SOURCES OF COMPANY FINANCE

2.0 Introduction
Companies have different alternatives for obtaining funds that is used
to finance investment project. They can issue debt or equity securities
to archive this goal. Some times lease is also used as an alternative
for long term financing. The source of finance has an implication on
cost of funds. To this end this chapter discusses the different sources
of finance including their merits and demerits.

A company can raise finance in the following ways:

1. From finance classified according to the relationship to the party
   giving the finance, e.g.

• Equity Finance- This is finance provided by real owners of the
  business i.e. ordinary shareholders. Equity securities represent
  ownership interest in a corporation. These securities include common
  stock and preferred stock. These two forms of securities
  provide a residential claim on the income and assets of a
  corporation. Thus, this section discusses these two sources of
  long-term finance.
• Quasi equity- This is finance provided by quasi-owners of the
  business i.e. preference shareholders.
• Debt finance- This is finance provided by outsiders i.e. creditors:
  thus it include loans, overdrafts, trade creditors, bills of
  exchange, debentures, hire-purchase, leases, mortgages, etc.

1. Classified according to the duration i.e. term of finance i.e. how
   long the finance will be in the business.

• Permanent finance- This is finance which cannot be refunded to the
  owners in the shortrun. Examples of this finance are:
  Ordinary share capital
  Irredeemable preference share capital
  Irredeemable debentures
  These are only refunded in the event of the company’s liquidation.
• Long term finance- If finance is in the business for a period of 7
  years and beyond, this finance is long-term, e.g. long-term debt
  finance. However, this term is relative because for a kiosk a 2
  years loan is long-term, and for a limited company a 2 years loan is
  short term.
• Short term finance- this is finance due to be refunded to lenders
  after a short period i.e. a period between one year and three years,
  e.g. overdrafts, short term loans, etc.

1. Classified according to the origin of finance:

Internal sources of finance- these are such finances as generated within
the business, i.e. from the businesses’ own operations. Examples of such
finances are

• Retained earnings
• Provision for depreciation
• Provision for taxation
• Adjustment in working capital items

The above finances are used as follows:-

• Undistributed profits transferred to the business i.e. ploughed back
  into the business.
• Provision for depreciation if a company has created a sinking fund
  to replace an asset after useful economic life. This finance can be
  used and replaced later when the asset is due to be replaced.
• Provision for taxation is a source of finance in as much as the tax
  liability falls due a bit later than when it is appropriated from
  the current profits, e.g. a company will provide for taxation in
  December and pay it at the end of March or thereafter. i.e. can be
  used up to the end of March.
• Adjustment in working capital serves as a source of finance in as
  much as the company will reduce the levels of working capital items
  to release finance which would have otherwise been tied up in those
  items.
• Sale of an asset; this is a source of finance under the following
  conditions:-
  If the asset is obsolete
  If the asset is sensitive to technology e.g. computers, aircrafts.
  If the asset cannot meet the company’s contemplated expansion programme.
  If the asset is not sensitive/ central of the company’s operations,
  and its sale will not substantially affect he productive capacity of
  the business.

1. Classification according to the rate of return i.e. in relation to
   the cost of that finance.

• Finance with variable rate of return VRT). In this case the return
  on such finance will vary with the profits made by the company; e.g.
  ordinary share capital and participative preference share capital
  are VRT.
• Fixed rate of return capital
  This will refer to the finance whose rate of return is fixed regardless of the profits made, e.g. preference share capital, loan finance, debenture finance etc

2.1 Equity Finance

This is the largest source of finance to any limited company and usually
forms the base on which other finances are raised. Equity is the total
sum of the company’s ordinary share capital plus the company’s retained
earnings also known as revenue reserves.

Ordinary Share Capital
It is that finance contributed by the ordinary shareholders of a
business. This is raised through the sale of the company’s ordinary
shares. It is finance contributed by real owners of the company. This
finance is only raised by limited companies. It is permanent finance to
the company and can only be refunded in the event of liquidation, i.e.
in Kenya; a company cannot buy back its own shares (ordinary shares).
This finance is paid ordinary dividends as return to the shareholder’s
investment. Ordinary shares carry rights and usually each share is equal
to one vote exercised in Annual General Meetings.

