Chapter 8 • Sources of long-term finance
However, the situation in real life is probably not quite as suggested by Figure 8.1
(page 219). There are anomalies in the primary capital market that can mean that
using one form of financing rather than another can be to the advantage of equity
holders. For example, loan finance attracts tax relief in a way that equity finance does
not. Convertibles are probably a cheaper way of issuing ordinary shares than is a
direct offer of equities to the public.
These points and those that will be discussed in the context of the gearing and
dividend debates later in the book explain why we find that businesses seem to
devote much effort to deciding on the most appropriate means of raising long-term
finance.
Perhaps we could generally conclude that businesses should assess all possible
methods of raising long-term finance. They should look for anomalies like the ones
mentioned above and then seek to exploit them as far as is practical, given the par-
ticular circumstances of the business.Risk and return are key issues in financing
lTo the business (that is, the shareholders) sources that are cheap in terms of
servicing costs (for example, loans) tend to be risky; those that are less risky
(for example, equities) tend to be expensive.
lTo the provider of finance, risk and reward are positively linked, that is, high
returns mean high risk, and vice versa.Ordinary shares
lThe owners’ (shareholders’) stake in the business.
lThe largest element of business financing, much of it from retained profits.
lRisky for the shareholders, low risk for the business; high levels of return
expected by investors, expensive for the business.
lTypically no legal or contractual obligation on the business either to pay divi-
dends or to redeem the shares.
lDividends are not tax deductible to the business, but are taxable in the hands
of shareholders.
lRetained profits can be slow and uncertain, but no issue costs.
lIssues to the public:
lRelatively rare in the life of the typical business.
lThe IPO premium is a significant cost to the issuing business.
lSignificant issue costs, perhaps 11 per cent of funds raised, though there are
economies of scale.
lPlacings of shares now an important approach to issuing shares.
lPricing is an important issue.
lNot always successful, though underwriter (in effect, insurer) may be used.
lControl may shift from the original to the new shareholders.