Costs & Benefits of each Source of Capital

Table of Contents

Chapter-1: Aims & Objectives
1.1. Background Context
1.2. Problem Statement
1.3. Aims & Objectives
1.4. Summary
2.1. Capital Structure

Chapter-2: Literature Review
2.2. Agency Theory
2.3. Trade-off Theory
2.4. Sources of Capital
2.4.1. Security Financing
2.4.1.1. Ordinary Shares
2.4.1.2. Preference Shares
2.4.2. Internal Financing
2.4.2.1. Retained Profit
2.4.3. Loan Financing
2.4.3.1. Bank Loans
2.4.3.2. Debentures
2.4.4. Lease Financing
2.4.4.1. Operating Lease
2.4.4.2. Finance Lease
2.4.5. Other Source of Capital
2.4.5.1. Trade Credit
2.4.5.2. Venture Capital
2.4.5.3. Overdraft
2.5. Summary

Chapter-3: Case Study
1.1. Sources of Capital: A Case Study Of Shanghai General Motors Corporation (Nam, 2010)
1.1.1. Capital Sources Capitalised for Shanghai General Motors Corporation (SGMC)
1.1.1.1. General Motors
1.1.1.2. Shanghai Automotive Industrial Corporation (SAIC)
1.1.1.3. Working Capital Needs
1.1.1.4. Findings
1.2. Summary

Chapter-4: Discussion & Conclusion
4.1. Discussion
4.2. Conclusion
4.3. Recommendation

Chapter-5: References

Abstract

There are many cases have been observed where the shareholders’ capital was not adequate enough to support the company’s working capital requirement which matter a lot to the companies’ growth and survival. Majority of time it has been observed and analysed that the companies considering to meet its working capital through the external sources are aware of every aspect of the different financial sources. It is important for the companies to take certain parameter (interest rate, term of usage, impact on company’s financial leverage, conditions of lending agreement, time to get the lending approval and the impact of proposed source on the company’s financial ratios) into consideration while making the financing decisions. The theory of Capital Structure is extensively be used to get insight that how much risky is the company’s approach in using external sources (prominently debt). The Trade-off theory intended that companies must have to balance the costs and the benefits of debts flow within the enterprises. Different sources of capital can be classified in various manners but for the convenience, the all of these sources are classified in to following categories (Security Financing, Internal Financing, Loan Financing, Lease Financing and Other sources). Shanghai General Motors Corporation (SGMC) is regarded as the largest international joint venture undertook in China. This venture was made for the accomplishment of long-term goals established by the both firms’ executive. The capital contributed by General Motors (GM)-China of $350 Million to the SGMC. $350 Million equivalent was contributed by SAIC to the SGMC. For meeting the working capital needs, SGMC required $821 Million Of which about the equivalent of $460 Million contributed through Chinese Banks and the Equivalent of of $361 Million was contributed through the International Banks. It has been understood that Different sources of capital have their positive and weak aspects to the associated companies. Therefore the company should use more than source of capital which thus would be resulted in forming company’s efficient portfolio of financing. In this manner by capitalising on different sources of capital, the company would be able to leverage its risk level. And if the associated company is risk averse then it should go for Security Financing or Loan Financing.

Chapter-1: Aims & Objectives

1.1. Background Context

The companies’ business capital is regarded as the advanced source of finance for the meeting the working capital needs (Cooper, et al., 1994; Cressy, 2006). There are many cases have been observed where the shareholders’ capital was not adequate enough to support the company’s working capital requirement which matter a lot to the companies’ growth and survival (Evans & Jovanovic, 1989). So in this situation they found the external source as a feasible option for them. Although these sources incorporates the cost which has to be paid by the borrowing company according the agreement signed at the initial stages and if the company tries to dodge the lenders then the lenders holds the authority in many cases to force the company go bankrupt. But on the other hand, the fund received by the company in the result of the lending agreement can support company in numerous ways, which not only intended the company to go through the development stages through the continuous expansion but also could enable the remain competitive in the long-run.

In the area of Corporate Finance, this process of acquiring funds from the different sources is known as the Financing Decision. Now a day, the Corporations are fiercely hiring the corporate managers for this particular process, because this process could permit the corporation to go through the projects which looks impossible for them to undergo on the individual basis. So this process not only resulted in maximizing the wealth of the company’s shareholders but also give the incentive back to the investors for making that major investment and keeping the trust on the company. Although there are many theories which intended the companies to try its best to utilise the fund from its available resources in order to keep the dividend to be paid the companies’ shareholders on the maximum level. One of that theory developed is Pecking Order Theory which alleged the company to look for its internal resources first at the time of making financial decision and if the company finds it really hard to meet the working capital requirement then it should verify the external resources. This theory is emphasised more on keeping the company’s debt and equity side on the balance term, this fact not only keeps the company’s financial position stagnant but also keeps the company to be focused more on towards the completion of its operations which is directly related to its corporate objective rather than diverted the company’s intention towards controlling and solving its debt repayment problems.

