Finance and Financial Reporting Chapter 1

Key Principles of Finance

Introduction to Finance
Real assets mean the resources used by the company in their normal line of business to generate profits. Real assets are of two types: 1) Tangible assets which physically exist 2) Intangible assets which physically do not exist Financial manager stands between the Firms objective and Financial Market. Main role of Financial manager is capital budgeting decision (What the real assets should the firm invest in?) and financing decision (How to raise the finance for the real assets?). For financial manager capital budgeting decision is often complicated because of a) There is to choose one project between many possible profitable projects. b) It is very difficult to anticipate the future profitability of the project. Normally Financial decisions are taken by remit of controller, many times it is known as Chief Financial Officers. Role of Treasures: 1) Looks for after the company s cash 2) Raises new capital and 3) Maintains relationships with banks, investors and shareholders. Financial Analysis: Progress in management depends on applying the logic to experiences, to known or assumed facts in order to enlarge the area of understanding. Financial analysis may not improve the actual fortune of the project but it may nevertheless be able to: 1) Delineate the risk involved with project. 2) Highlight the salient features of project. 3) Possibly suggest methods by which these risks can be reduced. In short financial analysis means, financial implications of different possible course of actions.

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Finance and Financial Reporting Bussiness Objectives:

There are many groups involved in running a company: shareholders, managers, employees, lenders, customers, suppliers, the government. We must consider their interests and their role. A company is owned by the shareholders, shareholders appoint board of directors to run a company on their behalf and directors appoint a managers which are expert in their field and director delegate the operational decision making to the executives while retaining the control of strategic issues. This is known as divorce of management from control.
Such separation of ownership from management has advantages i.e. freedom for changing ownership without affecting to change the operational activities, freedom to hire professional managers has disadvantage i.e. if the advantages of owner and managers diverge. Conflicts between providers of finance: Conflict can arise between the shareholder and lenders of the company, shareholders may be interested in the high return and high risk projects whereas lenders may not be interest in the such projects, they simply interested in the getting their capital payments and interest promised. This can be characterized as the difference between the lenders short term desire for security and the shareholders long term interest in the development of the company. Conflicts between employees and managers: Conflicts can arise between the shareholder and managers may wish to invest in labour-saving technology, but workers may fear the loss of jobs, and consumer fears issue of quality. Conflicts between companies and community/government: Shareholders, management and employees wish to expand production on a Greenfield site, but the local community and local government fear reduction in quality of life and air pollution and more congestion.

Agency Theory
Agency theory, which considers the relationship between the principal and its agent, includes issues such as the nature of the agency cost, conflicts of interest and how to avoid them and how to incentivize and motivate the agents a) Agency cost arise due to the monitoring the managers b) Agency cost arises due to the seeking to influence the managers action c) Agency cost arises due to the managers do not act in the owners best interest.

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Finance and Financial Reporting Maximisation of Shareholders Wealth

The needs of shareholders will vary according to the factors such as: 1) Attitude towards risk 2) Time preference and consumption needs 3) Balance between need of income and capital growth 4) Tax Position

Capital Markets
For large, publicly quoted companies, the stock market serves as the performance monitor. Share prices of company changes with the market s perception to the firm s profits and future expected performance. Business organizations are, therefore, directly and measurably subject to the disciplines of the financial markets. These markets are continuously determining the valuations of business firms securities, thereby providing measures of the firms performance. The presence of the capital markets continuous assessment therefore stimulates efficiency and provides incentives to business managers to improve their performance. Key effects of the capital markets on a firm's decisions include: Sound investment decisions require accurate measurement of the cost of capital Limitations in the supply of capital focus attention on methods of raising finance Mergers and take-overs create threats and opportunities to be exploited Externalities require managers to determine the appropriate role of organizations

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Finance and Financial Reporting Chapter 2

Company ownership
Types of business entity Sole Trader:
Description
A sole trader is business entity owned by one person and which is not a limited company. Sole traders have unlimited legal liability for their business debts. Definition refers to an ownership of a business, there can be sole traders who have employees working for them. The sole trader can decide what to do with the business. (eg pass it on to an offspring) The sole trader can draw the money as and when he or she needs it.

Liability
Sole trader has unlimited liability. Means if a customer sues the sole trader, the total personal wealth of the sole trader, including his house and bank deposits, would be available to pay off the liabilities.

Legal and accounting documentation

A sole trader has to fill in a normal income tax return & no specific documentation is needed to legally establish this form of the business.

Partnership:
Description
A partnership is business entity which is owned by more than one person and is not a limited company. Partnership can be owned in equal or unequal amount by partners. Usually, partners will be involved in the running of business, but some partners may just provide the money and don t participate in day to day running of the business, such partners are known as sleeping partners. Partners will draw money out of the business time to time. This can be more or less (often less) than their share of profits. The internal accounts will show any surplus/deficit in each partner s capital account resulting from over or under drawing and from capital (finance) provided to the partnership.

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Finance and Financial Reporting

Liability
The owners have unlimited liability towards their business debts. All the partners are jointly liable for the business debts. They will also be severally liable , that is, each partner is liable to the full extent of his/her personal estate for the deficiencies of the partnership.

Legal and accounting documentation

Most partnerships will have a legal documentation known as Partnership Agreement which sets out the rights of individual partners. Like who will be taking decisions and how profits are shared among partners. The partnership also needs to provide the accounts to Her Majesty s Revenue and Customs ( HRMC ) so that they can work each partner s liability for the tax on their share of profits. Partners pay income tax.

