Viability of Capital Instruments - Essay Example

?Financial Markets - Raising Capital Table of Contents Table of Contents 2 Introduction 3 Analysis of capital instruments 4 Viability of capital instruments 7 Recommendation 10 Conclusion 12 Reference 13 Bibliography 15 Introduction The growth of a business depends on its ability to raise adequate funds. A plan for business expansion may not be realised if there is a dearth of financial resources. This exemplifies the importance of ‘capital’ in a business. The business managers strive hard to achieve an optimal capital mix so as to maximise the firm value and minimise the average cost of capital. In fact the financing decisions form an integral part of a firm’s policy decisions. Usually, the financial managers prefer debt over equity on account of interest tax deductibility and low cost associated with debt. Mr Exposito plans to raise funds for the purpose of expanding his winery business. A careful analysis of the various sources of funding has been done to suggest the best available alternative based on the size of the winery business and the prevailing conditions in the market. Analysis of capital instruments There are two forms of financing - long term and short term. The long term financing instruments include debentures, bonds, term loans & shares and the short term debt instruments include bank overdraft & trade credit. Bonds- A bond is a long-dated financial instrument used by the companies to raise funds from the public. The bondholders are entitled to regular interest in the form of coupon payments. Normally, the bond is listed in the stock exchange. It has a fixed date of maturity which is the date at which the company agrees to pay back the principal amount to the holder of the instrument. The issue of a bond creates a legal binding on the company. Even in the event of a loss the company cannot dishonour the interest payments as this can have legal repercussions. The companies mostly issue fixed coupons bonds offering semi-annual payments until the date of maturity. There may be other types of bonds like fluctuating coupon bonds or bonds with an annual or quarterly payment feature. Besides there are zero coupon bonds that do not require any interest payments. The bonds can further be classified on the basis of the collateral as mortgage bonds, collateral trust bonds and equipment trust certificates. The real property is used as collateral in the case of mortgage bonds. The securities owned by the corporate act as a security for the collateral trust bonds whereas the inventories and company equipments act as security for equipment trust certificates. The price of the bond is inversely proportional to the interest rate. A rise in the interest rate can lower the price of the bonds and vice versa. Considering the interest rate sensitivity the bonds can be of two types- callable and non callable bonds. If after a bond issue the interest rates fall in the market then the corporate can call back the bonds issued at a higher interest rate and issue new bonds at a lower rate of interest (Rini, 2002, p.57). Debentures- The features of debentures are more or less similar to that of bonds except that unlike bonds the debentures carry a pre-determined rate of interest. Depending on ‘security’ the debentures can be classified as secured and unsecured. Secured debentures carry a charge on the company assets. The company cannot dispose-off these assets without the approval of the debenture holders. The unsecured debentures do not carry any such charge on the asset which makes it risky from the point of view of the investors. Again the debentures can be classified as per ‘convertibility’ into convertible and non-convertible debentures. The former gets converted into equity after a specified time period. Therefore in the future the debenture holders get an option to acquire a stake in the company. The non-convertible debentures are repaid at the end of the maturity and cannot be converted into equity. Depending on the ‘payment pattern’ the debentures can be classified as redeemable debentures and irredeemable debentures. The redeemable debentures are repaid as per the agreed upon terms but the irredeemable debentures are not repaid during the company’s lifetime i.e. they are paid back only in the event of liquidation (Hanif, 2001, p.37.3). Term Loans- If an enterprise requires a small amount of funds then it can take ‘term loan’ from a bank. This mode of funding is said to be less time consuming and inexpensive. Based on the loan size and the rapport of the client with the bank the term loan may be secured or unsecured. The amount paid back by the enterprises comprises of interest as well as principal (Stoltz, 2007, p.118). Bank overdraft- Bank overdraft facility is commonly employed by the enterprises in the capital structure as this offers financial flexibility on low rates. A bank overdraft is a type of short term loan that gives the company the facility to overdraw up to a certain amount of money from its current account. This limit is determined by the bank on the basis of the “cash flow projection” for the twelve month period. The limitation of this form of facility is that the rate of interest can increase without any prior warning. Other than this the bank can call back the amount from the client at any point of time. This mostly happens in the case of payment failure or crossing of the overdraft limit or if the bank fears that the client might default (Stoltz, 2007, p.120). Trade credit- Trade Credit is a form of “non interest bearing” financial instrument. This does not involve any contract between a bank and company rather it is a contract between two partners engaged in trade. This can be of two types of suppliers’ credit and consumers’ credit. In suppliers’ credit the company purchases the goods from the supplier on credit promising to pay at a later date (Kemmer, 2009, p.12). Equity Shares- An enterprise desiring to expand its operations can approach the capital markets to raise equity shares. By the issue of shares the enterprise gets listed on the stock exchange and thereafter its shares are traded in the secondary markets. The individuals contributing funds through the purchase of shares are called the ‘shareholders’. They enjoy ‘voting rights’ and for making any crucial business decisions the company is required to obtain the consent of the majority shareholders. The shareholders are the ‘owners’ of the company and the management looks after the business on the behalf of the shareholders. The shareholders are entitled to a share in the profits of the business commonly referred as ‘dividend’. However, the declaration of dividend is not mandatory. A company declares dividend only when it has surplus profits. The amount invested as share capital is paid back only at the time of liquidation. Viability of capital instruments A bond is issued for meeting the long term fund requirements of the company. The amount of capital required by Mr Exposito is $50 million. This is mainly needed for meeting the expansionary plans of business. The amount raised through bond issue can be paid back after a considerable length of time. As the amount is required for the purpose of expansion it means that Mr Exposito would require some time to pay the money back. Therefore, the issue of bond looks a viable proposition. The only hurdle that may arise is that the investors look at the credit rating of a company at the time of making an investment. However, Sparkling Wines being a small business may not appeal to the investors. Considering the high risk associated with investing in a newly listed company the investors may ask for high interest rates. This may not be feasible for the business. Alternatively, Mr Exposito can issue debentures. The features of debentures are more or less similar to the bond with an only exception that the bonds are not issued at a predetermined interest rate whereas the debentures are issued at a predetermined interest rate (Mittal & Jain, 2010, p8.5). The interest rate in the market is expected to soar in the coming years (ES London Limited, 2011). As the interest rate on debentures are determined at the time of issue and remain fixed till the maturity date the issue of debentures appears to be a wise choice. But it is better not to raise the entire amount through this mode of financing as the debenture holders are in a way creditors of the company. Too much of debt can weaken the balance sheet position of the business. Other than this, on the debentures the company has to make regular interest payments. Failure to meet any ‘due interest’ can have legal consequences. Too much of debt can be a financial risk for a small and expanding business. The funds spent towards expansion may not yield profits in the first few years but the interest payments will start immediately after the funds are raised. It is possible that the company may not have surplus cash flows to take care of the fixed interest burden in the initial years. Hence an excessive reliance on debentures should be avoided. The term loan is a type of short term fund assistance. The cost of this form of financing is low and it may not require security also. Going by all this it looks attractive but this form of financing is suited for the short term business needs. Mr Exposito requires funds for business expansion. This means that the funds will remain blocked up in the business for a considerable length of time. Therefore the term loans are no suitable for funding the expansionary plans of Mr Exposito. This type of funding may be used by the business in the near future i.e. as working capital. Once the winery business is firmly established then the term loans can be raised to meet the production and promotion related expenditures. The low cost and the unsecured nature of this form of funding make it a good option for short term financing. But the entrepreneur must wait for the right time before resorting to this financing mode. With time the business will be able to establish itself in the market. Based on this the business will be able to negotiate favourable terms of credit. The bank overdraft is another method of meeting the fund requirements of a business. But this too is a type of a short term financing instrument. The businesses already having a strong market presence may approach the banks to avail credit facilities on the current account. It is mainly used for meeting the working capital needs of the business and is not suitable for long term business requirements. Like bank overdraft, trade credit is also a type of short term financing instrument. Here the business enters into a credit agreement with the suppliers’. This form of financial assistance is limited to small amounts and is not enough to meet the expansionary plans of Mr Exposito. The issue of shares is a common method of raising funds for the long term business needs. Equity capital remains invested for a period of medium term to long term in lieu of an ownership position in the company. Once the company is able to get itself listed in the market it can avail a series of financing avenues. A listed company has to prepare its financials according to a set of accounting norms. This increases the credibility of their financial statements. Moreover, the regular news about the company in business papers gives it the necessary exposure attracting more investors. Besides the financial institutions extend credit on the basis of the financial strength of a company which gets reflected from the annual reports. Once a bank is convinced that the company has a strong equity position it does not hesitate in extending credit. The assets of the business act as a ‘surety’ for the banks. Unlike the debt holders the investors of share capital do not have the legal authority to claim interest payments. The shareholders are paid in the form of dividends which depends on the profitability of the business. As the shareholders bear the risk associated with the business it is commonly referred as “risk capital”. This form of capital is ideal for the purpose of funding expansionary needs. Initially the business may not be able to generate adequate cash to honour the interest on loans as the profits earned in the starting years go towards taking care of the core activities (Department for Business, Innovation & Skills-a, n.d.). One of the main advantages that exist in this form of financing is that the funds remain committed to the business for long time periods. The investors get a return on their funds