Sources of Finance for PLCSources of Finance for PLC

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Table of Contents

Executive Summary...............................................................................................................................3

1. Introduction.......................................................................................................................................4

2. Shares................................................................................................................................................5

2.1 Equity Shares...............................................................................................................................5

2.1.1 Critical Evaluation of Equity Shares.......................................................................................6

2.2 Preference Shares........................................................................................................................6

2.2.1 Critical Evaluation of Preference Shares...............................................................................7

3. Debentures........................................................................................................................................7

3.1 Critical Evaluation of Debentures................................................................................................8

3. Retained Earnings..............................................................................................................................9

3.1 Critical Evaluation of Retained Earnings......................................................................................9

4. Bank Loans.......................................................................................................................................10

4.1 Critical Evaluation of Bank Loans...............................................................................................10

5. Considerations of Choosing Type of Source Use..............................................................................10

5.1 Finance Availability....................................................................................................................11

5.2 Financing Requirements............................................................................................................11

5.3 Repayment Terms......................................................................................................................11

5.4 Cost of Financing.......................................................................................................................11

5.5 Other Considerations.................................................................................................................11

6. Conclusion.......................................................................................................................................12

References:..........................................................................................................................................13

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List of Figures

Figure 1.1 – Source of Finance 04

Figure 1.2 – Types of securities 05

List of Tables

Table 1.1 – Differences between equity and preference shares 07

Table 1.2 – Differences between shares and debentures 08

Table 1.3 – Analysis of sources of finance 12

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Executive Summary

The amount that a company needs for its establishment or growth is based on the nature and

size of its business. The scope of generating long-term finance depends on the sources from

which funds are easily available. This paper discusses and evaluates various sources of

finance available to a public listed company for generating capital internally or externally. A

total of four sources of finance (i.e. shares, debentures, retained earnings, and bank loans) are

identified and evaluated by considering the merits and demerits of each. In addition, these

sources were also evaluated on the basis of each factor that must be considered when a public

listed company is choosing a method of finance. It was found that funds generated from

shares and retained earnings are costless and easy in terms of repayment.

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1. Introduction

Finance is important to effectively run all business operations. In fact, finance is not only

required for starting a business, but it is also needed for its growth. While discussing about

the capitalisation, it has been seen that the amount of long term capital should not be less than

requirement nor it should be more than a requirement. There should be a situation of what

can be called as fair capitalisation. The next question which arises is what should be the

various sources from where the long term capital may be raised? Figure 1.1 illustrates

different sources of finance available to a company for generating funds.

Figure 1.1 – Source of Finance

Source: Sofat and Hiro (2010, p. 456)

These sources of finance can be categorised as owned capital and borrowed capital. Both

contain several securities that a public limited company can use to raise funds. Figure 1.2

shows a clear picture of these securities.

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Figure 1.2 – Types of securities

Source: Chandra and Bose (2006, p. 238)

In this paper, the following four sources of finance available to a public listed company are

discussed and evaluated critically:

Shares

Debentures

Retained Earnings

Bank Loans

2. Shares

A share represents a smallest unit of a company’s overall capital. Normally, a company itself

decides the nominal or face value of its share (MacKie-Mason, 2000). In normal

circumstances, a public limited enterprise can generate long-term finance by issuing two

kinds of shares:

Equity Shares

Preference Shares

2.1 Equity Shares

The financial structure of any company is primarily based on equity shares so this type of

shares is commonly used to raise long-term finance (Porter and Norton, 2009). Most of the

public listed companies use equity shares as their strength to procure other sources of finance.

The share is a company's owned capital which is split into a large number of small equal

parts, each such part being called a share. Those who purchase these shares are called 'equity

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shareholders'. They are the owners of the company. It is a permanent capital and provides a

base to the capital structure of a company (MacKie-Mason, 2000).

