1 Chapter Overview

• Long-Term Financing
  • Financing through Equity Capital
  • Debt Financing

2 Introduction

Sources of Long-Term Financing

If a company has a significant surplus of cash, there is no need for it to resort to external sources of financing in order to implement new investment projects.

However, if external financial resources are indispensable, the company may need to raise capital from the following sources:

1. Capital Markets:
   • Issuance of new shares, for example by companies placing their shares on the stock market for the first time;
   • Rights issues (the issuance of shares offered to existing shareholders);
   • Issuance of market-traded debt instruments.

   To raise funds through capital markets, a company must be listed (i.e., registered) on an official stock exchange.

2. Bank Loans:

   Long-term or short-term loans, including bank credit facilities such as revolving credit facilities (RCFs) and short-term credit lines.

3. Governmental and Similar Sources:

   These may include state-sponsored programs or other institutions providing financial support under specific conditions.

Overall, financing may be obtained either through equity capital or from debt sources.

3 Equity Financing

Equity capital refers to company shares or ownership rights in the business.

Key Terms

Share – a fixed, identifiable unit of capital with a nominal (par) value, which may differ from the market value of the share (CIMA Official Terminology, 2005).

Shareholders receive income from their investment in the form of dividends, as well as capital gains arising from fluctuations in the share price.

Ordinary Shares

Dividends on ordinary shares are paid at the discretion of the company's directors. Holders of ordinary shares are considered owners of the company and are entitled to participate in shareholder meetings and vote on key issues.

In the event of company liquidation, the claims of ordinary shareholders are satisfied only after the interests of other parties with prior entitlement to the company’s assets have been addressed—meaning they receive funds only if there is a surplus remaining after all other obligations, including those to preferred shareholders, have been met.

Preferred Shares

Preferred shares are equity instruments with a fixed dividend rate. Holders of such shares have a preferential claim to the distributable profits of the company, meaning they receive dividends before ordinary shareholders.

Likewise, in the event of company liquidation, the claims of preferred shareholders are considered after those of debt holders and creditors but take precedence over the claims of ordinary shareholders.

4 Capital Markets

Capital markets (stock markets) serve both primary and secondary functions.

Primary Function

The primary function of the stock market is to enable companies to raise new financing (through equity or debt instruments). By accessing the stock market, a company can reach a broad base of potential investors, significantly simplifying the capital-raising process compared to engaging with each investor individually.

Note that in the United Kingdom, to be eligible to raise capital on the stock market, a company must be registered as a public limited company.

Secondary Function

The secondary function of the stock market is to provide investors with the ability to sell their investments to other investors. Consequently, shares of a listed (or quoted) company are easier to buy and sell compared to those of an unlisted company, making listed shares more attractive to investors.

5 Various Types of Preferred Shares

There are four types of preferred shares:

• Cumulative preferred shares: Holders are entitled to receive any missed dividend payments. If a dividend is skipped in one year, the corresponding amount is paid in the following year along with the current year's dividend.
• Non-cumulative preferred shares: Missed dividends are not paid.
• Participating preferred shares: These allow the holder to receive a fixed dividend plus additional income under certain conditions (similar to ordinary shares).
• Convertible preferred shares: These can be exchanged for a specified number of ordinary shares on a predetermined future date.

Additionally, some preferred shares are redeemable, meaning that in the future, the company will return the capital to the shareholders (usually at par value).

Example of Convertible Preferred Shares

Convertible preferred shares are fixed-income securities that an investor can, on a specific date after a predetermined period, choose to exchange for a certain number of ordinary shares.

The fixed income provides a stable source of revenue and a degree of capital protection for the investor. Moreover, the option to convert these securities into ordinary shares offers the investor the opportunity to benefit from an increase in share price.

Convertible securities are particularly appealing to investors who wish to participate in the growth of rapidly expanding companies while mitigating market risks in case the rise in ordinary share prices does not meet expectations.

