Principal forms of financial instrument issued or used by private companies and the ways in which they may be issued

CB1 – Business Finance · IFoA (Institute and Faculty of Actuaries) · 5 min read

Welcome to Business Finance!

Hello there! Welcome to one of the most practical chapters in the CB1 curriculum. Think of a company like a growing family: sometimes it needs extra money to buy a bigger house or a new car. A company also needs funds to expand, buy machinery, or develop new products. This "money" usually comes from Financial Instruments.

In this chapter, we will explore the "menu" of options a company has to raise money and how they actually get these instruments into the hands of investors. Don't worry if this seems like a lot of jargon at first—we'll break it down using everyday examples!

1. Equity Finance: Owning a Piece of the Pie

When a company issues Equity, it is selling bits of ownership. If you buy a share, you aren't just lending money; you are becoming a part-owner.

Ordinary Shares (Common Stock)

These are the most common type of equity. They represent the residual interest in the company. This means ordinary shareholders are last in line: they get paid only after the taxman, the banks, and the suppliers have been settled.
Key Features:
• Dividends: Not guaranteed. They are paid at the discretion of the directors.
• Voting Rights: Usually, one share equals one vote. Shareholders use these to elect directors.
• Risk: High risk (you could lose everything if the company fails), but high potential reward through capital growth.

Preference Shares

Think of these as a "hybrid" between a loan and a share. They are "preferred" because they get their dividends before the ordinary shareholders.
Key Features:
• Fixed Dividend: Usually expressed as a percentage of the face value (e.g., a 5% preference share).
• No Voting Rights: Generally, preference shareholders don't get to vote unless their dividends are in arrears.
• Cumulative: If the company can't pay the dividend this year, they owe it to the shareholder next year (unlike ordinary shares).

Quick Review: Ordinary shares = High risk, high control, variable reward. Preference shares = Lower risk, no control, fixed reward.

2. Debt Finance: Borrowing the Money

When a company issues Debt, it is borrowing money that it promises to pay back with interest. The investors are Creditors, not owners.

Debentures and Loan Stock

A Debenture is a long-term debt instrument. In the UK, it is often secured against the company’s assets. If the company fails to pay, the debenture holders can sell the company’s assets to get their money back.
Security types:
• Fixed Charge: Secured against a specific asset (like a mortgage on a building).
• Floating Charge: Secured against a class of changing assets (like inventory or raw materials).

Convertible Loan Stock

This is a "chameleon" instrument. It starts as a loan (paying interest), but the holder has the option to convert it into ordinary shares at a pre-set price on a specific date.
Why use it? It’s attractive to investors because they get the safety of a loan with the "up-side" potential of shares if the company does well.

Deep Discount and Zero-Coupon Bonds

Instead of paying regular interest, these bonds are issued at a price much lower than their "face value."
Example: A company issues a bond for \$70 today and promises to pay back \$100 in five years. The \$30 difference is effectively the interest. A Zero-Coupon Bond pays no interest at all until the very end!

Did you know? Using debt is often cheaper for a company than using equity because interest payments are tax-deductible, whereas dividends are not!

3. How Shares are Issued: The "How-To" Guide

Raising money isn't just about choosing the instrument; it’s about the process. Here are the main ways companies issue new shares:

Public Issue (IPO)

This is when a company offers its shares to the general public for the first time. It is expensive and involves a lot of legal paperwork (a Prospectus).
• Direct Offer: The company sells directly to the public.
• Offer for Sale: The company sells shares to an Issuing House (an investment bank), which then resells them to the public.

Placing

Instead of inviting the whole world, the company "places" the shares with a small group of private investors or institutions (like pension funds).
Why do it? It is much cheaper and faster than a public issue because there is less red tape.

Rights Issue

This is an offer to existing shareholders to buy new shares, usually at a discount to the current market price. It is done in proportion to their current holdings (e.g., a "1 for 5" rights issue means for every 5 shares you own, you can buy 1 new one).
Key Benefit: It allows existing owners to maintain their percentage of control (no dilution).

