Companies have different alternatives for obtaining funds that is used to finance investment project. They can issue debt or equity securities to archive this goal. Some times lease is also used as an alternative for long term financing. The source of finance has an implication on cost of funds. To this end this chapter discusses the different sources of finance including their merits and demerits.
A company can raise finance in the following ways:
1. From finance classified according to the relationship to the party giving the finance, e.g.
- Equity Finance- This is finance provided by real owners of the business i.e. ordinary shareholders. Equity securities represent ownership interest in a corporation. These securities include common stock and preferred stock. These two forms of securities
provide a residential claim on the income and assets of a corporation. Thus, this section discusses these two sources of long-term finance.
- Quasi equity- This is finance provided by quasi-owners of the business i.e. preference shareholders.
- Debt finance- This is finance provided by outsiders i.e. creditors: thus it include loans, overdrafts, trade creditors, bills of exchange, debentures, hire-purchase, leases, mortgages, etc.
2. Classified according to the duration i.e. term of finance i.e. how long the finance will be in the business.
- Permanent finance- This is finance which cannot be refunded to the owners in the shortrun. Examples of this finance are:
Ordinary share capital
Irredeemable preference share capital
These are only refunded in the event of the company’s liquidation.
- Long term finance- If finance is in the business for a period of 7 years and beyond, this finance is long-term, e.g. long-term debt finance. However, this term is relative because for a kiosk a 2 years loan is long-term, and for a limited company a 2 years loan is short term.
- Short term finance- this is finance due to be refunded to lenders after a short period i.e. a period between one year and three years, e.g. overdrafts, short term loans, etc.
3. Classified according to the origin of finance:
Internal sources of finance- these are such finances as generated within the business, i.e. from the businesses’ own operations. Examples of such finances are
- Retained earnings
- Provision for depreciation
- Provision for taxation
- Adjustment in working capital items
The above finances are used as follows:-
- Undistributed profits transferred to the business i.e. ploughed back into the business.
- Provision for depreciation if a company has created a sinking fund to replace an asset after useful economic life. This finance can be used and replaced later when the asset is due to be replaced.
- Provision for taxation is a source of finance in as much as the tax liability falls due a bit later than when it is appropriated from the current profits, e.g. a company will provide for taxation in December and pay it at the end of March or thereafter. i.e. can be used up to the end of March.
- Adjustment in working capital serves as a source of finance in as much as the company will reduce the levels of working capital items to release finance which would have otherwise been tied up in those items.
- Sale of an asset; this is a source of finance under the following conditions:-
If the asset is obsolete
If the asset is sensitive to technology e.g. computers, aircrafts.
If the asset cannot meet the company’s contemplated expansion programme.
If the asset is not sensitive/ central of the company’s operations, and its sale will not substantially affect he productive capacity of the business.
4. Classification according to the rate of return i.e. in relation to the cost of that finance.
- Finance with variable rate of return VRT). In this case the return on such finance will vary with the profits made by the company; e.g. ordinary share capital and participative preference share capital are VRT.
- Fixed rate of return capital (WFR). This will refer to the finance whose rate of return is fixed regardless of the profits made, e.g. preference share capital, loan finance, debenture finance etc
2.1 Equity Finance
This is the largest source of finance to any limited company and usually forms the base on which other finances are raised. Equity is the total sum of the company’s ordinary share capital plus the company’s retained earnings also known as revenue reserves.
Ordinary Share Capital
It is that finance contributed by the ordinary shareholders of a business. This is raised through the sale of the company’s ordinary shares. It is finance contributed by real owners of the company. This finance is only raised by limited companies. It is permanent finance to the company and can only be refunded in the event of liquidation, i.e. in Kenya; a company cannot buy back its own shares (ordinary shares). This finance is paid ordinary dividends as return to the shareholder’s investment. Ordinary shares carry rights and usually each share is equal to one vote exercised in Annual General Meetings.
Ordinary shares are quoted at the stock exchange where they are sold and bought by the public through brokers. Ordinary share capital carries the highest risks in the company because it gets its return after other finances have got theirs, and also in the event of liquidation it is paid last (their voting right is assumed to be used wisely to minimize these risks.)
Ordinary dividends are not a legal obligation on the part of the company to pay. If the company’s profits are good, ordinary shareholders get the highest return because their dividends are varied. This is the only type of finance that grows with time and this growth is technically called growth in equity which is facilitated by retention of earnings.
Rights to Ordinary Shareholders
- They have a right to vote. This right is given to them by the company’s Act. They are also entitled to vote by Proxy in absentia
- They have a right to inspect corporate books e.g. Articles of association, Memorandum of Association and books of accounts.
