BUSINESS FINANCE

SOURCES OF FINANCE
EQUITY FINANCE
Is raised through the sale of ordinary shares to investors via a
new issue or a right issue
INTERNALLY GENERATED FINANCE (Internal sources of
Finance)
Retained earnings
The most common source of finance for most companies is to use
retained earnings. This is equity finance in that all the earnings of
the company belong to the shareholders. However, most
companies do not pay out all their earnings as dividends, but
instead retain a proportion of them as a source of finance in order
to expand the company.
Retained earnings are the best source of finance in that;
 They avoid issue costs and the cash is immediately
available.
 The use of retained earnings does not involve a change in
the pattern of shareholdings and no dilution of control.
 More so it is a flexible source of finance as companies are
not tied to specific amounts or specific repayment patterns.
 However, shareholders may be sensitive to the loss of
dividends that will result from retention for re-investment,
rather than paying dividends.
Increasing working capital management efficiency
It is important not to forget that an internal source of finance is
the savings that can be generated from more efficient
management of trade receivables, inventory, cash and trade
payables. As efficient working capital management can reduce
bank overdraft and interest charges as well as increasing cash
reserves.
Pecking Order Theory
According to Pecking Order Theory, companies should follow an
established pecking order to raise finance in the simplest and

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most efficient manner. The first justification for this theory is that
companies should want to minimise issue costs:
• The cheapest source of new finance is retained earnings, as
it has no issue costs. This is a form of equity, since retained
earnings would otherwise be distributable as a dividend to
shareholders.
• A bond issue or bank loan is the next cheapest source of new
finance. These are forms of debt.
• The most expensive source of new finance is a fresh equity
issue. For example, an initial public offering (IPO) on a
regulated exchange typically incurs issue costs of between
2% and 8% of the amount raised.

The second justification is that companies will want to minimise

the time and expense involved in persuading outside investors of
the merits of the project:
• If the company can use retained earnings, it does not have to
spend any time persuading outside investors.
• Otherwise, the time and expense associated with issuing debt is
usually significantly less than that associated with a share issue.

EXTERNAL EQUITY SOURCES

Initial Public Offering (IPO)

Ordinary shareholders take more risk than any other type of
investor in a company because:
• ordinary dividends are discretionary (i.e. the company has
no legal obligation to pay an ordinary dividend); and
• ordinary shareholders rank last in the event of
bankruptcy/liquidation.
Shareholders require high returns to compensate for this risk, and
therefore issuing new shares is an expensive source of finance.

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However, sometimes a new share issue is the only available

source of finance.
There are several factors that the company should consider
before doing an IPO:
• Legal restrictions.
• Costs including:
 Underwriting costs (i.e. the fees that must be paid to an
investment bank to underwrite/guarantee the share
issue) which are typically 5% to 7% of the offering.
 Stock market listing fee (initial charge) for the new
shares.
 Fees for the issuing house (investment bank), solicitors,
auditors, PR
 Cost of printing and distributing the prospectus (the
document in which the shares are offered for sale).
 Advertising in national newspapers.
• Valuation: the setting of a price for the new shares to be
issued.
• Stock exchange rules.
• Timing.

Official Listing Requirements

For a company to trade its shares on a stock exchange, it must be
able to meet that exchange’s listing requirements and pay both
the exchange’s entry and yearly listing fees.
Listing requirements vary by exchange but the requirements
typically measure the size and market share of the security to be
listed and the underlying financial viability of the issuing
company.
Exchanges establish these standards as a means of maintaining
their own reputation and visibility. For example, the UK Stock
Exchange normally requires a three-year trading record, 25% of

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shares to be in public hands and a minimum capitalisation of

£700,000.
SMEs
The costs of acquiring and maintaining an official listing mean
that it is not really a possibility for small or medium-sized entities
(SMEs).
In the UK, for example, these companies may find the London
Stock Exchange's Alternative Investment Market (AIM) market
more attractive as it has fewer regulations.
Investors recognise that due to the more limited regulation,
investing in AIM companies carries additional risk.

Rights issue
It is an offer to existing shareholders enabling them to buy new
shares in proportion to their existing shareholdings, usually at a
price lower than the current market price.
The number of shares that each shareholder is offered is in
proportion to their existing shareholding. For example, a rights
issue on a one for four basis at $ 280 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 $ 280
per new share.

The shares are offered at a relatively low price and the effect of
the issue is to reduce the market value of all the shares in issue,
such that the expected share price following the rights issue is
called Theoretical Ex-Rights Price (TERP)

OR
TERP = (Existing shares x existing share price) + (Right issue
shares x right issue price)
Existing shares + Right issue shares

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Although the formula is not published in the exam, it is simply the

forecast total market value of the company's equity after the
rights issue divided into the number of shares that will be in issue
after the rights issue.
Pre-existing value of equity = Existing shares x existing share
price
Proceeds of rights issue = Right issue shares × right issue price
Value of rights per new share = TERP – Rights issue price
Value of rights per existing share = Value of rights per new
share/existing shares OR Existing share price – TERP.

Notes for calculation of TERPs:

 Proceeds of the rights issue should be added net of any issue
costs.
 If project already announced, NPV will already be reflected in
share price and should not be calculated again.

Value of the rights

Is the theoretical gain a shareholder would make by exercising his
rights
Example 1
Existing no of share = 400,000
Existing share price = $5
Right Price = $4.20
Company is issuing one new share against every four shares
currently held.
Solution
TERP = (4 x 5) + (4.2 x 1)
4+1
= $4.84
Value of Right = 4.84 – 4.20

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= $0.64
Value of rights attached to existing shares
Value of Right/Existing Share = 0.64/4 = $0.16

Example 2
Current share price is $5 per share.
The company makes a rights issue of 1 for 4 at $3.
(a) What is the theoretical ex-rights value per share?
(b) What is the value of a right?
(c) What is the value of a right to each existing share?
The theoretical gain or loss to shareholders
The possible courses of action open to shareholders are;
a) To take up or exercise the rights, that is, to buy the new
shares at the rights price. Shareholders who do this will
maintain their percentage holdings in the company by
subscribing for new shares.
b) To renounce the rights and sell them on the market.
Shareholders who do this will have lower percentage
holdings of the company’s equity after the issue than before
the issue, and the total value of their shares will be less.
c) To renounce part of the rights and take up the remainder, for
example, a shareholder may sell enough of his rights to
enable him to buy the remaining rights issue shares he is
entitled to with the sale proceeds, and so keep the total
market value of his shareholding in the company unchanged.
d) To do nothing. Shareholders may be protected from the
consequences of their inaction because rights not taken up
are sold on a shareholder’s behalf by the company. If new
securities are not taken up, they may be sold by the
company to new subscribers for the benefit of the
shareholders who were entitled to the rights.
Example 3
The current share price is $8 per share.

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The company makes a rights issue of 1 for 3 at $6 per share.

(a) What is the ex-rights market value?
(b) What is the value of a right?
(c) Mrs X owns 1,200 shares. She takes up half her rights and sells
the other half.
Calculate the effect on her wealth.

Dividend policy
Retained earnings are the most important single source of finance
for companies, and financial managers should take account of the
proportion of earnings that are retained as opposed to being paid
as dividends.
• An increase in dividends (the dividend decision), will reduce
the level of retained cash available and increase the need for
external finance (the financing decision) in order to fund
capital investment projects (the investment decision).
• An increase in capital expenditure (the investment decision)
would also increase the need for finance (the financing
decision) which may be sourced internally by reducing
dividends (the dividend decision).
Directors must therefore decide when to pay a dividend and when
to retain earnings in the company.

Practical factors have a significant influence on the company's

dividend policy.
Legal Constraints
In most countries, a dividend can only be paid if there is a credit
balance in the retained earnings account in the statement of
financial position.

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No distributable reserves means no dividends.

Liquidity Requirements
Irrespective of any potentially detrimental effect on share price
that a change in dividend policy might cause, companies have to
maintain adequate liquidity.

Dividend restrictions may be imposed to stay solvent or meet

statutory capital maintenance requirements.
Cash for dividend payments may also be unavailable because the
company may wish to hold significant cash to meet both routine
and any unexpected expenses, and also to be able to move
quickly into investment opportunities.