2.1.1 Critical Evaluation of Equity Shares

In describing the merits of equity shares as a source of finance, Chandra and Bose (2006)

assert that raising finance from equity shares is a permanent base for any organisation or in

words, it can be said that a company does not need to repay its finances during its lifetime if

it generates funds from equity shares. Therefore, an organisation can acquire funds on

unsecured basis which means that a firm is not required to offer its assets as security to the

investors. The major advantage of equity shares is that the company does not pay fixed

dividends to the shareholders (Singla, 2007). The dividend payout ratio depends upon the

earnings of the company in a single financial year. Likewise, Chandra and Bose (2006)

referred equity shares as a risk free source for generating long-term finance where an

organisation does not perpetrate anything in return.

Singla (2007) on the other hand argued that raising funds through equity shares can be an

expensive option for the organisation because the associated cost of these shares is higher

than the cost of a borrowed capital. Also, if the company will issue equity shares in excess

then it will lose the cost advantage that will result in over capitalisation. Ross (2007) asserts

that if the company wants to issue additional equity shares, it is under legal obligation to offer

these equity shares to the existing shareholders first, before going to the open market as a

general offer. This right of equity shareholders is called “Pre-emptive Right”. Chandra and

Bose (2006) outline that if a public listed company will only consider equity shares for

generating funds, then it might not able to trade by issuing other securities in the long run.

2.2 Preference Shares

Preference shares are the shares which have the privilege over equity shares on the basis of

following two factors. In case of preference shares, the dividend payout ratio is fixed and

shareholders are paid fixed dividends over the period (Ferran, 2008). The amount invested in

preference shares is paid back to shareholders in case of winding up of the organisation. This

amount is basically paid back before paying back investments to equity shareholders (Quiry

et al., 2011).

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2.2.1 Critical Evaluation of Preference Shares

Funds acquired by an organisation through preference shares are needed to pay back before

the company winds up (Ferran, 2008) and this is the reason that according to the provisions

of section 80 of the Companies Act, any company in the UK cannot issue preference shares

more than 20 years of duration. As such, unlike equity shares, preference share is not a

permanent capital available for the company (ibid). In addition, companies are bound to pay

fixed dividends to shareholders which is payable by the company out of the profits earned.

However, unlike equity shares, the rate of dividend is prefixed and precommunicated to the

investors (Smart and Megginson, 2008). On the other hand, same like equity shares, an

organisation can acquire funds on unsecured basis using preference shares which means that

a firm is not required to offer its assets as security to the investors (Quiry et al, 2011). Table

1.1 illustrates clear distinctions between equity shares and preference shares.

Table 1.1 – Differences between equity and preference shares

Source: Chandra and Bose (2006, p. 242-243)

3. Debentures

A debenture often refers to a document from any organisation that contains an acceptance of

indebtedness, providing a responsibility to repay the debt within a specific time period. In

other words, it can be said that debenture is a loan certification which shows that company is

accountable to pay a specific amount including interest within specific time period to

debenture holders. The finance arranged through debentures later on turns into a part of

organisations’ capital structure but it does not become a part of company’s share capital. The

interest on debentures is a charge on the profit and loss account of the company (Ahmed,

2007). The debenture holders are not the company owners (Leland, 2004); they in fact are the

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company’s creditors who provided finance to the company. The interest rate on debentures is

fixed and determined at the beginning of the contract. Funds arranged through debentures are

needed to pay back to debenture holders during the lifetime of the enterprise.

3.1 Critical Evaluation of Debentures

The cost associated with debentures is comparatively less than the associated cost of equity

shares (Singla, 2007). The organisations sometimes borrow many small loans for a short

period of time which may prove to be expensive sources of generating funds. The companies

can however convert all those amounts into a single issue of debentures which can be

beneficial for them in terms of cost (Leland, 2004). In addition, the debenture holders are not

the company owners so they do not have right of voting. This means that the controlling

position of present shareholders is not affected when a company issues debentures (Chandra

and Bose, 2006). Using debentures, any organisation can acquire funds on secured basis

which means that a firm is required to offer its assets as security to the investors.

