A company needs ₦960m for expansion. Its profits will cover part. The rest must come from investors. It can ask the public to buy shares, ask a few big institutions, or ask its own shareholders. Each route has a different cost, speed, certainty and effect on who owns the company. A rights issue protects existing owners but makes shares cheaper.
A public offer reaches new investors but dilutes the old. The choice is a financing decision with real money on both sides.
This topic covers the sources of long-term finance, retained earnings and working capital release, why private companies find it hard to raise equity, the methods of issuing shares for cash (public offer, offer for sale, tender, placing, stock exchange introduction, rights issue), underwriting, share repurchases, the issue price and theoretical ex-rights price (including the yield-adjusted price), the value of rights, shareholders’ choices and the strengths and weaknesses of rights issues.
The previous topic covered CAPM. The next covers debt, convertibles and preference shares. The May 2014 and November 2014 Pathfinder papers tested share issue methods.
In 30 seconds
The main source of new equity is retained profit: no issue costs and no new shareholders, but limited by profits and dividend policy. Companies can also release cash from working capital.
New shares for cash come by public offer (to the public; an IPO for a first listing; an offer for subscription raises money for the company, an offer for sale transfers existing shares), a placing (to selected institutions), a rights issue (to existing shareholders in proportion) or, for a first listing without raising cash, a stock exchange introduction. Large issues are underwritten.
TERP = (n × cum-rights price + issue price) ÷ (n + 1). The value of a right per existing share = (TERP − issue price) ÷ n. A shareholder who takes up or sells the rights is no better and no worse off in theory. One who does nothing loses. Share repurchases return surplus cash and can raise EPS.
Key terms in plain English
| Term | What it means |
|---|---|
| Public offer | An offer of new shares to the general public |
| IPO | Initial public offering: a first sale of shares to the public by a company coming to market |
| Placing | Selling new shares to a few selected institutions |
| Rights issue | Offering new shares to existing shareholders in proportion to their holding |
| Stock exchange introduction | Getting existing shares listed without issuing new ones |
| Underwriting | An agreement by institutions to buy unsold shares for a fee |
| Cum-rights price | The share price before a rights issue, including the right |
| Theoretical ex-rights price (TERP) | The expected share price after the rights issue |
Syllabus check
This topic is in syllabus area C (financing decisions). It covers:
- the long-term sources of finance, including equity;
- methods of raising equity: rights issue, placement, public offer, stock exchange listing and listing on the FMDQ market;
- the value of a rights issue.
CAMA 2020 and equity finance
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 127 | A company may increase its issued share capital by allotting new shares | Raising equity |
| s. 142 | Existing shareholders of a private company must first be offered new shares in proportion to their holdings, and have 21 days to accept; the right no longer applies to public companies | Rights issues and pre-emption |
| s. 149 | The board may allot shares only with express authority from the company in general meeting or under the articles | Authority to issue |
| s. 154(1) | A return of allotment is filed with the CAC within one month | After the issue |
Internal sources of equity
For most companies, the main new equity is retained profit. Benefits: no issue costs (no new shares), it is readily available and needs no shareholder approval. Limits: the company must be profitable; retained profits must earn a decent return or shareholders will want higher dividends; and retention is limited by dividend policy. Working capital efficiency (better inventory, receivables and payables management) can also release cash once.
Raising equity externally
Private companies cannot offer shares to the public or trade on a stock market. Investors avoid them because their shares are hard to value and hard to sell, and owners may lack the capital to put in more. So most small and medium companies rely on retained profit.
Public companies can offer shares to the public and may have them traded, which gives the shares a market price and an exit for holders. To trade on an exchange, the company must meet the regulator’s requirements and gain the exchange’s acceptance. In Nigeria ICAN describes a main market and a secondary market for smaller companies.
The methods
- Public offer. Normally a large issue because of its cost. An existing listed company usually cannot make one without shareholders’ permission, since it would dilute them. An IPO brings a company to the market for the first time. An offer for subscription issues new shares and raises capital for the company. An offer for sale sells existing shares, so the proceeds go to the seller and the company’s capital does not rise. An IPO may combine both; only new shares raise capital.
