Corporate Finance - Sources of Finance and Capital Structure

Sources of Finance and Capital Structure

Chapter Outline

• Introduction

• Long-term sources of finance

• Medium-term sources of finance

• Short-term sources of finance

• Debt versus equity: a summary

• Gearing

• Optimal capital structure

• Capital structure theories

• Conclusion

Learning Outcomes

• Distinguish between long-, medium- and short-term sources of finance.

• Explain and discuss the different types of equity finance.

• Calculate and interpret the value of a right.

• Explain and discuss the different types of debt finance.

• Distinguish between equity and debt finance.

• Evaluate and advise management on whether to use borrow-and-buy or lease financing.

• Explain, calculate and interpret how gearing increases returns to shareholders and financial risk.

• Analyse and evaluate capital structure.

• Provide recommendations for achieving an optimal capital structure.

• Distinguish between the various capital structure theories.

Introduction

• Every business requires finance or capital.

• Two broad categories of capital/finance exist:

  • Equity instruments

  • Debt instruments

• These instruments can be divided into external and internal sources.

• Debt finance is cheaper but increases financial risk, known as gearing.

• The combination of equity and debt finance is known as the capital structure.

External Sources of Equity Finance: Ordinary Shares

• Ultimate owners of the entity.

• Highest risk for providers of capital.

• Return in the form of capital growth and dividends.

• Dividends are not tax-deductible.

• Can be listed on a stock exchange.

• Stock exchange acts as:

  • Primary market: helps entities raise capital.

  • Secondary market: matches investors who want to buy and sell shares.

Ordinary Shares: Methods of Listing on a Stock Exchange

• Offer for sale: existing shareholders sell shares to the public at a fixed price.

• Offer for subscription (IPO): entity offers unissued shares to the public.

• Offer for sale by tender (auction): shares are not issued at a fixed price but auctioned.

• Private placement: shares are offered to institutional clients.

• Rights issue: entity offers its existing shareholders additional shares.

• TERP (Theoretical Ex-Rights Price).

Example 12.1: Calculating a Rights-Issue Price

• Wrong Ltd needs to raise additional finance to fund an expansion project.

• It currently has five million ordinary shares in issue, which are trading on the JSE at a price of 300 cents per share.

• Management wants to raise R3 million and offers shares in the rights issue at a 20% discount to the current market price.

• The rights issue is expected to be fully subscribed. Ignore transaction costs.

Solutions

1. Calculate the rights issue price:

   • Current share price: 300 cents.

   • Discount: 20%.

   • Rights issue price: $300 \text{ cents} \times (1 - 0.2) = 240 \text{ cents}$.

2. Calculate the number of shares to be issued by Wrong:

   • Amount to be raised: R3,000,000.

   • Issue price: R2.40.

   • Number of shares: $\frac{R3,000,000}{R2.40} = 1,250,000 \text{ shares}$.

3. Calculate the TERP of one Wrong share:

   • The terms of the rights issue can be expressed as '1 for 4' (5 million shares ÷ 1,25 million shares).

   • Using a table:

     • 4 'Old' shares at 300 cents: 1200 cents

     • 1 'New' share at 240 cents: 240 cents

     • 5 Shares at 288 cents: 1440 cents

   • TERP = $\frac{1440 \text{ cents}}{5 \text{ shares}} = 288 \text{ cents or R2.88}$.

• Formula 12.1:
  $TERP = P<em>o \times \frac{N</em>o}{N} + P<em>n \times \frac{N</em>n}{N}$

  • Where:

    • $P_o$ = pre-issue share price

    • $P_n$ = new issue share price

    • $N_o$ = number of 'old' shares

    • $N_n$ = number of 'new' shares

    • $N$ = total number of shares

  • TERP = $300 \text{ cents} \times \frac{5 \text{ million}}{6.25 \text{ million}} + 240 \text{ cents} \times \frac{1.25 \text{ million}}{6.25 \text{ million}}$

    • TERP = $288 \text{ cents or R2.88}$

1. Calculate the value of one right:

   • Value of a right = TERP - Rights issue price

   • Value of a right = 288 cents - 240 cents

   • Value of a right = 48 cents per 'new' share or 12 cents ($\frac{48 \text{ cents}}{4 \text{ shares}}$) per 'old share'.

