Corporate Finance and Related Ethical Issues - Essay Example

 Organisations which aim to achieve their corporate goals do it through corporate investments and financing. Generally it has been noticed that either the fund is self-generated or assistance from the external sources are taken. This is obtained by equity and debt or through convertible securities and hybrids. The financial mix will affect the evaluation of the organisation, as in such cases both the cash flow and the hurdle rate gets affected. It is indicated that the management has to recognize the optimal mix for funding. This means developing a capital structure which would assist in deriving maximum value. When a project is financed, the debt of the firm results in a liability, which can be also termed as an obligation. However, equity financing is considered to be less risky because the commitments related to cash flow is respected, but this results in the dilution of the earning, control and share ownership. Moreover, as it is already known the cost of equity is higher than the cost of debt. This implies that equity financing can double the hurdle rate. This study is also based on such concepts of funding and investment (Spencer, 2000). Arthur Graham plc (AG) is a listed company which owns building merchant chains. It is located in the south of England. The company is mainly financed through equity, keeping in mind the organic growth of the firm. AG wants to acquire an unlisted company called Sandboy Ltd, which also owns building merchant chains. However, the problem is regarding the funding that AG has to make in order to acquire the company. The shareholders of Sandboy Ltd have demanded 25 percent of the market capitalization of AG, for acquiring their company, which was accepted by AG, as they found Sandboy Ltd. to be a good prospect for them. However, AG could not raise funds from its internal sources, so it has to find out ways to fund the acquisition. Moreover, all the three directors of the company have different opinion regarding the funding or investment process (Spencer, and Stradling, n. d.). In case of corporate financing there are certain principles that organisations have to follow before making investments. In this case AG plc will also have to follow such procedure. The structure of the firm is analysed, which means the management at AG plc will have to assess its organisational structure first. This includes assets in place and growth assets. The assets in place are those assets that are already with the firm and growth asset are those which the firm expects to acquire or invest in future. In order to finance such growth asset, the firm may raise money from investors or the financial institutions. The investors can be promised an interest that the firm will generate through cash flow. In this case the three principles of corporate financing have to be evaluated and discussed in order to consider the theories put forward by every director of AG plc, and derive a conclusion. The three principles are: a) Financing principle, b) Investment principle, and c) Dividend principle (Damodaran, n. d.). a) Financing Principle: Firms may be big or small, but their financing or funding techniques has always been a mix of both debt and equity. In case of public companies, the means of debt financing is bonds, and equity is common stock. However, in case of privately owned companies, the equity is the savings of the owners, and debt is the loan taken from bank or financial institutions. AG plc is a public company, and as discussed, it may issue bonds, debenture or preference shares to raise funds, issue right shares, etc., to raise equity financing or a mixture of both, for acquiring Sandboy Ltd. In such case the opinion of the directors has to be considered. Director A is against borrowing, so AG plc can rule out the option of raising money through loans from financial institutions, or bonds, as it will incur cost of interest payment, and this will minimise the earnings and share price of AG plc. Director B is against issuance of right shares, as the shareholders might not want to buy the shares, and might feel less secured and sell off their existing shares. However, he/ she suggest financing through loan notes. Director C supports issue of preference shares, keeping in mind the capital gearing issue. Director C indicates a neutral funding path keeping in mind the risk associated with funding and acquisition of companies. In this case, AG plc has to opt for a financing mix of debt and equity, which would partly include loan notes and preference shares. b) Investment Principle: In this section, the discussion would be on investment principle of corporate finance. The investment decisions would not only include profits and revenue generation, but also methods for saving money. Further, investment decisions also include inventory maintenance plans, credit that would be allowed to customers and decisions regarding working capital. Other than this, issues like entry into a new market and acquisition of other firms is also considered in the investment decisions. The management has to measure the return on the investment decisions and compare them to the minimum hurdle rate that is acceptable. The hurdle rate is considered to be higher for the risky projects and it also evaluates the financing mix that would be used to take forward the project. In case of AG plc, the hurdle rate in terms of investment is not so high because it has been stated that the shareholders of Sandboy Ltd have asked for 25 percent of the market capitalisation of AG plc, which is acceptable by AG plc as the prospect of growth is high in Sandboy and the price seems reasonable. In this case the hurdle rate won’t be high. However, in case of financial mix the above said strategy can be used. This means a combination of loan notes and preference shares would be good funding mode. Now, risk and return assessment has to be done in case of funding. There are three ways of measuring returns, such as traditional accounting earnings, time-weighted cash flow and cash flow. Time-weighted cash flow is appropriate because it not only estimates the cash flow, but also anticipates when they are going to come in. AG plc in such a case can undertake such measure to check the validity and reliability of the financial mixes that has been considered for Sandboy Ltd’s acquisition (Vishwanath, 2007). c) Dividend Principle: Companies generally like to have unlimited opportunities for investment that would yield returns more than the hurdle rates. Every company reach a point when the cash flow generated by its existing investments is more than the finance required to acquire any new investment. In such points companies have to take decisions regarding returning the excess fund to the owners. In case of private companies, owners may simply withdraw his/ her investments. In public corporations, shareholders or owners of the companies are paid dividend or issued stocks. Dividend policies are set by different companies based on the guideline, which determines whether dividend would be paid off or cash should be left in the business. In this case AG plc could have funded the acquisition of Sandboy Ltd through its retained earnings and stopped the dividend payments, informing the shareholders regarding the growth prospects of AG plc if they acquire the company. The probability of earning greater dividend in the next year would have motivated the shareholders of AG plc to support them in decision. The above explained principles would be helpful in explaining the financing or funding methods that AG plc can undertake to acquire Sandboy ltd without utilising its internal sources. The stated suggestion has been formulated keeping in mind the suggestions and the opinion of all the three directors. Since Director A does not consider borrowing as a good idea, due to the burden of interest payment, it would be recommended that direct loans should not be taken from financial institutions, as this would reduce the earnings of the company. Director B has stated that loan notes would be the most preferable. He/she does not prefer right issue of shares specifying several reasons. Loan notes would be recommended as it is not taking direct loan from financial institutions and it will also save the company from issuing right shares. Director C has suggested issue of preference shares to avoid capital gearing. The capital gearing will increase if the debt of the company will amplify dramatically. When a firm goes for leveraged buyout, it is important to consider the ability of the firm. Therefore, in case of AG plc it seems from the attitude of the directors that they are willing to go for leverage buyouts. In this context it can be recommended that the firm can issue preference shares, which will present a neutral situation for the company and make the acquisition process easy in terms of financing (Vishwanath, 2007). References Damodaran, A., no date. What is Corporate Finance? [online] Available at: [Accessed 21 February 2013]. Spencer, T., 2000. Finance 1: Using Financial Information. Hertfordshire: Select Knowledge Limited. Spencer, T., and Stradling, B., 2001. Financial Analysis. Hertfordshire: Select Knowledge Limited. Vishwanath, S. R., 2007. Corporate Finance: Theory and Practice. 2nd ed. California: SAGE. Read More