Long Term Finance

1 Ways in which a company may raise long-term finance

Generally, when raising funds it is wise to match the purpose of for which the money is needed with the length of the finance.

We do this ourselves in our private financial affairs:

Short term finance is used for short term assets whilst long-term finance is used for long-term assets. If a company wishes to make a major investment in, for example, new machinery, they are likely to need to raise the money from somewhere. Given that new projects are likely to be long-term investments, they will want to raise long-term finance.

There are two ways in which a company can raise long-term finance - either by issuing shares or by issuing long-term debt.

2 Share capital

If a company issues shares in the company, then investors pay cash to the company   and in return receive shares in the company.

There are two types of shares - ordinary shares (or equity) and preference shares.

Ordinary shares (equity)

Shareholders owning these shares are entitled to receive company profits in the form of a dividend. The amount paid as dividend will fluctuate and depends on how much profit the company has made, how much cash the company has available, and how much cash the company wishes to retain in order to be able to expand the company.

The ordinary shareholders have the right to attend company general meetings and to vote on matters such as the appointment of directors. The company will not repay the money initially invested by the shareholders unless the company goes into liquidation. In that case the shareholders will receive whatever cash remains after payment of all amounts owing by the company (which may mean that they end up receiving nothing!).

If the company does well the value of the equity shares will generally rise so equity shareholders can enjoy large capital gains.

Preference shares

Preference shareholders are entitled to a fixed dividend each year, regardless of the level of profits, and they are informed of the amount of the dividend when the shares are first issued. For example, 6% $1 preference shares will receive a fixed dividend of $0.06 per year; 5% $0.50 preference shares will receive an annual dividend of $0.025 per year.

Preference shares take priority over ordinary shares, and so ordinary shareholders are only entitled to whatever profit is left after payment of the preference dividend.

The dividend is limited to the amount of profit available, but if the shares are cumulative preference shares then in future years the preference shareholders must receive any arrears from previous years as well as their dividend for the current year.

Preference shares may be either irredeemable or redeemable. Irredeemable preference shares are never repaid - investors will carry on receiving the dividend each year. These are treated in the financial accounts as being part of the equity of the company.

Redeemable preference shares are repaid on a fixed date in the future. These are treated in the financial accounts like loans and are shown as non-current liabilities. The dividend is treated like interest on loans and included in finance costs.

3 Long-term debt finance

Long-term debt finance refers to borrowing money for a period (usually at least 5 years) of and paying interest each year over that period. This could be achieved simply by arranging a long-term loan from a bank, but for large amounts of borrowing a company is more likely to issue loan notes (also known as loan stock, debentures or bonds).

The company will state how much in total they wish to borrow, the rate of interest they will pay, and the date on which the borrowing will be repaid. Investors are then invited to lend however much money they want (usually in units of $100) and will receive a certificate for the amount they have invested called a ‘loan note’ or 'debenture'

Secured loan notes

Secured loan notes are secured on assets of the company. This means that if the company is unable to pay the interest or falls into liquidation, then the holder of the loan notes can take what they are owed from the sale of these assets (in priority to anyone else owed money).

Unsecured loan notes

These loan notes are not secured on specific assets. So if the company does go into liquidation, then although they are repaid before any money goes to equity, it is only   out of money left after the secured loan notes have been repaid. Because there is more risk therefore to the investors, these loan notes will pay a little more interest than that paid to secured loan notes.

Redeemable and convertible debt

Redeemable (i.e. repayable) debt is when the loan notes are repaid in cash on a fixed future date. Convertible debt is when the holders of the loan notes (the lenders) have the choice on the fixed future date of either taking cash or alternatively taking a fixed number of shares in the company. It is the investors who choose which to do when it comes time for repayment. Convertible debt is popular because it makes it more attractive for investors to lend money in the first place (relatively safe), then if the company does very well they the loan can be converted into equity shares so that capital gains can be made.