Limited Companies:
Description
A limited company is the business entity which has legal identity separate from the owners of the business. It can own or deal in property in its own right. It can arrange contracts on its own behalf. It can sue and sued. A company can be fined by the court (but can t be imprisoned!). Most of the companies are owned by shareholders. They hold a certificate which states the number of shares hold by them in the company. The shareholders appoint directors who are responsible for the control of the business. Directors appoint managers who carry out directors policies on day to day basis. Sometime directors are elected as managers, in which case they are known as executive directors. Directors who are not involved on daily basis are known as non-executive directors.

Liability
The owner s liability is limited to the fully paid value of their shares. Shareholders have been issued Partly Paid then, in the event of liquidation, shareholders will only be liable to the outstanding installments. If the shares are full paid, the shareholders have no further liability. If shares have been issued at premium to their par value, the whole of this Share premium is payable at the outset, even if the shares are issued on a partly-paid basis. If the company becomes insolvent, creditors cannot claim further payment from the shareholders personal wealth beyond the fully paid value of their shares.

Legal and accounting documentation

Limited companies must have a Memorandum of Association and Article of Association. The Memorandum of Associations states the name of the company, its objectives, the total share values, their par values, etc. It must be sent to the registrar of the company before the company can be

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formed. Articles of Association lay down the internal rules by which the directors run the company and set out the rights of owners of the different classes of share capital. The contents includes internal arrangements such as voting rights of different classes of shares, rules for electing directors, payment of dividends and winding-up provisions. All companies must produce audited accounts each year. Companies pay corporation tax on the profits earned. Employee pay income tax on the wages and salaries earned.

Limited Liability Partnerships:

Description
This is a business vehicle that gives the benefits of limited liability whilst retaining other characteristics of a traditional business partnership. Any firm consisting of two or more members engaged in profit making venture, may become LLP. Unlike limited companies, there are no directors and no shareholders. LLP is separate legal entity, which can hold the property and to continue in existence regardless of changes in membership. Any third party dealing with LLP makes a contact with the LLP rather than with a member.

Liability
Whilst the LLP is responsible for its assets and liabilities, the liability of it members is limited. (As with companies, however, actions may be taken against individual member who are found to be negligent and fraudulent in their dealings.)

Legal and accounting documentation

Unlike a limited company, it has no Memorandum and Articles of association. It is governed by the partnership agreement that may already be in force within the existing partnership. In the absence of any agreement mutual rights and duties, it will be governed by the default provision in the regulations. Like a company it has to be registered at Companies House. An incorporation document must be submitted and signed by at least two persons, who will become the first members of LLP. A LLP is required to appoint at least two designated members who will be responsible for number of duties in running the LLP. LLP is taxed in the same way as partnerships are taxed.

Private and Public Limited Companies:

Public limited company
A public limited company is a company whose memorandum states that it is a public company and has a share capital of at least 50,000 pounds. The name of the public limited company must end with Public Limited Company or PLC.

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Finance and Financial Reporting

Private Limited Companies
All other companies are known as private limited companies. The private companies name must end with word Limited . They are not allowed to issue their shares to public.

Pros and Cons of Limited Company

Advantages of Limited Companies
1) it makes easier to raise the capital. 2) It is important for business ventures involving a risk of incurring substantial debts. Ex. Insurance companies which cannot exist without limited liability. 3) It is also important for the business which requires large amounts of capital. 4) Limited Liability Company allows large number of people to invest small amount of money with relatively minimal checking of the company s prospect which allows them to diversify their exposure to the sectors and reduces the risk of failure. Tight Shareholding In small companies, each shareholder can be executive director and can have some control over the company which is known as tight shareholding. Divorce of ownership from control In most of the companies, number of shareholders is very large and they take little or no part in the management of the company which is known as divorce of ownership from control. It allows the changes in the ownership without interference to operation of the business. It also allows to hire the professional managers.

Disadvantages of Limited Companies

1) Once the company s assets have got exhausted, trade creditors have no way of ensuring the payment. 2) It allows people to invest in the company for their short term interest, without looking into the long term interest of the company. 3) For shareholders, managers interest may be different from that of shareholders which is known as agency problem. 4) There is also a problem of information asymmetries where different stakeholders in the company has a different information about the company.

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Finance and Financial Reporting

Medium Term Company Finances

Hire Purchase
A hire purchase is an agreement to hire goods for a particular period of time making regular rental payments and to buy the same goods at the end of rental period. Legal ownership of the goods passes to the buyer after the last rental payment made. If the buyer fails to make the payments due under the hire purchase agreement, the seller can take back the goods. Hire purchase is more popular with the seller particularly dealing with the people having dubious creditworthiness.

Credit Sale
A credit sale is normal sale of goods with agreement to make a payment by series of regular installments over a set period of time. Legal ownership passes to the buyer at outset. The seller cannot reclaim the goods even if purchaser defaults on his payments. Only it can do is can sue the purchaser for payments through courts.

Leasing
A lease is an agreement in which owner of an asset allows the lessee to use the asset for a particular period of time in return for a regular series of payments. Legal ownership does not changes hands.

There are two types of Lease: Operating Lease and Finance Lease Operating Lease: It is a type of lease in which owner holds all the risk associated with the asset and the period of lease will be less than the life of the underlying asset. Finance Lease: Under this, lessee will take all the risk associated with underlying asset and the life of asset will be equivalent to the life of asset.

Bank Loans
A bank loan is the medium term borrowing in which full amount is credited into the borrowers current account and borrower undertakes to make interest payment and capital repayments on the full amount of loan. Bank loans are usually secured on the borrower s assets using a floating charge, that is, all the assets of the borrower are assigned as security for the loan.

