Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 16 Long-term finance 435
■ Holland’s De Nationale Investeringsbank NV (DNIB) is a major player. Its ABS issue
in March 1999, worth 290 million euros, was its fourth inside two years.
■ Calvin Klein, GE Capital and Nestlé have all issued ABSs secured on trademarks.
■ In 2004, British football club Leeds United issued bonds secured on future revenue
from ‘gate money’, i.e. ticket sales, as part of a rescue package.
■ Also in 2004, in the USA, Florida’s Seminole Indian tribe sold $410 million of bonds
to fund development of its gaming resorts in Tampa and Hollywood, FA. The
bonds were secured on future gambling takings, and income from a joint venture
with Hard Rock Café.
■ Convertibles
A convertible begins life as a form of debt, but carries the right, at the holder’s option,
to convert into ordinary shares at some specified date in the future and on specified
terms, e.g. how many new ordinary shares can be obtained on conversion per unit of
convertible stock.
Firms that issue convertibles increase their gearing ratios and may be viewed as
being more risky. Yet the greater risk is not always reflected in a higher coupon rate.
As there is a prospect of making a capital gain should the share price market perform
strongly, convertibles can usually be issued at a lower rate of interest than straight or
‘plain vanilla’ debt. Until the date of conversion, the holder receives a fixed rate of
interest and is a long-term creditor of the company.
Convertibles are particularly suitable for companies facing relatively high business
risks but strong potential growth because they offer investors the possibility of partic-
ipating in future prosperity. This explains the ease with which many ‘dotcom’ compa-
nies were able to issue so much convertible debt. The downside for companies is that
interest, although tax-deductible, must be paid every year, good or bad, and the prin-
cipal requires repayment if holders do not convert.
The downside for existing shareholders is the prospect of dilution of their equity,
and hence a fall in EPS, as and when conversion occurs. Dilution is especially dam-
aging if the conversion terms are misjudged, e.g. if growth is a lot stronger than
expected, the conversion terms may be over-generous to convertible holders. It often
makes sense for existing shareholders to hedge against this risk by acquiring the
convertibles themselves. Indeed, convertibles may be issued initially to owners in a
rights issue.
The language of convertibles
Convertible conversion terms can be complex.
■ the conversion date (or range of dates) tells you when it can be converted.
■ the conversion rate tells you the terms on which conversion can be made. This is
stated either as a conversion price – the nominal value of loan stock that can be con-
verted into one ordinary share – or as a conversion ratio – the number of ordinary
shares that will be obtained from one unit of loan stock.
■ the conversion value is the market value of ordinary shares into which a unit of
convertible loan stock can be converted. This is equal to the conversion ratio times
the current market price per ordinary share.
■ the conversion premium is the difference between the market price of the convert-
ible and its conversion value.
■ the rights premium is the difference between the market value of the convertible
and its value as straight debt. Each of the last two terms can be expressed as an
absolute value or per share.
An example will help clarify this terminology.
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436 Part V Strategic financial decisions
Example: Cannon plc
Cannon plc’s balance sheet shows 10 per cent convertible loan stock, par value of
redeemable at par in seven years. Each unit of stock can be converted at any time in the
next three years into 20 ordinary shares. The debenture currently trades at inter-
est has just been paid and the current ordinary share price is The ex-interest mar-
ket price of the debentures of a company of similar risk is
At the initial issue date, the conversion value will be less than the issue price. Investors
hope that as the conversion date nears, and as the market price of the underlying
shares increases, the conversion value will rise accordingly i.e. conversion becomes
more attractive to investors. The conversion premium is proportional to the time
remaining before conversion occurs. As conversion approaches, the market value and
the conversion value converge until the conversion premium disappears. With no con-
version premium, the value of the convertible is simply its value as straight debt with
a similar coupon and maturity.
The market value of the convertible thus depends on:
■ the current conversion value
■ the time remaining to conversion
■ the market’s expectations regarding the expected returns
■ the degree of risk of the underlying ordinary shares.
The 2003–4 accounts of British Airways plc disclosed a convertible issue of 9.75 per
cent Convertible Capital Bonds with par value Holders of the stock were entitled
until June 2005 to convert these into ordinary shares on the basis of one ordinary share
for each of bonds held. At this date, BA can require remaining bondholders to
convert their bonds into ordinary shares which would then be sold on their behalf. On
10 January 2005, the closing market prices for the bonds and for the ordinary shares
were and respectively.£2.49£1.16
£2.34
£1.