Shareholder Expectations
Most shares in quoted companies are held by powerful
institutional investors (e.g. pension funds). Therefore, the
directors of quoted companies have to carefully manage investor
expectations regarding the level of dividends.
• If a large dividend is paid in the current year, this may
create expectations of the same, or even higher, in future. If
these expectations are then not met, key investors may sell
their shareholdings.
• In smaller owner-managed companies, there is no such
agency problem and the dividend decision is influenced
more by the personal tax position of the owner-managers
than sensitivity over expectations.

Signalling
In quoted companies, where there is significant "divorce of
ownership and control", investors do not have access to all
information about the company's operations and prospects; they
only have what is publicly available.

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Therefore, public announcements of the level of proposed

dividend are seen as key signals of company strength or
weakness.
• A surprise cut in dividend may be interpreted as a signal of
liquidity problems, even if the cut is actually to finance
attractive projects.
• A surprise increase may be taken as a signal of company
strength, although some investors may question why the
directors have not found suitable strategies for reinvestment
of surplus cash.

Stability
Companies often strive for a stable level of dividends or a
constant level of growth. This is done to avoid sharp movements
in share price.
• Companies will therefore try to maintain the level of
dividends in the face of fluctuating earnings.
• This is a very common approach for quoted companies.

Alternative Dividend Policies

Other policies that might be adopted include;
Constant dividend
This avoids surprises and signals stability, but may lead to
dissatisfactions if dividends are relatively low when earnings are
rising
Constant growth
Predictable and favoured by shareholders, but dividend might not
match the earnings growth rate.
Constant pay-out
Dividend represents a constant proportion of each year’s
earnings. While it sounds logical, it creates uncertainty so is rarely
adopted by quoted companies

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Zero dividend
In early years all cash may need to be reinvested into the
business, however at some point the company will find fewer
positive NPV projects available and should start paying dividends

Residual dividend policy

Under the residual dividend policy, retained earnings are used to
fund all positive NPV projects and any remaining earnings not
needed to fund such projects are paid out as a dividend.
This clearly links to Pecking Order Theory (i.e. retained earnings
are the cheapest source of new finance, so should be used to fund
projects first).
A residual dividend policy is likely to lead to fluctuating dividends,
so although it may excuse a cut in an otherwise stable dividend
pattern, it is not common for quoted companies.
When it is used, it is likely to be accompanied by detailed
information to support the decision, since this is effectively a form
of new equity issue.

Dividend Irrelevancy theory

In theory the shareholders will be indifferent between dividends
and capital gains, and the value of a company is determined
solely by the earning power of its assets and investments.
Modigliani and Miller (MM) argued that if a company with
investment opportunities decides to pay a dividend, so that
retained earnings are insufficient to finance all its investments,
the shortfall in funds will be made up by obtaining additional
funds from outside sources. As a result of obtaining outside
finance instead of using retained earnings. They further argued
that if a company pursues a consistent dividend policy, each

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corporation would tend to attract to itself a clientele consisting of

those preferring its particular payout ratio, but one clientele
would be entirely as good as another in terms of valuation it
would imply for the firm.

Under this theory, the pattern of dividends is irrelevant to

shareholder wealth. However, Modigliani and Miller made a series
of assumptions which may not hold in practice:
• No distortions from the personal tax system (i.e. dividends
and capital gains are taxed at the same rate in the hands of
investors).
• No transactions costs (i.e. investors can sell shares to
create a home-made dividend without incurring any trading
costs).
• Perfect markets (i.e. if the company defers the payment of
dividend, the current share price will fully reflect its value).

Traditional view
Is to focus on the effects of dividends and dividend expectations
on share price. The price of a share depends on both current
dividends and expectations of future dividend growth, given
shareholders’ required rate of return.

Alternatives to cash dividend

Alternatives to dividends include share buyback programmes,
special dividends and scrip dividends
Share Buyback Programmes
• The buyback can be performed either by writing directly to
all shareholders with an offer to buy shares at a fixed price
(a tender offer) or by purchasing shares via the stock market
at the prevailing price.
• The shares are either cancelled (and a non-distributable
reserve created) or held by the company as treasury shares

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for possible future reissue. If held by the company, the

shares carry no voting rights and receive no dividends.
• Distributable reserves must be reduced by the full value of
the buyback.
• As there will be fewer shares in issue after the buyback, the
share price should rise.
• Ratios such as earnings per share (EPS) and return on equity
(ROE) should also improve.
• In many countries, a share buyback is treated as a capital
gain in the hands of the investor rather than as income. This
can have tax advantages if capital gains are taxed at a lower
rate than dividends.

Special Dividends
• If a quoted company announces a larger than expected
dividend, this may raise market expectations that future
dividends will also be higher.
• Therefore, to avoid creating expectations of an
unsustainable level, a larger dividend may be announced as
a "special" dividend – basically a bonus dividend.
• The directors are communicating to the markets that, from
time to time, any exceptional cash surplus will be returned in
this way, but that this should not be built into dividend per
share forecasts.
• Like a buyback, the company distributes cash. Also, all
shareholders will receive cash (whereas, under a buyback,
only those who sell receive cash).

Scrip Dividends
A scrip dividend is a choice between a cash dividend and shares
in lieu of cash. Shareholders can choose to acquire new shares (if
they do not need the cash dividend) without transactions costs.

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The company conserves cash for reinvestment (the preferred

source of finance under pecking order theory).

Small and Medium considerations

SMEs are private companies with a limited number of
shareholders and, unless those shareholders are wealthy, there is
a limit to how much they can invest in the company.
SMEs therefore have to rely heavily on retained earnings for
equity finance, but this source is limited, especially when profits
are low. If they are restricted in the amount of equity they can
raise, they may have to rely on debt.

Perceptions of Risk and Uncertainty

SMEs are often viewed as unattractive investment opportunities
due to the perception that they have high levels of risk and
uncertainty attached to them.
• Larger businesses have a track record, especially in terms of
a long-term relationship with their bankers. New businesses,
typically SMEs, obviously do not have a track record.
• SMEs internal controls are often non-existent or very
limited.
• Larger businesses conduct more of their activities in public
than do SMEs. If information is public, there is less
uncertainty. For example, a larger business might be quoted
on a stock exchange and therefore be subject to press
scrutiny and stock exchange rules regarding the provision of
certain of its activities (including publishing accounts that
have been audited). Many SMEs do not have to have audits,
certainly do not publish their accounts to a wide audience
and the press are not really interested in them. They
therefore have fewer external controls.
• The fact that potential investors in an SME have much less
information about the business than its managers (i.e.

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asymmetry of information) contributes to their perception of

high risk.
• Often SMEs have one dominant owner-manager whose
decisions are rarely questioned.
• They tend to have limited assets to offer as security (see
below).

Absence of Security
If an SME seeks a bank loan, the bank will look to see what
security (collateral) is available for any loan provided. This is
likely to involve an audit of the entity's assets.
• Collateral is important because it can reduce the level of risk
a bank is exposed to in granting a loan to a new business.
• Many SMEs are based in the service sector where the main
asset is likely to be human capital as opposed to physical
assets. The directors may therefore be required to pledge
personal assets (e.g. their homes) to secure business loans.

Shares Lack Marketability

The equity issued by small companies is unquoted and difficult to
buy and sell.
• Sales are usually on a matched bargain basis, which
means that a shareholder wishing to sell has to wait until an
investor wishes to buy.
• This lack of marketability means that small companies are
likely to be very limited in their ability to offer new equity to
anyone other than family and friends.
Tax Considerations
Individuals with cash to invest may be encouraged by the tax
system to invest via large institutional investors rather than
directly into small companies.
• In many countries, personal tax incentives are offered on
contributions to pension funds.