- They have a right to sell their shares to other parties i.e. to transfer their ownership in shares of a company.
- They have a right to share in residual assets of the company during the company’s liquidation.
- They have a right to approve the purchase of capital assets.
- They have a right to amend the charters and by laws of the company (Articles and Memorandum of Association)
- They have a right to approve the sale of the company’s assets.
- They have a right to approve mergers, acquisitions and take-over’s.
- They have a right to appoint directors.
- They have a right to appoint/remove auditors of the company who will oversee the company’s affairs.
Features of Ordinary share Capital
- It is a permanent finance to the company which can be refunded only during liquidation.
- It is the largest source of finance to the Ltd Company.
- This finance has a residual claim on profits and assets during liquidation.
- Ordinary share capital is entitled to voting powers, each share usually being equal to one vote.
- This finance carries a varied return i.e. its dividends will vary with the profits made.
- Ordinary share capital carries no nominal cost to the company. i.e. dividends on ordinary share capital are not a legal obligation to the company to pay.
- It is the only finance which will grow with time as a result of retention.
- This finance cannot force the company into liquidation i.e. it does not increase its gearing; on the contrary, it decreases the gearing.
- It can be raised by limited companies only.
Advantages of Using Ordinary Share Capital by a Company
- Being a permanent finance the company will invest it in long term ventures without inconveniencies of paying it back.
- Dividend payment (to ordinary shareholders) is not a legal obligation to the company, thus no threat to liquidity of the company.
- This type of finance contributes valuable ideas towards the running of the company during the Annual General Meeting.
- This finance is available in large amounts in particular if the company is quoted on the stock exchange in which case it can raise substantial amounts of money to finance the company’s operations.
- Ordinary share capital forms a base and thus a security on which other money can be raised.
- Common stock does not obligate the firm to make payments to stockholders. A firm can not be obliged to pay divided when there are financial constraints. Had it used debt, it would have incurred a legal obligation to pay interest regardless of operating condition and cash flows.
- Common stock has no fixed maturity date. It never has to be rapid as would a debt issue.
- Common stock protects creditors against losses and hence, the sale of common stock increases the creditworthiness of the firm. This in turn raises it bond rating, lowers its cost of debt and increases its future ability to use debt. One of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when debt is used.
- The cost of underwriting and distributing common stock is usually higher than that of preferred stock or debt
- If the firm has more equity than required in its optimal capital structure, its cost of capital will be higher than necessary. Therefore, a firm would not want to sell stock if the sale would cause its equity ration to exceed optimal level
- Under current tax laws, dividends on common stock are not deductible for tax purposes, but interest is deductible. This raises the relative cost of equity as compare to debt.
Disadvantages of Using Ordinary Share Capital to a Company
- The cost of ordinary share capital (ordinary dividend is paid in perpetuity).
- This finance may disorganize a company’s policy in case shareholders’ votes are cast against the company’s present operations and policies.
- It does involve a lot of formalities in its raising and it may take a long time to raise as the company has to obtain permission from the capital market authority and other regulators.
- It is very expensive to raise as it involves a lot of costs commonly known as floatation costs e.g. printing the prospectus and share certificates, advertising expenses, cost of underwriting the issue, brokerage costs, legal fees, auditor’s fees, cost of communication.
- The issue of ordinary share capital means that the company’s secrets will be exposed to the public through published statements which may be dangerous from competitors point of view.
2.2 Quasi Equity/ Preference Share Capital
This is finance contributed by quasi-owners or preference share holders. It is so called quasiequity because it combines features of debt finance and those of equity finance. Preferred stock differ form common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that the holders of the preferred shares must receive a dividends (in the case of an ongoing firm) before holders of common share are entitled to anything. Preferred stock is a form of equity form a legal and tax stand point. It is important to note. However, the holders of preferred stock sometimes have no voting privilege. Preferred stock is sometimes convertible in to common stock and is often callable. So we can say that preferred stock is a hybrid form of financing combing features of debt and common stock. It is called preference share capital because it is accorded preferential treatment over ordinary shareholders in:-
- Sharing in dividend- It receives its dividend before those of ordinary shareholders. Thus it is said to be preferred to dividends.
- It is accorded preferential treatment in sharing of assets in the event of liquidation. Preference shareholders get their claims on asset before ordinary shareholders get theirs. Thus it is said to be preferred to assets.
In order for a share to be called a preference share it must be accorded the above preferential treatment over and above ordinary share capital.
