Long Term Finance – Equity and Debt Financing

The F2 syllabus expands on our knowledge from the operational level. The F1 paper focused on the short-term financing options but the management level of CIMA looks at more long-term financing solutions.

And this is where we need to understand the role of capital markets (the stock exchange) and the difference between Equity Financing and Debt Financing.

Long-Term Financing

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Most companies will need to find a source of long-term financing in order to grow and expand. Of course, organic growth will result in increased revenue and more available cash but in order to expand a business will usually need a large sum of money to either invest in research and development, buy new fixed assets or to acquire other businesses.

With this in mind, companies need to look at a range of sources for long-term financing and find the best solution for them.

The more traditional methods like long term bank borrowings are fairly straight forward to understand, so I thought it would be best to focus on the role of capital markets and explain the difference between Equity and Debt financing.

The Capital Markets

Otherwise known as the stock market or stock exchange. Most of us have an idea what the stock market is but we need to understand the role it plays for sources of long-term finance for businesses.

For example:

  • Joe Bloggs owns Company A and wants to raise finance through the stock market so it becomes a listed company (this means that Company is listed on the stock market and therefore investors can buy shares in the company).
  • However, in order for Joe to retain control of the company he needs to retain 51% of the shares in Company A.
  • Company A is valued at £400,o00 and is looking to raise £100,000.
  • It’s share price is £50 each – in order to raise the necessary finance they will need to sell 2000 shares (2000 x £50 = £100,000) which means giving away control of 25% of the company.

The above scenario is an example of Equity financing as it involves the company giving away a share of it’s equity (25% of ordinary shares) in return for capital investment.However, capital markets like the stock exchange can also involve debt financing which I’ll briefly explain before looking further into the equity side of things.

Debt Financing

This involves raising long term finance without losing ownership of the company. You might wonder how this is possible if it’s traded on the stock market? Well, bear with me for a moment.

Firstly, Company A would need to have some “security” to offer like fixed assets (land, building etc). Now the company can borrow a fixed amount of money against their security in return they will pay an interest fee without losing any control of the company. This is known as a Debenture (or bond, loan stock or note)

However, if Company A cannot make the repayments to the holder of the debenture then they risk losing their security.

In terms of the capital market; these Debentures CAN be traded by the holder on the stock market – although it’s worth noting that the holder has NO voting rights in the company.

Equity Financing – Ordinary and Preference Shares

As mentioned in our example above; when a company sells shares on the stock market then the ordinary shares of the company are sold to investors. This is the most common form of stock and a dividend is paid to the holder of the stock at the company’s discretion.

Meanwhile, a company also has the option to raise additional finance by offering Preference Shares (or preferred stock). The holder of preference shares do not have voting rights yet they are entitled to a fixed dividend paid each year.

Here is a run down of the different types of preference share and their characteristics.

Convertible Preference Share

– these types of shares are convertible from preference to an ordinary share. The holder has the right to be able to convert the share whenever they want. This maybe the case when the holder would like to have voting rights in the company.

Cumulative Preference Share

– this type of preference share entitles the holder to receive a regular dividend payment no matter what. For example, the company may pay a dividend in year 1 but not year 2 and year 3 – however, the company decides to pay a dividend in year 4 the holder will be paid out the cumulative balances from year 2 and year 3. Ensuring that the holder of the cumulative preference receives a FULL payment from all four years.

Non-Cumulative Preference Share

– as the above example, but the holder will not receive any dividend payment for years 2 and 3 when the company decided not to pay a dividend.

Participating Preference Shares

– this is a progressive type of preference share that entitles the holder an additional payment if the company hits certain targets that are pre-defined. For example, the holder will receive a share of the profits from the existing subsidiary if a specific sales revenue is hit.