## **Learning Outcomes**

After studying this article, you will be able to explain the main forms of equity financing for companies, evaluate the cost of equity, and assess how raising new equity can affect shareholder control and result in dilution of ownership and earnings per share (EPS). You will also be able to discuss practical considerations for businesses and shareholders.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand how equity financing decisions impact company cost, control, and dilution. Specifically, revision should focus on:

- The characteristics and implications of equity finance versus other sources
- How companies raise equity finance: rights issues, placings, and public offers
- Calculating and interpreting the cost of equity using appropriate models (e.g., Dividend Growth Model)
- Effects of new equity issues on ownership, voting control, and earnings per share
- The meaning and consequences of dilution for shareholders
- Control issues associated with different equity raising methods

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which method of equity finance most clearly protects existing shareholders from dilution of voting rights?
   a) Rights issue  
   b) Public offer  
   c) Sale and leaseback  
   d) Bank loan

2. What is the most direct cost to a company of raising equity through a public offering?
   a) Interest payments  
   b) Professional fees and underwriting  
   c) Preference dividend  
   d) Repayment at maturity

3. True or false? Dilution occurs only if new shares are issued at a price above the current market value.

4. Explain briefly what is meant by "cost of equity".

5. What effect could a large equity issue have on earnings per share (EPS)?

## **Introduction**

Equity finance is a key long-term funding method for companies, allowing them to raise capital by issuing shares. Understanding the cost of equity, effects on shareholder control, and the risk of dilution is essential for ACCA FM. Raising equity can change the ownership structure, impact existing shareholders, and send signals to the market. This article focuses on the main issues surrounding the cost, control, and dilution effects of equity financing.

> **Key Term: equity finance**
> The capital a company raises by issuing shares to investors, giving them partial ownership and voting rights in return for funds.

## **FORMS OF EQUITY FINANCING**

Companies may raise equity through:

### Rights Issues

A rights issue offers new shares to existing shareholders, allowing them to maintain their ownership percentage if they participate. The shares are usually issued at a discount to encourage take-up.

### Placings

Shares are sold directly to selected investors, often institutions. Placings are quicker and less costly than public offers but can dilute existing shareholders if they do not participate.

### Public Offers

In a public offer, shares are made available to new investors, including the public. This method can raise substantial funds but often dilutes existing shareholders' ownership and control.

## **COST OF EQUITY**

The cost of equity is the return that equity investors require on their investment, reflecting both the time value of money and the risk of investing in the company. Companies estimate this cost to make financial decisions and appraise projects.

> **Key Term: cost of equity**
> The minimum rate of return that a company must offer investors to compensate them for the risk of holding its equity shares.

The most common methods to estimate the cost of equity are the Dividend Growth Model (DGM) and the Capital Asset Pricing Model (CAPM):

- **DGM:** Uses expected dividends and their growth rate.
  $$k_e = \frac{D_1}{P_0} + g$$
- **CAPM:** Considers systematic risk (beta), the risk-free rate, and the expected return on the market.

### Influencing Factors

- Company risk profile
- Recent dividend patterns
- Market conditions
- Perceived long-term prospects

Cost of equity is generally higher than the cost of debt, since equity investors face greater risk (no guaranteed dividends or return of principal).

## **CONTROL ISSUES IN EQUITY FINANCING**

Raising equity can affect the control existing shareholders have over the company, particularly if shares are issued to new investors.

- **Rights Issues:** Allow shareholders to preserve control by subscribing for their proportion of new shares.
- **Placings/Public Offers:** May reduce existing shareholders' voting power and ability to influence decisions.

> **Key Term: dilution**
> The reduction in the ownership percentage, voting rights, or earnings per share held by existing shareholders caused by issuing additional shares.

### Control Dilution

If existing shareholders do not participate fully in a new issue (or are not offered the chance), their percentage ownership and ability to influence management declines. This can change the balance of power, potentially allowing new investors to influence or take control of the company.

## **DILUTION EFFECTS ON VALUE AND EPS**

When new shares are issued, the total number of shares increases, usually resulting in a lower earnings per share (EPS)—unless accompanied by sufficient earnings growth.

- **Market Perception:** A poorly managed equity issue may signal distress or lack of profitable investment opportunities, which could depress share price.
- **Earnings Dilution:** If funds raised do not produce corresponding profit growth, existing shares' value and EPS can fall.

### **Worked Example 1.1**

A company has 10 million shares in issue, earning \$3 million of profit after tax (EPS = \$0.30). It issues 5 million additional shares to new investors at a price close to the market value, but projected profit rises only to \$3.5 million.

**Question:** What is the EPS before and after the issue? Has dilution occurred?

> **Answer:**
>
> - Before: EPS = \$3m / 10m shares = \$0.30
> - After: EPS = \$3.5m / 15m shares = \$0.233
>
> Despite higher total profit, the new EPS is lower, so dilution of EPS has occurred for existing shareholders.

### **Worked Example 1.2**

An existing investor owns 8% of a company. The company undertakes a rights issue (1 new share for every 5 held). The investor does not take up any rights, and all new shares are bought by others.

**Question:** What happens to their ownership percentage?

> **Answer:**
>
> - After the issue, total shares increase.
> - The investor's ownership drops below 8%—they have been diluted.

## **DIRECT COSTS OF EQUITY FINANCING**

Raising new equity involves significant costs, including:

- Professional, legal, and accounting fees
- Underwriting and marketing charges
- Stock exchange listing fees (for public offers)
- Potential underpricing if shares are issued below market value to encourage take-up

These costs can be a substantial percentage of total funds raised and are typically higher for public offerings than for rights issues.

### **Exam Warning**

> Do not confuse dilution with loss of control. Dilution relates to a reduction in ownership percentage, voting rights, or EPS. Loss of control occurs only if a shareholder's voting power drops below an important threshold or a rival gains a significant stake.

## **Summary**

Equity financing is expensive compared to debt but has the advantage of no mandatory repayments. It can reduce existing shareholders' control and result in dilution of ownership and EPS. Rights issues offer some protection to existing shareholders; public offers and placings are more likely to dilute control. Companies must weigh the cost, impact on control, and dilution when deciding which method of equity financing to use.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define equity finance and its main forms: rights issue, placing, and public offer
- Explain the cost of equity and methods for estimation (DGM, CAPM)
- Recognise how new equity issues impact shareholder control and voting rights
- Describe dilution of ownership and EPS following new share issues
- Identify the main direct costs of equity financing
- Understand the circumstances in which dilution and control issues are most relevant

## **Key Terms and Concepts**

- equity finance
- cost of equity
- dilution

Equity financing - Cost, control, and dilution effects