofar as they allow the customer to take immediate

possession of the asset without paying the full cost. However, under the terms of an HP

agreement, the customer will ultimately become the legal owner of the asset, whereas under

the terms of a finance lease, ownership will remain with the lessor. While HP may be

considered a form of financing more widely used by small businesses, it is also used by large

businesses: for example, English Premier League club Everton Football Club Company

Limited had a small HP commitment according to its 2015 annual report.

8.11 GRANTS FROM PUBLIC FUNDS:

In the UK there are many different grants or funding sources that are provided at little

or no direct cost to businesses. Most of this funding comes from UK government sources or

from the European Union. Each grant is formulated to encourage businesses to act in a

particular way.

Examples of such actions include:

•

Investment in a new factory;

•

Development of the microelectronics industry;

•

Staff training and retraining;

•

Energy conservation; and

•

Research and development.

Many of the grants available only apply, or specifically, to businesses located in certain

regions of the UK.

Because there are so many different schemes, and because they are

tends to change frequently, it is probably not worth looking at the schemes one by one here. It

should be emphasized however that the amounts that individual companies can claim can be

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substantial, and that every effort should be made by financial managers to understand the

grants available and how to claim them. The Department for Business, Innovation and Skills

will provide information on most sources of grant funding. Government assistance in terms of

finance tends to relate to small businesses and we will discuss some relevant initiatives in

Chapter 16.

8.12 ISLAMIC FINANCE:

The increasing economic importance of individuals who follow the Islamic religion

has led to more attention being paid to their specific needs in terms of providing financing for

businesses. Many of these individuals are citizens of Islamic countries, but many are also

citizens of other countries, such as the United States and Western European countries,

particularly the United Kingdom and France.

Perhaps the defining feature of Islamic finance is the belief, based on the teachings of

Islamic scripture (the Quran), that it is wrong to charge pure interest. This stems from the

notion that earning income (in the form of interest) simply because money is lent is immoral.

Shariah law (the set of principles that guide Islamic practice) requires that investment income

should only be earned through risk-taking enterprises. There is no suggestion that Shariah is

against free enterprise capitalism; the problem is a lack of risk-taking. Yet it must be said that

Sharia is also against pure speculation. It is probably fair to say that Shariah favors profits

earned through hard work and effort, yet avoids profits from pure speculation and financing.

All of the above means that interest-bearing loans to businesses, be it term loans, loan

notes or other types of direct lending, are against the principles of Shariah law. To address

this, all investors, not just shareholders, need to bear some of the risks inherent in running a

business. A special type of bond has emerged to address this issue. UK-based supermarket

business Tesco plc issues Islamic bonds in Malaysia (denominated in ringgit, the local

currency).

Shariah law also prohibits investment in businesses whose activities are contrary to

Islamic principles, such as businesses that produce alcoholic beverages, pornography, tobacco

and so on. However, this is no different from the ethical investment practiced by many non-

Islamic investors, such as the Church of England.

8.13 CONCLUSION ON LONG-TERM FINANCE:

The existence of efficient capital markets, coupled with evidence of the relationship

between risk and expected returns, suggests that businesses will not benefit significantly from

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choosing one type of financing over another. Increased equity financing, which does not

expose common shareholders to increased risk, tends to be expensive. Secured loan financing,

which exposes them to increased risk, tends to be cheap. This suggests that there is no

advantage or disadvantage for common shareholders in raising further funding in one way

compared to another. One method may increase the expected return of ordinary shareholders,

but it is likely to increase their risk commensurately.

However, the real-life situation may not be as shown in Figure 8.1. There are

anomalies in the primary capital market which may mean that the use of one form of

financing over another may be favorable to the investor shareholders. For example, loan

financing provides tax breaks, while equity financing does not. Conversion may be a cheaper

way to issue ordinary shares compared to a direct offering of equity to the public. These

points and those that will be discussed in the context of the gearing and dividend debates later

in this book explain why we find that businesses seem to devote a lot of effort to deciding on

the most appropriate way to raise long-term funds. Perhaps we can generally conclude that

businesses should examine all possible methods of raising long-term funds. They should look

for anomalies such as those mentioned above and then seek to exploit them as far as possible,

given the particular circumstances of the business.

Risk and return are key issues in financing

•

For businesses (i.e. shareholders) sources that are cheap in terms of repayment costs

(e.g. loans) tend to be risky; those that are less risky (e.g. equity) tend to be expensive.

•

For finance providers, risk and reward have a positive relationship, meaning that high

returns mean high risk and vice versa.

Common stock:

•

Owner (shareholder) ownership in the business.

•

The largest element of business financing comes largely from retained earnings.

•

Risky for shareholders, low risk for business; high rate of return expected by investors,

expensive for business.

•

There is usually no legal or contractual obligation in the business to either pay dividends

or redeem shares.