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• These institutional investors themselves usually invest in

larger companies (e.g. listed companies) in order to maintain
what they see as an acceptable risk profile, and in order to
ensure a steady stream of income to meet ongoing liabilities.
This reduces the potential flow of funds to small companies,
although the government may try to mitigate this effect by
also offering tax advantages for investment in SMEs.
Funding Solutions for SMEs
Venture Capital
Venture capitalists are a potential source of financing for an SME.
Venture capital is equity capital provided to small and growing
businesses and is usually provided by a wealthy individual, by a
venture capital firm (e.g. the 3i Group) that manages a venture
capital fund or by a high-risk, potentially high-return subsidiary of
an organisation with significant cash to invest (e.g. a bank).
Typically, $1m minimum is involved for any one investment.
Venture capital trusts (VCTs) also serve as a potential financing
source.
• VCTs are listed investment trust companies which invest at
least 70% of their funds in a spread of small unquoted trading
companies.
• The UK government gives tax incentives to individual investors
in VCTs.
Private Equity Funds
A private equity fund attempts to gain control over a company in
order to put it through a restructuring programme before either
selling to another fund or listing the company on the stock
market.
• The difference between private equity and venture capital is
that private equity funds usually seek total control of the
target company, whereas venture capitalists provide growth
finance in return for partial control.

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• Private equity funds do not only target SMEs, they also buy
large quoted companies, take them off the stock market,
restructure them, and then re-list on the stock market.
Business Angels
Business angels are private individuals (or small groups of
individuals) who are prepared to invest equity (or perhaps debt)
into small businesses with big potential.
• Angels are often entrepreneurs who made their own fortunes
in the high-tech sector, were wise enough to sell before the
"dot.com" bubble burst, and now invest in small business as
a hobby (although they do expect to make gains).
• Angels also provide advice, experience and business
contacts.
• Angels will only be prepared to invest in a business with an
innovative product and talented management.
Government Assistance
Governments are often keen to support SMEs in raising finance
for profitable investments:
• to avoid lost investment opportunities and national wealth being
lower than it could be;
• to support innovation (an area in which SMEs often excel); and
• to boost employment.
Forms of government assistance include:
• Providing grants and guaranteeing loans.
• Providing tax breaks or incentives to those willing to take the
risk of investing in SMEs.
• Providing advice. For example, in Scotland, “Business
Gateway” is a government-funded organisation which
provides assistance to those setting up and running a
business, including advice on raising finance.
• Providing equity investment. Many countries have
government-backed venture capital organisations that are
willing to invest in the equity of SMEs. This is often done on a

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matching basis, where the organisation will match any

equity investment raised from other sources. For example,
“Enterprise Capital Funds” in the UK and the “Small Business
Investment Company” programme in the US.

DEBT FINANCE
Long term Finance
In order to finance long-term investments and the overall working
capital, the company needs to raise long-term capital. It is part of
the role of the Financial Manager to decide how best to raise this
capital. Overall the choice is between equity finance (from
shareholders) and debt finance (from lenders). In this chapter we
consider the different ways of raising debt finance.

Preference shares
Preference shares are legally equity, but they are often accounted
for as debt as they are similar in nature – i.e. in substance – to
debt.
Some of the common features of preference shares
include:
• The shares have a fixed percentage dividend payable before
ordinary dividends. This preference share dividend is
expressed as a percentage of the share's nominal value.
• The dividend is only payable if there are sufficient
distributable profits. If the shares are cumulative, however,
the right to receive dividends which were not paid is carried
forward (i.e. cumulative preference dividends). Any arrears
of dividend are then payable before ordinary dividends.
• As for ordinary dividends, preference dividends are not
deductible for corporate tax purposes. The preference
dividends are considered a distribution of profit rather than
an expense.

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• On liquidation of the company, preference shareholders rank

before ordinary shareholders and after debt holders.
• A participating preference share is a type of preference
share that gives the holder the right to receive an additional
dividend (if certain conditions are met) in addition to a fixed
percentage of the share’s nominal value.

Debenture (Loan note or Bond)

Bond – a negotiable security evidencing a debt governed by a
contract which specifies, for example, the coupon rate,
repayment schedule, security (if any), principal value, seniority (if
subordinate to other debt) and other covenants.

The terms "debenture", "loan note" and "bond" all basically refer
to the same thing (i.e. a written acknowledgement of a company's
debt which can then be traded).

Holders of loan note take lower risks, as they rank ahead of

preference shareholders on bankruptcy, and their debts may be
secured by a fixed or floating charge over assets. Providers of
loans therefore require lower returns than other providers of
finance.

Loan notes can be secured or unsecured. The security can be

specific assets (a fixed charge) or a class of assets (a floating
charge). The assets are used as security and are sold to pay the
loan note if default occurs.

Debentures can be traded on a stock exchange, normally in units

of $100 nominal. They carry a
fixed rate of interest and the interest is expressed as a % of
nominal value.

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In the UK, bonds are usually issued with a “face” value (“nominal”
or “par” value) of £100. They can then be traded on the bond
market and reach a market price. A bond with a face value of
£100 that is "selling at a premium" of 15%, sells for £115. Bonds
in the US typically have a face value of $1,000, and in the
Eurozone €1,000 (or multiples thereof).
Interest is usually a fixed coupon expressed as a percentage of
the bond's nominal value (e.g. an 8% loan note has a coupon of
8% and would pay interest of $8 against a nominal value of
$100).
Variable (floating) interest rate loan notes automatically adjust
their interest payment in line with an agreed market reference
rate (e.g. Euro Short-Term Rate – “ESTER”).

Type of Loan notes

Deep discount loan notes

Deep discount loan notes are loan notes issued at a large
discount to nominal value (issued well below nominal value) and
redeemable at par on maturity.
Investors in deep discount loan notes receive a large capital gain
on redemption, but are paid a low coupon during the term of the
loan.
These loan notes offer a cash flow advantage to the borrower.
This is especially useful for financing projects which produce weak
cash flows in early years.
For example; A company issues a five year, $100, 3% loan note at
$80. What cash inflows/(outflows) would be generated for the
issuing company?

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Zero coupon bonds

The ultimate deep discount loan note is a zero-coupon loan note
which is issued at a discount to nominal value and pays no
coupon, the investors will receive a large ‘bonus’ on maturity, but
because the discount is so large they are prepared to receive no
interest at all during the life of the bond.

Mortgage Loans
A mortgage is a legal agreement to lend, secure by a legal charge
over the borrower’s property. The loan is typically a long-term
loan (15 to 30 years or more) secured by property.
Advantages
 Given the security, mortgage loans have a lower interest
rate than shorter-term debt.
 Lower monthly repayments over a longer-term help cash
management, making it easier to budget and plan for the
long term.
 The growth in the property's value accrues to the company.

Disadvantages
 There are likely to be restrictive covenants concerning the
use of the property and its potential disposal.
 In the event of default on repayments, the lender may force
the sale of the property to recover the loan. This is a
significant risk to the business.
 A significant proportion of finance tied up in property may be
unsuitable for a business that needs liquid assets for
investment opportunities or operations.

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 A lengthy approval process (including property valuations)

make mortgage loans unsuitable for urgent finance.

Tax Relief on Debt interest

Interest expense is tax deductible; it reduces corporation tax
payments.
Therefore, the issue of debt is preferable to the issue of shares, as
dividends are not tax deductible.
This is one of the main reasons why debt is cheaper than equity
Points to note:
 The after-tax cost of debt (i.e. to the company) = Pre-tax
cost of debt × (1 − tax rate).
 The pre-tax cost of debt to the company = Return required
by the debtholders.
 The post-tax cost is said to be lower due to the "tax shield"
on the coupon payments.

Convertibles
Loan notes/preference shares which can be converted into a
predetermined number of ordinary shares.
 Pay a fixed coupon or dividend until converted.
 May be converted into ordinary shares on, or by, a
predetermined date, at a predetermined rate (conversion
ratio); and at the option of the holder.
 May have a conversion ratio which changes during the
period of convertibility to stimulate early conversion.
A warrant

A warrant offers the investor the right, but not the obligation,
to purchase new shares at a future date at a fixed price – the
“exercise” price of “subscription” price.

The main features of warrants are:

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 They may be attached to loan notes to make them more

attractive.

 They are an option to buy shares in the issuing company.

 They may be separated from the underlying debt so the

holder of the warrants may sell them rather than keep them
(i.e. they are traded independently).

Medium term Finance

Medium-term finance includes bank loans, leasing, sale and
leaseback and bank loans.

Bank Loans
Companies agree borrowings from the bank at a fixed rate, for a
specified period and with an agreed repayment schedule.

