Long-Term Financing: Equity, Debt, Hybrids and Leasing
Long-term financing
This domain covers equity issues, debt, hybrids and leasing. You must compare financing methods by cost, dilution, control, covenants and tax.
Core rules
- A rights issue offers existing shareholders new shares pro rata, usually at a discount; TERP reflects the blended value.
- Debt is cheaper pre-tax but increases financial risk and covenants; bonds may be fixed or floating.
- Convertibles combine a bond with an equity option; coupons are lower but conversion dilutes existing holders.
- Warrants are standalone options, often attached to debt.
- A finance lease transfers substantially all risks and rewards; an operating lease does not. Compare lease versus buy on incremental after-tax cash flows.
Worked example
A company has 1m shares at LKR 10 and makes a 1-for-4 rights issue at LKR 6. New shares = 250,000; total shares = 1.25m. TERP = (4 times 10 plus 1 times 6)/5 = LKR 46/5 = LKR 9.20. The value of the right is 9.20 - 6.00 = LKR 3.20 per new share. The shareholder who does not subscribe loses value as the price falls from 10 to 9.20, so the right compensates for dilution.
Traps
Do not confuse the subscription price with TERP; do not ignore dilution from convertibles; do not treat a finance lease as an operating lease; and do not compare lease and buy without tax and residual value.