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Financial Instruments.
Financial instruments package financial capital in readily tradeable forms. Their diversity of forms mirrors the diversity of risk that they manage. Financial Instruments can be categorised according to whether they are securities, derivatives of other instruments or so called cash securities. They can be categorised by 'asset class' depending on whether they are equity based or debt based. If it is a debt security, it can be further categorised into short term or long term. Financing a company through the sale of stock in a company is known as equity financing. Alternatively debt financing can be done to avoid giving up shares of ownership of the company.
Equity Finance
There are a variety of forms of shares, ordinary shares entitle the holders to the remaining distributable profits after prior interests e.g. creditors and prior charge capital have been satisfied. Preference shares, which carry a fixed rate of dividend. Preference shareholders have a prior claim over ordinary shareholders to any company profits available for distribution.
Bonus issues are when a company offers new shares to shareholders in proportion to the number that they already own, but without asking for more money.
A warrant is essentially a long-term option on the shares of a company; it entitles the holder to purchase a stated number of shares at a specified price up to a certain date.
Rights Issues is the most commonly used method of issuing shares involves offering new shares to existing shareholders in proportion to the number of shares already held at a price lower than the current market price.
Debt Finance
A convertible loan carries as one of the terms of issue the option for the holder to convert his stock within a given time period into equity shares at a specified price.
One of the most common forms of long-term debt finance is the debenture or loan stock. The holder of debenture is a creditor of the company who has a right to a fixed annual return with the promise of repayment of a fixed money sum either after a set term or on the winding-up of the company.
A Eurobond is a bond issued in a currency other than the company’s home currency, in an overseas country. If it is sold exclusively in one country (in local currency) it is called a foreign bond.
Deep Discount Bonds are variously known as Zero Coupon Bonds or Money Multiplier Bonds, depending upon the issuing company. The term 'Zero Coupon' arises, as these bonds are cumulative in nature and do not give any interest during their term.
Junk Bonds are high yield bonds issued by companies that are considered highly speculative because of risk of default.
Right Issue
The advantages of ordinary shares are there is no fixed charge attached to them. Only if the company generates enough earnings it will pay dividend but has no legal obligation to do so. They have no fixed maturity date and also increase the creditworthiness of the firm by providing a buffer against losses for creditors. Ordinary shares can also be sold more easily than debentures, since they offer a higher expected return then debentures or preference shares, and provide a better hedge against inflation.
The disadvantages of using ordinary shares are that they extend voting rights to the new holders, which could threaten the control over the company by the existing owner managers. More shares used leads to a wider distribution of profits. The cost of underwriting and distributing new issues of ordinary shares are usually very high and also the company’s cost of capital will rise due to the increase proportion of equity finance. Finally, dividends are not tax deductible, like interest payment on debentures, which can reduce profits available and can increase the cost of equity relative to debt.
Issue of 10% Preference Shares
The advantage of using preference shares is that they carry a fixed rate of dividend and payment of this can be deferred at the company’s discretion.
The disadvantage of using preference shares is that shareholders have a prior claim over ordinary to any company profits available for distribution and usually prior claim to the repayment of capital in liquidation. Superior voting rights generally, or special voting rights to approve certain extraordinary events (i.e. issuance of new shares or the approval of the acquisition of the company) or to elect directors, many preferred shares provide no voting rights
Issue of Loan Stock
The advantage of using loan stock is that debt interest is tax allowable whereas dividend paid to equity shareholders are not. Debt finance is therefore, subsidised by the government on the company’s behalf making it cheaper. Debt does not carry any voting rights. Thus the control of the company is not changed. Issue of loan stock is also fairly quick to arrange, thus, if a company needs cash quickly, debt may be more viable than equity finance. There is very little cost involved in terms of issue cost. As debt finance is cheaper than equity it often has a more beneficial impact on earnings to equity shareholders.
There are two main disadvantages of using debt finance, first is, the provider of loan may protect their interests by imposing restrictive covenants on the company. Secured assets may not be disposed of without the loan stockholders permission, dividend payouts, further rising of debt finance and power of veto over new investments.