only if the business is performing well as payment of dividend is not obligatory. In the future the business can also opt for rights issues. This is a type of follow-on-offer and is offered to the existing shareholders (Department for Business, Innovation & Skills-b, n.d.). If the business is able to prove itself in the eyes of the investors then it will have no problems in raising additional funds in the future. Therefore, the issue of equity is a good way of raising funds for long term. Moreover, in the initial stages the business may not be able to get loans on favourable terms and conditions as the banks and financial institutions are wary of lending to small or new businesses and demand higher interest rates. Recommendation The funds raised by Mr Exposito are meant for the expansion of his winery business. This means that the funds have to be committed to the business for a considerable length of time. So the short term financing sources like term loans, bank overdraft etc cannot be used for the funding program. The long term sources like debentures, bonds, equity etc should be used for financing. An analysis of the benefits and limitations reveals that Mr Exposito can rely on equity for financing most of the expansion. Together with equity the convertible debentures can also be used for funding. As the interest rate is expected to rise in the near future therefore, the issue of debenture is preferred over bond as the former carries a pre-set interest rate. The funds for expansion must be raised mostly in the form of equity shares as the shareholders can demand for funds only in the event of liquidation. Moreover, the issue of equity saves the business from making excessive payments in the initial years when the flow of surplus funds is already limited. However, equity issue has its own set of limitations like dilution of ownership, delays in decision-making etc. Therefore to overcome the above limitations the business can finance the expansion plan using a mix of equity shares and convertible debentures. The debentures can be issued with the feature of ‘conversion into equity’ after three years. This will give the business dual benefits. In the first place it will be able to take advantage of the current low interest rates prevailing in the market. Moreover the business will not be faced with the demand for repayment of capital in the initial years. This is very important as in the first few years it is difficult for the business to accumulate enough money for repayment. Although there is no legal obligation to pay dividends to the shareholders however the business must try and deliver good returns on the shareholders’ funds. The regular declaration of dividends will create a good image of the company in the market. This will garner more investor attention. It is beneficial from the long term standpoint. In the case of any additional requirements for funds for future growth opportunities the company can tap its existing shareholders’. As too much dependence on equity is not prudent the inclusion of convertible debentures is the capital mix is a good idea. However, the focus will be more on equity as the business being small may find it difficult to attract credit on favourable terms in the initial stages. Care must be taken that all the interest payments are made on time as this will improve the credit rating of the company. In the future the track record of clearance of interest dues is one of the factors looked into by the creditors at the time of extending loans and advances. A regular and timely payment will give the company a good ranking. A high credit rating like AAA and AA implies low risk and therefore the company would be able to access credit at low interest rates. Conclusion The financing policy of a business has an important influence on its value and overall cost of capital. This is the reason the financial managers’ work towards achieving an ideal capital mix that can maximise the value of the firm and minimise the cost of capital. A careful assessment of the relative merits and demerits of the various financing alternatives must be considered in conformance with the market conditions and business type at the time of making financing decisions. The managers are often inclined towards loans on account of low cost. But it is important to exercise caution as an excessive leverage may prove to be a financial hazard for the company. The fixed interest payments often retard business growth prospects. On the other hand high levels of equity capital result in dilution of ownership. Therefore it is important to achieve an ‘optimal capital mix’. The financial managers must give an ideal weight to both the forms of financing and not get lured by the ‘facade’ of low cost. Reference Department for Business, Innovation & Skills-a. No Date. What is equity finance and is it right for your business?. Equity finance. Available at: http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073789556&r.i=1073789573&r.l1=1073858790&r.l2=1084705429&r.l3=1074453334&r.l4=1073864776&r.s=sc&r.t=RESOURCES&type=RESOURCES [Accessed on March 2, 2010]. Department for Business, Innovation & Skills-b. No Date. Advantages and disadvantages of equity finance. Equity finance. Available at: http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073789573&type=RESOURCES [Accessed on March 2, 2010]. ES London Limited. 2010. Interest rates will surge to 6.5% by 2015, Barclays says. Business. Available at: http://www.thisislondon.co.uk/standard-business/article-23802401-interest-rates-will-surge-to-65-percent-by-2015-barclays-says.do [Accessed on March 2, 2010]. Hanif, M. 2001. Modern Accountancy. Tata McGraw-Hill. Kemmer, M. 2009. Alternatives in Short Term Financial Instruments and Criteria for Short Term Financing Decisions. GRIN Verlag. Mittal, R.K. Jain, K.A. 2010. Accountancy. FK Publications. Rini, A.W. 2002. Fundamentals of the securities industry. McGraw-Hill Professional. Stoltz, A. 2007. Financial Management. Pearson South Africa. Bibliography How To. 2009. Types of Debt Finance. Available at: http://www.howto.co.uk/business/finance-for-business/types_of_debt_finance/ Livingston, L. 1999. Bonds and bond derivatives. Wiley-Blackwell. Shim, K.J. 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