6 Listed vs. Private Companies

Private Limited Company (in UK terminology — Ltd)

A private limited company is a privately owned business. The owners of a private limited company, having issued shares (or equity), are not allowed to offer these shares to the public (i.e., for public trading).

The company’s Articles of Association define the rights and responsibilities of its members and specify that liability is limited to the initial capital contributed — the amount paid by shareholders when purchasing shares. In the event of company liquidation, this framework protects the members’ personal assets, meaning that only the money invested in the company may be lost.

A limited company may be either private or public. Public limited companies (plc) are subject to more stringent requirements than private ones, particularly regarding disclosure and the ability to offer shares to the general public on stock exchanges.

The key distinction between private and public limited companies lies in the right to sell shares to the public. Most companies, especially small ones, are private.

Public Limited Company (in UK terminology — plc)

A public limited company is allowed to sell its shares to the general public. Such companies may either be unlisted or listed on a stock exchange.

Stock Exchange Listing

When a company registers (gets listed) on a stock exchange, this is referred to as an initial public offering (IPO) — a release of new securities to the open market.

Advantages of Stock Exchange Listing

• A more accurate market valuation of the company after listing.
• Realisation of previously locked-in profits and the opportunity to buy or sell shares freely in the future.
• Enhanced reputation, which may positively affect income, trust from suppliers, and access to long-term financing.
• Improved capacity to attract investment capital.
• Easier access to employee share distribution programs.

7 Institutional Investors and Rights Issues

Institutional investors typically play the role of major shareholders who agree to purchase a specified volume of shares. However, organizations still need to engage and negotiate with them to secure these funds. There is no guarantee that investors will accept the offering.

The scale of institutional investors’ purchases significantly influences share valuation and market distribution.

Rights Issue

A rights issue occurs when newly issued shares are offered to existing shareholders in proportion to their current holdings.

The right to purchase new shares is primarily granted to the company’s existing shareholders. This is known as a pre-emption right and is typically specified during share offerings. It enables shareholders to maintain their proportionate ownership. This right is regulated by law and usually requires shareholder consent to be exercised.

Conducting a rights issue is generally less expensive than organizing a full public share offering.

Pricing the Issue

• The issue price must be low enough to ensure successful take-up of the offer.
• It must not be so low as to excessively dilute earnings per share.

Rights Issue: Detailed Explanation

Definition

A rights issue may be defined as the raising of new capital by offering existing shareholders subscription rights to purchase new shares in proportion to their current shareholdings. These shares are usually issued at a discount to the current market price (CIMA Official Terminology, 2005).

Explanation

Through a rights issue, a company aims to attract additional funding from its existing shareholders. The company offers them the opportunity to acquire additional shares, usually at a price below current market value. The discounted price is intended to provide an incentive, especially for shareholders who might otherwise prefer to buy more shares at market value or not participate at all.

8 Disadvantages of Stock Exchange Listing

• High costs for small companies (due to the expenses of issuing and placing new securities on the open market).
• Requirement to release a sufficient number of shares into the market, which may result in a loss of control by original owners.
• Stricter reporting and disclosure requirements.
• Stringent conditions for obtaining a stock exchange listing.

Capital Markets in the United Kingdom

In the UK, there are two key capital markets:

• The Stock Exchange — A market for large companies. Characterized by high entry costs and a very strict vetting process for listed companies. Listings in the "main market" gain the greatest public visibility and are accessible to a wide investor base.
• The Alternative Investment Market (AIM) — A market designed for small companies, with lower associated costs and less stringent admission criteria.

Stock Exchange Pricing Mechanism

Share prices on the stock exchange are determined by supply and demand. If a previously successful company underperforms, its shares become less attractive to investors. As a result, investors will try to sell, increasing market supply and pushing the share price down.

Role of Consultants in Share Issuance

Investment banks typically play a leading role in the share issuance process and provide recommendations on the following:

• Appointing other specialists (e.g., lawyers);
• Meeting stock exchange requirements;
• Forms of new capital to be made available;
• Required volume of issued shares and the issue price;
• Underwriting and placement of the securities;
• Drafting and publishing the offer documentation.

