Risks Associated by Sources of Finance in China - Term Paper Example

Risks associated by sources of finance in china Table of Contents Table of Contents 2 Executive summary 4 2.Introduction 5 3.Evaluation theories to the Chinese firms’ source of funds 6 4. Traditional theory 6 4.1 Advantages 6 4.2 Disadvantages 7 4.3 Traditional sources of fund available in china 7 5 The Modigliani & Miller Model 7 5.1 Advantages 8 5.2 Disadvantages 8 5.3 The effect of Modigliani & Miller to Sources of finance in china 8 6Perking order technique 9 6.1 Advantages 9 6.2 Disadvantages 9 6.3 Effects of perking order to the Chinese source of funding 10 7. Herding theory on source of financing 10 7.1 Advantages of herding 10 7.2 Disadvantages 11 7.3 Effects of herding in china 11 8 Effects of source of finance to the cost of capital 11 9.Conclusion 12 Bibliography 13 1. Executive summary Using various comprehensive analysis methods and some of the financial sources theories, this report investigates sources of finance from China and their effects both positive and negative to the international business. The report clarifies the contribution of funds to the general growth of global business industry. Financial scholars have discovered that, in order to exercise control on the integrity of Chinese funding to the international business, these institutions in china must be recognized as they play vital roles concerning the world economic growth and the business industry in general. Internal loans from Chinese firms are more effective to both the already developed and developing countries. For this reason, the Chinese government’s understands financing sources to be of high benefits to small firms within that country as well as across the china’s national borders. This report also uncover how the Chinese funding poses both positive and negative effects to the global economy especially on the firm sizes and finance and the growth domestic product of nations. By analyzing the global business advantage concerning the sources of funds from China, it is very clear that there is financial imbalanced especial to some of the developed countries who are perceived to be at the state of sustaining their economic balance. However, by optimizing global benefits achieved because of Chinese funding, most markets will be in a better position to promote debt funding or share division of market throughout the whole world 2. Introduction Despite the fact that sources of financing in china play tremendous role to the stabilization of internal business and international economy, their existence has brought several financial debates cross the whole world. With respect to this, there are two major views that support that these sources of funding have enabled most companies to enjoy recommendable return leading to the global recognition of China state. These views are the government support and the diversification of risks. Moreover, these sources of funds have also undergone criticism that their growth and stability relies on private sector and governance mechanism in contrary to the benefits they are perceived to enjoy throughout their period of existence. In contrast, there are several documented sources, which support Chinese sources of financing and their contribution to the global economic stability, as more industries in the international strata seems to enjoy higher economic growth (Arner 2007). In the previous 10 years, several corporations in china have experienced a transformational process brought about by both planed economy and market economy. Through this drastic transformation, most of the financing institutions have faced several risks due to improper planning on the structure of the organizational capital giving a leeway to financial crisis and economic mismanagement amongst the other issues. Several researches have since indicated that, prior identification of financial risks is more important to the development and performance of global enterprises. Moreover, the governance of such institutions shows there is a need for advanced planning and identification of financial advantage tool for risk analysis that, aid the decision-making process of managing firms in china. This strategy is perceived to be best financial and tactical strategy to the evaluation of local China’s companies and their relevance of gross profit analysis to the development in global arena (Qiang 2007, OECD 2005). 3. Evaluation theories to the Chinese firms’ source of funds According to Calomiris (2007), for every business both local and international, the source of financing is an essential element towards its sustainability. Therefore, in China the source of financing which is a specific means by which an organization raises fund have experienced asset back due to such risks. In this report, the risks are categorized both by their positive and negative aspects pertaining to how they affect the global economic stability. Just like in other countries, China’s enterprise sources of financing are classified as external, internal, direct, indirect equity and debt financing. This is why the traditional theory best illustrates the governing process in this process. According to this report, traditional source of funding in china gives conscience clarification either as internal and external sources. 4. Traditional theory Traditional theory simply entails the usually ordinary sources of finance available to the firms both locally and international. These are ways of funding that may not require an engagement of a third financier to the firm as the organization is able to generate is own funds through reduced capital, retained earnings or overdraft facilities (Brigham and Ehrhardt 2013). 