Factors to consider in respect of raising finance by retention of profits
Does dividend policy affect the net wealth of the shareholder?
If it does, then retaining one proportion of the profit, rather than another proportion,
will have some effect on the sum of the dividend paid and the ex-dividend price of the
share, that is, on the net wealth of the shareholders. We shall review the debate and
evidence on this topic in some detail in Chapter 12.
No issue costs
Other means of raising additional equity have explicit issue costs not applicable to
retained profits.
Profits are uncertain
Once the need for raising further finance has been identified, there is no guarantee that
sufficiently large profits will subsequently be made to meet the requirements. On the
other hand, once the funds have been generated from profits, their existence is certain
and their retention just a matter of a management decision. This latter point contrasts
with other methods of raising equity finance.
No dilution of control
Retaining profits does not alter the voting strength of any individual shareholder.
Equity issues to the public
Before we start to consider share issues in detail, it will be helpful to distinguish
between issues that are made by businesses that have just been listed by the London
Stock Exchange and are making their first significant issue of shares to the public,
known as initial public offerings (IPOs), and further issues made by businesses at some
time after their listing, known as seasoned equity offerings (SEOs).
Technically there are two ways of making public issues:
l The issuing business can sell the shares to an issuing house, usually a merchant
bank that specialises in such work. The issuing house then sells the shares to the
public. This is known as an offer for sale.
l The issuing business sells the shares direct to the public. Often such businesses are
advised by a merchant bank on such matters as the pricing of the issue. Here the
offer is known as an offer by prospectus.
Irrespective of which of these methods is used, the general procedure is the same.
Basically, the shares are advertised in newspapers and/or elsewhere. The advertisement is required, by law and by the regulations of the LSE, to give a large volume of
detailed information. This is very expensive to prepare, including, as it does, reports
from independent accountants and such like. The objective of including such voluminous and detailed information is to protect the public from the type of sloppy and
sometimes fraudulent claims that were made by businesses’ managements in the earlier days of the LSE.
As Table 8.1 shows, public issues are very popular, with newly listed businesses
accounting for an average of 55 per cent of new equity financing for this group during
the period 2000 to 2007. This contrasts with an average of only 7 per cent of total new
equity raised by seasoned businesses.
Placings
There is a variation on the issuing house selling the shares to the general public by
advertising. This is known as a ‘placing’. Here the issuing house ‘places’ (that is, sells)
the shares with several of its own clients, such as insurance businesses and pension.
funds. These could include existing shareholders. This is still a public issue, but here
‘public’ does not have its usual meaning. The advantage to the business raising
the equity finance is that certain costs, such as adverts and underwriting (see above)
are saved. There is still the need to provide the extensive and costly information of a
more traditional public issue, however. In April 2007 the rail maintenance business
Jarvis plc raised £25 million through a placing.
As we can see from Table 8.1, placings represent an important means of issuing new
shares, both as IPOs and SEOs. Over the period, placings have had a higher profile for
seasoned businesses, but they are still significant for newly listed ones. For both types
of business they seem to be gaining in importance over time. For 2007, the percentages
are historically high for both IPOs and SEOs.
Pricing of issues to the public
The pricing of issues of ordinary shares to the public is of vital importance to existing
shareholders.
If the new shares are priced at a discount on the value of the existing shares, unless
existing holders were to take up such a number of new shares as would retain for them
the same proportion of the total as they had before, it would lead to the new shareholders gaining at the expense of the original ones.
Since issues to the public tend to occur where the business is significantly extending its equity base, it is most unlikely that an existing shareholder will be able to take
up sufficient new shares to avoid being penalised by an issue at a discount.
It is a matter of judgement as to how well the issue price strikes the balance
between attracting the maximum amount of cash per share on the one hand, and
avoiding a very costly failure to raise the required funds, after spending large amounts
on promoting the issue, on the other. There are two ways in which the pricing problem can be mitigated. One is to have the shares underwritten. For a fee, underwriters
will guarantee to take up shares for which the public do not subscribe. This ensures
the success of the issue. The underwriters’ fee or commission is fixed by them
according to how many shares they are underwriting, the offer price and, naturally,
how high the underwriter believes the probability to be that some shares will not be
taken up by the public. Underwriters are, in effect, insurers. Most issues to the public
are underwritten. Underwriting costs tend to be in the order of 4 per cent of the
capital raised.