Corporate Finance: Expansion Plc case - Essay Example

?Corporate Finance   Executive summary This report is aimed at identifying the various sources of long term finance which Expansion Plc can use to fund its new operating division. The report covers all the relevant factors which the company should keep in mind before selecting any type of source of long term finance. The report highlights the risks and the relative advantage of each of the source of finance which the company’s management should analyse in detail while selecting the source of long term finance. Considerations to be taken while deciding on the proportion of leverage and other factors related to the market efficiency have been discussed and analysed in this report. Contents Corporate Finance   1 Executive summary 2 Contents 3 Introduction 5 Evaluation of different sources of long term capital 5 Sources 5 Cost 7 Risk 7 Advantages 7 Disadvantages 8 Issues involved in seeking an appropriate balance between different types of long term finance and the balance with the short and medium term finance 9 Gearing 9 Traditional and Modigliani and Millar theories 9 Risks associated and other issues related to practical situations 10 Explain and Evaluate Current Thinking on the Efficient Market Hypothesis 11 Introduction 11 The Three Forms of Market Efficiency 11 Tests for Efficient Market Hypothesis 12 Rationale for Fundamental and Technical Analysis 13 Insights from Behavioural Finance 13 Conclusions 13 Conclusion 14 Reference 15 Bibliography 18 Introduction Every company expand its operation at some or the other point of time. Companies have to raise funds to expand its operations. Funds can be raised from various sources but every source of finance has its pros and cons and the suitability of the various sources of finance also differs from the firm to firm. This project highlights the various sources of long term finance which can be used by the Expansion Plc to raise the required funds which is needed to finance the property, plant, equipments, current assets and other assets which are needed for its new operating division. This paper covers the entire area of long term financing which the Expansion Plc can consider. Along with the various sources of financing, the cost associated with the various sources, associated risks, positive and negative side of each of the popular sources have been discussed in order to identify the suitability of each source with the Expansion Plc. Apart from choosing the right source of finance one of the major issue regarding financial is the decision regarding the capital structure. The issues related to the gearing of capital structure have also been discussed in detail in order to find out the right balance of various sources of finance for Expansion Plc. The market efficiency has also been discussed in this paper. Evaluation of different sources of long term capital Expansion Plc which is a listed in London Stock Exchange has planned to open an operating division for manufacturing a brand new product. The company has some internal funds but has planned to raise the required additional fund from other sources. Various types of sources are available in the market which can be used for raising the additional funds but every type of long term financing may not be useful for every company as different type of source have different type of cost of capital, different risk profile and different benefits and limitation. Therefore every aspect of long term source of finance have been analysed in detail. Sources Equity: This is a one of the common source of long term finance which is used by almost every company. The capital raised by equity financing is also known as common stock or shareholders’ stock and it is a part of the owners’ fund. Through equity financing the long term capital is raised by issuing equity shares in the primary market. The equity share holders who provide the funds to the company by purchasing the equity share are the owners of the company. They have the right to attend the annual general meeting and participate in the crucial managerial decisions regarding the compensation by exercising their right to vote. This type of financing is generally practised by hose companies which have high earnings and are reputed in the market. When the company raises its long term funds by offering equity shares to the general public it is known as initial public offers. The company is not bound to give dividend every year to its equity share holders (Parameswaran, 2007, p.1-6). Preference share: Companies can also raise long term finance form the primary market by issuing preference share in the market. Unlike equity financing the ownership if the company is not affected raising capital through preference financing as the preference share holders does not have any right to participate in the managerial decision making of the company. The preference share holders are not the owners of the company. Again unlike equity capital the company has to pay a fixed percentage of dividends to its preference share holders of the company in case the company earns any profit (Price, 1995, p.13). Long term debt: Long term finance can also be raised by issuing debenture or corporate bonds, term loans etc. The company offers debenture or corporate bonds to the general. The debenture holders are like the company’s long-term creditors. The principal amount provided by the debenture holders are paid back to them after a specified period of time. The company is provides an interest at a specific percentage on the amount provided by the debenture holder (Stoltz, 2007, p.162). Companies can raise funds by issuing a number of debentures like convertible debenture, non convertible debenture, redeemable debentures, unsecured debenture, secured debenture with fixed charges or floating charges etc. Companies can also raise its funds by taking term loans, long term loans from various banks etc. This type of financing is generally done by those companies which are at maturity stage and want to expand its operation or diversify