Sources of finance: debt, convertibles and preference shares

A company can borrow, but borrowing comes with promises. Interest must be paid on time, the principal must be repaid, and a missed payment hands the lender legal rights. In return, debt is cheaper than equity and the interest saves tax. Between pure debt and pure equity sit hybrids: bonds that can turn into shares, bonds that carry share options, and preference shares.

Each mixes the features differently, and the finance manager has to know which mix fits the company.

This topic covers the nature of debt finance, long-, medium- and short-term debt, interest payments, tax relief on interest, straight debt, access to bond markets, the risks of debt to a borrower and its attractions to an investor, finance leases as debt, convertible bonds and the conversion premium, bonds with warrants, preference shares (types, advantages and disadvantages). The previous topic covered equity.

The next covers finance for small businesses and venture capital. The November 2014 Pathfinder paper asked about issuing bonds.

Key terms in plain English

Syllabus check

This topic is in syllabus area C (financing decisions). It covers:

• the long-term sources of finance, including debt;
• convertible debt, debt with warrants and preference shares;
• leasing as a source of finance.

CAMA 2020 and debt and preference shares

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

The nature of debt finance

In debt finance the borrower receives capital for a period (redeemable) or for ever (irredeemable), pays interest while the debt lasts and repays the principal at maturity. The main forms are bank borrowing and debt securities. A secured loan lets the lender recover from the secured assets if the borrower defaults. Both secured and unsecured lenders get covenants, including an undertaking to pay interest on time.

A breach is a default, and the lender may sue. In Nigeria, the FMDQ Securities Exchange is the main over-the-counter market for fixed income, currency and derivatives.

Term and commitment

• Long-term: usually bonds, also called loan stock or debentures.
• Medium-term (up to about five to seven years): bank loans, or short-dated bonds called notes.
• Short-term: overdrafts; large companies may use commercial paper or a bills acceptance programme.
• Irredeemable debt is uncommon.
• Committed funds must be provided until maturity. Uncommitted lending, such as most overdrafts, can be withdrawn at any time, so it is riskier for the borrower.

Interest

On a loan or bond, interest is charged on the whole amount. On an overdraft, only on the balance used. Bank loans usually carry a floating rate, a margin over the bank’s base rate or a reference rate (for example six-month rate plus 1%). Bonds and notes usually carry a fixed coupon: 6% bonds pay ₦30 every six months for each ₦1,000 nominal.

Interest is a tax-allowable expense. ICAN’s example: borrowing ₦10m at 5% costs ₦500,000, tax relief at 30% saves ₦150,000, so the net cost is ₦350,000, or 3.5% (5% × 0.7). Dividends get no tax relief.

Straight debt and bond markets

Straight debt is a fixed amount of redeemable debt at a fixed rate: ₦200m of 6% bonds for 15 years pays ₦12m a year and returns ₦200m at the end. Private companies cannot offer bonds to the public, so they rely on bank loans or private investors. Large public companies can issue bonds internationally, usually in US dollars or euros, and pay for a credit rating.

Smaller public companies find the bond markets hard to reach because their needs are too small for the big investors. Bond prices are fairly stable, so they offer little chance of quick capital gains.

Risk for the borrower, attraction for the investor

Risk for the borrower:

• lenders are paid before shareholders, so with large debt and low profits little is left for dividends
• late or missed payments are a default with legal consequences
• shareholders have no similar rights

Avoid too much debt, though views differ on how much is safe. Attractions for the investor: usually redeemable; interest is paid regardless of profit; may be secured; ranks above equity on liquidation.

Disadvantage: returns are fixed and predictable, so no share in the company’s success.

Finance leases

A finance lease lets a company use an asset for most of its life while the lessor pays for it. The lessee pays regular fixed rentals, each part capital and part interest, claims tax relief on the interest, pays for insurance and running costs and may claim capital allowances. Under IFRS 16, a lessee shows the leased asset as a right-of-use asset matched by a lease liability.

ICAN’s example: a ₦100,000 machine leased for six annual payments of ₦19,000 is shown as a ₦100,000 asset and a ₦100,000 debt, paid down over the term (total payments ₦114,000, so ₦14,000 is the finance cost).

Convertibles and warrants

Hybrid debt combines debt and equity features. Convertible bonds give the holder the right, but not the duty, to convert into a set number of shares at a set date. If the shares are worth more than the bond, the holder converts; if not, the bond is redeemed. ICAN’s example: ₦100m of 3% convertibles convertible after five years at 20 shares per ₦1,000.