- Offer for sale by tender. Investors bid their own prices and the issue price is the lowest bid that sells all the shares. Very uncommon now.
- Placing. A small number of new shares sold to selected institutions, when the amount needed is modest. Existing shareholders’ approval is needed.
- Stock exchange introduction. The company lists existing shares with no new issue and no cash raised. It may be possible only if enough shares are already held by the public. Later it can issue shares by placing or rights.
- Rights issue. New shares offered to existing shareholders in proportion. In Nigeria and the UK, as ICAN describes, any new issue for cash must go to existing shareholders first unless they waive their rights, so a large issue by a listed company is a rights issue.
ICAN’s example (Stabba). A flotation must raise ₦800m after issue costs of 5%. The issue price is ₦800.
- Gross = 800m ÷ 0.95 = ₦842.1m.
- Shares = 842.1m ÷ 800 = 1,052,625.
- Only new shares add to the company’s capital.
Underwriting
Large issues are underwritten: institutions agree to buy up to a stated number of unsold shares at the issue price for a commission. It guarantees the cash but costs money. A company may instead use a deep-discounted issue at a very low price, so that the shares sell without underwriting.
Share repurchases
A company may buy back and cancel shares. ICAN’s example: 50,000 shares bought at ₦300 cost ₦15m and reduce both cash and equity by that amount. Two main reasons: (a) it has surplus cash earning little, and cancelling shares raises earnings per share and perhaps the share price; (b) debt is cheaper than equity, so the company replaces equity with debt and raises its gearing.
Rights issues
The issue price is set below the market price to give an incentive to subscribe, usually about 10% to 15% below the pre-issue price. A 1 for 3 issue when the shares are ₦600 might be priced at ₦510 to ₦540.
Theoretical ex-rights price
The TERP is the weighted average of the cum-rights price and the issue price. ICAN’s example: a 2 for 5 issue at ₦300 when the market price is ₦370. Five shares at ₦370 = ₦1,850; two new shares at ₦300 = ₦600; total ₦2,450 for seven shares, so TERP = ₦350. The value of a right is ₦50 for each new share, or ₦20 for each existing share (₦100 ÷ 5).
A rights issue gives no real gain, because the shareholder pays cash equal to the fall in value.
Yield-adjusted TERP
If the new money will earn a different return from existing funds, adjust the issue price by new yield ÷ old yield for the calculation. ICAN’s example: a 1 for 4 issue at a 25% discount to ₦2.50, with new funds earning 14% against a WACC of 10%. Issue price = ₦1.875; adjusted = 1.875 × 14 ÷ 10 = ₦2.625; yield-adjusted TERP = (4 × 2.50 + 2.625) ÷ 5 = ₦2.525. The adjustment is only for the TERP, not for the cash raised.
The shareholder’s choices
- Take up the rights: in theory neither better nor worse off.
- Renounce and sell the rights: in theory neither better nor worse off.
- Take up some and sell the rest.
- Do nothing: the shares fall to the TERP and the holder loses, even if the company sells the unclaimed shares for him.
Advantages and disadvantages
Advantages: shareholders keep their proportion and are not diluted; the company cannot sell new shares at a discount to outsiders. Disadvantages: existing shareholders may not want or be able to invest; there is no reason to give them preference; and a wider offer might get a price nearer the market price.
The rules in more depth
Why a rights issue is priced at a discount
Shareholders must be given a reason to subscribe or sell the right. A discount makes the new shares attractive.
Why the discount does not hurt shareholders who act
The price fall on all shares is offset by the value of the right or by owning extra shares at the lower price. The cash they pay is the exact amount of value transferred to the new shares.
Why a company may prefer a placing
It is quicker and cheaper for a modest amount, and it avoids the wait of a rights issue.
Why a company buys back shares
With no good use for cash, returning it can raise EPS and allow a better capital structure. The lost interest on the cash has to be set against the gain.
Effect on analysis
State the method, the amount to raise, the number of shares and the effect on price, EPS and ownership.