Stockbrokers advise on how to gain access to trading on the exchange. They may collaborate with investment banks to identify institutional investors but are often involved in placing smaller issues of securities.

9 Share Pricing and Post-Issue Dynamics

Pricing Limitations and Shareholder Preference

A company cannot offer an unlimited number of shares at a discounted price. Doing so would drive the market value down to that level. Therefore, offerings made to existing shareholders are often capped—for example, one new share for every four held.

Setting the Issue Price

While there is no theoretical upper limit on the issue price, in practice it is rarely set above the prevailing market price (MPS), as shareholders would not be willing to buy shares they can already obtain at market value.

In most cases, the issue price is set at a discount to the market price—typically around 20%. The price is almost never below the nominal issue value. The final price is determined by balancing various factors. The lower the issue price, the greater the number of shares needed to raise the desired capital.

Determining the Number of Shares to Issue

The issue price is usually chosen first, then the number of shares is calculated accordingly. The new issuance should not significantly affect earnings per share (EPS), dividend yield, etc.

The number of shares is typically aligned with the number of existing shares to define the rights offering terms—for instance, a 1:4 ratio, meaning one new share can be purchased for every four currently held.

Market Price After Issuance

• After the announcement of a rights issue, the share price tends to decline.
• This temporary drop reflects uncertainty about:
  • The outcome of the issue;
  • Future earnings;
  • Future dividends.
• Once the issue is completed, the price typically falls again due to:
  • The increased number of shares in circulation (which dilutes EPS);
  • The fact that the new shares are issued at a discount to the market price.

10 Consequences of a Rights Issue

(a) From the shareholder’s perspective:

• The opportunity to buy shares at a favourable price;
• The possibility to gain cash by selling their rights;
• The ability to maintain their existing relative voting power (by exercising their rights).

(b) From the company’s perspective:

• Simplicity and low cost of executing the offering;
• Typically, a successful outcome ("fully subscribed issue");
• Often results in the spread of positive publicity about the company.

5 Debt Financing

This refers to the provision of borrowed funds to a company without the transfer of ownership. The core features of debt financing in transactions between independent parties are as follows:

• Repayment is serviced from pre-tax profits as operating expenses;
• In case of failure to repay interest and principal, there is a risk of default.

Security (Collateral)

Lenders usually require the borrower to provide some form of collateral for the funds issued. This means that if a default occurs, the lender has the right to seize the pledged assets in exchange for the amount owed.

There are two types of security that may be offered or demanded:

(1) Fixed Charge Security

The debt is secured against a specific asset, typically land, buildings, or similar fixed property. This type of security is considered stronger, as it gives the lender first priority in the event of company liquidation.

(2) Floating Charge Security

The debt is secured against the company’s assets in general. This form of security is weaker, offering only partial protection in liquidation and giving the lender the status of a preferential creditor — meaning they rank higher than unsecured creditors but lower than fixed-charge holders.

Covenants

Additional risk reduction measures for lenders are imposed in the form of covenants — restrictions on the actions of the borrowing company's directors. These may be legal or commercial in nature and are typically imposed as a condition for receiving debt financing. Examples include limits on dividends, asset sales, or new borrowing.

11 "Cum Rights" vs. "Ex Rights" Pricing

With Rights ("Cum Rights")

Once a rights issue is announced, existing shareholders have the right to subscribe to the new shares. These rights are attached to the shares, and shares are traded "cum rights."

Without Rights ("Ex Rights")

On the first day of trading in new shares, rights no longer apply, and previously issued shares are traded "ex rights" — meaning the rights are no longer attached.

Theoretical Ex-Rights Price (TERP) and Quantity

The TERP represents the theoretical market price at which the shares will trade once the rights have been exercised. It is calculated as follows:

(N × Cum Rights Price + Issue Price) / (N + 1)

Illustration 1: Rights Issue

Lauchlan plc has 2 million ordinary shares with a nominal value of $1 each. The current market price is $5. The company plans to issue rights to purchase new shares at $4 each, in a 1:4 ratio.

