SOURCES OF BUSINESS FINANCE

A company might raise new funds from the following sources:

The capital markets:

  1. i) New share issues, for example, by companies acquiring a stock market listing for the first time
  2. ii) Rights issues
  • Loan stock
    · Retained earnings
    · Bank borrowing
    · Government sources
    · Business expansion scheme funds
    · Venture capital
    · Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or ‘face’ value, typically of $1 or 50 cents. The market value of a quoted company’s shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.

Deferred ordinary shares

Deferred ordinary shares are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares.

Ordinary shareholders put funds into their company:

  1. a) By paying for a new issue of shares
    b) Through retained profits.

Simply retaining profits, instead of paying them out in the form of dividends, offers an important, simple low-cost source of finance, although this method may not provide enough funds, for example, if the firm is seeking to grow.

A new issue of shares might be made in a variety of different circumstances:

  1. a) The company might want to raise more cash. If it issues ordinary shares for cash, should the shares be issued pro rata to existing shareholders, so that control or ownership of the company is not affected? If, for example, a company with 200,000 ordinary shares in issue decides to issue 50,000 new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead?
  2. i) If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, we have a rights issue. In the example above, the 50,000 shares would be issued as a one-in-four rights issue, by offering shareholders one new share for every four shares they currently hold.
  3. ii) If the number of new shares being issued is small compared to the number of shares already in issue, it might be decided instead to sell them to new shareholders, since ownership of the company would only be minimally affected.
  4. b) The company might want to issue shares partly to raise cash, but more importantly to float’ its shares on a stick exchange.
  5. c) The company might issue new shares to the shareholders of another company, in order to take it over.

New shares issues

A company seeking to obtain additional equity funds may be:

  1. a) an unquoted company wishing to obtain a Stock Exchange quotation
  2. b) An unquoted company wishing to issue new shares, but without obtaining a Stock Exchange quotation
  3. c) A company which is already listed on the Stock Exchange wishing to issue additional new shares.

The methods by which an unquoted company can obtain a quotation on the stock market are:

  1. a) An offer for sale
    b) A prospectus issue
    c) A placing
    d) an introduction.

Offers for sale:

An offer for sale is a means of selling the shares of a company to the public.

  1. a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise cash for the company. All the shares in the company, not just the new ones, would then become marketable.
  2. b) Shareholders in an unquoted company may sell some of their existing shares to the general public. When this occurs, the company is not raising any new funds, but just providing a wider market for its existing shares (all of which would become marketable), and giving existing shareholders the chance to cash in some or all of their investment in their company.

When companies ‘go public’ for the first time, a ‘large’ issue will probably take the form of an offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately.

Rights issues

A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.

For example, a rights issue on a one-for-four basis at 280c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold, at a price of 280c per new share.

A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

Preference shares

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with ‘cumulative’ preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.

From the company’s point of view, preference shares are advantageous in that:

  • Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures).
  • Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not.
  • Unless they are redeemable, issuing preference shares will lower the company’s gearing. Redeemable preference shares are normally treated as debt when gearing is calculated.
  • The issue of preference shares does not restrict the company’s borrowing power, at least in the sense that preference share capital is not secured against assets in the business.
  • The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders.

However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks.

For the investor, preference shares are less attractive than loan stock because:

  • they cannot be secured on the company’s assets the dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved. 

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