As a senior financial manager, I understand that Spry plc have great opportunity for success in some large projects. Therefore, I suggest Spry plc a finance projects which cover amounts about £200 million to raise the necessary finance. There will be have limited cash for having reinvested profits in existing ventures while Spry plc are successful for the project. So, the differing sources of finance available such like the impact of the new finance on risk and the way it may influence the cost of capital markets are require for Spry plc to open the stock exchange either debt or a share issue to increase funds. Spry plc also need to understand the nature of the capital markets better to issue the probability shares and the theories of the efficient market hypothesis (EMH).
The Role and Importance of Capital Market
Medina, G.R. (1988) stated that capital markets are a part of the financial markets for long-term loanable funds transactions. Capital markets can define in two main functions which are primary markets and secondary markets. Primary markets are markets in which company raise capital by issuing new equity and debt. Secondary markets are the markets in which existing securities and other financial assets are deal among investors after they have been issued by company. Capital markets are very important for the companies because they provide a way to the companies to collect finance to operate their businesses. Any investor is willing to invest in the stock only if they have the option to liquidate and this is only provided through capital markets.
The Role and Importance of Efficient Market Hypothesis (EMH)
The efficient market hypothesis is concerned with setting and states the prices of capital market securities fully and fairly reflects all publicly available information on each security (Fama 1970). There are three common forms of this hypothesis.
The Three Forms of EMH
Weak form of the EMH
The weak form EMH asserts that the current stock prices reflect fully all the information contained in historical price movements. The technical analysis can be utilized to outperform the market and the market is impossible to make abnormal returns.
Semi-strong form of the EMH
The semi-strong from EMH asserts that the current stock prices reflect fully all publicly available information. There are no abnormal returns can be gained in a semi-strong from efficient market by using fundamental analysis or by studying public information about the stocks.
Strong form of the EMH
The strong form EMH asserts that the current stock prices reflect all information, whether it is public or private information. With this, there are no one can earn abnormal returns in the stock market, even if the investors consider a huge amount of research to achieve price gains.
Different Sources of Finance
The various sources of finance should be considering see whether are available to businesses. Due to each source have its own disadvantage and its own advantages, so different sources will be more suitable in different situation. Spry can determine the external finance whether debt or equity financing is more suitable to help them raise funds for their business. Broadly, the sources of finance available for any business are debt and equity.
Equity is defined as any financing method that is a residuary claim on the firm (Damodaran 2006). Equity finance is the base of the financial structure of a company and the source of most should be for long-term finance. The sale of ordinary shares to investors will raise equity finance.
Ordinary Share Capital
Ordinary share capital is financing which rose by a company through issuing new share and obtaining a stock market listing of the implications for a company. Ordinary shareholders are be given rights by ownership of ordinary on both an individual and a corporate basis. The shareholders are seldom exercise their power while the individual shareholders have influence over who manages a company and decision been express an opinion relating to their shares. The ultimate bearers of the risk associated with the business activities of the companies is ordinary shareholders. This is because orders of preference manage the distribution of the event of liquidation of a company going out of business. Ordinary shareholders expect the highest return in compensation while they carry the greatest risk of any of the providers of long-term finance. In terms of regular returns on capital, this means that ordinary shareholders expect the return they receive to be higher than either interest payments or preference dividends through capital gains and ordinary dividends.
Preference Shares Capital
Preference shares offer the holder a fixed rate of dividend, but there is no guarantee that an annual income will be received. They are part of shareholders' funds but are not equity share capital (Arnold 2008). The main advantages to firm of preference shares capital is dividend 'optional' means that preference dividends do not need to be paid if profits are low. The others advantages to firm of preference shares are influence over management, extraordinary profits and financial gearing considerations. Influence over management means that preference shares do not confer general voting rights and so will not dilute the influence of the ordinary shareholders on the firm's direction. Non-payment of preference dividends does not give preference shareholders the right to appoint a receiver, the ordinary shareholders receive all the extraordinary profits when the firm doing well. Financial gearing considerations stated that preference shares preserve debt capacity, since they are not secured. On the other hand, the disadvantage of preference shares to firm is high cost of capital. Preference shareholders need a higher level of return than debt holders because the higher risk attached to the annual returns and capital. Another disadvantage is the dividends are not tax deductible. This is because preference shares are regarded as part of shareholders' fund the dividend is regarded as to divert funds of profits. Before the deduction of the preference dividend, tax is payable on the firm's profit.
