Sources of finance - Equity, debt, mezzanine, and hybrids

Learning Outcomes

After reading this article, you will be able to identify and compare the main long-term sources of business finance: equity, debt, mezzanine, and hybrid instruments. You will understand their characteristics, benefits, and drawbacks, and evaluate their impact on capital structure, cost of capital, and shareholder value. Additionally, you will be able to apply this knowledge to recommend suitable financing options in various business scenarios, as required by the ACCA Advanced Financial Management (AFM) exam.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the range of sources of finance available to an organisation and how their selection impacts financial strategy and performance. It is important to be able to:

• Explain and assess the appropriateness of different financing methods, including equity, debt, mezzanine, and hybrid instruments
• Evaluate the impact of financing choices on financial position, financial risk, and shareholder value
• Apply capital structure theories when recommending financing decisions
• Compare sources of finance for acquisitions, mergers, and capital investments
• Advise on alternative financing methods and recent market developments

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 source of finance typically carries the lowest risk for investors but increases financial risk for shareholders?
   1. Ordinary shares
   2. Preference shares
   3. Secured debt
   4. Mezzanine finance

2. Identify two key features that distinguish mezzanine finance from standard debt finance.

3. True or false? Hybrid instruments always have fixed repayment terms and fixed dividends.

4. In what situations might a company prefer to raise finance through a convertible bond rather than a standard loan?

5. List three practical considerations when choosing between equity and debt finance for a large expansion project.

Introduction

Selecting the appropriate mix of long-term financing is a critical responsibility for financial managers. The four primary sources—equity, debt, mezzanine, and hybrids—differ in cost, risk, flexibility, and impact on company control. The optimal choice depends on factors such as company size, business risk profile, target gearing, market conditions, and investor requirements.

This article examines these key financing sources in detail, explaining their features, advantages and disadvantages, and implications for capital structure and shareholder value. You should be able to evaluate when each is appropriate and apply the knowledge in ACCA exam scenarios.

SOURCES OF FINANCE – AN OVERVIEW

A firm's capital structure is usually a combination of equity and various forms of debt. Increasingly, organisations consider mezzanine and hybrid instruments to balance cost, risk, and flexibility.

Key Term: capital structure
The mix of a company's long-term funding sources, typically combining equity and debt, which determines its financial risk and cost of capital.

Equity Finance

Equity finance is the issue of shares to investors (shareholders), who become owners of the company. Shareholders bear the highest risk since dividend payments are discretionary and there is no guaranteed return or repayment. However, they can benefit from capital appreciation if the company performs well.

Key Term: equity finance
Finance raised by issuing shares, granting ownership and residual claim on company profits and assets.

Main forms of equity finance

• Ordinary shares: Carry voting rights and entitlement to variable dividends.
• Preference shares: Often carry a fixed dividend but usually have limited rights and rank ahead of ordinary shares on liquidation.

Advantages of equity finance

• No obligation to pay dividends or repay capital
• Preserves cash flow flexibility
• May improve gearing ratios

Disadvantages of equity finance

• Dilutes existing ownership and control
• Higher cost of capital compared to debt (higher risk for investors)
• Dividend payments are not tax-deductible

Debt Finance

Debt finance involves borrowing funds with a legal obligation to pay interest and repay principal. It is lower risk for investors than equity, so attracts a lower required return. Debt increases the financial risk to ordinary shareholders due to the fixed commitments.

Key Term: debt finance
Funds raised by borrowing, for example through loans or bonds, requiring fixed interest payments and repayment of principal.

Main forms of debt finance

• Bank loans: May be secured or unsecured, with flexible terms.
• Bonds and debentures: Tradable long-term debt with fixed or floating interest rates.
• Leasing: Obtaining use of assets without upfront capital expenditure.

Advantages of debt finance

• Interest is usually tax-deductible, reducing the effective cost
• No dilution of control
• Often lower cost than equity if company is profitable

Disadvantages of debt finance

• Increases gearing and financial risk
• Fixed payments must be met even when profits fall
• High amounts may breach loan covenants or damage credit ratings

Mezzanine Finance

Mezzanine finance is a hybrid of debt and equity, generally subordinated to senior debt but ranking ahead of equity. It is often used in highly geared buyouts or as growth capital where a company is unable to raise further senior debt or wishes to avoid diluting equity.

Key Term: mezzanine finance
Subordinated debt, often with equity conversion rights, ranking below senior debt but above equity, used to bridge the financing gap.

