What is equity financing ?
Equity financing is one of the essential areas of corporate finance. Therefore, in this article, we describe the different ways to issue new equity capital. Also, it is vital to identify and evaluate optimal strategies to meet long-term financial needs. You should, therefore, consider the reasons for using different methods and their advantages and disadvantages. The article further then explores ways such as financing takeovers, management buyouts and leveraged buyouts.
Capital market instruments
There are various participants in the capital market which will help to finance the equity of the firm. Below chart summarizes all the participant to the capital market.
Let’s look into some of the crucial aspects of capital markets.
Stock markets
As one of the components of capital markets, we can use the stock market to raise long term funds for a company. There is well known significant stock exchange such as the New York Stock Exchange, Nasdaq, Japan Exchange, London Stock Exchange. Due to the high demand from the readers, soon we will come up with some tutorial regarding the investment side of the business.
Let’s look at some of the primary purposes of stock markets/purposes of stock markets.
- Primary market– companies can raise fresh capital through stock exchanges using IPO.
- Secondary market – Stock markets play a proper role as a secondary market to sale the existing shareholder’s stocks. Therefore, marketability of the shares will improve.
- Realization of value – In this instance, initial owners can realize some of their investment by selling it to the public
- Takeovers by share exchange – As finance manager/student, you are well aware that most of the acquisitions happen through buying more shares from the public.
Institutional Investors
These investors are the most prominent in any of the stock exchange. They have large amounts of funds to invest in the markets. Most of the time, they will invest in the shares and bonds, which will have the required rate of yield.
However, let’s move into the advantages and disadvantages of stock markets.
Advantages of stock markets
- Availability of access to a pool of funds
- Improved marketability
- It will enhance the company image
- More natural to seek growth by acquisition
Disadvantages of stock markets
- There will be higher legal requirements, public relations, accountability and scrutiny.
- Existing shareholders control power may dilute.
- There will be huge costs when you are going to list ( underwriting fee)
Methods of obtaining a listing
There are four methods that unquoted company can obtain their listings.
- IPO ( initial public offering )
- Prospectus issue
- Placing
- Introduction
IPO – This a method where a company raise fresh capital by inviting the public to invest in the company. Issuing house will acquire a large block of shares, and then it offers to the public. Most of the time an issuing house is usually an investment bank or sometimes a firm of stockbrokers . Ultimately, issuing house accepts responsibility to the public and gives the support of its reputation and standing to the issue. However, it is challenging to set the IPO price. Hence, issuing house will set a minimum amount to be offered and allow the shareholders to provide prices with above the fixed minimum price. So the shares are allotted among shareholders based on the highest prices offered. So, this price is called the strike price.
Prospect issue – In this method company will offer shares directly to the public. These issues are really risky because of the lack of guarantee that all the shares will be taken up. You can mitigate the risk using an underwriting firm.
Placing – This is kind of a private issue of shares. This does not include any offering of shares to the public. However, the shares are allotted among a small number of investors.
These are the benefits of choosing the “placing” method
- This is more less cheaper.
- A quicker way to obtain finance
- This will not dilute the controlling power of the existing holders.
Introduction – This method of obtaining a quote does not change any new shares or ownership. A company may need an introduction to gain more market share, a stock valuation known for heritage tax purposes, and easy access to additional capital in the future.
Underwriting
An underwriter is the financial institutions which accept the unsubscribed shares by the public. Therefore, the risk of not being able to sale the issues share will be removed.
What determines the stock price?
When issuing the shares for the first time, the company may doubt which price to set. For instance, if the company overpriced the shares, there will be under subscription of stock. If the shares are valued at the lower price, then there will be an oversubscription when the shares are issued to the market first. Therefore as financial managers, you should be aware of a few factors when you are setting the prices.
- Price of similar quoted companies
- Future trading prospects
- Current market conditions
- The desire for immediate premium
Rights issues
This is one of the methods of raising new capital by giving existing shareholders the right to subscribe to new equity in proportion to their current equity. These shares are usually issued at a market price discount. A shareholder who does not wish to exercise the rights may sell the rights.
However, there are advantages and disadvantages of issuing rights to the existing shareholder as a method of raising equity finance.
Advantages of rights issue
- This is one of the most cheaper methods to raise capital because there is no administration fee or underwriting fee as opposed to the IPO
- Existing shareholders can get the most of the benefits since the shares are issued at a discount value to that of the market value.
- If all the shareholders have taken up the rights, then there is no effect for the voting rights
- The rights issue will help to reduce the gearing
Disadvantages of a rights issue
- Since the funds will obtain from the exiting shareholders, the amount of finance raise may be limited.
- Sometimes there might be an issue when selecting the best price for the right issue.
- There is a major consequence of an issue of right. When the company announces for the right issue, then the market value of the share would tend to start decreasing. So when you are at the date of exercising the right issue, sometimes you may end up by a price which is significantly lower than the right issue. This process will fail the right issue.
For instance, If the right issue has announced today 20/05/2020 and the right issue exercise date will be announced as 30/05/2020. So today the price of the share would be $150, and the price of a right would be $120. Once the market got this information, the price of a stock will tend to reduce. Let’s say if the share price falls to $100 at the date of exercising date. Then this will be a problem.
However, further discussing the right issues, there are few things you should have some knowledge. Cum right price of a right issue is the market price which is there before the right issue is exercise. In contrast, the ex-right price is the market price of a share when the rights issue is taken up by the shareholders.
Theoretical ex right price (TERP)
N = number of shares required to buy one new share.
The value of rights
Where N = the number of shares required to buy one share (right).
Similarly, there are few options available to the shareholder when the right issue is announced.
- The shareholder can exercise rights.
- ‘Renounce’ the rights and sell them on the market.
- Renounce part of the rights and you can take up the remainder.
- Anyone who does not wish to take part in the right issue will do nothing.
However, when a investor/shareholder makes the decision, they will look into a few aspects.
- The expected rate of return on the investment
- The return obtainable from other investments
- The availability of liquid funds to invest in the new shares
As a result of any decision made by the investor, the following chart shows how the total share value, No of shares and the % of shares will change accordingly.
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