Ordinary Shares (Rights Issue)

• If shareholders take up their rights, they maintain their proportionate shareholding.

• If they do not, they experience a dilution of their existing shareholding.

• The issue of additional shares in a rights issue also results in a decrease in earnings per share.

Ordinary Shares: Discount and Classes

• If rights are issued at a significant discount, shareholders will experience a significant decline in the value of their shares.

• Different classes of ordinary shares à different voting rights to secure entity’s independence and prevent hostile takeovers.

• The primary purpose of B-BBEE is to address the legacy of apartheid and promote the economic participation of black people in the South African economy.

Preference Shares

• Entitle shareholders to a fixed rate of dividend.

• Carry part ownership in an entity.

• Dividends are not tax-deductible.

• Rank ahead of ordinary shares in liquidation but behind debt finance.

• Preference shares are a hybrid instrument.

Types of Preference Shares

• Convertible preference shares:

  • May convert into ordinary shares or other security.

  • May be the issuer’s option or holder’s option to convert.

• Cumulative preference shares:

  • Cumulative: Dividend accumulates when not paid; may receive voting rights; cumulative in nature unless specified otherwise.

  • Non-cumulative: Does not accrue, and dividend is forfeited.

• Participating preference shares:

  • Fixed dividend, and shareholders share profits with ordinary shareholders.

• Redeemable preference shares:

  • Preference shares that will be redeemed or repaid; characteristics of debt instruments.

Internal Sources of Equity Finance

• Reserves and retained earnings:

  • Includes retained earnings, revaluation reserves, and share premiums.

  • Accumulated profits entity has retained.

  • Important source of finance.

• Generally, the cheapest source of finance:

  • Cash is available, and no transaction costs.

  • Retained earnings are not a “free” source of finance à opportunity cost involved.

  • The amount of retained earnings depends on growth strategy and dividend policy.

Non-Current Debt Finance

• Debt may be classified as:

  • Fixed rate

  • Variable (floating) rate

• Debt may also be classified as:

  • Secured

  • Unsecured

• Types of non-current debt include:

  • Bonds and debentures

  • Mortgage bonds

  • Other non-current loans (such as term loans)

Medium-Term Sources of Finance

• Medium-term finance generally has a maturity of between one and five years.

• Sources of medium-term finance include:

  • Term loans

  • Leases

    • Sales-and-leaseback transactions

  • The borrow-and-buy versus lease decision

  • Business angels, venture capital, and private equity

  • Crowdfunding

Short-Term Sources of Finance

• Medium-term finance generally has a maturity of up to one year.

• Sources of short-term finance include:

  • Factoring

  • Invoice discounting

  • Bank overdrafts

  • Accounts payable

Debt Versus Equity

• Table 12.2 provides a quick guide to equity and debt finance, highlighting similarities and differences.

Optimal Capital Structure

• Financial gearing (or leverage) refers to the amount of debt included in an entity’s capital structure.

• Market values rather than book values should be used to calculate gearing (where possible).

Example 12.4: Illustrating the Benefit of Using Debt in the Capital Structure

• Extracts from the financial statements of Equity Ltd and Geared Ltd are provided.

• Equity Ltd is 100% equity financed, while Geared Ltd is 50% equity financed and 50% debt financed (non-current liabilities).

• The non-current liabilities of Geared consist of a 12% bank loan repayable in ten years.