Loan notes issued with a warrant

These are loan notes issued in one of the ways listed above but, in addition to receiving a certificate for the amount they have lent (and then receiving interest and then either repayment or conversion), lenders also receive a warrant, which is a bit like getting a gift voucher. The warrant entitles them to buy a certain number of shares in the company at a fixed price on a future date. It is the investors' choice on whether or not to buy the shares at the fixed price. It is completely separate from the loan notes themselves, but does make lending the money more attractive to investors.

4 The stock exchange

4.1 Introduction

When a company is established it will normally obtain capital from its founders, their families and friends. As the company grows it can boost its capital by retained profits and sometimes by outside investors such as business angels and venture capitalists (of which more later).

As companies become large, many choose to obtain a listing (quotation) on a stock exchange and this provides the opportunity to raise large amounts of capital from private individuals and organisations such as pension funds, hedge funds and insurance companies.

Many countries have several 'levels' of stock exchange. In the UK there are:

• The Alternative Investment Market (AIM)
  

• The Main Market
  

The AIM is used by smaller companies, often as a stepping stone to a full listing. It is subject to regulation but much less so than the main market. Therefore, shares on the AIM are more risky to invest in because the regulations are less onerous and also because the companies are younger. The main market is where major national and international companies are listed and it is subject to tight regulation.

A listing shows a company's share price (which will often change on a second-by-second basis) and will provide a platform for the instant purchase and sale of shares. The ease by which shares can be sold increases investors' confidence to invest in shares because they know it will be easy to sell their investment at any time. The market is said to be 'liquid'. One of the problems that arises with investing in unlisted (unquoted) companies is that it can be difficult and slow to find a buyer for shares if an investor wants out. The market for unlisted shares is said to be 'illiquid'.

4.2 Initial listing

The initial listing is when a company first goes onto a stock market. The occasion is often used to raise new capital from new investors. It is sometimes known as the 'primary market'. Subsequently, the shares can be bought and sold by investors at the prevailing market price but this has no effect on the amount of capital in the company. This is the 'secondary market'. So a fall in a company's share price has no effect on the capital in the company but it will affect the wealth of investors.

As part of the listing process the company has to present lots of financial information (eg its trading history) in a prospectus. Drafting the prospectus and ensuring that regulations are adhered to requires the services of professional firms such as accountants, lawyers merchant banks and stockbrokers. The fees charged by these firms are eye-watering, typically about 10% of the amount of capital raised.

There are several ways in which shares in a company can be listed (ie become 'floated' on the stock exchange:

A public offer

Shares are offered to the public and institutions. Typically, the offer is advertised in the financial press and application forms are submitted. The offer can be fixed price or an offer for sale by tender.

• Fixed price - shares are offered at say, $4.00 each. If applications are made for more shares than available then the offer has been oversubscribed and applications have to be scaled back. For example, everyone might receive 80% of the shares they applied for. Sometimes the share offer is undersubscribed so that is fewer shares are applied for than are available. That is very undesirable because the large costs of publishing the prospectus and organising the sale have been incurred for a disappointing amount of capital raised. It is also somewhat embarrassing for the company as it implies that the shares were offered at too high a price. To prevent the company being left with unsold shares, public issues are underwritten, meaning that a financial institution (for a fee) promises to buy all unsold shares. This insurance means that the company will always raise the capital it wanted to raise and so will be able to carry out its investment plans.
  

• Offer for sale by tender - investors bid for the shares. A range of prices will be offered and these are arranged in descending sequence. The highest price at which all shares would be sold is the strike price and all shares are sold at that price even if the investor offered a higher amount. For example, a company has 50,000 shares for sale and receives offers for 100,000 shares as follows:
  

  Number of shares bid for	Bid amount per share ($)
  5,000	10
  15,000	8
  30,000	5
  50,000	3

  At a price of $5/share, 50,000 shares could be sold (obviously if someone offered $10/share they would be very happy to buy at $5). The strike price is $5 per share and all are sold at that price to the top three categories of investor. Those who offered only $3/share are allocated no shares.
  

