Costs and benefits of raising capital through different sources

TABLE OF CONTENTS

Chapter-1. Background Context
1.1. Background Context
1.2. Motivation
1.3. Aims & Objectives
1.4. Method of Analysis
1.5. Description of Chapters

Chapter-2. Literature Review
2.1. What is meant by Financing Decision?
2.2. Capital Structure
2.3. Agency Theory
2.4. Trade-Off Theory
2.5. Sources of Funds
2.6. Internal Financing
2.6.1. Retained Profit
2.7. Security Financing
2.7.1. Ordinary Shares
2.7.2. Preference Shares
2.8. Loan Financing
2.8.1. Bank Loans
2.8.2. Debentures
2.9. Lease Financing
2.9.1. Operating Lease
2.9.2. Finance Lease
2.10. Other Sources of Financing
2.10.1. Venture Capital
2.10.2. Trade Credit
2.10.3. Overdraft

Chapter-3. Case Studies
3.1. Case Study on UK Government’s Bailout Package for Bank
3.1.1. RBS (Royal Bank of Scotland)

COSTS & BENEFITS OF RAISING CAPITAL THROUGH DIFFERENT SOURCES
3.1.2. Llyods Banking Group PLC
3.1.3. Barclays PLC
3.1.4. Findings
3.2. Case Study on Shanghai General Motors Corporation (SCMC)
3.2.1. Findings

Chapter-4. Analysis
4.1. Analysis

Chapter-5. Conclusion & Recommendations
5.1. Conclusion
5.2. Recommendations

Chapter-6. References

CHAPTER-1. BACKGROUND CONTEXT

1.1. BACKGROUND CONTEXT

Organisations business capital is categorised as advanced financial source for meeting their working capital needs. It has been evident from many companies’ cases that shareholders’ equity was found to be inadequate for supporting their working capital needs (Watson & Head, 2009). External funding sources were evident as best option for all of those companies. It has been inclined that all of funding sources (apart from shareholders’ capital) involve the cost of capital which is used to be paid by the borrowing companies to the lenders (financial institutions or financial markets). If there would be a situation where the company could not pay these charges to the lenders then in mostly cases, these lenders hold the authority of forcing these companies to liquidate their assets (Damodaran, 2010). Therefore, it has been discovered that the capital acquired by the companies as an outcome of lending agreement would not only make possible for these companies to successfully survive through the stages of development but also intend them to remain competitive and sustainable as well.

Therefore, companies should have to take account of certain parameters before making financial decision. Firstly, they would have to analyse the cost of raising capital of each source. Secondly, company management would have to analyse the term of use of all funding sources. Thirdly, they would have to examine the impact of each funding source on the underlying companies’ financial leverage. Fourthly, it is imperative for the company’s management to settle lending agreement terms during the initial phases so that it would not create trouble for the company in the future periods. Fifthly, it is vital for the company’s management to stimulate the influence of each source of capital on their company’s financial performance and financial position.

1.2. MOTIVATION

I have selected this topic because I want to work in the finance department of Multination National Corporation (MNC) operating in India. Finance is always remain as my favourite subject and I have great extent of knowledge about certain financial theories and frameworks that would accommodate me in both perspectives (academic and professional). Another reason for selecting this topic is the current financial crisis, it has been observed that the companies’ managers that had idea about the utilisation of funding sources at optimum level have managed to survive. Alternatively, the companies’ who does not had any awareness about this aspect have seemed to be in trouble. Raising of fund is seems to be ongoing issue as it could have direct impact on the relationships between the companies’ shareholders and their management.

1.3. AIMS & OBJECTIVES

Major aim of this theory into practice report would be to let know readers about all of form funding sources (that would make possible for the companies in meeting their working capital needs). This report will incorporate the merits and demerits of each source of capital. Correspondingly, this project will also contain the case studies of some companies that had been managed to get rid of financial problems or to pursue certain projects. The fundamental focus of this research report is focused on the approach of finding an adequate source of financing which would make possible for the companies in attaining their corporate objectives. Additionally, this report also has some objectives that have been outlined below:

- To signify certain funding sources that could be availed by the companies for the purpose meeting their working capital needs.
- To realise the significance of financing decision in regard to the raising capital for the purpose of meeting working capital needs.
- To identify various features that made each source of capital separable and unique from each other.
- To analyse the positive and negative aspects of each funding source.

1.4. METHOD OF ANALYSIS

This research project will follow the approach of secondary research. Case study method has been selected in this regard. All research aims and objectives of this report will be accomplished with creation of link between the literature review and case study method. Thus, such link will be created in the Discussion section. Major points of this report will be outlined in the conclusion section. Therefore, implications for further research will be mentioned in the recommendations section.

1.5. DESCRIPTION OF CHAPTERS

This secondary research report will be based on five chapters. In the first chapter (Background Context), important information regarding the concept of financing decision has been presented. In the second chapter (Literature Review), all sources of capital will be described from the perspective of different authors along with their advantages and disadvantages. In the third chapter (Case Studies), success stories of some companies will be illustrated. In the fourth chapter, link will be made between the previous all chapters. Additionally main objectives of this report will also be attained in this chapter as well. Last section (Conclusion & Recommendations), will contain major points of this research project along with further implications for future research studies.

