FINANCIAL

MANAGEMENT

5. THE COST OF LONG-TERM RESOURCES

In the previous section, we talked about a company’s different short-term financing

sources and the cost that each financing entails for the company. In this section, we will
address different long-term financing options for the company and their costs.

We cannot forget that the company’s non-current assets and part of its current assets
are financed by long-term resources, including its own and external funds. They all are
considered the basic financing of the company.

The structure or composition of a company’s financing sources whether short or long

term, internal or external, needs to have characteristics (term, cost, risks, guarantee,
etc.) related to and balanced with the business objectives. That is why financial planning
is becoming an essential tool in the business world.

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5.1. OBJECTIVES

ü Primary and Secondary Stock Markets

ü Issuance of shares.

ü Cost of share capital.

ü Issuance of debts. Obligations and promissory notes.

ü Long-term credit.

A company’s basic financing sources comprise a shareholder’s equity (own funds) as

well as third-party (external) long-term resources. One of the fundamental
characteristics of this financing is its permanent nature (long-term financing). These
resources are used by the company to finance mainly non-current assets of the company
(fixed assets) and partially to finance current assets, the so-called working capital.

As the company grows and evolves, their shareholder’s equity, together with resources
that have been generated through the periodic company results (profits) are usually not
enough to meet the growing financial needs of the company.

Therefore, it is usually necessary to resort to external financing. We can distinguish

between two sources of long-term external financing:

§ Internal financing, through the issuance of shares, increasing the share capital
of the company, etc.

§ Third party financing, through the issuance of debt (obligations) or long-term

bank financing.

Here, it is important to differentiate between external and third party financing. Third
party financing is constituted by all debts incurred by the company, whereas external
financing also includes increases in the shareholder’s equity.

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When a company decides to undertake a capital increase by issuing new shares or raising
the nominal value thereof, its own and external financial resources are also increasing
at the same time. Imagine, for example, a company listed on the Stock Exchange
undertaking a capital increase.

The stock market is made up of markets in which fixed-interest and equity securities are
issued, both in the medium and long term: the official primary and secondary markets.
Within the latter, we may distinguish between the Stock Exchange and the Bond Market
(represented through book entries), and other national markets in which securities
represented through book entries are also issued.

§ A stock market is a public market for the purchase and sale of companies’ shares
and their derivatives at an agreed price. (Source:
www.enciclopediafinanciera.com) (For more information see annex n. 01. -
Shares)

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§ Fixed income:

Fixed income occurs in investments where it is known beforehand (or at least at

an acceptable level of prediction) what the generated income flows will be
(which do not necessarily have to be constant or regular). An example of fixed
income investments are financial assets or securities such as bonds, obligations,
bills, and promissory notes, real estate for rent and savings systems such as term
deposits and savings accounts.

Generally, fixed income investments generate a lower return than variable

income (equity) investments, but they present a lower risk. Usually, these are
long-term investments.

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§ Variable income:

On the other hand, variable income is used in investments where it is not known
in advance what the generated income flows will be (which may even turn out
to be negative), since they depend on several factors such as the performance of
the company, the behaviour of the market, the evolution of the economy, etc.

Examples of variable income investments are shares, mutual funds, bonds and
convertible bonds.

In general, variable income investments generate higher returns than fixed

income investments, but present a higher risk. Usually, these are short or
medium term investments.

Fixed income investments present low profitability and low risk, while equity
income investments present high profitability and high risk.

The best way to reduce or manage risk is through diversification, "not putting all
your eggs in one basket", but rather diversifying investments.

One way to diversify investments is by acquiring fixed income investments and

variable income investments, namely, by building a portfolio that combines both
types of investments.

The proportion of these investments will depend on the objectives and profile of
the investor, for instance, if a greater profitability is expected, investments
should be more variable; and the lower the risk tolerance, the higher the fixed
income investments should be.

