ADVANCED FINANCIAL REPORTING

FINANCING CAPITAL PROJECTS

CHAPTER 1 – LONG TERM FINANCE

In order to understand the two categories of long-term finance, consider the

Accounting Equation covered in Financial Accounting 1.

ASSETS = EQUITY + LIABILITIES

From the above equation it is evident that long-term finance can either be equity
finance or debt finance. Furthermore, long-term finance can be sourced internally or
externally.

1. Sources of long-term finance

Companies can raise long-term finance from the following sources:

Capital markets - Capital markets deal with long-term finance only. Capital markets
are split into two categories namely primary market and secondary market. The
difference between these two is shown in Figure 1 below. However, there are capital
markets that fulfil both the primary and secondary functions. In the UK, the capital
market is split into two namely Full Stock Market and Alternative Investment Market
(AIM), where AIM is for smaller companies.

Figure 1: Primary and secondary markets Source (WallStreetMojo, 2023)

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FINANCING CAPITAL PROJECTS

In order to raise funds from the capital markets, a company must be listed on a
recognised stock exchange. When an entity obtains a listing for its shares, this is
referred to as a flotation or Initial Public Offering (IPO). Below is a table with
advantages and disadvantages of a listing.

Advantages of listing Disadvantages of listing

Once listed, the market will provide a more Costly (flotation costs, underwriting costs)
accurate valuation of the company
Creates a mechanism for buying and selling of Dilution of control of the original owners
shares in the future
Raise the profile of the entity Reporting requirements are more burdensome
Raises increased capital for future investment Stock exchange rules for obtaining a
quotation/listing can be stringent
Makes employee share schemes more
accessible

Key stakeholders in a share issue are discussed below:

• Investment banks - usually plays a significant role in a share issue, and they
advise on
o appointment of other specialists (e.g. lawyers)
o stock exchange requirements
o forms of any new capital to be made available
o number of shares to be issued and the issue price
o arrangements for underwriting
o publishing the offer
• Stockbrokers – provide advice on the various methods of obtaining a listing.
They may also work with investment banks on identifying institutional investors.
• Institutional investors – investors from large organisations or institutions.
• Registrars to an issue – provide administration functions such as collecting and
processing applications from potential investors, monitoring payments made to
and from investors.
• Public and investor relations – ensures that the communication regarding the
share issue is transparent, informative, and is understandable to those
investing.
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FINANCING CAPITAL PROJECTS

• Reporting accountants – provide advice regarding the impact on the financial

statements of any potential share issue.
• Underwriters – they assume the risk associated with new issue.

Banks and finance houses - Banks and finance houses offer both long term and short-
term finance.

Government and similar sources – include government grants and charitable grants.

Other sources of finance

• Retained earnings/existing cash balances
• Sale and leaseback
• Debt with warrants attached – a warrant is an option to buy shares at a specific
point for a specified price, and it can be sold separately.
• Convertible debt – similar to debt with warrants except that with convertible debt
the option to convert to debt is not traded separately.
• Venture capital – finance provided to growing, unlisted profit-making entities to
help them to expand.
• Business angels – business angels are wealthy investors who provide equity
finance to small businesses

2. Equity finance
Equity is another name for shares or ownership rights. The company issuing the
shares will recognise the share as an equity instrument or a financial liability.
Furthermore, only authorised shares may be issued. Below are the general
characteristics of equity finance:
• Shares will have a nominal value – take note that par value shares are no longer
applicable in South Africa except for companies that already had them.
• The nominal value is linked to the primary function of capital markets, where it
will reflect the minimum amount to be raised.
• Shares are traded at market value, and this market value fluctuate over time.
• Shares cannot be issued at a price lower than nominal value.
• Share price can drop below nominal value.
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FINANCING CAPITAL PROJECTS

Share – fixed identifiable unit of capital in an entity. Shareholders receive returns in

form of dividends received and increase in share prices.

Ordinary shares – these shares pay dividends at the discretion of the entity’s directors.
Ordinary shareholders have the right to attend meetings and vote. Below are the
characteristics of ordinary shares:
• Provide voting rights for shareholders.
• Dividends are discretionary.
• Shareholders are the last to be paid upon liquidation.