Current rights premium 1£117 £1092 £8 1or £0.40 per share2
Current conversion premium 1£117 £722 £45 1or £2.25 per share2
Current conversion value 120 £3.602 £72
£109.
£3.60.
£117,
£100,
Convertible loan stock: key features
■ Convertible loan stock can be issued more cheaply than a ‘straight’ loan because it offers an
equity incentive.
■ Companies perceived as relatively high risk can attract loan finance by offering the possibili-
ty of participating in future growth.
■ Interest on the loan (while it is a loan) is tax-deductible.
■ The bonds can also be traded on the Stock Exchange.
■ Where it is believed that the true worth of the company is not adequately reflected in the
share price, convertibles provide a means of raising capital that may eventually become
equity without diluting the value of existing equity.
■ Convertibles offer the benefits of both equity and loan stock, thereby attracting additional
investors.
■ If all goes as planned, the conversion to equity will occur, reducing the gearing ratio (but
also lowering Earnings Per Share).
■ If the conversion price is misjudged, the company is left with unwanted debt. If the equity
growth is faster than expected, conversions will take place on over-generous terms at the
expense of existing shareholders.
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Chapter 16 Long-term finance 437
■
Bond yields
Investors who buy debentures and loan stock will want to know the rate of return, or
yield, on their investments. Two ratios are of interest to investors. The flat yield or
interest yield is the gross interest receivable, expressed as a percentage of the current
market value of the stock. Thus a 7 per cent stock with a market value of and a nom-
inal value of has a flat yield of:
This represents the gross yield. The net-of-tax yield to the investor depends on his or
her tax position:
where is the personal rate of tax incurred by the bondholder.
The redemption yield combines the income accruing from interest payments with
the capital gain or loss on maturity. It will be greater than the flat yield where the cur-
rent value is below the redemption value because the investor will also receive a cap-
ital gain if the bond is held until maturity.
If the above stock has five years life to maturity, someone who buys it for will
receive a capital gain on redemption of Averaged over five years, this represents
an additional gain of p.a. Based on the purchase price of this raises the yield to
redemption thus:
However, this is only an approximation to the true redemption yield, which depends
on the precise timing of the investor’s returns. For example, assume he or she buys the
stock now, having just missed out on the interest payment, thus anticipating five future
annual interest payments plus the redemption payment of at the end of the fifth
year. The yield to maturity is the solution R in the following internal rate of return
expression:
The precise solution is 10.9 per cent. As above, this would be offset by the investor’s
liability to tax. As this figure is gross-of-tax, it is also called the gross redemption yield.
Similar principles apply in calculating yields on government securities.
£85
£7
11 R2
£7
11 R2
2
p
1£7 £1002
11 R2
5
£100
Flat yield £3>£85 8.2% 3.5% 11.7%
£85,£3
£15.
£85
t
p
Net interest yield Gross yield 11 t
p
2
£7
£85
100 8.2%
£100
£85
Self-assessment activity 16.6
A bond with nominal value of £100 and coupon rate of 8.3 per cent has market value of
£110 What is:
(a) its flat yield?
(b) its yield to maturity in three years?
(Answer in Appendix A at the back of the book)
■ Warrants
A warrant is an option to buy ordinary shares. We include warrants in the section on debt
finance because they are more frequently linked to debt issues than to equity issues
(although many companies distribute warrants to shareholders as a ‘sweetener’). The war-
rant holder is entitled to buy a stated number of shares at a specific price up to a certain
date. Each warrant will state the number of shares the owner may purchase and the time
limit (unless a perpetual warrant) within which the option to purchase can be exercised.
interest yield
The annual interest on a bond
or similar security divided by
its market price
redemption yield
The interest yield adjusted for
any capital gain or loss if the
security is held to maturity
gross redemption yield
The redemption yield before
allowing for income tax
payable by investors
perpetual warrant
A warrant with no time limit
for exercising it
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438 Part V Strategic financial decisions
Companies issue warrants for a number of reasons. They can be attached to loan
stock, thus providing loan stock holders with an opportunity to participate in the
future growth and prosperity of the company, or, alternatively, used to attract
investors by new and expanding companies. They may be also part of the purchase
consideration in a takeover. In both cases, they act as a ‘sweetener’ to the investor.
