ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Sources of Finance - Notes ^{4 / 9}

Debt v Equity

These are the things you need to think about when asked about raising finance - so just put all these in your answer and link them to the scenario. Job done.

• Gearing and financial risk

  Equity finance will decrease gearing and financial risk, while debt finance will increase them

• Target capital structure

  The aim is to minimise weighted average cost of capital (WACC).

  In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress)

• Availability of security

  Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets).

• Economic expectations

  If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead.

• Control issues

  A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.

Rights Issues

A 1 for 2 at $4 (MV $6) right issue means….

The current shareholders are being offered 1 share for $4, for every 2 they already own. 

(The market value of those they already own are currently $6)

• Calculation of TERP (Theoretical ex- rights price) 

  The current shareholders will, after the rights issue, hold:
  1 @ $4 = $4
  2 @ $6 =$12

  So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33

• Effect on EPS

  Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for them

  To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue

  Eg Using the above illustration
  EPS x 5.33 / 6

• Effect on shareholders wealth

  There is no effect on shareholders wealth after a rights issue. 

  This is because, although the share price has fallen, they have proportionately more shares

  Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up the right

The factors considered when reducing the amount of debt by issuing equity :

As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs.

Companies with high levels of financial distress would find it more costly to contract with their stakeholders. 

For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms.

1. Less financial distress may therefore reduce the costs of contracting with stakeholders.

2. Having greater equity would also increase the company’s debt capacity. 

   This may enable the company to raise additional finance

3. On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield.

4. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.