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Finance and Financial Reporting

Loan facility is the type of facility in which borrower can borrow amount in installments, giving bank a few days notice before each new bit is taken out. Multi currency loan is the type of loan in which bank acts as the middle man arranges the money for the borrower in whichever currency it is best to borrow in. Syndicated loan is the type of loan in which various banks come together and give loan to the single project.

Short Term Company Finance

Bank Overdrafts
An overdraft is the facility in which a borrower can withdraw money out of its current account such that it becomes negative, down to an agreed limit. The borrower makes interest payment on the amount by which he or she is overdrawn. No explicit repayments are made. Overdrafts offered to companies are secured by floating charge, which is more than the bank loan of same amount. A bank can demand immediate repayment of an overdraft without any prior notice.

Trade Credit
Trade credit is the type of agreement between the company and one of its suppliers to pay for the goods and services after they have been supplied. In most cases no explicit interest is charged, in most countries late payments are so common that explicit discounts can be negotiated for not using trade credit. Using trade credit to the full is the way to obtain free finance for the company, but the problem is that it can damage the company s credit image.

Factoring
There are two types of factoring: Non-Recourse Factoring & Recourse Factory (Invoice Discounting) Non Recourse factoring is where the supplier sells on its trade debts to a factor in order to obtain the cash payment before the actual due date. The factor takes over all responsibility for credit analysis of new accounts, payment collection and credit losses. Recourse factoring is where invoice is sent to the factor who then gives the supplying company the money. However, supplying company is still responsible for collecting its debts. When supplying company eventually gets paid by a customer, it passes the amount to the factor. The factor has no control over the collection of due payment, so it charges the supplying company interest on the amount of invoice it has paid initially from the date the advance was made to the date that the date on which supplying company gives back the money to factor.

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Bill of Exchange
A bill of exchange (effectively, a claim to the amount owed by a purchaser of goods on credit) may be accepted by a bank (for a fee). This means that bank guarantees payment against the bill to whomsoever holds the bill at maturity. The bill can be used to raise the short term finance. Bills of exchange is also known as two name paper because they carry the name of the issuing company which owes the money and of the accepting bank. Where the endorser is an eligible bank, the bill is known as an eligible bill of exchange . An eligible bank is an investment bank whose endorsed bills of exchange are eligible to be sold to the Bank of England.

Commercial Paper
Commercial paper is single name form of short-term borrowing used by large companies. It comes in the form of bearer documents for large denominations which are issued at discount and redeemed at par.

Companies that wish to raise finance by issuing sterling commercial paper have to meet certain minimum standards. Issuing companies must: be listed on the London Stock Exchange. issue a statement to confirm that they comply with the requirements of the Stock Exchange, and that there have been no adverse changes in the company s circumstances since they last published accounts in accordance with Stock Exchange rules. The minimum size in which sterling commercial paper can be denominated is 500,000.

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Finance and Financial Reporting Chapter-3

Taxation
Personal Taxation
It will be levied on all the financial resources of individuals. Financial Resources of the individual can be as follows: 1. Income (whether earned wages and salary or unearned investment income and rent) 2. Profit from operating as a sole trader or partner 3. Inherited wealth 4. Investment gains 5. Value of assets held Most countries also levi social security contributions on earnings apart from tax.

Considerations:
Taxing Cash flows
It is based on the cash available to finance the tax payable. Tax is determined on the value of assets, there is possibility that these assets may have to be realized in order to generate the funds needed to pay the taxes.

Taxing in Arrears
In addition to ability to pay tax, governments will also seek to ensure that citizens have sufficient retained income and wealth to meet their essential needs. It is common, therefore, to assess tax liabilities in arrears taking into account all relevant sources of wealth and/or income, and to exempt some basic levels of income or wealth from the calculations. There can be arrangement where tax can be levied on the source of income throughout the tax period in order to accelerate tax flow to the government. In UK most of the employees pay income tax by PAYE(Pay As You Earn) scheme on weekly or monthly basis. In this case, the final assessment for the period will establish the final payments (or credit) needed to generate the correct overall tax payments. The self employed in the UK pay income tax twice a year, in January and July. An estimate is made of the current year s earnings and when the actual earnings are known, and amendment is made.

Taxing Once
Governments will seek to ensure that revenue flows are taxed only once in the hands of recipients. However, if taxes are also levied on wealth or the value of specific assets, then double taxation will be likely (since the assets may well have been acquired from after-tax funds).

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Finance and Financial Reporting Calculating Taxable Income

Government makes adjustment to total income of the individual to arrive at a taxable income. The government might exempt some sorts of income and some sorts of expenditure from tax. They may also treat some sorts of benefits as income in kind and therefore taxable income. If any income is received from investments and savings this must be added on to total income, even if tax has been deducted at source. There is usually an allowance i.e. an amount that a person is allowed to earn before paying any tax. This is deducted from total adjusted income to arrive at taxable income.

Tax free Income

Certain items of income are tax-free. For example, in the UK the following are tax free: 1. Most profits from gambling 2. Most forms of social security benefit 3. Income from certain types of investment such as Individual Savings Account (ISA) In the UK most forms of means-tested benefits, such as income support, are tax-free and most benefits that are not means-tested, such as pensions, are taxable. Means-tested benefits are those which require a person s income (or means) to be assessed.

Tax-free expenditure
Tax relief may be available on certain forms of expenditure such as contributions to an approved pension scheme and charitable gifts.

