Sources of Finance for PLC

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Table of Contents
Table of Contents...................................................................................................3 ............................................................................................................................. 3 Executive Summary...............................................................................................5 1. Introduction....................................................................................................... 6 2. Shares................................................................................................................7 2.1 Equity Shares................................................................................................7 2.1.1 Critical Evaluation of Equity Shares........................................................8 2.2 Preference Shares........................................................................................8 2.2.1 Critical Evaluation of Preference Shares.................................................9 3. Debentures........................................................................................................ 9 3.1 Critical Evaluation of Debentures...............................................................10 3. Retained Earnings............................................................................................11 3.1 Critical Evaluation of Retained Earnings.....................................................11 4. Bank Loans......................................................................................................12 4.1 Critical Evaluation of Bank Loans................................................................12 5. Considerations of Choosing Type of Source Use..............................................12 5.1 Finance Availability.....................................................................................13 5.2 Financing Requirements.............................................................................13 5.3 Repayment Terms......................................................................................13 5.4 Cost of Financing........................................................................................13 5.5 Other Considerations..................................................................................13 6. Conclusion....................................................................................................... 14 References:..........................................................................................................15

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List of Figures Figure 1.1 Source of Finance 04 Figure 1.2 Types of securities 05 List of Tables Table 1.1 Differences between equity and preference shares 07 Table 1.2 Differences between shares and debentures 08 Table 1.3 Analysis of sources of finance 12

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Executive Summary
The amount that a company needs for its establishment or growth is based on the nature and size of its business. The scope of generating long-term finance depends on the sources from which funds are easily available. This paper discusses and evaluates various sources of finance available to a public listed company for generating capital internally or externally. A total of four sources of finance (i.e. shares, debentures, retained earnings, and bank loans) are identified and evaluated by considering the merits and demerits of each. In addition, these sources were also evaluated on the basis of each factor that must be considered when a public listed company is choosing a method of finance. It was found that funds generated from shares and retained earnings are costless and easy in terms of repayment.

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1. Introduction
Finance is important to effectively run all business operations. In fact, finance is not only required for starting a business, but it is also needed for its growth. While discussing about the capitalisation, it has been seen that the amount of long term capital should not be less than requirement nor it should be more than a requirement. There should be a situation of what can be called as fair capitalisation. The next question which arises is what should be the various sources from where the long term capital may be raised? Figure 1.1 illustrates different sources of finance available to a company for generating funds.
Figure 1.1 Source of Finance

Source: Sofat and Hiro (2010, p. 456)

These sources of finance can be categorised as owned capital and borrowed capital. Both contain several securities that a public limited company can use to raise funds. Figure 1.2 shows a clear picture of these securities.

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Figure 1.2 Types of securities

Source: Chandra and Bose (2006, p. 238)

In this paper, the following four sources of finance available to a public listed company are discussed and evaluated critically: Shares Debentures Retained Earnings Bank Loans

2. Shares
A share represents a smallest unit of a companys overall capital. Normally, a company itself decides the nominal or face value of its share (MacKie-Mason, 2000). In normal circumstances, a public limited enterprise can generate long-term finance by issuing two kinds of shares: Equity Shares Preference Shares

