BUSF_A01.qxd

Chapter 8 • Sources of long-term finance

of them, rather than paying them out as dividends, is in effect a way of raising finance.

After all, if the full profit were paid out as dividends and then shareholders bought

new shares in the same business with their dividend money, this would have much

the same effect as retaining the funds in the first place.

In fact, retained profits are a very important source of finance, probably accounting

for about half of all the long-term finance raised by UK businesses over recent years.

A free source of finance?

At first sight, retained profits seem to be a source that costs nothing to service.

A moment’s reflection, however, shows this not to be true. From the ordinary share-

holder’s point of view, there is a clear opportunity cost in that, if cash dividends were

paid, that cash could be invested in some income-yielding way. As the obvious com-

parison is an investment in equities of similar risk to those of the business under

consideration, retained profits logically have a cost similar to that of the original ordin-

ary shares.

Bonus shares

In much the same way as businesses can and do split nominal values, they can convert

retained profits into ordinary shares, known as bonus shares which are then distributed

to existing shareholders free of charge. This procedure is known as a bonus issue.

The following is a highly abbreviated balance sheet of a business that has been trading for

some period of time and which has retained at least some of its profits.

Balance sheet as at 30 June 2008

Sources of finance (claims) Uses of finance

£m (investments) £m

Ordinary shares of £1 each 4 Non-current assets 5

Retained profits 3

Equity 7 Working capital 4

Long-term loan 2

99

It is open to the business, with only the minimum of administrative difficulty, to convert

all or part of the £3 million retained profits to shares, which may be issued pro rata to the

ordinary shareholders. Let us assume for our example that £2 million of the £3 million

retained profits is so converted. The revised balance sheet would be:

Balance sheet as at 30 June 2008

Sources of finance (claims) Uses of finance

£m (investments) £m

Ordinary shares of £1 each 6 Non-current assets 5

Retained profits 1

Equity 7 Working capital 4

Long-term loan 2

99

Example 8.1

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