TERP Calculation:

• Cum Rights Price = $5
• Issue Price = $4
• N = 4

TERP = [(4 × $5) + $4] / 5 = $4.80

Exercise 1

Plover Co has 1 million ordinary shares with a nominal value of $1 each, currently trading at $4.50. The company plans to issue rights to purchase shares in a 1:5 ratio at a price of $4.20.

Task: Calculate the theoretical ex-rights price (TERP).

12 Revolving Credit and Capital Markets

A revolving credit facility is a flexible instrument of debt financing that allows a company to minimize interest costs, as the amount of borrowed funds fluctuates over time and never exceeds the company’s actual financing needs.

Revolving credit facilities are often provided by a single bank or, in the case of large financing needs, by a syndicate of banks to spread the risk among multiple lenders.

Capital Markets

Bonds

A bond is a debt security through which the issuer assumes a debt obligation and, under the terms of the bond agreement, undertakes to pay interest (coupon) and the principal amount in the future. A bond is therefore a formal agreement to return borrowed funds and to make regular interest payments over defined intervals.

A bond functions similarly to a loan: the issuer is the borrower (debtor), and the holder is the lender (creditor), typically referred to as an investor purchasing bonds in the market. Bonds are designed to provide companies with the financial resources needed for long-term funding.

Both shares and bonds are securities that can be traded in capital markets, but their key distinction lies in ownership. Shareholders own equity in a company (they are part-owners), whereas bondholders hold a portion of the company’s debt capital (they are creditors). Another difference is that bonds usually have a set term to maturity, after which they must be repaid, while shares may remain in circulation indefinitely.

Commercial Paper

Large commercial organizations may issue short-term unsecured debt instruments in the capital market, known as commercial paper.

These instruments typically mature within nine months, most commonly between one week and three months. They can be sold at any time prior to maturity.

13 Debt Covenants and Financial Restrictions

1. Dividend Restrictions

These are limits placed on the amount of dividends a company is allowed to pay. The purpose is to prevent excessive distributions that could significantly weaken future cash flows and thus increase the risk for creditors.

2. Financial Ratios

Specified thresholds for financial indicators below which the company may not fall — for example, asset-to-equity ratios or liquidity ratios.

3. Financial Reporting

Regular financial and accounting reports that must be submitted to the lender to monitor the company’s performance and compliance.

4. Issuance of Additional Debt

Restrictions may be imposed on the amount and type of additional debt the company is allowed to issue. Sometimes, subordinated debt (lower priority in repayment) is permitted, or unsecured obligations with the same status as existing debt.

Examples of Long-Term Debt Financing: Key Terms

Bank Financing

Money Market Borrowing

The money market consists of financial institutions and dealers that aim to either obtain or provide short-term loans.

Participants use the money market to engage in short-term lending or borrowing, typically for periods ranging from a few days to one year. This distinguishes it from capital markets, which focus on long-term financing instruments such as stocks and bonds.

The core of the money market is interbank lending, where banks lend to and borrow from each other. In addition, large commercial organizations also use the money market to obtain and provide short-term loans.

Revolving Credit Facility (RCF)

With a revolving credit facility, the borrower may draw or access funds within a pre-approved credit limit. The available balance decreases as funds are drawn and increases again as they are repaid.

The borrower pays interest only on the amount actually used. Repayment may be made in full or in part at any time.

14 Capital Markets: In-Depth Overview

The issuance of debt financing instruments (bonds) in the capital market allows a company to raise significant capital from a broad pool of potential investors.

The bond market can be divided into three main participant groups: issuers, underwriters, and buyers.

Issuers

Issuers bring bonds to the capital market to finance their business operations. This part of the market also includes governments, banks, and corporations.

The largest player in this category is usually the government, which uses bond issuance as a key tool for financing national budgets. In the long-term debt market, other participants such as banks and international institutions — like the European Investment Bank — may also act as issuers. Another major issuer group is corporations, which issue bonds to support their operational funding needs.

