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Why do firms borrow capital that has to be repaid rather than finance a firm with 100% equity?

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Why do firms borrow capital that has to be repaid rather than finance a firm with 100% equity?

Index

                                                                                                                                                                                        Page

  1. Introduction…………………………………………………………………………………1
  1. Literature Review
  1. Types of finances……………………………………………………………….1
  1. Bank borrowing/ bank loan……………………………………………….1-2
  1. Bank overdraft……………………………………………………………………2
  1. Mezzanine debt…………………………………………………………..……..2
  1. Equity financing…………………………………………………………….…..3-4
  1. MM view against traditional method……………………………………….….4-6
  1. Bankruptcy……………………………………………………………………………….….6
  1. Agency theory……………………………………………………………………………..7-8
  1. Conclusion…………………………………………………………………………………….9-10
  1. Bibliography

1.0 INTRODUCTION

Investing requires finance, thus, businesses need to raise capital and there are many different types of finances available to them. Therefore, this study will look into the types of finances available to the company along with the advantages and disadvantages of each type of finance and the advantages and disadvantages of equity financing followed by the MM view against the traditional view, bankruptcy risk and the agency theory. And finally, a conclusion will be drawn based on the study stating why firms borrow capital that has to be repaid rather than finance a firm with 100% equity 

2.0 LITERATURE REVIEW

2.1 Types of finances

Although there are many forms of finances available for a company such as bond, trust deed, syndicated loan, Mezzanine debt foreign bond, project finance and sale and leaseback etc, this study will look into the bank borrowing/ bank loan, bank overdraft and mezzanine debt followed by equity financing.

2.2 Bank borrowing/ bank loan

Bank borrowing is a way of borrowing money directly from the bank where there is no tradable security is issued. The firm than repays the bank with interest over time. The reasons as to why firms choose bank borrowing is that it cost low due to that there is no marketing expenses as the loan is negotiated directly with the bank. The procedure is quick and easy and also flexible in terms of negotiation if the economic circumstances of a company changes. However, on the other hand, there are other factors the firm needs to consider such as the cost that is involved in it, for example, the bank might request the borrower to pay an arrangement fee, normally a percentage of the loan. The borrower also needs to take into account the interest rate as it might be a fixed rate which could be high or floating rate which varies on a daily basis.

The bank might also be interested in the borrowers’ sincerity and capability to pay back the loan therefore might want to know why the loan is being taken out and thus will require detailed cash flow forecast. And, on the other hand, debt financiers mainly require security, which means they expect businesses to have some kind of evidence or assurance prior to they regard as making a loan for instance. (Watson & Head: 1998)

2.3 Bank overdraft

Bank overdraft is the permit to overdraw on an account up to the permitted amount.

Overdrafts are usually arranged for limited period and the interest is charged for the days it has been overdrawn with. The reasons as to why the companies choose to overdraw are that it is easy to arrange and it is also cheap as the company/ borrower only pays for the days it used the overdraft. However, besides the advantages there is also a major disadvantage to the company as the bank could withdraw the overdraft agreement at a short notice and at any time. (Arnold: 2005)

2.4 Mezzanine debt

Mezzanine debt offers high return in exchange for high risk and is either secured or unsecured loan. The interest rate for this debt is 2 to 9 point percentage more than the normal loan and gives the lender rights to the shares in equity values if the firm performs exceptionally well. The main advantage of mezzanine debt is that it allows the owner of the business to large amount of finance without giving away control of the company. (Arnold: 2005)

2.5 Equity financing

Equity financing is a method of obtaining resources which involves trading an element of curiosity in the company to the investors. The equity or ownership position that the investors acquire in replacement for their capital usually take the type of stock in the business. On the contrary to debt financing which include loans along with other forms of credit, equity financing does not grip a straight compulsion to pay back the finances. As an alternative, equity investors turn out to be partnership and part owners in the company, and therefore are capable to implement some power of control on the business on how it is run. (Arnold: 2005)

One of the main advantages of equity financing instead of debt financing for small businesses that has difficulties with cash flow is that there is no requirement to pay back the cash. Whilst, on the other hand, other forms of debt financing such as bank loan, overdraft etc, provides strict charges and penalty for those companies who do not make the monthly payments. Additionally, equity financing is furthermore probable to be available to the businesses than debt financing, because equity investors are frequently eager not to miss the opportunity on an excellent suggestion for the reason that they mainly seek growth opportunities. An added benefit of equity financing is that the investors frequently demonstrate to be superior sources of suggestion along with guide for the owners of the business.

