Dividends

Shareholders are entitled to a share of the profits made by the company.

Dividends are appropriations of profit after tax.

A company might pay dividends in two stages during the course of their accounting year:
In mid year, after the half year financial results are known, the company might pay an interim dividend.
At the end of the year, the company might pay a further final dividend.
The total dividend for the year is the sum of the interim and the final dividend. Not all companies pay an interim dividend. Interim dividends are, however, commonly paid out by public limited companies.

At the end of an accounting year, a company’s directors may have proposed a final dividend payment, which has not yet been paid. This means that the final dividend should be appropriated out of profits and shown as a current liability in the balance sheet.


Profits re-invested


Not all profits are distributed as dividends; some will be retained in the business to finance future projects. The “market value” of the share should, all other thing being equal, be increased if these projects are profitable.

The Share premium

By “premium” is meant the difference between the issue price of the share and its nominal value. When a company is first incorporated the issue price of its shares will probably be the same as their nominal value and so there would be no share premium. If the company does well the market value of its shares will increase, but not the nominal value. The price of any new shares issued will be approximately their market value.

The companies act states that “where a company issues shares at a premium, whether for cash or otherwise, a sum equal to the premiums on those shares shall be transferred to the share premium account”.

A share premium account is an account into which sums received as payment for shares in excess of their nominal value must be placed.

The share premium account cannot be distributed as dividend under any circumstances.

Types of Shares

We can distinguish three types of shares,
Preference shares
Deferred shares
Ordinary shares

Preference shares


Preference shares are shares which confer certain preferential rights on their holders.
The rights attaching to preference shares are set out in the company’s contribution. They may vary from company to company, but typically:

Preference shareholders have a priority right over ordinary shareholders to a return of their capital if the company goes into liquidation.
Preference shares do not carry a right to vote.
If the preference shares are cumulative, it means that before a company can pay an ordinary dividend it must not only pay the current year’s preference dividend, but must also make good any arrears of preference dividends unpaid in previous years.

Deferred shares


Deferred shares are equity shares that will receive a dividend only after other classes of shares including ordinary shares have received a specified rate of dividend, or will receive a dividend only after a specified time from issue.


Ordinary shares


Ordinary shares are shares which are not preferential with regard to dividend payments. Thus a holder only receives a dividend after fixed dividends have been paid to preference shareholders.
Ordinary shares normally carry voting rights; they are effective owners of a company. They own the “equity” of the business, and any reserves of the business belong to them.

Share Capital

The net fixed assets of a company, plus the working capital (i.e. current assets minus current liabilities) minus the long term liabilities, are “financed” by the shareholders’ capital.

Shareholders’ capital consists of both:
>The nominal value of issued capital (minus any amounts not yet called up on issued shares
>Reserves.

The share capital itself might consist of both ordinary shares and preference shares. All reserves, however, are owned by the ordinary shareholders, who own the “equity” in the company.

Reserves

A company’s share capital will remain fixed from year to year, unless new shares are issued. Reserves are difficult to define neatly since different reserves arise for different reasons, but it follows from the above that:

Reserves = net assets – share capital

So the total amount of reserves in a company varies, according to changes in the net assets of the business.

A distinction should be made between:
1)Statutory reserves, which are reserves which a company is required to set up by law, e.g., the revaluation reserve, and which are not available for the distribution of dividends.
2)Non statutory reserves, which are reserves consisting of profits which are distributable dividends, if the company so wishes.

Profit and Loss Reserves

The most significant non-statutory reserve is variously described as:
Revenue reserve
Retained profits
Retained earnings
Undistributed profits
Profit and loss account
Un-appropriated profits

These are profits earned by the company and not appropriated by dividends, taxation or other transfer to another reserves account.


Provided that a company is earning profits, this reserve generally increases from year to year, as most companies do not distribute all their profits as dividends. Dividends can be paid from it: even if a loss is made in one particular year, a dividend can be paid from previous years’ retained profits.


Very occasionally, you might come across a debt balance on the profit and loss account. This would indicate that the company has a accumulated losses.

Non Statutory Reserves

The company directors may choose to set up other reserves. These may have a specific purpose (e.g. plant and machinery replacement reserve) or not (e.g. general reserve). The creation of these reserves usually indicates a general intention not to distribute the profits involved at any future date, although legally any such reserves, being non-statutory, remain available for the payment of dividends.

Distinction between reserves and provisions

A reserve is an appropriation of distributable profits for a specific purpose while a provision is an amount charged against revenue as an expense. A provision relates either to a diminution in the value of an asset or a known liability, the amount of which cannot be established with any accuracy.

Provisions are dealt with in a company accounts in the same way as in the accounts of other types of business

Asset finance - introduction to hire purchase and leasing

Introduction

The acquisition of assets - particularly expensive capital equipment - is a major commitment for many businesses. How that acquisition is funded requires careful planning.

Rather than pay for the asset outright using cash, it can often make sense for businesses to look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the revenue generated by the business.The most common sources of medium term finance for investment in capital assets are Hire Purchase and Leasing.

Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment it requires and the finance company buys it on behalf of the business.

Many kinds of business asset are suitable for financing using hire purchase or leasing, including:

- Plant and machinery
- Business cars
- Commercial vehicles
- Agricultural equipment
- Hotel equipment
- Medical and dental equipment
- Computers, including software packages
-Office equipment
Hire purchase

With a hire purchase agreement, after all the payments have been made, the business customer becomes the owner of the equipment. This ownership transfer either automatically or on payment of an option to purchase fee.