Advantage
 As the loan is for a fixed term, there is no risk of early recall
(unlike overdrafts that are repayable on demand). This helps
with financial stability.
 A predetermined repayment schedule makes it easier to
budget and plan for loan repayments. This helps cash flow
management.
 Interest will usually be tax deductible; reducing the
company’s overall tax liability is cost effective.
Disadvantages
• Terms and conditions tend to be inflexible; fixed repayment
schedules may be non-negotiable. A bank may also restrict
how a loan can be used; a loan obtained for a specific
purpose cannot be redirected to another project without re-
negotiation.

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• Banks may require security (“collateral”). Valuable assets

that are pledged as security will be at risk if the company
defaults on the repayment schedule.
• It may require covenants, which are restrictions on the
company (e.g. limits on dividend payments, limitations on
further borrowing), designed to protect the debtholder and
could reduce the interest rate on the debt.
• Penalties or fees for early repayment can be a disadvantage
if a company want to repay a loan ahead of schedule (e.g. to
reduce interest costs).

Leasing
Instead of buying an asset outright, using retained earnings or
borrowed funds, a company may lease an asset.
Under a lease contract, the lessee has the right to use an asset
which is owned by the lessor, in exchange for a series of
payments.
Advantages
 There are many willing providers (often associated with
asset manufacturers and therefore offering attractive terms).
 A lease “matches” finance to the right to use the asset. A
company can use assets that might be too expensive to buy
outright.
 Very flexible packages available, some of which include
repairs and maintenance. This helps reduce the costs and
operational burden of asset maintenance.
Disadvantage
 Over the long term, leasing can be more expensive than
outright purchase; cumulative lease payments can exceed
the cost of buying the asset.
 At the end of the lease term, the company typically does not
own the asset unless it has an option to purchase it, at an
additional cost.

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 Leases can include restrictions on the use of the asset or

penalties for early termination. These terms may restrict the
company's operational decisions.

Sale and Leaseback

Under a sale and leaseback, a company sells property to an
institution, such as a pension fund, and then leases it.
Advantages
 Immediate injection of cash into the business can be used
for investment opportunities, debt reduction (interest
savings) or working capital requirements.
 Operational continuity in using the asset without disruption.
 It may realise a profit on the sale (subject to IFRS
requirements).
Disadvantages
 As the company no longer owns the property it will not
benefit from any appreciation in its value.
 The future borrowing capacity of the company will be
reduced, as there will be fewer assets to provide security for
a loan.

The net effect is equivalent to secured borrowing. A right-of-use

asset and a lease liability will be recognised. If the right-of-use
asset is greater than the carrying amount of the leased asset,
gearing (the proportion of debt finance to equity finance) will
increase

Mortgage Loans
A mortgage loan is a loan secured by property.
Advantages
 Given the security, the loan will have a lower rate of interest
than other debt.
 Institutions will be willing to lend over a longer term.

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 The company can still participate in the growth of the

property's value.
Disadvantages
 There are likely to be restrictive covenants concerning the
use of the property and its potential disposal.
 In the event of default on repayments, the bank may force
the sale of the property to recover the loan.

Short term Finance

Are usually needed for businesses to run their day to day

operations including payment of wages to employees, inventory
ordering and supplies. Businesses with seasonal peaks and
troughs and those engaged in international trade are likely to be
heavy users of short-term finance.

Bank Overdraft
A bank overdraft is a borrowing facility associated with a current
account. Where payments from a current account exceed income
to the account for a temporary period, the bank may agree to
finance a deficit balance on the account by means of an
overdraft. In jurisdictions where a bank overdraft is allowed, it is
often the liquidity fall back of choice for small- and medium-sized
entities (SMEs).
Advantages
 Flexible.
 Provides instant finance.
Disadvantages
 Usually technically repayable on demand.
 Expensive if used regularly.
Trade Credit
Businesses that offer trade credit invoice their customers with
payment terms or 30, 60 or 90 days, for example. Customers can

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take advantage of trade credit by delaying/slowing payments to

existing suppliers or using more of the credit offered by suppliers.
Advantages
 Generally cheap.
 Flexible.
Disadvantages
 May lose settlement (prompt payment) discounts.
 Temptation to delay payment beyond formal payment terms
may trigger penalties or lose supplier goodwill.

Bills of exchange
A bill of exchange is an acknowledgment of a debt to be paid on a
stated date
In international trade, an exporter typically requires a customer to
accept a bill before releasing documents of title to the goods.
The exporter may then:
 hold the bill to maturity (and receive payment from the
customer); or
 "discount" the bill with a bank to receive cash earlier. (If the
customer then fails to pay, the bank has recourse to the
exporter for payment.)
Bills of exchange are not widely used today – having been
replaced with alternatives (e.g. bank wires and credit/debit card
payments).
Short-term Bank Loans
A short-term cash injection can help companies in need of
working capital. Short repayment terms are typically from 3
months to one year.

Advantages
 Available to most companies (assuming a well-functioning
banking system).
 Typically, unsecured (i.e. no need to provide collateral)

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 Short-term interest rates are usually lower than long-term

interest rates, due to lower credit risk on short-term debt.
Disadvantages
• Arrangement fees may be high when expressed as an annual
effective cost.
• Refinancing risk (rollover risk). Every time a short-term loan
matures, the borrower faces the risk that it cannot be easily
replaced or refinanced, or that interest rates have risen.
Commercial paper
Commercial paper is short-term unsecured debt issued by high-
quality companies. The paper can then be traded by investors on
the secondary market. Commercial paper is appropriate for
financing short-term liabilities.
Advantages
 Large sums can be raised relatively cheaply.
 No security is required.
Disadvantage
 Only available to large companies with investment-grade
credit ratings

Small and Medium Sized Entities (SMEs)

Sources of debt available to SMEs include trade credit, factoring
and invoice discounting, leasing and bank finance.
However, SMEs often have difficulty facing debt finances. These
difficulties may be caused by the asymmetry of information, such
that banks fear making loans to entities which are not well known
and without published credit ratings.

Therefore, SMEs may need to look at grants and subsidies, loan

guarantees, business angels, supply chain financing and peer-to-
peer lending when trying to raise debt finance.

Grants and Subsidies

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Depending on the location and nature of the SME, regional,

national or even international grants may be available, either to
help start-up the business or to contribute towards the cost of
expansion. Subsidies may take the form of government loans
offered to SMEs at interest rates below commercial levels.
Government Loan Guarantee Schemes
The government may choose to act as guarantor for commercial
loans to SMEs. For example, under the Enterprise Finance
Guarantee scheme in the UK, the government will, for a small fee
from the SME, guarantee a large proportion of any loan advanced
by a bank. Banks are therefore potentially more willing to lend, as
most of their risk has been eliminated. The SME must, however,
be able to demonstrate to the lender that it should be able to
repay the loan in full.
Business angels - As described in Chapter 8, these are wealthy
individuals who are prepared to invest money and time in small
companies if they see high potential for growth.
If prepared to invest debt, they also may want the opportunity for
equity participation in the future. Convertible debt or debt with
warrants may therefore be appropriate.
Supply Chain Finance (SCF)
The use of financial instruments, practices and technologies to
optimise the management of the working capital and liquidity tied
up in supply chain processes for collaborating business partners.
 SCF provides short-term credit that optimises working capital
for both the buyer and the seller. It generally involves the
use of a technology platform to automate transactions and
track the invoice approval and settlement processes from
initiation to completion. The growing popularity of SCF has
been largely driven by the increasing globalisation and
complexity of the supply chain, especially in industries such
as car manufacturing and the retail sector.

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 SCF can be particularly beneficial to SMEs with a poor credit

rating (or lacking a credit history) that supply goods or
services to a large company with a good credit rating.
It allows the SME to take advantage of its customer's
superior credit rating and receive immediate payment at a
small discount to the sales invoice's face value. The
customer may also benefit from its bank offering extended
payment terms on the invoice.
 However, a disadvantage for SME suppliers is that larger
trading partners may be in a position to abuse their power
by demanding lower prices from them in exchange for
arranging SCF.

Peer-to-peer (P2P) lending

A method of debt financing that enables individuals to lend
money to small businesses without the use of an official financial
institution as an intermediary. P2P lending is also referred to as
"debt-based crowdfunding".
Advantages
 Loans generate interest income for lenders, which can often
exceed that which would be earned on a bank deposit
account.
 Borrowers have access to finance when banks refuse credit
or would charge very high interest rates.
 By effectively cutting out the middleman (i.e. the formal
banking system), interest rates can be relatively attractive to
both lenders and borrowers.

