How Might the Recent World Credit Squeeze affect Corporate Financial Structure for Firms - Essay Example

Running Head: Credit Squeeze How Might the Recent World 'Credit Squeeze' affect Corporate Financial Structure for Firms in any One Country of Your Choice [Writer's Name] [Institute's Name] How Might the Recent World 'Credit Squeeze' affect Corporate Financial Structure for Firms in any One Country of Your Choice Corporate Finance - Introduction The term corporate finance refers to that field of finance dealing with the financial decisions, which corporations make. Sometimes it also refers to the tools which are used by the corporations in their decision-making. The basic objective of a corporate finance is to increase corporate value and reduce financial risks lurking on the firms. This equally maximizes the Return on Capital of the corporation. Thus the main concept in the study of corporate finance is to address the financial problems of all firms. The discipline here relates to addressing corporations' financial problems and their solutions can be divided into long-term and short-term decisions. The long-term decisions and techniques include the Capital Investment Decisions . These are the decisions about which investment is received by the projects weather to finance that investment with debt or equity and when; or whether to pay shareholders with the dividends. Whereas short-term decisions can be listed under the 'Working Capital Management heading. The Corporate Finance deals with current assets and current liabilities short-term balance with focus on inventories; managing cash and short-term borrowing. It must also be noted that Corporate Finance term is also related with investment banking. The service which an investment banker offers is to typically evaluate the investment projects so that investment decisions could easily be made by the bank. (Aswath, n.p., n.d.) What 'Corporate Finance' Implies in the UK There are various definitions given to corporate finance by countries around the world. For instance, corporate finance in the US is used to cover a much wider area for describing techniques, activities, and decisions, which deal with many features of a company's capital and finances. While in the UK, the term 'corporate finance' covering a comparatively smaller area, tends to attach itself with much increased capital transactions so as to create and develop larger businesses. Also in the UK corporate finance, is frequently associated with ownership change in a business, and to some extent connected to corporate transaction that is a potent cause of the development of a new equity structure i.e. a shareholder base, the connected issue of the exchange or purchase of debt or equity. The transactions that are covered are of the following types: Seed raising, and start-up or development of capital expansion. 1. The sale or acquisitions of private companies, the mergers & demergers. 2. Takeovers of public companies (mergers, demergers including both public & private deals). 3. subsidiaries or divisions - typically backed by private equity i.e. similar of companies or buy-in & buy-out management. 4. The issues of equity by firms, having the companies flotation on an established stock exchange so that the capital for development and restructure ownership is raised 5. Capital raising for the refinance and restructure of businesses through other forms of debt, equity, and related securities 6. The financing of joint ventures like, public as well as private partnerships; privatisations project finance, and infrastructure finance 7. The secondary equity issues, either through private placing or via further issues on a stock market. 8. Restructuring and raising debt, when particularly linked to the types of above listed transactions. (Shean, n.p., 2005) What is Credit Squeeze The term 'Squeeze' denotes a period of tight monetary policy; borrowing is tight due to high interest rates. The tight monetary policy, a term opposite of 'easy monetary policy ', is a policy of the central bank intended to curtail inflation by depleting the commercial bank reserves and resulting into money supply through the operations of open market. The three versions of the term 'squeeze' are: a) Short squeeze b) Long squeeze c) Credit squeeze Short Squeeze The condition of short squeeze, which is more commonly opposite of long squeeze, is the situation in which the stock price rises and the investors that have sold short rush to buy it in order to make up for their short position and that their losses could be reduced. When the stock price rises, more of the short sellers seem to be inclined to cover their positions. Long Squeeze The long squeeze condition is one in which investors who posses long positions drastically feel the need to sell into a falling market to cut their losses. This results into leading to a more decline in the Market Prices. Credit Squeeze For the purpose of controlling and fighting against inflation, government designs measures in order to limit the supply of credit in the economy by curbing the money-supply growth. The most glaring examples of Credit Squeeze are the: i. Restrictions against bank-lending and Credit Sales ii. Increasing the Interest Rates Thus, in a situation where there is insufficient money supply to meet demand in macroeconomics, the term Credit Squeeze is used to explain the efforts of a government to diminish economic activity by decreasing the supply of money. Therefore the measures taken by a government to reduce the money supply include rising of interest rates so as to make the borrowing more costly, thereby discouraging the lending of money by the banks. [Note: The term 'Market Price' applies to the last sale price of a Security on an exchange, or the ask prices over-the-counter and its current bid. These are dynamically determined prices by buyers and sellers in an open market, which is also called the Market Value. ] Credit Squeeze Affecting the Financial Structures of Firms in the UK In the ensuing paragraphs, we shall discuss issues relating to the Credit Squeeze that are currently affecting the corporate financial structure of the firms in the UK and how does it affect the global financial markets. With the drying up of easy lines of credit, we can visualize the already sufferings of both small businesses and individuals. A London-based market-maker RV Capital, who trades in the future markets, became the latest victim of the credit market chaos after having put itself