Disadvantages of owners’ capital

1 The capital is tied up in the business throughout its life. A sole trader can overcome this problem by taking a partner; partnerships may expand in size by taking additional partners. Both sole traders and partnerships can decide to convert to companies. The owners of shares in a company can convert their holding in the company into cash only by selling their shares to somebody prepared to buy them. This is relatively easy if the company is listed on the Stock Exchange. The body that runs the Stock Exchange (the Stock Exchange Council) will accept a company for listing - and therefore for its shares to be bought and sold by members - only if it meets stringent financial requirements. People holding shares in unlisted companies find it more difficult to sell them. Aware of this problem, the Stock Exchange opened another market for shares. This is known as the Unlisted Securities Market (USM). The financial requirements needed to enter this market are less stringent than those required for listed securities but they still provide safeguards for people buying and selling shares on the Stock Exchange.

2 A high proportion of owners' capital increases the owners' risk. They may be shareholders in a listed company but if they wish to dispose of their shares at any time they may have to sell for a lower price than they paid, particularly if the dividends of the company have been low compared with the prevailing rate of interest or the dividends paid by other companies.

3 Raising money by issuing more shares is expensive in administrative costs. A rights issue, where shares are offered to existing shareholders, is the cheapest method. It is also difficult for a company to estimate the market price of its shares and, if underpriced, there is an additional cost to the company. Issuing shares by tender attempts to overcome this problem by stating the minimum price the company will accept for its shares and inviting the public to state how much they are prepared to pay for them.

Apart from the administrative costs of floating a share issue, owner capital appears the cheapest method of acquiring funds. The opportunity cost of using owner capital, that is the earning potential of alternative investment, should not be forgotten.

Preference shares

Between owners' capital and loans there is a less well-defined area of preference shares. The holder of a preference share:

– is not an owner of the company.

– receives a fixed rate of return but has no legal right to it.

– has priority over ordinary shareholders when a dividendis declared.

– has priority over ordinary shareholders when the company goes into liquidation.

Apart from these four points the rights of preference shareholders will vary from company to company. Companies design their preference shares to attract investors who do not want to take the risk of holding ordinary shares and who either do not have sufficient capital to lend to the company or wish to spread the risks of lending money. Cumulative preference shares have the right to claim arrears of dividends if the company does not pay a dividend in one year. Redeemable preference shares can be bought back by the company after a stated number of years. Some preference shares carry voting rights, others do not. The rights of the preference shareholders are laid down in the company's articles of association.

2. Comprehension check.

Read the text again more carefully. Here are some answers about the main sources of finance for any business. Write the questions.

a) __________________________________________________________________

Owners’ capital, borrowing from other people or organizations and obtaining goods on credit.

b) __________________________________________________________________

Using some of the private wealth, increasing the number of partners, floating a business as a company, issuing more shares by existing companies, etc.

c) __________________________________________________________________

Interest has to be paid on borrowed funds.

d) __________________________________________________________________

Shareholders can vote the directors out of office.

e) __________________________________________________________________

The capital is tied up in a business throughout its life, a high proportion of owners’ capital increases the owners’ risk, raising money by issuing more shares is expensive in administrative costs.

f) __________________________________________________________________

Companies design their preference shares to attract investors who do not want to take the risk of holding ordinary shares and do not have sufficient capital to lend to the company.

g) __________________________________________________________________

The rights of the preference shareholders are laid down in the company’s articles of association.

Discussion

Discuss in pairs. What type of shares would you prefer to have? Why?

Pre-reading task

Work in small groups.

Now you are going to read about borrowings. Do you have any idea about different kinds of borrowings?

Reading

1. Read text 17 quickly. Were your ideas about borrowings correct?

Text 17

Borrowing

Borrowing money places an obligation on a business to repay specified amounts of the money borrowed when they are due and to meet regular interest payments of an agreed amount. This obligation remains irrespective of the size of the company. Apart from these basic principles, the terms of loan negotiated between businesses and people or organizations prepared to lend money vary according to the needs of the business and the conditions the lenders feel are required to safeguard their money. The following list of definitions will give some indication of the variety of agreements that can be made between those who borrow and those who lend.

1 Secured loans In return for granting the loan the lender insists on some asset of the business being tied to the repayment of the loan. In the event of bankruptcy or liquidation that lender will then have priority on the money from the sale of that asset for the repayment of that loan. A specialized form of secured loan is a mortgage. In this case the asset is always land or property. Unsecured loans are repaid from the fund generated by the sale of all other assets if the firm goes bankrupt or into liquidation. Lenders are less certain they will be repaid. These securities are known as collateral for the loan, i.e. properties pledged by the borrower to provide security for the lender.

2 Syndicated loans A syndicate is a group of people who join together to carry out a certain transaction. Where a great deal of money is borrowed no one person or organization may be able or willing to provide the total sum. In these circumstances a syndicate may be formed to provide the money, with members stating how much they will each lend.