Advantages of Preferred Stock
By using preferred stock a firm can fix its financial cost and still avoid the danger or bankruptcy if earnings are too low to meet these fixed charges. This is because preferred stock earners a dividend but the company has discretionary power to pay it. The omission of payment doesn’t result in default.
Disadvantages of Preferred Stock
It has a higher after tax cost of capital that debt. The major reason for this higher cost is taxes preferred dividends are no deductible for tax purpose, whereas interest expense on debt is deductible.
Similarities between Ordinary and Preference Share capital
- Both finances earn a return in form of dividends
- If the preference shares are irredeemable then both will be permanent sources of finance to the company.
- In case the preference share capital is irredeemable both will receive dividends in perpetuity.
- Both form the company’s share capital/ share finance
- Both are difficult to raise due to a lot of formalities the company must go through to raise this finance.
- Both claim on assets and in profits after debt finance has had its claim.
- Payment of dividend to both is not a legal obligation for the company i.e. neither the ordinary shareholder nor the preference shareholder can sue the company to claim their dividends.
- Both finances are not secured i.e. no security is attached to such finance.
- Both finances are raised strictly by limited companies.
- Both finances are long-term finances to the company.
Differences between Ordinary and Preference Share capital
- Ordinary share capital carries voting rights whereas preference share capital does not except if it is convertible, and is converted.
- Ordinary share capital carries variable rate of dividends whereas preference dividends are fixed except for participative preference share capital.
- Ordinary share capital receives its dividends after preference share capital has been paid theirs.
- The share prices of ordinary shares will be higher if the company is doing well than those of preference shares.
- Preference share capital increases the company’s gearing level whereas ordinary share capital reduces the gearing level.
- For cumulative preference shares these may receive dividends in arrears ordinary shares cannot.
- Raising finance by way of ordinary share capital is easier than raising preference share capital as in the latter case the company has to be financially strong.
- Preference share capital is usually secured by the company’s financial soundness whereas ordinary share capital is not.
- Preference share capital cannot qualify for a bonus issue, while ordinary share capital can, i.e. preference shares cannot receive bonus issues.
- Ordinary shares have a chance to receive a rights issue whereas preference shares cannot get rights issues.
2.3 Debt Finance – Loan
In this section we will discuss debt financing by describing in some detail the basic features and advantages of bond financing.
Features of Bonds
Bonds are a major source of financing for corporations and government. A bond is a long term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond. Most corporate bonds contain a call provision which gives the insuring corporation the right to call the bonds for redemption. The call provision generally states that are called some other types of bonds have convertible features. A convertible bond is a debt instrument that is convertible in to shares of common stock at a fixed price at the option of the bond whereas a convertible features on a bond benefits the bondholders. A callable bond will generally require a higher interest payment than non callable bond because the investor will not be willing to buy a callable bond unless he receivers a better interest payment. When the market price of the bond of increases or equivalently, the market interest rate
decreases, the issuer of the bond will call the bond and issue a new bond at a lower interest rate. This puts the buyer of the bond at a disadvantage because when the bond gets attractive it will be taken away from the investor.
A convertible feature on a bond as stated before, benefits the bondholders. Thus investors would generally require the issuing corporation a higher interest payment on non convertible bonds than convertible bonds. The holders of convertible bonds have the option to convert these bonds to common stock any time they choose. Typically, the bonds are exchanged for specified number of common shares with no cash payment required. Because convertible have this option, they require a lower payment than non-convertibles. This is the type of finance which is obtained from persons other than actual owners of the company i.e. creditors to the company. This finance can be in any of the following forms:
- Bank overdrafts
- Trade creditors
- Borrowing against
- bills of exchange
- Lease finance
- Mortgage finance
- Hire purchase finance
All the above finances have a legal claim or charge against the company’s resources or assets.
Classification of Debt Finance
- Short term finance
This ranges from 1 month up to 4 years and is given to customers known to the bank or to lenders. The agreement of this loan will mention both the repayments of principal and interest, and for interest it must identify whether it is simple or compound interest. For principal, it has to be paid over some time. This finance is usually secured and the terms of the loan will be restrictive e.g. to be invested in an area acceptable to the bank or lender. Usually, this finance should be used to solve short-term liquidity problems.
- Medium-term finance
This finance will be in the business for a period ranging between 4-7 years. This term is relative and will depend upon the nature of the business. This type of loan is used for investment purposes and is usually secured but the security should not be sensitive to the company’s operations. The finance obtained must be invested while respecting the matching approach to financing i.e. the term and payback period must be matched. This type of finance is the most popular of all debt financing because most of the busineses will need it both in their growing stages and also in their mature stages of development.