Solutions

1. Calculate the earnings per share for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Profit for the period	72,000	50,400
   Number of issued ordinary shares	50,000	25,000
   Earnings per share	R1.44	R2.02

2. Calculate the return on assets for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Operating profit after tax	72,000	72,000
   Total assets	500,000	500,000
   Return on assets	14.40%	14.40%

   • Note 1: Return on assets is often calculated as Profit after tax ÷ Average total assets. However, it is often better to use the operating profit after tax.

3. Calculate the return on equity for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Profit for the period	72,000	50,400
   Total equity	500,000	250,000
   Return on equity	14.40%	20.16%

4. Calculate the financial gearing for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Interest-bearing debt	-	250,000
   Shareholders' equity + Interest-bearing debt	500,000	500,000
   Gearing ratio	0%	50%

Example 12.5: Illustrating the Negative Impact of Using Debt in the Capital Structure

• Extracts from the financial statements of Equity and Geared are provided.

Solutions

1. Calculate the earnings per share for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Profit for the period	18,000	(5,000)
   Number of issued ordinary shares	50,000	25,000
   Earnings per share	R0.36	(R0.20)

2. Calculate the return on assets for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Operating profit after tax	18,000	18,000
   Total assets	500,000	500,000
   Return on assets	3.60%	3.60%

3. Calculate the return on equity for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Profit for the period	18,000	(5,000)
   Total equity	500,000	250,000
   Return on equity	3.60%	(2.00%)

4. Calculate the financial gearing for both entities.

   Item	Equity Ltd (R'000)	Geared Ltd (R'000)
   Interest-bearing debt	-	250,000
   Shareholders' equity + Interest-bearing debt	500,000	500,000
   Gearing ratio	0%	50%

Capital Structure Theories

• Combination of debt and equity included in the long-term finance of an entity.

• Debt generally has a lower cost than equity.

• If the entity increases the amount of debt in the capital structure, it lowers its WACC and generates a higher return for the shareholders.

• Increasing return for the shareholders means additional financial risk.

• As financial risk increases, shareholders require a higher rate of return.

Optimal Capital Structure

• The Optimal capital structure is the capital structure that results in the lowest possible WACC.

• Results in the highest share price.

• In line with maximizing the wealth of the shareholder.

• Two theories explain the effect of changes in capital structure on the market value of the entity:

  • Modigliani and Miller’s theory of gearing

  • Traditional theory of gearing

Modigliani and Miller’s Theory of Gearing

• Proposed that an optimal capital structure does not exist.

• The value of a company is determined by the value of assets and not the method in which the entity is financed.

• Based on assumptions:

  • Individual investors borrow at the same rate and terms as the entity.

  • Taxation is ignored.

  • Transaction costs are ignored.

  • Financial distress costs are ignored.

Modigliani and Miller’s Theory of Gearing: Premise

• Based on the premise that an entity’s WACC will not change irrespective of the level of gearing.

• As more debt is added to the capital structure, financial risk increases.

• As a result, ordinary shareholders require a higher return for additional risk.

• The benefit of cheaper debt will be offset by more expensive equity.

• Optimal capital structure does not exist.

Modigliani and Miller’s Theory of Gearing: Limitations

• Individuals are not generally able to borrow at the same rate and same terms as entities.

• Taxation cannot be ignored in the real world:

  • Dividends are subject to additional withholding taxes and capital gains.

• Transaction costs are incurred in the real world.

• High levels of gearing do carry dangers and costs of financial distress.

Trade-Off Theory of Gearing

• As the gearing ratio increases, the WACC decreases à value of the entity increases.

• Increasing risk associated with entity leads to a higher required return by shareholders.

• Cancels out the benefits of lower debt.

• WACC starts to increase, and the value of the entity starts to decrease.

• Assumes WACC is lowest at level of gearing that represents the lowest point of the WACC line.

Trade-Off Theory of Gearing (Graphical Representation)

• Cost of capital graph showing the relationship between the cost of capital and the level of gearing.

• The graph includes the cost of equity ($k<em>e$), WACC, and cost of debt ($k</em>{dt}$).

• The optimal capital structure (OCS) is indicated on the graph.