4.1 Advantages The traditional sources of finance are believed to provide greater benefits to an organization for instance, there is no or minimal cost needed for the acquisition of such funds because, the business owner can simply make withdrawal from his account and use the funds to improve the business capital. In addition, such source helps the company to face unforeseen contingencies with little difficulties while stabilizing the dividends policies and this helps in harmonizing of the relationship between management and the business stakeholders. It also helps in the upgrade of in the future of the firm because the firm already has set funds to forge ahead to any aspect of modernization (Brigham and Ehrhardt 2013). 4.2 Disadvantages The major risk is that when the business invests its earning, there are high risks of losing the whole investment in case of a financial crunch. Moreover, in case of overcapitalization the company might lose dividend payments to its members. Besides, such sources are also seen as way of evading taxes and are prone of injection frustrations to the stakeholders (Brigham and Ehrhardt 2013). 4.3 Traditional sources of fund available in china Taking into account the internal sources of financing, China has limited number of companies that take part in stock exchange trade. These few listed companies enjoy huge profit margin of up to 70% of their invested capital (OLeary 2010). This forces small business organization to consider alternative source of funding such as advances received from customers. Local Chinese companies’ value advances from customers because it does not require business evaluation process and is often available within the reach of the stakeholders. Besides, they consider additional funding from other sources to improve the profit margin thorough an already existing capital. In addition, they also use short-term provisions such as trade credits and organization fixed deposits for a period less than one year (Du, J and Girma 2012). 5 The Modigliani & Miller Model According to Modigliani & Miller theory, it does not matter whatever the source of capital an organization uses to finance its operations, because the market value is often determined by the returns of the organization, risk management and capital settings for market securities such as bonds and dividends (Patterson 1995). 5.1 Advantages It uses the weighted average method (WACC) of determining the financing potential therefore, the organization who secures funds from such kind of sources are not associated by risks of taxes and the costs of transactions. This is due to the perception that weighted average cost of the company should remain constant despite a change in the company capital structure. It also maintains the borrowing cost at a cost between the borrower and the investor. Additionally, since there are no visible transitional benefits associated in the WACC, this theory articulates that, this avails similar information to both the investors and the company (Baker and Martin 2011). 5.2 Disadvantages This model makes it evaluation based on financial advantage of the firms because it is meant to improve the financial activities of the organization. Therefore, but it is being criticized for non-transparency and a subject of uncertainties. For instance, during the finical crunch it is very difficult to evaluate the amount of capital an organization can seek for especially from banks since it articulates a lot concerning the leverage ratios. The theory also illustrates that, organizations cannot misappropriate excess cash, which is untrue because, management are often known to spend excess cash after getting involved in risky financial investment in contrast to paying the stakeholders dividends from banks (Baker and Martin 2011). 5.3 The effect of Modigliani & Miller to Sources of finance in china Substituting this agreement in this report, China’s entrepreneurial source of financing is articulated by the derivative markets that constitute the cost of transactions, bankruptcy in case an organization is undergoing liquidity and the taxes levied by the concerned authorities. Taking into account these conditions, there are minimal benefits on the tax payments and this in turn derails the benefits that may be increased on borrowings. As such, most of the organizational capitals do not have impact to the stock exchange with little or no impact to the stock price. (Bishop et al 2010, Fung, Pei and Zhang 2006)). 6 Perking order technique The perking order theory illustrates that the cost of financing an institution is always at the increase with availability of systemic information. It narrows down an organizational source of funding into three main sources; internal funding, organizational equity and the debt funding. Most of the organization tends to prefer their own source of finance in contrast to debts and financial equities. This theory of financing is often under criticism because it is assumed that if the organization is overhauled then managers can seek undue advantage of over-evaluation (Cumming 2012). 