SOURCES OF LONG-TERM FUNDS
April 27, 2010
Long-term funds are those that are borrowed for a long-period usually five-years or more.
These funds may be raised in the following ways:-
A) New Issues of Share Capital usually in form of common or ordinary stock. This may be through:
i) Rights Issue
ii) A placing
i) Rights Issue
This is a method of raising new share capital by means of an offer to existing shareholders inviting them to subscribe cash for new shares in proportion to their existing holdings. Eg. A rights issue on a one for four basis at $ 2.80 per share means that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold at a price of $ 2.80 per new share. Any company, private or public can make a rights issue.
1. They are cheaper than offering shares for sale to the general public because no prospectus is required, the administration is simpler and the cost of underwriting will be less.
2. Rights Issues are beneficial to existing shareholders than to the general public since they are issued at a discount to the current market price and this discount would be enjoyed by whoever buys the shares when they are offered to the public.
3. Relative voting rights of shareholders are unaffected if they all take up their rights. A rights issue price must be one that is
i) low enough to secure acceptance of the shareholders
ii) not too low to avoid excessive dilution of earnings per share
Instead of offering all shares to the public they are instead offered to a small number of investors such as pension funds or insurance companies. Placings are much cheaper although they have the disadvantage of having the shares not being available for trading after they have been floated. This is a problem especially for small companies.
NB: Return on equities consists of both dividends and capital gains (or losses) in the share price. This is the cost of equity funds.
This is a long-term debt capital raised by a company and attracts interest at a fixed rate, usually paid half-yearly. 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 yield’ on this amount. For example, a 10% loan stock means that the coupon yield is 10% of the nominal value of the stock. The rate is the gross rate before tax.
Debentures – are a form of loan stock. They are written acknowledgements of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.
Features of Loan-stock and Debentures
1. Loan stock and debentures are usually secured either by a fixed charge on specific assets or a group of assets or by a floating charge on certain assets of the company. In case of default, the lender can lay claim on any asset of the company as long as there is no prior claim on that asset by any other lender.
2. They are usually redeemable i.e. They have a maturity date when they are paid back either at par or at a value above par. They are issued for a term of ten years or more.
3. Most redeemable stock have an earliest and a latest redeemable date e.g. A 12% debenture stock 2012/2014 is redeemable at any time between the earliest specified date in 2012 and the latest date in 2014. The issuing company can choose the date.
4. Some loan-stock have no redemption date i.e. Irredeemable or undated. Undated loan-stock can be redeemed by a company that wishes to pay off the debt but there is no obligation for the company to do so.
5. Loan-stock or Debt capital is an attractive source of finance because interest charges have a tax relief i.e. They reduce the profits chargeable to corporation tax.
Example
Company A has an issue of $ 1,000,000 7 ½% preference shares. Company B has 10% loan-stock of $ 1,000,000. Both companies have a profit before tax and interest of $ 1,500,000. The basic rate of income tax is 25% and the corporate tax rate is 30%.
Calculate the profits available to ordinary/common shareholders.
COMPANY A COMPANY B
$ ‘000 $ ‘000
Profit before tax and interest 1,500 1,500
Less Interest (10 % * 1,000,000) - 100
Profit before tax 1,500 1,400
Less tax 30 % 450 420
Profit after tax 1,050 980
Less preference dividend 75 -
Funds Available to shareholders 975 980
NB
1. The preference dividend is the amount actually paid. In the hands of the recipient, it will have a gross value for tax purposes of $100 being $75 + (25/75 * $75) and this is the same to an investor as 10% from the same stock.
2. The difference in amount available to equity shareholders of $5,000 is due to the difference between the rate of income tax 9hence 25% of 100,000 gross dividend) and the rate of corporation tax (hence 30% of $ 100,000 interest paid).
Reasons
1. Interest charges may be very high making debt capital quite expensive even after tax relief. Interest yields are higher than dividend yields on equity shares.
2. Heavy borrowing increases the financial risks for ordinary shareholders. A company must be able to pay the interest charges and eventually repay the debt from its cash resources and at the same time maintain a healthy balance sheet which does not deter would be creditors. There might be insufficient security for a new loan.
3. There might be restrictions on a company’s power to borrow:-
a) in the articles of association where there may be a limitation
b) trust deeds of existing loans may limit borrowing
c) Borrowing may be limited by the attitude of would be lenders who may expect something e.g. Security in form of a charge on a given asset, certain debt ratio or gearing ratio or a certain rate of interest cover.
The Stock Exchange
The Stock Exchange is a primary capital market in which companies and other institutions can raise funds by issuing shares or loan stock but it is more important as a secondary market for buying and selling existing securities. Dealers on the stock exchange are of 2 types: -
1. Market Makers or Security Dealers
These are the dealers in shares of selected companies whose duty is to ‘make a market’ in the shares of each of these companies. They must be members of the stock market. They quote the ‘bid price’ (the asking price) and the ‘ask price’ (selling price) for the shares and they decide on the share price. They also bring new companies to the market.
The dealer’s profit is the difference between the bid and ask prices which is also known as ‘bid-ask’ spread.
They act on behalf of individual clients who wish to buy or sell some of their shares or debentures. They earn a commission for their services, payable to the client.
This is a large collection of brokers and dealers working in different locations and doing their business according to their own procedures and rules, not according to a set of market rules.
They are connected electronically by telephones and computers and provide trading in unlisted securities.
This is a specific type of secured loan. Companies can place title deeds of freehold or long leasehold property as security with a bank or other mortgage brokers and receive cash on loan, usually repayable over a specified period.
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