Finance instruments: Description and cost evaluation

1.1  Long-Term Financing Alternatives

The decision of long-term finance mainly rests on equity and debt finance.  Equity finance takes the form of issue of shares, venture capital trusts and private placing, while debt finance has a wider array of instruments, like for example, debenture issues, loan stock, mezzanine debt, Eurobonds and leasing and sale-and-leaseback.  In the following sections we shall describe and evaluate the aforesaid finance mediums for long term finance.

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1.2  Equity Finance

1.2.1        Issue of Shares

This type of finance option is normally available for public companies.  An unquoted company[1] due to its nature has a limited number of persons from which equity finance can be raised.  Therefore they tend to rely more on debt finance.  With respect to public companies who can adopt such long-term finance measure at their discretion, can either opt for a new issue of shares or a rights issue of shares.  The former one consists of an issue of shares to the general public.  In such a stance the potential shareholders will purchase shares in the company in exchange of money according to the price set for the share, which can be higher or lower than the nominal value of the share depending on the circumstances of the company.  In this case the voting power of the present shareholders will alter.  The latter method, the rights issue of shares ensures that the voting power of the existing shareholders is not changed by offering the new shares to the present shareholders in line with the shares they hold.  For example if the company proposes a rights issue of 1,000,000 shares at 1 share for every 3 held.  The present shareholders will be able to buy in line with their shares.  For instance if a stock holder has 300,000 shares, he can purchase 100,000 rights issue shares.

The normal returns expected by shareholders are interim and annual dividend payments together with capital appreciation.  Being the final risk bearers of the company, equity investors request high returns in line with the high risk their investment holds.  Indeed the cost of equity is usually greater than the cost of debt due to such reasons.

1.2.2        Private Placing

A way that unquoted companies can increase the equity base and attain long-term equity finance is through private placing.  This entails an arrangement via a stockbroker or issuing house, in which shares are purchased by them and sold by such entities to their selected clients.  The cost of such finance instrument is the same as issue of shares, with the exception of additional fees that will be charged by the issuing house of stockbroker for their service.

1.2.3 Venture Capital Trusts

Venture Capital is a funding tool particularly directed for the development of existing companies with a sound financial health or new companies with revolutionary and business ideas.  Venture Capital falls into two main categories, independent companies and captive firms.  Independent companies comprise private venture capitalists that provide finance from a number of sources to aid such firms for a specified time.  Captive firms are subsidiary organizations of strong financial institutions, like banks and insurances that are set to invest in risky mediums like equity in companies.

Venture capitalists apart from requesting returns and capital appreciation like the latter two may also demand that they appoint some of their people in the board of directors of the company.  In practice however, this is infrequently done.  The expected return of venture capital trusts, even though it is a highly tax efficient system especially in the United Kingdom, is frequently high due to the inherent risks of equity finance.  In practice, a measure that is frequently adopted in order to mitigate such investment risk and diminish the cost of capital is to split the venture capital finance between equity and debt.

1.3  Debt Finance

1.3.1        Issue of Debentures

Debentures basically consist of secured loan stock.  Once debentures are issued they are sold at a nominal value and an interest commitment arises at this stage.  A debenture also frequently holds a maturity period, which once elapses have to be paid back.  The security of debentures can be either through a floating charge on all the assets of the organization or on specific assets like buildings.

The cost of debentures is usually lesser than that of equity finance due to the lower investment risks.  However, debenture payments are less flexible than equity returns thus lowering the financial stability of the firm.  If a company fails to pay the debenture interest on time, legal proceedings will normally arise leading the firm to bankruptcy.  This does not apply to equity finance.  Shareholders can wait a year or two without dividends during periods of weak financial performance.  In addition methods like bonus share issue can be adopted in replacement of a dividend payment.  Tax savings advantages can also arise from debt finance, which in turn will further lower the cost of such finance instrument.  Interest on debt is deducted before taxable profits, while dividends given to equity investors are deducted after the taxation charge.  Let us further illustrate this factor with the aid of an example.