2.1 Equity Shares

The financial structure of any company is primarily based on equity shares so this type of shares is commonly used to raise long-term finance (Porter and Norton, 2009). Most of the public listed companies use equity shares as their strength to procure other sources of finance.
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The share is a company's owned capital which is split into a large number of small equal parts, each such part being called a share. Those who purchase these shares are called 'equity shareholders'. They are the owners of the company. It is a permanent capital and provides a base to the capital structure of a company (MacKie-Mason, 2000). 2.1.1 Critical Evaluation of Equity Shares In describing the merits of equity shares as a source of finance, Chandra and Bose (2006) assert that raising finance from equity shares is a permanent base for any organisation or in words, it can be said that a company does not need to repay its finances during its lifetime if it generates funds from equity shares. Therefore, an organisation can acquire funds on unsecured basis which means that a firm is not required to offer its assets as security to the investors. The major advantage of equity shares is that the company does not pay fixed dividends to the shareholders (Singla, 2007). The dividend payout ratio depends upon the earnings of the company in a single financial year. Likewise, Chandra and Bose (2006) referred equity shares as a risk free source for generating long-term finance where an organisation does not perpetrate anything in return. Singla (2007) on the other hand argued that raising funds through equity shares can be an expensive option for the organisation because the associated cost of these shares is higher than the cost of a borrowed capital. Also, if the company will issue equity shares in excess then it will lose the cost advantage that will result in over capitalisation. Ross (2007) asserts that if the company wants to issue additional equity shares, it is under legal obligation to offer these equity shares to the existing shareholders first, before going to the open market as a general offer. This right of equity shareholders is called Pre-emptive Right. Chandra and Bose (2006) outline that if a public listed company will only consider equity shares for generating funds, then it might not able to trade by issuing other securities in the long run.

2.2 Preference Shares

Preference shares are the shares which have the privilege over equity shares on the basis of following two factors. In case of preference shares, the dividend payout ratio is fixed and shareholders are paid fixed dividends over the period (Ferran, 2008). The amount invested in preference shares is paid back to shareholders in case of winding up of the organisation. This amount is basically paid back before paying back investments to equity shareholders (Quiry et al., 2011).
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2.2.1 Critical Evaluation of Preference Shares Funds acquired by an organisation through preference shares are needed to pay back before the company winds up (Ferran, 2008) and this is the reason that according to the provisions of section 80 of the Companies Act, any company in the UK cannot issue preference shares more than 20 years of duration. As such, unlike equity shares, preference share is not a permanent capital available for the company (ibid). In addition, companies are bound to pay fixed dividends to shareholders which is payable by the company out of the profits earned. However, unlike equity shares, the rate of dividend is prefixed and precommunicated to the investors (Smart and Megginson, 2008). On the other hand, same like equity shares, an organisation can acquire funds on unsecured basis using preference shares which means that a firm is not required to offer its assets as security to the investors (Quiry et al, 2011). Table 1.1 illustrates clear distinctions between equity shares and preference shares.

Table 1.1 Differences between equity and preference shares

Source: Chandra and Bose (2006, p. 242-243)

3. Debentures
A debenture often refers to a document from any organisation that contains an acceptance of indebtedness, providing a responsibility to repay the debt within a specific time period. In other words, it can be said that debenture is a loan certification which shows that company is accountable to pay a specific amount including interest within specific time period to debenture holders. The finance arranged through debentures later on turns into a part of organisations capital structure but it does not become a part of companys share capital. The interest on debentures is a charge on the profit and loss account of the company (Ahmed,
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2007). The debenture holders are not the company owners (Leland, 2004); they in fact are the companys creditors who provided finance to the company. The interest rate on debentures is fixed and determined at the beginning of the contract. Funds arranged through debentures are needed to pay back to debenture holders during the lifetime of the enterprise.

3.1 Critical Evaluation of Debentures

The cost associated with debentures is comparatively less than the associated cost of equity shares (Singla, 2007). The organisations sometimes borrow many small loans for a short period of time which may prove to be expensive sources of generating funds. The companies can however convert all those amounts into a single issue of debentures which can be beneficial for them in terms of cost (Leland, 2004). In addition, the debenture holders are not the company owners so they do not have right of voting. This means that the controlling position of present shareholders is not affected when a company issues debentures (Chandra and Bose, 2006). Using debentures, any organisation can acquire funds on secured basis which means that a firm is required to offer its assets as security to the investors. In the books of finance, raising funds using debentures is not encouraged and considered as a cheap source of arranging finance because it is a very risky step for the company (Ahmed, 2007). Raising funds through debentures can be risky for the firms in two ways. First, the organisation is required to pay interest at pre-settled rate within pre-settled time period irrespective of unavailability of revenues. Secondly, a firm is required to pay back principal amount during its lifetime. In case, if the company is not earning stable profits or the demand of its commodities is highly elastic, then it is a very risky step for the company to generate funds through debentures. Therefore, issuing debentures cannot fulfil the requirement of raising long-term funds for a trading business because it may not have adequate fixed assets to be offered as security (Brigham and Gapenski, 1998). Table 1.2 differentiates debentures with shares on the basis of their characteristics.
Table 1.2 Differences between shares and debentures Shares Element of companys ownership capital Company pays dividend Dividend payable in case company gets profit Debentures Element of companys creditor-ship capital Company pays interest Interest payable in case of profit/loss

