Debt Financing

This is when a company gets a loan and promises to repay the loan overtime with interest.
Borrowing power
It is the ability to borrow more funds. It is the legal capacity of an incorporated firm to put itself
into debt. Directors of a firm are generally given the power to borrow on its behalf but, as
defined in the firms by laws or memorandum of association, certain limits are placed on their
ability to do so.1
The Board of Directors may borrow money by passing a resolution passed at the meeting of the
Board. The board may delegate its borrowing powers to a Committee of Directors. Such a
resolution should specifically mention the aggregate amount up-to which the money can be
borrowed by any authorized principal officer of the company as it may prescribe.
DEBT INSTRUMENTS
A paper or electronic obligation that enables the issuing party to raise funds by promising to
repay a lender in accordance with terms of a contract.
Mortgage of charges:
The legal ownership of the shares of the company is transferred to a lender who shall facilitate
the loan to the company. If the company fails to satisfy the debt upon maturity then the company
shall forfeit the shares. However should the company satisfy the debt then the lender shall
transfer the shares back to the company. It is important to note that such a transaction must be
registered with the Registrar of Companies. It would not be advisable to consider this type of
security because it is high risk. The company in this case requires a high loan of about 4 Billion.
If the company's shares are mortgaged and the debt remains unsatisfied the company shall forfeit
majority of its shares.
Debentures:
A formal document issued by a company acknowledging indebtedness. In this case a loan is
facilitated to the company by the lender against a formal document which creates a charge as
against the property or the assets of the company. Moreover, the lender has certain powers in
relation to the charged property. However the lender may issue high interest rates and if the
company fails to meet its loan obligations it shall forfeit the charged property.
Debenture stock:
1

http://www.businessdictionary.com/definition/borrowing-powers.html#ixzz3UNUxeRI9

This is where a company issues stock to a lender against a loan. The company has an obligation
during the currency of the relationship to pay out interest as and when due on the shares even
when profits have not been made. Thus payments to the loan can be paid out of capital unlike
shares. The disadvantages of such an instrument is that where a company fails to make profits
then this may lead to capital reduction. This may therefore greatly affect the business operations
of the company.
Corporate bonds:
A bond is a loan in which the terms, pay-back date and interest rates are detailed in a legal
document. It is a formal contract to repay borrowed money with interest. The company issues out
bonds to lenders who pay against such bonds. After a certain period of time, when the bonds
mature, the company shall pay the amount of the bonds and the interest accrued on the bonds.
This type of security is very high risk. Consequently, they will have low subscription.
Risks
Generally, the higher the risk, the higher the interest rate to be paid. When one decides to borrow,
they should also have mechanisms that will mitigate the risks.

Credit Insurance

For example, in cases on mortgages, lenders are protected against loss in market value of
collateral through mandatory insurance charged to the borrower.

Credit Default Swap/ Credit Derivative Contract

The buyer of a credit default swap receives credit protection, whereas the seller of the swap
guarantees the credit worthiness of the debt security. In doing so, the risk of default is transferred
from the holder of the fixed income security to the seller of the swap2.
For example, company A wants to expand its business and issue B, the bond buyer or lender,
bonds of 5 percent interest over 10 years. At maturity, the bond principal is to be paid back in
full. B takes the risk to that effect and assumes that A will be able to pay the principal when it
matures. Where A foresees a possibility of default, he may pay some interest towards the
purchase of a credit default swap to C, which may be a business or insurance company. As
regards this arrangement, C will ensure that the principal amount upon default, is paid to B on
As behalf.

Example of a company that used debt financing; Mumias Sugar Company

http://www.investopedia.com/terms/c/creditdefaultswap.asp#ixzz3Web4utap

It used debt financing so as to get funds. Got loans to carry out its businesses but defaulted in
payment because they do not have enough money to repay the loans. As a result, its credit rating
went down and this indicated uncertainty over its ability to service debts. The implication of low
credit ratings is that it will borrow at a stiffer interest rate and is likely to be damaging to the
company.

ALTERNATIVE TO DEBT FINANCING

Rights Issue
A rights issue is a common way for a company to raise fresh capital: it issues new shares,
offering them first to existing shareholders. This type of issue gives existing shareholders
securities called "rights," which give the shareholders the right to purchase new shares at a
discount to the market price on a stated future date. Essentially, the company is giving
shareholders a chance to increase their exposure to the stock at a discount price.3
Pre-emptive rights are any rights shareholders may have, to be offered shares in a company
before they are made available to anyone else. They can arise on the allotment, transfer or
transmission of shares. Such rights may be important to ensure that a shareholders proportion of
the voting and other rights in the company (such as dividend rights) are not diluted.4
Section 595 provides for the power to issue shares at a discount provided that it is authorized and
passed by resolution in a general meeting of the company, which has specified the maximum rate
of discount at which shares are to be issued and is issued within one month after the date of
which the issue is sanctioned.
Example of Uchumi Supermarket
Uchumi was working on its rights issue transaction which was delayed for 15 months. During
this time, it decided to borrow 600 million from KCB Bank and 405 million from Cooperative
Bank of Kenya as working capital to pay its suppliers. They made a financial loss within the 1 st 6
months due to the expensive bank loans. When the rights issue transaction got on track, the
investors made a 45 percent gain in just two weeks after the shares started trading in the NSE.