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4.2. PRIMARY & SECONDARY MARKETS

The primary securities market or new issue market is the market where securities are
sold for the first time (shares, bonds, etc.), while the secondary market or Stock
Exchange is where securities are traded once they have been "placed" in the primary
market. The secondary securities market is thus a "second hand" market or resale
market.

Stock Exchanges are the most important and best-organised part of the secondary
market. It is a private organisation that provides its members with the chance to make
purchases of securities, shares, public bonds, etc. We can find demanders of capital
(companies and public bodies), suppliers of capital (such as savers and investors) and
finally, intermediaries or brokers.

A primary market depends largely on the Stock Exchange, because if the secondary
market did not exist, the primary market would have serious operation problems, since
practically no one would like to buy shares/obligations that could not be sold easily
afterwards, when companies need liquidity.

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§ Stock Exchange:

It is an organised and regulated market where supply and demand of transferable

securities are centralised. Theoretical market prices of securities are set at the
intersection of supply and demand.

In this way, all holders of securities that need liquidity can go to a stock exchange (if
their securities are admitted to official listing), offering to sell these securities in
exchange for liquidity and vice versa with the additional guarantee that the transaction
is made at a reasonable market price. However, investors, who have transferable
securities or are willing to acquire them and have not been listed on a stock exchange,
will need to look for their counterparty personally, which in many cases is not possible.

Every day, the price (stock value) of shares from listed companies fluctuates according
to the supplies and demands of securities, i.e., their share price (value of a security on
the stock exchange).

The evolution of listed securities has given rise to a series of indexes. Thus, for example,
we have the General Price Index of the Madrid Stock Exchange, or IBEX 35, which is an
index that reflects the evolution of the 35 most representative or capitalised securities
(with the highest stock movement) of the Spanish Stock Exchange. Temporal analysis of
the evolution of these indexes indicates, in general terms, the growth/decrease in the
quotation of given securities.

For example, if we consider a general index, which has increased by 10% in one year
(going from a quotation of 100 to 110) then it can be said that on average the securities
considered for the listing of this index have been revalued by 10%.

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4.3. SHARE ISSUANCE

The issuance of shares is a way to obtain long-term financial resources from companies,
either for the incorporation of new companies through the creation of share capital, or
for the expansion of such capital when the organisation needs more resources.

Shares represent proportional parts of the company’s share capital. The law sets out the
minimum share capital that a company needs to have according to its size and
characteristics; thus, for example, the minimum share capital of a Limited Company (LC)
is €3,000. By law, limited companies need to disburse 100% at the time of constitution,
whereas the minimum disbursement for Limited Liability Companies (LCC) is 25%, which
may be made in cash or with the contribution of goods that have to be valued.

Shares may be issued on par, at par or under par, depending on the issue price thereof,
which can be higher, equal or lower than the nominal value. Spanish legislation does not
allow the issuance of shares under par.

§ Nominal value:

Also known as face value or par value in reference to securities, it can be described as
the stated value of an issued security, which disregards an item's market value. For
instance, measurements of economic growth and personal income that do not adjust
for inflation are nominal values, while measurements that adjust for inflation are real
values.

Nominal value results from dividing the shareholder’s equity in the company by the
number of shares issued.

For example, if the shareholder’s equity of a company is €1,000,000 and the number of
shares is 500,000, the nominal value of each share is 1,000,000/500,000 = €2 nominal
value per share.

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In any capital increase, old shareholders may exercise, within a specified period, the
right to subscribe new shares proportionally to the number of old shares they had. This
is called the pre-emptive right (also referred to as pre-emption rights, anti-dilution
provisions or subscription rights). This privilege may be extended to shareholders of a
company, thus granting them the right to acquire additional shares in the organisation
prior to shares being made available for purchase by the general public in the event of
a seasoned offering, which is a secondary issuing of stock shares.