For tax purposes, from the beginning of the agreement the business customer is treated as the owner of the equipment and so can claim capital allowances. Capital allowances can be a significant tax incentive for businesses to invest in new plant and machinery or to upgrade information systems.

Under a hire purchase agreement, the business customer is normally responsible for maintenance of the equipment.

Leasing

The fundamental characteristic of a lease is that ownership never passes to the business customer.

Instead, the leasing company claims the capital allowances and passes some of the benefit on to the business customer, by way of reduced rental charges.

The business customer can generally deduct the full cost of lease rentals from taxable income, as a trading expense.

As with hire purchase, the business customer will normally be responsible for maintenance of the equipment.

There are a variety of types of leasing arrangement:

Finance Leasing

The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease.

Although the business customer does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item.

When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.

Operating Leasing

If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it secondhand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals.

This type of leasing is common for equipment where there is a well-established secondhand market (e.g. cars and construction equipment). The lease period will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine.

Assets financed under operating leases are not shown as assets on the balance sheet. Instead, the entire operating lease cost is treated as a cost in the profit and loss account.

Contract Hire

Contract hire is a form of operating lease and it is often used for vehicles.

The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences.

Equity finance - new share issues to the public: introduction

Introduction

There are three main ways of raising equity finance:

- Retaining profits in the business (rather than distributing them to equity shareholders);

- Selling new shares to existing shareholders (a "rights issue")

- Selling new shares to the general public and investing institutions

This revision note outlines the process involved in the third method above.

How significant are new issues of shares in the UK?

Issues of new shares to the public account for around 10% of new equity finance in the UK.

Whilst not significant in the overall context of UK equity financing, when new issues do occur, they are often large in terms of the amount raised.

New issues are usually used at the time a business first obtains a listing on the Stock Exchange. This process is called an Initial Public Offering (“IPO”) or a “flotation”.

Methods

The process of a stock market flotation can apply both to private and nationalised share issues. There are also several methods that can be used. These methods are:

• An introduction

• Issue by tender

• Offer for sale

• Placing, and

• A public issue

In practice the “offer for sale” method is the most common method of flotation. There is no restriction on the amount of capital raised by this method.

The general procedures followed by the various methods of flotation are broadly the same. These include

- Advertising, e.g. in newspapers

- Following legal requirements, and Stock Exchange regulations in terms of the large volumes of information which must be provided. Great expense is incurred in providing this information, e.g. lawyers, accountants, other advisors.

Why issue new shares on a stock exchange?

The following are reasons why a company may seek a stock market listing:

(1) Access to a wider pool of finance

A stock market listing widens the number of potential investors. It may also improve the company's credit rating, making debt finance easier and cheaper to obtain.

(2) Improved marketability of shares

Shares that are traded on the stock market can be bought and sold in relatively small quantities at any time. Existing investors can easily realise a part of their holding.

(3) Transfer of capital to other uses

Founder owners may wish to liquidate the major part of their holding either for personal reasons or for investment in other new business opportunities.

(4) Enhancement of company image

Quoted companies are commonly believed to be more financially stable. A stock exchange listing may improve the image of the company with its customers and suppliers, allowing it to gain additional business and to improve its buying power.

(5) Facilitation of growth by acquisition

A listed company is in a better position to make a paper offer for a target company than an unlisted one.

However, the owners of a private company which becomes a listed plc (public company) must accept that the change is likely to involve a significant loss of control to a wider circle of investors. The risk of the company being taken over will also increase following listing.

Equity finance

Introduction

What is equity?

Equity is the term commonly used to describe the ordinary share capital of a business.

Ordinary shares in the equity capital of a business entitle the holders to all distributed profits after the holders of debentures and preference shares have been paid.

Ordinary ( equity) shares

Ordinary shares are issued to the owners of a company. The ordinary shares of UK companies typically have a nominal or 'face' value (usually something like £1 or 5Op, but shares with a nominal value of 1p, 2p or 2Sp are not uncommon).

However, it is important to understand that the market value of a company's shares has little (if any) relationship to their nominal or face value. The market value of a company's shares is determined by the price another investor is prepared to pay for them. In the case of publicly-quoted companies, this is reflected in the market value of the ordinary shares traded on the stock exchange (the "share price").

In the case of privately-owned companies, where there is unlikely to be much trading in shares, market value is often determined when the business is sold or when a minority shareholding is valued for taxation purposes.

In your studies, you may also come across "Deferred ordinary shares". These are a form of ordinary shares, which are entitled to a dividend only after a certain date or only if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares.

Why might a company issue ordinary shares?

A new issue of shares might be made for several reasons:

(1) The company might want to raise more cash

For example might be needed for the expansion of a company's operations. If, for example, a company with 500,000 ordinary shares in issue decides to issue 125,000 new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead?

- Where a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, this is known as a "rights issue".

(2) The company might want to issue new shares partly to raise cash but more importantly to 'float' its shares on a stock market.

When a UK company is floated, it must make available a minimum proportion of its shares to the general investing public.

(3) The company might issue new shares to the shareholders of another company, in
order to take it over

There are many examples of businesses that use their high share price as a way of making an offer for other businesses. The shareholders of the target business being acquired received shares in the buying business and perhaps also some cash.

Sources of equity finance

There are three main methods of raising equity:

(1) Retained profits: i.e. retaining profits, rather than paying them out as dividends. This is the most important source of equity

(2) Rights issues: i.e. an issue of new shares. After retained profits, rights issues are the next most important source

(3) New issues of shares to the public: i.e. an issue of new shares to new shareholders. In total in the UK, this is the least important source of equity finance

Each these sources of equity finance are covered in separate tutor2u revision notes.