Frequently, such an inducement enables the company to obtain a lower rate of inter-
est or less restrictive conditions in the debenture agreement. Whether or not war-
rants eventually give rise to additional finance by holders taking up their option to
purchase depends, of course, on the future trading success of the company and the
exercise price.
How warrants work
In 1998, when its ordinary shares carried a market price of XYZ plc issued deben-
ture stock with one warrant attached to each unit of stock giving the right to buy one
ordinary share at a price of in 2002. If, at the exercise date, the market share price
is, say, we would expect investors to exercise their rights, thus making a capital
gain of per share purchased. As a result of their purchases, the earnings of exist-
ing shareholders will be diluted – the company is, in effect, giving away per share,
which is not a problem if the same shareholders also hold the debentures, to which the
warrants are attached, although this is rather unusual. The accounting mechanism
would involve a reduction in the company’s reserves. Warrants are often called ‘time
bombs’ for this reason. This also explains why the issue of warrants may be used as a
takeover defence tactic – warrants implant a ‘poison pill’ for the predator to swallow.
Warrants can be traded separately from the securities to which they were original-
ly attached. In the XYZ example, if the ordinary shares are trading at the war-
rants will be worth 50p each, because they embody the right to buy ordinary shares at
a 50p discount. They also possess the attractive property of gearing. If the ordinary
shares rise in value by 5 per cent from to the warrant would also rise by
15p in value, but by the considerably greater proportion of
For this reason, they are referred to as ‘geared plays’.
115p>50p2 30 per cent.
£3.15,£3.00
£3.00,
£1.50
£1.50
£4.00,
£2.50
£2.00,
Self-assessment activity 16.7
What is the market value of a warrant that gives the right to buy one new share for every
four shares held, given market price per and the exercise price is £5?
(Answer in Appendix A at the back of the book)
share £8,
■ Mezzanine finance
Mezzanine finance is frequently used in the financing of management buy-outs
(MBOs). It is often described as a bridge between the secured debt that a business can
raise and pay interest thereon with reasonable comfort plus the equity that the man-
agement team can raise, and the purchase price. Although it lies nearer the former, it
ranks behind more formal borrowing contracts, which is why it is called ‘subordinat-
ed’ or ‘intermediate’ debt. Because of its low priority for payment, it attracts a rela-
tively high interest rate, usually 3–5 per cent above LIBOR, and usually carries
warrants and/or the right to convert into ordinary shares. The appeal of mezzanine
finance to investors is that it offers investors exposure to the upside potential of the
venture – if the MBO performs well, the warrants offer the prospect of capital gain.
However, these are chancy investments – both the company and the instrument carry
major risks.
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Chapter 16 Long-term finance 439
■
Foreign bonds
These are domestic issues by non-residents, e.g. an issue of stock by a US company in
London (a ‘bulldog’), or in Tokyo (a ‘samurai’) or in Australia (a ‘kangaroo’). Such
bonds are domestic bonds in the local currency – only the issuer is foreign. If British
Airways makes a bond issue in New York, this is a ‘yankee’ bond.
■ Eurobonds (‘International bonds’)
The term Eurobond is a misnomer – they need not be issued in Europe nor be denomi-
nated in a European currency! They are most easily understood as international loans
denominated in a currency other than that of the issuer, but technically they are any long-
term bonds issued by companies outside the country of the currency in which the bonds
are denominated. An example is a Eurodollar issue denominated (and thus repayable) in
dollars by a US corporation, issued via the Frankfurt capital market. They are issued only
by large, credit-worthy companies, development banks and state-owned corporations,
and are generally unsecured. The vast majority of Eurobond issues are denominated in
euros and in US dollars, e.g. the issue in 2004 by Cadbury-Schweppes, the confectionery
and beverages multinational, for and that by Vneshtorgbank of Russia for
US$300 million. However, issues in other currencies are not uncommon, e.g. also in 2004,
Volkswagen’s Turkish subsidiary raised TL34 trillion, and Lane Cove Tunnel Finance
raised A$1.1 billion for project finance. Many issues are made by development banks for
spending in a particular locality, e.g. the Asian Development Bank raised 5 billion Indian
rupees, the European Investment Bank raised 240 million Polish zlotys, and the European
Bank for Reconstruction and Development raised 13 billion Hungarian forints, all in 2004.
Eurobond issues are mainly organised and underwritten by international syndi-
cates of investment banks acting on behalf of such organisations. The market original-
ly developed in response to the desire by US companies to avoid the now defunct
withholding tax, which they were obliged to pay to the tax authorities on behalf of
investors who purchased bonds sold locally.
