Welcome to Capital Structure and Finance Costs!
Ever wondered how a massive company like Apple or Coca-Cola gets the money to build new factories or develop the next big iPhone? They don't just find it under a mattress! They raise "Capital." In this chapter, we will explore where that money comes from (Capital Structure) and what it costs the company to use that money (Finance Costs). Don't worry if this seems a bit "corporate" at first—we’ll break it down using simple everyday examples.
1. What is Capital Structure?
Think of Capital Structure as a recipe. To start a business, you need ingredients. Some of those ingredients you own (Equity), and some you have to borrow from a neighbor (Debt). Capital Structure is simply the mix of Equity and Debt that a company uses to fund its operations.
Equity: This is the owners' stake in the business. It includes the capital provided by shareholders and profits the company has retained over the years.
Debt / Borrowings: This is money borrowed from outside sources. It must be repaid, usually alongside interest.
Preference Shares (The Hybrid):
A key area examined in ACCA FA is the distinction between two types of preference shares:
• Irredeemable Preference Shares: The company is never required to buy these back. They form part of Equity, and their dividends are treated as an appropriation of profit in the Statement of Changes in Equity (SOCE).
• Redeemable Preference Shares: The company must repay or repurchase them on a future date. In accounting substance, these are debt (borrowings/liabilities), and their dividends are treated as Finance Costs (expenses) in the Statement of Profit or Loss!
Quick Review:
• Equity = Ordinary share capital, Share premium, Retained earnings, and Irredeemable preference shares.
• Debt / Liabilities = Bank loans, Loan notes (debentures), and Redeemable preference shares.
2. Equity: Issuing Ordinary Shares
When a company wants to raise money without borrowing, it sells "pieces" of itself called Ordinary Shares. There are two important values you need to know:
1. Nominal Value (Par Value): This is the "face value" of the share, often something small like \$1.00 or \$0.50. It is a legal requirement, but it is rarely what investors pay.
2. Market Value (Issue Price): This is what the investor actually pays the company.
The Accounting Entry for Issuing Shares:
When a company sells a \$1.00 nominal share for \$3.00, the \$2.00 "extra" goes into a special reserve account called the Share Premium account.
The Journal Entry:
Dr Cash (Total amount received): \( \$3.00 \)
Cr Share Capital (Nominal value only): \( \$1.00 \)
Cr Share Premium (Excess over nominal value): \( \$2.00 \)
Common Mistake to Avoid: Never put the full cash amount into the Share Capital account! Only the nominal value goes there. The rest belongs in Share Premium.
3. Bonus Issues and Rights Issues
Companies frequently issue additional shares to existing shareholders using one of two methods:
A. Bonus Issue (The "Freebie")
A Bonus Issue (or capitalisation issue) gives additional fully paid shares to existing shareholders in proportion to their holding, for free. No cash is received! The company converts reserves (usually Share Premium, or Retained Earnings) into permanent Share Capital.
Advantages:
• Rewards shareholders without spending company cash.
• Capitalises reserves into permanent share capital, increasing creditor protection.
• Lowers the share price, making shares more marketable to smaller investors.
Disadvantages:
• Raises no new cash for the company.
• Future earnings per share may be diluted across more shares.
Journal Entry:
Dr Share Premium (or Retained Earnings)
Cr Share Capital
B. Rights Issue (The "Discount Offer")
A Rights Issue is an offer of new shares to existing shareholders in proportion to their current holdings, typically at a discount to the current market price. Unlike a bonus issue, cash is received.
Advantages:
• Raises fresh cash for the business.
• Gives existing shareholders the right to avoid dilution of their ownership percentage.
• Cheaper and faster to organise than an initial public offering to outside investors.
Disadvantages:
• Existing shareholders must supply cash or see their ownership percentage diluted if they do not participate.
• Issued at a discount, which can reduce the market price per share.
Step-by-Step for Rights Issues:
1. Calculate the number of new shares issued (e.g., "1 new share for every 4 held").
2. Multiply the number of shares by the rights issue price to find the total cash received.
3. Record the nominal value in Share Capital and any excess in Share Premium.
4. Debt: Loan Notes and Finance Costs
When a company raises long-term funds without issuing shares, it issues Loan Notes (also known as debentures) or takes bank loans. The cost of using this borrowed money is called Finance Costs (interest expense).
Finance Costs: This interest is recorded as an expense in the Statement of Profit or Loss. Regardless of whether the company makes a profit or a loss, the contractual interest must be paid or accrued.
Calculating Interest:
Interest is always calculated on the Nominal Value of the debt, never on market fluctuations.
\( \text{Interest Expense} = \text{Nominal Value of Loan} \times \text{Stated Interest Rate} \)
Example: If a company has \( \$10,000 \) of \( 5\% \) loan notes:
\( \text{Annual Interest} = \$10,000 \times 0.05 = \$500 \)
Journal Entry:
Dr Finance Costs (Profit or Loss): \( \$500 \)
Cr Cash / Bank (or Accruals if unpaid at year end): \( \$500 \)
5. Dividends vs. Interest (Exam Focus!)
Understanding how payments to providers of capital are reported is a classic exam topic. Do not mix up the reporting locations:
1. Equity Dividends (Ordinary Shares and Irredeemable Preference Shares):
• These are distributions of profit to equity holders.
• They are not an expense in the Statement of Profit or Loss.
• They are presented as deductions in the Statement of Changes in Equity (SOCE).
• Ordinary dividends are discretionary: directors decide if and when to propose them.
2. Debt Interest and Redeemable Preference Dividends:
• Interest on bank loans and loan notes is a mandatory borrowing expense.
• Crucially, dividends on Redeemable Preference Shares are also treated as Finance Costs because the underlying instrument is classified as debt!
• Both are recognised as expenses in the Statement of Profit or Loss under Finance Costs.
6. Summary of Key Terms
Share Capital: The nominal value of shares issued to owners.
Share Premium: The amount received by the company above the nominal value on a share issue.
Retained Earnings: Cumulative profits kept in the business after distributions.
Redeemable Preference Shares: Debt-like shares repayable at a future date; dividends are treated as finance costs in profit or loss.
Irredeemable Preference Shares: Permanent capital; treated as equity, with dividends deducted in the statement of changes in equity.
Finance Costs: Borrowing expenses (loan interest and redeemable preference dividends) charged to profit or loss.
Final Encouragement: Capital structure comes down to knowing whether an item belongs in Equity or Liabilities, and whether payments are Finance Costs in profit or loss or Distributions in equity. Keep these rules clear, practice recording share issues, and you will ace these questions!