  Offers for sale allows the company to avoid deciding on a strike price and lets the market decide.
  

A placing

In this listing method, used for smaller flotations, shares are offered to institutions only. members of the public can only get shares by then buying from the institutions. It is a cheaper way to list shares and raise capital than a full public offer.

An introduction

An introduction is a method for listing shares already in issue.The shares are already so widely held by a diverse set of investors that there is an open market for the trading in these shares. No additional capital is raised via an introduction.

4.3 After the initial listing

Subsequent to an initial listing in which it is normal to raise substantial new amounts of equity capital, a successful company may be able to expand using its retained profits. Retained funds avoid share-issue costs, but are not free: shareholders forgo distributions and expect a return on the funds reinvested. However, sometimes there is a need for more equity capital to be injected from outside. This can happen if the company has been making losses and more capital is needed to ensure short-term survival. Or, perhaps the company wants to expand faster than retained profits allow, for example, if the company wanted to takeover another company.

New equity is then raised by means of a rights issue. This is where new shares are offered to existing shareholders on a pro-rata basis and they are usually issued below current market price to make the issue look attractive to investors. For example:

Equity shares in issue = 500,000

Current share price = $6

Rights issue: 1 for 4 shares at $5 per share.

So, if you were the owner of 200 shares, you are being offered 200/4 = 50 (ie one new share for every old four shares) shares at $5 per share. You would pay $250 for those shares. If every shareholder took up their rights then the company would raise:

500,000/4 x 5 = $625,000

Shareholders do not have to buy more shares and if they don't they will receive some money for selling their rights to other investors. If shares are bought under the rights issue then each shareholder maintain their relative stake in the company ie no dilution of control.

4.4 Advantages and disadvantages of a listing

Advantages:

• Access to very large amounts of capital
  

• Greater share liquidity (shares are easy to buy and sell on the market).
  

• An always-available share price
  

• Greater regulation and monitoring of listed companies can give investors and customers more confidence that the company is well-managed (perhaps this is an illusory belief).
  

Disadvantages:

• Dilution of ownership and control as many new shares are issued and many more shareholders are entitled to vote.
  

• Original owners can resent that more people are now involved and so others can determine the company's future.
  

• Greater scrutiny and comment. For example, newspapers can comment on every decision, result and piece of news leaving the company. Dealing with this can distract management.
  

• Greater focus on short term results and share prices. This can make it difficult for management to carry out long-term plans which might involve short term falls in profit.
  

5 Gearing: the debt:equity balance

Equity shares prices can be very volatile as can equity dividends. If the company fails equity shareholders are the last to receive any repayment - and only if any money is left after creditors and others. Therefore, equity shareholders suffer considerable uncertainty and risk.

Debt is much safer. The interest rate of a debenture is printed on the document and loans are often secured on valuable assets. Interest is therefore predictable and if the company goes into liquidation, debenture-holders will often recover all their investment.

Because equity is relatively risky, shareholders expect relatively high returns. Because debt is much safer, debt-holders are satisfied with lower returns.

Therefore, it makes sense for companies to have some relatively cheap debt finance in their capital structures. Debt is made even cheaper for companies because they receive tax relief on their interest payments but do not get tax relief on dividend payments.

The mix of debt and equity is measured by a company's gearing ratio:

  Either: Debt/Equity or alternatively Debt/(Debt + equity)

The term 'gearing' in finance (or 'leverage' in the USA and some other countries) is used in analogy to mechanical systems. For example, you turn the pedals of a bicycle once and if you are in a high gear the rear wheel might turn more than once. Similarly levers allow a small movement on one side of the pivot to produce a large movement on the other side.

For example, here is an ungeared company:

Low profits are half medium profits and high profits are twice medium profits. You will see that exactly there is exactly the same relationship in the profit after tax available for dividend.

Now see what happens if the company is geared and has to pay interest on its borrowings of, say, $400,000

The top line profits are still fall by 50% from medium to low and rise by 100% from medium to high but now profits available for dividends fall from 450 to 75 (to only 17% of what they were) and rise from 450 to 1,200 (a rise of 266% on what they were). So the profits available for dividends have become much more volatile.