Income in kind
Where an employee receives additional fringe benefits as well as a wage or salary, the value of the benefits is usually included in the definition of taxable income. Eg. Company cars available for private use, free housing, subsidized mortgages, medical insurance premiums

Investment income deducted at source

Investment income often has income tax deducted at source. For tax purposes, the grossed up equivalent is included as taxable income, and the tax deducted at source can be offset against the person s tax liability. In UK, income in the form of company dividends are paid net of tax, with an attaching tax credit for the recipient. This is termed franked investment income.

Allowances
A tax-free slice of income known as a personal allowance may be deducted from income before

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determining liability to tax. Other additional allowances may also exist like age allowances or additional allowances for married couples.

Company Taxation
Companies are liable for corporate income tax i.e. corporation tax on their taxable profits. Taxable profits usually include both income (less expenses) and capital gains.

Accounting profit
Profit on ordinary activities before taxation Sales revenue - Expenses = Operating Profit + Non-trading income (interest, dividends, capital gains) = Profit before tax and interest - Interest paid = Profit before tax

Taxable profit
1) Add back any business expenses or potential expenditure shown in the accounts which are not allowable for tax. (E.g. entertainment of customers, fine for illegal acts etc). 2) Add back any charges for depreciation, and instead subtract the allowable capital allowance . 3) Deduct any special reliefs, eg research and development costs may be able to be deducted immediately.

Use of corporation tax system

Dividends which are paid out of the post tax income, is known as franked income. Most governments give at least some credit to shareholders for the tax that has been already paid. In this way shareholders are imputed or ascribed at least part of the tax. Such an imputed tax system ensures that there is no disadvantage experience by the shareholder when a company distributes profits. However, governments sometimes seek to incentivize companies to retain and reinvest earnings for faster rate of economic growth. This may be achieved by levying higher taxes on dividends than on retained profits, or by allowing tax relief for new investment (such as the capital allowances mentioned above). Profits flowing from such investment would then be taxed in the usual way. Accelerated depreciation If company purchases a new equipment, then the life of equipment is estimated and cost of machine is

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therefore spread over the life of the machine. Accelerated depreciation allows the company to depreciate a large part of the machine in the early years, thus increasing the company s costs, decreasing its profit and therefore decreasing its tax liability in the early years. Profitability and therefore tax liability will increase in the later years.

Capital Gain Tax

Individuals and companies are typically subject to capital gain tax on chargeable gains. This is normally assessed in the year in which gain is realized, so that funds to pay the tax should be available. Assets that are exceptions for calculating chargeable gains 1) Private motor cars 2) A main private residence 3) Foreign currency obtained for personal use 4) British Government securities and other qualifying fixed-interest stocks 5) Small tangible moveable assets worth less than 6000 pounds Chargeable gain=Sale price purchase cost Sale price can be increased by any costs associated with the sale and purchase price can be increased by the cost associated with the purchase of the asset. Indexation allowance Some countries have allowances to remove the inflationary element of any gain, or to encourage individuals to retain assets. Inflation is calculated with reference to the Retail Price Index(RPI), which reflects the rise in the general level of prices of goods in the UK. Since April 2008 in the UK, for individuals( including sole traders and partners), no allowances are made for inflation. Capital Loss Capital losses can normally be offset against capital gains in the same year. Any unused capital loss may be carried forward to be offset against capital gains in any future years. The rules for offsetting capital losses do not apply if the loss is only caused by the indexation allowance.

Other taxes
1) Stamp duty on contract documents. 2) Inheritance taxes 3) Property taxes 4) Sales tax: It is collected only at the point of final sale to the consumer 5) Value Added Tax: It is collected at each stage of production process according to the value added at

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each stage of the production process. 6) Customs duties: It is a tax on imported goods. It is generally based on the physical size of the goods and special taxes for certain industries such as the car industry based on emissions. 7) Excise duties are duties are taxes levied on goods produced and sold within the country, eg duties on petrol, beer, cigarettes.

Double taxation relief

Double taxation relief (DTR) means that the local tax authority will allow companies and individuals with overseas income to offset tax paid overseas against their liability to domestic corporation (or income) tax on that income. The maximum offset is the rate of tax that would have been paid locally on the grossed-up income. DTR is only available on income received from abroad, not on revenue of a capital nature.

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Finance and Financial Reporting Chapter 4

Financial Instruments
Loan capital
A company issues loan capital to raise money from the investors. It promises to give the series of interest payments and capital payment which are specified at outset, If not specified then at least formula to calculation will be specified. Long term loan capital is known as Bonds . Short term loan capital is known as Bill . Issues of loan stock can be listed on stock exchange. Holders of loan stock are creditors of the company, they will not have a voting rights.

Features It is conventional to represent bonds in the units of 100 pounds nominal. It is usual to represent interest payment as a percentage of the par value. It is normal to issue a loan capital just near to, below or at par. All most loan capitals are redeemed at par. Variations There can be various variations in the issue of loan capital such as: 1) The capital payment can be made between two dates at the company s option. 2) Interest payment may be set as a fixed margin over a benchmark interest rate. These are known as variable rates issues . 3) Interest and redemption payments can be linked to inflation index, which is known as index linked bonds. 4) Interest rates may increase in steps as in stepped preference shares; these are known as stepped bonds. 5) The company may be able to repay loan anytime, known as call option on bonds. 6) The loan stock holder may be able to demand repayment at any time, known as put option on bond. 7) Capital payment can be made throughout the term of the loan, which is known as sinking bond. Rights of bondholders The rights of bondholders will be set out in the loan agreement drawn up when the loan is issued. In most cases, a trustee is appointed to act on behalf of the bondholders. Usually trustee is bank or insurance company. The legal documentation setting out the obligations of the company to its bondholders is known as trust deeds.