Characteristics of mezzanine finance

• Higher interest rates than senior debt due to greater risk
• May include warrants or options to convert into equity
• Flexible repayment structures (e.g., payment-in-kind interest, bullet repayments)

Advantages of mezzanine finance

• Provides additional capital when senior debt capacity is exhausted
• May be less dilutive than issuing new equity
• Attracts specialist investors (e.g., private equity, venture capital)

Disadvantages of mezzanine finance

• Still increases financial risk and gearing
• More expensive than senior debt
• Complexity of terms and potential for loss of control via conversion options

Hybrid Instruments

Hybrid instruments combine features of equity and debt to attract a wider range of investors or balance cost and flexibility. Common examples include convertible bonds and preference shares with equity characteristics.

Key Term: hybrid instrument
A financing instrument with both debt-like and equity-like features, such as convertibles or preference shares with conversion rights.

Common types of hybrid instruments

• Convertible bonds: Bonds that can be converted to ordinary shares at the holder's option.
• Preference shares with conversion rights: Preference shares that can convert to ordinary shares after a specified period or at a set price.
• Perpetual bonds: Debt with no fixed redemption date but potentially treated as equity by rating agencies.

Advantages of hybrid instruments

• Lower coupon rates than pure debt, as conversion rights add value
• Flexibility for investors and issuers
• Possible deferral of equity dilution

Disadvantages of hybrid instruments

• Can lead to future dilution if converted
• May be complex to account for and manage
• Redemption triggers or conversions may be unpredictable

IMPACT ON CAPITAL STRUCTURE AND COST OF CAPITAL

The correct balance between equity, debt, mezzanine, and hybrids aims to minimise the firm's weighted average cost of capital (WACC) while maintaining an acceptable risk profile and operational flexibility.

Worked Example 1.1

A medium-sized company needs to raise £30 million for an expansion. It can issue new shares, raise a secured loan, or issue convertible bonds. Senior lenders are only willing to offer £15 million. Management is reluctant to dilute ownership.

Question: Recommend an appropriate financing mix and explain the rationale.

Answer:
The company could raise £15 million in secured debt (max available from senior lenders) and consider issuing £10 million in convertible bonds and £5 million in new shares. The convertible bonds reduce immediate dilution and may attract investors seeking upside potential. The new share issue ensures some permanent capital and may be required to improve gearing ratios. This mixed approach balances cost, control, and risk.

CAPITAL STRUCTURE THEORIES AND PRACTICAL FACTORS

The choice between financing sources is also influenced by theoretical models and real-world factors:

• Modigliani and Miller theory: Suggests high gearing is optimal due to tax benefits, but ignores bankruptcy risk.
• Pecking order theory: Firms prefer internal funds, then debt, resorting to new equity last due to costs and market signals.
• Static trade-off theory: Firms aim for an optimal mix balancing the tax shield from debt and the risk of financial distress.

Key Term: pecking order theory
The view that firms prefer retained earnings, then debt, and consider new equity as a last resort due to increasing costs and negative market perceptions.

Practical considerations

• Cost and availability of funds
• Impact on financial ratios and covenants
• Flexibility in cash flow management
• Market sentiment and investor preferences
• Impact on credit ratings and future access to capital

Worked Example 1.2

A listed firm with volatile cash flows is choosing whether to fund a project through new debt, preference shares, or retained earnings.

Question: Which option is most suitable and why?

Answer:
Retained earnings are preferable as they add no new financial obligations and maintain flexibility. Given profit volatility, debt would be risky due to fixed repayments. Preference shares may be acceptable if the company can maintain regular dividends, but still increase obligations compared to using retained income.

Exam Warning

Raising excessive mezzanine or hybrid finance can lead to unforeseen dilution or debt-equity conversion, especially if triggers are based on adverse performance. You must clearly distinguish between features and risks of straight debt, equity, mezzanine, and hybrids in exam answers.

Revision Tip

List the main features, advantages, and disadvantages for each financing source in your revision notes. Practice exam scenarios that require you to justify choices with clear, concise recommendations.

Summary

Every major source of long-term finance—equity, debt, mezzanine, and hybrids—offers distinct risk and return profiles. Financial managers must weigh cost, control, flexibility, and stakeholder interests when constructing the optimal capital structure suited to business needs and market conditions.

Key Point Checklist

This article has covered the following key knowledge points:

• Describe the key sources of long-term finance: equity, debt, mezzanine, and hybrids
• Explain the features, advantages, and disadvantages of each financing source
• Apply capital structure theories to real business scenarios
• Assess when each source of finance is appropriate given company needs and market factors
• Recognise the impact of financing choice on shareholder value and financial risk
• Describe the practical steps and considerations for selecting an appropriate financing mix

Key Terms and Concepts

• capital structure
• equity finance
• debt finance
• mezzanine finance
• hybrid instrument
• pecking order theory