Underwriters

The underwriting segment of the bond market is typically made up of investment banks and other financial institutions that assist companies in selling bonds to the market.

In most large bond issues, a single agreement is executed, and a lead underwriter — often an investment bank — works together with other firms. The corporate bond market relies heavily on underwriters due to the numerous risks associated with this type of debt instrument.

Sometimes, underwriters place bonds with specific investors (a practice known as "private placement"), or they attempt to sell the bonds more broadly on the public market. In some cases, under medium-term note (MTN) programs, the issuer (through the underwriter) may issue debt securities on a regular or continuous basis.

Buyers

The third group in the bond market consists of those who buy the bonds. Buyers include all of the previously mentioned categories, as well as investors of all types — including individuals.

Governments also play a key role in the bond market. They not only issue bonds but also lend funds to other governments and banks. Additionally, governments often invest in bonds issued by foreign countries — particularly when trade surpluses result in excess reserves of foreign currency. For example, Japan is the largest foreign holder of U.S. government debt instruments such as Treasury bonds.

15 Yield to Maturity (YTM) and IRR

Example 1: Solution

Formula:
YTM = (Annual Interest / Current Market Price) × 100%

YTM = (5 / 95) × 100% = 5.26%

Note: The coupon rate is applied to the bond's nominal (face) value to calculate the annual interest. In other cases, nominal value is not used in the calculation.

Exercise 2

Fork plc, a company listed on the UK stock exchange, has issued several redeemable bonds with a coupon rate of 7% and a face value of $100. The current market price of these bonds is $93.50.

Task:
Calculate the yield to maturity (YTM) for these bonds.

Yield to Maturity on Redeemable Debt Instruments

For a debt instrument that will be redeemed at maturity, YTM is defined as the internal rate of return (IRR), taking into account:

• The bond's purchase price,
• The annual interest payments, and
• The repayment of the principal at maturity.

This means YTM includes all returns the investor expects to receive: both interest payments and the final repayment amount.

Internal Rate of Return (IRR)

Definition

The IRR is the interest rate at which the net present value (NPV) of all expected cash flows equals zero.

Calculation

The IRR can be estimated using linear interpolation between two NPV values based on different discount rates (L = low rate, H = high rate) as follows:

IRR = L + [NPVL / (NPVL - NPVH)] × (H - L)
 

16 Yield on Debt Instruments

An investor who purchases a tradable debt instrument (e.g., a bond) receives a return in the form of an annual interest payment (the coupon), and — if the instrument is redeemable — the final repayment of principal. The total return earned by the investor is referred to as the Yield to Maturity (YTM), or yield accounting for redemption value.

YTM is defined as:

YTM = the effective average annual percentage return earned by the investor, relative to the bond’s current market price.

If the bond is not redeemable, the calculation is simple. However, if redemption applies, the calculation becomes more complex.

Yield on Irredeemable Debt Instruments

For an irredeemable debt instrument:

YTM = (Annual Coupon / Current Market Price) × 100%

Example 1

Knife plc, a company listed on the UK stock exchange, has issued several irredeemable bonds with a coupon rate of 5% and a nominal value of $100. The current market price of these bonds is $95.

Task:
Calculate the yield to maturity (YTM) for these bonds.

Example 2

Knife plc has also issued several redeemable bonds with a 7% coupon rate and a nominal value of $100. These bonds mature in 5 years and include a redemption premium of 10%. Their current market price is $98.

Task:
Calculate the yield to maturity (YTM) for these bonds.

Example 2: Solution

The YTM of these bonds can be determined by calculating the IRR, based on the current market price ($98 at t₀), annual coupon payments (7 each year from t₁ to t₅), and redemption amount ($110 at t₅):

Period	Cash Flow ($)	DF (5%)	PV (5%)	DF (10%)	PV (10%)
t₀	(98)	1	(98.00)	1	(98.00)
t₁–t₅	7	4.329	30.30	3.791	26.54
t₅	110	0.784	86.24	0.621	68.31

Therefore:
IRR = 5% + [(10% − 5%) × 18.54 / (18.54 + 3.15)] = 9.27%

Exercise 3

Fork plc has also issued several redeemable bonds with a coupon rate of 4% and a nominal value of $100. These bonds mature in 3 years and include a redemption premium of 7%. The current market price is $95.

