Hoad Limiteds Alternative Sources of Funding - Essay Example

Hoad Limited’s Alternative Sources of Funding and their Impacts Hoad Limited’s Alternative Sources of Funding and their Impacts Hoad Limited is planning a large capital expenditure seeking to increase its production capacity by acquiring modern equipment. Hoad Limited is floated in a region where the stock exchange is under-developed, and its internal resources are not adequate to finance the projected capital expenditure. The paper will identify and analyze the alternatives Hoad limited can apply in the acquisition of funding as well as how the debt and dividend can affect the organization’s value. Capital expenditure refers to the funds necessary to the organization for the purchase or upgrading of physical assets. In the case of Hoad limited the capital investment is the resources needed to acquire new and replace old production equipment. Organizations should come up with efficient capital investment plans for how the budget should be allocated and how the financing will be acquired. An organization can obtain funds through two approaches namely equity and debt. Equity investments refer to a situation where the company offers ownership to investors or uses retained earnings to finance projects (Dow, 2009: p.91). In the case of Hoad limited, the retained earnings and issuing of more stock won’t be adequate to fund their intended capital expenditure. The other option that is viable to Hoad limited is the use of debts. Debt financing involves acquiring investors who receive a promise of future payments without acquiring ownership of the organization (Dow, 2009: p.91). Deciding on the best funding approach is relevant for Hoad Limited given that investment is a crucial component for organizations. Though markets may be the preferred mode of financing in developed countries for organizations, establishing an alternative finance option is critical in regions with underdeveloped stock exchange (Allen, Carletti, Qian, & Valenzuela, 2012: 4). In regions with under-developed stock exchange, a well-established system is crucial in exploiting the gains from trade. These opportunities ought to be matched with relevant funding based on the standard and non-standard sources and also domestic and international sectors. Before Hoad limited decides on the best approach to adopt in acquiring debts to finance the capital expenditure, the organization has to evaluate its capital structure and determine the best way forward. The business has to decide whether to use more equity or more debt in its capital structure (Dow, 2009: p.95). The company can increase its expected returns when the return from a capital investment is greater than the cost of acquiring the debt. Where the cost of acquiring the debt is higher than the projected returns, the use of debts will decrease Hoad’s returns. International bond placement Given that Hoad Limited has been established in a region where the stock exchange is underdeveloped, the business can seek funding by placing a bond in an international financial market. Well-developed financial markets are important because they offer numerous approaches to financial markets. International markets can provide Hoad Limited a reduced cost of mobilizing savings while facilitating its capital expenditure into the acquisition of highly productive equipment ((Allen et al. 2012: 9). Domestic and international bonds are crucial to the development of the business because they offer long-term funding that is relatively cheap as it is based on the organizational terms and conditions. Being listed in the local under-developed stock market is an indication of Hoad Limited transparency following the introduction of the harmonized accounting standards. The corporate bond is faced with numerous challenges that Hoad Limited needs to overcome. The corporate bond sector lacks sound accounting and auditing systems due to the availability of high bond rating agencies. This situation presents a low creditor’s protection, and potential creditors may fail to invest mainly in corporations at small economies. Lenders are wary of the low recovery rates contributing to underinvestment by both the locals and the foreigners. Hoad Limited can overcome this challenge by placing an assurance with a financial institution to improve the investors’ confidence (Allen et al. 2012: 10). Investors also fail to invest in corporate bonds preferring the treasury bonds that attract higher interest returns with flexible maturity durations. Placing a bond in the foreign market also requires Hoad Limited to prepare a reliable source of foreign currency that would cater for the repayment period. The use of foreign currency could present an undesired and unexpected crisis arising from fluctuations in the money market. To overcome this challenge, Hoad Limited should employ the swap-covered currency borrowing where the changes in the market cannot adversely affect the repayment process (Allen et al. 2012: 12). Bank loans Banks and other financial institutions demonstrate a relatively stable state in middle and lower economies as compared to stock markets. Bank credit is associated with some advantages that Hoad Limited can exploit in terms of long term relationships. The