Sources, Availability and Cost of Financial Support - Coursework Example

Sources of Finance 2008 A. Sources, availability and cost of financial support A company can seek external financial support either through debt or equity. While debt is in the form of borrowing from banks, financial institutions or any other source, equity finance is provided on the basis of ownership of the company. The ratio between debt and equity is called leverage and the extent of leverage depends on the company’s ability to sustain debt servicing through interest payments. The capital structure is the composition of the company’s finances through debt and equity. The main aim of the company is to maximize shareholders’ value. The debate on corporate structure began with Modigliani and Miller (1958), who thought that the shareholders’ value remains unchanged with the capital structure of the firm. As a corollary, shareholders’ value is also unchanged with dividend retention by the company, which increases internal funds and the need for external financing through debt (Modigliani and Miller, 1961). This theory, however, is based on assumptions of perfect capital markets in which there are no transaction costs, rational behavior of economic units, perfect knowledge about firms’ investment policies and cash flows and managers acting on behalf of the firm’s shareholders (Holder et al, 1998). The independence of shareholders’ wealth from capital structure and dividend policy will not hold true in the absence of any of these assumptions. For example, Titman (1984) shows that stakeholders other than equity holders have incentives to maximize shareholders’ wealth in order to reduce transaction costs, e.g that of job searches by employees or maintenance costs by customers (Holder et al, 1998). While debt is typically less costly than equity since lenders demand less as interest than investors ask for return on equity (Cbdd). Debts are less risky since these usually impose annual claims that are built in the balance sheet of the company. Besides, most of the debt is provided on the basis of security collateral. For a running company, debt can also be offset against tax liabilities. However, firms still limit debt and raise equity finance in order to hedge on risks since the company will be liable to pay interest on debt even when it is running in losses. The relationship between leverage (or gearing) to earnings per share (EPS) is shown in the diagram below. With the increase in the level of gearing, both risks and returns of the company tends to rise. In the real world, shareholders expect higher dividends. In most cases, announcements of dividends are usually followed by favorable sentiments in the share market indicating that shareholders’ are positively affected by higher dividend payouts, irrespective of Modigliani-Miller’s dividend irrelevance theory. This is perhaps because of the simplifying assumptions of the theory that is typically not adhered to. For example, investors do not usually have perfect information about the firm’s intrinsic values. The asymmetry of information exists between the firm’s managers and investors and the release of certain information immediately affects the firm’s share value. Dividend payouts have a signaling effect on the firm’s value in that it indicates that the firm will continue to pay out higher dividends in the future and also will be committed to higher earnings to sustain the dividend payouts. Also, higher dividend also indicates lower free cash flows of the firms, a phenomenon that is favorably accepted by investors in the face of conflict of interest between managers and investors of firms. Free cash flow usually affects the firm’s value negatively since investors perceive it as an indication to financial slack on the part of the managers. In both cases, higher dividend payouts increase the share value and higher shareholder value of the firm (Natti, 2006). While various attempts have been made to find an alternative to the Modigliani-Miller (1958) capital structure irrelevance theory, there have been differences in focusing on either debt or equity. In the static trade-off theory proposed by Myers (1977), an optimal capital structure is generated by agency costs of financial distress and tax deductions. Since interest payments can be deducted from income for the purpose of corporate taxes, companies may prefer to raise funds through debt when revenues are high and growing. On the other hand, interest liabilities are more prone to lead to corporate bankruptcies when revenues do not grow at the same pace. The optimal level of leverage, therefore, depends on balancing the advantages and disadvantages. In the alternative model of “pecking order” by Myers and Majluf (1984), there is a hierarchy of corporate resource mobilization from internal funds to debt to equity. Typically, firms avoid to issue equity because investors look for equity priced at a discount while firms issue equity when the stock is overpriced. As a result, firms issue debt as long as it is possible. This holds true for conservative projects since providers of debt funds usually impose covenants on the firm. For innovative projects, firms may have no option but to issue equity. Shyam Sunder and Myers (1999) found from a statistical analysis of 157 U.S. firms that the pecking order is empirically valid in that firms prefer internal funds initially while going on the next stages of debt and equity in the order of deficiency of funds. Chirinko and Singha (2000), however, found that this simple model is also restrictive and hence competing hypotheses may be necessary. Debt finance may become relatively more costly because of changes in the business environment, tax rules and information asymmetries between the firm and lenders. There may also be hidden costs to debt and hidden benefits of equity resulting in equity taking up the middle position rather than the last in the capital structure hierarchy. This results in a situation in which equity issues occupy a higher proportion than debt in the firm’s external finance. Such circumstances may arise particularly for innovative business enterprises for which investors and firms have relatively less information gaps than the restrictive conditions imposed by lenders (Smart Economist, 2006). Thus, there may be three situations in the capital structure: 1) an optimal leverage ratio as in the trade-off theory, 2) a financial