Spry plc is planning some large projects which believed great successful so long as they can raise the required funds. The budget of the projects amount to about £200 million and this large sum needs external funds, where the company must gain access to capital markets and considered either using long term debt or equity finance or both mixed to raise funds. This report has examined the risk and return of both equity and debt finance in addition to their costs and implications to capital structure of Spry plc.
Capital market is a financial market for long-term securities who offered a channel for large organisation to raise funds to support their operation. This function can be fulfilled in primary market for new issues of equity and debt. While, secondary markets are markets in which existing, already outstanding, securities are traded among investors. Investors sell their shares and bonds, or buy new ones to increase their portfolios through the information listed in London Stock Exchange (LSE) or Alternative investment market (AIM). LSE is the main UK market who offered the current value of debt and equity of listed companies with the requirement of minimum £700,000 of market capitalization and three years of fully audited financial statement. Secondary markets play a key role for corporate finance because by facilitating of selling and buying securities increase liquidity and hence raise fund for them. Due to the requirement of capital market, listed on certain stock exchange can indicate the quality of a company and hence increase the value to investors.
A desirable capital market is that achieving operational efficiency, allocation efficiency and price efficiency. Operation efficiency implies that the transaction cost should be as low as possible so that reduces the barrier to trading in capital market. When the prices of capital market securities fully and fairly reflect all information concerning past events that the market expects to occur in the future, the capital market achieves price efficiency. Through the medium of price efficiency, the funds go to the most profitable to the company and thus allocation efficiency. An efficient capital market is one in which stock process fully reflect available information. According to Fama E. (1970), Efficient Market Hypothesis (EMH) is the circumstances where the price of security fully and fairly reflects all available and relevant information. They are three forms of EMH which demonstrated the role of price information in stock market.
Weak Form Efficiency
In weak form efficiency, the security prices of this market reflect the past information only. It implies that a stock's price movement in the past is unrelated to its price movement in the future. Investors would expect a financial market to display because historical price information is the easiest kind of information about stock to acquire. If everyone foresees the profits simply by finding patterns in the stock price movement, the desired profits for issued company would disappear in the scramble.
Semi-strong Form Efficiency
A market is semi strong form efficiency when the prices reflect all publicly available information, including historical information. If the market is semi-strong efficiency form, the stock price would rise immediately upon the news release by issued company and thus investors would end up paying the higher price.
Strong Form Efficiency
If the price reflects all information, both public and private, the market is strong efficiency form. There is no secret in this type of market because of everyone knows about the stocks, even inside information. As soon as the insider trade on his or her information, the market would recognize what was happening, and the price would shoot up before he or she could buy any of the stock. Therefore, nobody consistently makes superior profits in type of market.
Apparently, an investor who uses the same information as the market cannot expect to earn abnormal returns. Conversely, the issued company whose wisely play the information of market price can reap many benefits from its issued debt and equity. Since timing to date the issue debt and equity is not critical because the market efficiency reflect correctly securities price, managers just need to focus on making the best investment decisions and effectively release information to the public.
Different sources of finance
Spry plc who seeking raise fund of £200million required consider either equity or debt capital depend on the risk and return of both finance. Basically, debt holders always more security because they have a contract specifying that their claims must be paid in full before the corporate can make payments to its equity holders. Another important is that payments to debt holders are generally viewed as a tax-deductible expense of the corporate, while the dividend on an equity instrument are viewed as a payout of profits and therefore not a tax-deductible expense.
Equity finance raised through sell the ordinary and preference share to investor who seeking a return from the security. Ordinary shareholder may be the new owners or the existing shareholders by the mean of rights issue. Through buying the ordinary share where listed in LSE, the shareholder take a sit in the company and have certain rights like attend general meetings or voting on the important matters of the company. While ordinary shareholders are the ultimate bearers of the risk associated with the business activities of the companies they own. Suppose the company facing liquidation, the company must pay debt, and then allocate the remaining profit as dividend to preference shareholder prior to ordinary shareholder. Since the ordinary shareholders bearing the highest risk, they expected higher return through capital gains and those dividends to be higher than other dividends payment. Rationally, ordinary share is acceptable to Spry plc who intend to issue new share because the shareholders take a little compensation in the event of liquidation.
