Long–Term Finance

Chapter 1 described the markets. This chapter describes what is actually sold on them: the instruments an incorporated entity issues to raise long-term finance, what each one promises the holder, and how each is brought to market. Chapter 3 then puts a price on all of them.

Incorporated entities use two primary sources of long-term finance:

• Equity — money invested in the business by its shareholders, who own it and are paid last.

• Debt — money borrowed from an investor or a financial institution, which must be paid interest and repaid, whatever the results.

Everything in this chapter is a variation on one of those two, or a hybrid of both.

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1 Equity finance

1.1 Ordinary shares

An ordinary share is a unit of ownership. It carries no promise of any return at all: the ordinary shareholder is the residual claimant, taking what is left after everybody else — suppliers, employees, lenders, preference shareholders and the tax authorities — has been paid. That is why the ordinary shareholder both bears the most risk and requires the highest return of any provider of finance.

1.2 Retained earnings

In practice the largest single source of new equity for most companies is the profit they do not distribute. Retained earnings have no issue costs, need no prospectus, cause no dilution and are available immediately.

1.3 Preference shares

Preference shares are a hybrid. They are legally shares, but they behave like debt: a fixed return, paid before the ordinary shareholders, with no ownership or voting rights in the ordinary sense.

The features of a preference share are as follows:

• A fixed dividend, expressed as a coupon percentage of nominal value (so an 8% $1 preference share pays 8c a year).

• Paid in preference to ordinary share dividends — no ordinary dividend may be paid until the preference dividend has been.

• Ranks ahead of ordinary shares on a winding up, but behind all debt.

• Normally carries no votes, except where the dividend is in arrears.

• The dividend is not tax deductible for the company, because it is a distribution and not an interest expense.

Preference shares come in several varieties, and the exam expects the differences:

2 Raising equity: unlisted and listed companies

2.1 Unlisted companies

Unlisted companies find it more difficult to raise equity finance than a listed company, for the following reasons:

• Lack of audited, public information — an outside investor cannot easily assess the company, so demands a higher return, or refuses.

• Marketability — there is no market on which the shares can be sold, so an investor may not be able to get the money back at all.

• Higher risk — unlisted companies are typically smaller, younger and less diversified.

• No market price — without a quoted price the parties must negotiate a valuation, which is slow and contentious.

The sources that remain open to an unlisted company are its own retained earnings, further investment by the existing owners, business angels, and venture capital or private equity. The last of these brings finance and expertise, but the investor will expect a high return, a seat on the board, restrictive covenants and an agreed exit route within a few years.

2.2 Obtaining a listing

An unlisted company will seek to become listed once it has grown enough to meet the requirements of the relevant stock exchange. The possible advantages and disadvantages are:

3 Methods of issuing shares

3.1 Fixed price offer for sale

An offer to the general public at a fixed price. It has the potential to raise the highest possible price for the company, as it is offered to the widest possible market.

If the price is perceived to be too high then the issue may not be attractive to investors, which creates a risk that it fails to raise the amount of finance required. If it is set too low, the company has given value away.

The risk can be mitigated by paying an underwriting fee, where the underwriter commits to buying any unsubscribed shares.

3.2 Offer for sale by tender

An offer under which investors bid for shares, and the shares are issued only to those investors who have bid at the strike price or above.

Investors are asked to state the price they will pay and the number of shares they want. Bids are then ranked from the highest price downwards and accumulated. If there are insufficient bidders at the top price, the price is moved down a bracket until either:

• the desired amount of capital has been raised, or

• the maximum possible capital has been raised.

There is more chance of a successful take-up of the shares with the flexibility of a sale by tender, which mitigates the risk of having to pay underwriting fees. It also lets the market rather than the sponsor set the price.

3.3 Private placing

Shares are placed with, or sold to, institutional investors. This keeps the cost of the issue to a minimum and thus makes the share issue cheaper, but it puts the shares into a small number of hands and raises less than a public offer would.

3.4 Stock exchange introduction

No capital is raised by the company, but the shares become listed on the stock exchange. The company's founders can then dispose of those shares more easily and realise a capital gain, whilst retaining (should they so choose) a controlling interest in the company.