In this sense, it is necessary to talk about the theoretical value of a share or its book
value, which results from dividing the Shareholder’s Equity by the number of shares:

!"#$%"& ( )*+, -./.01./ (34+.05/ 67*$%8)

THEORETICAL VALUE OF A SHARE =
:*;<.0 => /?"0./

There is an example of a company with the following structure below:

Percentage Shareholder’s equity N. Shares

25% €500,000 500

25% €500,000 500

50% €1,000,000 1,000

Shareholder’s equity €2,000,000

Fund Reserves €250,000 2,000

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Theatrical Value €1,125

Nominal Value €1,000

As previously indicated, in order to avoid dilution, former shareholders can exercise

their pre-emptive right to subscribe new shares and thus be able to maintain the same
proportion of ownership with respect to the shareholder’s equity.

If we assume, according to the previous example, that the company wants to carry out
a new capital increase at par, i.e., while keeping the issue price equal to the nominal
value of the shares by issuing 500 new shares (1:4). This means that for every four old
shares, it is possible to subscribe a new one, and they represent an increase of €500,000.
For this reason, former shareholders will have a pre-emptive right to participate in 25%,
25% and 50% of the capital increase.

If none of the shareholders would like to participate in the capital increase and a new
shareholder enters and subscribes to the entirety of the share capital increase, the
resulting percentages would be the following:

Percentage Shareholder’s equity N. Shares

20% €500,000 500

20% €500,000 500

40% €1,000,000 1,000

20% €500,000 500

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Shareholder’s equity €2,500,000 2,500

Fund Reserves €250,000

Theoretical Value €1,100

Nominal Value €1,000

As shown in the example, the entry of a new shareholder, who subscribes to the entirety
of a capital increase (since the former shareholders did not exercise their right of
preferential subscription), implied a decrease in the percentage of shareholding in the
company, while allowing each old shareholder to keep their number of shares.

However, the capital increase has had another effect. Since the balance sheet of the
company has not been altered, according to the calculation of the theoretical value of
the share, the number of shares issued has increased, and their theoretical value has
decreased: before the increase, it was €1,125, whereas after the increase it was €1,100.
Thus, the increase meant a dilution or loss to the old shareholders, considering that the
new shareholder also participates in the fund reserves (retained earnings not
distributed) under the same conditions as the old ones, when in reality he/she entered
the organisation later.

This loss of value may be determined through the following formula:

(@=A@B)C
d =
:(C

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Key:

N = number of shares before the increase.

P0 = theatrical value of the share before the increase.

M = number of shares issued in the increase.

P1 = issue price of new shares.

d = theoretical value of pre-emptive right.

Following our example:

(BBDEABFFF)EFF
d = = 25
DFFF(EFF

The result is 25, which coincides with the difference between the theoretical value of
the share before and after the issuance. This amount is the theoretical subscription
value. Therefore, if it is a 4:1 increase (one new share for every four old ones), the new
shareholder will have to make the next disbursement for each share that he/she wishes
to acquire.

- Purchase of subscription rights 100 (25 x 4)

- Disbursement amount (issue at par) 1000
- Total per share 1100

The total outlay would be 1100 x 500 = €550,000; €500,000 would go to the company as
a capital increase at par (500 x 1,000) and €50,000 to the former shareholders (25%,
25% and 50%), as a purchase of pre-emptive subscription rights. (For more information
see annex no. 03. - Analysis of partners to the financing of the company).

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5.4. COST OF SHARE CAPITAL

The cost of share capital in a company will be determined depending on the dividends
approved by the company, which in turn will be based on the bottom line of the
company. Since the bottom line of a company and dividends are not variables that can
be obtained directly, it is necessary to make estimates.

Provided that there are no significant changes in the composition of assets and a
company’s financing sources, the cost of share capital can be estimated according to the
following formula:

G$1$,.+,
CSC=
H?"0. I"#$%"&

This formula would be valid as long as dividends and the share capital remained
constant. If this is not the case, we can use a series that represents the evolution of
dividends based on share capital and, based on this series, estimate the average cost.

