Capital Structure and Financial Crisis - Coursework Example

INTERNATIONAL FINANCIAL STRATEGY s s School`s of School`s Capital Structure and Financial Crisis This paper analysis literature review to identify the key determinants of capital structures since the global financial crisis. There are varied literatures on the recession. However, each studies the recession from a different perspective of the other. From the covered literature, none of the materials provide a research done on how to firms can sail through the financial crisis (Powell, Nilipornkul, and Allen, 2013). Financial crisis begun in the USA, spread to Europe and the rest of the world. In the year 2007 to 2009, a deadly financial crisis hit the world (Jones, n.d.). Recession hit several countries such as UK, Spain, USA and Ireland, where the first experiences included raising expenses emanating from the housing. Economists, journalists, and other bodies like countries governments interpreted the recession widely (Munyo, n.d). According to Fosberg (n.d.), the financial crisis originated from subprime mortgage loans, and debts. These types of finances backed other financial elements deterioration. It extended their problems to other sectors. For example, Bear Stearns announced the initial indicator of financial crisis; two of their subprime hedge funds have translated into worthless assets in a short time (Leeuwen, 2011). Moreover, there was collapsing of the financial market in the USA when the auctioning rates collapsed in 2008. Buyers who failed to bid for securities in the market characterized it. According to Fosberg (n.d.), recession is a significant decline of economic action occurs in a period ranging from months to years. From the European Commission, there is no specific definition of the term economic activities (Smith, and mendoza, 2011). Instead, the European Commission is comparing the economy movers’ factors such as Gross Domestic Product (GDP), and Production and Income of the country as per its GDP. This explains the identification of an economy headed to recession (Grenville, 1999). Merrouche and Nier defines recession as a phase of business cycle whereby the overall output in the economic actions like income and employment declines for a period extended for more than 6 months (Munyo, n.d). The financial crisis constricts the business activity and the GDP reduces leading to lowering of the employment chances. Moreover, recessions occur when there is a decline in the state of Gross Net Product for more than half a year. Their definition and mentioning of the measures of the economic crisis is wider than just GDP (Zarebski, and Dimovski, 2012). The occurrence of the financial crisis had several negative impacts on the financial market. For instance, there was a reduction of securities issued by the firm such as the lending organizations (Powell, Nilipornkul, and Allen, 2013). Moreover, the world experienced various effects of the financial structure such as disrupted financial markets, the debt and the equity capital for company expenditure reduced, and severe recession in many countries. In addition, economic recession marked a significant change in the way people spend their income in terms of the pattern and habits followed when spending. The main problem required comprehending and anticipation of the expected new environment with an understanding of consumers’ attitudes and needs (Zarebski, Paul and Dimovski, Bill 2012 percentage). Moreover, the same year was characterized by rising of credits as many of the investment firms that used short term loans to fund their projects were having difficulties tapping the resource for their firm`s growth (Schwellnus, Goujard, and Ahrend, 2012). Before recession, early 2007, the USA was experiencing a growth GDP rate of 3 percent and the rate of unemployment was significantly lower than the current trends. However, indicators outlined that the housing cost fell sharply, at a rate of 9 percent. The credit card companies were reducing by refusing new applications (Allen, 2001). This made the consumers in the USA to feel the ground they stood on cracking up as some business lost their credit cards in most parts of the country (Claessens, Djankov and Klapper, 2002). Besides, some financial institutions were changing higher than the Federal Reserve (FED), which was pushing hard to lower the interest rates charged (Beck, Demirguc-Kunt and Maksimovic, 2002). The rates of unemployment started to move up and by the end of 2007, the USA economy was fully threatened by a financial downturn other businesses went out of the market (Fosberg, n.d.). This worsened the bad situation. As the financial news flew through the country, the consumers lost their confidence. The results of world and America`s recessions were everywhere on the American`s news (Schwellnus, Goujard, and Ahrend, 2012). To analyze the recession period, one can say that the stock market were at their peak in the October 2007. Afterwards, their trends shifted towards a downward turn (Nesadurai, 2000). This resulted to decline of GDP, reducing of the house pricing and many people losing their employment by the end of the year 2008 (Schwellnus, Goujard, and Ahrend, 2012). Therefore, the consequence of the recession was a significant drop of the household spends and almost 6 percent of the USA families reduced their family’s wealth. Many factories paused and slowed their rates of production as workers