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• Module overview
• 1. Introduction to budgets
  • 1.1 Introduction to the Budget Process
  • 1.2 Budget types
    • 1.2.1 The Budget Guidelines
    • 1.2.2 The Sales Budget
    • 1.2.3 Budget for Operating Expenses
    • 1.2.4 Profit Budget
    • 1.2.5 Cash-Flow Budget
    • 1.2.6 The Financial Position Budget
    • 1.2.7 Additional Types of Budgets
    • 1.2.8 Additional Budgeting Techniques
  • 1.3 The budget process and its objectives
  • 1.4 Budgets for performance management
    • 1.4.1 Master budget

• 2. Planning the budget

  • 2.1 Planning the Budget
    • 2.1.1 Business income
    • 2.1.2 Visual representation of sales and budgets
    • 2.1.3 The break-even point
    • 2.1.4 Contribution margin

• 3. Controlling the budget

  • 3.1 Controlling budgets
    • 3.1.1 Variance analysis
    • 3.1.2 Taking action to achieve the objectives of the budget
    • 3.1.3 Resource acquisition and usage

• 4. Introduction to Financial Management

  • 4.1 Business Objectives
    • 4.1.1 Maximising profit
    • 4.1.2 Maximising wealth
  • 4.2 Ethics and conflicts in business
    • 4.2.1 The dilemma of ethics in finance, investment and accounting
  • 4.3 Financial Managers
    • 4.3.1 Financial information and objectives
    • 4.3.2 Accounting, the financial information system
  • 4.4 The finance function
    • 4.4.1 Business and financial calculations

• 5. Elements of Business and Financial Management

  • 5.1 Business Structures
    • 5.1.1 Sole proprietors
    • 5.1.2 Partnerships
    • 5.1.3 Corporations and companies
  • 5.2 Reporting financial data and information
  • 5.3 Financial reports
    • 5.3.1 Statement of financial performance (profit and loss statement)
  • 5.4 Capital Markets
    • 5.4.1 Capital Markets
  • 5.5 Regulation and financial institutions
    • 5.5.1 Interest rates, supply and demand and market efficiency
  • 5.6 An overview of taxation implications

• 6. Obtaining Funds: Sources of Long Term and Short Term Finance

  • 6.1 Finance from external sources
    • 6.1.1 Equity finance
  • 6.2 Debt
  • 6.3 Long-term debt
    • 6.3.1 Debentures and unsecured notes (bonds)
    • 6.3.2 Mortgage loans
  • 6.4 Hybrids of debt and equity
  • 6.5 Leasing
    • 6.5.1 Operating Lease
    • 6.5.2 Financial Lease
    • 6.5.3 Distinguishing between an operating lease and a financial lease
    • 6.5.4 Sale and Leaseback
    • 6.5.5 The issue of gearing
  • 6.6 Short-term debt
    • 6.6.1 Bank Overdrafts
    • 6.6.2 Fully drawn advance
  • 6.7 Retained Earnings, internal funds and depreciation

• 7. Managing Working Capital

  • 7.1 Managing current assets and current liabilities
    • 7.1.1 Appropriate level of working capital
  • 7.2 Managing inventories
    • 7.2.1 Reasons for holding inventories
    • 7.2.2 The economic order quantity (EOQ)
    • 7.2.3 Re-order point (ROP)
    • 7.3.4 Safety stock (SS)
    • 7.2.5 Quantity discounts
  • 7.3 Managing trade debtors (accounts receivable)
    • 7.3.1 Credit policies
    • 7.3.2 Collection period
    • 7.3.3 Managing cash and near-cash assets
    • 7.3.4 Managing trade creditors (accounts payable)

• 8. Job Costing

  • 8.1 Accounting information about product, service and project costs
    • 8.1.1 Full costing
    • 8.1.2 Single product/service line
    • 8.1.3 Multi product/service
    • 8.1.4 Direct and indirect costs
  • 8.2 How costs behave
    • 8.2.1 Allocating Overheads
  • 8.4 Cost drivers
    • 8.4.1 ABC and the service industry
  • 8.5 Conclusion

6.1.1 Equity finance

As studied earlier, equity (shareholders' equity) and debt (non-current liabilities) are the two sources of long-term business finance reported in the statement of financial performance. Equity consists of paid-up share capital, the 'deliberate' investments or contributions by shareholders, and retained earnings, the 'involuntary' investments by shareholders.

Investments by shareholders

Investments by shareholders are referred to as paid-up capital, contributed capital, equity share capital or just share capital. In return for their cash contributions shareholders may take up ordinary shares or preference shares.