Shares can be issues at discount with legal Debentures can be issued at discount without 10 | P a g e

restrictions No charges payable to shareholders on assets of company

legal restrictions Charges are payable to debenture holders on assets of company claim over

Shareholders have no prior claim over debenture Debenture holders have prior holders in case of winding up shareholders in case of winding up

Source: Chandra and Bose (2006, p. 246)

3. Retained Earnings
Retained earnings is also a well-known source of generating long-term capital which denotes the profit of the company which is not actually given away as dividend, instead, keeping it aside for several purposes such as expansion of the business, modernisation, acquiring new assets or latest technology, meeting the requirement of working capital, or debt redemption (Asquith and Mullins, 2006). However, this source can be advantageous for the company but proper balance is to be maintained as regular use of this source would result in resentment of shareholders.

3.1 Critical Evaluation of Retained Earnings

A number of benefits of using retained earnings as an internal source of finance to a public listed company are mentioned by several experts. For example, Sofat and Hiro (2010) regard retained earnings as a low-cost source of financing that helps an organisation not to raise funds from outside financing agencies or banks. In this way, it minimises the reliance of external sources of finance. Similarly, it makes company more finally stronger by increasing its credit worthiness (Gitman and McDaniel, 2008). Millichamp (2001) mentioned that retained earnings enables an organisation to adopt a stable dividend policy. Some other benefits of retained earnings as a source of financing are: self-reliance, smooth business operations, no legal formalities, enhance business reputation, withstand in difficult situations, and increase in capital formation (Chandra and Bose, 2006; Gitman and McDaniel, 2008; Sofat and Hiro, 2010). On the other hand, it is argued that funds can be used inappropriately which can lead distrust or unrest of shareholders (Millichamp, 2001). Chandra and Bose (2006) assert that using retained earnings are a source of finance may result in over-capitalisation and it also affects the balanced industrial growth of a public limited company. Sofat and Hiro (2010) added that retained earnings may be misused by the management to speculate and increase the shares value.
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4. Bank Loans
Over the past few decades, long-term bank loans have become an encouraging source for companies to meet the requirements of long-term funds generation (Chandra and Bose, 2006). The advances in the operations of commercial banks make it easy for public listed companies to obtain long-term loans. Asquith and Mullins (2006) state that bank loan plays a very important role in the conditions of the credit constricts. Usually, the banks urge companies to obtain long-term loans at a higher rate of interest for a specific time period.

4.1 Critical Evaluation of Bank Loans

The organisations find bank loans as one of the most attractive sources for funds generation due to following reasons. Nowadays, raising funds by means of taking a bank loan is more convenient to companies than borrowing funds from other methods in terms of secure transaction and generating quick finance (Gitman and McDaniel, 2008). In addition, a large amount of money can be borrowed when required. The company can raise the funds which can be used for any purpose. The ultimate utilisation of raised funds through a bank loan does not committed by the organisation (Smart and Megginson, 2008). Asquith and Mullins (2006), bank loans are reliable and certain. This means that banks will give loans when an organisation is prospering as well as to support the company in crisis. In spite of above mentioned advantages, bank loan is subject to a number of disadvantages. For instance, in the opinion of Sofat and Hiro (2010), borrowing money from financial institution such as bank is a tiresome job which involves the fulfilment of several procedural requirements. For example submission of periodical statements, security requirements, margin money stipulation etc. Similarly, Chandra and Bose (2006) mentioned that the interest rate which organisation pays on bank loans is relatively higher than the interest rate payable on finance generated from other sources.