lost their jobs. Some banks were bankrupt; others corporation downsized and most consumers retained their cash instead of spending it. Financial Structures that Reduces the Financial Fragility As confirmed by new empirical analysis covering the OECD and emerging economies in the past four decades, the structures that exposes the country to external liabilities, nature and how they are integrated, determines the country`s financial liability in case the financial crisis appears (Munyo, n.d). Some of those factors include bias in the gross external liabilities towards raising the crisis risk. Moreover, it is increased by the country`s currency mismatch increase in the country currency against the other country`s domination liability cost when compared to the assets the country hold against other countries` currencies domination (Schwellnus, Goujard, and Ahrend, 2012). Other factors that have been noted to be contributing to the risks of the financial crisis is the international banking and the use of cross border lending for short term (Zarebski and Dimovski, 2012). Lastly, the taxing systems that encourages debt in finances more than the equity finances to an extent of undercutting the financial steadiness through raising the share of debt, both internal and external debt in the corporate finances (Fosberg, n.d.). This vulnerability to financial stability is minimized by an increase in the global liquidity and these tasks the central banks of many countries the role of ensuring there is enough international liquidity especially during the financial difficulties (Bank Negara Malaysia, 1998). Moreover, implementation of structural policies is noted to increase the stability of finances as they reduce the negative effect of the composition on financial account and the providence of covers on the contagion-induced financial shocks (Powell, Nilipornkul, and Allen, 2013). Lowering of distant barriers on the foreign direct investment and lowering of the market regulation on the product changes from leaning on the external liabilities from debt towards FDI (Demirguc-Kunt, and Maksimovic, 2002). Another factor that reduces the external liabilities is increasing the control of the targeted capital flow associated with the debt. Lastly, observing strict measure on disclosure of information on the capital requirement and creating powerful authorities to supervise minimizes the nation`s financial crisis risks. Organic Versus Merger Growth The organic of a business occurs in business when the firm grows its business through investing its own resources and assets. This therefore means that the company has to grow without merging with others, acquiring, or taking over. Mostly, investors and executives of firms recommend their firms to undergo organic growth considering the long term and solid commitment expected from them to grow the company to higher levels. Moreover, the organic growth can be used to describe a negative growth to a business, the business assists, and resource contracts (Zarebski, Paul and Dimovski, Bill 2012). Finally, many investors inquire about the business organic values to determine whether to invest in the business as they give actual figures of the business internal force of growing alone for the long term. Significance of Organic Business Growth According to Reuters, after recession and the company are recovering from the financial problems, many companies are engaging in acquisition, takeovers, privatisation, and disinvestment. The management thinks they will strengthen their financial position through this method (Buckley and Casson, 2007). However, the need to compare the advantages and disadvantages associated with the acquisition and organic growths of the firm. There are advantages and disadvantages emerging in the areas of market shares, efficiency, working conditions, taxes and the combined companies. The business will acquire new staff leading to extra skills, knowledge of the business operational sector and other intelligences related to the organisation. For example, a Rosneft Company has efficient and effective management and process system proves useful to acquire to a business wanting to upgrade its management. Therefore, it acquires TNK-BP holding Company. As a result, the business chosen for acquisition is usually weak in the area the business merging it is weak. Funds and other valuable assets are accessed easily through purchase other than new development. This facilitates better production and distribution services at lower prices than the prices dictated by new ones. For instance, a French equity private firm, Adrian experienced increased profit after merging with two firms in Europe through utilising the resources offered by the other firms. In most cases, the acquiring firm searches for the business that has used little funds and resources and the selling price of the business is low. Moreover, when a business is under-performing, it is wise to acquire other than concentrating on the internal development. For the case of Adrian, a middle size firm with exposures to international market merges with foreign campaigns from Europe, which are rich in assets. Acquisition increases the customer base and the market share of the business. For instance, the Bank Rossiya requests to purchase more than 50% percent of the Russia’s Telecom operator. Besides, the state controlled VTB banks had taken the full control of Nordic Telecom Company (Reuters, 