Preference shares are recorded in the balance sheet as equity however different from common shares in giving the holder preferential rights to receive a share of annual profits. As outline that ordinary dividend will not be paid unless all the preference dividends and debt due have been paid in full. Thus, preference shareholders also bear the risk of deficit suppose the company has no enough cash to service all of its debt. This type of equity share has the feature of debt as its dividend is fixed at the time of sale which has maturity date much like a bond. Almost of preference share are cumulative, which mean that the unpaid dividends can be accumulate and must be paid before ordinary share and therefore a company cannot be forced into bankruptcy for not paying its preferred dividends. Listed company would choose to issue preference share as it has debt-like characteristics which can reduce the company's financial gearing on the order hand lower the risk of dilute ownership and control because preference shareholders have no right to vote or share in any decision of the company. Whatever, preference share as form of equity is not tax deductible and result in higher costs than debt capital. In practice, ordinary preference share always less attractive than debt to listed company because equity share is rather risky. Suppose the company play a bad performance in the stock market, ordinary preference shareholder who likely to suffer a deficit would sell their shares to a bidding company. Again, the dividends paid to shareholders regard as a payout of profits which are not a tax deductible expense would lead to high costs compare with dept.
A major source of external financing is debt capital, also called fixed-income investment, is contract restraining a promise to pay a future stream of cash to investors who hold the contract.(). The main different between debt and equity is that debt holders legally to be paid in full before the company can make the payment to its equity holders. In other word, the more debt have been issued the more risky to the issued company because they required paid in full to debt holders before their own returns in the events of liquidation. One important of debt capital is that payment to debt holders regard as tax-deductible expense of the company and thus lower the cost of debt. They are several types of debt to be issued in the LSE, such as long term loans and debentures.
As noted that Spry plc is seeking a large amount of £200 million and thus must issued long term debt finance where the schedule of repayment spends more than a year. Debentures and loan stock are long-term debt securities with a par value which is usually £100 in LSE while the market price determined by trading in the bond market. Companies issue debentures or loan stock with acknowledge that it would fully paid back to the buyers at maturity date, within fixed or floating interest rate. Bank loan is a major part of total amount of debt that companies take on although the interest paid to bank is expensive. While, issuing debentures signify that is an unsecured debt, whereas a bond is secured by the mortgage on the corporate property. Debenture holders have a claim on the property that remains after mortgage and collateral trusts are taken into account. This leaves the issued companies freely use their assets to do other investments to raise capital. Companies would like to issue convertible bond because the interest payment lower than ordinary bonds which may decrease the overall cost and gearing of capital. Others, the conversion of bonds in the correctly time of issuing are self-liquidating in that the issuing companies no require redeeming them with cash; in contrast, straight bonds need to be redeemed on maturity. However, if the convertible bonds are outstanding, gearing will increased and affects the overall risk profile of the company.
Cost of Capital
As a matter of course, Spry plc seeks to minimize the costs of different source of finance they used to raise funds and try to mix the combination of debt and equity capital to reach its optimal capital structure. Weight average cost of capital (WACC) is a calculation to be used as a discount rate in investment appraisal and as a benchmark for company performance. In other word, by taking a weighted average, Spry plc can see how much interest it has to pay for every pound it finances.( http://www.investopedia.com/terms/w/wacc.asp ) 1st January. The WACC equationis the cost of each capital component multiplied by its proportional weight and then summing:
Ke = cost of equity
Kd = cost of debt
E = market value of the firm's equity
D =market value of the firm's debt
C=corporate tax rate
Therefore, to calculate WACC, Spry plc requires find the weightings of each of the sources of finance. For equity capital, the formula of cost of different types of equity as below:
- Cost of Ordinary share,(Ke)
- Cost of Preference share,(Kps)
While, for cost of debts capital, the formulas are:
- Irredeemable bonds
- Redeemable bonds
Where I represent as annual interest payment, P is par value or face value, NPD is net proceeds from disposal(market price of bond), and n means the number of years to redemption.