Similarly, when determining the dividend to be distributed and, especially if we consider

large companies with a large number of small shareholders who look for a periodic
dividend rather than the revaluation of the share, it is important to consider: the
profitability for the shareholder, the profitability of the market as an alternative
investment as well as the profitability of the shares that are being given by other
companies in the sector and the market in general.

For a company, the cost of share capital (understood as fully disbursed) would be the
minimum rate of return on the assets that needs to be obtained from the capital
invested.

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5.5. DEBT ISSUANCE. BONDS/PROMISSORY NOTES

Bond issuance is a common source of financing, usually for large companies. It is the
most frequent type of debt instrument, serving as an IOU between the issuer and the
purchaser. Investors loan money to an institution, such as a government or business;
the bond acts as a written promise to repay the loan on a specific maturity date.

Suppose that a company needs financing amounting to €1,000,000. It decides to issue
1,000 bonds, with a nominal value of €1,000. The holder of a bond issued by a company
is, in the end, another creditor of the company who receives a constant interest for
his/her subscription of bonds.

Bonds can be nominative and bearer, and they may be issued at par, on par and under
par. When they are issued under par, that is, below their value (in our example we could
take €900), we are talking about a discount bond.

Bonds may also be issued on par; a value higher than the nominal value has to be repaid.
Thus, in our example, if we took €1,100, we would have a premium bond. At times, both
bonds may occur simultaneously if issued under par but amortised above par. (For more
information see appendix no. 04. - Bond)

§ Long term bonds:

Long-term bonds are the most common forms of long-term financing for companies.
They are generally loans with a fixed repayment date, although some of them are non-
depreciable securities.

They usually pay a fixed interest rate. This interest needs to be paid before dividends
are paid to the shareholders.

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Moreover, most bonds are guaranteed by the borrower’s assets.

a) Bond-holders (normally known as investors): They do not have the right to

vote in the General Meeting of the company. They have separate meetings
where they can vote on other issues such as changes in the rights attached to
obligations.

b) Advantages of long-term bonds: The main advantage of this type of bond for
companies is the fact that they have a lower interest rate and, in general, the
repayment date is much better in comparison with other financing methods such
as regular loans. What investors find beneficial about long term bonds is that
they are easy to sell on stock exchanges and do not present as much risk as
equity.

c) Types of obligations:

- Convertible bonds: They confer to the bondholder the right to convert,

under stipulated conditions, their obligations into shares. These bonds may
be converted into ordinary shares of the issuing company after a
predetermined period of time. Convertible bonds are more attractive to
investors and companies since they tend to have lower interest rates than
non-convertible corporate bonds. In this case, when repaying the
obligations, the company will not need to have the funds to repay the
amortisation of the obligations; moreover, by increasing the company’s
shareholder’s equity as a result of conversion, its debt ratios will improve.

- Non-convertible bonds: They are regular bonds that cannot be converted

into ordinary shares of the company. As they do not have the ability to be
converted, they usually carry higher interest rates than convertible bonds.
(Source: http://www.e-conomic.es)

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- Obligations with warrant: Warrant gives the bondholder the right to

purchase a certain number of shares from the company issuing the
obligation. It is not a conversion, but a possibility for the bondholder to
acquire a company’s shares under previously determined conditions. The
issuance of bonds with warrant is attractive for investors.

Constant inflation has made investment in bonds less and less attractive. To
mitigate this negative impact, the so-called index-linked bonds and income
bonds have emerged in company results.

