Sources of Long-term Finance: Equity Finance Comprehensive Study Notes

Distinction Between Debt and Equity Finance

Equity Finance:
- Refers to capital paid into or kept within the business by shareholders, who are the owners of the firm.
- It represents long-term capital.
- It carries the greatest level of risk but attracts the highest potential returns.
Debt Finance:
- Refers to money invested in the business by third parties.
- Typically invested for a shorter duration than equity.
- Carries lower risk and consequently attracts a lower return.

Sources of Company Finance (U.K. Statistics 2020-2024)

Internal vs. External Generation: Finance can be generated internally (e.g., retained profits) or externally (e.g., share issues, bank borrowings).
Historical Data Breakdown (Percentage Share of Total):
- 2020: Retained Profits $64 \%$ , Ordinary Shares $10 \%$ , Debentures & Preference Shares $5 \%$ , Bank and Other Borrowings $21 \%$ .
- 2021: Retained Profits $56 \%$ , Ordinary Shares $18 \%$ , Debentures & Preference Shares $5 \%$ , Bank and Other Borrowings $21 \%$ .
- 2022: Retained Profits $49 \%$ , Ordinary Shares $5 \%$ , Debentures & Preference Shares $4 \%$ , Bank and Other Borrowings $42 \%$ .
- 2023: Retained Profits $44 \%$ , Ordinary Shares $2 \%$ , Debentures & Preference Shares $6 \%$ , Bank and Other Borrowings $48 \%$ .
- 2024: Retained Profits $51 \%$ , Ordinary Shares $4 \%$ , Debentures & Preference Shares $5 \%$ , Bank and Other Borrowings $40 \%$ .
- Average (2020-2024): Retained Profits $53 \%$ , Ordinary Shares $8 \%$ , Debentures & Preference Shares $5 \%$ , Bank and Other Borrowings $34 \%$ .

Main Factors to Consider When Raising Finance

Risk and Cost:
- Debt is considered less risky than equity for the investor.
- Because it is less risky, debt is usually a cheaper source of finance for the company.
Ownership and Control:
- Debt finance does not imply ownership in the company.
- Utilizing debt allows current owners to maintain control over the business.
Duration:
- Equity is characterized as a permanent form of finance.
- Debt is usually issued for specific, shorter periods.
Debt Capacity:
- If debt is cheaper, its inclusion in the capital structure will lower a firm’s Weighted Average Cost of Capital (WACC).

Cost of Capital and Optimal Capital Structure

The WACC Curve: In a graph plotting the Cost of Capital (Y-axis) against the Debt/Equity Ratio (X-axis):
- The Cost of Equity starts higher and generally increases as leverage (Debt/Equity) increases due to rising financial risk.
- The WACC (Weighted Average Cost of Capital) initially declines as cheaper debt is added to the mix.
- The Optimal Capital Structure is the point on the X-axis where the WACC is at its minimum value ( $0$ slope point).

Ordinary Shares

Nature of Ownership:
- Ordinary share capital is the primary source of equity finance.
- It represents a 'share' of the company's assets and a share of profits earned 'after other claims have been met.'
- Shareholders are the legal owners of the business.
Capital Return and Liquidity:
- Shareholders cannot demand that the company return their original stake.
- To recover investments, shareholders must sell their shares on the stock market at the current market price or force the company into liquidation.
Rights and Risks:
- Shareholders have full voting rights in general meetings to participate in business decisions.
- They are entitled to dividends (paid from profits) and capital repayment in liquidation only after all other claims (employees, creditors, debenture holders) are satisfied.
- Because they are the last to have claims met, they bear the greatest risk.
- In exchange for this risk, they enjoy benefits like higher dividends and capital gains during success and expect a higher rate of return than secure investments.

Preference Shares

Hybrid Nature:
- Preference shares fall between equity (shares) and debt (debentures).
- Debt feature: They usually entitle holders to a fixed rate of dividend each year, provided profits are earned.
- Equity feature: If no profits are made in a year, no dividend is paid (though it may be paid from accumulated reserves).
Rights and Priority:
- Usually possess no voting rights, except during liquidation process.
- Holders have preferential rights over ordinary shareholders regarding dividend payments and the ultimate repayment of capital.
- Preference dividends are paid as a fixed percentage before ordinary shareholders receive anything.
Accounting and Tax Distinction:
- Holders are considered part-owners because they participate in profit appropriation.
- Debt Interest: Must be paid regardless of profit; it is a tax-deductible expense that reduces the tax bill.
- Preference Dividends: Not tax-deductible. Tax is paid on profit figures before preference dividends are deducted.

