Capital Structure and Sources of Funds - Essay Example

Name: Instructor: Course: Date: Capital Structure and Sources of Funds Areas of need that necessitate funding for a company include asset acquirement, investment opportunities and probably debt payments. It is, therefore, important for companies to source money for goal-achieving operations. So, there are different reasons for capital structure which maximizes stockholder wealth, as the aim of choosing between debt and equity. There are many sources of funds for companies but the assessment considers but just some of the most probable ways. Capital structure is an essential financial management tool for creation of shareholder value. Ehrhard (135) suggest that value of a business depends on the present value of all the future cash flows that current assets will generate. Companies implement use of restrained earnings, borrowing through debt instruments and issuing new shares as the three main financial exercises of obtaining funds. Capital structure is developed depending to define ways of raising funds from both external and internal sources. It closely relates to a company’s capital cost and is a generally a mix of the long- term sources of funds that the company uses (Khrawish & Khraiwesh 176). Long-Term Sources Equity Shares Also known as ordinary shares, they are usually issued by company owners and ordinarily have a nominal value not much more than $1. Conversely, it is important to note that a quoted company’s shares have a market value determined by other factors and has no relationship with the nominal value of those shares. Sourcing from equity shares has the condition that when the equity shares are issued for cash then the price has to be either equal to or more than the shares’ nominal value. In this form, the company owners, who are basically the shareholders, put funds into the company by paying for new issues of shares and through retained profits. This brings the feature of deferred ordinary shares which are the form that is only entitled to a dividend after a certain period or when the company makes profits above some set value. The second type is rights issues which are a way of raising new share funds by offering shares to existing shareholders. The company has to set a price that is low enough for the shareholders to accept it. The third is preference shares which have a fixed dividend percentage before ordinary shareholders get any dividend. Apart from raising more cash, a company may also issue shares to float its shares on a stock exchange or issues shares to another company’s shareholders to subsequently to take over. A company would choose this type of source because the aspect of simply retaining profits offers the vital simple low-cost source of finance. On the other hand, this method may not provide enough funds for major projects like company growth. Government Assistance This is a source that is only opted for which critical necessities in many cases. Most of government financial assistances to companies are direct forms of assistance such as cash grants. This type of fund sourcing is in line with the government’s policies of helping key, if not all, stakeholders to grow and develop the national economy. Much of financial assistance from the government to companies is seen in the high technology industries and areas experiencing towering levels of unemployment. Apart from direct assistances, the government is also a source of funds for companies through it department. These are economic development organization commissioned by the government to help both minority firms and bigger companies with access to markets, capital and contracts. An example of such is the business development corporation of Zimbabwe was a government institution commissioned to assist small business companies in Zimbabwe. Franchising This is a long-term source though, to some extent, it depends on the operation strategies of the franchisee. It is an alternative to raising extra funds for the growth of a company. It is mainly meant to expand businesses on less capital than what would be actually required. Under such arrangement, the franchisee pays a franchisor to use the franchisor’s trade mark or name for the right of operating a local business. The franchisor initially bears certain costs and will then charge the franchising fee to cover these set up costs. This type of funding source relies on the subsequent regular payments for an operating profit, which are percentages of the business turnover, by the franchisee. To the franchisor, franchising has the advantages of reducing capital outlay needed for business expansion. It also improves the image of the business, which motivates the franchisee to achieving good results. For the franchisee, it has the benefit of obtaining business ownership for consented number of years. Venture Capital This is a long-term source involves money that is put into business and has the risk of being lost if the business fails. For this reason, business plans are subjected to extremely rigorous and accurate review and in most cases, less than 20 per cent of proposed is accepted. Venture capital associates with investment of money for equity stake in return. It is usually opted for in a management buy-out, new business start-up or chief expansion schemes. Accordingly, most venture capitalists take active roles in supervising and managing their companies of investment. They also only focus their investments on particular business sectors and industries that are recognizable and with which they are satisfactorily familiar. The risks involved herein are clear and quite probable as they include losing the entire investment. This is the reason why investors are quite exacting and keen in ensuring that every plan and strategy works as expected. So in this case, it is a venture capital institution investing in a company by providing funds needed by the company. The company sourcing funds from a venture capitalist has to recognize that the venture capitalist will want equity stake, authentication that the company is doing well and a representative in the country. Short-Term Sources Trade Credit Generally, this form of source does not prepare the cash available but uses it to enable purchases with later payment. It relies on credit from other different companies as the suppliers of current assets. It a credit that the sourcing company gets from its own suppliers who set a period for payment of the goods given. In this, interest is not charged on the trade credits and period allowed for payment depend on the company location, product nature, supplier’s financial resources and the company’s competitiveness in the market. It is short term in the sense that in most cases it takes a month or more. Bank Loans and Lending Loans from banks have become the major, if not primary, source of debt financing because they provide both short- term and long-term financing. In addition, bank loans finance all asset needs such as real estate, equipment and machinery acquisition as well as the working capital. Even though bank lending is mainly a short-term source, it remains an important source of finance for companies. As a short-term source, it is in the form of short-term loans or overdrafts kept by the company within a limit that the lending bank sets. For these, an interest is charged at variable rates. The interest charged on the lent money is at set margin whose size depends on the credit standing and risks involved of the bank for the borrower. In contrast, long-term bank loans are availed more so for the purposes of property purchase and this scenario the loan take the form of a mortgage. Consequently, before authenticating a loan, the bank takes into consideration factors such as loan purpose, amount of loan, repayment mode and guarantee, loan duration and loan security. Leasing Leasing, also known as hiring, involves a company paying for the use of a product but not for absolute ownership. Leasing of an asset lasts for a period that is agreed upon by the two parties after which it returns to the owner. The company in need of funds has to identify a lessee who needs a particular asset. Companies opt for this since it van be cheaper to lease rather than to buy an equipment whose use may not last long. In this arrangement, the entity that leases has the responsibility of maintenance of the equipment. Payments for a lease are fixed and have no variable factors like interest rates. Conclusion Reasons for fund sourcing are determining factors as seen in the example of venture capital where the market value and status of the company matters a lot for the venture capitalists. It is evident, as per this assessment, that a company’s capital structure does not only work to identify credible sources of funds but also to minimize the overall capital cost for the company. The secret to successful financing depends on business strategies and plans but also greatly relies on making right choices for capital source. This is because the outcomes of the exercise will influence and impact the company for quite a long period. Creativity is a factor in this and requires thorough preparedness by the company before approaching investors and lenders. This comes from the assessment which considered the five major sources of funds for companies. The strategy for finance sourcing becomes the difference between successful dominance and failure of a company. Work Cited Ehrhardt, Michael. Corporate Finance: A Focused Approach. Stamford: Cengage Learning, 2013. Print. Khrawish, Husni. and Khraiwesh, Ali. “The Determinants of the Capital Structure: Evidence from Jordanian Industrial Companies.” Economics and Administration 24.1 (2010): 173-196. Print. Read More