2 sources of finance
A firm can generally approach finance through two alternative ways, which are debt finance and equity finance. These may be summarized as follows:
Debt finance: (1) short-term; (2) medium-term;(3) long-term;(4) special purpose
(1) short-term includes: trade credit, bank overdrafts
(2) medium-term includes: bank loans, leasing, hire purchase(HP)
(3) long-term includes: bonds, debentures
(4) special purpose includes: government grants and loans, convertibles, warrants
Equity finance: (1) new issues; (2) internally generated
(1) new issues include: rights issues, placing, issuing to the general public
(2) internally generated: retained earnings
note: remember clearly the sources of finance and their category, it will be highly useful for you to answer the question related, such as if a firm is in financial deficit, the examiner will be apt to ask you the way to cope with the crisis, you should use the category above to avoid omitting some sources.
2.1 Sources of finance: debt
2.1.1 Yield curve
(1) Definition: A yield curve is a diagrammatic representation of the term structure of interest rates. The term structure of interest rates refer to the way in which the yield of a security varies according to the term of the security, also means to the length of time before the borrowing will be paid.
(2) Shape: In general, redemption yields will rise as term to maturity increase. However, in order to curb economic growth or inflation the short-term rates will be higher than longer-term rates leading to a falling yield curve.
(3) Function: financial manager should inspect the current shape of the yield curve when deciding on the term of borrowings or deposits, since the curve reflects the market’s expectation of future movements in interest rates.
For instance, a yield curve sloping steeply upwards suggests that interest rates will rise in the future, the manager may therefore prefer short-term variable rate borrowing or long-term fixed rate borrowing; a yield curve sloping steeply downwards suggests that interest rates will drop in the future, the manager may therefore prefer long-term variable rate borrowing.
2.1.2 Characteristics of debts
(1) Debts from the viewpoint of company:
Pros: -debt is cheap compared with equity. Debt is an allowable expense for tax, and the debt holder can accept a lower rate of return because the cost is fixed.
-no dilution of control.
Cons: -interest must be paid whatever the earnings of the company.
-high geared company will be required a higher dividend by the shareholder to compensate the risk they are faced with.
-with fixed maturity dates, provision must be made in advance.
-if the interest rates falls, it will be a burden for long-term debt.
(2) Debts from the viewpoints of holders:
Pros: -risk is low. Holder’s income is fixed and has priority in interest payment
when liquidation.
Cons: -commonly has no voting rights.
2.2 sources of finance: equity (including hybrids)
2.2.1 Some definitions of equity
-ordinary shares. Preference share is considered part of debt as it bears more
resemblance to debt finance.
-rights issue. An offer to the existing shareholders to subscribe for more shares, is
in proportion to their existing holding, usually at a relatively cheap price.
-bonus issue. A method of altering the share capital without raising cash, it is done
by changing the company’s reserves into share capital.
-scrip dividend. A firm allows its shareholders to take their dividends in the form
of new shares rather than cash.
-convertible debentures. A loan gives the holder the right to convert loans to
ordinary shares at a predetermined price.
-warrant. A firm give the holder the right to subscribe at a fixed future dates for a
certain number of ordinary shares at a predetermined price. It is merely an
option.
2.2.2 Right issue
(1) The price of right issue
Theoretical ex-rights price=[(market value of shares in issue)+ (proceeds from new share issue)]/number of shares after right issue
(2) Characteristics of right issue
-pre-condition: a company must have an authorized share capital which
exceeds the share capital that would be in issue after the rights issue.
-cost effective: right issue maybe the most cost effective way to raise finance, and it can be used to finance any type of long-term investment.
-easily raised: rights issue persuades existing shareholders to buy new shares, who have some levels of commitment to the company already, therefore it can be much easier than public offering.
-gain or loss: in an efficient market, the investor is no better nor no worse off by choosing to sell his/her rights.
Note： Remember whenever you analyze a question in relation to the price of stock or the gain or loss of some actions, you should try to apply to EMH.
2.2.3 Convertible debentures
(1) Effect on EPS. Step one is to calculate the adjusted profit after tax, which
adds back the interest on convertible debentures and gives consideration to
corporation tax; Step two is to calculate the diluted shares, which includes
the maximum number of shares converted.
A Case On 1 April 20X0, a company issued $1,250,000 8% convertible unsecured loan stock for cash at par. Each $100 nominal of the stock will be convertible in 20X3/X6 into the number of ordinary shares set out below.
On 31 December 20X3 124 shares
On 31 December 20X4 120 shares
On 31 December 20X5 115 shares
On 31 December 20X6 110 shares
Issued share capital: $500,000 in 10% cumulative preference shares of $1 and $1,000,000 in ordinary shares of 25p=4,000,000 shares.
Corporation tax is 45%.
Trading results were as follows for the years ended 31 December:

Calculate (1) basic earnings per share and (2) diluted earnings per share.
Solution
20x1 20x0
(1) basic EPS
Profit after tax $ 550,000 $ 504,250
Less: preference dividend $ (50,000) $ (50,000)
Earnings $500,000 $454,250
Shares 4,000,000 4,000,000
EPS $12.5p $11.4p
(2) Diluted EPS 20x1 20x0
Profit after tax $550,000 $504,250
Less: preference dividend $(50,000) $ (50,000)
Add back: interest on convertible $100,000 $75,000(only accounts
Loan for 3/4 of a year)
Less: corporation tax $45,000 $33,750
Adjusted earnings $555,000 $495,500
Adjusted shares(w1) 5,550,000 5,162,500
Diluted EPS 10p 9.6p
W1: for 20x1, the maximum number of shares issuable among 124, 120, 115,
110 is 124, hence the conversion is 124 shares per $100, and then
total shares=4,000,000+$1,250,000ｘ124/$100=5,550,000
for 20x0, the weighted average number of shares:
4,000,000ｘ1/4 + 5,550,000ｘ3/4 =5,162,500.
