Long-Term Financing of Companies - Essay Example

I. Introduction This paper aims to explore the various long-term sources of financing, which specifically delves with one debt source—the bond offerings, and one equity source—the seasoned equity offerings. The discussion revolves around academic studies that are referenced from various published journals. Also, companies such as Tesco Plc and Marks & Spencer have been analysed as regards their use of the long-term financing sources in order to give a better real-life insight into the discussion. II. Body A. The seasoned equity offerings Seasoned equity offerings or SEOs are stock issues for companies that are already publicly listed in the stocks market (Sherman 2003). If a company that has already undergone an IPO needs to raise substantial capital again and it chooses to issue new equity in order to finance it, this is called seasoned equity offering (Butler, Grullon & Wetson 2005). Seasoned equity offerings come in different variations as regards the terms of the offer such as offering the stocks at investors-at-large or through a rights offerings. Under the rights offering, the company can issue rights to the purchasing the new shares to recipient investors on a proportionate basis (Weller 1962). These rights can either be sold or utilised depending on the recipient investors (Weller 1962). In 2008, Tesco Plc has seasoned equity offering that amounted to 130 million pounds; this is consist of 3 million pounds in issue capital, and 127 million pounds in share premium (Tesco Plc 2009). According to Tesco Plc, part of this seasoned equity offering is to issue shares as stock options are exercised. The rest of it is used for additional financing to the company. On the other hand, Marks & Spencer has issued 0.5 million pounds in equity (Marks & Spencer 2009). In contrast to Tesco Plc, this issue of shares by Marks & Spencer is due to exercise of options. However, seasoned equity offerings are used by the two companies in raising funds to finance their operations. One major advantage of this source of long-term funding is the huge amount of capital that large companies such as Tesco and Marks & Spencer have access in the form of the stock market. As regards the size of the capital raised, seasoned offerings in the stock market really provide huge advantages to these companies. Seasoned equity offerings also have some shortcomings. For one, after an SEO, it is very usual that the stock price of the company gets lower because of the increase in price. There is a period of time before the price of the stocks will incorporate the information about the company, and this information will be reflected in the stock price (Lang 2008). This was apparent in the case of Tesco Plc when it has raised 781 million pounds, which represents 315 million in new shares in 2004; the company, with the help of Cazenove and Deustsche Bank used the accelerated book building method for this seasoned equity offering. (Euroweek 2004). This was part of the companys plan to grow its UK and overseas operations (Euroweek 2004). According to Euroweek, the new shares were 5% of Tescos equivalent enlarged capital during that time (2004). The shares were priced 3.88% below the companys closing share price of 258p. The companys share during that week continued to fall, 3.2% in decline one day after the offer, 0.3% in decline two days after the offer, and 2.1% decline three days after the offer, closing at 242p (Euroweek 2004). When a company announces an SEO, findings of some studies say that the public perceives the action as negative, which drives down the price of the companys stock (Lee & Kocher 2001). This is because of the information asymmetry between the investors and the management (Lang 2008). This is another indirect economic cost, a disadvantage to the issuing company. B. The bond offerings A bond is a debt security (Bharath 2005). When a company chooses to maintain the same level of control in terms of ownership, raising capital from the bond market is a good alternative (Altman & Tubiana 1981). When a company issues a bond in the bond market, it is obliged to repay the principal amount that it borrows, or the face value of the bond as well as the interest or the coupon rate that is indicated in the certificate (Altman & Tubiana 1981). The company is in essence, borrowing from the bondholder; because a bondholder is in essence another creditor to the company, it has a prior claim in its assets in cases of default, before the shareholders claim (Bharath 2005). Both Marks & Spencers and Tesco Plc utilises debt in funding 70% of their assets (Marks & Spencer 2009; Tesco 2009). In 2009, Marks & Spencer has a total of non-current liabilities amounting to 2,117.9 million pounds in the form of bank loans, 6.375% medium-term notes 2011, 5.875% medium-term notes 2012, 5.625% medium-term notes 2014, 6.250% medium-term notes 2017, 7.125% medium-term notes 2037, 6.875% puttable callable reset medium-term notes 2037, and other finance lease liabilities (Marks & Spencer 2009). Tesco Plc has 12,391 million pounds in non-current liabilities in 2009, which is comprised of finance leases, and, LIBOR + 1.33% Bond-TPF, 5.5% and 6.15% USD Bonds, and medium term notes that are comprised of the following denominations: 5.125%; 6.625%; 4.75%; 3.875%; 5.625%; 5%; 5.125%; 4% RPI; 5.875%; 5.5%; 6.125%; 5%; 3.322% LPI; 6%; 5.5%; 1.982% RPI; 5%; 5.125%; 5.2%, respectively along with other medium-term notes and other loans (Tesco 2009). It is very clear that both companies resort to bond offerings in order to raise