- Long-term finance
This is a rare finance and is only raised by financially strong companies. It will be in the business for a period of 7 years and above. This finance is used to purchase fixed assets in particular during the early stages of a company’s development. It is always secured with along term fixed asset, usually land or buildings. Its investment, however, must obey the matching approach. In all, the companies needing such finance do not have to be known to the lenders.
Advantages and Disadvantages of Debt Financing
In the previous section we noted the advantage of equity financing relative to debt financing. Though it may be a repeat let’s summarize the key advantages and disadvantages of debt financing relative to equity financing. The corporation payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. This makes debt financing a cheaper source of finance than equity financing. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the asset of the firm. This action can result in liquidation or reorganization tow of the possible consequences of bankruptcy. Thus one of the costs of issuing debt is the possibility of financing failure. This possibility does not exist when equity is issued.
2.4 Other forms of Debt Finance
These are very short-term sources of finance to the company and are usually used to finance the company’s working capital or solve its liquidity problems. This finance is usually not secured and is more costly than long-term loans as much as its interest is 1-2% higher than bank rates. Interest on overdrafts is computed on a daily basis although it may be paid monthly. Overdrafts are usually given to
very well known customers of the bank although over-reliance on overdrafts is a sign of poor financial management policies and as such they should not be used often.
2. Bills of Exchange
As a source of finance, bills of exchange can be:- Discounted, Endorsed or Given as securities for loans
A bill of exchange us defined as an unconditional order in writing addressed by one person to another signed by the person giving it, requiring the person to whom it is addressed to pay on demand at a fixed or determinable future date a certain sum of money to the order of the person or to bearer. Most of the bills mature between 90-120 days although they could be sight bills i.e. payable on sight or issuance i.e. payable in the future. In order for a bill to be valid and to serve as a source of finance it should be:-
- Signed by the drawer;
- Accepted by the drawee;
- Be unconditional;
- Bear appropriate revenue stamp.
3. Debenture Finance
It is a document that is evidence of a debt which is long-term in nature, and confirms that the company has borrowed a specific sum of money from the bearer or person named in the debenture certificate. Most debentures are irredeemable thus forming a permanent source of finance to the company. If these are redeemable then these will be long-term loans which range between 10-15 years. They can be endorsed, negotiated, discounted or used as securities for loans. They carry a fixed rate of interest which is payable after six months i.e. twice a year.
Classification of Debentures
1. Classification according to security
- Secured debentures- these are secured against the company’s assets or have a fixed charge against the company’s assets. In the event of the company’s liquidation such debentures will claim from that particular asset. They could be secured against a floating charge in which case the holder can claim on any or all of the company’s assets not yet attached by other secured creditors. A debenture holder with a floating charge has a status of a general creditor. However, the floating charges debentures are rare and they are sold by financially strong companies.
- Unsecured (naked) debentures- these carry no security whatsoever and such they rank as general creditors. They carry a residual claim to the first class creditors but a superior claim over ordinary shareholders. These are rare sources of finance and are sold by financially strong companies with a good record of dividend payment to the shareholders.
2. Classified according to redemption.
- Redeemable debentures- these are bought back by the issuing company. Like preference shares, these have two redemption periods. This is usually between 10-15 years, i.e. the company has the option to redeem these after 10 years but before expiry of 15 years. In most cases redeemable debentures are secured against specific assets e.g. land or buildings (mortgage debentures). Their interest is a legal obligation on the part of the issuing company.
- Irredeemable debentures (perpetual debentures)- these can never be bought back by the issuing company except in the event of liquidation and as such they form a permanent source of finance to the company. These debentures are rare and are only sold by financially strong companies which must have had some good dividend history. They are unsecured and thus are known as naked perpetual debentures.
3. Classified according to convertibility
- Convertible Debentures- These are the type of debentures which can be converted into ordinary share capital and this conversion is optional as follows:
At the option of the company i.e. at the company’s option.
At the option of both parties i.e. debenture holder and the company.
At the option of the holder.
However, the conversion price of the debenture is given by:-
Conversion Price = Nominal value of the debentures
Conversion Ratio = Nominal value of the debentures
Nominal value of the shares to be converted
In all, convertible debentures are never secured.
- Non-convertible debentures- These cannot be converted into any shares be it ordinary or preference shares and are usually secured.
4. Subordinate debentures (naked)
These are issued with a maturity period of 10 years and above, and usually they carry no security and depend upon the goodwill of the company. They are so called subordinate because they rank last in claims after all classes of creditors except trade creditors. Nevertheless their claims are superior to those of shareholders both preference and ordinary shares.
