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Sources of Investment Finance

By HWA | Publish On: September 5, 2012 | Posted In:

When the management of a company addresses the issue of financing it investment decisions, it faces, in principle, a wide range of options. The personal wealth of the manager(s) is one potential source of investment funds. A bank loan is another. Another possibility is to sell shares in the company to outside investors. Or the company could sell loan stock (bonds). Profits arising from previous business activity are another possible source of finance. The matter is complicated by the fact that there is also considerable scope in deciding on the detail of a particular fund-raising initiative. For instance, a company planning to issue bonds would need to decide on the loan period, on whether to pay a fixed or variable interest rate, on which market to undertake the issue (domestic or eurobond), on whether to make the offer callable, on whether to offer some form of security, on whether to offer terms for converting the bonds to shares, etc.

Furthermore, any decision about how best to acquire necessary funds is conditioned by the characteristics of the individual company and the business environment within which it is operating. The company’s size, trading record and public standing; the level of risk associated with the proposed investment; the tax implications of the various funding sources and the prevailing level of confidence concerning economic prospects are factors that have a major impact on financing decisions.

Yet, despite the multitude of factors to consider, the corporate financing decision is fundamentally a choice between two possibilities: debt or equity? And a critical factor influencing the decision is the cost of capital. The following notes outline the key characteristics of the two generic forms of corporate finance and identify how the cost of capital can be calculated. This is in preparation for our examination of the broader impact of the financing decision on the value of the firm and the level of shareholder wealth.

Equity (Share) Capital

Equity capital constitutes the most significant source of funding for most businesses and, in formal terms, is identified with a company’s issued (ordinary) shares1.. For a very small business, equity might simply exist in the form of personal wealth committed to the business by the owner, maybe, inviting friends and relations to contribute additional amounts in return for a shareholding. For larger businesses, new share issues might involve raising vast sums through carefully orchestrated promotional campaigns aimed at the investing public in general. In such cases, the company’s equity will be quoted on a recognised stock exchange.

Retained profits

Another means of increasing the scale of equity capital is for the management to retain at least a portion of earnings rather than distribute them in their entirety as dividends. When a company decides to retain profits it is, in effect, choosing to use the current shareholders’ newly generated wealth as a source of additional investment finance. The discretion that the management has over the distribution of shareholder wealth (often termed the dividend decision) is one area of financial decision-making that has attracted a good deal of academic interest. We will be returning to the matter in the coming weeks.

Managing Working Capital

The effectiveness with which a company manages its day-to-day operations also has a bearing on the amount of share capital available for investment. Companies that maintain systematically large monetary balances, have large amounts of resources tied up in illiquid stocks or operate extremely lenient debt collection practices may be guilty of tying up scarce resources unnecessarily. In other words, funds that could potentially be available for the expansion of a firm’s profit-generating potential are needlessly being wasted through inefficient working capital practices.

New Share Issues

Small, unquoted companies generally find it difficult to attract equity capital from sources outside of the personal wealth of owners and close associates. The large investment institutions that manage most people’s long-term savings (in the form of pensions, endowment policies, unit trusts, etc.) are wary of small companies with little public profile and limited track records. They are sensitive to the difficulties in valuing such shares accurately and realising their cash value. In addition, investing in large numbers of small companies increases transaction and portfolio management costs. Specialised venture capitalist operations are often cited as evidence of how new businesses can overcome the scarcity of equity funding. But the evidence concerning the importance of venture capitalists in providing equity to small businesses is patchy and subject to conflicting interpretations.

A company looking to raise equity capital from the wider public will need to be listed on a recognised stock exchange. In the UK, this means being granted admission to the London Stock Exchange (LSE) Official List by the UK Listing Authority (a division of the Financial Services Authority)2.. The process of ‘floating’ a company on a stock exchange is complex. The company must appoint a sponsor (usually an investment bank or broker). The sponsor coordinates a series of tasks; assessing the feasibility of flotation, preparing the flotation documentation, advising on the terms and method of offering the shares, organising the production of an issue prospectus, arranging for the offer to be underwritten if required and co-ordinating matters with the company’s auditors and bankers.

Assuming that the company successfully proceeds to flotation, its shares receive a market quotation via one of three methods. The first is an ‘Introduction’. This is an option available to companies that already have at least 25 per cent of shares in ‘public’ hands and an acceptable spread of shareholders. The most obvious example is that of a company that is already listed on one exchange (say, New York), but wishes to achieve a listing elsewhere (say, London). Note that a flotation does not, in itself, require the raising of additional capital by the sale of new shares. Not surprisingly, it constitutes the cheapest means of achieving a listing since the company avoids expenses such as producing an issue prospectus

The second possibility is a ‘public offer’. The company’s sponsor undertakes to sell the shares at a fixed price. In most cases the sponsor underwrites the issue, thereby ensuring that the newly floated company receives the funds whether or not the sale is successful. For the sponsor, there is a risk that the shares fail to sell at the issue price. This can be spread by ‘sub-underwriting’, whereby other institutions agree to underwrite part of the offer in exchange for a fee. In addition, the evidence suggests that floated companies tend to be valued conservatively, so that cases of shares failing to sell for the issue price are very rare (indeed, more sceptical commentators have suggested that underwriting fees paid to investment banks by newly floated companies are effectively free money as the companies are valued so conservatively as to make issue failure virtually impossible). In some cases, a public offer takes the form of a ‘tender offer’, whereby investors are invited to state a price they are willing to pay (above a pre-determined minimum). This might occur in cases where it is difficult to value the company, perhaps due to the lack of comparable listed companies.

The third option is a placing, which involves the sponsor finding clients (usually institutional) willing to subscribe to the new issue. Assuming that this is done successfully, the broker then purchases the shares and places them with the subscribers. A placing avoids much of the expense associated with a public offer, especially in relation to advertising, issuing a prospectus, employing professional advisors and underwriting. Nevertheless, stock exchange rules place restrictions on the use of placings. In the case of a newly quoted company, a placing must constitute at least 35 per cent of the company’s total issued share capital. This stipulation is designed to ensure that the new shareholders have sufficient clout to make the company’s existing owner-directors accountable for their future actions.

Companies that are already listed on a stock exchange may also wish to raise additional capital through the sale of new shares. Company law in the UK, as well as most other European countries, gives the existing shareholders a pre-emptive right to subscribe to the new issue. In other words, the company is required to undertake a rights issue involving offering the shares to its currently registered shareholders.

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