On the one hand, index-linked bonds are bonds in which payment of interest
income on the principal is related to a specific price index, usually the
Consumer Price Index. This feature provides protection to investors by
shielding them from changes in the underlying index. The bond's cash flows
are adjusted to ensure that the holder of the bond receives a known real rate
of return (For more information see annex no. 05. - Index-linked bond).
Regarding income bonds, also known as adjustment bonds, they are a type
of debt security in which only the face value of the bond is promised to be
paid to the investor, with any coupon payments paid only if the issuing
company has enough earnings to pay for the coupon payment. In this case,
the remuneration of the bond is divided into a fixed tranche (75%) and a
variable portion (25%). The fixed tranche will provide the investor with an
interest rate (previously known); the variable portion is not granted because
it requires the company to have profits. If the result in the period of time
considered were losses, this variable tranche/portion would not be
remunerated.

Another form of bond issue is to set a variable interest rate, based on the
Euribor plus a differential.

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§ Promissory Notes

Another form of company financing is the issuance of company promissory notes.

By signing this bond, a person (signatory) agrees to pay another person (holder) a certain
amount at a certain date and place.

Promissory notes are instruments that are endorsed by a financial institution and,
subsequently, repositioned by this banking institution among its clients. In this case the
financial institution, in addition to supporting the operation through the initial discount
of the promissory notes, grants a loan to the issuing company for their reimbursement.

By way of illustration, imagine that a company needs financing and reaches an

agreement with a financial institution to issue promissory notes for a total value of
€1,000,000; these promissory notes are deducted from the bank at 90%. Therefore, that
the company receives €900,000. In turn, the bank repositions these promissory notes
with a discount rate of 95%, so the financial institution receives €950,000 and manages
to transfer the risk to the acquirers of these promissory notes. At the time of
reimbursement, the bank grants a loan to the company for an amount of €1,000,000,
which is used by the company for the redemption of the promissory notes.

5.6. LONG-TERM CREDIT

This is a form of debt that is paid off over an extended time frame that exceeds one year
in duration. Obtaining a long-term loan provides a business with working capital that
may be used to purchase assets, inventory or equipment that can then be used to create
additional income for the business.

As with short-term financing of the company, in the long term it is also possible to resort
to financing via loans and credits through a financial institution.

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§ Credit:

A contractual agreement in which a borrower receives something of value now and

agrees to repay the lender at some date in the future, generally with interest. The term
also refers to the borrowing capacity of an individual or company. As a general rule,
long-term credits/loans are used by companies to obtain investments within their non-
current assets. Some examples of this type of operation are the acquisition of machinery
necessary for the industrial process (blast furnaces, the construction of a hydroelectric
power station, construction of a vehicle production line, acquisition or construction of a
building or an industrial warehouse), for the acquisition of a company (financial assets)
that may involve an expansion of the company (horizontal/vertical integration,
diversification, internationalisation), or the purchase of any patent or royalties that is
essential for industrial development (pharmaceutical patents, industrial patents, etc.).

In many cases when the volume of financing is very high, or when the risk diversification
is needed, financial institutions may group together and form the so-called bank unions.
These are simply groups of banks aimed at financing some credit operation that, due to
the volume or characteristics, make this union, led by a specific bank, necessary. (For
more information see annex no. 12. - Bank unions).

Long-term loans, unlike short-term loans, generate liquidity. Long-term financing should
be used, in general, when financing investments whose return of liquidity is not
immediate. To illustrate this, let us think about the construction of a boat. During the
construction process, this investment does not generate any cash return, which will only
begin to occur when the ship is fully built and operational. In such situations, a grace
period is usually set, which may allow the borrower not to pay amortisation of the
principal during the instalments of such initial period. Under some loan contracts,
payments outstanding during these periods are interest free, but the majority have
interest compounding during the grace period. At the time the asset is put into
operation, and with the generation of cash, the amortisation instalments include the
repayment of the loan principal plus interest.

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Generally, the cost of long-term financing tends to be lower than the cost of short-term
financing, just like short-term loans - referenced to variable interest rates (Euribor), to
which a differential is added. This fact has led to the need for hedging the interest rate
through the use of derivative products that, in general terms, eliminates the possible
uncertainty of the variation of these rates in the future, establishing an interval of
maximum and minimum cost in long-term financing.

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