White Ltd. and Black Ltd. are two companies operating in the same industry.  During the year ended 2004, both companies incurred a profit before interest and taxation of $100,000.  The capital structure of White Ltd. is made up of 500,000 ordinary shares of $1 each.  The capital structure of Black Ltd. is made up of $100,000 10% debentures and 400,000 ordinary shares of $1 each.  Each company intends to provide a divided of 10% from the available profits.  The corporate tax is assumed at 35% on taxable profits.

By preparing the following profit and loss appropriate account we can see the taxation charge each company will incur:

Profit & Loss appropriation account for year ended 31st December 2004.
White Ltd.

$
Black Ltd.

$
Operating profits
100,000
100,000
Less: Debenture interest ($100,000 x 10%)

10,000
Profit on ordinary activities before taxation
100,000
90,000
Less: taxation charge (see note 1)
35,000
31,500
Profit on ordinary activities after taxation
65,000
58,500
Less: Ordinary dividend proposed (see note 2)
50,000
40,000
Retained earnings
15,000
18,500
Note 1:

Calculation of taxation charge = Profit before taxation x 35%

White Ltd. = $100,000 x 35% = $35,000

Black Ltd. =    $90,000 x 35% = $31,500

Note 2:

Calculation of dividend proposed = Share capital of company x 10%

White Ltd. = $500,000 x 10% = $50,000

Black Ltd. = $400,000 x 10% = $40,000

As we can see, Black Ltd. paid lower corporation tax due to the tax saving of $3,500 ($10,000 x 35%) arising from debt finance.

1.3.2        Unsecured Loan Stock

The features of an unsecured loan stock are similar to that of debentures with the exception that no securities are put in place by the loan stock holder.  As a result, higher investment risk will arise leading to a rise in investment cost, probably exposed in greater interest commitments.

1.3.3        Mezzanine Debt

This type of formal borrowing contract is normally known as intermediate or subordinated debt.  Mezzanine debts are more costly than the aforesaid debt instruments because they hold a low priority for payment and thus carry a higher interest rate.  These debts are frequently utilized for management buy-outs, because they provide the possibility for investors to expose the rising potential of the business venture.

1.3.4        Eurobonds

Eurobonds are not associated in any way with the European currency nor do they imply that they are issued solely in Europe as their name implies.  These are international loans that are denominated in a currency different from the one in which the issuing company was formed.  For example a Eurobond would be a bond issued by an American company in the Japanese capital market.  The cost of Eurobonds can be either straight, through a fixed rate of interest or floating-rate via a variable interest rate.  Such bonds normally hold an interest cost advantage together with less rigid convents and lower disclosure of financial information upon their issue when compared with local bonds.

1.3.5        Leasing and Sale-and-leaseback

An organization can also finance its capital projects through leasing.  Lease payments together with interest charges are the normal costs incurred in leasing transactions.  This is a highly desirable long-term finance instrument especially when the finance is directed towards the purchase of long-term significant tangible assets.

The costs of leasing can also be diminished through sale-and-leaseback to a financial institution or other interested party.  This is usually applied to property and consists of the lessee leasing the tangible asset to another entity thus transferring the ownership with the right of using it for a specified period.  The main limitation of such leasing approach is that the capital appreciation that might arise will be lost since the asset was leased to another institution.

1.4  Final Thought – Most Optimal Financing Instrument

No correct answer can be given to the question which is the most optimal financing instrument, unless the financial situation and need of such long-term finance are carefully evaluated.  Thus before deciding on the financing medium to adopt it is imperative that a proper examination is made of the firm’s financial position and stability together with the reasons necessitating such long-term finance.

 

References:

 

Jones P. C. (2002). Investments: Analysis and Management. Eight Edition. United States: John Wiley & Sons Incorporation.

 

Pike R.; Neale B. (1999). Corporate Finance and Investment. Third Edition. England: Pearson Education Limited.

 

 

[1] Unquoted company is a private company, whose shares are not listed on the stock exchange.

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