GEARING
Gearing is the amount of debt finance a company uses relative to
its equity finance. Debt finance tends to be relatively low risk for
the debt holder as it is interest bearing and can be secured. The
cost of debt to the company is therefore relatively low. The

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greater the level of debt, the more financial risk (of reduced
dividends after the payment of debt interest) to the shareholder
of the company, so the higher is their required return. The cost of
equity therefore increases with high gearing.

Gearing ratios
The financial risk of a company’s capital structure can be
measured by a gearing ratio, a debt / equity ratio or by the
interest cover.
Financial gearing
Financial gearing is a measure of the extent to which debt is used
in the capital structure.
Note that preference shares are usually treated as debt.
It can be measured in a number of ways:
Prior charge capital
Financial gearing (Equity gearing) ¿ Equity capital (including reserves)

Prior charge capital

Financial gearing (Total or Capital gearing) ¿ Total capital employed
Prior charge capital = Preference share capital plus Long-
term debt

Note
 If a question specifies a gearing formula, for example by
defining an industry average for comparison, you must use
that formula.
 Since preference shares are treated as debt finance, prefere
nce dividends are treated as debt interest in this ratio.

Operational gearing
Is one way of measuring business risk. Business risk refers to the
risk of making only low profits or even a loss, due to the nature of
the business that the company is involved in.
Operating gearing = Contribution

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Profit before interest and tax (PBIT)

Operating gearing indicates the degree to which an organization’s
profits are made up of variable (as opposed to fixed costs).

The significance of operational gearing is as follows;

a) If contribution is high but PBIT is low, the company has a
high proportion of fixed costs, which are only just covered by
contribution. Business risk, as measured by operational
gearing, will be high. High-C – FC = PROFIT- Low -BR
High
b) If contribution is not much bigger than PBIT, the company
has a low proportion of fixed costs, which are fairly easily
covered by contribution. Business risk, as measured by
operational gearing, will be low.
Operating gearing, like financial gearing, affects the volatility of
earnings. If a company has high operational gearing, a small
percentage change in sales turnover will have a much greater
percentage change in operating profits. The proportional size of
the change is higher than for a company with low operating
gearing.
A company with both high operational gearing and high financial
gearing is likely to have highly volatile earnings and earnings per
share.

Interest coverage ratio

Is a measure of financial risk which is designed to show the risks
in terms of profit rather than in terms of capital values.
Interest coverage ratio = Profit before interest and tax
Interest
Note

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An interest coverage ratio of less than three times is considered

low, indicating that profitability is too low given the gearing of the
company. An interest coverage ratio of more than seven is usually
seen as safe.
Debt ratio
Another measure of financial risk is the debt ratio
Debt ratio = Total debts: Total assets
Debt does not include long-term provisions and liabilities such as
deferred taxation. There is no firm rule on the maximum safe debt
ratio, but as a general guide, you might regard 50% as a safe limit
to debt.

Earnings per share

Is calculated dividing the net profit or loss for the period
attributable to ordinary shareholders by the weighted average
number of ordinary shares outstanding during the period.
EPS = PAT – Preference dividend
No of ordinary shares

Price-earnings (P/E) ratio = Market price per share

Earnings per share
P/E ratio reflects the market’s appraisal of the share’s future
prospects. If the earnings per share falls because of an increased
burden arising from increased gearing, an increased P/E ratio will
mean that the share price has not fallen as much as earnings,
indicating the market view positively the projects that the
increased gearing will fund.

Dividend cover
Is the number of times the actual dividend could be paid out of
current profits.
It’s calculated = Earnings per share
Dividend per share

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To judge the effects of increased gearing on dividend cover, you

should consider changes in the dividend levels and changes in
dividend cover. If earnings decrease because of an increased
burden of interest payments, then:
a) The directors may decide to make corresponding reductions
in dividend to maintain levels of dividend cover.
b) Alternatively, the directions may choose to maintain
dividend levels, in which case dividend cover will fall. This
will indicate to shareholders an increased risk that the
company will not be able to maintain the same dividend
payments in future years, should earnings fall.
Dividend yield
Here we are looking at the effect on market price of shares. If
additional debt finance is expected to be used to generate good
returns in the long term, it is possible that the dividend yield
might fall significantly in the short term because of a fall in short
term dividends, but also an increase in the market price reflecting
market expectations of enhanced long-term returns. How
shareholders view this this movement will depend on their
preference between short term and long-term returns.

Is calculated as Dividend per share x 100%

Market price per share

Questions
1. T Co is a medium-sized manufacturing company which is
considering a 1 for 5 rights issue at a 15% discount to the
current market price of $4.00 per share. Issue costs are
expected to be $220,000 and these costs will be paid out of
the funds raised. It is proposed that the rights issue funds
raised will be used to redeem some of the existing loan stock
at nominal value. Financial information relating to T Co is as
follows:

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Current statement of financial position

$’000
$’000
Non-current assets 6550
Current assets
Inventory 2,000
Receivable 1,500
Cash 300
3800
Total assets
10,350
Ordinary shares (nominal value 50c)
2,000
Reserves
1,500
12% loan notes 2X12
4,500
Current liabilities
Trade payables 1,100
Overdraft 1,250 2350
Total equity and liabilities
10,350
Other information:
Price / earnings ratio of T Co:
15.24
Overdraft interest rate: 7%
Tax rate: 30%
Sector averages: debt / equity (book value):
100%
Interest cover: 6 times

Required

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a) Ignoring issue costs and any use that may be made of the
funds raised by the rights issue, calculate:
i. The theoretical ex rights price per share;
ii. The value of rights per existing share
b) What alternative actions are open to the owner of 1,000
shares in T Co as regards the rights issue?
Determine the effect of each of these actions on the wealth of the
investor.
c) Calculate the current earnings per share and the revised
earnings per share if the rights issue funds are used to
redeem some of the existing loan notes.

2. R Co is a small, profitable, owner-managed company which

is seeking finance for a planned expansion. A local bank has
indicated that it may be prepared to offer a loan of $100,000
at a fixed annual rate of 9%. R Co would repay $25,000 of
the capital each year for the next four years. Annual interest
would be calculated on the opening balance at the start of
each year. Current financial information on R Co is as
follows:
Current turnover $210,000
Net profit margin 20%
Annual taxation rate 25%
Average overdraft $20,000
Average interest on overdraft 10% per year
Dividend payout ratio 50%
Shareholders’ funds $200,000
Market value of non-current assets $180,000
As a result of the expansion, turn over would increase by $45,000
per year for each of the next four years, while net profit margin
would remain unchanged. No tax allowable depreciation would
arise from investment of the amount borrowed.

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R Co currently has no other debt than the existing and continuing

overdraft and has no cash or near-cash investments. The non-
current assets consist largely of the building from which the
company conducts its business. The current dividend payout ratio
has been maintained for several years.
Required
a) Assuming that R Co is granted the loan, calculate the
following ratios for R Co for each of the next four years
i. Interest cover
ii. Medium to long term debt/equity ratio
iii. Return on equity
iv. Return on capital employed

COST OF CAPITAL

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Is the rate of return that the enterprise must pay to satisfy the
providers of funds and it reflects the riskiness of providing funds.
It has 2 aspects;

 Cost of funds that a company raises and uses

 The return that investors expect to be paid for putting funds
into the company.

It is therefore the minimum return that a company should make

on its own investments, to earn the cash flows out of which
investors can be paid their return. Different investments have
different degrees of risk. The higher the risk, the higher the return
required to cover that risk. Importantly, this helps as a starting
point to the identification of a cost of capital.

The relative risk/return of equity and debt is based on their

relative priority for repayment on liquidation - the creditor
hierarchy.

On liquidation, the company's assets are sold and the cash raised
is paid out according to the priority of creditors:

• Secured loans and secured loan notes are repaid first. Some
may be secured by "fixed charge" over a specific asset such
as property, others by "floating charge" over classes of
assets such as working capital. Secured creditors would
expect to receive most, if not all, of what they are owed in
the event of liquidation.

• Trade creditors and unsecured debt are repaid next. When a

company is forced into liquidation, by definition the value of
its assets is likely to be below the value of its liabilities. In
this case, unsecured creditors may not receive everything
they are owed.