Besides the advantages of equity financing there are also disadvantages of equity financing, which is that the owners of the company must give away some control of the business to the shareholders, which indicate that if the investors in the company has a different suggestion about the business’s day to day procedure or the planned direction, they can masquerade troubles for the industrialist.

In addition to the above disadvantages, public offerings can be exceptionally difficult and also very expensive to manage, for the reason that such equity financing might require convoluted official filings plus a great arrangement of official procedure to act in accordance with different types of policy. Therefore, for a lot of firms, equity financing might require enlisting the assist of accountants and attorneys, thus dear. (Arnold: 2005)

3.0 MM VIEW AGAINST THE TRADITIONAL METHOD

The plan of the traditional method is that a best capital structure does subsist and as a result that the business can enhance its entire value by the sagacious exercise of debt financing inside its capital constitution.

The traditional method approach relies on no tax existence, ordinary equity shares or debt financing, change of capital structure not including redemption cost or issue cost, dividends payable on all distributable earnings, risk linked with the firm is stable over time and that the firms’ earnings and dividends do not increase over time.

The MM approach states that the value of the company remains unaffected no matter how that company is financed avoiding bankruptcy cost and taxes.

There are two main differences among the traditional method of capital structure and the Modigliani Miller view.

The first dissimilarity lay in the traditional view's disagreement that the cost of capital and the value of a company are interconnected to the capital structure, while the Modigliani Miller analysis contends that they are not linked of each other (See graph 1). The second difference is that the Modigliani Miller analyses indicate a linear liaison between the company’s influence and the shareholder rate of return, thus, which means that the cost of equity increases quicker under Modigliani miller approach at low level of debt than it does under the traditional view (See graph 2). (Watson & Head: 2004)

Graph 1

Traditional View

image00.png

Source: http://images.google.co.uk/imgres?imgurl=http://lh4.google.com

Graph 2

Modigliani Miller with risky debt

image01.png

Source: http://images.google.co.uk/imgres?imgurl=http://upload.wikimedia.org

Where:

Ko: average cost of capital

Kd: cost of debt

Ke: cost of equity

B: market value of debt

S: market value of equity

4.0 BANKRUPTCY

The noticeable exclusion from the second model of Miller and Modigliani study is bankruptcy risk. In their second model they assumed that capital markets are perfect, thus in a perfect capital market, the company will always be able to raise finance and thus be able to prevent bankruptcy. Although, capital markets are measured to be resourceful and competent, they cannot practically be measured to be faultless. Thus, in actuality, if there is high level of gearing than there is considerable likelihood of a firm envisioning on its interest commitment and therefore being acknowledged bankrupt. (Watson & Head: 2004)

Thus in the happening of the business malfunction, the firm would still be asked to pay back any money payable to the bank (such as loans and overdrafts) and financial institutions, or rearrange the debt payment under bankruptcy payment protection plan. Equity investors usually don’t have the same constitutional rights as debtors. For the reason that the equity investors could not ask the business to return their original venture they invested in, in case of business failure. (Shapiro et al: 2000)

5.0 AGENCY THEORY

In addition to the bankruptcy cost, there is also cost linked with the problem of agency at higher levels of gearing.

Agency theory is a theory which amplifications the connection between the agent such as the firm’s executives and the shareholders, where the chief hires or delegates an agent to execute a task. The principal dealings of agencies in the businesses are those between the shareholders and the managers and those between the debt holders and the shareholders. Because, since the gearing levels are high, shareholders would in that case have a lesser stake in a firm and have less resources at risk if the firm fails. As a result of this they would desire the firm to invest in high risk/ high return scheme, for he reason that they could enjoy the benefits of higher returns that takes place whilst providers of debt finance will not allocate the higher returns from the high risk project, for the reason that their returns are independent from the firm’s performance. Consequently, they will take actions to prevent the company from taking such risky project which may put their investment at danger. (Watson & Head: 2004)

Agency theory raises a primary issue in organizations self interested behavior. A possible disagreement of concern might exist between the managers and the shareholders, in view of the fact that the shareholders empower managers to administer the firm’s assets, for the reason that a firm’s manager could have a personal target that vie with the owner’s objective of shareholders wealth maximization.

