SESSION 08 EQUITY FINANCE

0801
OVERVIEW
Objective
To understand the options available to a company considering an issue of equity funds.




DIVIDEND
POLICY
METHODS OF
SHARE ISSUE
OTHER TYPES OF
SHARE ISSUE
Quoted
Unquoted
Considerations
Official Listing
AIM Listing
Rights issue
Enterprise Investment Scheme
Venture capital
Bonus issue
Stock splits
Scrip dividends
INTERNAL
EQUITY FINANCE
Stable
Constant payout ratio
Residual dividend policy
Clientele theory
Bird in the Hand Theory
Dividend Irrelevance Theory
Share Buy Back Programmes
Special Dividends
Practical considerations
EQUITY
FINANCE DIVIDENDS

SESSION 08 EQUITY FINANCE
0802
1 METHODS OF SHARE ISSUE
1.1 New shares quoted companies
If a company is already listed the following methods are available for the issue of new
shares.
Method Explanation
Offer for subscription
(public issue)
A sale direct to the general public. This is generally the most
expensive method of issuing new shares.
Offer for sale A sale indirect to the public via selling shares directly to an issuing
house (merchant/investment bank) which then sells them to the
public.
Placing In a placing the sponsor (normally a merchant bank) places the
shares with its clients. At least 25% of shares placed must,
however, be made available to the general public. This is
generally the least expensive method of issuing new shares.
Rights issue An offer to existing shareholders to buy shares in proportion to
their existing holdings.
Offer for sale or
subscription by tender
Like an auction the public is invited to bid for shares. Useful
where setting a price for the shares is difficult.
Vendor placing Sometimes used in takeovers when a predator company buys a
target company by offering its own shares but pre-arranges third
party buyers for those shares. The result is that the target
company shareholders are confident that they will be able to sell
the shares they receive in the predator company.
1.2 Options for unquoted companies
Become quoted, i.e. raise new equity finance at the same time as becoming listed
known as an IPO (Initial Public Offering) The method could be an offer for
subscription or sale, tender, or placing.
Stay unquoted. Use rights issue or private placing. However there may be a limited
source of funds from either existing owners or new private investors.
Introduction. Existing shares are given permission to be traded/floated on the Stock
Exchange. No new finance is raised. Public must already hold at least 25% of the shares
in the company.
Commentary

The terms quoted, floated and listed all refer to the same thing i.e. shares which
are traded on a stock exchange.


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Many small or medium sized enterprises (SMEs) find that raising equity is difficult. This is
an acknowledged problem and has been addressed by both government and commerce.
Attempted solutions include the AIM, Enterprise Investment Schemes, Venture Capital and
Venture Capital Trusts (discussed later).
1.3 Considerations when considering a share issue
Legal restrictions;
Cost e.g. fees must be paid to an investment bank to underwrite/guarantee the share
issue
Pricing problems;
Stock Exchange rules as contained in the Yellow Book;
Timing.
1.4 The requirements for an Official Listing
Before the shares of a company can receive an Official Listing i.e. become traded on the full
London Stock Exchange, the following requirements must be met:
The market capitalisation (value) is at least 700,000;
There is a three year trading record;
At least 25% of the shares are made available to the general public;
Detailed disclosure requirements are met;
Any new issue of shares is accompanied by a detailed prospectus.
The costs of acquiring and maintaining an Official Listing mean that it is not really a
possibility for Small or Medium-sized Enterprises (SMEs). These companies may find the
AIM market more attractive.
1.5 The requirements for an Alternative Investment Market (AIM) Listing
The AIM market has fewer regulations and in this way is attractive to smaller companies.
Investors recognise that due to the more limited regulation, investment in AIM companies
carries additional risk.
The requirements include:
Companies must have plc or equivalent (if non-UK) status;
The accounts must conform to UK or US accounting practice;
A prospectus must be published prior to the initial quotation and any following issue of
securities;
The company must appoint a nominated advisor which may be an investment bank,
accountancy or law firm to ensure that it understands and obeys the rules of the market.
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0804
1.6 Rights issue
In a rights issue existing shareholders are offered more shares (usually at a discount to the
current market price) in proportion to their existing holding.
UK company law guarantees shareholders pre-emptive rights i.e. the right to purchase
new shares before they can be offered to other investors. This is to protect shareholders from
dilution of their control
The result of issuing these shares at a discount is to reduce the market value of all the shares
in issue.
Calculation of a theoretical ex-rights price.
Example 1

A company has 100,000 shares with a current market price of $2 each.
It then announces that it is to take on a project with a NPV of $25,000.
The project will be financed by a rights issue of one new share for every two
existing shares. The rights price is $1 per new share.
Required:
What is the theoretical ex-rights price of the companys shares?