Advantages:
3

http://www.investopedia.com/walkthrough/corporate-finance/5/raising-capital/rights.aspx

http://www.companylawclub.co.uk/topics/preemptive_rights.shtml

Section 59 Company Act, Kenya

It is cheaper than a public share issue

The company avoids financial obligations and reduces the risk of losing its
assets or property unlike other borrowing instruments.

It also cushions shareholder from dilution of shares in the event of

oversubscription, provided they take up their rights. The existing shareholders do not

suffer on account of dilution in the value of their holdings if fresh shares are offered to
them because value of the shares is likely to fail with fresh issue. This decrease in the
value of the shares will be compensated by getting new shares at a price lower than the
market price. They are likely to suffer on account of the dilution in the value of their
holdings if fresh shares are offered to the general public

Controlling of the company is retained in the hands of the existing shareholders. Issue of
right shares makes possible equitable distribution of shares without disturbing the
established equilibrium of shareholdings because right shares are offered to the persons
who on the date of rights issue are the holders of equity shares of the company
proportionately to their equity shares on that date.

The expenses to be incurred, if shares are offered to the general public, are avoided.
The image of the company is improved when rights issues are made from time to time
and existing shareholders remain satisfied.
There is more certainty of getting capital when fresh issue of shares is made to the
existing shareholders instead of to the general public.
Directors cannot misuse the opportunity of issuing new shares to their friends and
relatives at lower prices and at the same time retaining more control in their hands when
right shares are issued because in rights issue shares are offered proportionately to the
existing shareholders according to their existing holdings
If right shares are offered by the shareholders enthusiastically, it proves that financial
position of the company is sufficiently good, and the company can obtain more loans at
lower rate of interest.

Disadvantages

There is a limit to how much can be raised through this method as existing shareholders
are only willing to invest so much. A rough rule of thumb is that a rights issue could raise
up to 25% of the existing equity value of the firm.

If shareholders do not take up their rights, then their shareholding will be diluted.

The shareholder's options with a rights issue are to:

(1) Take up his rights by buying the specified proportion at the price offered

(2) Renounce his rights and sell them in the market

(3) Renounce part of his rights and take up the remainder
(4) Do nothing
In the case of PrakashKantilalGadani v Kenya Airways6 the company sought to raise revenue
through a rights issue by a resolution passed by the majority shareholders. It was held that the
majority of the shareholders passed the resolutions which were in full compliance of the
requirements in their articles of association. As such, the injunction sought by the appellant was
not granted.
In the event shareholders do not take up their rights, the shares may be offered to the public so as
to raise the required funds. An important document that is required is the prospectus. It is a legal
document issued by companies that are offering securities for sale.7 When a company wants to
offer shares to the public, they usually use a document called a prospectus.
Key features;

What a company will do in terms of making profits

The risks and in what circumstances an investor could lose their money

Future profit forecast, assumptions that build the basis for that forecast,

How the company has performed in the past,

Who the directors and managers are, if they have the right experience and their track
record.

If there are any related parties and if they will benefit under the offer or in the future.8

Under section 43 of the Companys Act, it should be registered before it is released to the public.
It must be dated and signed by relevant parties.
Importance of a prospectus
1. To make investors aware of the risks of a particular investment. Without this information,
they would essentially have to make investments "sight unseen."

Petition No 111 of 2012

http://www.investinganswers.com/financial-dictionary/mutual-fundsetfs/prospectus-929

Kate O'Rourke and Jane Eccleston what to look for in a prospectus before you invest.
https://www.moneysmart.gov.au/investing/shares/how-to-buy-and-sell-shares/prospectuses

2. To protects the company from claims that it did not fully disclose enough information
about itself or the securities in question.

REFERENCES

Johnstone Ole Turana Corporate Kenya takes to rights issues for growth financing
Posted Tuesday, July 6 2010 at 00:00 Business Daily

Kaplan Financial Knowledge bank http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki

%20Pages/Rights%20Issues.aspx?mode=none

Mark Stamp Practical Company Law and Corporate Transactions 3rd edition

Rohan Khanna COMPANY ACCOUNTS