Eurobonds are bearer bonds (i.e. they are transferable), with interest paid annually,
and gross of tax, which may appeal to investors eager to delay (or evade) tax. Empirical
evidence suggests that this feature may allow companies to borrow at rates lower than
on their own domestic markets, although any such yield differential would be eliminat-
ed by arbitrageurs if the international bond market were efficient and unsegmented.
;1,200 million,
Fireball QXL: Dotcom star bought out by managers
QXL Ricardo plc was set up in 1997 (as plain QXL plc) as a European answer to eBay. Briefly, it
was a shooting star of the dotcom era, but fell to earth with a bump, but not before floating
on the London Stock Exchange in 1999, valued at £200 million.
In November 2004, its life as a listed company ended with the acceptance of a bid for just
£12 million made by Tiger Acquisition Corporation, a bid vehicle set up by the Chief Executive
and the Finance Director and financed by Great Hill Partners, a Boston-based private equity firm
that invests in smaller companies. The CEO denied that QXL was in urgent need of cash, but
stated that it was easier for a firm of this type to raise funds if it came off the stock market.
In between times, QXL’s value had rocketed to £2.5 billion at the zenith of the dotcom
boom. In 2000, it acquired Ricardo, a German rival, for over £600 million. By 2004, QXL was
operating in France, Italy, the Netherlands and Belgium, where it was making losses, but also
enjoyed market leadership in Scandinavia and Switzerland, where it operated profitably.
Source: Based on article in the Financial Times, 26 November 2004.
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440 Part V Strategic financial decisions
Coral Eurobet makes £400 m capital return
By Peter Smith, Private Equity Correspondent
FT
Coral Eurobet, Britain’s third-
biggest betting shop chain, has
made £560 m of capital repay-
ments to investors since it was
acquired by a Charterhouse-led
buy-out team for £860 m slight-
ly more than two years ago.
Coral this week finalised a
£1.25 bn refinancing, its sec-
ond in nine months, tapping
into receptive debt markets at
a time when the group’s under-
lying trading has exceeded
growth targets.
This year, it repaid a £160 m
shareholder loan, and is now
returning a further £400 m of
capital.
Charterhouse has recouped
more than its original equity
investment of £278 m and
retains its 75 per cent stake.
Coral might float in 2005 or
2006. An initial public offering
is an obvious exit route,
adding Coral to William Hill, a
listed competitor and the sec-
ond biggest operator, and
Ladbrokes, the industry
leader owned by Hilton.
Jeremy Greenhalgh, the
Charterhouse partner responsi-
ble for the refinancing, said
Coral’s recapitalisation was the
result of the group’s solid per-
formance in the past nine
months.
‘Retail, internet and tele-
bet, our three business chan-
nels, are growing strongly,’ he
said. ‘This business is enjoying
industry-leading organic
growth rates and there are
still further opportunities to
expand the chain and launch
new products.’
Coral this year launched
Coralpoker.com, which has
helped drive the internet
business.
Based on a multiple of nine
times earnings before interest,
tax, depreciation and amortisa-
tion – what Charterhouse paid
for the business – Coral’s enter-
prise value has risen from
£1.35 bn in February to £1.6 bn.
The group generated pro-forma
ebitda of slightly more than
£180 m
in the past 12 months.
Total net debt after the
refinancing is £1.15 bn, with
additional facilities available
to finance acquisitions.
The chain, which comprised
874 shops at the time of the
buy-out, has now expanded to
1,106 outlets.
Coral’s continued growth
will be influenced by the out-
come of the gambling bill, cur-
rently at the parliamentary
committee stage.
Deregulation and growth
from internet-based opera-
tions will help drive sales,
while more competitive pric-
ing for new gaming machines
should result in costs savings.
Coral this year appointed
Philip Bowman, chief execu-
tive of Allied Domecq, the
drinks group, as chairman.
Charterhouse expected
Coral to expand faster than
listed rivals. It said this
would be achieved by the roll-
out of betting terminals,
growth in the size of the
chain, the increased populari-
ty of gambling and industry
deregulation.
Source: Financial Times, 1 December 2004.
