The Financial Market: Transforming Dramatically Post World War II - Essay Example

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). These days the large companies spend a lot of resources in deciding their optimal capital requirement (National Bank Share and Bond Trading, 2008). This assignment aims to explore how companies raise capital from the bond and equity markets. These include initial public offering, seasoned equity offering, and straight debt issues. Various finance literatures which explore the topics in-depth are looked into. Also, the importance of the capital asset pricing model for firms which want to evaluate their cost of capital, is explored in the next part. The link between CAPM, the required return on equity and the weighted average cost of capital is explored, with the help of various resources. What is the deference between financing from equity and bonds There are many ways for the companies to raise the capital, the most common way is from stock markets, in this way the investor will be part from this company and the benefits will be based on the company performance and the company success is important for the shareholder. Another option is from bonds markets, in this way the bond owner does not have the ownership in the company and the benefit not very important for the bondholders, also the bondholder does not care about company success (Young, A 2009). 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. Bonds investment tools provide flexible funding and appropriate for companies, and at this time business companies need many way for funding, because the business sector now is changeable (Fadak, T 2004). Buy and sell debt was one of the main reasons for the occurrence of the global financial crisis, because that we have to be careful (Almarshad, M 2009). In my opinion In this argument I agree with the first writer, because at this time the business sector has many challenges and we must provide appropriate solutions for problem especially the problem of funding. A. Raising capital from bond and equity markets 1. The initial public offering When a company is in need of capital, there are two options which will comprise the mix of its capital structure: one is debt, and the other is equity. If the company chooses to raise capital from equity financing, there are also various options. One of these options include raising capital from financial markets such as the stocks market either through seasoned offering or a new issue, most commonly known as the initial public offering (Lee, I et al. 1996). The initial public offering takes place when a company decides to issue stocks that is available for the public's investors (Strategies for raising equity capital, 2003). The company employs underwriters-investment banks that first buy the securities from the issuing corporation and re-selling it to the investors-at-large (Szewczyk, H. S. et al. 1991). Underwriters usually help the issuing company to prepare the prospectus, which is a document that describes the company as well as its prospects. A lot of practitioners as well as academicians regard IPOs as one of the most costly ways to raise equity capital. IPOs are required, by law to be registered in the Securities and Exchange Commissions (Gay, K 1999). The issuing company pays for administrative and legal fees, which are part of the IPO registration (Lee, H. W. et al. n.d). 2. Seasoned equity offerings If initial public offerings is for issuing company that does not have an existing issued stocks in the stocks market, seasoned equity offerings (SEOs) are stock issues for firm that is already publicly scheduled in the stocks market (Strategies for raising equity capital, 2003). If the firm that has already undergone an IPO wants to raise substantial capital again and it chooses to issue new equity in order to finance it, that is called seasoned equity offering (Butler, W.A. et al. 2005). Seasoned equity offerings come in different variations as regards the terms of the offer for instance offering the stocks at investors-at-large or through a rights offerings, under the rights offering, the firm can issue rights to the purchasing the new shares to recipient investors on a proportionate basis (Weller 1961). If the IPO is already considered expensive, SEO also has some shortcomings. For one, after an SEO, it is very usual that the stock price of the company gets lower because of the increase in price. There is a period of time before the price of the stocks will incorporate the information about the company, and this information will be reflected to the stock price (Lang, M. H. 2008). 3. Straight debt issues The company can raise capital from equity financing, and the other hand the firm can choose to employ debt financing through bond issues, when bank overdrafts and long-term loans are no longer the firm's options, the company can raise capital through debt issues, the difference between this and the equity issue is the financial instrument that is being sold, when bonds are bought by bondholders, they will not be part owner of the company, instead of that they will be creditors to the firm (Bharath 2005). The issues of debt undergo the same process to the issues of equity (Szewczyk, H. S. et al. 1991). B. Relevance of the capital asset pricing model (CAPM) to a company seeking to evaluate its 'cost of capital'. The capital asset pricing model (CAPM): evaluation of risk and return, and required return on equity, cost of capital and the (CAPM) valuation. CAPM is significant to firms that look for to evaluate their cost of capital because the link between the required return on equity and weighted average cost of capital of firms, the weighted average cost of capital for firms is