Ordinary shares are quoted at the stock exchange where they are sold and
bought by the public through brokers. Ordinary share capital carries the
highest risks in the company because it gets its return after other
finances have got theirs, and also in the event of liquidation it is
paid last (their voting right is assumed to be used wisely to minimize
these risks.)

Ordinary dividends are not a legal obligation on the part of the company
to pay. If the company’s profits are good, ordinary shareholders get the
highest return because their dividends are varied. This is the only type
of finance that grows with time and this growth is technically called
growth in equity which is facilitated by retention of earnings.

Rights to Ordinary Shareholders

• They have a right to vote. This right is given to them by the
  company’s Act. They are also entitled to vote by Proxy in absentia
• They have a right to inspect corporate books e.g. Articles of
  association, Memorandum of Association and books of accounts.
• They have a right to sell their shares to other parties i.e. to
  transfer their ownership in shares of a company.
• They have a right to share in residual assets of the company during
  the company’s liquidation.
• They have a right to approve the purchase of capital assets.
• They have a right to amend the charters and by laws of the company
  (Articles and Memorandum of Association)
• They have a right to approve the sale of the company’s assets.
• They have a right to approve mergers, acquisitions and take-over’s.
• They have a right to appoint directors.
• They have a right to appoint/remove auditors of the company who will
  oversee the company’s affairs.

Features of Ordinary share Capital

• It is a permanent finance to the company which can be refunded only
  during liquidation.
• It is the largest source of finance to the Ltd Company.
• This finance has a residual claim on profits and assets during
  liquidation.
• Ordinary share capital is entitled to voting powers, each share
  usually being equal to one vote.
• This finance carries a varied return i.e. its dividends will vary
  with the profits made.
• Ordinary share capital carries no nominal cost to the company. i.e.
  dividends on ordinary share capital are not a legal obligation to
  the company to pay.
• It is the only finance which will grow with time as a result of
  retention.
• This finance cannot force the company into liquidation i.e. it does
  not increase its gearing; on the contrary, it decreases the gearing.
• It can be raised by limited companies only.

Advantages of Using Ordinary Share Capital by a Company

1. Being a permanent finance the company will invest it in long term
   ventures without inconveniencies of paying it back.
2. Dividend payment (to ordinary shareholders) is not a legal
   obligation to the company, thus no threat to liquidity of the company.
3. This type of finance contributes valuable ideas towards the running
   of the company during the Annual General Meeting.
4. This finance is available in large amounts in particular if the
   company is quoted on the stock exchange in which case it can raise
   substantial amounts of money to finance the company’s operations.
5. Ordinary share capital forms a base and thus a security on which
   other money can be raised.
6. Common stock does not obligate the firm to make payments to
   stockholders. A firm can not be obliged to pay divided when there
   are financial constraints. Had it used debt, it would have incurred
   a legal obligation to pay interest regardless of operating condition
   and cash flows.
7. Common stock has no fixed maturity date. It never has to be rapid as
   would a debt issue.
8. Common stock protects creditors against losses and hence, the sale
   of common stock increases the creditworthiness of the firm. This in
   turn raises it bond rating, lowers its cost of debt and increases
   its future ability to use debt. One of the costs of issuing debt is
   the possibility of financial failure. This possibility does not
   arise when debt is used.
9. The cost of underwriting and distributing common stock is usually
   higher than that of preferred stock or debt
10. If the firm has more equity than required in its optimal capital
    structure, its cost of capital will be higher than necessary.
    Therefore, a firm would not want to sell stock if the sale would
    cause its equity ration to exceed optimal level
11. Under current tax laws, dividends on common stock are not deductible
    for tax purposes, but interest is deductible. This raises the
    relative cost of equity as compare to debt.

Disadvantages of Using Ordinary Share Capital to a Company

1. The cost of ordinary share capital (ordinary dividend is paid in
   perpetuity).
2. This finance may disorganize a company’s policy in case
   shareholders’ votes are cast against the company’s present
   operations and policies.
3. It does involve a lot of formalities in its raising and it may take
   a long time to raise as the company has to obtain permission from
   the capital market authority and other regulators.
4. It is very expensive to raise as it involves a lot of costs commonly
   known as floatation costs e.g. printing the prospectus and share
   certificates, advertising expenses, cost of underwriting the issue,
   brokerage costs, legal fees, auditor’s fees, cost of communication.
5. The issue of ordinary share capital means that the company’s secrets
   will be exposed to the public through published statements which may
   be dangerous from competitors point of view.