Lower overseas interest rates are not necessarily good news. Many corporate treasur-
ers who try to take advantage of relatively low overseas interest rates often overlook the
reasons why interest rates are lower overseas. Domestic interest rates are linked to future
expected inflation rates and to expected exchange rate movements. If the inflation rate in
Switzerland is lower than in the UK, the Swiss franc will appreciate against sterling and
current interest rates in London will exceed those in Zurich. This is to compensate both
domestic investors for inflation and also overseas investors from, say, Switzerland for the
prospective reduction in the Swiss franc value of investments in London. If a British cor-
porate treasurer borrows ‘cheap’ in Zurich, he or she should not be surprised to find that,
when it comes to repay the loan in Swiss francs, the sterling cost has increased, following
depreciation of sterling. What is won from the interest rate savings will probably be lost
from the capital value change. However, for treasurers who believe that exchange rate
movements can be predicted in advance, Eurobonds may offer speculative opportunities.
For those who simply want to create an overseas liability to offset an exposure in relation
to an overseas income flow, Eurobonds may present an attractive way of hedging. (These
aspects are examined in more detail in Chapter 21.)
In addition to interest cost advantages, Eurobonds usually involve fewer, if any,
restrictive covenants, and usually require less disclosure of information than is
required for similar issues on domestic markets. The unregulated nature of the market
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Chapter 16 Long-term finance 441
has probably contributed to its innovativeness in terms of the features attaching to
many issues, whereby bonds can be tailored to specific corporate requirements.
■ Floating rate notes (FRNs)
These are Eurobonds that pay a variable rather than a fixed interest rate. FRNs are espe-
cially favoured by financial institutions that conduct a great part of their business at a
floating rate and therefore value the protection given by the ability to borrow at a float-
ing rate. As rates of interest rise, banks’ income rises, as do their costs – FRNs are thus
a way of achieving a neat match between assets and liabilities.
Abbey National plc (now part of Banco Hispanico Santander) is very active in the
Eurobond market, borrowing in a wide variety of currencies, e.g. yen, US and
Canadian dollars, euros, Swiss francs, at both fixed and floating rates. The reason why
it borrows in so many currencies and at fixed rates is bound up with the swaps mar-
ket. Abbey may not want the currency for itself nor even want a variable rate liability.
It is borrowing in the currency in which, at prevailing market conditions, it is easiest
and cheapest to borrow, say, the Eurodollar market. It can then use the swap market
to exchange the US$ for the currency it really requires.
A swap works in two stages. Take the case of Abbey’s issue of US$500 million FRNs
repayable in 2012. This can be swapped into sterling via another bank (the ‘swap bank’)
at the time of issue, perhaps at a fixed rate. The parties agree to swap back at maturity
so that Abbey can repay the bond. The swap bank then passes to Abbey a stream of ster-
ling until 2012 with which to pay the interest, in return for which it receives from Abbey
a fluctuating stream of USD with which to pay its own interest liability up to 2012.
In this swap, there is an exchange not only of currencies but also a floating liability for
a variable one. This is called a Combined Interest Rate and Currency Swap (CIRCUS).
The point of this is to enable the two parties to raise money where the terms are most
attractive before swapping it into the currency they really want. At other times, Abbey
National itself may borrow at floating rates both in sterling and in other currencies.
A new financial market takes wing
In July 2001, Emirates, the Dubai-based airline (and Chelsea FC sponsor) launched a Floating
Rate Note (FRN) issue, amounting to dirhams* 1.5 billion, repayable at par in 2006, and
denominated in 100,000 dirham units. The minimum subscription was 5 million dirhams, tar-
geting the issue at corporate and institutional investors plus (very) high net worth individuals.
The issue was over-subscribed two-and-a-half times and taken up by pension funds (7%), cor-
porates (6%), professional investors (14%) and banks (73%).
The finance was needed for Emirates’ aggressive expansion plans, including investment of
14.5 billion dirhams in fleet and equipment modernisation. Its growth ambitions involve tre-
bling its fleet size over 2001–10, including the acquisition of 43 Airbus A380 Superjumbos.
This issue was the first bond issue made on the nascent Dubai Financial Market, the largest
dirham-denominated bond issue to date and the first made by a United Arab Emirates corpo-
rate borrower. Interest on the notes is to be paid semi-annually at 70 basis points (0.7%)
above the six-month Emirates Interbank Offered Rate (EBOR), a formula resulting in a rate of
4.675% for the first interest period.
*3.678 United Arab Emirate dirhams one US dollar
16.7 LEASING AND SALE-AND-LEASEBACK (SAL)
Lease contracts were discussed in Chapter 15 where long-term leases for certain assets,
such as ships and aircraft, or for property were discussed.
