CPA P1 Managerial Finance

Syllabus 2 – Sources of Finance

Sources of business finance can include:

- Share capital
- Loan stock
- Convertibles and warrants
- Government assistance

We will evaluate each one of these as a potential source of finance.

Share Capital

Share capital is the foundation of most businesses finance. Ordinary shares are issued to the
owners of a company. The ordinary shares of an Irish company have a nominal or ‘face’ value at
which they are shown on the balance sheet. This is typically €1 or 50c.

The market value of a company’s shares bears no relationship whatsoever to their nominal value
except that when ordinary shares are issued, the issue price will be equal to or more than the
nominal value of the shares.

The stock exchange does not normally allow a new issue of shares by a quoted company with rights
inferior to those of another class already in existence. A new issue of shares might be made in a
number of different circumstances:

- The company needs cash

- The company may want to ‘float’ on the stock market
- To take over another company

Another important source of funding for companies is retained profits. This is crucial as there is no
cost associated with using retained profits for future funding.

Preference shares entitle their owners to a fixed percentage dividend before any dividend is paid to
ordinary shareholders. As with ordinary shares a preference dividend can only be paid if there are
sufficient profits available. Cumulative preference shares give the right to carry forward unpaid
dividends to later years.

Preference shares have become a less attractive source of finance in recent years mainly because
these dividends are not allowable for corporation tax purposes (where interest on loans is). To the
investor they are also less attractive as they cannot be secured on the company’s assets and the
dividend is generally too low to provide an attractive investment.

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Rights Issues:

A rights issue is a method of raising new share capital by inviting existing shareholders to pay cash
for new shares in proportion to their existing shareholding. For example, a rights issue on a one for
four basis at 300c per share is inviting shareholders to subscribe for one new share for every four
shares they currently hold at a price of €3 per new share.

A rights issue may be made by any type of company, public or private, listed or unlisted. We are
mainly concerned however, with listed companies. Advantages of rights issues include:

- Cheaper than offers for sale to the general public

- More beneficial to existing shareholders than an offer to the general public as it gives
existing shareholders a discount on the market price for new shares
- Shareholders voting rights will be unaffected if they take up the rights offer

The offer price of a rights issue will be lower than the current market price of shares; however it
must be above the nominal value of the shares. If current market price is below nominal value, then
a rights issue is not possible.

The theoretical ex rights price (market price after a rights issue):

When a rights issue is announced, all existing shareholders have the right to subscribe for new
shares and so there are rights attached to the existing shares. The shares are therefore described as
being ‘cum rights’ (with rights attached) and are traded cum rights. On the first day of dealings in the
newly issues shares, the rights no longer exist and the old shares are now ‘ex rights’ (without rights
attached). In theory, the new market price will be the consequence of an adjustment to allow for the
discount price of the new issue, and a theoretical ex rights price can be calculated.

Example:

F plc. has 1,000,000 ordinary shares of €1 in issue, which have a market price on 1/9/12 of €2.10 per
share. The co makes a rights issue and offers its shareholders the right to subscribe for one new
share at €1.50 each for every four shares held. After the announcement of the issue, the share price
fell to €1.95 but just prior to the issue being made it had recovered to €2 per share.

Required: Calculate the theoretical ex rights price.

Solution:

1,000,000 shares at cum rights value of €2 = €2,000,000

250,000 shares issued at €1.50 = €375,000

---------------

Theoretical value of 1,250,000 shares = €2,375,000

The theoretical ex rights price is €2,375,000 / 1,250,000 = €1.90 per share.

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The value of a right:

The value of rights is the theoretical gain a shareholder would make by exercising his rights.

In the above example, where the price offered in the rights issue is €1.50 per share and the market
price is expected to be €1.90 then the value of a right can be calculated as €1.90 - €1.50 = 40c. A
shareholder would then expect to gain 40 cent for each new share he buys.

The value of rights attaching to old shares is calculated in the same way. If the value of rights on a
new share is 40 cent and there is a one in four rights issue, the value of rights attaching to each
existing share is 40 / 4 = 10 cent.