2.2 Quasi Equity/ Preference Share Capital

This is finance contributed by quasi-owners or preference share holders.
It is so called quasiequity because it combines features of debt finance
and those of equity finance. Preferred stock differ form common stock
because it has preference over common stock in the payment of dividends
and in the distribution of corporation assets in the event of
liquidation. Preference means only that the holders of the preferred
shares must receive a dividends (in the case of an ongoing firm) before
holders of common share are entitled to anything. Preferred stock is a
form of equity form a legal and tax stand point. It is important to
note. However, the holders of preferred stock sometimes have no voting
privilege. Preferred stock is sometimes convertible in to common stock
and is often callable. So we can say that preferred stock is a hybrid
form of financing combing features of debt and common stock. It is
called preference share capital because it is accorded preferential
treatment over ordinary shareholders in:-

• Sharing in dividend- It receives its dividend before those of
  ordinary shareholders. Thus it is said to be preferred to dividends.
• It is accorded preferential treatment in sharing of assets in the
  event of liquidation. Preference shareholders get their claims on
  asset before ordinary shareholders get theirs. Thus it is said to be
  preferred to assets.

In order for a share to be called a preference share it must be accorded
the above preferential treatment over and above ordinary share capital.

Advantages of Preferred Stock
By using preferred stock a firm can fix its financial cost and still
avoid the danger or bankruptcy if earnings are too low to meet these
fixed charges. This is because preferred stock earners a dividend but
the company has discretionary power to pay it. The omission of payment
doesn’t result in default.

Disadvantages of Preferred Stock
It has a higher after tax cost of capital that debt. The major reason
for this higher cost is taxes preferred dividends are no deductible for
tax purpose, whereas interest expense on debt is deductible.

Similarities between Ordinary and Preference Share capital

1. Both finances earn a return in form of dividends
2. If the preference shares are irredeemable then both will be
   permanent sources of finance to the company.
3. In case the preference share capital is irredeemable both will
   receive dividends in perpetuity.
4. Both form the company’s share capital/ share finance
5. Both are difficult to raise due to a lot of formalities the company
   must go through to raise this finance.
6. Both claim on assets and in profits after debt finance has had its
   claim.
7. Payment of dividend to both is not a legal obligation for the
   company i.e. neither the ordinary shareholder nor the preference
   shareholder can sue the company to claim their dividends.
8. Both finances are not secured i.e. no security is attached to such
   finance.
9. Both finances are raised strictly by limited companies.
10. Both finances are long-term finances to the company.

Differences between Ordinary and Preference Share capital

1. Ordinary share capital carries voting rights whereas preference
   share capital does not except if it is convertible, and is converted.
2. Ordinary share capital carries variable rate of dividends whereas
   preference dividends are fixed except for participative preference
   share capital.
3. Ordinary share capital receives its dividends after preference share
   capital has been paid theirs.
4. The share prices of ordinary shares will be higher if the company is
   doing well than those of preference shares.
5. Preference share capital increases the company’s gearing level
   whereas ordinary share capital reduces the gearing level.
6. For cumulative preference shares these may receive dividends in
   arrears ordinary shares cannot.
7. Raising finance by way of ordinary share capital is easier than
   raising preference share capital as in the latter case the company
   has to be financially strong.
8. Preference share capital is usually secured by the company’s
   financial soundness whereas ordinary share capital is not.
9. Preference share capital cannot qualify for a bonus issue, while
   ordinary share capital can, i.e. preference shares cannot receive
   bonus issues.
10. Ordinary shares have a chance to receive a rights issue whereas
    preference shares cannot get rights issues.

2.3 Debt Finance – Loan

In this section we will discuss debt financing by describing in some
detail the basic features and advantages of bond financing.