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Debenture stocks
Debenture stocks are the loans which are secured on some or all assets of the company. This means that, if the company fails to make any of the interest or redemption payment then the debenture holder can appoint a receiver to intercept the income from secured assets or can take possession of the assets and can sell them to meet their debt.

There are two types of debentures: 1) Mortgage debentures(Fixed charge) Loan will be secured on the specific asset specified in the loan agreement. 2) Floating charge debenture The company can change the secured asset during the normal course of business. It is trustee s responsibility to give permission for the change of assets. When a company fails to make the payment, then debenture holder can apply to court to make the floating charge become the fixed charge. This is known a crystallizing. Interest payment to debenture holder is tax deductible, as it is paid by the company before the tax calculation of the company. Risk Payments on the debenture are legal obligation to the company, loan holder gets fully repaid in the event of the winding of the company before shareholder can receive anything. Therefore debenture of a company is the secured for of investment than the ordinary or preference share of a company. The rights of the debenture are secured in hands of trustee. Risk is still associated with debenture, as if the total assets secured become insufficient to repay the loan in case of winding up. Return As debentures are the form of secure investment, hence it provides lower returns. This return can be eroded against the inflation. Total return of a debenture would be expected to be Superior to that of convertible preference share since convertible share offers not only the income yield but a capital gain as well. Hence lower than the debenture. Less than that of an unsecured loan stock, because unsecured loan stock is more riskier and offer no capital growth. Marketability Marketability of debenture is usually worse than the government bonds; there are bigger

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spreads between the buying and selling prices and lower the volume trades. Therefore trading in debentures is less frequent.

Unsecured loan stock

Unsecured loan stocks are the loans which don t have any specific security. If the issuing company defaults the payment then to sue the company is the only remedy to the holder of unsecured loan stock. The unsecured loan stock holder stands after the debenture holder. Other creditors rank equally with the unsecured loan stock holders.

Risk Since there is no security for an unsecured loan stock it is more riskier and return is more than the high rank loans. Rights of the unsecured loan stock holder is specified in the trust deed and handled by trustee.

Return Gross redemption is yield is more than on the debentures to compensate for poorer marketability and more risk.

Corporate bonds are much more like government bonds. They are less secure than the government bonds. The level of security depends on the type of security, the company that has issued it and term. They are less marketable than the government bonds, mainly because of its issue size is much smaller than the government bonds.

Subordinated debt
Subordinate debt ranks after the general creditors of the firm but before the preference shares or ordinary shares. The rating of the debt and, consequently the terms on which it is issued, will reflect this lower level of security.

Eurobond loan capital

It is used to raise the money overseas. When a borrower issues a sterling denominated bonds in the UK market it is known as bulldog. When a borrower issues a sterling denominated bonds in the US market it is known as Yankee bonds.

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Eurobonds are the form of bearer documents. Most Eurobonds are redeemed at par on a set date with fixed coupon payments during the term of the Eurobond. Eurobonds are usually make coupon payment annually rather than semi-annually. Almost all Eurobonds are unsercured. Eurobonds are issued to raise large sum of money minimum acceptable issue is $75m or more. Key difference between Eurobonds and unsecured loan stock is the way Eurobonds are marketed.

Floating Rate Notes

Floating rate notes are medium term debt securities issued in the Euro market whose interest rate float with short term interest rates, possibly with a stipulated minimum rate. It is common for floating-rate notes to have a minimum interest rate below which the coupons will not fall even if the benchmark interest rate falls lower. This is known as an interest-rate floor. Thus, the issuer does not need to estimate the likely levels of future inflation and interest rates when issuing the notes, and the lender does not require an inflation risk premium. If inflation increases, short term interest rate increases. Hence issues of the floating rate notes and the borrower, both of them need not worry about the future interest rate.

Share Capital
Ordinary Shares(Equities-Residual)
Ordinary shares give rights to a share of the residual profits of the company, and to the residual capital value if the company is wound up, together with voting rights and various other rights. This is the major way by which companies are financed. Ordinary shareholders are the owner of business. They have voting rights equal to the proportion of the shares they held. They are eligible to receive the dividend payment. Dividends are not legal obligation of the company. They are paid at the discretion of the directors of the company. In practice they try to pay a steadily increasing stream of dividends. Dividends are paid from the after tax profit of company, giving shareholder a tax credit. This is known as franked investment income. Ordinary shares are the lowest ranking form of investment. On winding up of the company they will rank after all the creditors of the company. Ordinary shares are always irredeemable. They have a par value which is not related to the market value of share. No company is allowed to issue the ordinary share below its par value. The accounts of a company show the nominal value of the issued share capital(number of shares x par value)

The Memorandum of Association will set out the total nominal value of authorised share capital. This is the maximum amount that the directors can issue without calling for a vote from the shareholders.

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Above this limit the directors need the shareholders approval to increase the amount of share capital. The issued share capital is the nominal amount actually issued. The issued share capital cannot be greater than the authorized share capital.