To calculate the value of a right attaching to an old share the following formula can be used:

Value of a right: Ex rights price – issue price

-----------------------------------

Where N = number of old shares held for every one share

Using the formula on the above example:

1.90 – 1.50

-------------- = .10

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The theoretical gain or loss to shareholders:

The possible courses of action open to shareholders are;

- To exercise their rights i.e. buy the new shares at the rights price. This will maintain their
proportion of total equity in the company
- To renounce the rights and sell them on the market. This will reduce their percentage of
equity in the company.
- To renounce part of the rights and take up the remainder. This strategy is often adopted by
shareholders who want to take up the offer but do not have the necessary cash. If the
shareholder sells some of his rights he will raise cash and can use that to purchase the
remaining rights shares.
- To do nothing at all. In this case the rights not taken up may be sold on the shareholders
behalf, however the shareholder could also lose wealth and it is up to the shareholder to
take effective action to maintain his existing wealth.

Question:

G plc. has issued 3,000,000 ordinary shares of €1 each, which are at present selling for €4 per share.
The company plans to issue rights to purchase one new equity share at a price of €3.20 per share for
every three shares held.

A shareholder who owns 900 shares thinks he will suffer a loss in his personal wealth because the
new shares are being offered at a price lower than the market value. On the assumption that the
actual market value of shares will be equal to the theoretical ex rights price, what would be the
effect on the shareholders wealth if:

a.) He sells all the rights

b.) He exercises half the rights and sells the other half
c.) He does nothing at all

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Solution:

First of all we need to calculate the theoretical ex rights price:

3,000,000 shares cum rights x €4 = €12,000,000

One for three = 1,000,000 new shares x €3.20 = €3,200,000

-----------------

€15,200,000

TERP = €15,200,000 (value of shares) / 4,000,000 (no of shares) = €3.80

Value of rights per new share = €3.80 - €3.20 = 60c

The value of rights attaching to an existing share = €3.80 - €3.20 / 3 = 20c.

a.) If the shareholder sells all of his rights:

Before the issue he had 900 shares at €4 market value = €3,600

Sale value of the rights of his shares = 900 x .20c = €180

TERP of his existing shares = 900 x €3.80 = €3,420
€3,420 + €180 = €3,600

Therefore there is no change in shareholder wealth

b.) If the shareholder exercises half of his rights:

He has 900 shares and is exercising rights on half of those = 450 at one for three = 150
shares at €3.20 = €480 to buy the shares.
His existing shareholder wealth is 900 x €4 (cum rights) = €3,600
Total shareholder value = €480 + € 3,600 = €4,080

Sale value of rights = €0.20 x 450 shares = €90

Market value of his 1,050 shares at €3.80 (ex-rights) = €3,990
Total shareholder value = €90 + €3,990 = €4,080

Again there is no change in shareholder wealth, although the shareholder has increased his
holding in the company by €480 and has an extra 150 shares as a result.

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 c.) To do nothing (assuming all other shareholders exercise their rights or sell them):

Market value of shares cum-rights 900 x €4 = €3,600

Market value of shares ex-rights 900 x €3.80 = €3,420
Loss in wealth €3,600 - €3,420 = €180

Therefore we can say that to protect his investment the shareholder should either exercise
his rights or sell them to another investor.

The actual market price after a rights issue:

The actual market price of a share after a rights issue will differ from the theoretical ex rights price.
This is because the market will take a view of how profitably the new funds will be invested and will
value the shares accordingly.

Question:

M plc. currently has 4,000,000 ordinary shares in issue, valued at €2 each and the company has
annual earnings equal to 20% of the market value of the shares. A one for four rights issue is
proposed, at an issue price of €1.50. If the market continues to value the shares on a price/earnings
ratio of 5, what would be the value per share if the new funds are expected to earn, as a percentage
of the money raised:

a.) 15%
b.) 20%
c.) 25%

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Solution:

Again we must first calculate the TERP:

4,000,000 X €2 = €8,000,000

1,000,000 X €1.50 = €1,500,000

€8m + €1.5m = €9.5m 4m shares + 1m shares = 5m shares

€9,500,000/5,000,000 = €1.90

The current earnings are 20% of the market value of existing shares 4,000,000 shares x €2 =
€8,000,000 x 20% = €1,600,000

The new funds will raise €1,500,000 in finance (1,000,000 shares at €1.50)

Additional earnings Current Earnings Total earnings after issue

15% €225,000 €1,600,000 €1,825,000

20% €300,000 €1,600,000 €1,900,000

25% €375,000 €1,600,000 €1,975,000

If the market values shares on a P/E ratio of 5, the total market value of equity and the market price
per share would be:

Total Earnings Market Value Price per share (5m shares)

15% €1,825,000 €9,125,000 €1.825

20% €1,900,000 €9,500,000 €1.90

25% €1,975,000 €9,875,000 €1.975

We can see from above that if earnings stay the same as at present at 20% of the market value of
shares then the actual market value will be the same as the TERP i.e. €1.90

However if the earnings are only 15% of value then the market value will fall below the TERP i.e.
€1.825.

