EC2607 Lecture: Sources of Long-term Finance: Equity Finance

Overview of Sources of Long-term Finance: Equity Finance

• Recommended Reading Material:     * Hillier: Chapter 7 (Sections 7.2 & 7.3) and Chapter 14.     * Supplementary: Arnold (Chapter 6), Pike and Neale (Chapter 16).

• Learning Objectives:     * Define equity finance and distinguish it from debt finance.     * Identify factors firms consider when raising finance.     * Analyze similarities and differences between ordinary and preference shares.     * Explain the tax deductibility feature of debt.     * Discuss alternative sources and methods of raising equity finance.

Distinction Between Debt and Equity Finance

• Equity Finance:     * Capital paid into or kept within the business by shareholders (the owners).     * Categorized as long-term capital.     * Carries the greatest risk for the providers.     * Attracts the highest potential returns to compensate for risk.

• Debt Finance:     * Money invested in the business by third parties.     * Usually provided for a shorter duration compared to equity.     * Carries lower risk for the investor and consequently yields a lower return.

Types of Company Finance and Trends in the U.K.

• Internal vs. External Generation: Finance is generated through both internal (retained profits) and external (shares, debt) sources.

• Sources of New Finance for U.K. Companies (2020-2024) by Percentage (%):     * 2020: Retained Profits ($64$), Ordinary Shares ($10$), Debentures & Preference ($5$), Bank and Other Borrowings ($21$).     * 2021: Retained Profits ($56$), Ordinary Shares ($18$), Debentures & Preference ($5$), Bank and Other Borrowings ($21$).     * 2022: Retained Profits ($49$), Ordinary Shares ($5$), Debentures & Preference ($4$), Bank and Other Borrowings ($42$).     * 2023: Retained Profits ($44$), Ordinary Shares ($2$), Debentures & Preference ($6$), Bank and Other Borrowings ($48$).     * 2024: Retained Profits ($51$), Ordinary Shares ($4$), Debentures & Preference ($5$), Bank and Other Borrowings ($40$).     * Average (2020-2024): Retained Profits ($53$), Ordinary Shares ($8$), Debentures & Preference ($5$), Bank and Other Borrowings ($34$).

Main Factors to Consider When Raising Finance

• Risk and Cost:     * Debt is less risky for investors than equity, making it generally cheaper for the firm to obtain.

• Ownership and Control:     * Debt does not grant ownership rights; therefore, existing control remains with the current owners.

• Duration:     * Equity is a permanent form of finance (no repayment date).     * Debt is typically issued for shorter, defined periods.

• Debt Capacity and WACC:     * Leveraging cheaper debt can lower a firm's Weighted Average Cost of Capital (WACC).     * The optimal capital structure is the point on the Debt/Equity axis where WACC is minimized.

Characteristics of Ordinary Shares

• Definition: Ordinary share capital is the primary source of equity finance and represents a stake in the ownership of the firm.

• Share of Assets and Profits: Represents a "share" of company assets and profits earned "after other claims have been met."

• Investor Exit: Shareholders cannot ask the company to return their stake. To regain funds, they must:     * Find a buyer on the stock market at the current market price.     * Force the company into liquidation.

• Shareholder Rights:     * Full rights to participate in business matters via voting in general meetings.     * Entitled to dividends paid out of profits.     * Repayment of capital in liquidation occurs only after all other claims (employees, creditors, bondholders) are satisfied.

• Risk and Reward Profile:     * Ordinary shareholders bear the greatest risk as the last claimants.     * They enjoy the full benefits of corporate success via higher dividends or capital gains after meeting other obligations.     * Expected returns are higher to compensate for this secondary claimant status.

Preference Shares: Hybrid Securities

• Hybrid Nature: Positioned between equity and debt.

• Debt-like features: Usually entitle holders to a fixed rate of dividend each year, provided profits are earned.

• Equity-like features: No profits usually mean no dividends (though they can be paid from accumulated reserves).

• Rights and Limitations:     * Usually carry no voting rights, except during liquidation.     * Preferential rights over ordinary shareholders for dividend payments and capital repayment in liquidation.     * Considered part-owners because they participate in the appropriation of profits.

