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Which of the following statements about equity finance is correct?
A) Equity finance reserves represent cash which is available to a company to invest
B) Additional equity finance can be raised by rights issues and bonus issues
C) Retained earnings are a source of finance
D) Equity Finance includes both ordinary shares and preference sharesI have a doubt regarding few points here such as:
I don’t understand option A because why can’t the company use its retained earnings to invest if they want?
B is wrong because bonus issue does not raise any finance rather they are issued for free to existing shareholders
C is correct
D is wrong because Rights Shares Issue is also considered to be Equity Finance (which is not given in the option otherwise it would have been correct)
Please correct my doubt if you think what I have written is wrong!
A is wrong because just because they have reserves does not mean that they have cash available (the cash might already have been invested or might already have been paid out as dividend).
What you have written about B is correct.
D is wrong because preference shares are not classed as being equity.
Reserves are the amounts in the SOFP owed to shareholders over and above the share capital. e.g. retained earnings, share premium account etc..
As regards to Option A; I have two questions that:
1) You said that retained earnings may have been invested (but invested in what exactly in positive NPV projects?)
But even if the company has invested the money in projects then it might not reduce the retained earnings since they have already been invested?
2) And if the dividend is paid out from retained earnings then it might also reduce the retained earnings at the year-end?
1. It doesn’t mater where they have been invested (although hopefully they will only have invest in machines etc that gave a positive NPV).
Investing cash in new machines does not affect the retained earnings at all.
2. Dividends paid always reduce the retained earnings.
You really should remember from Paper FA (was F3) that the balance on retained earnings is simply total profits that have ever been reported less the total dividends that have ever been paid. That certainly does not mean that the company has that much cash available!
By law, the maximum dividend that can be paid is the balance on retained earnings. However they obviously cannot pay out more than the cash they have available.
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