The Disadvantages of Raising Loan Capital to Black Books Plc - Essay Example

Company Law There are advantages and disadvantages for Black Books plc of raising loan capital rather than share capital Debt financing gives the directors of Black Books plc the opportunity to keep and reinvest more of the company’s profits instead of paying it out as dividends to shareholders (Reference for Business, n.d.). Shareholders prefer to have an increased or constant dividend per share rather than a reduction in dividend per share. Issuing more shares to raise capital may result in a reduction in the dividend per share and this may cause the price of Black Books plc shares to fall. The interest paid on loan capital is allowable for deduction before taxes and therefore provides a shield for part of the company’s income. The lender does not share in the profits of the company as the shareholders do. The only requirement of the lender is for Black Books plc to make payments of principal and interest on time (Peavler, n.d.). Loan financing can be cheaper than equity financing because loans are paid at a fixed rate while buying back shares can be very expensive, especially when the price of Black Books plc shares is rising. An additional advantage is that the company’s loan obligations are limited to the loan repayment period after which the lender has no further claim on the business. Claims by equity shareholders on the other hand do not end until their stock is sold. As long as the debts are paid back on time the credit rating of Black Books plc would be enhanced, therefore making it much easier for the company to obtain further loans in future (Reference for Business, n.d.). Loans are easier to administer than shares as it does not have the complex reporting requirements that accompanies some form of equity financing. Furthermore, debt financing allows the current shareholders to retain ownership in contrast with equity financing that would broaden the ownership in which case the proportional ownership would not be the same. The disadvantages of raising loan capital to Black Books plc are numerous. The more money that Black Books plc borrows the higher the risk of bankruptcy that the company faces which means that the shareholders would lose their investment in the company as creditors have a prior claim to the assets of the company. Issuing loans rather than shares results in financial risk. According to Brigham and Ehrhardt (2005, p. 554), financial risk is the additional risk to ordinary shareholders because of the decision taken to finance with loan capital. If loans are not paid on time this could result in late fees and additional penalties such as the loan being called in early or the lender taking possession of collateral on which the loan has been secured. However, this is usually a last resort as lenders prefer repayments from the first source rather than the second source. Each month a fixed amount has to be paid. This is not so for shareholders who are generally paid dividends after the year end or when it appears certain that profits will be made. The company may also have difficulty making these payments as a result of cash flow problems or other obligations which has to be made to keep the business going. Defaulting on loans will result in a decline in the credit rating of Black Books plc. This may also cause the price of the companies stock to decline in value. This could further result in an increase in the cost of obtaining additional debts for the company. The debts are secured by fixed and floating charges which increases the possibility that the company may have to give up assets if it defaults in any way. Furthermore, interest expense on loans reduces the company’s profit margin. Dividends paid to shareholders are appropriations of profits and therefore have no such effect on the company’s profitability. The Formalities and Legal Consequences of Creating Debenture Clauses The debenture is a debt instrument through which the Black Books plc acknowledges its obligations to repay the sum owed at a specified rate along with the interest at specified intervals, usually monthly. The power to issue debentures is given in the companies articles of association. However, permission has to be given by its shareholders to borrow amounts in excess of the company’s paid up capital and free reserves since Black Books plc is a public company. Debentures may be issued at their nominal (face or par) value, at a premium or at a discount. An agreement has to be given to the debenture holder to make interest and principal payments in full and on time. Some debentures are secured on specific assets which mean that the Black Book plc cannot dispose of the specific assets without the prior consent of the lender or at least, until the loan has been repaid in full. According to Parnell (2003) the clause in the debenture deed indicates that: In the event of liquidation or insolvency, the secured debenture holder will be paid before any unsecured creditors under what is known as a floating charge debenture. The fixed charge debentures means that the asset to which the debenture is attached cannot be sold until the loan is repaid. Creating debentures requires documentation so that they will become enforceable. To be enforceable these documents have to be registered. Debenture deeds sometimes have a clause to indicate that the lender can appoint a receiver. The secured assets provide a second source of repayment if the first source which is the regular monthly payments fails to materialise. The lender prefers the first source because it provides more revenue over the long term. According to Emile Wolfe (2010) a company is required by law to maintain a record of all charges that they have given on their assets. These charges are recorded in a Register of charges which all companies are to maintain. The Register of Charges represents one of the statutory registers that the company is required by law to maintain. The law also requires that both fixed and floating charges are registered with the registrar of companies within 21 days of their being created. If that is not done then the charge will be invalid. Therefore, the onus is on lenders (creditors) to make sure that this is done within the specified time period since they are the ones bearing the risk. Most creditors normally ensure that this is done before they do their part. If the charge is not registered then the creditor has no claim to the asset and they would have no preference over any other creditor. The registrar will actually stamp the document giving title giving ownership to the asset to indicate that a lien(s) or charge(s) is registered on it. A copy of the document is held at the Registrar of Companies office and the borrower also retains one. This is done so that it is available to the public which should always check on these things when giving unsecured loans to a company in order to ensure that the company’s assets are not all tied up. If the company’s assets are tied up then they would be at risk of losing their investment in the form of the loan. The legal consequences of Supplier and Pressing of the England Cricket Team losing the One Day test series in Australia Supplier has a first floating charge over the company’s assets to the extent of ?100,000. This means that the company is free to use the assets as it