(2) Characteristics of convertible debentures
-convertibles can provide immediate finance at lower cost since the conversion option effectively reduces the interest rates payable.
-convertibles represent attractive investments to investors since they are effectively debts risks for future equity benefits. Hence, finance is relatively easy raised.
-convertibles allow for higher gearing levels than would otherwise be the case with straight debt, because costs are potentially lower with convertibles.
-where company wish to raise equity finance, but share prices are currently depressed, convertibles offer a safeguard share issue method.
-where convertibles are converted into shares, the problem of repayment disappears.
2.2.4 Warrant
(1) Effect on EPS. Step one is to calculate the number of shares that would have been issued at fair value, step two is to calculate diluted shares left.
Case 5 On 1 January 20X2 a company issues 1,000,000 shares under option. The net profit for the year is $500,000 and the company already has 4,000,000 ordinary shares in issue at that date.
During the year to 31 December 20X2 the average fair value of one ordinary share was $3 and exercise price for shares under option was $2.
Calculate the earnings per share for the year ending 31 December 20X2.
Solution
Basic earnings per share: =12.5p
Diluted earning per share:

Earnings per share: =11.5p
2.2.5 Dividend
(1) Dividend policy, arguments for the relevance of dividend policy
?dividend signaling; ?preference for current income; ?taxation.
(2) Dividend valuation model:
for constant annual dividend: p=d/r
for dividend keep growing: p=d(1+g)/(r-g)
where g is the expected annual growth rate in dividend, r is the anticipated return
on investment of the equity shareholders.
g=return on new investmentｘthe proportion of earnings kept
Another function: this model can be used to calculate the cash flow after the project life, for example: the cash flow at the end of project life is 10 million, cash flow is expected to grow by 2% per year, current discount rate is 9%, what the cash flow after the project life.
Solution: use this model=10(1+2%)/(9%-2%)=145.71
2.3 Capital structure
2.3.1 Choosing between equity and debt
-Growth and stability of sales. If growth rate is high or stable, high gearing can maximize the gain for equity, debt is a choice then.
-Control. Debt is irrelevant to control, while equity will dilute control.
-Tax position. If the tax shield doesn’t work, the company may still suffer agency and insolvent costs. In this situation debt financing is not attractive.
-Asset quality. Company with a high proportion of intangible assets will be required to pay a higher return by its creditors, because creditors know it’s harder to get the money back than company having land and buildings.
2.3.2 Comparing debt and equity finance
-commonly debt is cheaper than equity on an after-tax basis. One reason is debt is less risky, the other reason is tax shield.
-debt is more flexible because it can be borrowed, repaid and re-borrowed in general terms.
-debt is normally evidenced by a straightforward contract, creating rights and obligations on both sides. Equity carries with the additional benefits of ownership of the business, including the right to elect directors and appoint auditors.
-however, debt still has some weakness.
2.3.3 Gearings
(1) Operating gearing. It is the relationship between fixed and variable costs, measuring the cost structure of a company. Firms with high levels of fixed costs are usually regarded as high operating gearing and the operating earnings are more volume-sensitive, because fixed costs must be made irrespective of the level sales volume. Hence a company with higher operating gearing will have greater variability in earnings before interest and tax (EBIT) relative to a given level of variability in sales.
Operating gearing= fixed costs/ variable costs
(2) Financial gearing. It is used to measure the financial risk in a company’s long-term capital structure. High financial gearing is risky, for fixed interest payment must be made regardless of the level of earnings. Therefore, a company with higher financial gearing will have greater variability in returns to shareholders relative to a given level of variability in earnings before interest and tax (EBIT).
Two financial gearings are introduced here, capital gearing and income gearing based generally on book value.
-Capital gearing concerns the relationship between the company’s debt and equity capital values, it can be shown by two similar gearings .
Total gearing= (preference share capital + long-term debt)/total long-term capital
Equity gearing= (preference share capital + long-term debt)/ordinary shares + reserves
-Income gearing= debt interest/operating profit before debt interest and tax
Here debt interest includes preference dividend.
(3) Relationship between financial and operating gearing
If the sales of a company vary, the ultimate variability of returns to shareholders will be determined by the level of operating gearing-which determines the EBIT variability- as ‘amplified’ by the level of financial gearing. So there is a trade off between operating and financial gearing, if a firm has a high degree of operating gearing, then unless sales were stable, it would prefer to avoid financial gearing , and vice versa.
2.4 Weighted cost of capital(WACC)
(1)Definition: weighted average cost of capital is the average cost of the company’s finance(equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of capital. WACC is calculated by reference to market value.
(2) Effect of gearing level: an increase in gearing leads to: higher equity cost for additional risk shareholders taken; a larger element of cheaper finance.
The two opposing effects will impact on WACC. If the increased cheap debt can outweigh the increase of cost of equity, WACC will decrease. If the increased cheap debt can’t outweigh the increase of cost of equity, WACC will increase.