For small companies, this is personal savings (contribution of owners to the company). For large companies equity finance is made of ordinary share capital and reserves; (both revenue and capital reserves). Equity finance is divided into the following classes:
a) Ordinary share capital – this is raised from the public from the sale of ordinary shares to the shareholders. This finance is available to limited companies. It is a permanent finance as the owner/shareholder cannot recall this money except under liquidation. It is thus a base on which other finances are raised.
Ordinary share capital carries a return that is variable (ordinary dividends). These shares carry voting rights and can influence the company’s decision making process at the AGM.
These shares carry the highest risk in the company (high securities – documentary claim to) because of:
a) Uncertainty of return
b) Cannot ensure refund
c) Have residual claims – claim last on profits, claim last on assets.
However this investment grows through retention.
Rights of ordinary shareholders
- 1.Right to vote
- a.elect BOD
- b.Sales/purchase of assets
2. Influence decisions:
a) Right to residual assets claim
b) Right to amend company’s by-laws
c) Right to appoint another auditor
d) Right to approve merger acquisition
e) Right to approve payment of dividends
Reasons why ordinary share capital is attractive despite being risky
- Shares are used as securities for loans (a compromise of the market price of a share).
- Its value grows.
- They are transferable at capital gain.
- They influence the company’s decisions.
- Carry variable returns – is good under high profit
- Perpetual investment – thus a perpetual return
- Such shares are used as guarantees for credibility.
Advantages of using ordinary share capital in financing.
- They facilitate projects especially long-term projects because they are permanent..
- Its cost is not a legal obligation.
- It lowers gearing level – reduces chances of receivership/liquidation.
- Used with flexibility – without preconditions.
- Such finances boost the company’s credibility and credit rating.
- Owners contribute valuable ideas to the company’s operations (during AGM by professionals).
b) RETAINED EARNINGS
i) Revenue Reserves
These are undistributed earnings. Such reserves are retained for the following reasons:
. To sustain growth through plough backs. They are cheap source of finance.
- . They are used to boost the company’s credit rating so they enable further finance to be
- . It lowers the company’s gearing ratio – reduces chances of receivership/liquidation.
ii) Capital Reserves
1. It is raised by selling shares at a premium. (The difference between the market price (less floatation costs) and par value is credited to the capital reserve).
2. Through revaluation of the company’s assets. This leads to a fictitious entry which is of the nature of a capital reserve.
3. By creation of a sinking fund.
c) PREFERENCE SHARE CAPITAL (Quasi-Equity)
It is also called quasi-equity because it combines features of equity and those of debt. It is preference because it is preferred to ordinary share capital that is:
i) It is paid dividends first – preferred to dividend
ii) It is paid asset proceeds first – preferred to assets.
Unlike ordinary share capital, it has a fixed return. It carries no voting rights. It is an unsecured finance and it increases the company’s gearing ratio.
i) Redeemable Class
Redeemable preferential shares are bought back by issuing company after minimum redemption period but before expiring of maximum redemption period after which they become creditors. (Can sue the company).
ii) Irredeemable Preference Shares
Are perpetual preference shares as they will not be redeemed in the company’s lifetime unless it is under liquidation, (it is permanent).
Company XYZ Limited has the following capital structure:
10,000 Sh.10 ordinary shares
10,000 Sh.20 preference shares
Total share capital
If the company’s assets proceeds were Sh.400,000 show how this would be shared under:
Share participation taking into account the par value.
i)If the preference shareholders are participative:
Less preference claims
Less ordinary shareholders claim
Total share capital =
Participative claim of ordinary shareholders is given by:
ii) Sharing under ratio
Less preference claim
Less ordinary share capital
Preference share capital claim =
= = Shs.33,000
Ordinary share capital claim =
= = 16,667%
iii) Non-Participative Preference Shares
These do not claim any money over and above their par value, but are usually cumulative and redeemable.
V) Cumulative Preference Shares
These can claim arrears e.g. if a company sold 10% Shs.20 preference shares and did not pay dividends for the next two years, then in the third year shareholders will claim:
10% x 20 x 3yrs = Shs 6 less withholding tax:
= Shs 6 less 5% of Shs 0.30
= Shs 5.70 net
vi) Non-Cumulative Preference Shares
These cannot claim interest in arrears.
These can be converted into ordinary shares (which is optional).
Conversion ratio = par value of ordinary share/par value of preference shares e.g if par value of ordinary shares is Sh.10 and that of preference shares is Sh.20, then conversion ratio = i.e for every preference share you get 2 ordinary shares.
Conversion price par value of preference shares/no. of ordinary shares to be acquired.
Company XYZ Ltd has sold 10,000 ordinary shares of Shs.30 (partly called up) plus 20,000 Shs.45 preference shares, which are convertible. Compute the total number of ordinary shares after conversion.
Conversion ratio = 30/45 = 2/3 for every 2 preference shares you get 3 ordinary shares.
= 30,000 ordinary shares.
Conversion price =
Total = 40,000 ordinary shares after conversion.
viii) Non-Convertible Preference Shares.
These cannot be converted into ordinary shares.