How to Raise Capital - Essay Example

Introduction: It can be defined as the increase in the capital , that the company seek refuge to transfer or increase the value of assets that were used in their production, that is, whether it is a joint stock company will be set up new more shares by closed subscription, or through grants or through the sale on the open market to obtain additional funding to expand in their production, or to meet the expenses expected to be an emergency in the future, or even expansion strategy, and perhaps also an attempt to take advantage of the exceptional economic conditions may force them to increase the capital.(Shopokshi, 2006). Capital increase varies between companies, as some companies raise capital by issuing new shares and do not like bonds. Other companies, believe that the best way to invest is to buy their own shares back.(Tyson, 2008). Raising capital from bonds market: Big companies always look for the best ways to raise capital and could not have grown to its current size without the use of good roads and effective to increase the capital to help them in their strategies and plans for future expansion. Bonds are the best way to raise capital of large companies. Roughly about 25% of the capital comes through bonds. Companies get benefit greatly from the issuance of bonds because investors pay a lower interest rate than the rates of other types of borrowing. Also, because the interest paid on bonds is exempted from business taxes. Therefore, companies must make interest payments even if profits do not appear. If there is doubt from investors that the company does not have the capability to meet the obligations of interest, or it could refuse to buy bonds or that the demand for interest rate will be higher to compensate them for their increased risk. (U.S.Department, 2009). One of the most common methods of raising capital is through bonds , where we define bonds are loans made to governments and institutions by investors as the investor get a specific interest rate because he invests his money in good investment idea. In return, the borrower gets the money it needed, also the investor gets the original amount invested (the principal amount or value of the bond issue) and can issue bonds for a long period of up to 20 and 30 years. Bonds are classified according to their quality bonds or prospects for reimbursement. Bonds do not usually find the same attention, such as equity from investors and the media. Since the bonds offer many advantages better than stock. In addition, safety of bonds is over stocks and more confident. (Mohammed, 2005). There are many companies planning to raise their capital. For example, Lloyds Bank announced that it will raise the bank's capital to 7.5 billion pounds, through the exchange of bonds. (Glover, 2009). The bond market can be divided into three parts: Domestic bonds: Shall be handled through the local currency and it is issued by domestic borrowers. Foreign bonds: Shall be handled by the local currency and is also trading in the domestic market but issued from foreign borrower and always common on the comprehensive follow-up of power. Eurobonds: Eurobonds is underwriting by multinational banks and these bonds are not taken by the trading in all markets and specific national or local markets, these bonds are currently has role in the production of some of the major currencies and some small currencies. There are many types of bonds are offered in the market. These bonds can be dividing it as follows: Straight bonds: Can be called fixed-income securities as they have a fixed price and are paid on time. Bonds paid in part: These bonds the same straight bonds, but there is a difference that the investor must pay a certain portion of the capital from 0 to 33 on the closing date and paid the remaining of the capital after 6 months. Zero-coupon bond: These bonds also the same straight bonds, but the difference is that it does not have a fixed time for the payment of benefits, but there is a problem in high-value discounts and must pay the original amount at maturity. Floating rate bonds: this type of bond has a variable interest rate and rates of change are after a few months and up to one year. Perpetual bonds floating rate: These bonds the same floating bonds but have no maturity date and these bonds need a lot of time, compared with equity. Convertible bonds: These bonds as possible transferred to other assets with a fixed exchange rate at the same time the problem was identified, such as bonds issued by the interest rate is high and these rates may be reduced soon. Bonds with warrants: These bonds are very similar to convertible bonds but these bonds have warrants possible traded in the market. (Susmel. N.d., p. 1-10). Raise capital from equity: Raise capital in the large companies will be through issue equity of nominal value. Thereafter, transfer value of the equity issued from the reserve and added to the capital. For example, if the original number of equity in the company is million and the nominal value per share is 50 Pound, the capital will be 50 million pounds. Also if the company has reserves of 100 million pounds, the rights of shareholders will be equal to 150 million pounds is the sum of capital plus reserves. However, when the company double the capital it would be 2 million shares and the new capital will be 100 million pounds and the reserves will reduce to 50 million pounds. (Algohani, 2007). From the previous example it is clear that does not have any change in the company's position, where the rights of shareholders remained as 150 million pounds, but the change that happened is there was distribution for shareholders. As a result, has been an increase in the capital of the company and the value of reserves decreased by the same value. There are some ways to increase capital from equity: Issuance of preferred shares: Many large companies choose to issue preferred shares to raise capital, where the buyers of this equity are not exposed to great risk in the event of any interface company in financial difficulties. Selling Common equity: If the company in good financial position, they can raise capital through the issuance of common equity as some investment banks help companies in the issuance of such equity and give the companies agree to buy any equity issued at a specified price if the price is right for the public. Borrowing: Companies can raise capital by taking loans from banks or from any other lenders organisations to finance its expansion, and this method is common in the present time. Using profits: Companies can use profits to finance their expansion through retained earnings as the strategy for retaining earnings is different between companies. For example, electricity companies, water and public is about 50% of the profits to shareholders and the remaining percentage to be the work of the company's expansion. In small companies prefer to re-invest the majority of income in the company's expansion and the aim is to reward investors by rapidly rising share value.