2013). The targeted company also acquires new firm`s channel and market that will be exploited by the business to enhance more customer`s reach. It also brings about the diversification of resources utilisation, output, and the long term expectations from the business (Nesadurai, 2000). For instance, when the Britain`s Royal Mail sells its 60 percent share, its total valuing will increase, share prices will improve and the company will have acquired enough resources for expansion and modernisation of its operations (Reuters, 2013). The new target business have new resources, output and prospects that when incorporated with the newly acquired market they leads to great diversification in production, channels of distribution, and long term prospects. Besides, it reduces the cost and overheads through marketing the shareholder`s budget (Davidsson, Achtenhagen, and Naldi, 2006). To illustrate, the American Pacific Corp shares improved by 11 percent after the company considered to sell. The new owners rise to factors such as hiring of experts to learn the company attribute the (Reuters, 2013). As a result, acquisition improves the purchasing power and minimizes the cost. It also lower the competition through absorption of new intellectuals’ product and services is easy. Lastly, it facilitates the organic growth as businesses in the same economic region pulls resources together to attain a developmental goal. For instance, the relationship between the Hungary and Croatia countries is tensed and it is recommended that the Croatia investors consider buying the Peer INA as a way of recovering the sour relationship (Reuters, 2013). They also reduce the cost of resources, duplication of services and goods offered and this increases the overall revenue. Disadvantages There are various advantages associated with organic business growth. For instance, sometimes the organic business growth is cheaper than the acquisition (Claessens, and Klapper, 2002). Acquisition occurs when another business buys or is involved in a contract with another business to attain a given goal. The business therefore pays premium for buying the new business. This exposes the finances used to buy another firm at risk and this may end up wiping out the investor cash instead of increasing the worth of the investor`s cash. The cost of purchasing a new firm is high. Hence, the firm may have inadequate capital required to purchase the stated company and the cash can never be put into other investment goals. In case the company borrows funds to make a purchase, it levels of debt increases. Additionally, the use of organic growth helps determine how the association is well run by the management of the company by utilizing the internal powers of the company to improve the output, profit and sales. Organic growth disqualifies the use of mergers and acquisition in their calculation despite of their positive boost in terms of the company’s growth through the provision of new market, services and technology to increase output of sales and revenues. This is because they cloud the real picture of the company. Once the executives and investors focus on the organic growth, they view the real picture of how the company is meeting its goals by internal means. The organic growth of the business also affects the workforce. Many executive and investors prefer growing their investment organically on considering the complexities and challenges facing them when running the organization. For instance, when two companies are merged, it merges two company`s workforce. Workers from each company had different cultures and moral beliefs. This crushes the two companies` cultures and causes conflicts among the workers of the two merged firms. Besides, it makes employees to refuse the changes in the line command and the workflow procedures as after merging they must change. These bring in high turnover of the employee leading to unstable organization and extra cost of training employees who are constantly leaving the company. Disadvantages The growth of the company in organic ways is capital-intensive process, time demanding, and high managerial resource allocations. The equipments needed for establishing a new expansion, hiring labor, and establishment of sales conduits. At most, the company employs mergers and takeovers to gain the services of a fully developed business unit instead of reinventing the wheel. Besides, the organic growth is a way of placing the business resources at risk. However, use of mergers and takeovers reserves the company`s resources, which would otherwise be used to acquire new business unit (Barney, 1991). The acquisition is a good way of sharing a significant amount of risk between the core company and the newly added company. In conclusion, the organic growth of a business consumes a lot of time. The time needed to build the necessary infrastructures for the new business, hiring, recruiting human capital, and buying technology (Barney, 1988). In case the business is risky, the owners of the company will bear the loss alone. Hedging Payment or Receipt The forward market hedging will involve drawing profit through prediction of the contract earlier before buying and selling of goods in the future. On the other hand, the money market hedge will include exchanges between single currency and another at the same time in the future as a way of hedging the transaction exposures (John, 2000). Mostly, the money market is