Sources of Finance
Financing Decisions
Sources of Finance
Syllabus tag: KASNEB CPA | Intermediate Level | CA22 Financial Management | Topic 7 Sources of Finance
Lesson objectives
By the end of this topic, you will be able to:
- Classify sources by term and by whether they are internal or external
- Compute the theoretical ex-rights price and the value of a right
- Show that a rights issue leaves a shareholder no better or worse off
- Compare a rights issue, a placing and a public offer
- Outline the main considerations in leasing rather than buying
Why this matters
Capital Structure decided how much debt to carry. This topic is about where the money actually comes from, and what each source demands in return.
Words to know
- Rights issue — new shares offered to existing shareholders in proportion to their holding.
- Cum-rights price — the market price before the rights are separated.
- Theoretical ex-rights price (TERP) — the price the shares should settle at once the issue is made.
- Placing — new shares sold to a small number of chosen investors.
- Sale and leaseback — selling an asset and immediately leasing it back.
Classifying the sources
By term. Short-term for working capital — overdraft, trade credit, invoice discounting. Long-term for non-current assets — equity, debentures, term loans, leases. Matching the two matters: funding a factory on an overdraft is how solvent companies fail.
By origin. Internal is retained earnings, tighter working capital, and selling surplus assets. External is everything else. Retained earnings are the largest source of finance for most established companies, and the one with no issue costs at all.
Rights issues
A company with 4,000,000 shares trading at KES 45 makes a 1-for-4 rights issue at KES 30.
Theoretical ex-rights price
TERP = [(4 × 45) + 30] / 5 = 210 / 5 = KES 42
Value of a right = 42 − 30 = KES 12 per new share, or 12 / 4 = KES 3 per existing share held.
Funds raised = 1,000,000 new shares × 30 = KES 30,000,000
Is the shareholder better off? Take a holder of 4 shares:
| KES | |
|---|---|
| Before: 4 shares at 45 | 180 |
| After: 5 shares at 42 | 210 |
| Less cash subscribed | (30) |
| Net position | 180 |
Unchanged. The "discount" is not a gift — the price falls to absorb it exactly. What a rights issue does protect is control: because every shareholder is offered the same proportion, nobody's stake is diluted unless they choose not to take it up.
A shareholder who cannot afford to subscribe should sell the rights rather than let them lapse, since the right itself is worth KES 3 per share held.
:::checkpoint A shareholder ignores the rights offer entirely and does nothing. Show what happens to the value of their holding, and say why "doing nothing" is the one genuinely bad choice available. :::
Rights issue, placing or public offer
- Rights issue. No dilution of control, low issue costs, but limited to what existing shareholders will fund.
- Placing. Quick and cheap, since only a few investors must be persuaded. Existing holders are diluted.
- Public offer. Raises the most and widens the shareholder base, but is slow and carries by far the highest issue costs.
Debt finance
Term loan. Fixed repayments, usually secured, with covenants attached. Simple and quick to arrange.
Debentures or bonds. Larger sums, often at a lower rate than a bank will offer, but they require a market and carry issue costs.
Convertibles. Debt that may later become equity. The company pays a lower interest rate in exchange for the conversion option, so it is cheaper debt now at the cost of possible dilution later.
Leasing
An operating lease is short relative to the asset's life; the lessor keeps the risks of ownership. A finance lease transfers substantially all those risks and rewards to the lessee, and is accounted for much as if the asset had been bought with a loan.
The real questions in a lease-versus-buy decision are cash flow timing, who gets the tax allowances, whether the asset dates quickly, and who carries maintenance. A company with no cash for a deposit may lease even where buying is cheaper overall.
Sale and leaseback releases cash tied up in an asset the company still needs to use. It is a way of turning a building into working capital — at the cost of losing any future gain in that building's value.
:::checkpoint A profitable but cash-tight company needs new machinery. It can borrow at 12% or lease. Name three things you would need to know before advising, and say why the headline lease rate alone cannot settle it. :::