But in real sense, it has been proved that the Debt is best alternative available at hand for the companies with good credit ratings. This source is also cheap and sometime resulted in enhancing the firm’s enterprise value and also gives the company an option to pursue the projects which incorporates higher return for its stakeholders. The debt is the best source which increases the size of the given industry and thus keeping the entering barriers higher which then keeps the given industry attractive and more competitive.

There is also another set of studies which discussed the fact that the companies before making the financial decisions are going to evaluate the cost and benefit of each source. So this point drawn the fact majority of time the companies to meet its working capital through the external sources are aware of every consent of the different financial sources. And sometime it has also been observed that the companies are sourcing funds from multiple sources which not only intended the companies to expand its existing operations in rapid manner but also to decrease the cost of capital.

Another study has outlined certain parameter which must be taken into consideration while making the financing decisions. The first one is to carefully analysed the interest rate of each source of capital. The second one is term of usage of particular sources. The next point is related to consider the effect of each source of capital on its company’s financial leverage. The next important point to settle the term of lending agreement on the initial stages so that it would not threaten the company in the future. The company also have to stimulate the effect of each source on the company’s financial performance and also on its financial position as well. The company also has to analyse that how long each source would take to approve so as the company would able to meet its working capital needs on time.

1.2. Problem Statement

In order to meet the working capital requirements, the companies needed to identify and evaluate the cost and the benefits of each source of capital through which the companies would able to employ funds in the current operations. These all sources are needed to carefully evaluated which would enable the company to make the financial decision regarding its financial leverage in the effective and efficient manner.

1.3. Aims & Objectives

The main aim of this report is to inform the readers about the all possible sources of capital which would permit the company to meet its working capital needs in a wise manner. This report will include the advantages and disadvantages of each funding source from the different Scholars’ perspectives. Hence this report will also include some case studies which will intended the company towards the successfully stories of number of organisation which were not only able to use the debts on the optimum level but also encompasses itself successfully from the stage of survival and expansion.

The central focus of this report is emphasised on the way of finding the appropriate source of finance which not only increases the company’s capability to accomplish its strategic level objectives but also leaded the company to maximise its shareholders’ wealth which is an important purpose of company’s financial management. The academic research objectives behind this Applied Management Project are briefly discussed below:

- To learn about the different sources of capital which can be employed and utilised by the corporation the meet its working capital needs.
- To discover the distinct features of each source of capital, which make each source separable and unique from the other sources.
- To understand the importance of the financial decision making with the companies which usually covers the large proportion of its working capital needs from utilisation and harmonisation of these all sources.
- To evaluate the pros and cons of each source of capital with the intention of make a judgement that in what manner each specified source can support the company in improving its financial position and also to have good impact of these sources on the company’s financial performance over a long-run.

1.4. Summary

There are many cases have been observed where the shareholders’ capital was not adequate enough to support the company’s working capital requirement which matter a lot to the companies’ growth and survival. The Pecking Order theory is emphasised more on keeping the company’s debt and equity side on the balance term, this fact not only keeps the company’s financial position stagnant but also keeps the company to be focused more on towards the completion of its operations which is directly related to its corporate objective rather than diverted the company’s intention towards controlling and solving its debt repayment problems. The usage of debt is cheap and sometime resulted in enhancing the firm’s enterprise value and also gives the company an option to pursue the projects which incorporates higher return for its stakeholders. Majority of time it has been observed and analysed that the companies considering to meet its working capital through the external sources are aware of every aspect of the different financial sources. It is important for the companies to take certain parameter (interest rate, term of usage, impact on company’s financial leverage, conditions of lending agreement, time to get the lending approval and the impact of proposed source on the company’s financial ratios) into consideration while making the financing decisions. The fundamental objective of this report is to suggest the corporation with the appropriate source of finance which not only increases the company’s capability to accomplish its strategic level objectives but also leaded the company to maximise its shareholders’ wealth which is an important purpose of company’s financial management.

The next chapter will review the literature on the cost and benefit of each source of capital which are categorised on the basis of nature of financing which could be utilised to meet the working capital needs.

Chapter-2: Literature Review

2.1. Capital Structure

The matter of meeting the companies’ working capital requirements is directly linked up with concept of Capital Structure (Modigliani & Miller, 1958). This concept analysed the company’s capital composition in term of equity and debt employed in the company. Many Scholars are of perspective that the company’s capital structure helps the outside evaluators to analyse the mixture of different sources of capital being utilised by the specified company in meeting its working capital needs (Dewatripont & Tirole, 1994). This concept is extensively be used to get insight that how much risky is the company’s approach in using external sources (prominently debt). Normally the companies which are profoundly financed through the debt capital are poses greater risk and in other sense these companies are ranked higher on the leverage scale (Myers, 2001).

2.2. Agency Theory

This concept of agency theory is used comprehensively to explain the type of relationship exist between the principals (Shareholders) and agents (Management), hence this theory deal with the resolving of problem which exist in the given agency relationship (Jensen & Meckling, 1976).