Features of Bonds
Bonds are a major source of financing for corporations and government. A
bond is a long term contract under which a borrower agrees to make
payments of interest and principal on specific dates to the holders of
the bond. Most corporate bonds contain a call provision which gives the
insuring corporation the right to call the bonds for redemption. The
call provision generally states that are called some other types of
bonds have convertible features. A convertible bond is a debt instrument
that is convertible in to shares of common stock at a fixed price at the
option of the bond whereas a convertible features on a bond benefits the
bondholders. A callable bond will generally require a higher interest
payment than non callable bond because the investor will not be willing
to buy a callable bond unless he receivers a better interest payment.
When the market price of the bond of increases or equivalently, the
market interest rate
decreases, the issuer of the bond will call the bond and issue a new
bond at a lower interest rate. This puts the buyer of the bond at a
disadvantage because when the bond gets attractive it will be taken away
from the investor.

A convertible feature on a bond as stated before, benefits the
bondholders. Thus investors would generally require the issuing
corporation a higher interest payment on non convertible bonds than
convertible bonds. The holders of convertible bonds have the option to
convert these bonds to common stock any time they choose. Typically, the
bonds are exchanged for specified number of common shares with no cash
payment required. Because convertible have this option, they require a
lower payment than non-convertibles. This is the type of finance which
is obtained from persons other than actual owners of the company i.e.
creditors to the company. This finance can be in any of the following forms:

• Loans
• Debentures
• Bank overdrafts
• Trade creditors
• Borrowing against
• bills of exchange
• Lease finance
• Mortgage finance
• Hire purchase finance

All the above finances have a legal claim or charge against the
company’s resources or assets.

Classification of Debt Finance

1. Short term finance
   This ranges from 1 month up to 4 years and is given to customers
   known to the bank or to lenders. The agreement of this loan will
   mention both the repayments of principal and interest, and for
   interest it must identify whether it is simple or compound interest.
   For principal, it has to be paid over some time. This finance is
   usually secured and the terms of the loan will be restrictive e.g.
   to be invested in an area acceptable to the bank or lender. Usually,
   this finance should be used to solve short-term liquidity problems.
2. Medium-term finance
   This finance will be in the business for a period ranging between
   4-7 years. This term is relative and will depend upon the nature of
   the business. This type of loan is used for investment purposes and
   is usually secured but the security should not be sensitive to the
   company’s operations. The finance obtained must be invested while
   respecting the matching approach to financing i.e. the term and
   payback period must be matched. This type of finance is the most
   popular of all debt financing because most of the busineses will
   need it both in their growing stages and also in their mature stages
   of development.
3. Long-term finance
   This is a rare finance and is only raised by financially strong
   companies. It will be in the business for a period of 7 years and
   above. This finance is used to purchase fixed assets in particular
   during the early stages of a company’s development. It is always
   secured with along term fixed asset, usually land or buildings. Its
   investment, however, must obey the matching approach. In all, the
   companies needing such finance do not have to be known to the lenders.

Advantages and Disadvantages of Debt Financing

In the previous section we noted the advantage of equity financing
relative to debt financing. Though it may be a repeat let’s summarize
the key advantages and disadvantages of debt financing relative to
equity financing. The corporation payment of interest on debt is
considered a cost of doing business and is fully tax deductible.
Dividends paid to stockholders are not tax
deductible. This makes debt financing a cheaper source of finance than
equity financing. Unpaid debt is a liability of the firm. If it is not
paid, the creditors can legally claim the asset of the firm. This action
can result in liquidation or reorganization tow of the possible
consequences of bankruptcy. Thus one of the costs of issuing debt is the
possibility of financing failure. This possibility does not exist when
equity is issued.

2.4 Other forms of Debt Finance

1. Overdrafts
   These are very short-term sources of finance to the company and are
   usually used to finance the company’s working capital or solve its
   liquidity problems. This finance is usually not secured and is more
   costly than long-term loans as much as its interest is 1-2% higher than
   bank rates. Interest on overdrafts is computed on a daily basis although
   it may be paid monthly. Overdrafts are usually given to
   very well known customers of the bank although over-reliance on
   overdrafts is a sign of poor financial management policies and as such
   they should not be used often.
2. Bills of Exchange
   As a source of finance, bills of exchange can be:- Discounted, Endorsed
   or Given as securities for loans

A bill of exchange us defined as an unconditional order in writing
addressed by one person to another signed by the person giving it,
requiring the person to whom it is addressed to pay on demand at a fixed
or determinable future date a certain sum of money to the order of the
person or to bearer. Most of the bills mature between 90-120 days
although they could be sight bills i.e. payable on sight or issuance
i.e. payable in the future. In order for a bill to be valid and to serve
as a source of finance it should be:-

• Signed by the drawer;
• Accepted by the drawee;
• Be unconditional;
• Bear appropriate revenue stamp.