The agency cost consists of three most important costs which are as follows: firstly, expenses to scrutinize supervisory activities. Secondly, expenses to structure the business in a method that will bind unwanted supervisory deeds and finally, opportunity costs which are incurred while shareholder compulsory restrict the limit and the aptitude of managers to precede events that progress shareholders wealth. (Mclaney: 2006)

Although there are disagreement between the shareholders and the managers, these can be dealt with by two methods. To begin with, the managers are remunerated utterly on the basis of the stock price changes; as a result, if this is the case, managers have enormous incentives to exploit shareholders wealth for the reason that the agency cost will be low. However on the other hand it would be dear to take into service a endowed manager under these contractual stipulations, due to the fact the firms earnings would be effected by economic procedures that are not under supervisory power. Secondly, shareholders could scrutinize every step and or action taken by the manager; however this would be exceptionally dear and ineffective. Besides monitoring, the following mechanisms persuade managers to proceed in shareholders benefit: the intimidation of conquest and dismissal, performance based encouragement strategy and direct involvement by shareholders. (Watson & Head: 2004)

6.0 CONCLUSSION

In conclusion, businesses obtain finances from various sources such as loans and equities. Brian Hamilton, in Financing for the Small Business listed numerous factors to facilitate the entrepreneurs on what to judge and how to judge when selecting a method of financing.

Firstly he mentioned that the entrepreneur should consider on how much control and ownership they wished to give up at present as well as in the future. Secondly, the entrepreneur supposed to make a decision on how advantageous the company can contentedly be, or its best possible ratio of debt equity.

Thirdly, they should also establish what other types of finances are obtainable to the firm given the stages of expansion and growth and the capital it requires, and accordingly judge against the necessities of the diverse kind. And lastly, the industrialist should establish on whether or not the firm is in a situation at the moment and or will be in a position in the future to make monthly payments on loans or other types of finances.

As W. Keith Schilit mentioned in The Entrepreneur’s Guide to Preparing a Winning Business Plan and Raising Venture capital the entrepreneur’s should remember that the further equity they give to the investors, the further they will be functioning for somebody else rather than for themselves as they are handing over the power to the investors.

A number of entrepreneurs have a tendency to consider equity financing as a kind of free borrowing, but in actual fact it can reasonably be a dear way to increase capital. To formulate equity financing gainful, small businesses should be capable of commanding a reasonable price for its stock. This entails influential prospective investors that the business has a sturdy impending for future earnings growth and a high current valuation. Schilit suggested the entrepreneurs to make sure the business growth that they had to ensue carefully and make an endeavor to make use of more than one kind of financing. Furthermore he also pointed out that they must reflect on the consequences of equity financing on the firm’s future and current capital structure and also to judge against the cost equity financing to that of supplementary financing options. On the other hand types of loan finances seems to be not expensive and straightforward to obtain, however, the existence of loan finance does raise the threat attached to the returns of the equity holders.

Therefore, to conclude, the reason of why companies finance though capital investment instead of 100 percent equity financing is mainly that they are not prepared to hand over the control of the company to the shareholder as well as they are also not willing to share the profit with the shareholders. Thus, practically it seems probable that businesses can decrease their cost of capital by integrating reasonable levels of debt financing in to their industry.

                  Word count: 2349

7.0 BIBLIOGRAPHY

Arnold, G. (2005). Corporate Financial Management (3rd Edition). Harlow: Pearson Education Limited.

Atrill, P., & Mclaney, E. (2006). Accounting and Finance: for non specialists (5th Edition). Harlow: Pearson Education Limited.

Hamilton, B. (1990) Financing for the Small Business. U.S. Small Business Administration. [online]. Available from:http://www.sba.gov/idc/groups/public/documents/sba_homepage/pub_fm14.pdf [Accessed: 20.12.2009]

http://images.google.co.uk/imgres?imgurl=http://lh4.google.com

http://images.google.co.uk/imgres?imgurl=http://upload.wikimedia.org

Mclaney, E. (2006). Business Finance: Theory and Practice (7th Edition). Essex: Pearson Education Limited.

Schilit, W. K. (1990) The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capita. Cliffs: Prentice Hall.

Shapiro et al. (2000). Modern Corporate Finance: A Multidisciplinary Approach to Value Creation. New Jersey: Prentice Hall.

Watson, D., & Head, T. (2004). Corporate Finance (3rd Edition): Principles and Practice. Harlow: Pearson Education Limited.

Watson, D., & Head, T. (1998). Corporate Finance: Principles and Practice. London: Financial Times Pitman Publishing.

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