The introduction of debt or the increase of debt in the company’s given capital may give rise to the agency problem (Jensen, 1986). This happen because of the fact the increase of debt is directly linked up with increase of cost of capital which not only incremented the operating expenses but also decrease the company’s retained earnings as well. The second cause of problem in the agency relationship is the wealth transformation this happen as a result of raising capital through the long-term debt, which meant that the increase will also incremented the company’s financial leverage which thus be resulted in the wealth transfers between given sets of beneficiaries (Shareholders). This wealth transfer will be occurred from the capital beneficiaries (Shareholders) to the income beneficiaries (Lenders or the Supplier of Funds). Thus larger the increase of debt made by the management will be resulted in increasing the extend of transfer of wealth in the same pattern described before.

2.3. Trade-off Theory

This concept refers to the thought that in order to meet the working capital needs, the companies have to balance the costs and the benefits of debts flow within the enterprises and this can only be done through the usage of debt only up to the optimisation level (Kraus & Litzenberger, 1973). Any increase beyond that point will no further increases the marginal benefits of debt but only be resulted increasing the marginal cost that debt. So it has been understood that this concept urge the Corporations to use the debt only up to the optimisation level which entails to offset the costs of debt in relation to the benefits of debts (Modigliani & Miller, 1963).

2.4. Sources of Capital

Commonly, there are different sources of capital available for the companies to meet its working capital needs. These working capital requirements are not only critical for the new firms in supporting its survival but also for also existing companies in supporting their expansion stage even in the period their maturity as well. Currently variety of financing opportunities are available in the financial markets which not give an incentive to the investors but also offering funding support to the companies at the less rate of return. So in this manner, the companies are not only successful in meeting its working capital requirements but also able boost up its retained earnings up to the desirable level.

These sources of capital can be classified in various manners but for the convenience, the all of these sources are classified in to following categories (Security Financing, Internal Financing, Loan Financing, Lease Financing and Other sources).

2.4.1. Security Financing

It is considered as the traditional source of finance through which the companies are initiating towards the intention of meeting its working capital need (Lawton, 1996). It is also regarded as the alternative of Loan Financing because these sources are backed by giving the lenders the ownership stakes within the company (Barr, 2005). In these financing options, the lenders usually buy the share issued by the company in the initial period of time and thus authorised to get the dividend payment at the end of every financial period (normally on semi-annual basis). Different forms of this financing will be discussed below with their appropriate advantages and disadvantages to the companies.

2.4.1.1. Ordinary Shares

This is the most widely used financing instrument in almost all industries (Stoltz, 2007). The corporations are looking to raise the capital through the issuance of ordinary shares which not gives the ownership authority in the given but also granted the voting rights which can be exercised in the context of making and setting the company’s strategic objectives and strategic decisions (Alexander, et al., 2007). The advantages and disadvantages of this source are listed below:

Advantages

- The payment of dividends is only made in the condition where the company has the surplus retained earnings. This is a plus sign for the company who are unable to post enough profit during the specified financial period.
- The company is eligible to not to make the repayment of capital collected from as a result of this source until it declare itself as solvent.
- The company can source as much funds as it desire through this source. But the management has to keep track of this financial leverage which may be resulted in giving rise to the agency problem or liquidation situation in engaging firm.
- The accessibility feature of this source intended the company to use this source as a suitable option to meet its working capital requirements or also to keep the shareholders’ wealth on the increasing pattern.

Disadvantages

- In term of cost, this source is not a suitable option because of two factors (Advertisement and Subscription). Although these costs incurred at once only but sometime bearing that much cost would indulged the company in more financial difficulty from which it is really difficult to make recovery.
- The loss of control feature is also incorporated in this source, which only resulted in the wealth transfers from the capital beneficiaries (Shareholders) to the income beneficiaries (Lenders or the Supplier of Funds) but also distribute the right to making strategic decisions the capital beneficiaries to the income beneficiaries.
- Sometime this source would take longer to get fund approval because of necessary procedures to be followed to meet the working capital requirements.
- Because of the transfer of wealth feature this source incorporates more risk with itself in the context of financial leverage. And thus this factor more frequently leads the companies towards the phenomena of increasing cost of capital which would have a bad impact on the companies’ expected rate of return on the long-term basis.

2.4.1.2. Preference Shares

This hybrid source of finance can be used by the companies to meet its working capital needs. It is regarded as the hybrid security because of its characteristics as it can be employed in the form of debt or equity depending entirely upon the companies’ financial needs and also on its financial position (Chandra, 2008). The holders of these shares are entitled to get regular payments of dividends at the end of each financial period but they don’t have any voting rights within company’s decision making (Bhattacharyya, 2006). But they got preference in relation to the ordinary shareholder in the situation where the company go bankrupt make the repayment of principal amount of its all shareholders (Dornseifer, 2005). The advantages and disadvantages of preference shares are outlined in the portion below:

Advantages

- The preference shareholders are not authorised to force the company to declare itself solvent in the case where the company is unable to make regular payment of dividends to them.
- Because of its hybrid feature, it can be utilised by the companies to reduce its financial leverage which would make the companies’ financial position impressive in the financial market and also reduces the liquidation risk attached with the too much usage of debts.
- The superior feature of this source is that it would not intend the company to dilute its existing shareholders’ control which would also reduce the risk of arising of agency problem within the enterprises.

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