SAL involves selling assets (usually property) to a financial institution seeking good
quality investments with potential for long-term growth in capital value. The seller,
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442 Part V Strategic financial decisions
Boots to generate £300 m in sale and leaseback
By Jim Pickard and Elizabeth Rigby
FT
Boots, the health and beauty
retailer, plans to raise an esti-
mated £300 m through the
sale and leaseback of some of
its 1,400 stores.
About a third of the group’s
stores are freehold, though it
is understood that it does not
plan to sell and leaseback the
entire portfolio.
Boots is in need of capital as
it is half-way through a costly
three-year turnround pro-
gramme. Richard Baker, the
former Asda man who took
over as chief executive last
year, has been cutting prices
on thousands of products while
also investing in IT and longer
opening hours in an effort to
lure customers.
The retailer is investing
£390 m in the current finan-
cial year, with £250 m going on
capital investment and a fur-
ther £140 m being ploughed
into its much-heralded price-
cutting programme and 60
new store openings. It plans to
invest more next year.
Proceeds from a property
deal could also help fund Boots’
two-year £700 m share buy-
back programme, announced
last May. The retailer plans to
return £350 m to shareholders
by March, although the timing
of the second tranche would be
determined by the perform-
ance of the business and its
generation of net cash flow.
However, some experts
warned that a sale and lease-
back could put pressure on
Boots’ credit rating, because
bondholders often see proper-
ty ownership as a sign of
financial strength.
Standard and Poor’s cut its
rating on Boots from A-plus
to A-minus after the group
unveiled its share buy-back.
Moody’s Investors Service
rates Boots at A3.
One person familiar with
Boots said: ‘With everything
else that is going on in retail,
the lack of confidence in the
management, my guess is that
the credit rating agencies may
pull a long face and say this is
a negative.’
Several retailers have car-
ried out sale and leaseback
deals in recent years.
J. Sainsbury, the super-
market group, raised
£340 m
in 2000 through the sale and
leaseback of 16 food stores.
The following year, Marks
and Spencer sold £348 m of
property to Topland, a private
company.
One industry observer said:
‘If you look at who else has
done such deals, it is not a sign
of confidence or strength – it is
a sign that things aren’t going
too well.’
Source: Financial Times, 25 January 2005.
while giving up the ownership rights to the property, will then arrange to lease the
premises from the new owner. SAL, therefore, is a transfer of ownership with retention
of rights to use for a specified period. Its attraction to the vendor is the raising of capi-
tal, although its obvious disadvantage is usually the loss of any entitlement to capital
appreciation. However, for a company eager to grow, the returns in the early years of
strategic growth projects could outweigh the lost capital gains. This was the reasoning
behind the SAL by Tesco, the supermarket chain, of many of its store sites in the 1980s
when it was eager to claw back the market share advantage held by Sainsbury (it sub-
sequently grew to number one in the supermarket league by 1996). The finance gener-
ated by a series of SALs was used to purchase and develop new sites for stores.
In 1997, Imperial Chemical Industries (ICI) sold its headquarters office building in
London’s Millbank to the Prudential insurance company for over million. The funds
raised were partly to finance ICI’s acquisition of Unilever’s speciality chemical business.
£100
■ Sale and manage-back
A variant of the SAL is the sale and manage-back (SAMB) tactic adopted by several
hotel chains in 2004–5. Rather than lease back the sold property, the vendors undertake
the management of it. One of the first exponents was Whitbread plc in October 2004,
when it announced a wide-ranging disposal of properties, including its historic site in
the City of London, for around million. Half of the cash generated was to be£800
CFAI_C16.QXD 10/28/05 4:57 PM Page 442
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Chapter 16 Long-term finance 443
returned to shareholders, and the remainder would be used to reduce its pension fund
deficit and to pay down debt. Among the disposals were 12 Marriott-branded hotels
(later increased to 46) that it would continue to manage.
In early 2005, the Hilton Group, Intercontinental and the French Accor group all
announced SAMB programmes. The two British firms intended to return the sale pro-
ceeds to shareholders, while Accor planned to accelerate its expansion into budget
hotels. In all these cases, while the planned use of cash differed, the common thread
was that the vendors felt they could earn higher returns on hotel management rather
than owning upmarket hotels.
Sources: Whitbread plc press release 28 October 2004, articles in the Financial Times 29 October 2004, and
in The Economist, 19 March 2005.