• Variations:     * Cumulative: Unpaid dividends are carried forward to future periods if current profits are insufficient.     * Non-cumulative: Dividends not paid in a period are lost.     * Participating: Dividend payments are linked to corporate performance rather than being strictly fixed.

Tax Deductibility of Debt vs. Equity

• Debenture (Debt) Interest: A tax-deductible expense that reduces the company's taxable profit and overall tax bill.

• Preference Dividends: Not tax-deductible; tax is paid on profits before these dividends are deducted.

• Numerical Case Study (Costa Coffee):     * Setup: New shop requires $\text{\pounds}1,000,000$ finance. Options: Equity or Debt at $10\%$ p.a.     * Projections: Revenues = $\text{\pounds}500,000$; Costs = $\text{\pounds}200,000$; Corporation Tax = $30\%$.     * Equity Scenario:         * Earnings Before Tax (EBT) = $\text{\pounds}500,000 - \text{\pounds}200,000 = \text{\pounds}300,000$         * Tax @ $30\%$ = $\text{\pounds}90,000$     * Debt Scenario:         * Interest Expense = $10\% \times \text{\pounds}1,000,000 = \text{\pounds}100,000$         * Earnings After Interest Before Tax (EAIBT) = $\text{\pounds}500,000 - (\text{\pounds}200,000 + \text{\pounds}100,000) = \text{\pounds}200,000$         * Tax @ $30\%$ = $\text{\pounds}60,000$     * Tax Saving: $\text{\pounds}90,000 - \text{\pounds}60,000 = \text{\pounds}30,000$ per annum.     * Present Value (PV) of Tax Shield in Perpetuity: $\frac{30,000}{0.1} = \text{\pounds}300,000$

The Equity Market Structure

• The London Stock Exchange: The U.K.'s primary exchange and one of the world's largest.

• Primary Market:     * Where companies raise finance for the first time through new issues.     * Initial Public Offering (IPO): The process of offering shares to the public for the first time (e.g., Google, Meta).

• Secondary Market:     * Where existing/quoted shares are traded among investors.     * No new funds go to the issuing firm in this market, only between buyers and sellers.

• Seasoned Equity Offering (SEO): A listed company releasing additional stocks to raise further capital.

Sources of Equity Financing

• Individual Investors: Friends, family, or the public. Often invest small amounts, requiring many individuals. They may provide industry expertise.

• Founders: Provide the initial equity at the time of company formation.

• Angel Investors: Wealthy individuals/groups investing large sums at early stages, seeking high returns.

• Venture Capitalists (VCs): Firms making substantial investments in high-growth companies.     * Often exit at the IPO stage.     * May demand majority ownership or involvement in management (Management Buyouts) to protect investments.

• Crowdfunding: Many individuals investing small amounts via online platforms like Kickstarter, Indigogo, and GoFundMe.

Methods of Issuing New Shares

• Offer for Sale: The most common method. The issuing company sells shares to an "Issuing House," which then offers them to the public.     * Risk: Finding the correct price to equate demand and supply.     * Underwriting: The Issuing House insures against undersubscription for a fee (typically $1\% - 2\%$ of the issue value).

• Public Issue: The company offers shares directly to the public. Typically used by well-known companies for large issues.

• Private Placing: Shares are sold privately to specific clients and market dealers rather than the general public. Cheaper than an offer for sale; used for smaller amounts.

• Offer for Sale by Tender: Investors bid at or above a set minimum price.     * Striking Price: The highest price that ensures all shares are taken up.     * Usage: Companies with unique characteristics (e.g., privatized utilities) coming to market for the first time. It is the most expensive method.

Raising Finance for Already Quoted Companies

• Rights Issues:     * Offering new shares to existing shareholders in proportion to their current holdings.     * Benefits: Maintains voting control, cheaper than public issues, can be authorized by directors.     * Discount: Shares usually offered at a discount (approx. $20\%$) to the market price, making it logical for shareholders to participate.

• Scrip Dividends:     * Issuing new shares instead of cash dividends.     * Benefit: Preserves company liquidity by keeping cash inside the firm.     * Impact: Share price usually doesn't fall if the cash saved is reinvested at a satisfactory rate of return.