Task:
Calculate the yield to maturity (YTM) for these bonds.

17 Other Sources of Financing

Retained Earnings and Cash Reserves

There is a common misconception that if a company has a large retained earnings figure in its financial statements, it can freely finance new investment projects using these profits. This is not the case.

A company can only fund new projects internally if it has sufficient liquid cash reserves. The retained earnings figure reflects accumulated profit over the company's entire history and does not represent the actual available cash.

Sale and Leaseback

This involves selling high-quality fixed assets (such as buildings or facilities) and leasing them back for a long-term period (often over 25 years). This allows the company to unlock cash through the economic use of existing assets.

However, the company forfeits any potential appreciation in asset value.

Sale and leaseback is a common financing method in retail, where companies like Tesco or Marks & Spencer own substantial property in prime locations.

Subsidies

These sources of finance are usually linked to technological development, job creation, or regional policy. Subsidies are especially valuable to small and medium-sized enterprises (SMEs), particularly those not listed on public exchanges. The main benefit is that they are non-repayable.

Subsidies may be granted by local or national authorities, or by large institutions such as the European Union.

Debt Instruments with Warrants

A warrant is an option to purchase shares at a predetermined price on or before a future date. Warrants are often issued along with bonds to make the offering more attractive to investors.

The warrant offers potential capital gains if the share price exceeds the exercise price. In some cases, warrants may be detachable and traded separately from the bond.

18 Convertible Debt Instruments and Equity Funding

Convertible Bonds

These work similarly to warrants attached to a debt instrument, but in this case the conversion option cannot be separated and sold independently. The investor may convert the debt into shares at a predetermined price, on a specified date or during a defined window in the future.

The investor receives fixed interest payments and gains potential capital appreciation if the share price rises above the bond’s value. If not, the investor may simply hold the bond to maturity.

Venture Capital

This type of funding is typically provided to early-stage or newly formed commercial ventures to help them grow. It usually takes the form of equity investment, though it may also involve some debt financing.

Venture capitalists generally accept lower initial dividends and instead aim for capital gains when exiting the investment. The most common exit strategy is an initial public offering (IPO) or sale of shares in the open market after flotation.

Business Angels

Business angels operate similarly to venture capitalists, but typically invest in smaller businesses. Venture capital firms are often reluctant to invest in very small companies because overseeing their operations may not be cost-effective.

Business angels are wealthy private investors who provide funding to small companies in exchange for equity.

Government Support

Governments often run programmes that offer financial support in the following areas:

• To small and medium-sized enterprises;
• To companies planning expansion or relocation to specific regions;
• To stimulate innovation and technological development;
• To support projects that aim to create or preserve jobs.

19 Applied Calculations and Yield Scenarios

Exercise 4: Solution

1. Cumulative Preferred Shares – dividends missed in the current year are carried over and must be paid in a future year.
2. Participating Preferred Shares – these provide fixed dividends and may also entitle the holder to additional income if certain conditions are met.
3. Secondary Market Function – provides companies with the ability to raise new capital.
4. Theoretical Ex-Rights Price (TERP):
   TERP = [(3 × $5) + $4] / 4 = $4.75
5. Yield to Maturity (YTM):
   YTM = (Annual Coupon / Market Price) × 100% = (6 / 96.25) × 100% = 6.23%
6. IRR Calculation (8.0% Example):

Year	Cash Flow ($)	DF (5%)	PV (5%)	DF (10%)	PV (10%)
0	(94)	1	(94.00)	1	(94.00)
1–5	5	4.329	21.65	3.791	18.96
5	108	0.784	84.67	0.621	67.07

Conclusion:
IRR = 5% + [(10% − 5%) × 12.32 / (12.32 + 7.97)] = 8.0%