At a share price of ₦60, ₦1,000 of bonds becomes shares worth ₦1,200, so holders convert.

The conversion premium is the market price of the convertible less the value of the shares it converts into. ICAN’s example: a 4% convertible at ₦1,015 convertible into 30 shares when the share price is ₦25. Premium = 1,015 − (30 × 25) = ₦265 for each ₦1,000. The premium exists because investors expect the share price to rise.

Advantages for the company:

• tax relief on interest now, with a hope of converting debt into equity later
• a lower interest rate than on straight bonds
• it can meet strong investor demand

For investors: a fixed minimum income plus a share in a rising price. Risk: if the share price does not rise, they would have done better with straight bonds at higher interest.

Bonds with warrants carry options to subscribe for new shares at a fixed price. ICAN’s example: ten-year 4% bonds with, for each ₦1,000, the right to buy ten shares after four years at ₦55. The holder exercises if the share price is above ₦55 and lets the right lapse otherwise. The difference from convertibles: warrants are detachable. The bonds are redeemed in the usual way, and the warrants can be traded separately.

With convertibles, the right is part of the bond, and on conversion the bond is surrendered.

Preference shares

Preference shares are near-debt: neither debt nor equity but closer to debt. In financial reporting they are often shown as liabilities. Features: a fixed annual dividend (for example 7% on ₦1 shares is ₦0.07 a year); dividends paid from after-tax profit, with no tax relief, so they cost more than debt; paid before equity dividends; and on liquidation they rank after debt but before equity.

Types: redeemable or irredeemable; cumulative (unpaid dividends build up as arrears and must be paid before equity dividends resume) or non-cumulative; participating (share in excess profits, so the stated dividend is lower); and convertible into equity.

Advantages for the company: the dividend is fixed and predictable; a missed preference dividend is not a default, unlike missed interest. Disadvantages: no tax relief; not very attractive to investors. They are uncommon, except in companies largely financed by venture capital.

The rules in more depth

Why debt is cheaper

It ranks first, so lenders bear less risk and want less. The interest is also tax-deductible.

Why too much debt is dangerous

Fixed payments continue even when profits fall, and a default allows lenders to act against the company.

Why the convertible coupon is lower

Investors pay for the option to share in the share price rise by accepting lower interest.

Why a warrant is a separate asset

It can be sold on its own, so the holder can keep the bond, sell the warrant, or the reverse.

Why preference shares cost more than debt

There is no tax relief, and the holders bear more risk since they rank after lenders.

Effect on analysis

Match the instrument to the need: cost, risk of default, tax, control and flexibility.

Worked examples

1. Interest = ₦1.6m.
   Tax saved = 30% × 1.6 = ₦0.48m.
2. Net cost = ₦1.12m.
3. After-tax cost.
   1.12 ÷ 20 = 5.6% (8% × 0.7).

1. Share price ₦60: shares worth ₦1,200, above ₦1,000, so convert.
2. Share price ₦40: shares worth ₦800, below ₦1,000, so redeem.
3. The break-even share price is ₦50.

1. Share price ₦70: exercise.
   Gain = 10 × (70 − 55) = ₦150 per bond.
2. Share price ₦50: let the warrants lapse.
3. The warrants can be sold before they are exercised.

1. Annual dividend = ₦0.7m.
2. Arrears = 2 × 0.7 = ₦1.4m.
3. Before any equity dividend, the company must pay ₦1.4m arrears plus ₦0.7m for the current year, a total of ₦2.1m.

How to score full marks

• Compare instruments on cost, risk, tax, security and control.
• Use the after-tax cost for debt and none for preference shares.
• Calculate the conversion value and premium.
• State the detachable feature of warrants.
• Link the choice to the case facts.
• Give both advantages and disadvantages.

Common mistakes in the exam

• Giving preference dividends tax relief.
• Calling a missed preference dividend a default.
• Confusing convertibles with warrants.
• Calculating the premium on the face value, not the market price.
• Ignoring covenants and security.
• Saying debt has no risk for the borrower.

Quick revision

• Debt: interest, repayment, security, covenants; tax relief on interest.
• Overdraft: uncommitted and riskier.
• Convertible: premium = price − value of shares; warrants detach.
• Preference shares: near-debt, no tax relief, cumulative arrears.
• Finance lease: IFRS 16 right-of-use asset and liability.
• CAMA 2020: ss. 147, 182, 204, 222.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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