Welcome to Long-Term Debt and Equity Finance!
Hello there! Welcome to one of the most practical chapters in your F2 journey. Think of this chapter as the "shopping for money" guide for big businesses. When a company wants to build a new factory or launch a global product, they rarely have all that cash sitting in a drawer. They need to find it elsewhere.
In this section, we are going to explore the two main "buckets" of money: Equity (money from owners) and Debt (money from lenders). Understanding how these work is vital because how a company raises money changes its financial statements and its risk profile. Don't worry if this seems like a lot of jargon at first—we will break it down into bite-sized pieces!
1. Equity Finance: Sharing the Ownership
Equity finance is money raised by selling a piece of the company. If you buy a share, you become a part-owner. Unlike a loan, the company doesn't usually have to "pay back" the equity, but they might share their profits with you through dividends.
Ordinary Shares
These are the most common type of shares. If you hold ordinary shares, you usually have voting rights (you can have a say in how the company is run) and the right to a dividend (but only if the directors decide to pay one).
The Rights Issue
A Rights Issue is when a company offers new shares to its existing shareholders, usually at a discount to the current market price. It’s like a "members-only" sale.
Why do it? It’s cheaper and faster than finding new investors. To calculate the value after a rights issue, we use the Theoretical Ex-Rights Price (TERP).
Step-by-Step TERP Calculation:
1. Find the value of existing shares (Number of shares × Market Price).
2. Find the value of new shares (Number of new shares × Issue Price).
3. Add these together to get the Total Value.
4. Divide the Total Value by the Total Number of Shares (Old + New).
\( \text{TERP} = \frac{(\text{Existing Shares} \times \text{Market Price}) + (\text{New Shares} \times \text{Issue Price})}{\text{Total Shares}} \)
Bonus Issues
A Bonus Issue is when a company gives out free shares to existing shareholders. No cash changes hands! It's like a pizza shop cutting the same pizza into 12 slices instead of 8. You have more pieces, but the same amount of pizza.
Quick Review:
• Rights Issue: Shareholders pay for new shares at a discount.
• Bonus Issue: Shareholders get new shares for free; it just reshuffles the "Equity" section of the Balance Sheet.
2. Debt Finance: Borrowing the Money
Debt finance is money borrowed from outside sources. You have to pay it back, and you usually have to pay "rent" on that money in the form of interest.
Bonds and Debentures
A Bond (or Debenture) is a formal contract where the company borrows money for a set period at a fixed interest rate (the coupon rate). Unlike equity, interest must be paid even if the company makes a loss. This makes debt "riskier" for the company but "safer" for the lender.
The "Substance Over Form" Rule (IAS 32)
This is a favorite topic for examiners! Sometimes things look like equity but are actually debt. Under IAS 32 Financial Instruments: Presentation, we look at the substance (the reality) of the deal, not just its legal name.
The Golden Rule: If the company has a contractual obligation to deliver cash (like mandatory interest or a mandatory repayment), it is Debt (a Financial Liability). If the company can choose whether or not to pay, it is Equity.
Preference Shares: Are they Debt or Equity?
Don't let the word "Share" fool you! You must check the terms:
• Redeemable Preference Shares: These must be paid back at a certain date. Because there is an obligation to pay back the cash, they are treated as Debt (Liability).
• Irredeemable Preference Shares: The company never has to pay the principal back. These are usually treated as Equity.
Key Takeaway: If you must pay it back or must pay a dividend, the accounting world calls it a liability.
3. Hybrid Finance: The Best of Both Worlds?
Sometimes, companies use "hybrid" instruments that start as debt but can turn into equity.
Convertible Bonds
A Convertible Bond gives the lender a choice: at the end of the term, they can either take their cash back OR swap the bond for a certain number of shares. Because it has two parts (the loan and the option to swap), we use Split Accounting.
How Split Accounting Works:
1. Calculate the value of the Liability (the present value of the future cash payments).
2. The leftover amount (The Total Proceeds minus the Liability) is the Equity component.
Warrants
A Warrant is a "ticket" that gives the holder the right to buy shares at a fixed price in the future. They are often given to lenders as a "sweetener" to encourage them to lend money at a lower interest rate.
Did you know? Companies love convertible debt because the "option" to convert is valuable to investors. This allows the company to pay a lower interest rate than a normal bond!
4. Comparing Debt and Equity (The Pro-Con List)
Choosing between debt and equity is a balancing act. Here is a simple way to remember the differences:
Equity (Ordinary Shares):
• Cost: Usually higher (investors want higher returns for the risk).
• Risk: Lower for the company (no mandatory payments).
• Control: Dilutes ownership (more owners = more opinions).
• Tax: Dividends are NOT tax-deductible.
Debt (Bonds/Loans):
• Cost: Lower (interest rates are usually lower than expected equity returns).
• Risk: Higher for the company (must pay interest and principal).
• Control: No dilution (lenders don't get to vote).
• Tax: Interest IS tax-deductible (the "Tax Shield").
Memory Aid: Think of Debt as Dangerous but Deductible (for tax). Think of Equity as Expensive but Easy-going (no fixed repayment).
5. Common Pitfalls to Avoid
• Treating all "Shares" as Equity: Remember to check if preference shares are redeemable! If they are, they belong in Liabilities, and their "dividends" are actually interest expenses in the P&L.
• Mixing up Bonus and Rights Issues: In a bonus issue, no cash comes in. In a rights issue, cash flows into the company.
• Forgetting the Tax Shield: When comparing costs, remember that debt interest reduces the tax bill, making it even cheaper than it looks.
6. Summary Key Points
• Ordinary Shares represent ownership and carry the most risk for investors.
• Rights Issues raise cash from existing owners at a discount.
• IAS 32 requires us to classify instruments based on whether a contractual obligation to pay cash exists.
• Convertible Debt is a "compound instrument" that must be split into debt and equity components.
• Gearing (the ratio of debt to equity) is a key measure of a company’s financial risk.
Don't worry if the calculations for TERP or Split Accounting take a few tries to master. They are mechanical processes—once you practice the steps three or four times, they will become second nature! You've got this!