Difficulty in Raising Capital - Essay Example

? (Assignment) Corporate Finance Introduction Business firms generally find difficulty in raising capital for their further expansion. In the case of very big business projects, the founder alone cannot meet the firm’s initial capital requirements. Under such circumstances, companies issue shares of specific value to the general public with intent to raise capital for meeting business operation expenses. Share price refers to the price of a single share that company issues for subscription. While taking decision on share subscription, an investor compares the share price with company’s financial statements. If a company cannot raise an attractive surplus from its operation, it cannot fix a high price for its shares. It is observed that the market stature of a company has a direct impact on its share price. Every firm aims at maximizing its share value by improving profitability. Empirical evidences suggest that share prices may be affected by an array of factors. Share price is mainly categorized into two such as internal and external variables. This paper will explore how these factors affect share prices. Internal variables affecting share prices Internal variables are the strengths or weaknesses of a business which may largely affect the share prices more than any other factor. Profitability, leverage, size, bonus issue, and warrant exercise are the main internal variables that influence the share price to a large extent. They are described below in detail. 1. Profitability Obviously, the ultimate objective of every business is wealth maximization. Therefore, an investor is always curious about the economical status of the company in which he wishes to invest. A firm’s audited financial statements prepared at the end of the fiscal year give vital information to investors and other shareholders. An investor mainly considers the company’s total revenue, expenses, and profitability so as to assess its current market position. For making an investment decision, an investor may give high emphasis on the firm’s Earning Per Share (EPS) that represents rate of return on a share at the end of the financial year. In other words, when the EPS rises, investors are more likely to invest with the company. 2. Leverage Leverage is a business term that indicates the amount of money borrowed to finance the purchase of assets; and it can be determined by calculating Debt-to-equity ratio. Although leverage is beneficial for the company to promote growth through the purchase of assets, a high leverage would raise high risks including the drop of share price. An investor would never like to purchase the assets of a company that owes huge debts to other entities because investors are less likely to support a risky venture. Hence, a low leverage may benefit the business to maximize its share price. For instance, as Chatterjee (2011) reports, the Reliance Communications have recently cut down share price target for December by 49 percent to 82 rupees mainly as a result of high leverage. 3. Size Fernando, Gatchev, and Spindt argues that the size of the firm can directly influence the share price; an increase in firm’ size causes a proportional increase in share price and vice versa. Generally, it is believed that huge firms would have abundant potential financial sources that can be effectively employed to meet different business needs. Similarly, large sized firms would probably maintain many potential market segments which would assist the firm to confront with difficulties in times of business contingencies. Moreover, large firms would be well established in the market and therefore, they can keep stable market demand to some extent regardless of the changes in market trends. These factors offer a minimum profit guarantee to investors even if the business faces unexpected losses. Schutts points out that Wal-Mart’s large size has assisted the firm maintain its share price steadily. 4. Bonus issue Bonus issue indicates the act of issuing additional shares to the firm’s existing shareholders. This process enables the company to take advantages of the dividend cash as it can be reinvested for better earnings growth. This way, the company can maintain its share price at cheaper rates without splitting the stocks. It is identified that this technique also benefits firms to reward long term stock investors. Generally, the share price diminishes in proportion to bonus issue. For instance, if the company wishes to issue additional shares to its existing shareholders in a way that one new share for their each shares, the company’s share price will drop by 20%. 5. Warrant exercise Warrant exercise is a business provision by which one can acquire shares from a company after the exercise date at a specified price. Since more shares share the same earnings, its earning will be diluted and consequently share price will drop the same ratio of number of exercised shares. For instance, share price will drop by 10% if the exercised share is 10% of the existing number of shares. External variables affecting share prices External variables refer to the opportunities or threats of a business which also play a crucial role in determining share prices of a company. Mainly, the external variables include inflation rate, exchange rate, interest rate, GDP, and unemployment rate. 1. Inflation rate Inflation refers to the sustained increase in the prices for goods and services and it lasts over a period of time. As inflation rate increases, each unit of currency acquires fewer volumes of goods and services. In other words, high inflation rate reduces the purchasing power of money. It is evident that the volume of trade transaction decreases during the times of high inflation, and it adversely affects the profitability of the company; naturally, this situation causes a proportional decrease in firms’ share prices (How to invest for inflation). Since the inflation creates future uncertainty, investors hesitate to play with their money. During the periods of inflation, firms cannot effectively practice various financial tools. This condition will impede the economical growth of the organizations, which in turn will cause a decline in share price. 2. Exchange rate From the study conducted by Dimitrova, it is observed that exchange rate fluctuations have a negative impact on stock prices by which “a depreciation of the currency may depress the stock market” (Dimitrova). The author adds that there will be a less than one percent decline in stock price to a once percent depreciation of the exchange rate. A fall in exchange rate would cause huge losses to organizations that are engaged in international trade. At this juncture, investors hesitate to acquire new shares. This situation will force the firms to cut down their share prices. 3. Interest rate Although interest rate affects share prices, it cannot determine share market. The interest rate has wide and varied impact on the economy. When the interest rate is raised, it trims down the amount of money in circulation; and this situation works to keep inflation down (how do interest rates…). Moreover, increased interest rates make borrowing money more expensive. Subsequently, it will increase business expenses and decreases economic earnings. Hence, increase in interest rates causes negative impacts on stock market making it a less attractive place for investment. 4. GDP GDP or Gross Domestic Product is a measure that represents total goods and services produced in a country over a specific period of time. The GDP is measured to judge the economic growth rate of a country. Hence, an increase in GDP indicates the increased economic growth of a nation. Under a high level of GDP, an investor invests more as he gets a favorable economic environment for wealth maximization. Naturally, this economic condition would improve the firms market stature and thereby their share prices. 5. Unemployment rate A lower unemployment rate indicates a stronger economy and it offers all favorable conditions for economic growth. More and more investors are attracted toward a country where unemployment rate is low. An organization can fix higher prices for its shares when a large group of potential investors are ready to invest with the firm at any share prices. In contrast, a high unemployment rate causes many adverse impacts on the nations’ economy including a considerable decline in companies’ share prices. Conclusion The above discussion reveals that there are two classes of elements such as internal and external variables that affect the share price of a company. Internal variables relate to particular aspects of an organization and affect the share prices of only that organization. In contrast, external variables relate to the external environment of an economy and widely affect the share prices of all business concerns of the economy. Evidently, a firm can control internal variables to some extent; whereas, external variables are completely out of its control. In short, an organization can improve its share prices to a great extent by effectively controlling the internal variables. Works Cited Chatterjee, Sumeet. “As debt piles up, RCom faces key test.” CIOL: Making It Your Advantage. March 2011. Web. 10 April 2011. Fernando, Chitru S., Gatchev, Vladimir A and Spindt, Paul A.“Ownership structure, share price levels, and the value of the firm.” JEL Classification. November 2006. Web. 10 April 2011 Schutts, Larry. “Wal-Mart Stores (WMT): Share Price Advances through Positive Trading Channel.” Blogging Stocks. Aol Money & Finance. Aug 2008. Web. 10 April 2011. “How to Invest for Inflation.” Eurosharelab: Global Investment Advice. n.d. Web. 10 April 2011. Dimitrova, Desislava. “The Relationship between Exchange Rates and Stock Prices: Studied in a Multivariate Model”. Issues in Political Economy. The College of Wooster. 14. (August 2005). Web. 10 April 2011. “How do Interest Rates Affect Inflation.” Bank Of England. n.d. Web. 10 April 2011. Read More