In the books of finance, raising funds using debentures is not encouraged and considered as a

cheap source of arranging finance because it is a very risky step for the company (Ahmed,

2007). Raising funds through debentures can be risky for the firms in two ways. First, the

organisation is required to pay interest at pre-settled rate within pre-settled time period

irrespective of unavailability of revenues. Secondly, a firm is required to pay back principal

amount during its lifetime. In case, if the company is not earning stable profits or the demand

of its commodities is highly elastic, then it is a very risky step for the company to generate

funds through debentures. Therefore, issuing debentures cannot fulfil the requirement of

raising long-term funds for a trading business because it may not have adequate fixed assets

to be offered as security (Brigham and Gapenski, 1998). Table 1.2 differentiates debentures

with shares on the basis of their characteristics.

Table 1.2 – Differences between shares and debentures

Shares Debentures

Element of company’s ownership capital Element of company’s creditor-ship capital

Company pays dividend Company pays interest

Dividend payable in case company gets profit Interest payable in case of profit/loss

Shares can be issues at discount with legal restrictions

Debentures can be issued at discount without legal restrictions

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No charges payable to shareholders on assets of company

Charges are payable to debenture holders on assets of company

Shareholders have no prior claim over debenture holders in case of winding up

Debenture holders have prior claim over shareholders in case of winding up

Source: Chandra and Bose (2006, p. 246)

3. Retained Earnings

Retained earnings is also a well-known source of generating long-term capital which denotes

the profit of the company which is not actually given away as dividend, instead, keeping it

aside for several purposes such as expansion of the business, modernisation, acquiring new

assets or latest technology, meeting the requirement of working capital, or debt redemption

(Asquith and Mullins, 2006). However, this source can be advantageous for the company but

proper balance is to be maintained as regular use of this source would result in resentment of

shareholders.

3.1 Critical Evaluation of Retained Earnings

A number of benefits of using retained earnings as an internal source of finance to a public

listed company are mentioned by several experts. For example, Sofat and Hiro (2010) regard

retained earnings as a low-cost source of financing that helps an organisation not to raise

funds from outside financing agencies or banks. In this way, it minimises the reliance of

external sources of finance. Similarly, it makes company more finally stronger by increasing

its credit worthiness (Gitman and McDaniel, 2008). Millichamp (2001) mentioned that

retained earnings enables an organisation to adopt a stable dividend policy. Some other

benefits of retained earnings as a source of financing are: self-reliance, smooth business

operations, no legal formalities, enhance business reputation, withstand in difficult situations,

and increase in capital formation (Chandra and Bose, 2006; Gitman and McDaniel, 2008;

Sofat and Hiro, 2010).

On the other hand, it is argued that funds can be used inappropriately which can lead distrust

or unrest of shareholders (Millichamp, 2001). Chandra and Bose (2006) assert that using

retained earnings are a source of finance may result in over-capitalisation and it also affects

the balanced industrial growth of a public limited company. Sofat and Hiro (2010) added that

retained earnings may be misused by the management to speculate and increase the share’s

value.

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4. Bank Loans

Over the past few decades, long-term bank loans have become an encouraging source for

companies to meet the requirements of long-term funds generation (Chandra and Bose,

2006). The advances in the operations of commercial banks make it easy for public listed

companies to obtain long-term loans. Asquith and Mullins (2006) state that bank loan plays a

very important role in the conditions of the credit constricts. Usually, the banks urge

companies to obtain long-term loans at a higher rate of interest for a specific time period.

