Long-Term Sources of Finance

SHARE CAPITAL

Ordinary Shares

The main features are:

• Issued to the owners of the company (equity).
• Nominal or “face” value (e.g. 1000rwf.).
• Market value moves with market‟s view of the company‟s performance/prospects.
• Shareholders are not liable for the company‟s debts on a winding-up (limited liability).
• Carry voting rights
• Ordinary shareholders are entitled to the residue after other parties are rewarded. This applies to both annual profits and capital on a winding-up.
• Subscription privileges apply in the event of a new issue of shares (“pre-emptive rights”).
• Shareholders may be rewarded by dividends (income), or retained profits (capital gain). Some companies offer concessions on their products to shareholders – e.g. discounts or vouchers.
• Some companies have different classes of ordinary shares. For example, Non-Voting similar to other shares in every respect, except holders cannot vote.

Advantages to the Company

• No fixed annual charges are payable – no legal obligation to pay a dividend.
• Do not have a maturity date and are not normally redeemable.
• Usually more attractive to investors than fixed interest securities.  Might increase the creditworthiness of a company as they reduce gearing.

Disadvantages to the Company

• Issue might reduce EPS, especially if the assets acquired do not produce immediate earnings.
• Extend voting rights to more shareholders.
• Lower gearing as a result of the issue might result in a higher overall cost of capital than is necessary.
• Issues often involve substantial issue and underwriting costs.
• Dividends are not a tax allowable expense.

Preference Shares

The main features are:

• Holders are entitled to a fixed maximum dividend.
• Dividends are only paid if sufficient profits are available.
• Rank prior to ordinary shares (both dividends and capital on a winding-up).
• Cumulative Preference Shares the right to any arrears of dividend carried forward and they must be paid before any dividend is paid to the ordinary shareholders. Preference Shares are cumulative, unless expressly stated to be non-cumulative.
• Restricted voting rights – usually only available in a situation where the rights attaching to the shares are being amended or if dividends are in arrears.
• Some companies have different classes of preference shares. For example,

Redeemable – generally redeemable subject to sufficient profits being available or sufficient cash being raised from a new issue. Convertible – the right to convert to ordinary shares as per the terms of the issue.

Advantages to the Company

• A fixed percentage dividend per year is payable no matter how well the company performs, but only at the discretion of the company‟s directors.  Do not normally give full voting rights to holders.
• Preference shares are mostly irredeemable.

Disadvantages to the Company

• Cumulative arrears of dividend are payable.
• Dividends are not a tax allowable expense.

  LOAN CAPITAL

The main types are Loan Stock and Debentures.

• Loan Stock – long-term debt (usually > 10 years duration) on which a fixed rate of interest (coupon rate) is paid. Generally unsecured.
• Debentures – a form of loan stock, legally defined as a written acknowledgement of debt. Usually secured.  Trustees appointed to look after investors‟ interests.  Can be redeemable or irredeemable.
• Loan capital ranks prior to share capital (both interest and capital on a winding-up). The ranking of individual debt will depend upon the specific conditions of each issue.
• Restrictive covenants are often included in the lending agreement (e.g. restrictions on further borrowings, the payment of dividends, or major changes in operations; the maintenance of certain key ratios in the accounts etc.).
• If security is provided the cost to the company may be cheaper. Security may be in the form of a fixed or floating
• Interest payments are allowable for Corporation Tax.
• If the net cost of debt is low why do companies not borrow more and more? Some of the reasons are:
  • A high level of debt will increase the financial risk for the shareholders.
  • Interest charges at a particular point in time may be high.
  • The company may have insufficient security for new debt.
  • There may be restrictions on further debt – Articles of Association; restrictive covenants; credit lines fully used etc.

Redemption of Loan Capital

• Most redeemable stocks have an earliest and a latest date for redemption.
• Redemption is at the company‟s option anytime between these two dates.
• When should the company redeem? Generally, if the coupon rate is below current interest rates delay to the later date and vice versa.  However, the following factors should be considered:
  • If internally generated funds are to be used, consider their availability.
  • If a further issue of debt is to be used, consider issue costs.
  • The trend in future interest rates.
  • If new equity is to be used, shares should be issued when the price is relatively high.

Convertible Loan Stock

This is debt paying a fixed rate of interest but also providing the option to convert to equity at a pre-determined rate on pre-determined date(s).