Rights of ordinary shareholders: 1) To attend and speak at company meetings. They also have right to appoint a proxy who can attend the company meetings on their behalf but can t speak. 2) To receive the annual report, accounts and memorandum and article of the company 3) To appoint a company directors 4) To vote to change the companies borrowing power 5) To reduce the dividend but not to increase 6) To vote to forego the pre-emptive rights to be offered any new shares to be issued Variations in the issue of Ordinary Shares: 1) Deferred shares which come in two varieties: either no dividends are paid until normal ordinary shareholders receive it or profit reach a certain level, or no dividends are paid until a given date. 2) Redeemable ordinary shares which will be repaid by the company on a certain date 3) Non-voting shares 4) Shares with multiple voting rights 5) Golden shares in newly privatized industries. Golden shares are those held by the government following a privatization. These shares give the government certain rights, such as voting rights or veto on some issues. Expected return on the ordinary shares, will be influenced by the two things 1) How much yield it expects achieve 2) How much capital growth it expects to obtain by holding the share over a certain period. Dividend yield=net dividend paid per share/market price per share

Ordinary shares are the riskiest form of an investment. This can be defined into two components. 1) The uncertainty and volatility of the future income stream 2) The uncertainty of capital return in case of winding up of company Since they are riskiest investment options, they give high return Marketability of the Ordinary Shares Marketability of the ordinary shares is much better than the marketability of the other loan capital of the same company. This is mainly because of 1) For many companies, bulk of their capital is raised through the ordinary shares 2) For some companies, they have only ordinary shares whereas their loan capital is fragmented in

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different issues 3) Investors tend to buy and sell ordinary shares more frequently than the other loan capitals

Preference Shares
Preference shares are much less common than ordinary shares. The investment characteristics are much more like unsecured loan stock rather than ordinary shares. Assuming that the company makes a sufficient profit fixed stream of dividend is paid to the preference shareholder. They usually do not carry voting rights. They have preferential right over either dividend or capital growth or both, compared to the ordinary shareholder. If no dividend paid to preference shareholder then no dividend is paid to ordinary shareholders. Preference shareholders have voting rights, if the rights attaching to their shares are being varied. Dividends on preference share are set to a limited amount which is always paid. Most preference shares are cumulative or irredeemable. Cumulative preference shares require any unpaid arrears of dividends, as well as the current year s dividend, to be paid before any dividend can be paid to ordinary shareholders. Variations: 1) non-cumulative 2) Redeemable 3) Participating 4) Convertible 5) Stepped Preference share rank below the loan capital and above the ordinary shares, if the company wound up. Risk of preference shareholders not getting their dividends is greater than the risk of loan stockholder not being paid, but less than the risk of ordinary shareholders not being paid. Preference shares offer a relatively predictable future income stream, but uncertainty about the return of capital in the event of winding up. If there were no tax complications, the expected return on preference share will be more than the expected return on loan capital for all shareholders.

Other types of long-term finance

Convertibles: These are the form of the securities like unsecured loan stocks or preference shares that convert into ordinary shares of the issuing company. Convertible preference shares are preference shares which give the right to convert into ordinary shares at a later date. The investor does not pay anything to convert other than surrendering the convertible preference shares. Convertible unsecured loan stocks are unsecured loan stocks which give the right to convert into ordinary shares of the company at a later date.

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The only difference between convertible loan stocks and convertible preference shares is the form of the capital before it converts into equity. Convertible loan stocks are part of loan capital until conversion, whereas convertible preference shares are part of share capital. They are popular in the United States as a form of finance for new companies. These companies have no track record and might find it difficult to raise funds in more conventional ways. Investors have the security of a fixed return in the short term and the possibility of long term capital gain if they convert to ordinary shares in the future. This additional prospective return means that the issuer does not have to offer excessively high rates of interest on the loan stocks in order to attract lenders. If the holder chooses not to convert, then the security might continue as a loan stock or preference share for a period of time known as the stub. Alternatively it might be redeemed on a prescribed basis immediately. There will be a specified number of ordinary shares for each convertible. The date of conversion might be a single date or, at the option of the holder, one of a series of specified dates. The period prior to the first possible date for conversion is known as the rest period. The period during which conversion may take place is, not surprisingly, known as the conversion period . At any time, the cost of obtaining one ordinary share by purchasing the required number of convertible securities and converting can be compared with the market price of the share. The difference is known as the conversion premium. The characteristics of a convertible security in the period prior to conversion are a cross between those of fixed-interest stock and ordinary shares. As the likely date of conversion (or not) gets nearer, it becomes clearer whether the convertible will stay as loan stock or become ordinary shares. As this happens, its behavior becomes closer to that of the security into which it will convert. There will generally be less volatility in the price of the convertible than in the share price of the underlying equity. The security of dividend payments for a convertible is higher than that of an ordinary share, and the option to convert to an ordinary share or leave it as a fixed-interest security allows the investor to be sure of a minimum expected return. Because convertibles do not benefit from the dividend growth enjoyed by ordinary shareholders, convertibles generally provide higher income than ordinary shares. Conversely, because they do offer the prospect longer term of benefiting from the growth of the dividends, convertibles will provide a lower income than conventional loan stock or preference shares.

Warrants
Warrants are call options written by a company on its own stock. When they are exercised, i.e. when the purchaser exercises his/her right to buy the shares, the company issues more of its own shares and sells them to the option holder for the strike price. Thus, the exercise of a warrant leads to an increase in the number of shares that are outstanding. This, in turn, leads to some dilution in the value of the equity. Warrants are also often given to investment banks as compensation for underwriting services or used to

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compensate creditors in the case of bankruptcy. Typically, a warrant lasts for a number of years. Once they have been created, they sometimes trade separately from the bonds to which they were originally attached.