And if earnings are 25% of value we can see that the market value will be above the TERP i.e. €1.975
and shareholders will gain from the rights issue.

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 Loan Stock

Loan stock is long-term debt capital raised by a company for which interest is paid, usually half-
yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a
stated coupon on this amount. For example, if a company issues 10% loan stock, €100 of loan stock
will receive €10 interest each year.

Debentures are a written form of loan stock which contain provisions about the payment of interest
and the eventual repayment of capital.

Debentures with a floating rate of interest allow the issuer to change the rate of interest in
accordance with market rates of interest. Floating rate debentures prevent borrowers from having
to pay high rates of interest on their debenture when market rates of interest have fallen. On the
other hand, they allow lenders to benefit from higher rates of interest on their debentures when
market rates of interest go up.

Deep discount bonds are loan stock issued at a price which is a large discount to the face or nominal
value of the stock and they will be eventually redeemable at par (or above) on redemption.

For example a company may issue €1,000,000 of loan stock in 2000, at a price of €50 per €100 of
stock, and redeemable at par in the year 2020. In practice, the company is receiving €500,000 in
2000, and doesn’t have to make any repayments until 2020, but it must repay €1,000,000 in 2020.

Investors will be attracted by the large capital gains which can be made, but interest rates will be
very low.

Zero coupon bonds are similar in they are issued at a discount, but there is no interest paid on them.
Again the investor can make large capital gains. The advantage for borrowers is the access to
immediate cash and no cash outlay until redemption date. Also the redemption date is known so the
borrower can plan to have cash available to repay the bonds at maturity.

Loan stock will often be secured on a fixed charge or a floating charge. A fixed charge would be
related to a specific asset and the company cannot dispose of that asset without the borrower’s
permission prior to maturity. A floating charge will be secured against certain class of assets of the
company e.g. stock or debtors. In event of a default a claim for payment can be made against any of
these assets.

Advantages of debt:

- Interest charges can reduce profits chargeable to corporation tax

- Companies can avoid dilution of shareholdings

Disadvantages of debt:

- Expensive even after tax relief (interest yields higher than dividend yields on equity shares)
- Large scale borrowings can damage company balance sheet

In practice companies will use a mix of debt and equity as sources of finance.

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 Convertibles and Warrants

Convertible securities are fixed return securities that may be converted, on pre-determined dates
and at the option of the holder, into ordinary shares of the company at pre-determined rates. Once
they are converted they cannot be converted back into the original fixed return security. Conversion
terms often vary over time.

A warrant is a right given by a company to an investor, allowing him to buy new shares at a future
date at a fixed, pre-determined price known as the exercise price. They are usually offered as part of
a package along with loan stock and the purpose of this is to make the loan stock more attractive as
an investment.

The main advantage to a company of warrants is that they do not involve the payment of any
interest or dividends. For investors there is the potential for high profit on a relatively low initial
outlay and profits will be subject to capital gains tax as opposed to income tax.

Government assistance

Government grants or assistance should not be ignored as a potential source of finance. This is
generally done in high technology industries (e.g. robotics or fibre optics) as the government would
like to see this develop quickly to help stimulate the economy or in areas of high unemployment.

Agencies which can provide financial assistance to companies include the IDA, Udaras na Gaeltacht
and Fobairt along with the European Regional Development Fund (ERDF).

Smaller Businesses

The various sources of finance discussed above are suitable only for fairly large companies. Small
businesses generally have to rely on bank borrowing, retained earnings and maybe issuing more
shares to private shareholders.

It is important to note that you will lose marks in an exam if you suggest a financial source which is
unsuited to the size of the company in question.

As well as the government assistance discussed above smaller companies can also apply for the
Enterprise Investment Scheme (EIS) which is intended to encourage investment in the ordinary
shares of unquoted companies.

Franchising is a method of expanding a business on less capital than otherwise would be needed.
Here the franchisee pays the company for the right to operate a local business, under the companies
trade name e.g. Domino’s Pizza, Spar, KFC.

For the company the capital outlay required to expand the business is greatly reduced, the image of
the business is improved and the company will receive a % of the franchises profits.