hierarchy in which internal financing is the most preferred option, followed by debt and then equity as in the pecking order theory and 3) an alternative financial hierarchy in which internal funds is followed by equity and then debt. Kayhan and Titman (2003), too, found that cash flow, investment expenditure and corporate histories in terms of profitability record affect corporate debt structures but over time, the importance of these variables tends to get reduced. Internal finance is the most preferred choice over the short term. Firms tend to raise funds through equity issues when stock prices are high and repurchase when stock prices are low. Thus, timing the market is usually an effective way to raise funds. Over the long term, finds converge towards the target debt ratios, reducing the pressure on equity and internal funds. The leverage rate also depends on the institutional factors, that is, the financial system. In market-based economies like the United States, firms tend to raise more funds through equity while in bank-based economies where the financial markets are less developed, firms tend to depend on banks and have higher leverage. In countries where political risks and local inflation are high, tax and capital market conditions more restrictive, debt becomes more costly as a result of which firms depend on internal financing (Desai, Foley and Hines, 2003). Thus, when a company decides to source external financial support, it should target an optimal leverage ratio that will be able to sustain its revenue and cash flows. While approaching banks and financial systems, the firm needs to undertake a study of the prevailing interest rates and decide on the quantum of borrowings on the basis of future cash flows. Although interest payments are tax deductible hence less costly for the profit-making firm, a new business may find the interest burden too heavy to sustain. Besides, the availability of borrowings from banks and financial institutions may be difficult in case the firm is in a new business and there is asymmetric information flows between the firm and the lender. It is likely that investors would provide funds through equity for new ventures that have higher return prospects but also higher risks. There is usually no liability for recurring payments on equity in the short term but the investor would expect a dividend payout over a certain time frame or an increase in shareholders’ value. For a running business, the firm may consider equity issues if the capital market is booming and repurchase the shares when the stock prices are down. Thus, the firm’s corporate history and future in terms of income and cash flows, the tax environment and the capital markets together determine the different avenues for external financing for the firm. B) ‘Business Angels’ as a source of finance A start-up can access sources of finance that are known as ‘business angels’, that is, financiers that play a crucial role in the early part of the risk capital cycle. These are usually private individuals who invest money and experience is small and medium unquoted companies that have innovative business propositions. Most typically, business angels are ‘cashed-out’ entrepreneurs who have money, experience and network of connections that they put on availability for new ventures that they believe have high return potential. Business angels enter the risk capital cycle earlier than formal venture capital more on the basis of intuition rather than on the value of the balance sheet of the company. Hence, for a new company that does not have a corporate history, availability of this form of finance becomes critical. Usually, business angels operate within a narrow geographical area since they want to keep a close contact with the start-up company and its entrepreneur. Since it forms the early stage of the life cycle of the firm, business angel deals are usually of small value and may also involve sharing a seat in the board of the company. Since business angel investments usually involve own money of the individual, tax implications of deferred income from investment or the possibility of offsetting losses on new ventures with profits elsewhere may determine the decisions of the business angels. Usually, venture capitalists do not entertain deals below a certain amount. For example, it was found that in the United States, venture capitalists deals in 2004 were only those of over $2 billion while business angels considered deals of above $ 100,000. Thus, migration of venture capitalists above a threshold level of deals increases the reach of the business angels. Although most ventures begin with funding from business angels, graduating to venture capital as the business grows before entering the debt and equity markets, many businesses continue the relationship with business angels. The business angels in different countries and across countries have their own networks, thereby enabling them to share information of potential candidates for investment. They also have networks with venture capital firms, which make small-sized deals that they cannot service available to them. There are also informational networks that bring together business angels, venture capital, lawyers and accountants, entrepreneurs and business schools (OECD). Although venture capital is the most publicized form of independent source of finance, this form of finance is typically available to firms that are in the preferred set of industries. Most high-potential but mid-market firms get their initial dose of funding through business angels. There is an estimate 350,000 business angels in the United States, who are typically high net worth individuals who are on the look out for investment opportunities in businesses that it can monitor. For a company that decides to access sources of finance from a business angel, the first problem is that such financiers are not easy to spot, despite being local, because they form an informal network and do not advertise like venture capitalists do. The best way to draw the attention of the business angels in the locality is to employ the professional networks like the lawyers and accountants or even other acquaintances or entrepreneurs. In the recent times, some business angels are themselves forming their own networks, making it easier for the companies to locate and approach them. To get funding from a business angel, the company should first have a solid