5. Considerations of Choosing Type of Source Use

A number of factors must be considered when a public listed company is choosing a method of finance. These factors are as follows:

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5.1 Finance Availability

The first consideration when choosing a type of source use is to evaluate different alternative sources for finance availability. Most of the public listed companies usually do not rely on a single source for cash needs (Keller, 2011).

5.2 Financing Requirements

Financial requirements are different for each source of finance for a limited company. Some common requirements include financial ratio tests like interest coverage ratio and debt to equity ratio, credit score requirements, legal requirements, and permissions from stakeholders or debenture holders. Lumby and Jones (2003) emphasised the need to ensure all prerequisites before the final decision of choosing a specific source of finance.

5.3 Repayment Terms

It is also to consider how long funds agreement is structured to end. Long-term borrowings may require a considerable amount of interest over time. In contrast, short-term borrowings can save a large amount of interest (Dillon, 1985). If there is no loan, then no interest expense is required. In addition, it is also important to consider the periodic payments to repay borrowings in order to avoid difficulties (ibid). Carmichael et al (2007) believe that it is better practice for companies to look for borrowings with a higher allocation to principal to reduce the overall cost.

5.4 Cost of Financing

It is also important to consider all interrelated costs with each financing type before reaching a final decision (Ogilvie, 2009). Some common costs associated with sources of finance may include origination fees, interest rates, brokers fees, application fee in case of loan, dividend payments, venture capitalist etc. Furthermore, financing via stock offerings can result in management change and a move in strategic focus (ibid).

5.5 Other Considerations

An asset or collateral is required to be considered when selected a particular source of finance because the lenders may liquidate companys assets for payments. Therefore, it is better

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practice to read the loan documents carefully. Similarly, the amount of financing does matter as well. Table 1.3 contains an analysis of different sources of finance on the basis of each factor that must be considered when a public listed company is choosing a method of finance.
Table 1.3 Analysis of sources of finance

6. Conclusion
The long-term finance refers to the permanent source of finance. The financial sources are broadly classified into share capital (both equity and preference) and debt (including debentures, long-term borrowing). A total of four sources of finance are discussed in this paper. These sources are evaluated on the basis of their advantages and disadvantages. In addition, a number of factors that must be considered when a public listed company is choosing a method of finance are also included in this paper. To find out which source of finance out of a total of four is better, the author analysed these sources on the basis of each factor that must be considered in selecting a method of finance. It was found that funds generated from shares and retained earnings are costless and easy in terms of repayment (see table 1.3).

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Millichamp, A. H. (2001). Finance for Non-Financial Managers. 3rd edition, Cengage Learning EMEA Ogilvie, J. (2009). CIMA Official Learning System Financial Strategy. 6th edition, Elsevier Pagan, A. (2008). Econometric Issues in the Analysis of Regressions with Generated Regressors." International Economic Review, 25, pp. 221-247. Porter, G. A. and Norton, C. L. (2009). Financial Accounting: The Impact on Decision Makers. 6th edition, Cengage Learning Quiry, P., Fur, Y. L., Salvi, A., Dallochio, M. and Vernimmen, P. (2011). Corporate Finance: Theory and Practice. 3rd edition, John Wiley & Sons Ross, S. A. , (2007).The Determination of Financial Structure: The Incentive-Signaling Approach." Bell Journal of Economics, 8, pp. 23-40. Singla, R. K. (2007). Business Studies. India: FK Publications Smart, S. and Megginson, W. L. (2008). Corporate Finance. Cengage Learning EMEA Sofat, R. and Hiro, P. (2010). Basic Accounting. 2nd edition, PHI Learning Pvt. Ltd

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