into administration. According to Nick Wood, a partner at Grant Thornton, The RV Capital, which is an options market-maker on three exchanges, ran into acute difficulties of liquidity starting in August 2007. It was facing losses of 15m to 20m so far, he said. The losses at RV Capital originated from trades mainly in sterling interest rate futures and options said Mr Wood . "Their positions became very volatile starting in August and they have been trying to recover their long-term positions. They realised their calls for margin were increasing and they didn't have the liquidity to meet them. He added that they required a call for immediate halt. Chung, Joanna. (Joanna, n.p., 2007) Credit Squeeze Grows to Worst as Cost of Borrowing Hits New High The new intensity in the credit card crunch reached when the cost of borrowing money in markets in London hit a new high. This reach in the new high occurred despite the attempts of the Bank of England's and its pledge to keep the system cool by injecting more cash The bank's decision to increase cash was interpreted as a sign of markets that were still worried about the Bank's decision in so far as not to inject as much liquidity into the system, by way of cheap borrowing. Whereas, as against the rise in the sterling market, the Libor rates for euros and dollars have dropped considerably for the last three following days. Also the cost of increased wholesale borrowing comes at a rough time for the banks and firms in the UK, just because of the fact that nearly 70bn of short-term money market loans are due to mature until recent past. With the closure of inter-bank lending market, banks apprehend that they might have to finance the debts with their own reserves, which may cause enormous strain on their balance sheets. It is because of this that John Wraith of Royal Bank of Scotland warned of potential knock-on effects for the broader economy, since higher borrowing rates would then begin to be experienced by the businesses and consumers. (Conway et al, n.p.,n.d.) Credit Squeeze in form of 'Debt Spirals' Hit Consumers As Britons default on a record amount of personal loans and credit card debt, the high street banks are already preparing to write-off an unprecedented 6.6 billion loan. The rise in interest rates and high Council Tax and utility bills are ever playing havoc. The already strangled borrowers who could before find a new source of credit to tide them over are searching cut off supplies as banks are closely tightening their lending criteria. Lloyds TSB recently disclosed that its personal customers in Britain defaulted on 1.24 billion in 2006, including 740 million of personal loans and 490 million of credit-card debt. Lloyds also foretold that the write-offs were up by 16 per cent on 2005 and would continue to rise this year. Earlier Barclays also wrote off a record 1.7 billion because of bad debts in its UK retail division and in its Barclaycard operation in 2006, up by 36% on 2005. It is strongly hoped that HBOS, Royal Bank of Scotland and HSBC in the coming weeks are soon going to announce the write-offs of 1.24 billion, 1.35 billion and 943 million respectively because of defaulting customers. (Hosking, n.p., 2007) Banks Get Tough as Credit Squeeze Hits Contacts Building and banks societies have withdrawn around 40% of their mortgage deals in over the the past three months. The latest signs appearing, following the turmoil in the financial markets, are the lenders who are squeezing their loan offers in an attempt to recover lost profits. In different home loans totaling, 5,511 have been withdrawn since July 2007, since the time many banks and building societies have struggled to borrow money in the wholesale markets. This has increased their passed-on customer's costs by withdrawing their best deals or raising rates. According to a reputed statistician on UK Money famous websites, the fall in the number of products on offer is quickest in the sub-prime sector, as banks and building societies have forbidden home loans to people with poor credit histories. (Telegraph Mortgage Service (2007) References Beaney, Shean (2005). What is Corporate Finance. Retrieved on October 30, 2007; from: http://www.icaew.co.uk/index.cfmroute=122299 Damodaran, Aswath. (NY University) Corporate Finance. Retrieved on October 30, 2007; from: http://en.wikipedia.org/wiki/Corporate_finance Image 1: Damodaran, Aswath. (NY University) Corporate Finance.Retrieved on October 30, 2007; from: http://pages.stern.nyu.edu/adamodar/New_Home_Page/AppldCF/other/Image2.gif Investopedia: 'Basics of Corporate Structure'. Retrieved on October 30, 2007; from: http://www.investopedia.com/articles/basics/03/022803.asp Definition. Credit Squueze.Retrieved on October 30, 2007; from: http://www.investorwords.com/1213/credit_squeeze.html Definition. Squeeze. Retrieved on October 30, 2007; from: http://www.investorwords.com/4671/squeeze.html Definition. Tight Monetary Policy. Retrieved on October 30, 2007; from: http://www.investorwords.com/4974/tight_monetary_policy.html Short Squeeze. Retrieved on October 30, 2007; from: http://www.investorwords.com/4559/short_squeeze.html Long Squeeze. Retrieved on October 30, 2007; from: http://www.investorwords.com/2883/long_squeeze.html Market Price. Retrieved on October 30, 2007; from: http://www.investorwords.com/2984/market_prices.html Credit Squeeze. Retrieved on October 30, 2007; from: http://encyclopedia.farlex.com/credit+squeeze Credit Squeeze. Retrieved on October 30, 2007; from: http://creditsqueeze.co.uk/ Chung, Joanna. (London - 24 Oct 2007). Credit Squeeze hits RV Capital. Retrieved on October 31, 2007; from: http://www.ft.com/cms/s/0/959c05e4-8265-11dc-a5ae-0000779fd2ac.html Conway, Edmund. & Aldrick, Philip. Credit Squeeze Grows To Worst For 20 Years As Cost Of Borrowing Hits New High. (11/09/2007)Retrieved on October 30, 2007; from: http://www.telegraph.co.uk/money/main.jhtmlxml=/money/2007/09/11/cncredit111.xml Hosking, Patrick. (The Times 24 Feb. 2007)). Consumers Hit by Credit Squeeze as Debt Spirals.Retrieved on October 30, 2007; from: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article1431936.ece Definition: Credit Squeeze. Retrieved on October 30, 2007; from: http://dictionary.cambridge.org/define.aspkey=18170&dict=CALD Telegraph Mortgage Service. Banks Get Tough As Credit Squeeze Hits Contacts. (20/10/2007) Retrieved on October 30, 2007; from: http://www.telegraph.co.uk/money/main.jhtmlxml=/money/2007/10/20/cmcrunch20.xml Read More