Welcome to the World of Long-Term Finance!
In your F2 studies, you’ve likely looked at how to report the numbers, but have you ever wondered where a company actually gets the millions (or billions!) of dollars it needs to build a new factory or acquire a competitor? That is what this chapter is all about.
We are diving into Markets for Long-Term Funds. Think of this as a giant marketplace where companies "shop" for money and investors "shop" for opportunities to grow their wealth. Don't worry if this seems like a lot of jargon at first—we will break it down step-by-step!
1. The Big Picture: Primary vs. Secondary Markets
Before we look at specific types of money, we need to understand where the trading happens. The capital market is split into two main areas:
The Primary Market
This is where new securities (shares or bonds) are created and sold for the first time. The money goes directly from the investor to the company.
Analogy: Buying a brand-new car directly from the manufacturer's showroom. The money you pay goes to the car company to help them build more cars.
The Secondary Market
This is where investors trade existing securities with each other (like the London Stock Exchange or the New York Stock Exchange). The company that originally issued the shares does not get any money from these trades.
Analogy: Buying a used car from a friend. The car company doesn't get any of that cash; it just changes hands between you and your friend.
Quick Review:
- Primary: Company gets the cash. New shares/bonds created.
- Secondary: Investors trade with each other. Provides "liquidity" (the ability to turn investments back into cash quickly).
2. Raising Equity Finance
Equity finance means selling a piece of the business. When a company issues Ordinary Shares, it is inviting people to become part-owners.
Methods of Issuing Shares
1. Initial Public Offering (IPO): A private company "goes public" for the first time. It’s expensive and involves a lot of legal paperwork, but it raises huge amounts of capital.
2. Placing: Shares are offered to a small group of "big" investors (like pension funds) rather than the general public. It's faster and cheaper than an IPO.
3. Rights Issue: Offering new shares to existing shareholders at a discount to the current market price. This is a very common F2 topic!
Focus on: Rights Issues
In a rights issue, the company gives current shareholders the "right" to buy more shares in proportion to what they already own (e.g., a "1 for 4" rights issue means for every 4 shares you own, you can buy 1 new one).
Why do companies do this? It's cheaper than an IPO and avoids "diluting" the control of existing shareholders if they all take up their rights.
Key Formula: Theoretical Ex-Rights Price (TERP)
When a rights issue happens, the share price usually drops because new shares are being sold at a discount. We calculate the expected new price using this formula:
\( \text{TERP} = \frac{(\text{Market value of existing shares} + \text{Cash raised from new shares})}{\text{Total number of shares after the issue}} \)
Key Takeaway: Equity finance doesn't have to be paid back, but you are giving away ownership and future dividends. It's often seen as "expensive" because investors demand higher returns for the higher risk they take.
3. Raising Debt Finance
Debt finance is simply borrowing money. The company must pay interest (the "coupon") and eventually pay back the original amount (the "principal").
Common Types of Long-Term Debt
1. Debentures/Bonds: Written acknowledgments of a debt. They can be traded on the secondary market.
2. Deep Discount Bonds: Issued at a price much lower than their "face value." The investor makes money from the massive jump in value at the end rather than high annual interest.
3. Zero-Coupon Bonds: No annual interest at all! You buy it cheap and get the full face value at the end.
4. Convertible Bonds: These are "hybrid" instruments. They start as debt (paying interest), but the investor has the option to turn them into shares at a later date.
Why use them? They usually have a lower interest rate because the "option" to get shares is valuable to the investor.
Did you know?
Debt is often cheaper for a company than equity because interest payments are tax-deductible. This is known as the "tax shield."
4. Islamic Finance: A Special Source of Funds
CIMA requires you to understand the basics of Islamic finance, which operates on Sharia principles. The most important rule? Interest (Riba) is forbidden.
So, how do they raise money?
- Sukuk: These are often called "Islamic bonds." Instead of paying interest, the investor earns a share of the profit generated by an underlying asset.
- Murabaha: A "cost-plus" arrangement. The bank buys an asset and sells it to the company at a markup, allowing the company to pay in installments.
- Ijara: Very similar to a lease. The bank owns the asset and the company pays rent to use it.
Memory Aid: Think of Islamic finance as "Risk Sharing." Rather than just lending money for a fixed fee (interest), the "lender" and "borrower" share the risks and rewards of the project.
5. Choosing the Right Source of Funds
Deciding between Debt and Equity is like a balancing act. Here is a quick comparison to help you remember the pros and cons:
1. Risk:
- Debt: High risk for the company (must pay interest even if making a loss). Low risk for the investor (they are first in line if the company goes bust).
- Equity: Low risk for the company (dividends are optional). High risk for the investor (they are last in line if the company goes bust).
2. Control:
- Debt: No voting rights. Lenders don't own the company.
- Equity: Shareholders have voting rights and can influence how the company is run.
3. Cost:
- Debt: Cheaper (lower interest rates + tax relief).
- Equity: More expensive (investors want a high return for taking high risks).
Common Mistakes to Avoid
1. Confusing Bonus Issues with Rights Issues: A bonus issue is free shares (no cash is raised). A rights issue involves selling shares (cash is raised).
2. Forgetting Tax: When comparing debt and equity, always remember that interest is tax-deductible, but dividends are not. This makes debt look more attractive on paper!
3. Mixing up Primary/Secondary: Remember, the company only gets the cash in the Primary market.
Summary Checklist
Before moving on, make sure you can:
- Explain the difference between primary and secondary markets.
- Define a Rights Issue and understand why a company would use one.
- Describe Convertible Bonds and why they might have lower interest rates.
- Identify the key difference between Sukuk and traditional bonds (No interest!).
- Compare the pros and cons of Debt vs. Equity.
Keep going! You're doing great. Financing capital projects is the backbone of financial strategy, and once you master these basics, the complex calculations will become much clearer.