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Finance and Financial Reporting Chapter 6

Issue of shares
Obtaining a stock exchange quotation
Quotation means price of the security of the company is included in the official list of the exchange. There are two different types of markets for UK equities: 1) Alternative Inevestment Market (AIM Established in Jun 95) 2) The main market Full listing in main market requires 25% of shares to be in public hands ( There is no such requirement for an AIM) Full listing requires a three-year trading record ( There is no such requirement for an AIM)

The reason for seeking a quotation

Obtaining a quotation has costs (eg. Accountants, solicitors and broker fees), also maintaining costs (eg. Annual fees paid to the stock exchange) To raise the capital for the company obtaining a quotation allows company to sell new shares in wide market and thus raise large sums of money as cheaply as available. Vast majority of companies choose a method of obtaining a quotation which simultaneously raises new funds. To make it easier for the company to raise further capital once the company has quotation it will be easier to sell a new shares in future. In addition, providers of debts finance will be happier to lend more money to listed companies as they need to fulfillment the stock exchanges requirements. To give existing shareholders and exit route This allows existing shareholders to capital. Specialist providers of equity capital to small unquoted businesses usually want to realize their investment after few years, So quotation gives them a exit route. To make shares more marketable and easy to value 1) The fact that shares can be easily values helps with inheritance and CGT tax calculations 2) Shareholders will find the shares more useful as backing for their own borrowing 3) Quoted companies usually offer their shares to offer to the target company s shareholders in a takeover bid. Quoted shares are much more effective for this purpose. 4) Some companies offer employees share schemes to help motivates staff. Such schemes will be more attractive if the companies have quoted shares.

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Finance and Financial Reporting Methods for obtaining a quotation

Offer for sale (at a fixed price)
In an offer for sale at a fixed price, a predetermined number of shares is offered to the general public at a specified price via an issuing house. This is most common type of method used by companies to obtain the quotation. The issuing house and underwriting Rather than selling shares directly to public, company or existing shareholders sell their shares to an issuing house. And then, issuing house takes all the responsibility to sell shares to public. In this way issuing house underwrites the issue. Issuing house are generally part of investment bank. Along with underwriting the offer for sale, their role is to act as professional adviser to the issuing company, to overview the whole process and to coordinate with other professional advisers. Issuing house get the payment either charging the fees to company or the price at which company issues share to the issuing house is slightly lower than the subsequent price at which issuing house sell shares to the public. Time table for the issue of shares About an year before offer The directors of company will start to talk to an issuing house at least an year before in order to issue of shares. The issuing house will try to ensure the pre launch comments in the press are in their favor. The company will also need to prepare itself eg by changing its Memorandum of Association to make it a public limited company. The weeks leading to the issue In this period issuing house will advise on the price which should be set. The tradition is to be fairly conservative in pricing new shares i.e. to set the price on low side. However, price will not be set until the final prospectus is published. Impact Day Once the offer price is set prospectus is published and made available to public. It will also be reproduced in any of the national newspaper, and the prospectus may be made available through the other channels such as high street banks. The prospectus contains a great deal of information about the company, its objectives, activities, financial position, reasons for the issue and people involved in the issue. There is a duty of the professional advisers to disclose all relevant information. Applications Typically, applications from the public to buy securities can be made for a period of about a week following the issue of the prospectus. If issue is oversubscribed by the time the offer is closed. Issuing house needs to determine the basis of allocation ie how it will determine which offers to accept in full, which to reject, and which to scaledown.

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There are two objectives to be balanced: 1) Ensuring that the securities are widely held (so that there is an active market in the shares) 2) Reducing administration costs. Letters of acceptance Letters of acceptance is sent out to everyone whose applications have been selected. And refund cheque will be sent to those whose application got rejected or scaled down. Official trading will take place after the day of posting the letter of acceptance.

Offer for sale by tender

An offer for sale by tender is similar to an offer for sale at a fixed price. However, instead of inviting applications at a specified price, the issuing house invites members of the public to submit a tender stating the number of shares which they are prepared to buy, and the price which they are prepared to pay. After the offer closes, the issuing house will determine a single strike price. This may be the highest price at which all the stock can be allocated. However, a lower strike price will be chosen if this is necessary to ensure a sufficient spread of shareholders. All applicants who bid at least as much as the strike price will have their applications accepted. All successful applicants will pay the strike price, regardless of how much more they had bid. Applicants who bid less than the strike price will have their applications rejected. Disadvantages of offer for sale by tender 1) Allocation process is more complex in nature. 2) Probability for more concentrated ownership of the shares which leads to detrimental to their marketability. 3) Smaller investors are put off by the tender process.

Offer for subscription

These are similar to offers for sale. They are normally at a fixed price, but can be by tender. However, the whole issue is not underwritten. The company sells shares directly to the public. The issuing company bears (at least part of) the risk of under subscription. An issuing house will still be employed as an adviser to the issue.

Placing (Selective Marketing)

A simpler, cheaper method of making small issues is known as a placing or selective marketing . The issuing house first buys the securities from the company. The issuing house, or a stockbroking firm, will then individually approach institutional investors such as pension funds and life offices directly. The institutions will be offered securities, but no public applications are invited. Companies like placings because they are cheaper for two main reasons: advertising and administration costs are minimised no sub-underwriting is needed (the process of a placing itself is very similar to the process used to obtain sub-underwriters anyway).