Worked examples
Example 1: a public offer. A company needs ₦500m net. Issue costs are 4% of the gross amount. The issue price is ₦250.
- Gross = 500m ÷ 0.96 = ₦520.8m.
- Shares = 520.8m ÷ 250.
- New shares = 2,083,333.
Example 2: TERP. A 1 for 4 rights issue at ₦300 when the shares are ₦400 cum-rights.
- Four shares at ₦400 = 1,600; one at ₦300 = 300; total 1,900 for five shares.
- TERP = ₦380.
- Value of a right.
(380 − 300) ÷ 4 = ₦20 per existing share.
Example 3: shareholder choices. A holder has 1,000 shares in the company in Example 2.
- Take up.
subscribe for 250 shares at ₦300 = ₦75,000.
Holding = 1,250 × 380 = ₦475,000, against ₦400,000 before.
Gain ₦75,000 less cash paid ₦75,000 = nil. - Sell.
receive 1,000 × 20 = ₦20,000.
Shares are worth 1,000 × 380 = ₦380,000.
Total ₦400,000 = nil change. - Do nothing: holding ₦380,000, a loss of ₦20,000.
Example 4: a repurchase. A company with profit of ₦100m and 20m shares buys back and cancels 5% of them. Ignore the lost interest on cash.
- EPS before.
100 ÷ 20 = ₦5.00. - Shares after.
19m, so EPS = 100 ÷ 19 = ₦5.26, a rise of about 5.3%. - Lost interest on the cash used would reduce this gain.
How to score full marks
- Name the method and say why it suits the case.
- Compute the shares to issue after costs.
- Use the weighted-average TERP formula.
- Show the effect of each shareholder choice in naira.
- Compare the methods on cost, speed and control.
- State the effect on ownership and EPS.
Common mistakes in the exam
- Forgetting issue costs when finding the shares to issue.
- Using the issue price instead of the weighted average for the TERP.
- Saying a rights issue gives shareholders a gain.
- Mixing up the offer for sale and the offer for subscription.
- Calling a stock exchange introduction a source of cash.
- Ignoring the cost of underwriting.
Quick revision
- Retained profit is the main source; it has no issue costs.
- Methods: public offer, tender, placing, introduction, rights.
- Offer for subscription raises capital; offer for sale does not.
- TERP = weighted average; right = (TERP − issue) ÷ n per existing share.
- Take up or sell: no change; do nothing: loss.
- Repurchase: surplus cash or more gearing.
- CAMA 2020: ss. 127, 142, 149, 154(1).
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.
Question 1. The main source of new equity for most companies is:
- Retained profit
- A public offer
- A placing
- A tender
Show the answer
A. There are no issue costs.
Question 2. An offer for sale of existing shares:
- Raises capital for the company
- Raises money for the seller, not the company
- Is a rights issue
- Is underwritten by shareholders
Show the answer
B. It is a transfer of shares.
Question 3. A stock exchange introduction:
- Raises new cash
- Lists existing shares without raising cash
- Is a rights issue
- Is a placing
Show the answer
B. No new shares are issued.
Question 4. A placing is a sale of new shares to:
- The whole public
- A small number of selected institutions
- Existing shareholders only
- Employees
Show the answer
B. It suits small amounts.
Question 5. The TERP is the:
- Weighted average of cum-rights and issue prices
- Issue price
- Cum-rights price
- Dividend
Show the answer
A. After the rights issue.
Question 6. A 1 for 4 issue at ₦300 with shares at ₦400 gives a TERP of:
- ₦380
- ₦400
- ₦350
- ₦300
Show the answer
A. (4 × 400 + 300) ÷ 5.
Question 7. A shareholder who does nothing in a rights issue:
- Gains
- Loses value
- Is unaffected
- Receives a dividend
Show the answer
B. The shares fall to the TERP.
Question 8. Underwriters are paid:
