Raising Capital from Equity and Bond Market and Capital Asset Pricing Model and Cost of Capital - Term Paper Example

International Finance Market Table of Contents Introduction 3 Rising capital from Equity and Bond markets 4 Capital asset pricing model (CAPM) and cost of capital 7 Effect of company’s capital structure on its cost of capital 10 Reference 12 Bibliography 16 Introduction The financial market worldwide has transformed dramatically post World War II. Presently a strong interconnecting link has developed between the various financial markets (Coles, 1981). The term “capital” refers to the fund that a company raises initially to meet its operating expenses. When a company is set up, it raises capital from the lenders and investors to fund its operations. Large companies spend a lot of resources in deciding their optimal capital requirement (National Bank Share and Bond Trading, 2008). When a new business is being started, companies have three main elements with which they set their capital structure and these are Debt, Equity and Grants. All three elements have certain positive as well as certain negative sides. For example if a firm undertake debt to finance the business, it will help the owner to retain the ownership but it will result in regular payment of interest and the lenders are less interested in success of the company, so if the owner relay more on debt fund, it will enhance financial risk. On the other hand if capital is raised through equity, then large volume of fund can be raise for longer time period and the investors will be more interested in growth and success of the company but there will be loss of ownership as the equity share holders have the voting right to participate in decision making process. The good side of government grant is it neither results to loss of ownership nor it requires monthly payment of interests, but it is a highly competitive and available for limited sectors. The grant’s amount also has certain cut-off limits (Fleming, n.d.). Undertaking the advantages and disadvantages associated with equity and debt, the owner plans a capital structure. Rising capital from Equity and Bond markets Bond market is a good source of capital for large enterprises. It has been evident that in the large firms around 25 percent of the capital comes from corporate bonds. In the large firms, debt/equity ratio remain within the range of 0.76- 2.61 which varies from industry to industry. International debt market had its origin long back in the history, at present it is divided into three groups: Domestic bonds are issued by the local borrowers in the local currency. Foreign bonds are issued by the foreign borrower in the local market and in local currency. These are traded in under the local markets authority’s supervision. Eurobonds are underwritten by syndicate of multinational banks and these bonds do not trade in the local or specific national bond market. Initially these bonds were traded in Euro, but at present these are issued in all the major currencies and even in some minor currencies. Several types of bond instruments are being offered in the market with different interest rate and complex option clauses. These bonds can be categorised as follows: 1. Straight bond is also known as fixed income bond and it has a fixed interest rate which is payable at a fixed date. At maturity the principal is paid and the coupon rate is calculated as certain percentage of the issue price. 2. Partly paid bond is same as straight bond, but the only difference is, the investor have to pay a certain part of the capital (0 to 33percent) on the closing date, and the rest part of principal is payable after six months. 3. Zero-coupon bond is also same as straight bond but there is no fixed periodic payment of interest. The issuer issue it at a high discount and on the maturity date principal amount is paid. 4. Floating rate bond has a variable interest rate and the rates changes after regular period of time which can be 3 months, 6 months or 1 year. The coupon is basically the money market rate like LIBOR along with certain margins. 5. Perpetual floating rate bond are same as floating rate bonds but they does not have any fixed maturity date. Many a time these bonds are compared with equity. 6. Convertible bonds can be converted to other assets with a fixed conversion rate which was determined at the time of issue. Such bonds are issued when the interest rate is high and there exists an expectation that rates will fall soon. 7. Bonds with warrants are similar to convertible bonds, but these bonds have warrants that can be traded in the market. 