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• If there are any preference shares in issue, they would be

repaid next should there be any cash remaining after paying
all creditors.

• Ordinary shareholders rank last on liquidation and would be

unlikely to receive anything.

In practice, other stakeholders may have claims on liquidation

(e.g. employees, tax authorities and the liquidator).

The two main sources of capital

It is likely that a company’s total finance comes from a number of

sources. Initially, we will limit our studies to the two main sources
of finance:

1. Equity

Ordinary shareholders make an investment which carries with it

all the risks of the business.The annual return to ordinary
shareholders is in no way guaranteed or predictable and, so, can
be defined as ‘risky’.

2. Debt

Banks and individuals make loans to a company with contractual

terms for payment of interest and repayment of the capital lent.
The company is obliged to make any such payments before being
allowed to distribute earnings to shareholders. The lender often
insists on ‘security’; the right to seize specified assets should the
borrower default on the loan. The contractual obligation plus any
security make debt a far less risky form of finance with a
correspondingly lower required return from investors.

The cost of equity

The rate of return that is paid to the equity holders of the
company. The symbol used to represent cost of equity is Ke.

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This may be calculated in one of two ways:

1. Dividend Valuation Model (DVM).

2. Capital Asset Pricing Model (CAPM).

Dividend Valuation Model

Shares may be valued by the market (all shareholders) based

upon future dividends and dividend growth.

P0 = D0 (1+g)
Ke-g
If our company has a listed share price (P 0) and we know what
dividend and dividend growth the shareholders are expecting,
then we can rearrange the formula to find the cost of equity
(Ke) that shareholders must have used to arrive at the share
value.
Ke= D0 (1+g) +g
P0
Where g = a constant rate of growth in dividends
D0 = Current dividend
P0 = The current “ex-div” share price
Note: D0 (1+g) finds the dividend expected in one year’s time
(D1)
“ex-div” is the share price immediately after a dividend has
been paid “cum-div” is the price immediately before a dividend
is paid. The difference between “ex-div” and “cum-div” is the
value of the dividend, D0
Example 1
Clarence Co has a share price of $4.00 and has recently paid
out a dividend of 20 cents. Dividends are expected to grow at
an annual rate of 5%.
Required: Calculate the cost of equity.
Example 2

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Wendy house Co has a cum-dividend share price of 369 cents

and due to pay out a dividend of 36 cents per share. Dividends
are expected to grow at an annual rate of 4%.
Required:
Calculate the cost of equity

Estimating Growth rate of Dividends

When using the formula for the cost of equity, we need to know
the rate of dividend growth that shareholders expect in the
future. If this figure is given us in the examination then there is
obviously no problem. However, you may be expected to
estimate the dividend growth rate. The growth rate of
dividends can be estimated using either of two methods:
extrapolation of past dividends, or Gordon’s growth model.

From Past Dividends

This method analyses historical growth to predict future

growth:

OR g =((do/dn) ^(1/n)) - 1

where Do = current dividend

Dn = dividend n years ago
n = Years of growth
Example 1
S Co paid a dividend of 20 cents per share 4 years ago, and the
current dividend is 33 cents. The current share price is $6 ex
div.
Required:
(a) Estimate the rate of growth in dividends.

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(b) Calculate the cost of equity.

Example 2
M Co paid a dividend of 6 cents per share 8 years ago, and the
current dividend is 11 cents. The current share price is $2.58
ex div.
Required:
Calculate the cost of equity.

Example 3
Below is information relating to ABC Co.
Year Dividends ($) Earnings ($)
20X1 150,000 400,000
20X2 192,000 510,000
20X3 206,000 550,000
20X4 245,000 650,000
20X5 262,350 700,000
What is the rate of growth in dividends?

Gordon’s Growth Model

According to Gordon’s Growth Model, growth is achieved by
retention and reinvestment of profits.
g = rb
where r = rate of return on reinvested profits
b = proportion of profits retained (retention ratio)
These figures can be obtained from the statement of financial
position and statement of profit or loss.
Example
The ordinary shares of Tories Co are quoted at $5.00 cum div. A
dividend of 40 cents is just about to be paid. The company has a

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return on capital employed of 12% and each year pays out 30% of
its profits after tax as dividends.
Required:
Calculate the cost of equity.

The capital asset pricing model (CAPM)

CAPM starts from having a measure of risk (ß) to calculating the

required return. It is particularly useful where our company does
not have listed shares and so we don’t have a P 0 for the dividend
valuation model.
CAPM formula (given in the exam)
E (ri) = Rf + ßi (E(rm) – Rf) OR Ke = Rf + ß (Rm – Rf)
Where: E (ri) is The expected return from investment “i" / Ke
Rf is the risk-free rate
ßi is the beta measuring the risk of investment “i" / ß
E (rm) is the return from the market / Rm
Example
The market return is 15%. C Co has a beta of 1.2 and the risk-free
return is 8%.
Required:
Calculate the cost of equity.
Market premium (E (rm) – Rf)
The difference between the average expected return from the
market and the risk free rate is referred to as the ‘market risk
premium’.

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Example
The risk-free rate of return is 6%. The market risk premium is 8%.
The beta factor for
K Co is 0.8.
Required:
Calculate the expected annual return.

Cost of debt
The after-tax return paid to the debt holders of the company. The
symbol used to represent after-tax cost of debt is Kd (1 – t).

Loan note:

A security instrument (so it is tradable) that acknowledges a

company’s debt. Also called a bond or a debenture, a loan note:

• Usually pays a fixed coupon

• May be secured or unsecured

• If quoted it will trade on an exchange at a price determined

by that market

Coupon rate: the interest rate printed on the loan note

certificate

• Therefore: annual interest = coupon rate x nominal value

Nominal value: the value that is stated on an issued security.

Nominal value is also known as par value or face value

Market value (MV): normally quoted as the MV of a block

of $100 nominal value For example, 10% loan notes quoted at
$95 means that a $100 block is selling for $95 and annual interest
is $10 per $100 block.

Market value (ex-int): is when interest has just been paid

Market value (cum-int): includes the value of accrued interest

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Debt can be irredeemable, redeemable or convertible, preference

shares can also be considered as debt.

Irredeemable Loan notes

Irredeemable loan notes are a type of debt finance where the
company will never repay the principle but will pay interest each
year until infinity. They are also referred to as undated loan notes.
It does not exist in practice, but in the examination, you assume
debt to be irredeemable unless told otherwise.
I (1−t)
Kd¿
Mv

Example
The 10% irredeemable loan notes of Raffe Co are quoted at $120
ex int. Corporation tax is payable at 30%.
Required:
Calculate the cost of debt.

Redeemable debt (can be redeemed at par or at a discount or a

premium)
A loan note that can be redeemed by the issuer prior to its
maturity date. Also referred to as callable loan notes.
Early redemption would usually be at a premium above the loan
note’s nominal value.
Cash flows are not a perpetuity because the debt will be repaid.
To find the cost of debt for the company, find the IRR of
the following cash flows.
The relevant cash flows would be:
Year Cash flow
0 Market value of the loan note (Po/MV)
1-n Annual interest payments I (1-
T)
n Redemption value of loan RV

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The IRR is found as usual using linear interpolation – for which we

have a function in the spreadsheet workspace in the exam.
Exam advice: Usually NPV calculations present future cash flows
as inflows. When future cash flows are presented as outflows (as
above), however, if the first NPV calculation is positive, NPV
should be recalculated at a lower discount rate to get closer to
zero.

Example 1
W Co has 10% loan notes quoted at $102 ex interest redeemable
in 5 years’ time at par. Corporation tax is paid at 30%.
Required:
Calculate the cost of debt.
Example 2
A company has in issue $200,000 7% loan notes redeemable at a
premium of 5% on 31 December 20X6. Interest is paid annually
on 31 December. It is currently 1 January 20X3 and the loan notes
are trading at $98 ex-interest per $100 nominal value.
Corporation tax is 33%.
Required
Calculate the company’s cost of debt.

