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Share Investment: An Introduction

In determining whether to fund its expansion through the use of debt or equity, a business must consider the current debt to equity ratio, and the associated degree of financial risk. If the ratio is such that an increase in the proportion of debt can be sustained without an undue increase in financial risk, it is in the interests of the existing owners for the expansion to be funded through debt rather than equity. Once reaching an appropriate debt to equity ratio, further expansion must be accompanied by the injection of additional equity.

For a business not already listed on the stock exchange, the choices are very limited. Most companies will incorporate as limited liability companies and issue ordinary shares. In the case of a more speculative venture, such as a prospecting company, incorporation as a no liability company may be appropriate. In either case, the business will retain financial advisers who have the necessary expertise to advise the business on the procedures for listing, on the appropriate from of incorporation, and on the timing, structure and pricing of the share flotation. The advisers may also ensure that in all respects the structure of the share issue meets the stockmarket prerequisites for the admission of a company to its official list and for the official quotation of its shares.

It may also be possible for a business to adopt a trust structure and obtain equity participation through the sale of units in the trust. Property trusts are one type of listed trust that can distribute all of their taxable profits, and they remain an active vehicle for the raising of equity.

For those companies already listed on the stockmarket and with a good track recorded of management, good profitability and share price performance, the range of equity funding options is much more extensive than for the newly listed business. Additional ordinary shares may be issued on a pro-rata rights basis to existing shareholders and to those who hold convertible notes or options. Those with a right to purchase the new shares are usually offered a discount to market price. The discount feature, plus the fact that pro-rate rights issues may have about 2 months between announcement and receipt of the proceeds, may cause the company to prefer a direct placement of shares with institutions. Placement can be finalised much more quickly than can rights issues, and a considerably smaller discount applies. Additional ordinary shares may also be issued as full of part payment in a takeover bid.

Of the techniques employed by the listed companies, dividend reinvestment scheme have provided a major injection of new equity. Under such scheme shareholders may elect to convert their dividends into new shares in the company. These schemes may be suspended in low-growth periods.

Preference shares may be issued by a company to raise additional equity capital. They differ from ordinary shares in that they offer a fixed dividend that is set at the issue date, and most frequently have a fixed term to maturity. In both of these attributes they are more like debt than equity. However, they rank behind the company’s creditors in their claim on the assets of the company if the business fails. A preference share issue may or may not be cumulative, redeemable, participating, convertible or have different priority rankings.

Convertible notes are another form of instrument that has attributes of both debt and equity. The holder of a convertible note receives a predetermined rate of interest on their investment. The note holder, however, has the option to convert the note into shares in the company and thus is treated as a shareholder in that they are entitled to participate in pro-rata rights issues.

The other forms of equity discussed in the chapter were company-issued options, and warrants. A company issued option provides the holder with the right to purchase, from the company, an ordinary share at a predetermined price on a specific date. A warrant may be attached to a bond issue and provide the holder with the right of conversion to ordinary shares in the company, also at a determinable price and at a specified date.