This is fine if the company is doing well and profits before interest are increasing, but worrying if profits before interest fall. Profits wouldn't have to fall much further (or interest rates rise by much) before profits do not cover interest.

Therefore, the conclusion is that it is good to have some borrowing in a company's capital structure to make use of relatively cheap finance, but as borrowings rise shareholders are exposed to more risk, both more volatile dividends and a higher chance that the company will fail because it can't meet its interest payments. Lenders are also exposed to more risk because all good company assets will already have been used to secure loans and there is an increasing risk of company failure if interest and loan repayments cannot be made on time.

Earnings per share show the same volatility. Look at the calculations below on the assumption that the capital structure of the ungeared company is 10,000,000 shares and the structure of the geared company is 6,000,000 shares and 4,000,000 10% debentures.

6 Small and medium-sized enterprises (SMEs)

6.1 Venture capital

Very small, new companies are initially funded by their founders either using their own money, personal loans from banks and sometimes investment by friends and relatives.

Large and very large companies can raise capital through the Alternative Investment Market (AIM) or by a listing on the full market.

However, medium-sized companies can often find it difficult to raise capital: they are too large for friends and family to make an impact and too small for a listing. The absence of suitable finance for these companies is known as the funding gap. In particular they have difficulty in obtaining medium-term finance (typically for 3 - 5 years and this is the maturity gap. Being small and new means that it can be difficult for these companies to provide lenders with adequate security for loans. Additionally they have short trading records and this makes risk assessment difficult.

To some extent. the problem is addressed by business angels and venture capitalists. Business angels are wealthy individuals who invest in young companies, providing them with venture capital. Venture capitalists are organisations which specialise in funding relatively new businesses. Both hope that they will earn gains through the companies' future success and they do not expect profits or dividends in the short term. Typically, a venture capitalist will invest in up to just below 50% of the company's shares and will very likely expect a seat on the board so that they can keep an eye on their investment.

When deciding whether or not to invest the capital providers will:

• examine and assess the company's products and services
  

• look at whatever trading history is available
  

• assess the business assets (eg patents owned)
  

• critically review budgets, including cash flows, typically for at least the next 5 years
  

• understand why the company needs additional capital
  

• assess the quality and experience of current employees and directors
  

• assess any security that can be offered
  

To make a profit from their investment the investors have to have an exit route that will allow them to realise their investment. This is usually either via selling the company to another (a takeover) or obtaining a listing for the company on a stock exchange. This lets the investors easily sell their shares - hopefully at a profit. Occasionally, the exit route is via the original founders buying out the other investors, but this is rare.

Because of the high risk involved when investing in relatively new companies, business angels and venture capitalists are typically looking for returns in the order of 30%pa.

6.2 Other sources of funds for SMEs

Government schemes

Local government, national government and supra-government organisations (like the European Union) often offer grants and incentives to smaller businesses. The grants and incentives are usually made available to directed at companies which are in regions where the economy is relatively poor with high unemployment and where regeneration is needed. Grants are amounts of money given permanently to a business (though the business usually has to comply with certain undertakings if the grant is not to be repaid. Other forms of incentive include soft loans (where the interest rate is reduced because of government contributions) or loan guarantee schemes (where banks are encouraged to lend money because the government will underwrite any bad debts.

The grants and other government help available change frequently.

Hire purchase/instalment credit

This is an important source of medium term finance and is often used for the purchase of non-current assets with lives of around five years, such as vehicles, computers and some machinery. With HP, the supplier of the equipment retains ownership of the asset and the user company pays (typically) monthly instalments for the use of the asset. This is the 'hire' element of HP. If the user stops paying instalments the supplier can seize the goods. When the last instalment is due the company can opt pay a purchase fee (usually small) and it is then that ownership of the asset transfers.

