There are increasingly more instruments which are bridging the debt and equity. The three discussed below are typical examples.
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Convertible bonds
Convertible bonds give the holders the option to convert into ordinary shares, rather than have a cash repayment of the bond. They have two advantages:
(1) the interest rate is lower because of the conversion option
(2) the company may not have to repay the loan, just issue additional shares (subject to shareholder approval in the UK).
These bonds will now show as part of the company’s debt, as FRS 4 requires that the debt conversion should not be anticipated. They are discussed in detail in Chapter 6.
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Redeemable preference shares
Redeemable preference shares are a form of equity that is repaid at a fixed date, normally at the nominal value. FRS 4 requires that these should be included in the shareholders’ funds and classified as non-equity shares. As the dividend is usually fixed and the payment is not dependent upon the company’s performance, they can be regarded as a quasi-debt instrument.
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Mezzanine finance
Mezzanine finance is another example of a debt–equity hybrid. It tends to be used in young companies or management buy-outs and buy-ins. In these situations, there is a limited amount of debt that can be raised and/or a limited amount of cash available for a share issue.
Mezzanine finance is a loan that ranks behind the company’s other loans, with a higher rate of interest than the other debt, to reflect the increased risk. It is convertible into shares and is discussed in detail in Chapter 6.
5 Debt–equity hybrids
There are several instruments that have some of the characteristics of both debt and equity. Only redeemable preference shares will be shown as part of the shareholders’
funds. The others are classified as debt instruments, and are separately disclosed as part of convertible debt.
SUMMARY
Reserves can be classified into distributable reserves, which can be used to pay dividends and undistributable reserves. The only distributable reserve is the profit and loss account. This is the accumulated retained profits and exchange adjustments. It may also be reduced by goodwill arising on business acquired before December 1998.
Undistributable reserves usually arise from:
● unrealised profits – the revaluation reserve;
● a premium paid, above the nominal value, to acquire the company’s shares – the share premium account;
● the cancellation or redemption of shares – the capital redemption reserve. SUMMARY
American Depository Receipts (ADRS) A mechanism used in the USA to simplify the procedures for holding shares in foreign companies.
Authorised share capital The shares that the directors are currently authorised to issue.
Bonus issue/scrip issue/capitalisation issue Some of the company’s reserves are converted into share capital.
Convertible preference shares Preference shares that have the right to be converted into ordinary shares at a predetermined rate at a future date.
Cumulative preference shares A share where the entitlement to dividend is carried forward. Conse- quently, a company not paying a dividend to these shareholders is postponing the payment.
Deferred shares Shares where the dividend is deferred until a future date, or when ordinary share- holders’ dividends have reached a certain level.
Employee share ownership plan (ESOP) A plan that offers employees the opportunity to buy shares in the company at a discounted price.
Equity shares Shares that are not classified as non-equity shares. Most ordinary shares would be classed as equity shares as long as they are not redeemable and do not have limited rights in a liquidation.
Issued share capital The shares that have been issued on the date of the balance sheet.
Mezzanine finance A loan that ranks behind other loans and is convertible into ordinary shares at a predetermined rate.
Nominal/par value A notional value for a share. Share issues should be at this or a higher amount.
Any premium paid above the nominal value will be shown in the share premium account.
Non-equity shares Shares that have any of the following characteristics: entitlement to a fixed dividend, limited rights in a liquidation, or that they are redeemable. Most preference shares are non-equity shares.
Ordinary share The commonest form of share. However, it is possible to have different types of ordinary shares with differences in: voting rights, entitlement to dividends, redemption, and entitlement and ranking in the event of a liquidation.
Participating preference shares Shareholders may receive two dividends: a fixed dividend and a vari- able dividend that is dependent upon the company’s performance.
Placing New shares are placed directly with investors.
Placing and open offer clawback A company sells shares to its financial adviser, who then offers the shares to existing shareholders in proportion to their existing holdings.
Preference shares Shares that have a fixed dividend that must be paid beforeother dividends can be paid.
Redeemable preference shares These have to be repaid by a fixed date. These are often regarded as debt, and dividends can even be linked to interest rates.
Revenue reserve Another name for the profit and loss account. It is the company’s distributable reserve.
Rights issue The existing shareholders are offered the opportunity to buy new shares in propor- tion to their existing holding.
Scrip dividend A dividend that is paid in shares, rather than cash.
Share buy-back The company buys shares in the open market and then cancels them, thus reduc- ing the number of shares in issue.
Share consolidation Several shares are consolidated into one, increasing the nominal value of each resulting share.
JARGON
Share premium account A non-distributable reserve reflecting the premium that has been paid, above the nominal value, in share issues.
Share split The nominal value of the share is reduced and extra shares are created. A share split does not involve the capitalisation of the company’s reserves.
Vendor placing This is often used in acquisitions where the company wishes to acquire a company through a share exchange. The acquirer arranges, in advance, for the shares to be sold to other investors.
Warrant A type of option, often attached to bonds, that gives the holder the right to buy a spec- ified number of shares in the company at a predetermined price on or before an expiry date.
Warrants issued on their own are called naked warrants, whereas those attached to bonds are called covered warrants.
5 The balance sheet: share capital and reserves