Alternative Financing Methods - Essay Example

1. INTRODUCTION The alternative financing methods that a listed company can use to raise extra cash to finance a new long-term investment project arestock and long-term debt. Section 2 and Section 3 discuss the alternative financing methods in detail. The last section evaluates the potential impacts on the company's market value once the announcement of financing method is made. 2. STOCK The term common stock has no precise meaning. It usually is applied to stock that has no special preference either in dividends or in bankruptcy. Owners of common stock in a corporation are referred to as shareholders or stockholders. They receive stock certificates for the shares they own. There is usually a stated value on each stock certificate called the par value. However, some stocks have no-par value. The total par value is the number of shares issued multiplied by the par value of each share and is sometimes referred to as the dedicated capital of a corporation. Shares of common stock are the fundamental ownership units of the corporation. The articles of incorporation of a new corporation must state the number of shares of common stock the corporation is authorised to issue. The board of directors of the corporation, after a vote of the shareholders, can amend the articles of incorporation to increase the number of shares authorised; there is no limit to the number of shares that can be authorised. There is no requirement that all of the authorised shares actually be issued. Although there are no legal limits to authorising shares of stock, some practical considerations may exist. Authorising a large number of shares may create concern on the part of the investors, because authorised shares can be issued later with the approval of the board of directors but without a vote of the shareholders. Capital surplus usually refers to amounts of directly contributed equity capital in excess of the par value. The sum of the par value, capital surplus, and accumulated retained earnings is the common equity of the firm, which is usually referred to as the firm's book value. The book value represents the amount contributed directly and indirectly to the corporation by equity investors. The conceptual structure of the corporation assumes that shareholders elect directors who in turn elect corporate officers-more generally, the management-to carry out their directives. It is the right to elect the directors of the corporation by vote that constitutes the most important control device of shareholders. Directors are elected each year at an annual meeting by a vote of the holders of a majority of share who are present and entitled to vote. A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares. For convenience, the actual voting in large public corporations usually is done by proxy. Many companies have hundreds of thousands of shareholders. Shareholders can come to the annual meeting and vote in person, or they can transfer their right to vote to another party by proxy. The value of a share of common stock in a corporation is directly related to the general rights of shareholders. In addition to the right to vote for directors, shareholders usually have the following rights: (1) the right to share proportionally in dividends paid (2) the right to share proportionally in assets remaining after liabilities have been paid in a liquidation (3) the right to vote on matters of great importance to stockholders, such as a merger, usually decided at the annual meeting or a special meeting (4) the right to share proportionally in any new stock sold (Ross, Westerfield, and Jaffe, 1996, p. 365-369). A distinctive feature of corporations is that they issue share of stock and are authorised by law to pay dividends to the holders of those shares. Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the corporation by the shareholders. The payment of dividends is at the discretion of the board of directors. Here are some important characteristics of dividends: (1) Unless a dividends is declared by the board of directors of a corporation, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. As a consequence, corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend-and even whether or not it is paid-are decisions based on the business judgment of the board of directors. (2) The payment of dividends by the corporation is not a business expense. Dividends are not deductible for corporate tax purposes. In short, dividends are paid out of after-tax profits of the corporation. (3) Dividends received by individual shareholders are for the most part considered ordinary income and are fully taxable (Ross, Westerfield, and Jaffe, 1996, p. 369-370). 3. LONG-TERM DEBT Another financing method that a listed company can use to raise extra cash to finance a new long-term investment project is long-term debt. Debt represents something that must be repaid; it is the result of borrowing money. When corporations borrow, they promise to make regularly scheduled interest payments and to repay the original amount borrowed (that is, the principal). The person or firm making the loan is called a creditor or lender. The corporation borrowing the money is called a debtor or borrower. The amount owed the creditor is a liability of the corporation; however, it is a liability of limited value. The corporation can legally default at any time on its liability (for example, by not paying interest) and hand over the assets to the creditors. This can be a valuable option. The creditors benefit if the assets have a value greater than the value of the liability, but this would happen only if management were foolish. On the other hand, the corporation and the equity investors benefit if the value of the assets is less than the value of the liabilities, because equity investors are able to walk away from the liabilities and default on their payment (Ross, Westerfield, and Jaffe, 1996, p. 371). From a financial point of view, the main differences between debt and equity are the following: 1. Debt is not an ownership interest in the firm. Creditors do not usually have voting power. The device used by creditors to protect themselves is the loan contract (that is, the indenture). 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Thus interest expense is paid out to creditors before the corporate tax liability is computed. Dividends on common and preferred stock are paid to shareholders after the tax liability has been determined. Dividends are considered a return to shareholders on their contributed capital. Because interest expense can be used to reduce taxes, the government is providing a direct tax subsidy on the use of debt when compared to equity. 