Debt is defined as any financing method that is a contractual claim on the company (Damodaran 2006). If the company is in financial trouble, borrowing creates a duty to make cash flow payments in operation and provides the lender with previous claim. Because of the lower rate of return required by finance providers, lower transaction costs of raising the funds and the tax deductibility of interest, so debt finance has a lower cost than equity finance.
Long Term Loan
Long-term loan which is a loan that not due to be repaid for at least one year (Glossary of Terms 2006). When a company is plan to "fund" its short-term debt, means that its securities of longer maturity has been replaced with short-term debt. Funding does not means that the financial manager need to places money with a trustee or the other repository; it just a simply part of the jargon of finance, and it means that the manager replaces short-term debt with long-lasting capital Pacific Gas & Electric Company (PG&E) give a good example of funding. PG&E has some construction program, and it's typically uses short-term debt to fund framework expenditures. Anyway, in case that while short-term debt built up to about £ 100 million, the company who want to sell a stock issue, and uses the proceeds to pay fund to its bank loans, and the cycle start again. There is a fixed cost which selling stocks to make its quite expensive to issue small amounts. Hence, the process PG&E used and these securities are quite logical. The advantage of a long-term loan is which can help the firm can borrow quite high sums of money and keep its monthly low repayments (Loan Advantages 1995). Otherwise, the disadvantage of a long-term loan is constituted a long-term financial agreement and firm have to considering the applying for a loan which will analyze its finances situation (Advantages & Disadvantages of a Personal Loan 2009).
Debenture is a not secured bond and it provides no lien against specific property as security for the duty (Brigham 1989). Interest paid is tax deductible, which reduces the cost of debt finance. Debenture holders are, therefore, general creditors whose claims are protected by property not otherwise mortgage. In practice, the use of debentures depends both on the nature of the firm's assets and on its general credit strength. The debenture can secured against the firm assets by a fixed or a floating charge. A large and strong company, such as, Spry plc will tend to use debentures because it simply does not need to put up property as security for its debt. Debentures are also issued by companies in industries in which it would not be practical to provide security through a pledge on fixed assets. Examples of such industries are the large mail-order house and commercial banks, which characteristically hold most of their assets in the form of inventory or loans, respectively, neither of which satisfactory security for a mortgage bond. The disadvantage for debenture is that it need repayment duty and fixed interest and, it will cause financial distress, and it imposes restrictions that can reduce the borrowing firm's operating flexibility (Chandra, P 2008).
Cost of Capital
The cost of capital is the rate of return that a firm has to offer finance suppliers to include them to buy and hold a financial security. The returns offered on alternative security with the same risk to determine this rate.
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital is the weighted average of the after-tax costs of each of the sources of capital used by a company to finance a project, where the weights reflect the total financing raised proportion from each source (Keown et al. 2006). A weighted average of the element preferred stock, costs of debt, and common equity. The target proportions of debt, preferred stock, and common equity, along with element costs of capital, are used to calculate the firm's weighted average cost of capital, WACC = ka. The weights can be base either on the accounting values to shown on the market values of the different securities or on the firm's balance sheet (book values). Theoretically, the weights can be based on market values, but if a firm's book value weights can be used as an alternate for market value weights. We shall assume that the firm's market values are approximately equal to its book values and then use book values capital structure weights.
Cost of Equity
The cost of equity, ke is the current market rate of return that investors require to invest in the equity of a company. All of the risk and return models need a risk-free rate and a risk premium (in the CAPM) or premiums ( in the APM and multifactor models). The cost of equity can be estimated using risk and return models- the CAPM, where risk is measured relative to a single market factor. On the other hand, the APM, the sensitivity to multiple unspecified economic factors is determining where the cost of equity; or a multifactor model, where sensitivity to macroeconomic variables is used to measure risks.