3 Personal guarantee Limited liability protects the owners of a business from the need to repay debts above the amount they have directly invested in a business. A bank lending to a small limited company may demand a personal guarantee that the debt will be repaid. Effectively this removes the advantages of limited liability for the principal shareholders in that they will have to use personal assets to repay the loan if the assets of the business are inadequate.

4 Debentures These are known collectively as stock. A debenture is a long term loan which does not have to be repaid until an agreed date (its maturit y). Debenture holders are entitled to a fixed rate of return each year and have priority over all shareholders. Unlike other forms of debt, debentures can be bought and sold on the Stock Exchange. The company will continue to pay the agreed rate of return to the new owner.

Because the rate of return is fixed when the loan is negotiated the price of a debenture will fluctuate according to the rate of interest. A fixed rate of interest of 10 per cent means that for every £100 the company gains from a particular debenture they will pay £10 each year to whoever owns that debenture. Let us assume that the rate of interest paid by a commercial bank on deposit accounts rises to 12.5 per cent. In practical terms it means that if a 10 per cent debenturestock is purchased at the price at which it was first issued buyers would be sacrificing £2.50 for each £100 of stock bought. The maximum price they would be prepared to pay would be one which gave them a return of 12.5 per cent, in this case £80. You should try the same calculation assuming a general interest rate of 8 per cent. The value of stock varies inversely with the rate of interest.

5. Bank loans These are possibly the simplest forms of loans available to business. The average bank manager dealing with a small to medium sized firm and responsible to head office for the performance of the branch uses a set of well-defined criteria when making a loan. Like other loans, a bank loan is for a fixed amount at a fixed rate of interest. There is likely to be a demand for regular repayments.

In practical terms a business may simply see its loans as those which will need to be repaid in the next accounting period (current) and those which have more than a year to run.

2. Read text 17 more carefully. Try to guess the words underlined from the context. Then use your dictionary to check the words.

3. Comprehension check.

Working in pairs, take turns answering the questions.

a) What obligation is placed on a business in case of borrowing money?

b) Can you differentiate between secured and unsecured loans?

c) What is the procedure of granting syndicated loans?

d) What is the main idea of the personal guarantee?

e) Why do debenture holders have priorities over all shareholders?

f) Why is a bank loan considered to be the simplest form of loan available to business?

4. Solve the problem.

What is the minimum opportunity cost to a small business owner who invests ₤10000 in the business when the rate of interest paid on bank deposit accounts is 9,5 per cent? What other sacrifices might be involved in this decision?

5. Draw a graph showing the changes in the value of stock with a nominal value of ₤100 when the interest rate changes as follows: 8 per cent, 10 per cent, 12 per cent, 14 per cent, 11,5 per cent.

Pre-listening tasks

1. The words and word combinations in A are in the text you will hear. Use your dictionary if necessary and match each of them with a definition in B.

A 1. financial capital 2. liquid assets 3. cash 4. bond 5. share 6. physical asset 7. stock capital

B a. the money the company has gained from loans b. the most common shares, also known as equities c. to close a business and sell everything it owns, usually in order to pay money that is owed d. the money paid to shareholders out of profits e. money available to purchase capital goods (machinery and equipment), goods which not directly satisfy human wants

8. debenture capital 9. loan 10. dividend 11. preference shares 12. ordinary shares 13. deferred shares 14. senior management 15. risk 16. regular income 17. investment 18. precedence 19. to liquidate

f. the status or importance of other people or things g. commitment of resources to a particular project h. assets which can be converted into money (cash) without loss of value i. money that someone regularly gets from working or from investing money j. shares with deferred (later) payment of dividends k. a person or company considered according to how safe it is to lend them money or give them insurance or credit l. notes and coins available for someone when he needs it m. capital received from the company’s stocks n. money provided by a bank to a customer, for an agreed purpose o. the people who control and operate a business or organization p. part of the capital structure q. land, buildings, machinery and equipment r. a document given to someone who invests money in a government or company, promising to pay back the money with interest s. one of the equal parts of a company that you can buy as a way of investing money

Listening

Т² Тhe text you are going to hear explains the essence of financial capital. Listen to it and answer the questions.

1. What is financial capital?

2. What are the key components of financial capital?

3. What is special about debenture capital?

4. How is stock capital connected with various types of shares?

5. What is the difference between preference and ordinary stocks?

6. What is special about deferred shares?

7. What makes debentures relatively a safe form of investment?

Discussion

1. Work in pairs.

Discuss which type of share do you think offers the most advantages to the investor and why?

2. Work in small groups.

Say what is the difference between shares and debentures? Which do you think is the safer form of investment and why?

Reading

1. Read text 18 about other sources of funds and fill each gap with one of these words.

benefit liquidity loan less agreement remains lessee hirer nominated obsolete cause flexible terms same provide attract limited reduces account

Text 18

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