(U.S.Department, 2009). There are two opinions for raise capital from equity, where one financial expert from Emirates have reported that, if the goal of the capital increase is the increase in business expansion in the company, this belief is wrong because the process when there was no change in the company's financial position or cash flows increase and there was no change in the company's obligations. Since the company can expand even before the increase and that the reason is to stimulate the trading of shares. (Algohani, 2007). On the other hand, One of the top businessmen in Saudi Arabia reported that, his company have plan to invest in economic and industrial cities in Saudi Arabia and this requires a capital increase by approximately 50% of the company's shares for public subscription during the next year so the company can expand its construction and the ability to compete in local and regional market. (Almotawa, 2005). I believe that the first opinion is wrong because any company even if it have money, it cannot face competition in the market without a lot of liquidity, which comes through the capital increase. However, the second opinion said that the right way to expand the company's business also to be able to compete with foreign companies that have started to enter the Saudi market after the approval of the World Trade Organization is to increase the capital by selling percent of the equity through public underwritten. So, I fully tend to the second opinion. CAPM and cost of capital: Companies follow many methods to determine the equity rate and debt for their capital structure. Increases the capital of the company through a debt lead to increased risk in the company and also affect the rate of profits and return as the debt and equity has its own cost of capital. Capital Asset Pricing Model Explains the relationship between the expected returns on assets and risk as well as it determines the price of risky assets. There are seven steps to evaluate Capital Asset Pricing Model with cost of capital: Equity assessment - Be Assess the risk of free-market rate debt - RFdept Assess the corporate tax rate - tc Assess the expected return on the market - E(rm) and the SML slope for this case will be: [E(rm) - rfdebt (1-tc)] or assess risk of market = E(rm) - rfdebt and the SML slope for this case will be: [ + tc rfdept] Assess the cost of debt and calculate the WACC: Assess firm's of debt beta Be and use it to calculate the firm's asset beta Use the asset beta: Basset= 1-tc) and the WACC SML to assess the WACC : WACC = rfdebt (1-tc) + Basset [E(rm) - rfdept(1-tc)]. (http://finance.wharton.upenn.edu/benninga/fnce728/chap09.pdf)(How can I reference this website And put it in reference page also check the equations from this website and re-write all equations in this assignment in good style) B = Cov (stock - market) / 2 Cov= Covariance between stock return and market return and 2= market risk. So, B= response of stock to market movement. (New York University, n.d. p.3). This model is used to determine the cost of capital also assumes that there are two types of risks associated with closely linked to the security of any portfolio: The first type: these are the same risk, called market risk is the risk of each stock also it cannot be several types. The second type: Non-systemic risk that can diversify and be specific to the industry or particular company. (Hotvedt & Tedder, 1978). May be there is positive or negative effect for structure of company capital on cost of capital. For example, the cost of capital is considered as the expected rate of return for investors in the company and the rate of return should be higher than this rate or be equal. We can calculate this as follows: WACC = re (E/V) + rd (D/V) V=E+D= assess the company re= cost of stock rd= debt cost E= equity D= debt. It will decrease the WACC as re > rd even if the debt is high. But this leads to raise the expectations of investors. However, the WACC will go up and this financial leverage raises the systematic risk for companies. Therefore, if the company is arrangement to reduce the cost of capital for the trade-off between risk and return and the risk markets is high must take action to reduce the financial leverage as it is, if the condition is that the market is steady and organized, the risk will be less then the company can raise the financial leverage and this is after the availability of all the factors. Therefore, the company must develop a plan for its capital. Conclusion: To conclude it is very fair to say that the current trend is to raise capital through equity rather than through bonds. This conclusion is arrived at after extensive research and the research was primarily conducted on European companies. In Saudi Arabia the modern markets began about six months ago. The capital raised from equity is much better than the capital raised by binds, companies get into a partnership agreement with other big companies and this is how they make money through equity. Reverences: Algohani, A (2007). Raise Capital in stock market. Available at: http://www.nqeia.com/vb/showthread.phpt=51082 (accessed 13 Nov 2009). Tyson (2008). investing for dummies. 5th ed. Canada: Wiley publishing Inc. 71. Shopokshi, H (2006). Methods of raise capital. Available at: http://www.alarabiya.net/programs/2006/05/04/23440.html (accessed 9 Nov 2009). U.S. Department of State. How Corporations Raise Capital. Available at: http://economics.about.com/od/smallbigbusiness/a/corp_capital.htm (accessed 11 Nov 2009). Mohammed, H (2005). The definition of stock market. Availableat: http://www.alnwady.com/stock/archive/index.php/t-56157.html (accessed 11 Nov 2009). Glover, J (2009). Lloyds to Raise Capital Coco Securities, Stock (Update3). Available at: http://www.bloomberg.com/apps/newspid=20601102&sid=aoC.bktCZJ1o (accessed 14 Nov 2009). Susmel, R, No date. Introduction to international bonds market. Available at: http://www.bauer.uh.edu/rsusmel/7386/ln12.pdf (accessed 7 Nov 2009). Hotvedt, E. J. & Tedder,L. P. (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 10 Nov 2009). New York University. No date. Estimating Risk Parameters and Costs of Financing. Available at: http://pages.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch8.pdf (Accessed 10 Nov 2009). Almotawa, N (2005).Practical steps for stocks underwritten. Available at: http://www.aawsat.com/details.aspsection=6&issueno=9607&article=288652&feature (Accessed 15 Nov 2009). Read More