Shareholder wealth and rights issues
Example 2

Assume in Example 1 above that Mr X owns 1,000 shares in the company.
Required:
Show Mr Xs position if:
(i) he takes up his rights;
(ii) he sells his rights;
(iii) he does nothing.

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1.7 Enterprise Investment Scheme (EIS)
A UK scheme designed to encourage private investors to buy shares in unlisted trading
companies.
Tax relief, at an income tax rate of 20%, is available for investors.
Maximum investment is 100,000 per annum
Shares must be held for five years.
1.8 Venture capital
What is it?
Venture capital simply means equity capital for small and growing businesses. It
includes funds provided for management buy-outs. Typically $1m minimum is
involved.
Who provides it?
Specialist venture capital providers, e.g. Investors In Industry (the 3i Group);
Banks, insurance companies, pension funds;
Local authorities and development agencies.
What do they look for?
Product with strong potential e.g. a new innovation ;
Solid management;
High returns.
What conditions are normally attached?
Providers of funds would normally expect:
a business plan with medium-term cash flow and profit projections ;
board representation;
a dividend policy which promotes growth i.e. high reinvestment of profits;
an exit route e.g. proposed time-scale for seeking a market quotation;
provision of regular management accounting information.

Venture Capital Trusts (VCTs)
VCTs are listed investment trust companies which invest at least 70% of their funds
in a spread of small unquoted trading companies.
An investment trust company one is which invests in other companies.
The UK government gives tax incentives to individual investors in VCTs
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2 INTERNAL EQUITY FINANCE
As an alternative to issuing new shares (or debt) a company can finance its investment
projects using retained earnings i.e. using internal finance rather than external finance.
The amount of internal finance available = cash generated from operations dividend
payments.
Creating accounting profits is not enough the company must be converting profits
into positive cash flows.
Note that Microsoft did not pay any dividends for many years - it reinvested all cash to
produce growth of the company and its share price. Any shareholder that required a
dividend could simply sell some shares to take a capital gain and create a home- made
dividend.
Company managers may prefer to use internal finance rather than external finance for
the following reasons:
a belief that using internal finance costs nothing in fact this is not true as retained
earnings belong to the shareholders who expect significant returns.
asymmetry of information external investors do not have as much knowledge
of the business as the management and are therefore often reluctant to provide
finance or will only provide it at high cost. This is particularly significant for SMEs
which often have problems attracting new investors due to little public knowledge
of the business. Using internal finance avoids the problem.
no issue costs on internal finance
internal finance avoids possible change in control due to issue of new shares
taxation position of shareholders: - they may prefer to make a capital gain than
receive current income via dividends e.g. in the UK individuals are given a large
tax-free limit on capital gains.
This preference for internal finance has been refereed to as Pecking Order Theory
3 DIVIDEND POLICY
3.1 Stable
Stable level of dividends or constant level of growth to avoid sharp movements in share
price.
Maintains the level of dividends in the face of fluctuating earnings.
Very common approach for quoted companies.
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3.2 Constant payout ratio
Constant proportion of earnings paid out as dividend;
Not particularly suitable as dividends will fluctuate.
3.3 Residual dividend policy
Remaining earnings, after funding all attractive projects, are paid out as dividend i.e.
dividend = cash generated from operations capital expenditure.
Links to Pecking Order Theory i.e. a dividend is only paid if more cash is available than
required for reinvestment back into the business.
However it is likely to lead to fluctuating dividends and may not particularly suitable
for quoted companies.
3.4 Clientele theory
The companys historical dividend policy may have attracted particular investors to
whom the policy is suited in terms of tax, need for current income, etc
The company should then maintain a stable dividend policy or risk losing key investors.
Management should view shareholders as their clientele
3.5 Bird in the Hand Theory
Shareholders may prefer higher dividends (and therefore lower potential capital gains)
as a cash dividend today is without risk whereas future share price growth is uncertain.
3.6 Dividend Irrelevance Theory
Modigliani and Miller (finance theorists) argue that shareholders are indifferent to
dividend policy.
If a company pays no dividend then the share price should rise due to reinvestment of
earnings. Any shareholder that requires a dividend can sell part of their holding to
create a capital gain i.e. to manufacture a home made dividend.
3.7 Share Buy Back Programmes
In recent years there has been a trend for traditional dividend payments to be replaced
by share repurchase schemes.
With approval from shareholders the company uses surplus cash to buy back part of its
share capital, on the assumption that shareholders can reinvest this cash more
effectively than the company.
The buy back 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.
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The shares are either cancelled as held by the company as Treasury Shares for possible
future reissue. If held by the company the shares carry no voting rights or dividend.
The result of a buy back programme is that there will be fewer shares in issue, and
hence the share price should rise.
Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also
improve.
3.8 Special Dividends
If a quoted company announces a larger than expected dividend this may raise market
expectations of at least the same in future.
To avoid raising expectations to an unsustainable level the dividend may be announced
as a special dividend basically a bonus dividend.
The company is telling 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.
3.9 Practical considerations
Company law - a dividend can only be legally paid if there is a credit balance on
retained earnings in the statement of financial position.
Level of inflation.
Liquidity position.
Stability of earnings if earnings are stable, a larger dividend can be more easily
maintained.
Signalling dividend announcements are seen by the financial markets as a sign of
company strength/weakness.
4 OTHER TYPES OF SHARE ISSUE
4.1 Bonus issue
Reserves e.g. revaluation reserve is converted into share capital which is distributed as
new shares to existing shareholders in proportion to their existing holdings.
No finance is raised
Purpose Increases the marketability of the shares, as it increases the number in
existence and reduces their price.
Bonus issues can also be referred to as Scrip Issues or a Capitalisation of Reserves.
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4.2 Stock splits
Where ordinary shares are split in value, e.g. $1 shares converted into two 50 cent
shares.
This reduces the market price per share, increasing their marketability.
4.3 Scrip dividends
Shareholders are offered extra shares instead of a cash dividend.
This preserves corporate liquidity and releases cash for reinvestment back into the
business - linking to Pecking Order Theory