Cost of Debt
The cost of debt capital, kd, is the current market cost for a risk class of debt. The cost to the company is reduced to the extent that interest will take out from taxable profits. Many companies understand that and consider the cost of debt allow for the corporate tax rate to decrease the effective cost. All the companies are using the cost of long-term debt. The majority like to chose and base the cost of debt on the cost of government debt and either take this as the cost of debt or add a credit risk premium. There got companies which took the yield on their own outstanding bonds and the remainder chose a long-term bond yield 'based on experience'. 'We do not put in our real cost of debt. There are certain, for example tax driven, vehicles which give us actually quite a low cost of debt...so we tend to ignore those. That does build up a nice margin of safety within the target (cost of capital) of course'(Company C: Gregory and Rutterford, 1999, p.46).
Importance of Cost of Capital
The cost of capital is a critically important to maximize a company' value. The managers must to minimize the cost of all inputs, including capital. Beside to minimize the cost of capital, the managers must be also able to measure it. The financial managers got a lot of thing such like to bond refunding, related to leasing, and to work capital policy which require evaluate of the cost of capital. Financial managers require an estimate of the cost of capital to make correct capital budgeting decisions.
Capital structure is the balance of the company's capital which is equity or debt (Arnold 2008). Even the firm's capital structure is quite complicated, but we need to focus on three basic sources of capital such as bonds, common equity, and preferred stock. Target (optimal) capital structure means that the percentages of debt, preferred stock, and common equity that will maximize the price of the firm's stock (Brigham & Houston 2007). Each company has target (optimal) capital structure, which is that mix of debt, preferred stock, and common equity that will cause its stock price been maximized.
The Traditional Approach to Capital Structure
The proposition of the traditional approach to the optimal capital structure question was that an optimal capital structure did exist for individual companies. A company should therefore use the combination of debt and equity finance that minimises its overall cost of capital in order to maximise the wealth of its shareholders.
Miller & Modigliani (I): the net income approach
Miller and Modigliani (1958) present the first proposition that a company's WACC is constant at all levels of gearing, suggest that no optimal capital structure exists for a particular company. They argued that a company's market value depends on its commercial risk and expected performance; the market value of a company and its average cost of capital are therefore independent of its capital structure. The assumption at this stage is all taxes are been ignored and a perfect capital market is assumed. In a perfect capital market, the company in financial difficulty are always increase additional finance.
Miller &Modigliani (II): corporate tax
Later, in the second paper, Miller and Modigliani (1963) revised their earlier model by to take account of the tax implication of debt finance and argued that companies should gears up by replacing equity with debt and it will shields more and more of its profits from corporate tax. The tax advantage enjoyed by debt finance over equity finance implies that a company's WACC decreases as gearing increases and this suggests that the optimal capital structure for a corporate is 100 per cent finance.
Implications of Cost of Capital on Capital Structure
In the traditional approach to capital structure, the company's WACC will fall at beginning because of the benefit of the cheaper debt finance exceeding any increase in the cost of the company's remainder equity finance. Then, the WACC of the company curve will rise at an even faster rate at very high levels of gearing. Besides that, in the Miller and Modigliani (I), the company's WACC remains constant and significance that no optimal capital structure exists. In the Miller and Modigliani (II), when a company gears up its WACC curve now falls. To understand the impact of cost of capital on capital structure, please refer to the appendix 2, 3 & 4.
In conclusion, the source of finance ordinary share capital has been suggest to Spry plc because the ordinary shareholders can expect higher return they receive than either preference dividend or interest payments through ordinary dividends and capital gains. The other source of finance such as debentures also used by Spry plc due to it simply and no need to provide property as security for its debt. Spry plc also need the calculate of weighted average cost of capital (WACC) to show the investment of a firm minimum return and produce enough to satisfy the lenders. Refer to the appendix 1, and then we can see that WACC is 16%. If WACC is16%, the return of Spry plc investment need to over 16%, if the investment of Spry plc is under16%, then, the Spry plc will facing the risk and losses because WACC is cost of capital. The WACC is under traditional approach to capital structure for Spry plc. The traditional theory will increase the Spry plc's total value by advisable use the debt finance within its capital structure.
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