4.1 Critical Evaluation of Bank Loans

The organisations find bank loans as one of the most attractive sources for funds generation

due to following reasons. Nowadays, raising funds by means of taking a bank loan is more

convenient to companies than borrowing funds from other methods in terms of secure

transaction and generating quick finance (Gitman and McDaniel, 2008). In addition, a large

amount of money can be borrowed when required. The company can raise the funds which

can be used for any purpose. The ultimate utilisation of raised funds through a bank loan does

not committed by the organisation (Smart and Megginson, 2008). Asquith and Mullins

(2006), bank loans are reliable and certain. This means that banks will give loans when an

organisation is prospering as well as to support the company in crisis.

In spite of above mentioned advantages, bank loan is subject to a number of disadvantages.

For instance, in the opinion of Sofat and Hiro (2010), borrowing money from financial

institution such as bank is a tiresome job which involves the fulfilment of several procedural

requirements. For example submission of periodical statements, security requirements,

margin money stipulation etc. Similarly, Chandra and Bose (2006) mentioned that the interest

rate which organisation pays on bank loans is relatively higher than the interest rate payable

on finance generated from other sources.

5. Considerations of Choosing Type of Source Use

A number of factors must be considered when a public listed company is choosing a method

of finance. These factors are as follows:

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5.1 Finance Availability

The first consideration when choosing a type of source use is to evaluate different alternative

sources for finance availability. Most of the public listed companies usually do not rely on a

single source for cash needs (Keller, 2011).

5.2 Financing Requirements

Financial requirements are different for each source of finance for a limited company. Some

common requirements include financial ratio tests like interest coverage ratio and debt to

equity ratio, credit score requirements, legal requirements, and permissions from stakeholders

or debenture holders. Lumby and Jones (2003) emphasised the need to ensure all

prerequisites before the final decision of choosing a specific source of finance.

5.3 Repayment Terms

It is also to consider how long funds agreement is structured to end. Long-term borrowings

may require a considerable amount of interest over time. In contrast, short-term borrowings

can save a large amount of interest (Dillon, 1985). If there is no loan, then no interest expense

is required. In addition, it is also important to consider the periodic payments to repay

borrowings in order to avoid difficulties (ibid). Carmichael et al (2007) believe that it is

better practice for companies to look for borrowings with a higher allocation to principal to

reduce the overall cost.

5.4 Cost of Financing

It is also important to consider all interrelated costs with each financing type before reaching

a final decision (Ogilvie, 2009). Some common costs associated with sources of finance may

include origination fees, interest rates, broker’s fees, application fee in case of loan, dividend

payments, venture capitalist etc. Furthermore, financing via stock offerings can result in

management change and a move in strategic focus (ibid).

5.5 Other Considerations

An asset or collateral is required to be considered when selected a particular source of finance

because the lenders may liquidate company’s assets for payments. Therefore, it is better

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practice to read the loan documents carefully. Similarly, the amount of financing does matter

as well.

Table 1.3 contains an analysis of different sources of finance on the basis of each factor that

must be considered when a public listed company is choosing a method of finance.

Table 1.3 – Analysis of sources of finance

6. Conclusion

The long-term finance refers to the permanent source of finance. The financial sources are

broadly classified into share capital (both equity and preference) and debt (including

debentures, long-term borrowing). A total of four sources of finance are discussed in this

paper. These sources are evaluated on the basis of their advantages and disadvantages. In

addition, a number of factors that must be considered when a public listed company is

choosing a method of finance are also included in this paper. To find out which source of

finance out of a total of four is better, the author analysed these sources on the basis of each

factor that must be considered in selecting a method of finance. It was found that funds

generated from shares and retained earnings are costless and easy in terms of repayment (see

table 1.3).

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Chandra, D. and Bose, C. (2006). Fundamentals of Financial Management. PHI Learning Pvt. Ltd

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Ferran, E. (2008). Corporate Finance Law. Oxford: Oxford University Press

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Leland, H. E. (2004).Corporate Debt Value Bond Covenants, and Optimal Capital Structure. Journal of Finance, 49, pp. 1213-1252.

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