cash and increase their leverage. In 2006, for example, Tesco Plc has raised 1.2 billion pounds from its bond offering (Euroweek 2006). This is comprised of the 500 million Euro-denominated five-year bonds, 350 million pound-denominated 17-year bond, 300 million pound-denominated 36-year bond, and 175 million pound-denominated 30-year inflation-linked bond (Euroweek 2006). Marks & Spencer also raised albeit a smaller amount of 250 million pound-denominated callable and puttable for 25 years, after five years bond, or a 30-year bond, under this more flexible structure (Euroweek 2007). The difference in the two companies ability to raise cash from the bond market depends on both their size as well as their credit ratings. Tesco Plc for example, is much larger than Marks & Spencer and has larger capital needs. The main advantage of issuing a bond is that the costs associated with it, the interest rate is usually lower than the rates that banks charge for overdrafts (Anderson & Mansi 2009). This is seen in the range of interest rates of the bond denominations of both Marks & Spencer and Tesco Plc. However, these interest rates are usually dependent on the companys credit risk profile as seen by the investors, which is determined by their credit ratings. As of 2006, Tesco Plc has a credit rating of A1/A+/A+ rating (Euroweek 2006). Marks & Spencer has a credit rating of Baa2/BBB/BBB+ as of 2007 (Euroweek 2007). Also, because it is debt, it enables the company to raise cash without giving up a certain degree of control in ownership (Altman & Tubiana 1981). For some investors, they prefer bonds over shares because bonds are more stable in terms of cash payments, i.e. interests are required to be paid for bonds according to the terms, while dividends are usually at the discretion of the company. Bonds are usually issued the same way as stocks, that is, by employing investment banks which buy the securities first before they are issued to the investors-at-large (Edwards, Harris, & Piwotar 2007). The issue of bonds have also experienced innovation over the years. With the popularity of CMBS or commercial mortgage-backed securities, companies such as Tesco Plc is able to issue bonds which are more appealing to investors as these investment securities are linked with the companys income-generating properties. In June 2009 for example, Tesco has launched its 430 million pound-denominated CMBS, a fixed rate 30-year bond where the interest and principal payments will come from the rental income that is generated by Tesco (Euroweek 2009). Following this, the company has issued 559 million pound-denominated CMBS is backed by 17 properties of the company (Euroweek 2009). These bonds have been bought by UK pension funds and other investment institutions. The 72% of the repayments will come from the companys supermarkets, while the remaining 28% will come from its distribution centres (Euroweek 2009). However, issues of bonds do not usually provide the economies of scale that come with stocks issues. This is because, issues of bonds have a direct effect on the companys credit rating (Szewczyk & Varma 1991). The higher the amount of the bond issue, the bigger the distortion is to the total capitalisation of the company, and the higher the perceive risk is to the bondholders (Szewczyk & Varma 1991). Therefore, the cost of bond increases as the credit rating of the company goes down, as in the case of Marks & Spencer in 2004 where bondholders have been wary of the companys too much utilisation of leverage that its outstanding 2 billion plus pound-denominated bonds are threatened with a junk rating, especially during prospective takeover scenarios (Financial Times 2004). Also, if the issuing company is listed in the stocks market, the higher the amount of the bond issue, the higher the cost of equity becomes because the additional risk is being shouldered by the current equity investors (Edwards, Harris, & Piwotar 2007). Bond transaction costs, because it is less regulated than the stock market, adds to transaction costs because of the lack of transparency in terms of the transactions (Edwards, Harris, & Piwotar 2007). III. Conclusion There are two types of financing the company can choose from when it decides to raise additional capital. These are equity and debt financing. While there are private issues of both of these types of financing, this paper explores the ways companies raise capital from long-term sources such as raising from equity and capital markets through securities offerings. These public issues are usually very costly. These costs include direct costs such as the cost of registration, administrative and legal costs for the issuing company. There are also indirect economic costs to the companies such as lower spread because of investors negative perceptions and lack of economies of scale, in the case of bonds. Although for large companies such as Tesco Plc and Marks & Spencer, the major advantage of raising capital from these markets is the access to huge amounts that they need in funding their operations. However, it is apparent that both companies prefer the use of bonds over equity when it comes to funding their long-term operations. Innovation has been apparent in the two companies practices are also slightly seen in the discussion. Methods such as accelerated book building for seasoned equity offerings, and the securitisation in the form of CMBS or commercial mortgage-backed securities are some of the new methods as regards the offering in these capital markets. 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