wishes without advising Supplier. Supplier’s debt also has a negative pledge clause attached to it. According to Emile Wolfe (2010, p.275), the negative pledge clause that Supplier has instituted in the loan agreement is a means to protect the floating charge. It is a condition of a loan wherein the borrower, in this case – Black Books plc has agreed not to create a fixed charge over assets that would give the new charge priority over the floating charge. This charge, however, would not be attached to the land as Black Books plc as it has already been given as security for the mortgage. It therefore means the floating charge relates to any other assets that the company has such as receivables and inventory. However, under this charge Black Books plc is allowed to continue trading – buying and selling inventory items and using proceeds from this to carry on its business. This is different from a fixed charge wherein Black Books plc would not be allowed to dispose of the asset until the company has repaid the mortgage or without the consent of the mortgagor. Pressing has a second floating charge in the sum of ?50,000. This includes an automatic crystallisation clause in the event that the England Cricket Team loses the One Day test series in Australia on January, 2011. The England Cricket team lost the One Day test series, which therefore implies that the charge has crystallised. However, Supplier has a first floating charge with a negative pledge clause which implies that there is a conflict. If Supplier did not give written consent this suggests that the agreement with Supplier has been breached. However, if the negative pledge has a provision for automatic security on breach which is also a form of floating charge, then it means that Supplier’s floating charge would also crystallise at the same time that the event takes place. That is, when the results of the One Day test series indicated that England lost the match, the crystallisation of the debt of Pressing would occur. According to Hill (2008), if the borrower – in this case Black Books plc creates or permits to subsist any encumbrances which is created without the prior written knowledge and consent of Supplier - the Lender, then all of Black Book plc’s obligations to Supplier shall be automatically and immediately secured upon the same assets equally and rateably with the other obligations (such as Pressing’s fixed charge) secured on them. Pressing’s debt is now secured by a fixed charge on assets of the company other than land for which a fixed charge has already been recorded in the Register of charges. However, Hill (2008) further points out that Supplier’s interest can be classified and protected by disposing of any of the assets that are potentially the subject of the automatic security clause. This disposal will remove them from the scope of the security. Black Books plc could also try to pay up Pressings debt since Pressing is owed much less than Supplier. This would be more financially prudent to pay as Pressing is owed just ?50,000 compared to Supplier’s ?100,000. This would be done in order to remain in good faith with Supplier to whom Black Books plc has a larger indebtedness. The remedies available to Lender, should Black Books plc default on the quarterly interest payments on its loan, due on March 1, 2011 If Black Books plc defaults on quarterly interest payments on its loan due on March 1st 2011, Lender can exercise the rights available under the debenture deed which would have indicated that non-payment of interest and principal payments when they become due constitutes a breach of the agreement. Failing further attempts to collect, Lender would seek to enforce his rights by taking the matter to the Courts. The Courts would then appoint a receiver to take charge of the assets in order to secure payment since the first source which relates to the payment of interest and principal in a timely manner, on set dates, has failed to materialise. If it is necessary for Black Book plc to be wound up, the receiver will then become the liquidator. The liquidator will then use his powers granted to him under the powers of the court as contained in the debenture deed to wind up the company. The property and all other assets will be sold and the parties with fixed charges including Lender, Supplier and Pressing would be paid ahead of other creditors. Lender would be given first preference and following Supplier and Pressing simultaneously. If the sums are not enough to pay Pressing and Supplier all of their funds then they will be paid proportionally. Therefore if only ?100,000 is left then that would represent only two-thirds of the amount owing to both Supplier and Pressing. They would therefore receive ?66,667 and ?33,333 respectively. If however, amounts are sufficient then they will be paid in full once the assets on which their loan is secured is able to pay them in full. This also applies to Lender. The assets on which floating charges assuming they are now fixed charges based on the crystallisation and the automatic security clause have to be sold to repay Supplier and Pressing. Any excess would be used first to pay up preferential creditors which include wages and holiday pay for employees. After they are paid all other creditors would be paid with the balance of the funds. Any creditor that has a floating charge on assets will rank in the same manner as the other unsecured creditors. The employees are given preference over creditors with floating charges if any exist. The balance of funds remaining will be paid proportionally to all other creditors to whom amounts are due. For example, if ?100,000 cash remains after creditors with fixed charges and amounts due to employees for wages and holiday pay, up to a prescribed limit, have been paid, with a balance of say ?300,000 still owing then the remaining creditors which include statutory amounts outstanding and expenses owing will simply get a proportion based on the proportion of the total outstanding debts due to them. This simply means that they will rank equally and will therefore get (100,000/300,000) a third of the balance owing to them. The shareholders will get whatever is left if any. In this example there would be none. They are neither obligated to pay any debts due nor are they entitled to share any balance on the same basis as the creditors. References Brigham and Ehrhardt. (2005) Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Hill, G. (2008) Negative pledge with provision for automatic security on breach: a form of floating charge. Butterworth’s Journal of International Banking and Finance Law: Nov 2008. p. 528-531 Peavler, R. (n.d.). Debt and Equity Financing: The Advantages and Disadvantages of Debt and Equity Financing. Retrieved: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm. Last accessed 4th May 2011 Purnell, R. (2003). What is a Debenture and its purpose? What is a floating charge?. Retrieved: http://www.purnells.co.uk/limited-company/administrative-receivers/what-is-a-debenture.html. Last accessed 4th May 2011 Reference for Business (n.d.). Debt Financing. Encyclopedia of Business, 2nd ed. Retrieved:http://www.referenceforbusiness.com/small/Co-Di/Debt-Financing.html. Last accessed 4th May 2011 Woolf, E. (20109). F4-Corporate and Business Law. 2nd ed. Berkshire,UK: Emile Woolf International Publishing Ltd. Read More