into some other sector. Long term loans are secured as a result the company has to provide collateral security against the loan provided by the bank or other financial institution. The company has to bear the liability of paying interest on the amount raised from long term loan (Khan and Jain, 2005, p.18.5-18.6). Cost Expansion Plc can raise its funds from any of the long term financing source discussed above like equity financing, long term debt etc but raising capital from any of these source the company will incur some costs. If Expansion Plc raises its funds through issuing equity shares or preference shares then the company would have to incur the costs associated with the public offer like the underwriter’s commission, payments to be made to the distributers, advertising costs, fees of merchant bankers etc. In case of long term debt if the company raises the funds by issuing bonds or debenture then also the company has to provide the fees to the underwriters, commissions to the brokers, stationary costs etc. Each source of financing will have different cost of capital that is the minimum required rate of return that the company will have to earn in order to satisfy the fund providers. The cost of long term debt will be less than that of the equity or preference capital as the company will have a tax advantage over the interest payment on the long term debts (Mead and Sagar, 2006, p.266). Risk Risk is one of the important factors which should be kept in mind while deciding on raising funds for any expansion or diversification. Expansion Plc should choose that source of long term finance whose risk profile matches with the company's financial position. If the Expansion Plc raises its funds by issuing equity shares then the company would not have to make any mandatory periodical payments like interest payment or fixed dividend and would not have to repay the principal amount to the shareholders (Hall et al, 2007, p.311). Hence for the company, equity financing is less risky than the debt financing or preference financing but the company has to earn at a higher rate as the cost of equity capital is higher among all the other sources of finance. From the point of view of investors the bonds and loans are secured therefore they are less risky than the equity financing which does not guarantee any fixed return. Advantages Every source of long term finance has its own advantages and disadvantages. The main advantage of equity financing is absence of any obligation of fixed charges. If the Expansion Plc raises its capital through equity financing then the company would not have to bear the burden of paying fixed charges to the fund providers. This will help the company in the initial years of the new product if the company cannot breakeven or if it just touches the breakeven as the company would require cash in the initial years after launching the product (Arnold & Kumar, 2008, p.400). In case of preference financing the company would not have to pay any charges to the fund provider if the company could not earn profits. This would be typically advantageous for the Expansion Plc as it is seeking funds for the new product and it in the initial years of the product the company fails to generate excess earnings over income then the company would not have to repay any amount to the fund providers from its own reserves. Unlike equity, preference financing does not affect the ownership of the company therefore this source help the company to retain its ownership intact (Bradshaw and Brooks, 2007, p.152-153). The main advantage of Debt financing is the tax advantage which the firm enjoys over the interest paid on the borrowed funds. The cost of capital of debt capital is also lower than that of the equity and preference capital which is advantageous for companies like Expansion Plc who are launching a new product (Harper, 2006, p.267-268). Disadvantages The main disadvantage of equity financing is the cost associated with the raising of capital through equity. Expansion Plc will incur more cost while raising the funds through equity financing than other source of finance. The equity shareholders become a part owner of the company which in turn dilutes the company’s ownership. Moreover the dividends given by the company to the shareholders are taxable which in turn increases the cost of the company (Seidman, 2005, p.26-27). The main disadvantage of preference capital is that cost of capital is greater than that of the debt funds (Chandra, 2009, p.18.10). This will be a series limitation for the companies like Expansion Plc who from the initial period of launching of the product will have to earn at a higher rate which is very difficult for any new product. Again if Expansion Plc raises its funds with the help of long term debt then it will have to bear the obligation of paying fixed charges periodically which will be difficult for the company in the initial years after launching the new product (Advani, 2006, p.68). Issues involved in seeking an appropriate balance between different types of long term finance and the balance with the short and medium term finance The various sources of long term finance have been discussed in the previous section. Expansion Plc has the choice of selecting any of the long term sources of finance or a mix of the different sources to fund the financial requirements for the new operating unit. The real issue that the companies face while funding their requirement is the right balance between the different sources of financing. The financial decisions have a major impact on the capital structure of the company. Therefore the major issue that the management of the Expansion Plc has to decide is the percentage of leverage which the company can use in its capital structure by using the long term debt. Gearing As discussed earlier the major issue that the companies face while raising the additional funds from external source is the various sources which can be used for funding and the right proportion of those funds. In the earlier sections the main advantages and disadvantages