Comparison of Tax Deductibility: Debt vs. Equity Example

Scenario (Costa Coffee Shop):
- New finance required: $£1,000,000$ .
- Options: Equity or Debt at $10 \%$ per annum (p.a.).
- Projected Revenues ( $R$ ): $£500,000$ p.a.
- Projected Costs ( $C$ ): $£200,000$ p.a.
- Corporation Tax Rate: $30 \%$ .
Financial Comparison:
- Equity Option:
  - Revenue: $£500,000$
  - Costs: $£200,000$
  - Earnings Before Tax (EBT): $£300,000$
  - Tax at $30 \%$ : $£90,000$
- Debt Option:
  - Revenue: $£500,000$
  - Costs (including $10 \%$ interest on $£1m$ ): $200,000 + 100,000 = £300,000$
  - Earnings After Interest Before Tax (EAIBT): $£200,000$
  - Tax at $30 \%$ : $£60,000$
Conclusion:
- Annual Tax Saving using Debt: $90,000 - 60,000 = £30,000$ p.a.
- In perpetuity, the Present Value (PV) of this tax shield is calculation:
  - $PV = \frac{30,000}{0.1} = £300,000$
- Debt/Debentures are generally cheaper than preference shares for raising long-term finance due to this tax shield.
Variations of Preference Shares:
- Cumulative: Unpaid dividends from lean years are carried forward and must be paid before ordinary dividends in the future.
- Non-cumulative: Unpaid dividends are lost if they cannot be paid in a specific period.
- Participating: Dividend payments are not fixed but linked to corporate performance, similar to ordinary shares.

The Equity Market Structure

The London Stock Exchange (LSE): One of the world's largest stock exchanges and the base of the U.K. market.
The Primary Market:
- Where companies raise finance for the first time.
- Involves new share issues and obtaining a market quotation.
- Initial Public Offering (IPO): The process of a private company offering shares to the public (e.g., Google or Meta/Facebook raising billions).
The Secondary Market:
- Where existing quoted shares are traded among investors.
- Investors buy/sell at current market prices.
- Crucial Note: No funds from secondary market trades go to the company itself.
- Seasoned Equity Offering (SEO): When an already listed company releases additional stocks to the market.

Alternative Sources of Equity Financing

Individual Investors:
- Includes friends, family, and members of the public.
- Usually contribute small amounts, necessitating many investors to reach a goal.
- May provide industry expertise or skills.
- Founders provide the initial equity financing when a company is formed.
Angel Investors:
- Wealthy individuals or groups.
- Invest large sums at early stages of development.
- Expect high returns on their investment.
Venture Capitalists (VCs):
- Firms or individuals investing in companies with extremely high growth prospects.
- Usually enter early and exit at the IPO stage to realize profits.
- Often demand a majority or noteworthy ownership share and significant management involvement (Management Buyouts) to protect assets.
Crowdfunding:
- Many individuals investing small amounts via online platforms.
- Examples include Kickstarter, Indigogo, and GoFundMe.

Methods of Raising Equity Finance via New Share Issuance

Categorization:
- Private Placement: Method C below.
- Public Stock Offerings: Methods A, B, and D below.
The Four Major Methods:
1. Offer for Sale: The most common method. The issuing company sells shares to an "Issuing House," which then offers them to the public. To prevent undersubscription, the Issuing House underwrites the issue for a fee (typically $1 \%$ to $2 \%$ of the issue value), acting as a risk premium.
2. Public Issue: The company makes the offer directly to the public. Usually reserved for large issues by well-established companies.
3. Private Placing: Shares are sold privately to specific clients and market dealers rather than the general public. This is cheaper than an offer for sale and is typically used for smaller placings.
4. Tender Offer: The issuer sets a minimum price; investors bid at or above this level. Shares are allotted at the "striking price" (the highest price ensuring all shares are sold). This avoids the risk of setting an incorrect issue price but is the most expensive method. Often used for unique companies like privatized utilities.

Finance Methods for Already Quoted Companies

Rights Issues:
- New shares are offered to existing shareholders in proportion to their current holdings (e.g., $1$ new share for every $1$ held).
- Advantages:
  - Allows shareholders to maintain voting control.
  - Cheaper than public share issues.
  - Can be decided by directors without consent from shareholders or the Stock Exchange.
  - High success rate: Shares are typically offered at a discount (often around $20 \%$ ), making it economically sensible to take up the rights.
Scrip Dividends:
- The company issues new equity shares to existing shareholders instead of a cash dividend.
- Advantage: Preserves company liquidity by keeping cash within the firm.
- The share price typically remains stable provided the issue isn't too large and the saved cash is reinvested at a satisfactory rate of return.

Sources of Long-term Finance: Equity Finance Comprehensive Study Notes

Recommended Readings and Learning Objectives

Distinction Between Debt and Equity Finance

Sources of Company Finance (U.K. Statistics 2020-2024)

Main Factors to Consider When Raising Finance

Cost of Capital and Optimal Capital Structure

Ordinary Shares

Preference Shares

Comparison of Tax Deductibility: Debt vs. Equity Example

The Equity Market Structure

Alternative Sources of Equity Financing

Methods of Raising Equity Finance via New Share Issuance

Finance Methods for Already Quoted Companies