From a company viewpoint, share capital is permanent equity as shareholders cannot withdraw their investments in the normal course of business, but only when the company is wound up (closed down) or there is an approved buy back. When a public company invites investors to subscribe for its shares (makes a 'share float') investors taking up the offer make a deliberate decision to take up shares and to invest a fixed amount of cash.

From a shareholder perspective the investments are not permanent because they can liquidate them by selling their shares to someone else through a broker or directly. So this form of finance has advantages for both parties.

Ordinary Shares

The issue of ordinary shares by public companies is a major source of finance for large businesses. Companies can offer shares to the general public by what is called a share float , or by placing shares privately with one or more persons or institutions, called a private placing . Companies making a public float must first produce and make public a disclosure document called a prospectus .

Ordinary shares are issued in perpetuity as they have no maturity date, and remain in issue as long as the company continues to operate or until an approved buy back takes place. The share issue procedure is started when a company issues a prospectus and invites investors to apply for shares and send in cash for the required share price amount. Successful applicants are allotted shares and unsuccessful applicants have their money refunded.

The Corporations Law gives directors the right to issue shares at any price. Investors may be required to pay the asking price in full when they apply for shares or they may be allowed to pay the price in instalments (for example, Telstra). Directors will choose an asking price that they expect will attract investors. In other words the determining factor in fixing an issue price is the market place.

An existing public company can make subsequent public share floats and private placings, or make rights issues to existing shareholders (giving them the right to take up extra shares).

A public company is formed with the ability to issue shares in terms of its set of replaceable rules , as listed in the Corporations Act 2001.

As you know already, ordinary shareholders have limited liability for company debts, which cannot exceed any unpaid instalments on their shares. If a shareholder pays the full issue price on application there is no further financial obligation to the company.

Ordinary shares offer investors the highest potential return on shares in the form of dividends (dividend payout), and an increase in value through increases in the share price in the market. But they carry the risk that the directors may decide not to pay dividends, and if the company is wound up the shareholders will only be refunded their investment after all other financial claims have been satisfied. If the company fails, ordinary shareholders may not recover any of their investments.

The main disadvantage of public floats is that the company must pay advertising and administrative costs that can be very high. Another disadvantage of shares generally is that dividends are not tax deductible.

Share Options

Another way a company can issue shares is to give individuals or investor organizations the option (right) to buy its shares within a specified time and at a predetermined price. Three major provisions included in an options agreement are:

• The price of exercising the option
• The period during which the option can be exercised (maximum of five years)
• The rights of option holders when the company is issuing new shares

For example

A company may issue, at no cost to existing shareholders, 100 000 options which may be exercised by the payment of $1.00 per option (the current market price) at any time within the next five years as from the issue date.

The holders of the options have the right to convert these options to ordinary shares by paying $1.00 per share at any time within the next five years. The option holders normally will exercise their options if and when the market price of the shares increases, or may sell their options at the increased quoted market price (there is a separate market for share options).

It is common practice for large companies to grant their top managers share options as part of their remuneration packages. The idea is that managers will work hard to make profits that will increase the market price of their options, and will stay in their jobs for at least the period of their options. Managerial share options have become controversial because some managers have made huge personal profits from them and there is an ongoing debate about how companies should report them. However, they are not a major source of company finance.

Preference Shares

Preference shares are another category of equity finance, although they are no longer popular with investors for public share floats. Preference shares give investors some privileges over ordinary shareholders. These include:

• The right to a fixed rate of dividend, which must be paid before any dividend on ordinary shares
• Preference in the return of their investment if the company is liquidated

They may also include:

• The right to receive an extra dividend (more than the stated preference dividend) if the company has a very profitable year (participating preference shares)
• The right to be paid all accumulated preference dividends not paid in previous years before any ordinary dividend is paid (cumulative preference shares)
• The right to have their shares redeemed (bought back) at the company's convenience, which gives them the same status as lenders (redeemable preference shares)

The most common form of preference share on issue is non-redeemable, cumulative and non-participating. In this form preference shares are part of a company's permanent equity. The advantage to the issuing company, and to the investors, is that the rate of dividend is known and fixed. The risk to investors of not receiving dividends is reduced (as is the possibility of earning a greater return).

Activity

Prepare a table comparing the features of ordinary and preference shares. List the factors managers might consider when deciding between an issue of ordinary and preference shares.

Ordinary shares	Preference shares

 

Text reading

Atrill, Mclaney, Harvey & Jenner, pages 440-442 and 454-459

Note the use of rights issues and bonus issues. The latter don't bring in any new finance (cash)! Also note the role of the stock exchange (ASX) and the meaning of venture capital

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