Example 3
W Co has in issue 10% bonds of a nominal value of $100. The
market price is $90 ex- interest. Calculate the cost of this capital
if the bond is

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a) Irredeemable
b) Redeemable at par after 10 years
Ignore taxation

Convertible debt
Convertible loan notes allow the investor to choose between
redemption for cash at some future date or conversion into a
predetermined number of ordinary shares
To find the post-tax cost of convertible debt, we need to find the
IRR of the after-tax cash flows here, the last cash flow will be
the higher of the redemption value/forecast conversion
(i.e. we assume investors will choose whichever has the higher
value to them).
Again, we can use the IRR formula in the CBE spreadsheet.
Conversion value = Po (1+g) n R
Po – Is the current ex-div ordinary share price
g - Is the expected annual growth of the ordinary share
price
n - Is the number of years to conversion
R - Is the number of shares received on conversion.
Example 1
A company has issued 8% convertible bonds which are due to be
redeemed in 5 years’ time. They are currently quoted at $ 82 per
$ 100 nominal. The bonds can be converted into 25 shares in five
years’ time. The share price is currently $ 3.50 and is expected to
grow at a rate of 3% p.a. Assume a 30% rate of tax
Calculate the cost of the convertible debt.

Example 2
A company has in issue some 8% convertible loan notes currently
quoted at $85 ex-interest. The loan notes are redeemable at a 5%
premium in five years’ time or can be converted into 40 ordinary
shares at that date. The current ex-div market value of the shares

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is $2 per share and dividend growth is expected at 7% per year.

Corporation tax is 33%.
Required:
Calculate the cost of the company of the convertible loan notes.

Cost of preference shares:

The return paid to the preference shareholders of the

company. The symbol used to represent cost of preference
shares is Kp. A fixed rate charge to the company in the form
of a dividend rather than in terms of interest. Preference
shares are normally treated as debt rather than equity but
they are not tax deductible. They can be treated using the
dividend valuation model with no growth;
do
Kp¿ Mv

Non – tradable debt

A substantial proportion of the debt of companies is not
traded. Bank loans and other non-traded loans have a cost of
debt equal to the coupon rate adjusted for tax.
Kd = interest (Coupon) rate x (1-T)

Weighted Average Cost of Capital (WACC)

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The weighted average cost of capital is the average of cost of the

company’s finance (equity, loan notes, bank loans, and
preference shares) weighted according to the proportion each
element bears to the total pool of funds. We have seen how to
calculate the cost of both equity and debt. However, most
companies are financed using a mixture of both equity and debt.
It is useful for our later work to be able to calculate the average
cost of capital to the company. We do this by calculating the cost
of each source of finance separately and then calculating a
weighted average cost, using the ex div market values of the
equity and debt.
Weighted Average Cost of Capital is often used as the discount
rate for investment appraisal, but as we will consider in this
chapter, it is only suitable in certain circumstances.
Companies are usually financed by both debt and equity (i.e. they
use some degree of financial/capital gearing). The WACC
represents a company’s average cost of long-term finance.
In the exam the formula given is:

For presentation in a CBE environment in Section C for

constructed response questions, the above can be presented as
below;

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Market values of equity/debt (where available) are used to weight

the individual costs of capital. However:
• If the company’s shares are not listed on the stock market,
the book value of equity will have to be used;
• Similarly, for debt (i.e. if the company has issued loan
notes);
• Use book values for bank loans.

Implications of WACC for project Financing

WACC is a potential discount rate for project appraisal using NPV
So, use company’s existing WACC as discount rate only if:
• The project exposes investors to the same level of business
risk as they currently face; and
• The finance for the project does not alter the financial risk
the company faces (i.e. it does not change its gearing)
If the above does not apply (which is likely to be the case, as they
are very restrictive), the project represents a change in risk and
so investors will expect a different return and the cost of capital
will change.

Example
The following information is in the statement of financial position
of Barrows Co:
$’000
9% bonds redeemable in seven years’ time
8,000
Ordinary Shares, par value 25c
5,000
Retained Earnings 3,000
The ex-div share price of B Co is $3.00. The 9% bonds are trading
on an ex-interest basis at $85.00 per $100 bond. The cost of
equity has already been calculated at 15% and the cost of debt is
7.6%.

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Required:
Calculate the weighted average cost of capital.

CAPITAL STRUCTURE AND THE COST OF CAPITAL

WACC can only be used if the capital structure (financial risk) of a

company remains unchanged.
Impact of debt financing on the WACC
Two competing effects
Reduction in WACC Increase in
WACC
Debt finance is cheaper because: Debt introduces
financial risk which
increases Ke, should lead to
an increase
in WACC
Less risky to investor The risk associated
with debt
Tax relief in interest paid financing is borne
by the shareholders
Kd ‹ Ke, an increase in debt funding
should lead to a fall in WACC

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Financial risk
A shareholder’s earnings in any company are risky, depending on
the nature of business carried out by the company. If the
company adds debt to the capital structure, by borrowing, the
earnings available to shareholders become even more risky as
the lenders will have a ‘prior charge’ (often fixed) over the
company’s earnings.
Illustration
All Equity Including
Debt
Year 1 2 3 1 2 3
PBIT 12,000 18,000 6,000 12,000 18,000
6,000
Interest - - - 3,000
3,000 3,000
Taxable 12,000 18,000 6,000 9,000 15,000
3,000
Tax (30%) 3,600 5,400 1,800
2,700 4,500 1,200
PAT (Earnings) 8,400 12,600 4,200 6,300
10,500 1,800

GEARING/ CAPITAL STRUCTURE THEORIES

These theories explain the impact on the cost of capital of the
company due to change in the capital structure of the company. It
includes the following theories:
 The Traditional View
 Modigliani-Miller (MM) Theory (without tax)
 Modigliani-Miller (MM) Theory (with tax)

The traditional view of capital structure

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The traditional View is that there is an optimal capital structure at

which the company’s weighted average cost of capital is at its
minimum and hence the value of the company is maximized.

The traditional view is as follows:

a) As the level of gearing increases, the cost of debt remains
unchanged up to a certain level of gearing. Beyond this
level, the cost of debt will increase.
b) The cost of equity rises as the level of gearing increases and
financial risk increases. There is a non-linear relationship
between the cost of equity and gearing
c) The weighted average cost of capital does not remain
constant, but rather falls initially as the proportion of debt
capital increases, and then begins to increase as the rising
cost of equity (and possibly of debt) becomes more
significant.
d) The optimum level of gearing is where the company’s
weighted average cost of capital is minimized.
Modigliani and Millers’ theory without Tax (Net operating
income view of WACC)
Modigliani-Miller stated that, in the absence of tax, a company’s
capital structure would have no impact on its WACC and market
value.

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MM argued that the costs of capital would change as

gearing changed in the following manner:
 The cost of debt remains constant whatever the level of
gearing.
 The cost of equity rises in such a way as to keep the WACC
constant.
Therefore, only investment decisions affect the value of the
company and the value of the company is independent of the
financing decision.
Modigliani and Millers’ theory with corporation tax
In the theory with tax model:
 ke rises (as before) to reflect the increased uncertainty due
to financial risk;
 kd is constant (as MM ignore the risks of financial distress).

This can be shown as a graph…

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MM’s theory with tax implies that there is an optimal gearing level
and that this is to maximise debt in the capital structure to
generate maximum value for the shareholders.
This is not true in practice (because companies’ capital structures
are not geared as much as possible) because, for example:
This suggests that companies should have a capital structure
made up entirely of debt. This does not happen in practice due to
existence of other market imperfections which undermine the tax
advantages of debt finance.
Problems with high gearing
 Bankruptcy costs
MM’s theory assumes perfect capital markets so a company
would always be able to raise finance and avoid bankruptcy.
In reality, however, at higher levels of gearing there is an
increasing risk of the company being unable to meet its
interest payments and being declared bankrupt. At these
higher levels of gearing, the bankruptcy risk means that
shareholders will require a higher rate of return as
compensation.
 Agency costs
At higher levels of gearing there are also agency costs as a
result of action taken by concerned debt holders. Providers
of debt finance are likely to impose restrictive covenants
such as restriction of future dividends or the imposition of
minimum levels of liquidity in order to protect their
investment. They may also increase their level of monitoring
and require more financial information.
 Tax exhaustion
As companies increase their gearing they may reach a point
where there are not enough profits from which to obtain all
available tax benefits. They will still be subject to increased

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bankruptcy and agency costs but will not be able to benefit

from the increased tax shield.