Self-assessment activity 16.8
What is the effect of a sale and lease back on a firm’s Balance Sheet?
(Answer in Appendix A at the back of the book)
SUMMARY
Chapter 16 has discussed the features of the principal forms of long-term finance
available to companies, and their benefits and drawbacks.
Key points
■ The main factors in considering the appropriate source of finance are risk, owner-
ship, duration and debt capacity.
■ Over half of the new finance raised for UK companies is usually through retained
profits. This is not a free source of finance as it involves an opportunity cost in
terms of the return that shareholders would have obtained had they received the
profit as dividends and re-invested it elsewhere.
■ New shares are issued through a private placing, stock exchange placing, public
issue (prospectus issue, offer for sale or issue by tender) or by a rights issue.
■ The enhanced ability to make a rights issue is a major attraction of a Stock Exchange
listing.
■ Equity capital is an attractive form of finance to companies because there are no inter-
est charges or capital repayments; to investors, it offers a hedge against inflation, and
a higher yield than loan stock. On the other hand, equity capital can be expensive to
raise, and new issues to the public dilute the control of existing members.
■ Debt finance (debentures, loan stock, etc.) is flexible, offering a wide range of financial
products to the corporate treasurer. Interest payments are tax-deductible, but restric-
tions (e.g. charges over assets and monitoring of activities) are common practice.
■ Convertible loan stock is a debt instrument that can, at the option of the holder, be
converted into equity. It offers investors and firms the benefit of loan stock in the
early years and, if all goes to plan, will enable the benefits of equity to be captured
when the business is better established.
Further reading
Weston and Copeland (1992) devote considerably more space to this area than we have been
able to. A practitioner’s guide is found in Rutterford (1992).
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444 Part V Strategic financial decisions
Questions with a coloured number have solutions in Appendix B on page 709.
1 The ordinary shares of Anglia Paper Company are currently trading at Existing shareholders are offered
one new share at for every three held.
(i) What is the theoretical ex-rights price?
(ii) What is the nil-paid rights price?
2 Cambridge Castings Ltd plans a major expansion to modernise its manufacturing plant, thereby improving
productivity and reducing unit costs. The existing capital base is fairly evenly divided between equity and
debt, and it is clear that the capital investment programme can only partly be funded through profit retention.
It is suggested that the additional finance could be raised through a preference share issue. You are
required to evaluate this source of finance for the company, compared with equity or debt:
(a) from the company’s point of view;
(b) from the viewpoint of investors.
3 Shaw Holdings plc has 20 million ordinary shares of 50p in issue. These shares are currently valued on the
Stock Exchange at per share. The directors of Shaw Holdings believe the company requires additional
long-term capital and have decided to make a one-for-four rights issue at per share.
An investor with 2,000 shares in Shaw Holdings has contacted you for investment advice. She is unde-
cided whether to take up the rights issue, sell the rights, or allow the rights offer to lapse.
Required
(a) Calculate the theoretical ex-rights price of an ordinary share.
(b) Calculate the value at which the rights are likely to be traded.
(c) Evaluate each of the options being considered by the owner of 2,000 shares.
(d) Explain why rights issues are usually made at a discount.
(e) From the company’s viewpoint, how critical is the pricing of a rights issue likely to be?
(ACCA Certified Diploma)
4 Burnsall plc is a listed company which manufactures and distributes leisurewear under the brand name
Paraffin. It made sales of 10 million units world-wide at an average wholesale price of per unit during its
last financial year ending at 30 June 1995. In 1995–96, it is planning to introduce a new brand, Meths, which
will be sold at a lower unit price to more price-sensitive market segments. Allowing for negative effects on
existing sales of Paraffin, the introduction of the new brand is expected to raise total sales value by 20 per cent
To support greater sales activity, it is expected that additional financing, both capital and working, will be
required. Burnsall expects to make capital expenditures of million in 1995–96, partly to replace worn-out
equipment but largely to support sales expansion. You may assume that, except for taxation, all current assets
and current liabilities will vary directly in line with sales.
Burnsall’s summarised Balance Sheet for the financial year ending 30 June 1995 shows the following:
Assets employed £m £m £m
Fixed (net) 120
Current:
stocks 16
debtors 23
cash 6
45
Current liabilities:
Corporation tax payable (5)
Trade creditors (18)
(23)
£20
£10
£1.30
£1.60
£2
£3.20.
QUESTIONS
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