The main features are:

• Conversion is at the option of the holder.
• Conversion terms usually vary over time.
• Once stock is converted it cannot be converted back.

Advantages to the Company

• It is cheaper than straight debt due to the conversion rights. The lower coupon rate may suit projects with low cash flows in the early years.
• A high-risk company may have difficulty raising long-term finance no matter what coupon rate is offered. Convertibles may attract investors due to the “upside potential”.
• If conversion takes place, the debt is self-liquidating. Conversion will reduce gearing and enable further debt to be raised in the future.
• Interest payments are tax deductible.
• Convertibles are often not secured and have less restrictive covenants than straight debentures.
• The number of shares eventually issued on conversion will be smaller than if straight equity is issued.

Advantages to the Investor

• If the market value of the company‟s shares falls the value of the convertibles will not fall below the market value of straight debt with the same coupon.
• If the market value of the company‟s shares rises the value of the convertibles will rise also.
• Convertibles rank before shares on a winding-up.
• If the company‟s fortunes improve dramatically investors can share in this by exercising their option.

Floating Rate Bonds

• These are debt securities whose interest is not fixed but is re-fixed periodically by reference to some independent interest rate index – e.g. a fixed margin over National Bank of Rwanda Interbank Rate. These are commonly referred to as Floating Rate Notes or FRNs.  Coupons are re-fixed, and coupon payments made, usually every six months.
• When market interest rates fall the issuer (borrower) is not saddled with high fixed coupon payments. Likewise, when interest rates rise the investor is not stuck with a fixed income but will see his income rise in line with market rates.
• The market value of such securities should be fairly stable as interest rates will rise/fall in line with market interest rates.

Deep Discount Bonds

These are debt securities which are issued at a large discount to their nominal value but will generally be redeemable at par on maturity.  To compensate for the fact that a large capital gain accrues on maturity, the ongoing coupon rate is substantially lower than other types of loan stock.  An example might be:

2% Bond 2015, which was issued in 2005 at a price of RWF70 per cent.

• The price of the bond in the secondary market will gradually appreciate as the maturity date approaches.
• Many projects require funding up-front, but are unlikely to give rise to an income stream to service interest costs for some period of time – e.g. a building project where income from rentals or sale of the building would be received much later. A Deep Discount Bond can be a useful source of funding for such a project as it helps to match cash flows.
• An attraction to the investor is the advantageous taxation treatment in certain countries – e.g. the capital gain at maturity is subject to CGT, which may be at a lower rate than income tax, or the gain is taxed as income in one lump sum on maturity or sale rather than as interest each year.

Zero Coupon Bonds

Zero Coupon Bonds are very similar to Deep Discount Bonds except that no interest is paid during the life of the bond and are, therefore, issued at a large discount to their nominal value.  An example might be:

0% Bond 2020, which was issued in 2010 at a price of RWF50 per cent.

Instead of interest payments the investor receives as a return the difference between the issue price and the higher redemption proceeds.

WARRANTS

• Holder has the right (but not the obligation) to purchase a stated number of shares, at a specified price, anytime before a specified date.
• If not exercised the warrants lapse.
• Warrants are often issued as a “sweetener” to make a loan stock issue more attractive, or to enable the company to pay a lower coupon rate.
• The warrant-holder is not entitled to dividends/voting rights.
• Unlike convertibles, new funds are generated for the company if the warrants are exercised.
• Generally, the warrant is detachable from the stock and can be traded separately.  The value of the warrant is dependent on the underlying share price.

 

 METHODS OF SHARE ISSUE

Offer For Sale

 Public at Large  Fixed Price

Offer For Sale By Tender

• Public at Large
• Not a Fixed Price
• Set a Minimum Price & Invite Tenders
• Shares Issued at Highest Price where All Taken-up

 

Placing

Shares “Placed” with Target Audience – generally institutions

Rights Issue

Shares Issued to Existing Shareholders

Pro-rata to Existing Shareholding (e.g. One for Five Issue)

Possible Choices

• Subscribe for new shares (exercise rights)
• Sell “rights” to new shares
• Exercise rights (part) & sell rights (part)

Do nothing

BANK LENDING

The main considerations by the bank before advancing a loan can be summarized by the mnemonic PARTS.

P     URPOSE

A     MOUNT

R     EPAYMENT

T     ERM

S     ECURITY