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action may result in liquidation and bankruptcy. Thus one of the costs of issuing debt is the possibility of financial failure, which does not arise when equity is issued (Ross, Westerfield, and Jaffe, 1996, p. 371). Typical debt securities are called notes, debentures, or bonds. A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property. However, in common usage the word bond is used indiscriminately and often refers to both secured and unsecured debt. A note usually refers to a short-term obligation, perhaps under seven year. Debentures and bonds are long-term debt. Long-term debt is any obligation that is payable more than one year from the date it was originally issued. Sometimes long-term debt-debentures and bonds-is called funded debt. Some debt is perpetual and has no specific maturity. This type of debt is referred to as a consol (Ross, Westerfield, and Jaffe, 1996, p. 372). Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt installments is called amortisation. At the end of the amortisation the entire indebtedness is said to be extinguished. Amortisation is typically arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds. Debt may be extinguished before maturity by a call. Historically, almost all publicly issued corporate long-term debt has been callable. These are debentures or bonds for which the firm has the right to pay a specific amount, the call price, to retire (extinguish) the debt before the stated maturity date. The call price is always higher than the par value of the debt. Call prices are always specified when the debt is originally issued. However, lenders are given a 5-year to 10-year call-protection period during which the debt cannot be called away. In general terms seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt cannot be subordinated to equity. Security is a form of attachment to property; it provides that the property can be sold in the event of default to satisfy the debt for which security is given. A mortgage is used for security in tangible property; for example, debt can be secured by mortgages on plant and equipment. Holders of such debt have prior claim on the mortgaged assets in case of default. Debentures are not secured by a mortgage. Thus, if mortgaged property is sold in the event of default, debenture holders will obtain something only if the mortgage bondholders have been fully satisfied (Ross, Westerfield, Jaffe, 1996, p. 372-373). 4. POTENTIAL IMPACTS ON THE COMPANY'S MARKET VALUE The different finance theories predict different potential impacts on the company's market value using different financing methods. The contributions of Modigliani and Miller path breaking 1961 article to the theory of corporate finance are justly celebrated. According to them, capital structure is irrelevant. Therefore, there would be no impact on the company's market value regardless of the financing method. Yet, there continue to co-exist between financial theorists two opposing views on the relevance of capital structure. The first view, by Ross (1977, p. 23-40) and Myers and Majluf (1984, p. 187-221) argues that managers may use financial policy decisions, in the form of changes in the capital structure, to convey information to the market. Leland and Pyle (1977, p. 371-387) also present the relevance of the signaling theory on capital structure from the viewpoint of the owners. The second view, by Jensen and Meckling (1976, p. 303-360), argues that the probability of cash flow of a company is dependent on its structure and this could help find optimal structure of firms. Hence, according to these theories, since an optimal capital structure exists, the choice of the financing method would have potential impacts on the company's market value. 4.1. Irrelevance of Capital Structure in a World without Agency Cost and Signaling Miller and Modigliani (1958, p. 261-291) presents the argument that the value of the firm and the average cost of capital are unaffected by capital structure in a world without taxes or transaction costs. Therefore, under this theory, there is no impact on the company's market value whichever financing method is used. Assumptions: 1. Capital markets are perfect. 2. Individuals and companies can borrow and lend at the same rate of interest. 3. There are no bankruptcy costs. 4. Firms only issue stocks and bonds. 5. All shares in the same class have the same risk. Therefore, shares are perfect substitutes for each other. 6. No taxes. 7. All cash flow streams are perpetuities. 4.2. Signaling Theory There are two competing theories of capital structure - tradeoff theory and pecking order theory. In tradeoff theory, the search is for an optimum capital structure. The tradeoff is between the interest tax shield, bankruptcy costs and agency costs. The firm would seek the optimum debt ratio that maximises the value of the firm. It therefore balances the marginal present values of interest tax shields against bankruptcy costs and agency costs. The theory therefore predicts the mean reversion of the actual debt ratio towards a target or optimum and also predicts a cross-sectional relation between average debt-ratios and asset risk, profitability, tax status and asset type. In pecking order theory, there is no optimal debt ratio. Due to asymmetric information and signaling problems associated with issuing equity, financing policies follow a hierarchy, with preference for internal over external financing and for debt over equity. The debt ratio is therefore a cumulative result of hierarchical financing over time. 4.2.1. Incentive Signaling Approach (Ross, 1977, p. 23-40) Assumptions: 1. Information asymmetry: managers have monopolistic access to information about firm's expected cashflows. 2. Managers are prohibited from trading in the shares of the firm. This prevents them from going against the interests of the firm, example short-selling the shares before announcing bad news about the firm even though the firm is doing well. 3. Investors use the face value of debt held by the company to tell whether the firm is successful (type A) or unsuccessful (type B). 4. By changing the capital structure, the firm alters the perceived market value of the firm even if the true value of the firm remains the same. The implications of the incentive signaling approach are: 1. Greater financial leverage can be used by managers to signal an optimistic future for the firm. 2. Signals cannot be mimicked by unsuccessful firms because such firms do not have sufficient cash flows to back them up and managers have incentives to tell the truth. 