8. Dual currency bonds are purchased in one currency but the interest or the maturity amount is paid in other currency. Such bonds are common in Japan. These bonds resemble common bond with a forward contact (Susmel, n.d., p. 1-10). With the changing market conditions, new debt instruments are coming up and companies are taking due care to manage their capital structure in the best possible way (Opler, 1995). Another common way to raise capital for the business is by issuing equity share in the equity market. Equity market is a highly volatile market, where the shares are traded. These reason for which company issues equity can be summarised as below: Low cost of capital for the firm Provide liquidity to the stock market Low financial risk Information regarding the company’s market position can be determined by its stock price movement (Simon University & Rochester, n.d.). The three main types of costs which are directly associated with issue of equity are transactional cost, market pricing cost and the equity cost of capital (NetTel, n.d.). For developing countries, the private source of capital is highly important. As the international portfolio is diversifying itself, more and more foreign investment is entering in these developing nations. This will help the local companies to perform better in the stock market (Woepking, n.d.). Capital asset pricing model (CAPM) and cost of capital Different companies follows different Debt/Equity ratio for their capital structure. A firm which relies more on the debt funds (like bond) has higher financial leverage and it is considered more risky because increase in the financial leverage leads to high risk and return and Earning per Share (EPS) also increases. Both equity and debt has its own cost of capital, so using appropriate method. a form individually find-out the cost of each element. For example cost of Equity can be determined by Miller and Modigliani (M & M) model. So the cost of equity can be calculated as: Re = Ra + (Ra - Rd) × (D/E) {Where Re is cost of equity, Ra is weighted average cost of capital (WACC), Rd is cost of debt and D/E is debt-equity ratio}. Capital Assets Pricing Model (CAPM) explains the relationship between risk and expected return on an asset while setting the price of a risky asset. It is generally expressed as- ra = rf + βa (rm – rf) {Where ra is the expected rate of return, rf is the risk free rate of return, βa is beta of the security and rm is the expected market return} (Investopedia, 2009). As per the CAPM model, β (beta) is the risk which the investor adds to ones market portfolio. β can be calculated with the help of regression of the historical return of an investment against the market index. β = Cov(stock, market)/σ2 {Where Cov = Covariance between stock return and market return and σ2 is the market risk}. Hence β represent the sensitivity of the stock in response to movement of market index (New York University, n.d. p.3). This model is often used for determining the cost of equity capital. This model assumes that two types of risks remain associated with any security or portfolio; these are systematic risk which is also known as market risk. This risk is common to all the securities and it cannot be diversified. The other type of risk is unsystematic risk which can be diversifying and it is specific to a particular industry or a company (Hotvedt & Tedder, 1978). β of the portfolio is weighted average of all the assets’ β. When the portfolio is made up of only equity, it is called unlevering β and when both the elements are present, it is known as relevering β. When the portfolio is made up of only equity, β of asset is equal to β of equity, but when both equity and debt elements exist in the portfolio, β of equity has to be determined as follows: βequity = βassets + (βassets – βdebt) D/E Let’s take an example, the equity β of company X be 1.5 and the debt β is zero; D/E is 1:2 where as there is another company Y of almost same size and belonging to the same industry which has a plan to issue equity share for the first time, so its equity β can be determined by obtaining unlevering equity β of company X and then adjusting it with the proposed capital structure of company Y’s capital structure where D/E is 1:1. βassets = D/V × βdebt + E/V × βequity [V=Valuation of the company and it equals to equity + debt] = (1/3) × 0 + (2/3) × 1.5 = 1.0 So using this value, equity β for the company Y is calculates: βequity = βassets + (βassets – βdebt) D/E 1.0 + (1.0 - 0) (1/1) = 2.0 Thus the equity β value for company Y is 2.0 So from the above given example it can be concluded that equity share holders of company Y bear higher risk, hence they require higher risk premium. Therefore cost of equity is higher for the company Y. Cost of equity is the expected rate of return for the equity investors and cost of debt is the expectation of debt investors. For any company the total cost of capital is the weighted average of both cost of equity capital as well as the cost of debt (Pratt & Grabowski, 2008, P. 79-87). It has been found that other things remaining constant, changing the degree of financial leverage increases β of equity. If the firm is leveraged, it will yield higher income when the conditions are favourable, but due to fixed interest