1. Debenture Finance
   It is a document that is evidence of a debt which is long-term in
   nature, and confirms that the company has borrowed a specific sum of
   money from the bearer or person named in the debenture certificate. Most
   debentures are irredeemable thus forming a permanent source of finance
   to the company. If these are redeemable then these will be long-term
   loans which range between 10-15 years. They can be endorsed, negotiated,
   discounted or used as securities for loans. They carry a fixed rate of
   interest which is payable after six months i.e. twice a year.

Classification of Debentures

1. Classification according to security

• Secured debentures- these are secured against the company’s assets
  or have a fixed charge against the company’s assets. In the event of
  the company’s liquidation such debentures will claim from that
  particular asset. They could be secured against a floating charge in
  which case the holder can claim on any or all of the company’s
  assets not yet attached by other secured creditors. A debenture
  holder with a floating charge has a status of a general creditor.
  However, the floating charges debentures are rare and they are sold
  by financially strong companies.
• Unsecured (naked) debentures- these carry no security whatsoever and
  such they rank as general creditors. They carry a residual claim to
  the first class creditors but a superior claim over ordinary
  shareholders. These are rare sources of finance and are sold by
  financially strong companies with a good record of dividend payment
  to the shareholders.

1. Classified according to redemption.

• Redeemable debentures- these are bought back by the issuing company.
  Like preference shares, these have two redemption periods. This is
  usually between 10-15 years, i.e. the company has the option to
  redeem these after 10 years but before expiry of 15 years. In most
  cases redeemable debentures are secured against specific assets e.g.
  land or buildings (mortgage debentures). Their interest is a legal
  obligation on the part of the issuing company.
• Irredeemable debentures (perpetual debentures)- these can never be
  bought back by the issuing company except in the event of
  liquidation and as such they form a permanent source of finance to
  the company. These debentures are rare and are only sold by
  financially strong companies which must have had some good dividend
  history. They are unsecured and thus are known as naked perpetual
  debentures.

1. Classified according to convertibility

• Convertible Debentures- These are the type of debentures which can
  be converted into ordinary share capital and this conversion is
  optional as follows:
  At the option of the company i.e. at the company’s option.
  At the option of both parties i.e. debenture holder and the company.
  At the option of the holder.
  However, the conversion price of the debenture is given by:-
  Conversion Price = Nominal value of the debentures
  Conversion Ratio = Nominal value of the debentures
  Nominal value of the shares to be converted
  In all, convertible debentures are never secured.
• Non-convertible debentures- These cannot be converted into any
  shares be it ordinary or preference shares and are usually secured.

1. Subordinate debentures (naked)
   These are issued with a maturity period of 10 years and above, and
   usually they carry no security and depend upon the goodwill of the
   company. They are so called subordinate because they rank last in claims
   after all classes of creditors except trade creditors. Nevertheless
   their claims are superior to those of shareholders both preference and
   ordinary shares.
2. Hire Purchase
   This is an arrangement whereby a company acquires an asset by paying an
   initial installment usually 40% of the cost of the asset and repays the
   other part of the cost of the asset over a period of time. This source
   is more expensive than bank loans. Companies that use this source of
   finance need guarantors as it does not call for collateral securities to
   raise. The company hiring the asset will be required to honor all the
   terms of the arrangement which means that if any term is violated then
   the hire may repossess the asset. This finance is kind and the hirer
   will not get a good title to the asset until he clears the final
   installment and an optional charge in some cases.
   Companies that offer this finance in Kenya are:- National Industrial
   E.A. Ltd., Diamond Trust(K) Ltd., Kenya Finance Corporation, Credit
   Finance Co. Ltd. They avail hire purchase facilities for such assets as:
   Plant and machineries, vehicles, tractors, heavy transport machines,
   aircrafts, agricultural equipments.
3. Lease Financing
   Leasing is an important source of equipment financing. For some
   equipment, the financing is long term in nature. This section discusses
   the features of a lease their types and advantages and

