Capital, Equity & Debt
In this lesson, you’re expected to learn about:
– the difference between ordinary and preference shares
– the main sources of funding for a company
– corporate bonds, convertible bonds and other types of corporate debt
Equity / Share Capital
Generally, a company obtains funding from two sources: Shareholders and the bank.
The cash that shareholders put in was ordinary share capital – it was a long-term investment that could only pay a dividend if the company did well.
The better the company did, the better would be the shareholders’ return.
The other source of funding (the bank) is different from the shareholders’ investment in that the length of the loan was known and the return on the loan was not only known but had to be paid by the company, unlike dividends or share capital.
There are many different forms of both equity and share capital and often you may come across things that seem like a combination of the two.
Together equity instruments and debt instruments are known as capital instruments.
Also known as common shares, these shares are characterized by their residual claim and limited liability.
· Residual claim: means that shareholders are subordinated in the priority of payment to all other claims on a company’ assets and dividends.
· Limited liability: in the event of bankruptcy, an investor is not personally liable for the company’s obligation and can lose at most their initial investment.
Some companies may have two classes of ordinary shares. For example – A ordinary shares and B ordinary shares. These two classes of shares might have identical rights except that one of the two might have no right to vote.
Properties of Preference Shares:
· Usually have a fixed annual dividend, which must be paid before any dividend is paid on the ordinary shares.
· If the company is wound up (i.e. liquidated), the preference shareholders usually get their money back before any money is returned to the ordinary shareholders. The amount they get back will however be the amount they put in or some other predetermined amount. Ordinary shareholders get what’s left over, which could be more or less than what they put in.
Thus, preference shares are less risky than ordinary shares but there is less opportunity for the preference shares to become worth a large amount.
Types of Preference Shares
There are four main types of preference shares:
2) Participating preference shares include conditions whereby the dividend on the shares will be increased, i.e. when the company does particularly well.
3) Redeemable preference shares have a fixed date on which the company must return the capital invested by the preference shareholders.
4) Convertible preference shares can be converted into ordinary shares at a certain time and price per ordinary share.
Shares as Debt
Although legally considered shares, some shares have to be treated as debt in a company’s accounts. This is because they behave more like debt than equity.
The company would have classified the instruments appropriately according to the following guidelines:
· If the holder of the instrument has the right to demand cash either as a form of payment or to wholly or partly redeem the instrument, then the instrument is more likely debt and is thus treated as such.
· If the company can decide if and when any such payments are to be made, then the instrument is more likely equity and should be treated as such.
Is a Preference Share a debt or equity?
Whether it’s treated as debt or equity, it doesn’t really matter as it represents a claim over the assets of the company either way. The only differences are:
– If it’s treated as debt, then any dividend on the preference shares will actually be treated as interest and will be included in the P&L.
– The various funding structure ratios will be different.
There are two types of bank debt which we’ve seen earlier:
– an overdraft
– a loan
Let’s now look at a new concept known as revolving credit facility.
· It is similar to an overdraft in that the company can draw down funds from the bank up to the limit and then repay them. Subsequently, the company can draw them down again and so on as often as it likes.
· While an overdraft is almost always repayable on demand, an RCF is typically a ‘committed’ facility. This means the bank can’t demand its money back until the end of the agreed term unless the company breaks one or more covenants relating to the RCF.
On an agreed date, the principal is returned to the investors. These kinds of borrowings are known collectively as corporate bonds but are also known as notes (short-term) or commercial paper (usually less than a year).
Companies issue their debt to investors via the bond markets. These are electronic market places where investors can:
· buy new bonds from companies that need to raise funding.
· buy and sell previously issued bonds among themselves in the secondary market.
A majority of corporate bonds are issued in US$ or Euros and are typically issued in tranches of $1,000 or €1,000 face value. The face value is the amount of principal used to calculate how much interest is paid.
So, for example, if the interest rate is 3.25% and you have bought bonds with a face value of $10,000, you will receive $325 of interest each year.
As an investor, you may not have paid $10,000 for those bonds. Depending on the market conditions at the time, those bonds might be selling for $11,000. So, as the investor, you would still be getting $325 of interest but will only get $10,000 back at the end of the bond’s term though you would have handed over $11,000 for those rights. Thus, in effect, you’d be accepting a lower interest rate.
The prices of bonds change constantly and companies can’t change the interest rate on their new bonds to exactly match the price investors would be prepared to pay when they are going to be issued. So a company will pick an interest rate that is roughly correct and then issue the bonds for as high a price as they can get at the time. This could be slightly more or slightly less than the face value.
How is this entered on a balance sheet?
In order to account for this, we use something called the effective interest rate method. On issue of the bonds, you would account for them by increasing cash and increasing the liabilities to bond-holders.
The rate that will discount the bond’s future interest payments and its maturity value to the bond’s current selling price – it is a bond investor’s yield to maturity. –
It is also known as the market interest rate.
Companies also issue bonds that are the same as we’ve just seen with the additional feature that the holder of the bond can convert the bond (at a prescribed price) into ordinary shares in the company.
Companies benefit from making a bond convertible, as buyers of the bonds will accept a lower interest rate during the time before the bond is converted into shares. Buyers have to believe that the bond will be worth converting into shares otherwise they would simply buy a non-convertible bond that would give them a higher interest rate.
Companies also issue debt to investors in a less standardized form than corporate bonds. Usually such debt will not be traded and may have many more complicated terms than vanilla corporate bonds*.
This other corporate debt is also referred to as loan stock or debentures.
– shares in a business that have been pledged as collateral for a loan.
– this is most valuable for a lender when the shares are publicly traded on a stock exchange and are unrestricted so that the shares can easily sold for cash.
Properties of Debentures:
– a medium to long-term debt format that is used by large companies to borrow money.
– the most common type of long-term loans that can be taken.
– typically loans that are repayable on a fixed date.
– some debentures are irredeemable securities which means that they do not have a fixed date of expected return of the funds.