Normally, almost company's cost of equity higher than the cost of debt because the cost of equity involves risk premium. Suppose Spry plc estimates the WACC of 14%, its means that the projects should be made that give a return higher than the WACC of 14%. In other words, the mix of capital structure which is bringing the lower WACC to Spry plc will be accepted.
A company's average cost of capital is a fundamental determinant of its market value, since its cost of capital is used as the discount rate in investment appraisal methods such as net present value (NPV) and internal rate of return (IRR). NPV is the different between the present value of future benefits and the present value of capital invested, discounted at a company's cost of capital. The higher cost of capital would lead to a lower NPV and is not recommended to Spry plc because the decision rule of project is to seek the positive NPV. While IRR is the cost of capital or required rate of return of an investment project which, when used to discount the cash flows of a project to reduces a NPV of zero. Usually, the rate of return of a project should not exceed the cost of capital of the company, therefore the lower cost of capital would adds value for Spry plc. The cost of capital of a company also relevant to the payback period which means the length of time required to recover the cost of an investment. For example, Spry plc's project for £ 400milliom yields cash inflow of £200 million in year 1, £200millionin year 2, and £250 million in year 3, assume the cost of capital is 10%. The payback period before discount of future cash flow is exactly 2 years, however, the discounted payback period is a little over 2 year because of 10% discount of cost of capital. (http://www.investopedia.com/terms/p/paybackperiod.asp ) 1Jan
Implications of cost of capital to capital structure
Managers should choose the capital structure that they believe will have the highest firm value because this capital structure will be the most beneficial to the company's shareholders. Generally, the lower WACC of company, the higher net present value of its future cash flows and therefore the higher its market value. Hence, the consideration of the combination of how many debt or equity should be issued is extremely important role that influence the WACC of Spry plc. They are several theories argued the existing of optimum capital mix structure.
This graft demonstrates that as company starts to replace expensive equity(Ke) with cheaper debt(Kd), WACC falls. As gearing increase due to rising financial risk and bankruptcy, Ke and Kd increase and thus offsetting the benefit of cheap debt. Optimal capital structure reached at the lowest WACC where is before the increase of Kd.
Miller and Modigliani I Theory
In Miller and Modigliani (1958) approach, capital markets are assumed to be perfect and there is no tax service or any tax efficiency occurred. The Kd and WACC are flat thus no optimal capital structure existed implied that the cost of debt is irrelevant to WACC. This theory is criticized since the no taxes requirement of debt finance is impossible in the real world.
Miller and Modigliani II Theory
Miller and Modigliani (1963) improve their model by recognizing the existence of taxation in their paper two. Due to the tax deductibility of interest payment, company would gears up by replacing equity to debt to add more values. When the company enjoys the tax efficiency of debt over than equity, the WACC would decrease when the gearing is increasing. This implies that optimal capital structure reached for 100 per cent dept finance.
Implications of cost of capital to capital structure
Most listed company would like to assess to debt capital because it is less risk relative to equity capital. Since the profits of the company is irrelevant to the payment to debt holders lower the risk, the company expected low return from debt finance. In addition to low risk, debt as tax deductible efficiently reduces the cost of capital. In contrary, cost of equity is rather higher because of tax inefficiency although the expected return is rather high. On the other hand, one of the features of ordinary share is that this share cannot buy back would lead to high risk of over taken. If the overall cost is high, a project cannot be assessed because of high gearing and therefore company would intend to replace equity finance to debt finance to reduce risk.
Conclusion and recommendation
In virtually, debt finance is more acceptable to Spry plc since the tax deductible beneficial the overall cost of capital relative to equity finance. The higher cost of equity would lead to high gearing and finally influence the value of shareholders of Spry plc. However, owing to the financial distress can be reduced but not eliminated, Spry plc will not finance entirely debt where selects debt-equity ratios would access to optimum capital structure. As a recommendation, in part of debt finance, Spry plc may issues some non-bank loans from syndicates of wealthy private investors and institutions, such as insurances companies, are less expensive than bank debt as a way to raise funds.