CHAPTER-2. LITERATURE REVIEW

2.1. WHAT IS MEANT BY FINANCING DECISION?

From the perspective of Corporate Finance, the method or process of acquiring capital through different sources is termed as Financing Decision (Stulz, 1999). The Corporations are actively recruiting financial managers mainly for the successful execution of financial decision. It has been understood that by sourcing funds from different sources, it would become feasible for the specified company to undergo desirable projects (Jacque, 2014). In short, it is a useful process for the maximising of companies’ shareholders wealth. In this way, the company’s management would generate incentive for their shareholders. Moreover, there are various theories that direct the companies to capitalise on all available sources as it would make possible for the companies to pay dividend on frequent basis and also to experience adequate growth level. First theory in this regard is Peck Order Theory, which intends the company’s management to give first priority to the capitalisation of internal resources (specifically net profit) for the purpose of making financial decision (Agar, 2005). If there would be a situation that it become difficult for the company to acquire funds from the internal resources then the company’s management would have to consider the option of acquiring funds through the external sources. Mainly, this theory is oriented more on keeping a balance between the company’s equity and debt.

Second theory is focused more on the acquiring of funds through debts and outlined it as best funding source for the companies having good credit ratings. Additionally, debt is considered as cheap funding sources and often outcome in increasing the companies’ enterprise values. Debt is also useful for enhancing the size of specified industries and in this way the given industry remains competitive. It has been ascertained that the companies would have to evaluate the cost and benefit aspects of each source before making financial decision. It meant that the companies’ managers should have awareness about each and every aspect different sources. It has been observed that the companies that acquire funds from both internal and external sources collectively would manage to experience more growth and expansion than the other companies focusing on using one source at one time. It has been examined that the approach of sourcing capital from multiple would also the companies to reduce its cost of capital (Graham & Smart, 2011).

2.2. CAPITAL STRUCTURE

It has been inclined that meeting working capital needs matter is associated with an important concept of corporate finance known as capital structure. This concept is focused more on analysing the capital composition of underlying company in term of debt and equity (Baker & Martin, 2011). It has been contended that this concept is useful for the external evaluators in regard to determine the fact that to how much extent a company is risk averse or risk taker. It has been believed that the companies that source capital profoundly through debt would poses more solvency risk (Ghosh, 2012).

2.3. AGENCY THEORY

This financial concept is oriented more on explaining the kind of relationships existing between the specified companies’ shareholders (principals) and management (agents). It has been assumed that acquiring of capital through external sources could results in an agency problem (Berger & Bonaccorsi di Patti, 2006). Primary reason behind occurrence of agency problem is that the sourcing of funds could outcome in increasing the given company’s cost of capita. In this way, it would decrease the amount of dividends that used to be paid to shareholders at frequent interval. Second reason is that the using debts enhance the risk of wealth transformation (Wolf, 1999). It meant that any problem in repayment of funds would result in transferring wealth of shareholders to the lender of funds. .

2.4. TRADE-OFF THEORY

Trade-off theory urge companies to develop a balance between their debts’ costs and benefits flow within a firm. It could only done through the usage of debt at optimum level (Eckbo, 2011). Therefore, any increase further this level would only increase the cost of debts.

2.5. SOURCES OF FUNDS

Generally, there have been various sources of funds that could be utilised by companies for meeting their working capital needs. It has been observed that with the utilisation of funds from different sources not only made possible for the underlying firm to survive through difficult periods but would help it in expanding its operations as well (Watson & Head, 2009). In this manner, a firm management would have a chance to undergo desirable projects and thus general more profits for the firm (Jacque, 2014). All of these sources are classified in to five main classes: Internal Financing, Security Financing, Lease Financing, Loan Financing and other sources.

2.6. INTERNAL FINANCING

It is regarded as most common financing type. It intends on the approach of reinvesting of company’s earning either for meeting working capital needs or for expanding company’s operations (Guerard & Schwartz, 2007).

2.6.1. RETAINED PROFIT

Retained profit is determined as an amount of funds which used to be held by the company after paying off all of its liabilities. This source is categorised as most secured source of capital as it has nothing to do with the cost of capital aspect (Harris & Raviv, 1991). While, sometime ploughing of too much funds from this source could force a company’s management to scrap the dividends payment for a certain period of time (Mohana, 2007). Pros and Cons of this source of capital has been shown below:

Pros

- It accommodates company in lessening the burden of debt on it.
- By using funds from this source, a company would issue bonuses in form of accumulated profits.
- Acquiring funds through retained profit would lead corporations their price of share.
- It could strengthen the corporation’s capital composition or formation. Cons
- It could intend corporations to scrap the payment of dividends paid to their shareholders. A moment like this would raise chances of occurring of an agency problem.
- It could direct corporation towards over capitalisation. As an impact of this, the company’s financial position would become weak. - It could send bad signals to the external investors or financial institutions. By using too much funds from this source would force an underlying company management to pay less amount of dividends to their shareholders.

2.7. SECURITY FINANCING

Security Financing is all about issuing of company’s shares of different kinds. These shares then sold through initial public offering (IPO). Buyers of these shares become company’s shareholder for a specified period of time and these are also entitled for getting dividend payment at the end of each financial period (Berk et al., 2013).

2.7.1. ORDINARY SHARES

It is considered as most common form of security financing. It has been seen that by raising funds through this source, a company not only sell shares to its lenders but also reward them through periodic dividends payment (Romano et al., 2001). Moreover, owners of ordinary shares are also gets voting rights in regard to taking part in company’s strategic decision making process (Marney & Tarbert, 2011). This source of capital has following advantages and disadvantages:

Pros

- Company would only pay dividends in case that it would have surplus retain earnings.
- Company is not bound to repay capital funds to ordinary shareholders until its liquidation.
- Company’s management could raise as much funds as they wish but they would also have to take account of their company’s financial leverage.
- Corporations could raise funds with ease through this source than other sources.

Cons

- Two aspects (such as Advertisement and Subscription costs) of this source make this source as least preferred one. It has been examined that sometime, these costs direct companies towards tough situation.

[...]