5. Hire Purchase
This is an arrangement whereby a company acquires an asset by paying an initial installment usually 40% of the cost of the asset and repays the other part of the cost of the asset over a period of time. This source is more expensive than bank loans. Companies that use this source of finance need guarantors as it does not call for collateral securities to raise. The company hiring the asset will be required to honor all the terms of the arrangement which means that if any term is violated then the hire may repossess the asset. This finance is kind and the hirer will not get a good title to the asset until he clears the final installment and an optional charge in some cases.
Companies that offer this finance in Kenya are:- National Industrial E.A. Ltd., Diamond Trust(K) Ltd., Kenya Finance Corporation, Credit Finance Co. Ltd. They avail hire purchase facilities for such assets as: Plant and machineries, vehicles, tractors, heavy transport machines, aircrafts, agricultural equipments.
6. Lease Financing
Leasing is an important source of equipment financing. For some equipment, the financing is long term in nature. This section discusses the features of a lease their types and advantages and
disadvantages of lease financing.
A lease is a contract whereby the owner of an asset (the leaser) grants to another party (the leasee) the executive right to use the asset in return for the payment of rent (i.e. lease payment). In other words, through leasing, a firm can obtain the use of certain fixed assets for which it must make a series of contractual periodic payments form the lease points of view; this lease payment is tax deducible. Here we discuss lease as an alternative source of financing and hence we shall see the effects of leasing on the lease business.
Types of Leases
Leases can be basically classified in to two; operating lease and capital or financial lease. An operating lease is relatively short term in length and is cancelable with proper notice. The term of this type of lease is shorter than the assets economic life. Operating leases for instance may include the leasing of copying machines certain computer hardware and word processors. In contrast to an operating lease a financial lease is longer term in nature and is non cancelable. The lessee is obligated to make lease payments until the lease term expires which approaches the useful life of the asset.
If an operating lease is held until the term of the lease, at the maturity date will return the leased asset to the owner (leassor) who may lease is again or sell the asset. However, if the leasee decides to return the asset before maturity (i.e. cancel the lease) it may be required to pay a predetermined penalty for cancellation.
In case of financial lease the leasee can not cancel the lease contract and is obligated to make leasee payment over the term of the lease regardless of whether the leasee needs the service of the asset or not. But at the maturity date, the lease may transfer ownership of the asset to the lessee or the may have the opportunity to purchase the leased asset at a bargain price. For capital (or financial) lease the value of asset along with the corresponding lease liability must be shown on the balance sheet. Capital leases are commonly used for leasing land, buildings and big equipment. More specifically, a lease is considered as a capital (or financial) lease if it meets any one of
the following conditions:
- The lease transfers title to the assets to the leasee by the end of lease period
- The lease contains on option to purchase the asset at a bargain price.
- The lease period is equal to or greater than 75 percent of the estimated economic life of the assets.
- At the beginning of the lease the present value of the minimum lease payments equal or exceeds 90 percent of the value of the leased property of the lessor.
If any of the above condition is not met, the lease is classified as an operating lease. Essentially, operating leases give the leasee the right to use the leased properly over a period of time, but they do not give leasee all the benefits and risks associated with the asset.
Advantages of Leasing
- Leasing allows the lease to deduct the total payment as on expense for tax purposes.
- Because leasing results in the receipt of service from an asset possibly with out increasing the liabilities on the firm’s balance sheet, it may results in favorable financing rations.
- Leasing provides 100 percent financing as opposed to loan agreement where the purchase of the asset (borrower as well) is required to pay a portion of the purchase price as a down payment.
- In a lease arrangement, the leasee may avoid the cost of obsolescence if the lessor fails to accurately anticipate the possibility for obsolescence of the asset and set the less payment too low.
Disadvantage of Leasing
- A lease does not have a stated interest cost. Besides at the end of the term of the lease agreement, the salvage value of an asset, if any, is realized by the leaser. Thus in many of the leases, the return to the lessor is quite high.
- In a lease of an asset that subsequently becomes obsolete, under a capital lease the leasee still makes lease payments until maturity.
Firms have different alternative sources of long term finance including equity debt and lease. Equity financing could simply mean raising long term funds by selling common or preferred stock. Debt financing can be through the issuance of debt securities like bonds. In lease financing the leasee agrees to pay the periodically for the use of leaser’s assets. Because of this contractual obligation leasing is regarded as a method of financing similar to borrowing. There are two types of lease agreements. These are operating lease and capital (or financial lease). The principal factor affecting the decision to use equity or bond financing is tax. Dividends on equity are not tax deductible whereas interest on debt is deductible. This raises the relative cost of equity compared to debt.