3.5 Rights issue

A rights issue is an issue of new shares to existing shareholders, in proportion to their existing holdings, at a price below the current market price. It is the normal way a listed company raises new equity, because pre-emption rights usually oblige it to offer the shares to its own members first.

• Issue costs are much lower than for a public offer — there is no prospectus to market to strangers.

• Control is not diluted, provided every shareholder takes up the rights.

• The discount to the market price is not a cost to the company: it is offset by the fact that each shareholder is buying more shares. A shareholder who takes up the rights in full is no better and no worse off.

• A shareholder who does not want to subscribe can sell the rights, because the right to buy at below the market price is itself worth money.

After the issue the share price settles at the theoretical ex-rights price (TERP) — the weighted average of the old shares at the cum-rights price and the new shares at the issue price:

TERP = [(N × cum-rights price) + (1 × issue price)] ÷ (N + 1)

where N is the number of existing shares required to obtain one new share. The value of a right is the TERP less the issue price — what the buyer of the right gains by paying the issue price for a share now worth the TERP.

4 Debt finance

There are two main points to consider when issuing debt:

• Debt interest is tax deductible, so debt can be cheaper than equity finance — and cheaper still after tax than its coupon suggests.

• Debt interest must be paid before dividends and irrespective of profit levels, so there is a risk of default if interest and principal payments are not met.

Other points to consider when opting for debt finance include the following.

4.1 Security

The debt holder will normally require some form of security against which the funds are advanced. This means that in the event of default the lender will be able to take assets in exchange for the amounts owing.

• A fixed charge attaches to a specific asset, typically land or buildings, which cannot then be disposed of without the lender's consent.

• A floating charge attaches to a class of assets that changes from day to day, such as inventory and receivables; it crystallises onto whatever is in the class at the date of default.

Debt with no security at all is unsecured, ranks behind secured debt on a winding up, and therefore carries a higher interest rate.

4.2 Covenants

A further means of limiting the risk to the lender is to restrict the actions of the directors by means of covenants. These are specific requirements or limitations laid down as a condition of taking on debt finance. They may include:

• dividend restrictions;

• financial ratios that must be maintained (for example gearing or interest cover);

• limits on the issue of further debt, or on the disposal of major assets.

Breaching a covenant usually makes the whole loan immediately repayable, which is why covenant compliance is monitored far more closely than the interest payments themselves.

5 Types of debt finance

Debt may be raised from two general sources: banks, or investors.

5.1 Bank finance

For many companies bank borrowings are the primary form of debt finance. These could be the ordinary commercial banks or, more likely for larger companies, banks concentrating on securitised lending. The main forms are:

Bank borrowing is not traded, so it has no market price. Its market value is taken to be its book value, and its cost to the company is the interest rate adjusted for tax — the calculation in Chapter 3, section 6.

5.2 Traded debt

Traded debt instruments — bonds, loan notes, debentures — are sold by the company, through a broker or a bank, to investors, and can then be bought and sold between investors. Typical features are:

• The debt is denominated in units of $100; this is called the nominal or par value.

• Interest is paid at a fixed rate — the coupon rate — applied to the nominal value, not to the market price.

• The debt has a lower risk than ordinary shares, and may be further protected by charges and covenants, so the return demanded is lower.

• The market price moves with interest rates and with the issuer's credit standing, and is quoted per $100 nominal.

Instruments could be:

• Redeemable — the amount borrowed will need to be repaid at a particular point in the future, at par or at a premium.

• Irredeemable — the amount borrowed never needs to be repaid; the holder receives interest in perpetuity.

• Convertible — the investor has the option, at a stated date, to take cash or a specified number of shares in the company.

5.3 Other types of long-term debt

5.4 Issuing bonds

The process follows the sequence in Chapter 1 — advisors, due diligence, an offering document, marketing and pricing — with two features of its own:

• A credit rating is normally obtained. It is the single biggest determinant of the coupon the company must offer, and a downgrade later can breach a covenant.

• Bonds may be issued to the public or placed privately with a small number of institutions, which is faster and cheaper but reaches fewer investors and produces a less liquid instrument.

6 Choosing between equity and debt

The cheaper source is therefore debt — but only up to the point at which the extra financial risk starts to raise the return that both lenders and shareholders demand. Chapter 3 combines the two into a single weighted average cost of capital, which is the figure the company actually uses to appraise a project.

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