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Introducitons
Not all of the reasons for wanting a stock exchange listing involve the immediate desire to raise new money or the sale of existing shares. In these cases, a stock exchange may allow the shares to be introduced to a stock exchange listing. Introductions do not involve the sale of any shares. They simply mean that the existing shares will in future be quoted on the London Stock Exchange. As always for a full listing, 25% of shares must be in public hands, that is, the free float of shares available for purchase excluding strategic holdings in subsidiaries or cross-holdings must be at least 25% of the issued shares. The Stock Exchange only allows introductions in cases where this requirement is already met. Introductions can be used in several circumstances. For example: where an overseas company is already listed in, say, the USA, but wants to have a UK Stock Exchange listing as well where an already listed company wants to de-merge into two or more separate companies; the new companies will obtain a quotation by way of an introduction where an unquoted company already has shares in wide ownership and sufficient capital but wants to become quoted.

The role of underwriting

1) Rather than run the risk of not managing to sell all the shares and raise enough money, the company arranges to sell all the shares at an agreed price to the issuing house. The company will pay the issuing house a fee. Alternatively, in the case of an offer for sale, the fee can be included in the difference between the price at which the shares are sold to the issuing house and the price at which the issuing house sells them to the public. 2) The issuing house accepts the risk that all the shares may not be bought. However, the issuing house will not want to retain the entire risk. The issuing house will arrange sub-underwriting. In return for a commission the sub-underwriters agree to take a proportion of the shares that are not bought by the public. 3) Issues are priced so that they should be successful. Issuing houses take care not to over-price issues. The main risk faced by underwriters is that an unexpected event occurs between agreeing to accept the underwriting and the closing date for the offer for sale. 4) Fully subscribed issue: The issue goes ahead, and is fully subscribed. The issuing house and the subunderwriters will have made an underwriting profit equal to their underwriting commission less any administrative expenses. Partly subscribed issue: The issue goes ahead, but not all of the shares are purchased. The underwriters and sub-underwriters get their fee/commission, but they also need to pay for all the shares that have not been purchased.

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Issues made by the company already quoated
Company wanting to raise new ordinary share capital Company wanting to increase the number of shares in issue, without raising new money Company wanting to raise the new loan (or preference share) capital Existing shareholders wanting to sell large block of shares

Rights Issues
A right issues the issue in which company offers further shares to existing share holders in proportion to the number of shares held by them. The price will be discount to the current price of the shares price. The main effects of a successful rights issues are: 1) New shares are created 2) New money is raised for the company 3) Total value of the company is increased by the extra money raised 4) Price of the share falls depending on the number of shares issued and level of discount provided Purpose of a rights issue 1) 2) 3) 4) 5) The company has a fundamental problem and its future depends on the new money raised To reduce the debt equity ratio Company has expanded too quickly, hence require more money to manage the expenses To pay for the purchase of the new company To finance the expansionary investment programs

Time table for the rights issue Three to four weeks before company starts discussing with the professional advisors regarding rights issue. Generally company uses rights issue in high market so as to maximize its new capital. A price is set and company publishes the offer document for the rights issue. Shareholders are sent a provisional allotment letters and the shares start to trade ex-rights ie seller of the shares have the rights not the buyer of a shares. Shareholders will be given 3-4 weeks to accept the offer or to sell their nil paid rights ie rights for which shareholder has not paid anything. Impact on share price Market capitalization = P x number of shares Before a rights issues, the share price is given by: P*= (Original market capitalization + extra value)/(Total number of shares) P=Share Price

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Extra value component in the calculation + The amount of new money raised by the rights issue --- The expense of issue +/- The change in the value based on the market s revised perception of the company and the use to which the money is being put. Deep Discount Companies can avoid an underwriting by offering the issue at a cost very low to the market value of a share. This is called as deep discount. Problems with the deep discount: The bigger the discount, higher is the price of nil-paid rights. This increases the CGT liability of the investors who wish to sell their rights of issue. Companies are not allowed to issue a offer less than its par value. This places an upper bound on the size of the issue. Deep discount is sometime used by the companies who don t get any underwriter for the issue, therefore, a deep discount is generally taken as weakness of a company.

Scrip Issue
A scrip issue is also known as capitalization or bonus issue. In this free shares are given to the shareholders in a proportion to the number of shares they hold. No new money is raised. The basic impact of a scrip issue should be: y New shares are created y No money is raised y The fundamental value of the whole company remains unchanged y The price per share should fall in proportion to the increase in the number of shares y The total value of each shareholders holding should remain unchanged y Shareholders reverse in the balance sheet should change to share capital Purpose of Scrip issue 1) By lower price and more number of shares, the marketability gets increased. 2) Shareholders might like the idea of being given extra shares free of charge. 3) Scrip issues can take place only if there are sufficient reserves to be capitalized. This means that scrip issues tend to be associated with successful companies which have built up large reserves from retained profits. 4) A scrip issue reduces the price of a share. Therefore, having a scrip issue may reduce a company s ability to have a future rights issue if its share price declined following the scrip issue. So, if the directors decide to have a scrip issue, they must be confident about the company s future prospects. 5) Some companies have a habit of having light scrip issues (eg 1 for 10) and subsequently keeping the same dividend per share. In these cases, a scrip issue may lead to, or be a sign of, higher dividends. 6) If dividends are expressed as a percentage of the nominal value the figure may seem excessive. This could cause public relations problems, or problems with

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employees who feel that dividends are too high. This could be avoided by a scrip issue. 7) It is a requirement of the Companies Act 1985 that a company must have a minimum issued share capital of 1m before it can act as a trustee. A scrip issue converts reserves into share capital, so may allow a company to meet this requirement. Disadvantages The administrative costs such as issuing new shares and informing shareholders are met by the company. Whenever records of dividends or share prices are needed, for example for investment research or CGT calculations, care is needed to eliminate the artificial effect of a scrip issue.

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