banks and financial institutions provide the facilitation necessary for the business control mechanisms and easier funding than the stock exchange due to limited legal requirements (Allen et al. 2012: 8). Hoad Limited can also seek the services of a specialized financial lender to acquire the desired capital expenditure. Where the organization seeks to initiate a particular project growth, project finance from a specialized provider who would also entail a specialized bank could be the best alternative (Walton, n.d: 10) Despite the advantages associated with bank loans, Hoad Limited should be wary of some of the disadvantages associated with the financial institutions. Most financial institutions require a predetermined liquidity and solvency approach and impose stringent conditions and results in high monitoring costs. Hoad Limited should also be wary of the vulnerability associated with funds from financial institutions in periods of economic crisis. These vulnerabilities might lead to higher valuation losses during the banking crisis that would result in significant reduction in its capital expenditure and profitability. Financial institutions have a problem of increasing loan interests and decreasing the lending quantity that can cause adverse effects to Hoad Limited (Allen et al. 2012: 9). Trade credit Trade credit would offer Hoad Limited an alternative source of capital expenditure funding. Trade credit can be used to access funding as a whole or used to complement other sources of funding. In the case of Hoad Limited, the business can use trade credit to complement its internal sources of funding. Trade credit primarily depends on the level to which Hoad Limited is seeking funding to determine whether it’s a full or partial supplier credit. A supplier credit for Hoad Limited would reduce the actual cost of equipment purchase when the supplier offers a fixed deadline discount and subsequently Hoad Limited paying before the deadline. Even with the failure to pay the supplier within the agreed time, Hoad Limited trade credit with suppliers is better than most sources of funding. This advantage occurs as the amount to pay will result in the initial undiscounted price (Deutsche Bundesbank, 2012: 53). One of the alternative financing approaches is trade credit with the suppliers of the said equipment. Trade credit is the situation where the supplier lets the business delay payments for the equipment delivered. This approach would give Hoad Limited an opportunity to manage better its cash flows to a point when they can use their retained earnings to pay fully for the equipment. Trade credit is essential as a form of business financing due to several factors. Supplier credit has an advantage over financial institutions debts. The advantage occurs as they lend to the business based on an efficient supplier-customer relationship (Deutsche Bundesbank, 2012: 53). Through trade credit, the suppliers can extend their terms of the agreement with the business to provide Hoad Limited with more certainty involving the timing of the scheduled payments. Another factor that makes trade credit favorable is the ability to be used as a tool for price discrimination. With trade credit, the supplier will offer the equipment to Hoad limited regardless of the businesses underlying credit quality. By doing this, Hoad limited is benefitted in that its payment is effectively lower than when other options of finance that attract interest are used. According to Fitzpatrick and Lien (2013), trade credit accounted for over eighty billion dollars in March 2013 in Australia that would amount to around eight percent of the country’s total liabilities. Trade credit is an essential source of funding to Hoad Limited. It is essential in that the business can deal with the payment of the suppliers at a later date having put in place the measures to accumulate retained earnings. In this case, the equipment contributes to the recovered of the incurred debt. The capital expenditure can also be conducted without the fear of low-quality equipment as the trade credit contract can outline some of the equipment insurance with the suppliers. Supplier credit serves as a means of overcoming informational asymmetry that exists between the seller and the buyer regarding the quality of the supplied equipment. Rights issue Hoad Limited can turn to the rights issue to acquire the desired capital expenditure. Through the rights issue, Hoad Limited would grant the existing shareholders an opportunity to purchase new shares at a discounted price to the prevailing trading price. A rights issue is typically an invitation to the already owners of the company to buy new shares in Hoad Limited and increase their exposure at a discount (McClure, 2015). The existing investors can trade their rights on the market in case of inadequate funds the same way shares are sold. Rights issues are used by companies to finance debts or increase their growth (McClure, 2015). In the case of Hoad Limited, the rights issue will be used to fund replacements and the acquisition of new equipment. There are several advantages that Hoad Limited could experience following the issuance of the rights issue and not adopting other funding approaches. The control of Hoad Limited