F2A - Chapter 1: Long-term finance

Question 1

What are some sources of external funding?

Answer 1

Capital markets - new shares issue, rights issue, issue of marketable debt
Banks and finance houses
Government and similar sources

Question 2

What are shares?

Answer 2

A fix identifiable unit of capital in an entity

Question 3

What are ordinary shares?

Answer 3

Pay dividends at the discretion of the directors.
Owners of the company that have the right to attend AGMs and vote.

Question 4

What are preference shares?

Answer 4

Shares that pay a fix dividend, which is paid before ordinary share dividends.

Question 5

What is a redeemable preference share?

Answer 5

Shareholder will be paid their capital at a future date

Question 6

What is a irredeemable preference share?

Answer 6

Shareholders not repaid their capital in the future

Question 7

What is a cumulative preference share?

Answer 7

Dividends must be rolled forward if company has insufficient reserves to be able to pay a dividend

Question 8

What is a non-cumulative preference share?

Answer 8

Missed dividends do not have to be paid later

Question 9

What is a participating preference share?

Answer 9

Shareholder receives fixed dividends plus extra variable dividends linked to performance

Question 10

What is a convertible preference share?

Answer 10

Can be exchanged for a specified number of ordinary shares on a given fixed date

Question 11

What are the three most commonly used methods of issuing new shares?

Answer 11

an IPO (initial public offering) or flotation
A placing
A rights issue

Question 12

What is an initial public offering (IPO)?

Answer 12

IPOs occur when a company seeks to be listed on a stock market for the first time.
Shares are offered for sale to investors, through an issuing house.
Offers could be made at a fixed price set by the company or via a tender offer.

Question 13

What is a rights issue?

Answer 13

A rights issue is where new shares are offered for sale only to existing shareholders, in proportion to the size of their shareholding.
They are cheaper to organise than a public share issue
Issue price must be set which is low enough to secure acceptance, not too low to avoid excessive dilution of the earnings per share.

Question 14

What happens to the market price after issue?

Answer 14

After announcement of a rights issue there is a tendency for share prices to fall.
Temporary fall is due to uncertainty about consequences of the issue, future profits and future dividends.
After the actual issue the market price will normal fall again because there are more shares in issue and new shares were issued at a discount on market price

Question 15

How do you calculate the theoretical ‘ex rights’ price (TERP)?

Answer 15

(N x cum rights price) + issue price
/
N + 1

N = number of shares required to be held in order to receive one rights issue share

Question 16

What are the implications of a rights issue from the viewpoint of the shareholders and the company?

Answer 16

Shareholders:
They have the option of buying shares at a preferential price
They have the option of withdrawing cash by selling their rights
They are able to maintain their existing relative voting position

Company:
Simple and cheap to implement
Usually successful
Often provides favourable publicity

Question 17

What are the characteristics of ordinary shares?

Answer 17

Provide voting rights for shareholders
Dividends are discretionary and payments are linked to performance
Shareholders are the last to be entitled to payment upon liquidation of the entity

Question 18

What are the characteristics of preference shares?

Answer 18

Carry no voting rights
Dividends are guaranteed and based on a % of nominal value
Positioned above ordinary shareholders, but below other creditors, for entitlement to payment upon liquidation

Question 19

What are the general characteristics of equity finance?

Answer 19

Shares will have a nominal value
Nominal value linked to primary function of the capital market
Shares will be traded at market value
Market values of shares are different to nominal value and fluctuate over time due to the secondary function of the capital markets
Shares cannot be issued at a price lower than nominal value
Share prices can drop below nominal value over time

Question 20

What are the key characteristics of debt financing?

Answer 20

Interest paid out of pre tax profits
Carries a significant risk of withdrawal of the finance if interest and payments are not met
Nominal values for debt can be attributable to debt finance
Market values of debt represent the cash received when raising finance through debt
Debt finance can be issued at prices lower than nominal value

Question 21

What are covenants?

Answer 21

Covenants are specific requirements or limitations laid down as a condition of taking on debt financing. Covenants will act to limit the risk that a lender is exposed to by restricting the actions of the directors.

Question 22

What may be included in covenants?

Answer 22

Dividend restrictions - limitations on the level of dividends a company is permitted to pay
Financial ratios - specified levels below which certain ratios may not fall
Financial reports - Regular accounts and financial reports to be provided to the lender to monitor progress
Issue of further debt - amount and type of debt that can be issued may be restricted

Question 23

What are some other sources of finance?

Answer 23

Retained earnings/existing cash balances
Sale and leaseback
Grants
Debt with warrants attached
Convertible debt
Venture capital
Business angels