disadvantages of lease financing.
A lease is a contract whereby the owner of an asset
the leaser) grants to another
party (the leasee) the executive right to use the asset in return for
the payment of rent (i.e. lease payment). In other words, through
leasing, a firm can obtain the use of certain fixed assets for which it
must make a series of contractual periodic payments form the lease
points of view; this lease payment is tax deducible. Here we discuss
lease as an alternative source of financing and hence we shall see the
effects of leasing on the lease business.

Types of Leases

Leases can be basically classified in to two; operating lease and
capital or financial lease. An operating lease is relatively short term
in length and is cancelable with proper notice. The term of this type of
lease is shorter than the assets economic life. Operating leases for
instance may include the leasing of copying machines certain computer
hardware and word processors. In contrast to an operating lease a
financial lease is longer term in nature and is non cancelable. The
lessee is obligated to make lease payments until the lease term expires
which approaches the useful life of the asset.

If an operating lease is held until the term of the lease, at the
maturity date will return the leased asset to the owner (leassor) who
may lease is again or sell the asset. However, if the leasee decides to
return the asset before maturity (i.e. cancel the lease) it may be
required to pay a predetermined penalty for cancellation.

In case of financial lease the leasee can not cancel the lease contract
and is obligated to make leasee payment over the term of the lease
regardless of whether the leasee needs the service of the asset or not.
But at the maturity date, the lease may transfer ownership of the asset
to the lessee or the may have the opportunity to purchase the leased
asset at a bargain price. For capital (or financial) lease the value of
asset along with the corresponding lease liability must be shown on the
balance sheet. Capital leases are commonly used for leasing land,
buildings and big equipment. More specifically, a lease is considered as
a capital (or financial) lease if it meets any one of
the following conditions:

• The lease transfers title to the assets to the leasee by the end of
  lease period
• The lease contains on option to purchase the asset at a bargain price.
• The lease period is equal to or greater than 75 percent of the
  estimated economic life of the assets.
• At the beginning of the lease the present value of the minimum lease
  payments equal or exceeds 90 percent of the value of the leased
  property of the lessor.

If any of the above condition is not met, the lease is classified as an
operating lease. Essentially, operating leasesgive the leasee the right to use the leased properly over a period of time, but they do not give leasee all the benefits and risks associated with the asset.

Advantages of Leasing

1. Leasing allows the lease to deduct the total payment as on expense
   for tax purposes.
2. Because leasing results in the receipt of service from an asset
   possibly with out increasing the liabilities on the firm’s balance
   sheet, it may results in favorable financing rations.
3. Leasing provides 100 percent financing as opposed to loan agreement
   where the purchase of the asset (borrower as well) is required to
   pay a portion of the purchase price as a down payment.
4. In a lease arrangement, the leasee may avoid the cost of
   obsolescence if the lessor fails to accurately anticipate the
   possibility for obsolescence of the asset and set the less payment
   too low.

Disadvantage of Leasing

1. A lease does not have a stated interest cost. Besides at the end of
   the term of the lease agreement, the salvage value of an asset, if
   any, is realized by the leaser. Thus in many of the leases, the
   return to the lessor is quite high.
2. In a lease of an asset that subsequently becomes obsolete, under a
   capital lease the leasee still makes lease payments until maturity.

Summary

Firms have different alternative sources of long term finance including
equity debt and lease. Equity financing could simply mean raising long
term funds by selling common or preferred stock. Debt financing can be
through the issuance of debt securities like bonds. In lease financing
the leasee agrees to pay the periodically for the use of leaser’s
assets. Because of this contractual obligation leasing is regarded as a
method of financing similar to borrowing. There are two types of lease
agreements. These are operating lease and capital (or financial lease).
The principal factor affecting the decision to use equity or bond
financing is tax. Dividends on equity are not tax deductible whereas
interest on debt is deductible. This raises the relative cost of equity
compared to debt.