Pecking order theory

It states that firms will prefer retained earnings to any other
source of finance, and then will choose debt, and last of all equity.
The theory is based on the view that companies will not seek to
minimize their WACC; instead they will seek additional finance in
an order of preference or pecking order.
Research has shown that the following hierarchy emerges:

Retained Earnings
Internal finance (i.e. reinvestment of profit) is preferred to raising
external finance. There are several practical advantages of using
internal finance:
 Management time is not consumed by paperwork;
 No issue costs;
 No change in the company's control structure;
 Privacy (e.g. no need to publish a prospectus); and/or
 External finance may not be available, particularly for SMEs
due to asymmetry of information (a perceived high risk due
to a lack of public information about the business).
Issue Debt

If internal finance is not sufficient (e.g. because existing

shareholders require a significant dividend), external finance
must be raised. Here the preference is for debt because:
 Debt is cheaper than equity;
 Interest is tax allowable, which results in a tax shield;
 Issue costs are lower on debt than equity; and/or
 Debt can be raised more quickly than equity.

Issue Equity

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If debt cannot be raised (e.g. due to lack of assets for security), a

share issue is inevitable. A new share issue ranks last in pecking
order theory because:
 The cost of equity is high because equity investors are
exposed to high risk (business and operating risk);
 Dividends do not give a tax shield;
 Issue costs are high; and/or
 Share issues take much time and effort to organise.

Capital Asset Pricing model (CAPM)

Systematic and Unsystematic risk

Investment risk, the uncertainty or variability of returns on
investments, can be split into two elements:
1. Unsystematic risk; and
2. Systematic risk.

Unsystematic risk: the risk which is unique to each company’s

share. (Also called Unique, diversifiable or industry specific risk).
It is the element that can potentially be eliminated (“diversified
away”) by investors building a diversified portfolio (i.e. positive
and negative exposures cancel out). For example, if the price of
copper rises, prices of shares in copper mining companies will
rise, but the price of shares in manufacturing companies that use
copper will fall.

Systematic risk: the risk which affects the market as a whole

rather than a specific company’s shares. (Also known as market
risk or undiversifiable risk). It cannot be diversified away. This risk
is associated with the financial system and still remains even in a
well-diversified portfolio. For example, both copper mining and

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manufacturing companies are exposed to increases in interest

rates and the general state of the economy.

The sum of systematic risk and unsystematic risk is called total

risk. Therefore, a portfolio of shares has a total risk that is made
up of these two types of risk. As more different shares are added
to the portfolio, the unsystematic risk is diversified away and the
amount of total risk reduces to approach systematic risk.

This means that investors should only be rewarded for risks they
cannot avoid – systematic risk
A well-diversified portfolio of shares still has some degree of risk
or variability (i.e. to macro-economic changes) because all shares
are affected by market risk.
This systematic risk will affect the shares of all companies
although some will be affected to a greater or lesser degree than
others. For example:
• A supermarket chain will have a relatively low risk because
people will always buy food, regardless of the state of the
economy.
• A tour operator will have a higher risk because, during a
recession, demand for holidays will fall.
This sensitivity to systematic risk is measured by “an index of
responsiveness of the returns on a company’s shares compared
to the returns on the market as a whole” called a beta value or
beta factor, or simply beta.
A beta, therefore, simply describes a share's degree of sensitivity
to changes in the market's returns, caused by systematic risk.
For a typical share, beta lies between 0.2 and 1.6:
Beta = 1 − Indicates a “neutral” share that is as sensitive as the
market to systematic risk. Such shares should earn the market
return.

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Beta > 1 − Indicates an “aggressive” share that is more sensitive

than the market. Therefore, if the market in general rises by 10%,
the returns from this share are likely to be more than 10%.
Beta < 1 − Indicates a “defensive” share that is less sensitive
than the market and is likely to rise and fall in value less than the
market in general. For example, if a share has a beta of 0.5, the
expected will increase by only 5% if the return on the capital
market increases by 10%.
The market return is the return on the market portfolio (i.e. a fully
diversified portfolio with a representative sample of all traded
shares).

CAPM
CAPM assumes that investors hold fully diversified portfolios. If a
company’s shareholders hold well-diversified portfolios, they are
concerned only with systematic risk. Therefore:
• The return these shareholders require is a reward for only the
systematic risk of an investment.
• Since systematic risk is measured by a beta, the required return
from an investment must be related to its beta.

The CAPM formula as provided in the exam formulae sheet is:

The market portfolio is a portfolio containing every share on the

stock market.

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(E(rm) – Rf) is known as the equity market premium, the equity risk
premium, the market risk premium, or simply market premium
(i.e. the extra return an investor expects for holding a diversified
portfolio of shares rather than a risk-free security).

Example
S Co is a listed company whose shares have a beta of 0.7 and a
cost of capital of 17% p.a. rf = 10% and rm = 20%. A new project
has arisen with an estimated beta of 1.3.
Required:
What is the required return of the project?
Geared and Ungeared Companies
Asset Beta
Suppose a company, A Co, is ungeared. As it has no debt it has no
financial risk and so the only risk that it faces is business risk. The
unsystematic business risk can be diversified away by investors,
so the investors face just systematic business risk. The beta
factor for such a company is called the asset beta (because the
company has assets, no debt) ßa. As long as the business
operations – and therefore the business risk – do not change, the
asset beta (also called the ungeared beta) remains constant.

Equity Beta
Suppose B Co is identical to A Co except that its capital structure
includes debt. Gearing increases and financial risk is added to
business risk. This will increase the effects of the systematic risk
investors in B Co face, and so the return they require will increase
to compensate for the increasing risk. The beta factor for B Co’s
shares, called the equity beta, increases as gearing increases.

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The equity beta (also known as the geared beta) measures the
sensitivity to market risks of the equity shareholders’ returns.
• In the all-equity financed company, A Co, (ungeared company)
the asset beta and the equity beta are the same; ßa = ße.
• In the geared company, B Co, however, the equity beta exceeds
the asset beta; ße > ßa.
As the equity beta, ße, measures the sensitivity to market risks of
the equity shareholder returns, it can be used in the CAPM as the
required return for the equity shareholders.
The CAPM can therefore be used as an alternative to the Dividend
Valuation Model for estimating the cost of equity.

Project specific Cost of Capital

If the financial manager is considering an investment in a new
project, then the required return will be affected both by the
business risk of the project and by the way in which the project is
financed. By;
• Identify a proxy company having same Business Risk

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• Chose the βe of that proxy company.

• Calculate the βa using the Proxy Company’s current financial
structure (Un-gearing Beta).
Ve
β a= X βe
V e + V d (1−T )
• Calculate βe of the investment using capital structure to be
used for the investment. (Re-gearing Beta)
V e +V d (1−T )
β e= X βa
Ve
• Use βe to calculate Ke using CAPM
• Calculate WACC
This is summarized as below;
(a) Determine the βa for the project, using a similar
company’s Ve and Vd. (Un gearing the beta), hence
acquiring the business risk.

(b) Re-gear the βa by making βe the subject, (this means

you would have attained the financial risk also)

(c) If the project is to be financed entirely from equity, the

project specific cost of equity can be used as the discount
rate, and will be determined directly from the βe calculated
in step (b), using CAPM formula.
(d) If it’s to be financed by both equity and debt, a project
specific WACC would need to be calculated.

Example
FAQ is a profitable, listed manufacturing company, which is
considering a project to diversify into the manufacture of

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computer equipment. This would involve spending $220 million on

a new production plant.

It is expected that FAQ will continue to be financed by 60% debt

and 40% equity. The debt consists of 10% loan notes, redeemable
at nominal value after 10 years with a current market value of
$90. Any new debt is expected to have the same cost of capital.

FAQ pays tax at a rate of 30% and its ordinary shares are
currently trading at 453c. The equity beta of FAQ is estimated to
be 1.21. The systematic risk of debt may be assumed to be zero.
The risk-free rate is 6.75% and market return 12.5%.

The estimated equity beta of the main competitor in the same

industry as the new proposed plant is 1.4, and the competitor’s
capital gearing is 35% equity and 65% debt by book values.

Required

a) Calculate the after-tax cost of debt of FAQ’s loan notes.

b) Calculate a project-specific discount rate for the proposed
investment.

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