Trade-Off Theory of Gearing

• WACC will decrease until a certain point and then start to increase as the rising cost of equity becomes significant.

• Cost of equity ($k_e$) increases as the level of gearing increases.

  • Financial risk causes profits to become more volatile, and shareholders will require higher returns.

• Debt is assumed to be a cheaper source of finance than equity.

  • Interest is tax-deductible.

Trade-Off Theory of Gearing

• The cost of after-tax debt ($k_{dt}$) increases after a certain level of gearing as interest cover reduces.

  • Few assets to offer security.

• WACC falls initially as the level of debt increases and then increases as the cost of equity becomes more expensive.

• The optimum level of gearing is where the WACC is at a minimum (Point OCS).

• The capital structure that minimizes the WACC also maximizes the value of the entity.

Signalling Theory of Gearing

• M&M based their theory of capital structure irrelevance on the assumption that all investors have access to the same information as management.

• Management is likely to have access to better information than shareholders.

• Many shareholders focus on management decisions to determine the value of entity.

  • E.g., if management decides that the market price of its shares is overvalued, it may decide to issue additional shares to raise new equity.

Signalling Theory of Gearing

• Because of asymmetrical information, the value of an entity could be influenced by its choice of capital sources.

  • The decision to issue new shares could result in a decline of in share prices à current share price is overvalued, or management is concerned about the future performance of entity.

• Signalling theory of gearing - management should ensure that reserve borrowing capacity is available to be used when investment opportunities become available.

Signalling Theory of Gearing

• Entities may include more internal equity capital in their capital structures than expected under the trade-off theory.

Pecking-Order Theory of Gearing

• Information asymmetry between management and investors gives rise to the development of the pecking-order theory of gearing.

• Managers should first utilize internally generated funds (in the form of retained earnings) to finance viable investment opportunities, followed by the use of short- term and long-term debt financing.

Pecking-Order Theory of Gearing

• Only when insufficient capital can be raised should management issue additional preference and ordinary shares in the entity (in that order).

• Implication of this theory à management may increase financial gearing to dangerous levels to avoid increased scrutiny by investors associated with the issuing of new equity and debt.

Pecking-Order Theory of Gearing

• Management may also reduce the levels of cash distributions that are made to the entity’s shareholders to increase retained earnings.

Conclusion

• The mix of debt and equity finance that an entity adopts is known as the capital structure.

• An entity’s capital structure consists of various sources of long-term and medium-term finance.

• Short-term finance forms part of an entity’s working capital management.

• Equity and debt are the two main categories of finance available to entities to fund their operations.

Conclusion (Cont.)

• Equity sources of finance include external sources, such as ordinary shares and preference shares.

• Equity sources of finance also include internal sources, such as retained earnings and reserves.

• Retained earnings are not a ‘free’ source of finance.

• Rights issues occur when an entity wishes to raise additional ordinary share capital from existing shareholders.

Conclusion (Cont.)

• In a rights issue, existing shareholders are given the first right to purchase shares, usually at a discount to the current market price.

• Non-current debt finance includes bonds and debentures, mortgages, and term loans.

• Various types of medium-term sources of finance are available to businesses, including term loans and leasing.

• Small entities may find it more difficult to raise finance than larger entities.

Conclusion (Cont.)

• Therefore, sources such as business angels, venture capital, private equity, and crowdfunding may be appropriate.

• Sources of short-term finance include factoring, invoice discounting, bank overdraft, and accounts payable.

• There are various implications that an entity must consider when deciding between equity and debt sources of finance. These include the tax effect, the risk and return effect, and the effect on control via voting rights.

Conclusion (Cont.)

• Gearing (or leverage) refers to the amount of debt included in an entity’s capital structure.

• The trade-off theory of gearing states that entities have an optimal capital structure or gearing ratio. The optimal capital structure refers to the ratio at which an entity’s WACC is at its lowest point, so that returns for shareholders are maximized.