- A commission for agreeing to buy unsold shares
- Dividends
- Interest
- Nothing
Show the answer
A. It guarantees the cash.
Question 9. A common reason for a share repurchase is:
- Surplus cash with no use
- A lack of cash
- To raise equity
- To cut gearing
Show the answer
A. It can raise EPS.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Distinguish a public offer, a placing and a rights issue. (6 marks) (b) Explain the purpose of underwriting and its drawback. (4 marks)
Question 12 (20 marks). Nene Plc has 10m shares at ₦600 cum-rights. It plans a 1 for 5 rights issue at ₦480. (a) Calculate the number of new shares and the cash raised. (3 marks) (b) Calculate the TERP and the value of a right per existing share. (4 marks) (c) A holder of 5,000 shares can take up, sell or ignore the rights. Show the effect of each.
(8 marks) (d) State two advantages and two disadvantages of a rights issue. (4 marks) (e) State one reason to use a placing instead. (1 mark)
Question 13 (10 marks). (a) A company must raise ₦500m net after issue costs of 4% by selling shares at ₦250. Calculate the number of shares. (3 marks) (b) State the two main reasons a company repurchases its shares. (4 marks) (c) Explain the difference between an offer for subscription and an offer for sale. (3 marks)
Model answers
Show the model answer to Question 11
(a) Methods (6 marks). A public offer sells new shares to the general public, usually a large issue and the route for an IPO. (2) A placing sells a small number of new shares to selected institutions. (2) A rights issue offers new shares to existing shareholders in proportion to their holdings. (2)
(b) Underwriting (4 marks). Institutions agree to buy unsold shares at the issue price for a commission, so the company is sure of raising the cash. (2) The drawback is the commission cost. (2)
Show the model answer to Question 12
(a) New shares (3 marks).
- 10m ÷ 5 = 2m new shares. (1.5)
- Cash = 2m × ₦480 = ₦960m. (1.5)
(b) TERP (4 marks).
- (5 × 600 + 480) ÷ 6 = 3,480 ÷ 6 = ₦580. (2)
- Value of a right.
(580 − 480) ÷ 5 = ₦20 per existing share. (2)
(c) Choices (8 marks).
- Before.
5,000 × 600 = ₦3,000,000. - Take up.
subscribe for 1,000 shares at ₦480 = ₦480,000; holding 6,000 × 580 = ₦3,480,000; value gained ₦480,000 equals cash paid, so no change. (3) - Sell.
rights = 5,000 × 20 = ₦100,000; shares 5,000 × 580 = ₦2,900,000; total ₦3,000,000, so no change. (3) - Do nothing: holding ₦2,900,000, a loss of ₦100,000. (2)
(d) Pros and cons (4 marks). Advantages: shareholders keep their proportion; new shares cannot be sold cheaply to outsiders. (2) Disadvantages: shareholders may not want or be able to invest; a wider issue could achieve a price nearer the market price. (2)
(e) Placing (1 mark). It is quicker and cheaper for a small amount of money. (1)
Show the model answer to Question 13
(a) Shares (3 marks).
- Gross = 500m ÷ 0.96 = ₦520.8m. (1.5)
- Shares = 520.8m ÷ 250 = 2,083,333. (1.5)
(b) Repurchase (4 marks). The company has surplus cash earning a low return, so cancelling shares raises EPS and perhaps the share price. (2) Debt is cheaper than equity, so replacing some equity with debt lowers the cost of capital and raises gearing. (2)
(c) Offers (3 marks). An offer for subscription issues new shares and the proceeds go to the company. (1.5) An offer for sale sells existing shares, so the proceeds go to the seller and the company’s capital does not change. (1.5)
Pathfinder on Share issue methods, TERP and rights issues
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The question asked which is NOT a method of raising capital from existing and prospective shareholders from offer for subscription, tender offer, rights offer, offer for sale and stock exchange introduction. The answer is stock exchange introduction, because it raises no new cash. Read the section on the methods of raising equity.
Revise first: Raising equity externally
The question asked for four steps to improve the chances and success of an IPO for a family pharmaceutical company that wants to list. Read the sections on public companies and the public offer.
Revise first: Raising equity externally
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: May 2014 multiple-choice 19; November 2014 question 4(b).
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