strategies for locking a specific variable that is linked with the exchanges in the foreign cash and the cash equivalent. Their movements facilitate management of the volatility but they do so as they are faced with significant disadvantages and risks. The disadvantages include their complication, disclosure practices, and inflexible categories. Other disadvantages include employment of the hedging strategies and the incapacity of participating in the constructive drifts of the financial market (John, 2000). The forward contract features agreement of paying as for the delivery of a commodity, the delivery process, and the minimum quality acceptable (Cassar, and, 2003). The difference between the forward and the future contracts comprises that futures are exchanges that have been traded and the broker is significant for the deal to be completed but the forward contracts are simple agreements (John, 2000). They have a one-day settlement date when they will be paid, however, the future is settled daily. The main strategies behind forward contract are to hedge and minimize the risks or uncertainties (Cassar, and, 2003). For instance, for the farming, the involved parties reduce the risk through guaranteeing the prices. For instance, grocers Mary and Martha farmer reduce their chances of price changes and they engage in contracts signing with indication of the date and the condition of delivering goods. The commodity seller and manufacture determines the products day`s price against the spot price. For instance, if Martha and Mary signs a contract at $2.5 per 50-kilogram bag of vegetables and the vegetable prices reduce to $2.0 at the time of delivery, Martha is happy about the contract. The effect of the forward contract is stabilizing the market through determining the quantity of risk (Cassar, and, 2003). Once the risk is minimized, it boosts production and boosts the trade. For instance, a company transporting goods to another country may predict that the country`s currency is going to lower in the next month. To hedge against this, it may engage the currency-exchanging firm into contract today (Abraham and Patrice, 2005). Besides, for the contract, it works when parties honour the contract and send transparent information (John, 2000). For the forward contract to work as stipulated, the policies need to be transparent. For example, the government may heavily subsidize manufacture of ethanol through maize corn and this will lead to lowering of the corn prices Unhedged Currency Movements The below are currency risk that may arise from the likelihood of defaults in the setting of advanced currency volatility (John, 2000). The unhedged financial movement occurs between currencies of two countries. It occurs when the country`s foreign rates of interest are higher than the borrowing that country and will never get lower. For instance, it may happen between the Australia and the USA. The USA has lower interest rates than the Australia. It also has maintained it that way. As a result, borrowing from USA to Australia will be borrowing unhedged funds (Cassar, and, 2003). The USA may borrow currency from the USA and invest it. The world of unhedged currencies in their profit is higher than the hedged but they are more risky. Example of Transaction that Easy Jet Might Hedge Easy Jet is a company Importing spares of small jets from the USA. The Easy Jet Company is situated in the Australia. It specializes in importing airplane parts and assembling them. The company imports parts once in four months time. Three month before importing another set of parts, the financial analyst realizes that the price of the spare part will increase considering the change in the management and acquisition of the firm manufacturing the spare parts by another firm. The management realizes that the rise in price will bring losses to him, as more will be charged to the company (Keith, 1996). Moreover, due to inflation, the value of Austrian currency is to reduce against the USA dollar. Therefore, the company will lose more currency by paying extra Australian Dollar to meet the exchange rate value. The company will also lose money through increase prices of parts of airplanes. To avoid this and losses, the company may engage an institution dealing with foreign exchange in the USA and sign a contract with the present currency exchange rates. The company can also sign a contract with the company manufacturing airplane spare parts for a longer duration like half a year. The Australian Company is to pay USA $ 300,000 to the USA firm one moth before importing. The USA interest rate is 8% and the interest rate for the Australia is 12% while the spot rate is considered to be 0.60A$/US$. Therefore, the present value of A$: 300,000(1+0.003) =A$291 262.14 Borrowed amount is (291 262.14*0.60) USA$ 174 757.28. Then, convert this to a spot rate of A$ 291 262.14 The firm can therefore use the Australian dollars to make a deposit of the Australian dollar expecting it to grow into $300, 000 in future of 3 months time. Else, they can pay {174 757.28(1+0.8/4)}USA$178 258.43, plus the interest for settling the USA loan. 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[Online] Available at < http://ideas.repec.org/p/red/sed011/235.html > Zarebski, Paul and Dimovski, Bill 2012, Determinants of capital structure of A-REITS and the global financial crisis, Pacific rim property research journal, vol. 18, no. 1, pp. 3-19 Read More