Preference shares – these shares pay a fixed dividend, and it is paid before ordinary
share dividends. Preference dividends are paid out of post-tax profits, and these
dividends can be discretionary or non-discretionary. Below are the different types of
preference dividends:

• Redeemable preference shares

• Irredeemable preference shares
• Cumulative preference shares
• Non-cumulative preference shares
• Participating preference shares
• Non-participating preference shares
• Convertible preference shares

The above preference share types are not mutually exclusive. Below are the
characteristics of preference shares:
• They have no voting rights.
• Dividends are almost guaranteed and based on a % of the nominal value.
• They are positioned above ordinary shareholders.
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FINANCING CAPITAL PROJECTS

3. Methods of issuing shares

The most common ways to issue shares are an IPO, a placing, a rights issue. An IPO
is for companies that seek a listing on the stock exchange for the first time, whereas
a placing and a rights issue are for entities already on the stock exchange.

Initial Public Offering (IPO) – the offer could be made at a fixed price set by the
company or via a tender offer. Regarding a tender offer, investors are invited to tender
for new shares at their own price. The company would have to decide on the best price
that will raise the required capital. Below is an example of a tender offer.

Example of a tender offer

Delco Co needs to raise R100 000 to invest in a new project. The following offers have
been received.

Maximum price offered per share Shares requested at this price

R1.80 80 000
R2.50 8 000
R3 20 000
R3.50 15 000

If Delco set its price at R3.50, it will raise R52 500 (R3.50 x 15 000), and this amount
is not enough. Then, if the price is set at R3, the company will raise R105 000 (R3 X
35 000), and this will be enough. Hence, Delco Co should set its share price at R3.

Placing – shares are placed directly with certain investors (normally institutions), on a
pre-arranged basis.

Rights issue – shares are offered for sale (usually at a discounted price) to existing
shareholders. This right to buy shares before outsiders is known as pre-emption rights.
Regarding a rights issue, the set price should be low enough to secure acceptance,
but, not too low so as to avoid excessive dilution of the earnings per share.
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FINANCING CAPITAL PROJECTS

Market price after a rights issue

• After the announcement of a rights issue, the share price usually falls due to
uncertainty about:
o consequences of the issue,
o future profits,
o future dividends.
• After the actual issue, the market price will normally fall again because:
o more shares in issue cause an adverse effect on earnings per share,
o new shares were issued at a discount on market price.

Cum rights
Soon after a rights issue is announced, existing shareholders will have the rights to
participate in the new issue. At this point, existing shares will be traded “cum rights”.

Ex rights
Once the rights issue has started, old shares will be traded without the rights “ex
rights”.

Theoretical ‘ex rights’ price (TERP)

This is a theoretical price after a rights issue. It is calculated as follows:

(𝑁 × 𝐶𝑢𝑚 𝑟𝑖𝑔ℎ𝑡𝑠 𝑝𝑟𝑖𝑐𝑒) + 𝐼𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒

𝑁+1

N = number of shares required to be held in order to receive one rights issue share
(e.g. 1 for 5 rights issue, N = 5).
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FINANCING CAPITAL PROJECTS

4. Long-term debt finance

With debt finance, a business gets funds (loan) without conferring ownership rights.
Debt finance creates an obligation for the repayment of capital and interest payments.
Key characteristics of debt financing are:
• Interest is paid out of pre-tax profits.
• Carries a significant risk of withdrawal of finance if repayments are not met.
• Debt finance can have nominal values (e.g. bonds and debentures).
• Market values of debt represent the cash received.
• Debt finance can be issued at prices lower than the nominal value.

Security – charges – Sometimes lenders require some form of security against the
funds. There are two types of security, and these are:
• Fixed charge – the debt is secured against a specific asset, normally land or
buildings.
• Floating charge – the debt is secured against underlying assets that are subject
to change in quantity or value (e.g. inventory).

Covenants – specific requirements or limitations laid down as a condition of taking deb

finance.
• Dividend restrictions – limitations on the level of dividends a company is
permitted to pay.
• Financial ratios – specified levels below which certain ratios may not fall under.
• Financial reports – regular accounts and financial reports to be provided to the
lender.
• Issue of further debt – the amount and type of debt that can be issued may be
restricted.
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FINANCING CAPITAL PROJECTS

REFERENCES
Kaplan. 2019. Advanced Financial Reporting (F2), CIMA Official Study Text, 2019
Edition. London: Kaplan Publishing.

Service, C. 2022. Gripping GAAP: Your guide to International Financial Reporting

Standards, 22nd Edition. Durban: LexisNexis.

WallStreetMojo. 2023. Secondary market. Available from:

https://www.wallstreetmojo.com/secondary-market/ (Accessed 29 January 2023)