Bonus (Scrip) Issue

This is a bit of "accounting magic." The company gives free shares to existing shareholders. No new money is raised. It simply moves money from the company's reserves into its share capital account.
Analogy: Imagine you have a pizza cut into 4 slices. A bonus issue is like cutting those same 4 slices into 8 smaller ones. You have more pieces, but the same amount of pizza!

Common Mistake to Avoid: Don't confuse a Rights Issue with a Bonus Issue. A Rights Issue brings in new cash from shareholders. A Bonus Issue brings in zero cash.

4. Warrants: The "Golden Ticket"

A Warrant gives the holder the right (but not the obligation) to buy shares at a fixed price at some point in the future. Warrants are often attached to bonds to make them more attractive—like a "buy one, get a coupon for later" deal.

Summary and Key Takeaways

1. Equity vs. Debt: Equity is ownership (permanent, no fixed cost); Debt is borrowing (must be repaid, fixed interest cost).
2. Risk/Return: Ordinary shares are riskiest for investors; Secured debentures are safest.
3. Issue Methods: Public Issues are for the masses; Placings are for the "big players"; Rights Issues are for existing owners.
4. Convertibles and Warrants: These provide flexibility, allowing debt-holders to potentially become shareholders.

Quick Formula Note: While this chapter is mostly descriptive, remember the relationship for the cost of a zero-coupon bond (where $P$ is price, $F$ is face value, $r$ is the annual yield, and $n$ is years):
$ P = \frac{F}{(1 + r)^n} $

Don't worry if the different types of issues feel similar—just remember to ask: "Who is being asked for money?" (The public? Institutions? Existing owners?). If you can answer that, you’ve mastered the core of this chapter!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What are the primary characteristics of ordinary shares?

Ordinary shares represent the residual interest in a company, meaning shareholders are paid only after all other obligations are met, providing voting rights but carry higher risk.

How do preference shares differ from ordinary shares regarding dividend payments?

Preference shares pay a fixed dividend that must be settled before any dividends are paid to ordinary shareholders, and these dividends are often cumulative.

What is the difference between a fixed charge and a floating charge in debt security?

A fixed charge is secured against a specific, identifiable asset (like a building), while a floating charge is secured against a class of changing assets (like inventory).

What defines a convertible loan stock?

Convertible loan stock is a debt instrument that gives the holder the option to exchange their loan for ordinary shares at a pre-determined price and date.

What is a zero-coupon bond?

A zero-coupon bond is a debt instrument that pays no periodic interest but is issued at a deep discount to its face value, providing return through capital growth.

Why is debt finance often considered cheaper for a company than equity finance?

Debt is usually cheaper because interest payments are tax-deductible expenses, reducing the company's overall tax liability, whereas dividends are paid from after-tax profits.

How does a Direct Offer differ from an Offer for Sale in a public issue?

In a Direct Offer, the company sells shares directly to the public; in an Offer for Sale, the company sells shares to an Issuing House, which then resells them to the public.

What is a share placing and why might a company prefer it over a public issue?

A placing is the sale of shares directly to a small group of institutional investors, preferred because it is faster and involves lower administrative costs than a public offer.

What is the primary purpose of a rights issue?

A rights issue allows a company to raise new capital from existing shareholders in proportion to their current holdings, preventing the dilution of their ownership and control.

What is a bonus (scrip) issue and how does it affect company cash flow?

A bonus issue is the distribution of free additional shares to existing shareholders; it has zero impact on company cash flow as it is purely an accounting adjustment.

What is a warrant in the context of corporate finance?

A warrant is an instrument that gives the holder the right to purchase a specific number of ordinary shares at a fixed price at a future date.

What is the formula for the price of a zero-coupon bond?

The price $ P $ is calculated as: $ P = \frac{F}{(1 + r)^n} $, where $ F $ is face value, $ r $ is the annual yield, and $ n $ is the number of years to maturity.

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