The second is that companies using a high proportion of debt finance in their capital structure run a higher risk of insolvency. This is because interest must be paid but dividends can be passed. If the company is experiencing temporary cashflow difficulties and cannot pay its interest it will be wound up the loan stockholder. This worries the stock market and depresses the share prices of highly geared companies.
Current Earning per share (EPS)
EPS = 
EPS is defined as the profit in pence attributable to each equity share after deducting preference dividend, divided by the number of equity shares in issue (FRS 3).
EPS = 
EPS post Rights Issue
A Rights issue of ordinary shares at £2.50 per share would increase the number of shares by an additional 40M shares. However, the new project would generate an extra 14.6M profit after tax (assuming a tax rate of 33%) Therefore the EPS would changes as follows:
EPS = (60,000,000 +13,400,000 / 140,000,000) x100 = 52.42
Effect on Gearing
The nature of the capital structure has important implications for financial management purposes, and in this respect, the gearing is an important consideration.
Debt/equity (pre project) = [(180+120) / (50+50+120)] x 100 = 136.36%
Debt/equity (post project) = [(180+120) / (50+40+50+60+120+13.4)] x100 =89.98%
This form of project finance will significantly reduce the gearing of the company. This is due to the constant level of total debt, but increase in reserves of 13.4M from increase profit from the project and also increase of 40M from new ordinary share issue and an additional 60M in premium.
EPS post 10% Preference share Issue
An issue of 10% preference shares at par would result in a deduction of 10M from equity profit in terms of payment for preference dividend. This would result in a change to EPS as follows:
EPS = 
Effect on Gearing
Debt/equity (post project) = [(180+120+100) / (50+50+120+13.4-10)] x100 =179.05%
This increases the company’s gearing ratio from 136% to 179%, this is due to the increase in debt in form of 100M preference share capital with an increase of 13.4M in reserve (assuming no extra ordinary dividend is paid) with extra 10M preference dividend paid.
EPS post Loan Stock Issue
An issue of loan stock would result in extra interest payment, assuming the new 100M debentures has an interest rate of 12% would mean an extra 12M-interest payment. This would lead to a change in EPS as follows.
EPS = ((60,000,000 +13,400,000 -12,000,000) / 100,000,000) x 100 = 61.40p
Effect on Gearing
Debt/equity (post project) = [(180+120+100)/(50+50+120+13.4-12) = 180.67%
Therefore, using debt finance will further increase gearing and make the company more debt laden and may have disproportionate effects upon the return accruing to ordinary shareholders in the cast of highly geared company, and hence on the pricing of shares on the Stock Exchange.
Other Factors to consider
-
Liquidity – Especially if the project has a development phase, the finance selected should minimise the drain on cashflows during the initial period.
-
Risk – If the firm has substantial outstanding borrowing obligations already, or has liquidity problems at all, then debt financing will be too risky, and equity financing will be preferable. On the other hand, if the project necessitates the issue of a substantial amount of ordinary shares, there may be a ‘risk’ to existing shareholders, in the sense that their ownership control may be threatened.
Summary
|
CURRENT POSITION |
POST PROJECT FINANCE |
||
|
EPS |
Gearing |
EPS |
Gearing |
Rights Issue |
60.00p |
136.36% |
52.42p |
89.98% |
Preference Shares |
63.40p |
179.05% |
||
Loan Stock |
61.40p |
180.67% |
||
From the above table it appears that preference share is a better form of finance than loan stock as it increase EPS by 2.00p more and also the gearing by 1.6% less. However, the directors must decide if they are happy with a situation where the preference shareholders have a superior rights in terms of dividend payment and capital in liquidation.
As the company is already fairly geared with a current gearing of 136.36%, it may be preferable to accept a decline in EPS in order to reduce gearing to 89.98% via a rights issue. However, will the existing shareholders be happy to extend their voting rights to new shareholders?
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