of various sources have been discussed. Hence which ever source the company chooses will definitely have some advantages which will be beneficial for the company and also some limitation which the company will have to bear. The financing decision of Expansion Plc will have an impact on the overall financial health of the company. The main objective of Expansion Plc will be to increase the value of the company therefore the company will have to decide the various aspects of the debt capital which can be used for funding like the amount which can be raised with the help of long term debt, the current short term and long term financial position of the company, the company’s operating cash flow which will be needed to fulfil the necessary debt obligation etc while deciding on the exact proportion of the debt which can be used by Expansion Plc (Ogilvie, 2008, p.150-151). Traditional and Modigliani and Millar theories Many studies have been conducted on the identification of the optimum capital structure which could help the company to increase its value. The two main theories which in this regard are the ‘traditional theory of gearing’ and the Modigliani Millar approach of capital structure. As per the traditional theory, the amount of debt to be used in the capital structure has a major impact on the overall value of the firm. According to the traditional theory the value of the company will increase if the weighted average cost of capital decreases. This approach states that the company optimal capital structure at a point where the cost of capital is minimum. Hence as per this approach, the company’s market value is related to the capital structure decision. The main limitations of this theory are the assumption on which it is based. The traditional approach assumes than the earning and the investors’ expectation will be constant which is quite impossible in the practical situation and this approach ignores taxation which in real situation cannot be done (Ogilvie, 2008, p.166-167). The Modigliani Millar (MM) approach of capital structure is quite different to that of the traditional approach of optimum capital structure. As per the MM approach the value of the company does not depend on the capital structure decision. Hence the proportion of gearing used in the company’s capital structure has no impact on the company’s market value. As per this approach, the concept of optimum capital structure does not exists and gearing have no impact on the company overall cost of capital. The main limitation of this theory are its assumption like absence of taxation, transaction, costs, agency costs etc which are quite absurd in real situation (Correia et al, 2007, p.14.7). Risks associated and other issues related to practical situations Usage of debt in the capital structure will definitely increase to an extent the financial risk of the company but usage of certain amount of debt in its capital structure as it not only costs less than the equity and preference capital but also the cost of loan capital is lower than the own capital as a result the expectation of the shareholder does not increases much. In some of the studies done on the interdependence of firm’s capital structure with that of the industrial or sector’s average usage of debt, it has been found that the capital structure of the firms are not related to that of the industry average. In fact the factors which influence the capital structure are the organisation’s size, status, structure of assets and profitability (Coleman, n.d, p.114-115). Hence Expansion Plc must evaluate its profitability, its status of credit worthiness, risk profile and the other factors which can influence its operation in the long run which would help the company to decide on the term and type of loan which can be taken. Explain and Evaluate Current Thinking on the Efficient Market Hypothesis Introduction The efficient market hypothesis (EMH) attempts to provide a theory for developing an understanding of the stock markets and their relative efficiencies. The hypothesis suggests that investors and traders in the stock markets should not aim to benefit from publicly information in competitive markets and the profits should be understood in the context of new information (Lundholm, 1991). The Three Forms of Market Efficiency The three forms of market efficiency as described by the literature on stock market efficiency include the weak form, semi-strong form and strong form efficiency (Beaver, 1981). Weak Form Efficiency The weak form efficiency is a condition when the stock market price incorporates the historical information regarding the price and volume of shares traded in the present value of the stock. The investors are unable to generate arbitrage profits from the trading of shares that is dependent on the historical price trends or technical analysis of the stock market (Piotroski & Roulstone, 2004). Semi-Strong Form Efficiency The weak-form efficiency implies that publicly available information including the information provided by the financial statements published by companies is incorporated into the stock prices and the investors are unable to benefit from trading based on fundamental analysis. The semi-strong form efficiency implies that stock price movements are based on the new information related to stocks as it becomes available (Piotroski & Roulstone, 2004). Strong Form Efficiency The assertion made by strong form efficiency is relatively strong as it prevails when the existing stock market prices incorporate both the publicly available information and the private information in the market prices. The existence of strong form efficiency would imply that investors cannot profit from insider information. Tests for Efficient Market Hypothesis The tests for EMH provide some evidence in favour of weak form and semi-strong form efficiency but the empirical results are ambiguous (Badarinathi & Kochman, 1996). The event studies used to test for the ability of investors to realise significant profits based on insider trading provide evidence that strong