payment, income of the firm will be negatively affected when market conditions are unfavourable. Hence leverage enhances variance in the net income of the company and makes equity investment more risky. As debt component in the capital have a tax benefit, so undertaking this fact β of equity can be calculated as follows: βe = βu [1 + (1 - t) (D/E)] {Where βe is levered beta of equity; βu is unlevered beta of the firm; t is the corporate tax rate and D/E is debt-equity ratio}. As the D/E ration increases, beta of equity also increases and hence the expectation of the equity investor increases. It can be concluded that financial leverage multiplies the business risk of a firm. A company which has a stable business will be benefited if they take financial leverage under consideration but on the same way a company which has just started the business or have an unstable bunnies earning, might face problem by leveraging the capital. Effect of company’s capital structure on its cost of capital The cost of capital (weighted average cost of capital) is the expected rate of return of the investors and the company’s rate of return must be equal or higher than this rate. It is calculated as- WACC = re(E/V) + rd(D/V) {Where V=E+D= valuation of the firm; re = cost of equity; rd = cost of debt; E= equity and D=debt} So if the debt is high, it will reduce the WACC as re > rd but on the same time beta of the equity will be enhanced and expectation of equity investors will be go high; as a result the WACC will move up. Such financial leverage increases company’s systematic risk, so if the company want to reduce its cost of capital, it has to trade off between risk and return. If the market risk is high, a lower financial leverage should be taken whereas, if the market condition is stable and systematic risk is lower, company can go for higher financial leverage. Thus after undertaking all the factors, a company should plan its capital structure. Reference Coles , H. M. 1981. International Securities Markets. Foreign Companies Raising Capital In The United States. Journal of Comparative Corporate Law and Securities Regulation 3 (1981) 300-319 102 North-Holland Publishing Company. [Pdf]. Available at: http://www.law.upenn.edu/journals/jil/articles/volume3/issue3/Coles3J.Comp.Corp.L.&Sec.Reg.300(1981).pdf [Accessed on November 01, 2009]. Fleming, S. No date. Raising Capital: Practical Tips for Entrepreneurs. Georgia Tech venture Lab. Available at: http://smartech.gatech.edu/bitstream/1853/15323/1/Fleming_RaisingCapital6.pdf [Accessed on November 01, 2009]. Hotvedt, E. J. & Tedder,L. P. July 1978. Systematic and Unsystematic Risk of Rates Of Return Associated With Selected Forest Products Companies. Southern journal of agricultural economics. [Pdf]. Available at: http://ageconsearch.umn.edu/bitstream/30276/1/10010135.pdf [Accessed on November 01, 2009]. Investopedia. 2009. Capital Asset Pricing Model – CAPM. [Online]. Available at: http://www.investopedia.com/terms/c/capm.asp [Accessed on November 01, 2009]. National Bank Share and Bond Trading. 2008. Capital Structure. [Online]. Available at: https://sharesandbonds.nationalbank.co.nz/education/edu_CMIcapitalstructure.aspx [Accessed on October 29, 2009]. NetTel. No date. Session 1: Equity Finance. Chapter: 11: Module 2.2: Financing Sources for ICTs. Financial Analysis revised. [Online]. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page30.htm [Accessed on November 01, 2009]. New York University. No date. Chapter 8: Estimating Risk Parameters and Costs of Financing. [pdf]. Available at: http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch8.pdf [Accessed on November 02, 2009]. Opler, T. April 1995. Changing Patterns Of Business Financing. [Online]. Available at: http://fisher.osu.edu/fin/resources_education/credit.htm [Accessed on November 01, 2009]. Oregon State University. June 2006. Capital Structure (Ch. 12) [Ppt]. Available at: http://classes.bus.oregonstate.edu/spring-06/ba340/Mathew/Power%20Point%20Slides/Chapter12.ppt [Accessed on November 01, 2009]. Pratt, P. S. & Grabowski, J. R. 2008. Cost of capital: applications and examples. 3rd ed. John Wiley and Sons. Simon University & Rochester. No date. Why Issue Public Equity? Corp Finl Policy & Control. [Pdf]. Available at: http://www.simon.rochester.edu/fac/Schwert/f423ipo.pdf [Accessed on November 01, 2009]. Susmel, R. No date. Introduction to International Bond Markets. Chapter XII: International Bond Markets. [Pdf]. Available at: http://www.bauer.uh.edu/rsusmel/7386/ln12.pdf [Accessed on November 01, 2009]. Woepking, J. No date. Private Capital Became Very Important to Development in the Late 1990s. International Capital Markets & Their Importance. University of OWA Centre for International Finance and development. [Online]. Available at: http://www.uiowa.edu/ifdebook/ebook2/contents/part3-II.shtml [Accessed on November 01, 2009]. 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