•

Dividends are not tax deductible for businesses, but are taxable in the hands of

shareholders.

•

Retained earnings can be slow and uncertain, but do not incur issuance costs.

•

Problems faced by the public:

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1) Relatively rare in business life in general.

2) The IPO premium is a significant cost to the issuer's business.

3) Issuance costs are substantial, perhaps as much as 4 percent of the funds raised,

despite economies of scale.

4) Share placement is now an important approach to share issuance.

5) Pricing is an important issue.

6) It doesn't always work, although underwriters (who are actually insurance companies)

can be used.

7) Control can transfer from old shareholders to new shareholders.

•

Rights issue = issuance to existing shareholders at a discount to current market value.

Shares are offered pro rata to existing holdings.

1. Fundraising costs about 3 percent of the funds raised, but there are economies of scale.

2. The price issue is not a big deal.

3. Tend to be successful.

4. Control remains in the same hands if the old shareholders take up their rights.

5. Shareholders who do not wish to take over can sell their rights.

•

Shares are easy to liquidate if they are listed on an exchange; otherwise, it is very difficult.

Major stocks:

•

Shares that carry the right to the first portion of any dividend paid, up to a maximum limit.

•

Relatively little used in recent years.

•

Relatively low risk to shareholders, some risk to common shareholders as preferred

shareholders are usually entitled to dividend savings as well as rights for the current year

before common share dividends can be paid.

•

Relatively low business costs and low returns for preferred shareholders.

•

The ratios used by preference investors are dividend yield and dividend coverage.

•

There is usually no legal or contractual obligation in a business to pay dividends, but

sometimes there is an enforceable obligation to redeem the shares.

•

Dividends are not tax deductible for businesses, but are taxable in the hands of

shareholders.

•

The issuance and cost methods are similar to equity.

•

Shares are easy to liquidate if they are listed on an exchange; otherwise, it is very difficult.

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Notes and debentures

•

Long-term loans, with contractual interest payments and usually also redemption

payments, although some loans are perpetual.

•

It is usually an important source of finance.

•

Usually very low risk for the lender, high risk for the business; low expected return for the

investor, cheap for the business.

•

Interest is tax-deductible for businesses (making it appear cheaper) and taxable in the

hands of lenders.

•

Issued to the public through advertising or investment intermediaries, such as

stockbrokers, at a cost of up to about 2 percent of the funds raised.

•

The existence of financing loans can severely limit a business's freedom of action.

•

Loan notes are easy to liquidate if they are listed on the stock exchange; otherwise it is difficult.

•

Loan covenants (or restrictions) may be involved.

Convertible loan notes:

•

Debt securities that entitle the holder to convert into common shares on or after a certain

date at a certain conversion rate.

•

Not a very important source of funding in recent years.

•

Tends to be used when investors prefer the certainty of a loan, with the option to convert if

the equity performs well - it is an option to convert, not an obligation.

•

Loans can liquidate themselves; they do not require cash outflow from the business.

•

The relatively low cost of issuing debt securities means that, ultimately, convertible bonds

are a cheap way to issue equity.

•

Other factors are similar to pre-conversion loans and post-conversion equity.

Warrant:

•

Options sold by, or attached to loan notes issued by a company. They give the holder the

right to subscribe for new shares issued by the business at a specified price on, or after, a

specified date.

Term loan:

•

Loans negotiated between businesses and financial institutions, such as clearing banks.

165

•

A very important source of finance for businesses of all sizes.

•

Cheap to negotiate - publishing costs are very low.

•

It can usually be negotiated to suit the borrower's business needs.

•

Most aspects of a term loan are the same as a loan note.

Asset-backed financing (securitization)

•

Raising funds by selling rights to future cash flows in the form of securities.

Finance lease

•

An agreement where a financial institution purchases an asset and then leases it to a user

for most of the asset's life.

•

Quite an important source of finance.

•

It is essentially a loan secured on the asset concerned and the factors associated with loan

financing apply to finance leases.

Sold and leased back

•

An agreement with a financial institution that will purchase assets already owned by the

business and lease them back.

•

Quite an important source of finance.

•

It is also similar to a loan that is secured over the asset concerned and the factors relating

to loan financing also apply to finance leases.

Installment purchase method

•

An agreement to purchase an asset in installments, where ownership of the asset is transferred to

the buyer immediately transfers to the buyer, but legal ownership does not transfer until the last

installment is paid.

Grants from public funds

•

Especially from the government or the EU.

•

Aimed at encouraging businesses to act in a certain way.

•

Schemes change frequently.

Islamic Finance

•

Islamic religious teachings prohibit investors from receiving pure interest on the amount

invested in a business; they are also hostile to investors who earn only speculative profits.

•

Specific types of investment vehicles have been designed to try to ensure that the profits

earned by all investors comply with Sharia law.

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