6.1 Advantages While most of the financing structures are often static, perk order, theory target is the capital structure. This allows for dynamic approach in determining the source of financing. Besides, it empowers the firm’s capital structure as a positive investment opportunity since it incurs minimal cots during sourcing. This gives a lot of reward to the organization while offering sales regression to the equity ratio. In conclusion, it increases the capital ratio of the firm leading to an improvement in the financial slack. It also enhances financial stability of the firm while ensuring long-term profitability through laughing back of the profits (Perkins 2004). 6.2 Disadvantages This theory does not give clear illustration concerning the taxes, the costs of securities and the additional cost incurred when hiring additional agencies during the financial sourcing process. Moreover it does not clarify about the problem that might be incurred in case of a financial slack. Lastly, perking order theory does not indicate resultant returns associated by low security price hence considered as an alternative to the other sources (Perkins 2004). 6.3 Effects of perking order to the Chinese source of funding This report also realized that political perking order is posing some serious danger concerning the allocation of resources. The government of China allocates almost 80% of the funding to the public corporations in contrast to the amount given to the private companies. As such, most of the firms therefore engage in forming of joint venture to enjoy the economies of scale just as the state owned organizations, it can also be seen that some the private companies that seem highly competitive to the state owned firms always reduce their chances of funding. Consequently, firms that are located within the environment inhibited by state firms receive 70% potential of financial assistance in contrary to the firm, which are in far most regions (Poncet and Steingress 2009). 7. Herding theory on source of financing Herding theory simply entails investor’s mentality characterized by personal judgment in decision making thus causing people to have almost similar investment perception. For instance, an influence drawn by majority investment in securities or shares is perceived to be because of herding. It is an important tool in analyzing how investors decisions because it affects the economic returns by illustrating that, indecisive investment opportunities can easily cause a fall in prices subjecting the market price to much lower value than the fundamental value (Schindler 2007). 7.1 Advantages of herding Herding contributes to appositive social behavior in financing thus leading to investing in business considered lucrative with higher potential returns. This ensures maximum returns as evidenced from the other social group members. It also helps in sharing of risks especially where invertors face common unfavorable market conditions. For instance, banks faced by similar economic crisis may decide to seek for alternative investment in order to safeguard their interest. Moreover, herding is a vital aspect in diversifying of uncertainties of unknown values (Fiske and Markus 2012). 7.2 Disadvantages Herding has also been known to cause a number of problems concerning the source of finance. To start with, herding subjects deterioration concerning the lending standards in banks. Secondly, it causes a systemic risk by increasing the stock prices hence violating the market value. Besides, herding is considered irrational because it does not give room for alternative investment decision because it characterized by influence of the majority. Lastly, it is considered an impulse form of investment and it is susceptible to huge loss (Fiske and Markus 2012). 7.3 Effects of herding in china China face additional business financial risks attributed by the issues of capital budgeting. The report discovered that some of the organizations apply the use of cost of herding in determining the total rate of return in relation to the anticipated risks. While investments in China are said to encounter most of the predominant risks such the difference in exchange rate, the issue of politics and difference in cultural settings. This encourages investment along social line with an intention to share potential risks (Bruce 2010). 8 Effects of source of finance to the cost of capital One major problem that the repot discovered is that, there is some basic assumption concerning the cost of capital and the international organizational investments in china. Since the level of international investment is highly controlled by the state, their level of financing becomes minimal, such companies therefore receives returns in compensation for the risks as compared to the existing local state owned firms (Loechel 2010, Urio 2010). Source of financing in china also affects international organizational cost of capital because it alters the risk of firms’ investments (Shapiro 2009). For instance if the government of China allows international businesses to invest in the production of local products that have been left for the state owned firms then their risk on cost of capital shall have gone down. The empirical study in this report has also indicated that the cost of capital outperforms the domestic companies in China as compared to the international organizations as constituted by the behavior of stock returns (Paul 2009). 9. Conclusion Using comprehensive analysis, this report has investigated about then risks associated by various sources of financing institutions in china to the international business. The report has critically exposed how the government controls most of the corporation’s hence limiting private and international owned firms from receiving the higher amounts of finance. 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