comprised of the cost of utilising debt and the cost of utilising equity for a firms capital structure (Litzenberger, R. et al. 1980). Because the CAPM is commonly method which used in estimating a firms required return on equity, it is valuable for computing for the firms weighted average cost of capital (Treynor. J. L. 1993). Capital Assets Pricing Model (CAPM) explains the relationship between risk and expected return on an. It is generally expressed as ER = r + B ( ERm - r ) So the return on any stock can be viewed as being equal to the risk-free rate plus a risk premium, where the risk premium is given by B ( ERm - r ) - that is, by the beta of the stock and the expected excess return on the market (i.e. the equity risk premium) (Cuthbertson, K. et al. 2008). This model is often used for determining the cost of equity capital, also this model assumes that two kinds 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 kind of risk is unsystematic risk which can be diversifying and it is specific to a particular industry or a company (Hotvedt, E.J. et al. 1978). Cost of equity is the expected rate of return for the equity investors and cost of debt is the expectation of the 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, P.S. et al. 2008). Investors in form of companies or individually, whenever make investments, they always expect a return. This return is a combination of various factors, and it is called the required rate of return. The required rate of return includes compensations for various risks that investors might face. These would include risk of default which is called, in the financial terminology the Default Risk Premium (DRP) and also the risk of decrease in value of money (inflation). Another very important risk is measured by the beta. This is the relevant risk of an individual security in its contribution to the risk of a well diversified portfolio. In a simpler terminology it measures the movement in value of any security with the movement in price of the market as a whole. This factor can be a very important in establishing a portfolio (Daves, B 2007). We can understand the cost of capital as follows: Vfirm = Where n years is the assumed life of the firm and WACC uses the after-tax cost of debt, the value of the firm calculated the above equation is often to as the fair value, since it is your best estimate of what the firm is really worth, of course the markets value of the firm formed by the views of many market participants may be different from your personal estimate of fair value - but the implication of that need not concern us here, at the moment we just want to calculate fair value. The important note that if we can lower the WACC by changing the proportions of debt and equity finance, after that this will increase the value of the firm, also we are mainly concerned with valuing the whole firm, the issues discussed can also be applied to valuing a specific investment project of the firm (Cuthbertson, K et al. D 2008). Capital asset pricing model is very simple that it requires some assumptions in order for the analysis to be valid, when the market is assumed to be in a completely competitive state where information are available to everybody, and the people are rational investors who maximize their economic utility, CAPM is valid (McNulty et al. 2002), and that assumption of the perfect competition includes the assumption that buyers are small enough to influence the price of the securities in the market, so there is less imperfections and distortions in the market as regards the rates that are used for a model (Mullins 1982). CAPM has many advantages, but there some criticism for example, in estimating the beta of the firm's stocks is its reliance on historical data, since the stock market as well as the company cannot be predicted mainly on the basis of the historical performance, the risks that the beta represents does not include the risks that the future decisions of the firm's management will incur in relation to undertaking some projects (McNulty et al. 2002). Conclusion There are two types of financing the company can choose from when it decides to raise additional capital, these are equity and debt financing, each of these types has advantages and disadvantages, and any company, according to their investments, circumstances and objectives using one of these two types or both of them based on their targets. In this assignment we focused in the capital asset pricing model (CAPM) and the relationship between this model with returns and risks, also the impact for (CAPM) on cost of capital. In my opinion If the company able to obtain financing through bonds, that is butter for it, because the financing from bonds does not give the investors ownership on the company. And this will give the opportunity to achieve company goals in the long term, because the financiers does not have eligibility to vote in the company decisions, on the other hand in the case of financing of the equity the financiers able to vote in the company decisions, this causes antagonism in the opinion and make decision from people without experience. References: Almarshad, M. 2009. Alaswaq Alarabiah. Available at: http://www.alaswaq.net/views/2009/06/13/24718.html [Accessed on November 13, 2009]. Bharath, K. 2005. Going the debt route: raising cash through debt increasing in SA. Finance Week : 62-65. Business Source Premier, EBSCOhost (accessed November 4, 2009). Butler, W.A., Grullon, G and Weston, P.J. 2005. Stock Market Liquidity and the Cost of Issuing Equity. 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Available at: http://www.ehow.co.uk/facts_4761143_difference-between-stocks-bonds.htmlcr=1 [Accessed on November 13, 2009] Read More