will be maintained with the current shareholders that would result in the retaining of the management team and an efficient capital expenditure. Rights issue provides the possibility of distributing shares without the actual change in the management structure (Khanna, 2012). This maintenance is achieved in that Hoad Limited will offer the rights issue proportionately with the prevailing equity shares. The subsequent dilution of the stock price does not affect the investors due to the compensation afforded by the accusation of the new shares at a discounted price. Hoad limited will also avoid incurring any costs regarding the issuance and also achieves improved shareholder satisfaction arising from the acquisition of more shares from the business. The likelihood of acquiring the desired financing from the rights issue is higher than issuing shares to the general public (Khanna, 2012). The problem associated with the rights issue is the dilution of the existing share price. If Hoad Limited requires the approval of the existing shareholders before issuing, the issuance may fail due to diverse shareholders’ opinion. To avoid this situation Hoad limited should maintain a number of unissued shares and as such the management can depend on the rights issue to receive more funding. If shareholders’ approval is necessitated, the management should present a list of some of the advantages the shareholders are set to receive following the intended capital expenditure. New and improved equipment could result in increased productivity that would subsequently lead to increased revenue resulting to increased shareholders’ dividend. The shareholders will then base their decision on the set advantages before accepting or rejecting the rights issue. The impacts of debt policy on a firm Debts are the fixed claims on a firm’s cash flow. When the company changes its debt, the cash flows to equity are affected. An increase in a firm’s debt results into a riskier equity that pushes the cost of the capital upwards and vice versa (Damodaran, n.d: 7). In the firm’s adjusted present value, the valuation is considered in terms of the value without debt and the effect of debt on the firm. A debt can only affect the value of a firm only if there are tangible benefits and costs that are associated with the use of debt and not equity. In the case of Hoad Limited, acquiring a debt to finance its capital expenditure would result in a change in the company’s value. Where the benefits obtained from the use of the debt exceed the costs, the value of the firm is expected to increase and vice versa. The value of the firm will remain unchanged when the costs of acquiring the debt equal the benefits generated from the debt (Damodaran, n.d: 12). However, in a situation where there is a perfect market debts will not affect the value of the firm as the capital structure is not relevant. A perfect market refers to a situation without taxes, agency costs, and default risks. A company can use various tools to assess the effects on a firm’s value due to debts. The cost of capital approach results in the minimization of a firm’s cost of capital by the optimal debt ratio. In the use of the adjusted present value, the optimal debt ratio leads to a maximized overall value. The measure of the debt ratio using the life cycle approach suits the firm’s present situation and value. The dividend policy The dividend policy is a decision by the firm’s financial manager on the extent to which the company should distribute and retain earnings. Dividends are those profits paid to the shareholders annually for their investment in a business. Most shareholders tend to measure the firm’s growth through the dividends paid. The firm cannot retain all earnings and has to dedicate a significant share to distribute among the investors to ensure investor satisfaction. However, firms may experience harsh financial situations where they distribute all the earnings as dividends to the investors (Ashamu, Abiola, & Bbadmus, n.d: 22). A firm can adopt one of the two approaches to dividend policies, the managed policy, and the residual policy. In the case of residual policy, the firm distributes a dividend of what is left once desirable investments are achieved using the net present value rule. Managed dividend policy is adopted where the dividend is of significant importance to the investor. Firms take the dividend policy based on the present stage of its life cycle. Firms with higher cash flows and limited or no projects pay more dividends than those with little cash flows and numerous projects (Kapoor, 2009: 5). The relationship between the policy adopted, and the value of the firm can be observed in the case of perfect markets. The dividend policy when based on the firm’s investment policy affects neither the value of the firm nor the shareholders’ return. However, imperfect markets characterized by differential tax rates, conflicts between investors and management, and information asymmetries can affect the value of the firm (Kapoor, 2009: 8). Dividend payouts do not influence the value of the firm, but the investment policies, the earnings of a firm, and the managed dividend policy can affect the value of the firm. 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