form market efficiency does not exist in most markets and inside traders can benefit from private information (Kripke, 1980). Laffont and Maskin (1990) provide evidence that markets tend to be weak-form efficient as technical traders enjoy zero returns over the long-term. The argument for weak-form efficiency is based on the assertion that if it was possible to generate significant profits from simple historical trend and volume information than most traders would tend to participate in generating arbitrage profits (Pastor & Stambaugh, 2002). The fact that such an analysis would attract significant attention of the traders would result in the elimination of arbitrage profits. This reduces the rationale to support technical analysis (Keane, 1986). The tests for semi-strong form market efficiency involve event studies aimed at determining the responsiveness of the stock market prices to new information (Jordon, 1983). The event studies aim to determine if the market over or under reacts to new information; these events may include mergers, acquisitions, restructuring of business operations, earnings surprises, issue of new stock and change in dividends etc. Literature suggests that investors often tend to overreact to negative news and that market is not semi-strong efficient (Preston & Collins, 1966). The test for the usefulness of fundamental analysis is also used to determine the semi-strong efficiency of a market because when fundamental analysis is useful the market tends to lag in terms of incorporating the publicly available information into its prices. The earlier tests for semi-strong efficiency suggested that market was semi-strong form efficient but the results obtained from recent event studies do not support this hypothesis (Falk & Levy, 1989). Therefore, the tests regarding semi-strong form efficiency provide conflicting results and remain inconclusive suggesting that market can be semi-strong form efficient or inefficient depending on the overall circumstances (Athanassopoulos & Thanassoulis, 1995). Rationale for Fundamental and Technical Analysis The rationale provided for fundamental analysis is the fact that not all investors are sophisticated enough to make sense of the information provided in the financial statements. It is also argued that fundamental analysis does not act in isolation and the superior financial analysts aim to update the information available from the financial statements and direct communication with the management to generate value from the forecasts. The general public as the user of the financial statements tend to lack the ability to incorporate information such as the off-balance sheet items and the true value of the intangibles of the company but expert fundamental analysts can generate profits (Fama, 1991). The rationale for technical analysis is associated with the fact that the fact that technical traders attempt to manipulate trends in the stock market movements to generate profits results in closing the gap in the markets and provides more efficiency to the stock markets (Peng, 2009). Insights from Behavioural Finance The literature on behavioural finance provides evidence that investors will not always act rationally. The irrational behaviour of investors can result in market anomalies and such anomalies can persist from short-to-long term. The presence of anomalies in the stock market implies that stocks may not always move towards the intrinsic value even at times when fundamental analysis provides useful insights into the true worth of a stock (Boldt & Arbit, 1984). The behavioural finance provides evidence of instances when the market tends to overreact or under-react to information based on its inherent fears instead of a lack of awareness or understanding of the information. The stock market is also seen to exhibit herding and such behaviour of investors tends to move market by more than the movement that would be expected as a result of new information (Ferson et al., 2005). Conclusions The EMH provides insight into the stock market framework and the characteristics of efficient and inefficient stock markets. The EMH is understood in the context of three forms of market efficiency: the weak form, semi-strong form and strong form (Dow & Gorton, 1997). The weak form efficiency suggests that technical analysis does not lead to trading profits as all historical prices and volume information is already included in the stock prices. The semi-strong form efficiency argues that publicly available information such as the information provided in the financial statements is incorporated into the stock prices and fundamental analysis does not result in arbitrage profits (Malkiel, 1989a). The strong-form efficiency suggests that private information is also incorporated into the stock prices and insider trading is not beneficial in realising abnormal profits (Malkiel, 1989b). The tests for the three forms of market efficiency show that there is some evidence of weak and semi-strong form efficiency in markets. Conclusion On analysing the various sources of finance which can be used for raising long term funds it can be said that Expansion Plc first of all has to analyse its own financial condition in terms of profitability, liquidity, gearing and efficiency before deciding on any of the source of raising long term funds. The financing decisions do affect the overall financial health of the company which in turn affects the organisational performance and company’s market value. Therefore Expansion Plc should select that type of financing which would complement its overall financial condition. If Expansion Plc does not want to dilute its present share of ownership and it is financially sound then the company can opt for any type of debt for funding its requirements. If in case Expansion Plc opts for equity financing then the company has to monitors its share price movements and market efficiency in order to decide on the perfect timing of initiating the new issue. Reference Advani, A. (2006). 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