Instalment credit involves the seller of the asset arranging a loan for the user of the asset. The loan is used to buy the asset immediately and the loan is gradually paid off. If the buyer of the asset stops paying then finance company can pursue the borrower for unpaid amounts, but the asset remains the property of the buyer.

Leasing

Similar to hire purchase and instalment credit but ownership of the asset never transfers. In effect, the asset is being rented. This is also useful as a source of medium term finance.

Sale and leaseback

Usually applies to land and buildings but can also apply to large, valuable items of equipment. The business owns the asset and this is then sold to a finance company which leases it back to the seller. The business receives a large influx of cash from the sale then pays lease instalments to keep using the asset. This would usually be regarded as a long-term source of finance.

Debt factoring and invoice discounting

A factor takes over the receivables of a business, maintaining the receivables ledger and chasing customers for payment. Customers pay the factor who then pays the original seller net of a commission . The normal arrangement is that the factor pays the seller earlier than the money is received from the customer. Speeding up cash receipts is of great help to the seller. Additionally, the seller is relieved of the administrative burden and expense of maintaining the receivables ledger.

An invoice discounter pays the seller a percentage of certain sales invoices when these are presented. Again, the seller receives sales revenue more quickly but in this case sellers of goods maintain their own receivables ledger.

7 Merits and limitations of medium-term finance

Compare term, total cash cost, payment pattern, security and operational flexibility with the asset’s use. Lease-or-buy calculations are not required by FFM.

8 Gearing and earnings per share

State the gearing definition. Example: debt $100,000, ordinary share capital $200,000 and reserves $100,000. Equity is $300,000: debt/equity = 33.3%; debt/(debt + equity) = 25%. Include reserves in equity.

EPS = profit available to ordinary shareholders / ordinary shares. Profit after interest and tax of $30,000 less preference dividends of $6,000, divided by 200,000 ordinary shares, gives $0.12 (12 cents) per share.

Compare structures consistently: if another structure has $20,000 available to 100,000 shares, EPS is 20 cents. If that structure has $200,000 debt and $200,000 equity (including reserves), debt/equity is 100% and debt/total capital is 50%, compared with 33.3% and 25% above. Higher EPS alone does not establish superiority; additional debt increases interest commitments and financial risk.

9 Internally generated funds

• Cash retained from operations can finance growth without a new securities issue. Releasing surplus inventory/receivables and selling unwanted assets can also release funds.

• Accounting retained profit is not necessarily available cash. Forecast working-capital needs, taxes, dividends and asset spending before deciding how much can be reinvested. Internal funding is limited by cash generation and has an opportunity cost.

10 SME finance requirements and the information gap

• Specify the purpose (start-up, equipment, expansion or seasonal working capital), amount needed and period. Support the request with realistic cash forecasts, accounts, order evidence and a repayment plan.

• SMEs may have a short trading history, limited collateral and less reliable public information. Lenders face an information gap and higher assessment costs, which can mean refusal or higher rates/security requirements.

• Good records, credible forecasts, owner investment and clear information reduce uncertainty, but do not guarantee funding. Match short seasonal needs to suitable facilities and long-lived investment to longer-term finance.

11 Chapter 9 questions

Question 1

Match the following expenditure to the most suitable type of finance:

Expenditure

A   Increasing inventory in preparation for an expected, seasonal busy period

B   Acquiring a piece of land on which to build a new factory

C   Buying several desktop computers with expected lives of about 5 years

Finance

1   A rights issue

2   Instalment credit

3   An overdraft

Question 2

A company has 200,000 $1 shares in issue, with market value $3.50 per share. It intends to raise money by a 1 for 5 rights issue at $3.20 per share.

If all investors take up their rights, how much will be raised and how many shares will then be in issue?

Question 3

A company is financed by both ordinary and preference shares. Which type of share:

(a)   Gives the most stable dividends?

(b)   Will rise more in value if good profits are made?

(c)   Will fall more in value if the company does poorly?

(d)   Is paid out ahead of the other if the company goes into liquidation?

Question 5

What is an offer for sale by tender?