Question

Berry Ltd is a public retail company that is currently expanding their operations. In order to do this, the directors need a substantial injection of cash to finance the new development.

Required: You have been asked as the graduate accountant, to prepare a report to the board of directors summarising the major differences between the company raising funds by a share issue versus the issue of debentures. Include in your report the different effects each choice would have on the financial statements, what advantages (if any) each choice would provide the company and what financial commitments the company would be liable for under each option.

Please help me with the highlighted topics. The answer should include all of the highlighted topics. Please provide references as well. Thank you  

Answer 1

We will look into the advantages and disadvantages of each option seperately:

1.Raising funds by issue of share capital

Share is the smallest division of ownership of the company. The shares are issued to private institutions, underwriters, high net worth individuals and to public through the share market. A price is fixed for initial offer of shares, and then the price changes according to the market conditions. On the financial statement the Equity share capital side will increase. Cash under asset side will increase. No other effects.

Advantages:

• There is no obligation to payback the shareholders.
• There is no interest cost or fixed annual payments, dividends can be determined according interest of the company.
• There is a huge potential market for share issue , when compared to debt market, as public take part in earlier.

Disadvantages:

• Ownership of the company will be further diluted.
• There is too much work and compliance requirement on issuing shares.
• There could be shift in control of management after a company goes public, which might hinder the promoters with corre idea from making decisions.

2.Raising funds by issue of Debentures

Debentures are debt instruments (mainly for long term) issue by the company to finance its projects. This is basically borrowing of money, with promise to repay and payment of regular interests. Interest rates and repayment schedule will be disclosed in prospectus for debentures. On the financial statement the Longterm liability side will increase. Cash under asset side will increase. No other effects.

Advantages:

• Ownership of the company will not be diluted.
• Interest and prices are stable when compared to issue of shares and dividend payments.
• Can be issued at discount prices without much legal compliances, when compare to shares.

Disadvantages:

• There is an obligation to payback the debunture holders.
• Interest payments , and timely retiremnent of debuntures will have to made even in cases with no profit.
• There will be a charge of fixed assets of the company.

What effect would each option have on the financial statements?

Issue of shares:- Issue of shares will not effect the income statement as there is no fixed obligation to pay. The issue of shares will effect the balance sheet, as the share holders equity will increase. Further, payment of dividends will be from the retained earnings, which would decrease the share holders equity side.

Issue of debentures:- Issue of debentures will effect the finance costs in the income statement, there by reducing net income. In the balance sheet, Long term liabilities will increase with issue of debentures.

financial commitments the company is liable under each option.

Issue of shares:- There is no financial commitment as the common share holders are owners and are last in line to receive the residual income of company.

Issue of debentures:- There is a financial commitment to pay the debenture holders irrespective of the financial condition of the company.