3. There would be no signaling equilibrium if there were no incentives to signal truthfully. Under this theory, the value of the company will increase if it announces the use of long-term debt. 4.2.2. Pecking Order Theory (Myers and Majluf, 1984, p. 187-221) When encountered with an investment opportunity, the firm would have to make the decision on how to finance it. Assumptions: 1. Managers have information, like the expected future state of the firm while investors do not have such information. Therefore, there is information asymmetry. 2. Managers act in the interest of old shareholders, those who hold shares at the time the investment decisions are made. 3. Old shareholders are assumed to be passive in the sense that they do not actively rebalance their personal portfolios to undo the decisions of management. If they do so managerial financial decisions become irrelevant. 4. Capital markets are perfect and efficient with respect to publicly available information. No transaction cost is incurred in issuing stock. The implications of the pecking order theory are that: 1. Debt is issued by the firm in some states where equity is not, that is, when D b < E. 2. When both debt and equity could be issued, the ex ante value of equity held by old shareholders is greater under debt financing. Therefore, debt financing is preferred over equity financing. In conclusion, there exists a pecking order in financing, with preference for internal over external financing and for debt over equity. Again, the value of the company will increase if it announces the use of long-term debt. 4.3. Agency Cost Jensen and Meckling (1976, p. 303-360) use agency cost to argue that probability of cash flow of a company is dependent on its structure and this could help find optimal structure of firms. Agency costs arises from agency relationship, which consists of agency cost of equity and agency cost of debt. An owner-manager with wholly owned firm maximises his welfare by fully bearing the costs of doing so, such as taking an afternoon break or traveling in first class flights. When the owner-manager sells off a portion of his shares of the firm to outside shareholders, conflicts of interest arise. He may maximise his welfare at the expense of the new shareholders. The manager does not fully conduct activities that the new shareholders desire him to do so as to increase their welfare and wealth. Thus co-ownership of equity implies agency problems. The new shareholders will have to incur monitoring costs to ensure that the original owner-manager acts in their own interest. It is assumed that agency costs of equity increase as percentage of financing supplied by external equity goes up. Agency costs of equity can be decreased if managers and shareholder agree to hire an independent auditor (monitoring costs) or if manager volunteers to provide accounts and financial information to report to the external shareholders (bonding costs). Even if these are done, there will still exist divergence of ideal maximisation of shareholders' wealth (residual cost). Consider two investment projects, both requiring 10,000 initial outlay. Probability Project 1 Project 2 0.5 9,000 2,000 0.5 11,000 18,000 Suppose firms show only project 1 to lenders and ask for a 7,000 loan. Lenders will lend as returns are enough to cover the loan. If owners have the ability to switch to project 2, they will do so. The result is a transfer of wealth from bondholders to shareholders. Shareholders will gain from high returns of the investment if outcome is 18,000. However, bondholders will bear most of the losses if outcome is 2,000 return. Hence, bondholders need to have protective covenants and monitoring devices to protect their interests. Written covenants will incur monitoring costs, including costs of writing and enforcing the covenants and the reduced flexibility of management to increase cash flows to the firm. Bonding costs incurred by the manager would also arise as the manager would also have to supply financial statements to bondholders. There are contractual methods for reducing agency costs. Jensen and Meckling (1976, p. 303-360) focused on secured debt as a way of reducing agency costs. However, the cost of writing these covenants may be non-trivial (monitoring costs). Bondholders must charge higher yields to compensate them for the possible wealth expropriation. Total agency costs Agency cost of debt Agency cost of equity Optimal Capital Structure B/(B + S) Jensen and Meckling suggest that, given increasing agency costs with higher proportion of equity on one hand and higher proportion of debt on the other, there is an optimum combination of outside debt and equity that will be chosen because it minimises total agency costs. In this case, it is possible to argue for the existence of optimum capital structure even in a world without taxes or bankruptcy costs. Therefore, according to this theory, the impact of the company's market value would depend on its existing capital structure. 4.4. Informational Asymmetries and Financial Structure (Leland and Pyle, 1977, p. 371-387) Leland and Pyle (1977, p. 371-387)'s focus is on owners and not managers. It is assumed that entrepreneurs have better information about the expected value of their project than outsiders, resulting in informational asymmetries. A higher proportion of ownership serves as a signal of good project quality. The major implication is that a business going public with a high proportion held by the original owners will enable it to achieve higher valuation. In return, a higher valuation will allow the firm to have greater debt capacity and use greater amount of debt. Debt is not a signal in this model. Therefore, according to this theory, the company's market value would increase if it announces the use of stock. REFERENCES Jensen, C & Meckling, WH 1976, 'Theory of the firm: managerial behavior, agency costs and ownership structure'. Journal of Financial Economics, vol. 3, pp. 303-360. Leland, HE & Pyle, DH 1977, 'Information asymmetries, financial structure, and financial intermediation', Journal of Finance, vol. 32, pp. 371-387. Miller, M & Modigliani, F 1958, 'The cost of capital, corporation finance and the theory of investment', American Economic Review, vol. 48, no. 3, pp. 261-291. Myers, SC & Majluf, NS 1984, 'Corporate financing and investment decisions when firms have information that investors do not have', Journal of Financial Economics, vol. 13, no. 2, pp. 187-221. Ross, SA 1977, 'The determination of financial structure: the incentive-signaling approach', Bell Journal of Economics, vol. 8, pp. 23-40. Ross, SA, Westerfield RW & Jaffe, J 1996, Corporate finance, McGraw-Hill, United States of America Read More