Welcome to Capital Structure and Finance Costs!
Ever wondered how a massive company like Apple or Coca-Cola gets the money to build new factories or develop the next big iPhone? They don't just find it under a mattress! They raise "Capital." In this chapter, we will explore where that money comes from (Capital Structure) and what it costs the company to use that money (Finance Costs). Don't worry if this seems a bit "corporate" at first—we’ll break it down using simple everyday examples.
1. What is Capital Structure?
Think of Capital Structure as a recipe. To start a business, you need ingredients. Some of those ingredients you own (Equity), and some you have to borrow from a neighbor (Debt). Capital Structure is simply the mix of Equity and Debt that a company uses to fund its operations.
Equity: This is the owners' stake in the business. It includes the money the owners put in and the profits the company has kept over the years.
Debt: This is money borrowed from outside sources, like banks. It must be paid back, usually with interest.
Quick Review:
• Equity = Ownership (Ordinary shares, Share premium, Retained earnings).
• Debt = Borrowing (Bank loans, Loan notes/Debentures).
2. Equity: Issuing Ordinary Shares
When a company wants to raise money without taking a loan, it sells "pieces" of itself called Ordinary Shares. There are two important values you need to know:
1. Nominal Value (Par Value): This is the "face value" of the share, often something small like $1 or $0.50. It’s a legal requirement, but it’s rarely what people actually pay for the share.
2. Market Value (Issue Price): This is what the investor actually pays the company.
The Accounting Entry for Issuing Shares:
When a company sells a $1 nominal share for $3, the $2 "extra" goes into a special account called the Share Premium account.
The Journal Entry:
\nDr Cash (Total amount received): \( \$3.00 \)
Cr Share Capital (Nominal value only): \( \$1.00 \)
\nCr Share Premium (The "extra" amount): \( \$2.00 \)
Common Mistake to Avoid: Never put the full cash amount into the Share Capital account! Only the nominal value goes there. Think of the Share Premium account as the "VIP Tip" the company gets for being a good investment.
3. Bonus Issues and Rights Issues
Sometimes, companies issue more shares to people who already own them. There are two main ways they do this:
A. Bonus Issue (The "Freebie")
A Bonus Issue is when a company gives free shares to existing shareholders. No cash changes hands! It’s like a pizza place giving you a free slice because you're a loyal customer. The company simply moves money from its reserves (like Share Premium) into the Share Capital account.
Why do it? It makes the company's shares more affordable and shows confidence.
Journal Entry:
Dr Share Premium (or Retained Earnings)
Cr Share Capital
B. Rights Issue (The "Discount Coupon")
A Rights Issue is an offer to existing shareholders to buy new shares, usually at a price lower than the current market price. Unlike a bonus issue, cash is received here.
Step-by-Step for Rights Issues:
1. Identify how many new shares are being issued (e.g., "1 for every 5 held").
2. Multiply the number of new shares by the issue price.
3. Record the nominal value in Share Capital and the excess in Share Premium.
Key Takeaway: Bonus Issues = 0 Cash. Rights Issues = Cash received (but usually at a discount).
4. Debt: Loan Notes and Interest
If a company doesn't want to give away ownership, it borrows money. This is often done through Loan Notes (also called Debentures). The company must pay Interest on this money.
Finance Costs: This is the interest the company pays on its debt. It is recorded as an expense in the Statement of Profit or Loss (SPL). It doesn't matter if the company made a profit or a loss; they must pay the interest.
Calculating Interest:
Interest is always calculated on the Nominal Value of the loan, not the market value.
\( \text{Interest Expense} = \text{Loan Amount} \times \text{Interest Rate} \)
Example: If a company has a \( \$10,000 \) loan at \( 5\% \) interest:
\n\( \text{Interest} = \$10,000 \times 0.05 = \$500 \)
\nJournal Entry:
\nDr Finance Costs (SPL): \( \$500 \)
Cr Cash/Bank (or Accruals): \( \$500 \)
5. Dividends vs. Interest (The Big Difference)
\nThis is a favorite topic for exam questions! Students often get confused about where these two payments go.
\n\nDividends: These are rewards for Equity holders (owners). They are not an expense. They are a distribution of profit. They appear in the Statement of Changes in Equity (SOCE), not the SPL.
\nInterest: This is a cost for Debt holders (lenders). It is an expense (a "Finance Cost") and appears in the Statement of Profit or Loss (SPL).
Memory Aid (The "D" Rule):
\nDividends = Discretionary (Company chooses to pay) = Distribution of profit.
\nInterest = Inevitability (Company must pay) = Income statement expense.
Did you know? Even if a company makes a billion dollars in profit, they aren't legally forced to pay a dividend to ordinary shareholders. But if they owe just $1 in interest to a bank, they must pay it or risk legal action!
6. Summary of Key Terms
Share Capital: The nominal value of shares issued.
Share Premium: The amount received above the nominal value.
Retained Earnings: Profits kept in the business from previous years.
Finance Costs: Interest expense on loans and debt.
Ordinary Dividends: Payments to shareholders from profits.
Final Encouragement: You've just covered the backbone of how businesses are funded! Recording these transactions is all about putting the right numbers in the right "buckets" (accounts). Practice a few journal entries for share issues, and you'll be an expert in no time!