Key points

Ordinary shareholders take more risk than any other type of investor in a
company.
This is because (i) ordinary dividends are discretionary i.e. the company has
no legal obligation to pay an ordinary dividend (ii) 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.
However sometimes a new share issue is the only available source of
finance and therefore you need to be familiar with the methods of issue
available to both listed and unlisted companies.


SESSION 08 EQUITY FINANCE
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FOCUS
You should now be able to:

describe the methods available for issuing new shares;
describe ways in which a company may obtain a stock market listing;
calculate the theoretical ex-rights price of a share;
explain the importance of internally generated funds;
discuss the main dividend policies followed by companies;
explain the purpose and impact of a bonus issue, scrip dividends and stock splits;
discuss the financing problems of small and medium sized enterprises (SMEs);
suggest appropriate sources of equity finance for SMEs e.g. AIM, venture capital, EIS.
SESSION 08 EQUITY FINANCE
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EXAMPLE SOLUTIONS
Solution 1
Ex-rights price
=
rights - ex shares of No.
NPV + issue rights of Proceeds + issue rights - pre shares old of MV


=
000 , 50 000 , 100
000 , 25 $ ) 1 $ 000 , 50 ( ) 2 $ 000 , 100 (
+
+ +
= $1.83
Value of a right per new share
= Ex-rights price Subscription price
= $1.83 $1 = 83c
Value of a right per existing share
= 83c 2 = 41c
Note - If the market price of the existing shares had been given post the announcement of the
project, then the NPV of $25,000 would already be included in the MV of the old shares.
This is the more usual circumstance.
Solution 2
(i) Takes up rights
$
Wealth prior to rights issue 1,000 $2 2,000

______

Wealth post rights issue 1,500 $1.83
1
/3 2,750
Less Rights cost 500 $1 (500)

______
2,250

______

$250 better off
SESSION 08 EQUITY FINANCE
0812
(ii) Sells rights
$
Wealth prior to rights issue 1,000 $2 2,000

______
Wealth post rights issue
Shares 1,000 $1.83
1
/3 1,833
1
/3
Sale of rights 500 $0.83
1
/3 416
2
/3

______
2,250

______

$250 better off
(iii) Does nothing
$
Wealth prior to rights issue 2,000

______

Wealth post rights issue 1,833
1
/3

______

Loss of $166