business proposition that will have a reasonable stream of revenues to the tune of at least $10 to 15 million in five years. Business angels typically invest in businesses that they know best hence it is best to approach angels in the same industry. For example, one of the founders of Sun Microsystems saw a prelaunch version of Google search engine and became the business angel of the fledgling company by giving the grad student entrepreneurs a funding of $100,000. Being a technology expert himself, the business angel realized the potential of the business model. Before approaching the business angel, the company should have the prototype of the operations up and running and a viable business plan as well as a presentation ready. The business plan should lay out clearly the exit plan for the investor. When a new business is envisioned, a clear picture of the pros and cons of the market being served is needed. Even if it is assumed that the product or service has tremendous customer demand, there should be careful planning with regard to market survey, customer profiling, sizing of the market, the financial requirements and the timeline of various stages of the business. It is essential to define a unique selling position of the business that would enable it to beat the competition. For the purpose of the business plan, a thorough market research, that is a systematic process of collection and analysis of data and information regarding customers, competition and the market is required. The typical questions that are asked by the business angels are 1) who are the customers and what are their needs, 2) which other companies provide the particular product or service, 3) what needs of customers are unsatisfied, 4) what is the size of the market and how much of it is unsatisfied? In order to develop an effective marketing strategy, that is to target the right customer with the right product, it is essential to forecast the demand for a particular product or service. Demand forecasting is also required to manage inventories so that the company can react to changes in demand. In order to analyze consumer and business markets, it is essential to study the tastes and needs of customers, the pricing trends of competing firms, demand-supply positions, demand and supply forecasts and the changes in the business environment. Market segments are groups of people who share common tastes and needs for a particular product. Since each segment is more or less homogenous, a certain marketing strategy would be necessary to target customers in this segment. Broadly, a market may be segmented on the basis of broad criteria, like age, gender, race and ethnicity, income, socio-economic status, etc. Certain niche segments may also be identified on the basis of specific requirements. In order to create a new strategy successfully, a business needs to study the industry and the competition. It also has to secure commitment to the strategy down the line of executives so that it can be successfully executed. It is often more difficult to execute a strategy than creating it since it may come up with resistance from some quarters. A wide array of managerial skills need to be garnered to make a strategy winning. It is most important to integrate different types of skills across different management levels in a coordinated manner. The entire strategy must be put down in black and white along with the responsibilities down the chain. In order to develop strategic plans regarding the product design and specifications, pricing, promotions and distribution channels, it is essential to study the consumer trends, the competition, resource availability with the company and the possible marketing networks. Such strategic plans allow the company to allocate resources systematically and effectively. As part of the company’s marketing strategy, it is important to maintain customer loyalty through satisfaction. Ways to build customer loyalty involves maintaining communication with the customers, offering reliable services and product awareness, flexibility over services and interaction with customers. Thus, the entire business strategy should be clearly chalked out before approaching the business angel. Although the business angel usually does not interfere into the operational management of the firm, it does insist on a board seat so that it can be part of the business growth. Works Cited Miller, M.H. and F. Modigliani, 1961, "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business (October), 411-433. Titman, S., 1984, "The Effect of Capital Structure on a Firm's Liquidation Decision," Journal of Financial Economics (March), 137-151. Natti, Keisuke, 2006, Does Dividend Policy Enhance Shareholders’ Value, http://www.nli-research.co.jp/eng/resea/econo/eco060309.pdf Holder, Mark E., et al., 1998, Dividend policy determinants: an investigation of the influences of stakeholder theory - Special Issue: Dividends, Financial Management, Autumn, http://www.findarticles.com/p/articles/mi_m4130/is_3_27/ai_53649447 Modigliani, F and Miller, M (1958) The cost of capital, corporation finance and the theory of investment, American Economic Review, 48, 261-297 Myers, S.C (1977), Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147-175 Myers, S.C and Majluf, N (1984), Corporate Financing and Investment Decisions when firms have information that investors do not have, Journal of Financial Economics, 13, 187-221 Chirinko, R S and A R Singha (2000) Testing Static Trade Off against Pecking Order models of capital structure: A critical comment, Journal of Financial Economics, http://jfe.rochester.edu/99377.pdf Keyhan, A and T Sheridan (2003) Firms’ History and their Capital Structure, October 7, http://www.stern.nyu.edu/fin/pdfs/seminars/003w-titman1.pdf The Smart Economist, The Debt-Equity Choice, Report 137 March 2006, http://www.smarteconomist.com/insight/137 Network for Capacity Building and Knowledge Exchange in ICT Policy: Regulations and Applications, Introductions to Capital Structure, http://cbdd.wsu.edu/kewlcontent/cdoutput/tr505r/page22.htm Organization for Economic Cooperation and Development (OECD), The SME Financing Gap, Presented at the OECD Global Conference on "Better Financing for Entrepreneurship & SME Growth", held in Brasilia, Brazil in March 2006 Luecke, Richard (2004) Entrepreneur’s Toolkit: Tools and Techniques to Launch and Grow your Business, Harvard Business School Press Read More